Lennox International Inc. (LII) Earnings Call Transcript & Summary

Great. Well, thanks very much, everyone, for coming in. Welcome back after the first break. It's my pleasure to have here now Joe Reitmeier, CFO of Lennox International. We'll start off with, obviously, Q&A. Any questions you might have, please submit them through the app or your hand up. And please take the time to click on that code. That's where you can submit questions but also the audience response survey. And we'll share the results in due course with you, of course, with Lennox. So thanks very much, Joe.

I suppose we'll just start off with a broad question on demand trends. Thoughts on the recovery slopes in commercial HVAC, refrigeration and residential. In residential in particular, we always have these concerns about tough comps, a good year last year. Is there any reason to worry more this year than what we've seen in the past?

Well, first of all, good morning, everyone, and thank you for having us join. It's a pleasure to be here. Our residential markets, it's steady as she goes, quite frankly. Well, the biggest challenge there is meeting end market demand. So end market demand remains strong. With some of the disruptions from COVID impacting supply chain and, to a lesser extent, production, it's been a situation where inventory is pretty lean. So demand remains strong. We're meeting end market demand today. And once again, we still think there's plenty of runway in the residential side of the house where market growth will continue to be a multiple GDP.

And if you look at how the year has kind of started out demand-wise -- and the reason I ask is hardly for a general update but also just many companies at this conference, it's a sort of abnormally back-end-loaded year for various reasons. How does Lennox view overall kind of seasonality this year?

Yes. You mentioned tough comps earlier. It seems like we always have tough comps to varying degrees, of course. But it's a situation where last year, we had a very strong first half and then the second half with escalating commodity costs and more disruptions from COVID and supply chain challenges resulted in being a little bit more challenging in the second half of the year. All in, we had a record year last year. It just didn't feel like it, unfortunately. This year, what we expect is increased profitability in the first half and margin expansion in the second half, once again setting us up for another record year, and we're off to a great start.

And if you look at the -- you mentioned residential inventories are lean. Is that a comment about Lennox' own sort of carefully controlled distribution? Or is it -- how would you assess the broader market? You have a lot of competitors, large ones, who use a more disaggregated...

Yes. I think on the residential side, I think our challenges are consistent with the broader market. Once again, with component shortages, supply chain disruptions, COVID disruptions to varying degrees all led to production being adversely impacted. So that was the situation last year. And our expectation is that we're going to have our supply chain replenished or our distribution channels replenished back here in 2022. We expected on doing that last year but demand remained strong and we sold what we had. So here in 2022, it's going to be a resetting of sorts where once again, we'll be able to meet end market demand and replenish our distribution channels so that we can better serve residential end markets.

Perfect. And when you look at market share dynamics, perhaps there were some competitors in light commercial and residential last year [ out ] somewhat and then that relates to different comps the year before, differences in some procurement in here. How confident are you that Lennox can stabilize market share? Maybe give us some update on how it's working through those supply chain -- sort of some of the productivity issues like they try to...

Yes. We can pat -- once again, we've got -- some of the unsung heroes in our organization are our sourcing team. They just did a fabulous job of navigating the complexity of whatever we encountered when it came to component shortages, et cetera. So it's a situation where we're in great shape. It's a situation where we were flat on share on residential last year, but we didn't fully reengage in our distribution strategy. And that's been the largest catalyst for share gain for us in that business -- or one of the largest. We'll be fully engaged with that back here in 2022. On the commercial side, with limited components, limiting our ability to manufacture products, resulting in us focusing on certain areas, so we prioritize our planned replacement and national account customer segment. And that resulted in us taking some resources away from what would normally be share gain initiatives around emergency replacement. We pulled back on that. That's where we lost share. We did lose share in light commercial. We lost it primarily on the emergency replacement side of the house. The key to success in that end market is there's very little loyalty. When it comes to that, it's really about having the right product at the right place at the right price. And once again, we just didn't have the inventory. So we'll be back on track and reach replacement certainly by midyear sooner.

And are those issues in the commercial business -- partly it's procurement and partly it's issues in demand?

Yes.

Two, they're related but sort of distinct. How do you feel on both of those right now?

Yes. We have one factory in Stuttgart, Arkansas that manufactures light commercial equipment. As we -- certain points of the fourth quarter, as much as 25% of the workforce was impacted with COVID and related absenteeism. So that was a challenge for us. And then component shortages in a configure-to-order business can be even more challenging. And those were some of the other disruptions that we encountered. I think we've largely gotten the component shortages behind us. Now having said that, that can change on a dime. But we continue to be challenged with absenteeism in the plant, once again COVID-related. It's gotten better but it's not -- we're not as healthy as we need to be in that plant.

Got it. So the point is it's not getting -- neither they [ just got ] got worse...

No. They've...

Or maybe [ faster ].

Yes, all trending in the right direction. We're just not where we need to be just yet, which the team continues to work very hard there.

Yes. And on the light commercial market, obviously predominantly domestic exposure for Lennox, how have you seen the recovery to date if you're comparing, say, greenfield with replacement activity? And what's kind of to come if you think about this year and next on replacement versus...

Yes. I think really for the last couple of years, we've seen probably more growth on the planned replacement side. So that means it remains robust. It's the new construction side really where it's been lagging. Quite frankly, it's been lagging for a couple of years now. So we expect that to continue. One of our core strengths is on planned replacement. So it plays to our strengths. So we're looking forward to, in commercial in 2022, getting back on track to where we need to be. We expect increased profitability in the first half and then margin expansion as we get into the second half of the year in that business.

And do you see that greenfield aspect sort of picking up from here? Or it's just...

I wish I could predict that, Julian. I certainly don't know. From all indications, it's probably going to be a while before we see, particularly where we play, robust new construction. I mean there's just a lot of capacity out there today. But those that are maintaining and running the properties are maintaining them well and still seeking opportunities to drive down their operating costs with the types of products that we can offer where it will save them on energy, energy consumption and then also some of the indoor air quality capabilities that we can also deliver to them.

Got it. And when we think about the residential business, you have that SEER change next year. Maybe how do you assess the sort of the magnitude of that change versus the one 6 or 7 years ago? And any implications for what that might mean to sell-through or sell-in the next kind of 18 months?

Yes, just to level set everyone, the SEER transition is for those states south of the Mason–Dixon line. The new minimum efficiency is going from 14 to 15 SEER. And it's on the installation date. So it has to be installed before December 31, 2022. In the north, minimum efficiency is moving from 13 to 14 SEER, and it's on the manufacturing date, so as long as that product was manufactured before December 31, 2022, if we install the new ones. And I don't expect it to have any significant effect in demand -- or rather, I don't want to see abnormal. It's different than it would -- normally would be just simply because of limited product availability across the industry. It's getting better. It's getting better [ at one ]. I think it's getting better in the industry. But I don't expect a significant prebuy. It might as well open products won't be available before a prebuy, to be honest with you. So...

And if you think about residential margins, not quite the plant issues in commercial, again the supply chain issues there, how do you feel about that business kind of getting back full rate...

Yes. There's -- once again, I think all of our initiatives around productivity are reengaging here in 2021. We have some challenges because of escalating commodities and component costs. So typically, I'd be up here talking to you about $30 million in net savings. Unfortunately, we have $30 million in net cost headwinds that we got here in 2022 because of escalating commodity costs and component costs and how they're impacting. So once I think we're on the other side of 2022, once again, it's all predicated on how inflation is tracking, but we would expect to be back in full throttle on productivity both in the factory and on material cost reduction.

And if you look at the competitive landscape, Lennox' portfolio has been fairly steady for a decade. Some of those others, Trane, Carrier, JCI, a lot of change and maybe they're sort of settling down now with the latest portfolios. Has anything changed competitively? Or do you think it's a more disciplined industry post that change?

Yes. I think people suspected that there would be some cataclysmic shift when these companies became more independent or smaller [ than we want ]. And then there's been -- they were well-run companies when they were part of larger organizations, and they still are today. So once again, there's been no significant change in competitive dynamics or the landscape at this point.

So maybe switching to Refrigeration. It gets sort of less airtime than the other 2 divisions on investors. Maybe remind us kind of what are the aspirations there around growth and margin and sort of the positives.

Yes. Once again, it's our most geographically dispersed business. If you look at the margins here in North America, really, the margins in our North American refrigeration business are on par with our other 2 businesses. So it's a situation where it gets diluted a little bit when we layer in Europe, where we're subscale and we're working to, once gain, size and scale there but still opportunities in that business for us. Once again, we're a leader here in North America in commercial refrigeration systems. We have a small footprint in Europe that we think we can build upon. And really, it's the same playbook. We win with innovation, effective distribution, and then we have an intense focus on costs. And that lends itself to driving increased margins over a longer horizon.

And on the Europe side, is that -- can you get the scale you need for higher profitability organically? Or do you think it will require, at some point, M&A to get there?

Yes, yes. I think we will continue to consider M&A when the time is right for opportunities in Europe. I think the only way we get there is through M&A. There may be some opportunities for us to grab share, but the way to characterize us in Europe is I think we're more of an ankle biter than anything. So we can take share there. But I think we really need to get to where we need to get. We need to -- and we have been and we will continue to do -- to look at the M&A opportunities there. It's much more fragmented than North American HVAC. So once again, the table is set there for us.

And that is one area -- going back to those peers that you have seen some change very recently. It's around the VRF technology. Carrier has made a couple of strategic moves there to sort of bulk up its presence. How satisfied is Lennox with that [ day ] partnership? How is the kind of the market share and the growth in that VRF right now?

Yes. Unfortunately, Julian, we haven't had a normal year since 2017. We're impacted by the tornado in 2018 then the pandemic hit once we sort of lifted our head from the tornado recovery. So it's something that is opportunistic for us going forward. We've always felt it was an opportunity for us to take that product category and encroach on the smaller side of the applied market. And it's -- technology has been here for a while. As contractors and building owners and commercial customers continue to be educated on the benefits of VRF technology, we think that's still an opportunity for us going forward.

And do you think the partner you have is the right one to get you what you...

As of today, yes. Once again, we'll continue to assess that. And if there is a desire for us to do something different or with someone else, we'll certainly evaluate that. And that's something that we do continue to look at.

And if we look at sort of a broad commercial building and obviously on sort of the lighter side, the lower story category of nonresidential buildings, but on the controls side of things, Lennox has a controls offering. Some of the other companies here have a much more comprehensive kind of one-stop shop approach for commercial building owners. And developers' and operators' defense is more of a sort of best-of-breed focus. So I guess when you look at sort of technology changes underway out there, is it what customers are telling sort of sales [ contributor ]? Do you see anything changing on that one-stop shop versus best-of-breed in terms of this is the right one to win? Or no, there's -- it's always case by case?

It's always case-by-case, I believe, situation, too, where that's -- when we talk about some of our competitors being in building automation, it's different than the controls that we design and sell to our customers. But we afford them the opportunity to plug into -- with open protocols to plug into their old building automation systems and capabilities. We looked at that for a segment of the market where we thought there might be an opportunity for us to get into building automation services and support and leverage our capabilities in our commercial service business where we have something similar to that in controls monitoring. But we found out that it was so fragmented, that it was very difficult to come up with a consistent and unique product that serve the various applications that were out there effectively. So we decided that, that was the best suit for us. Our objective is to continue to look at controls in the equipment side but afford them the opportunity once again with open protocols to plug into more broader commercial building automation systems.

And is there an argument that as technology has got faster and more capable and the cost of it have come down, maybe the best-of-breed is the right way? Because it's easier now and cheaper now for the building operator to connect disparate hardware, whereas 20 years ago, it was more expensive, too complicated, they needed a sort of a one-stop shop to do everything for them. Is that something that you think is becoming apparent maybe in the market or...

It may be for the market, but I don't think it's right for Lennox. We -- our competitors are very well entrenched in that area and with those capabilities. And it would be something, like I said, that -- I don't know if it's the best for Lennox.

And if we look at profitability for a second, you sort of think back maybe to that period a decade ago where cost inflation -- what happened to Lennox' profitability back then. If we do go into a normal inflationary environment a year from now, how confident are you that there could be a decent price cost tailwind for the next -- perhaps in the gross margin?

Yes. We remain very confident, very disciplined with price. And we historically hung on to those things. Typically through full commodity cycles, when you regain the price, our margins take a little bit of hit because of the inflation. It will probably take us a little bit of time to recover all of that. We got price increases that were now effective January 1. We expect about a 5% yield, which is similar to what we -- quite frankly, it's more than what we did last year, significantly more, but it's a way that we can cover those costs over time. And then when commodities do ease, our ability to hang on, on that price will remain opportunistic and, once again, should lend itself to margin expansion when that occurs.

Are you seeing any -- or when you look out there at demand and have the conversations with distributors, is there any evidence that, okay, the price increases, at some point, will damage volume demand or not at all because inflation is so entrenched now?

I think it's a couple of things. Limited product availability is another dynamic. And once again, the health of the consumer remains strong, and that's the thing that we continue to pay very close attention to. It's the health of the homeowner, consumer spending, et cetera, unemployment, all of those variables. And those things remain healthy. At some point, they will take their toll on the consumer. At that point, that's when we'll have to think differently maybe about some things. But it's a situation right now where end market demand remains strong. Our ability to get price remains very high.

And if you think about sort of that dynamic of rising interest rates in the U.S., is your perception, yes, at some point, there's a risk but it's nothing imminent partly because most of your business is replacement business?

Right. Yes. That may -- and I think even with a few ticks on interest rates, it's -- interest rates are still going to be relatively pretty low. So I don't expect that to really have an adverse impact. And I think inflation is the biggest concern right now.

And as a reminder, everyone, please look at that QR code for the audience response stuff. It just takes at least 25 seconds, something like that. I suppose switching back, Joe, to the cash flow partly because of supply chain issues. That conversion has been maybe below what I might have hoped for last year and this year. So maybe talk through how you expect that working capital sort of lump to normalize. And where should we think about cash flow conversion on margin?

Yes. If you look back at 2020, we converted cash flow at 150% of net income. Last year, it was close to 90%. We target 100%. Here in 2022, we targeted $400 million of free cash flow, which is roughly 80%. But the reason for that is we need to replenish finished goods inventory in the residential side of the house. Otherwise, we would be much closer to that 100% conversion rate on free cash flow.

100% is what you should get?

That's what we would target. Now there -- it may ebb and flow a little bit due to different levels of capital investment. This one is a little bit unique in that it's working capital because inventory levels, particularly on the residential side of things, have driven down to historic lows.

When we look at kind of operating margins, what's the kind of -- again, assuming a normal cost inflationary environment, what sort of operating leverage do you think is Lennox' kind of entitlement? And so there's a couple of specific things to think about maybe next 18 months. One is does -- that SEER change, could that impact resi margins in any way? And then in commercial, how do we think about that kind of emergency replacement activity coming back and what that does often?

Yes. I think both of those are mix questions. So I think as we get into 2022, we may see a little bit of a lift -- or excuse me, into 2023, we may see a little bit of a lift on residential mix because of that SEER conversion, but I don't think it's going to be anything monumental. And then on the commercial side, we did get a mix lift last year. As I mentioned, we focused on, in 2021, our national account customers, who are consumers of 4 of our premium products. We saw a mix lift in commercialized results that -- I expect that to go back. But once again, I don't think either of those dynamics are going to be harmful from a margin perspective on the commercial side of the house.

When you think about reinvestment requirements, again, I think some of those peers have been at various stages of reinvesting, JCI 5 years ago, maybe Carrier the last few, Trane has been pretty consistent. When you look at things like R&D requirements or investments in technology, say, for that controls platform, do you see that there's any extra requirement now on Lennox' part because of regulatory changes or what competitors are doing or it's a fairly steady state?

It's going to be fairly steady state. I think the one thing that we've done and when we've had higher levels of capital spend, it's because we stood up additional manufacturing capacity. But I think that will be the one thing that we'll continue to look at. We're going to continue to drive innovation, and that takes a recurring stream of capital to accomplish that. And then we have emerging technologies, and we have control automation and digitization of the business that remain priorities for us.

And we're sort of waiting, as I'm sure you are to a degree, to see what happens, CEO news at Lennox. I think when you look at M&A, that could be one area you'd say that Lennox has been quiet at for the last few years for better or for worse. Do you think that there is an opportunity under the next CEO to perhaps revamp that? Any areas that you might say, "Maybe here we could bulk up?" I think European refrigeration, you mentioned very clearly. Any other areas that you think perhaps Lennox could kind of lean into more on the inorganic front?

Yes. I don't know if we'd -- I'd characterize it as leaning in more. I think we've waited patiently for someone to make a move in North American unitary. And should someone do that, we feel that we're positioned. We're good operators. We'll be great stewards. And I feel that we would be an effective consolidator of North American unitary, whether that be on the commercial or residential side. And then with respect to the new CEO coming in, Todd committed to sticking around through the middle of the year. When I look back at the last CEO search when they brought Todd in, the timeline was almost the same. So there's no significant differences here. I would expect an announcement sometime here in the first half of the year.

And I think one point of emphasis for a lot of companies selling into maybe more nonresidential buildings and residential is going to get that service component up, increase the share of recurring business, a lot of talk about that. How does Lennox assess that? Maybe it's more of an applied HVAC point. But even on unitary, there's some opportunity for contractual service. What's the sort of ambition there?

Well, we have our commercial service business today, and we focus largely on national account customers. So we're not going to do Julian's Bowling Alley, but we are going to do Lowe's, Home Depot and places like that, where they can come to us and hand us a significant portion of their stores or all their stores in the case of some of our customers. And that's where we focus our attention. As of right now, I don't think there's any aspirations to get into the applied side with our service arm. We're growing that business double digits, and it's got very attractive margins, some of the best in the company. And we continue to feed that. And you're right. I mean those contracts are annuities that work very well. And we'll continue to, once again, focus on that business. And it's a great partnership where we can sit down with a national account customer and talk about not only their equipment needs but also satisfying some of their service needs as well.

And has there been any change since COVID in terms of that sort of service pricing or service content per square footage of building? I think a year ago when we're doing this event virtually, it felt like you could get some huge wave of indoor air quality placement, outcome-based service centered around IAQ. A year later, for better or for worse, some of that -- a lot of that talk has dissipated. And what's your perspective on -- did anything really change as a result of COVID in that respect around sort of IAQ replacement, IAQ-driven service among nonresi part?

Yes. I think there's a lot of attention obviously. It's a situation where it always comes down to the economics. And it's a situation where if folks see the economic value, they'll pursue it. There are some extreme cases with medical facilities and schools where I think the characteristics or the profile are a little different. But when we talk to our national account customers, it always comes back to the economics.

And the point is that, what, it's not clear that they're investing in...

Yes. I can sit down with a national account customer and talk to them about efficiency gains and energy savings. It's pretty difficult to economically assign value to indoor air quality to an extent. So that -- I think that became a challenge with some of the metrics that you mentioned earlier, were just that.

And then lastly, I suppose, and maybe least, you always get these sort of mechanistic models around residential replacement, where -- the debates of all the sort of predictive utility of those but it doesn't stop them being talked about very frequently. What's your sort of latest assessment of that type of approach to the market? Have you noticed any acceleration structurally in utilization rates that may mean that those replacement periods are just a lot shorter than people what have been used to?

Yes. One of the things that we now have the ability to do now that we have are our more sophisticated controls capabilities as we can look at the run times of equipment in certain households and geographies, et cetera. And we're able to conclude that during the early onset of the pandemic, households were running their HVAC equipment 30% more. It may have dissipated a little bit in 2021 as some folks migrated back to the office, but it's still probably around 20%. That's what -- north of that. And it is affecting the useful life of equipment but it's not cutting in half or having a significant impact. It's just stressing the equipment a little bit more, which may slide that -- those parts of the bell curve together. But it's -- from our perspective, it's not pulling significant demand forward. There's been speculation around that. Homeowners are still going to replace their equipment when there's a catastrophic failure and when the economics justify the investment. And that's what we're seeing today. But that end market remains very robust. And like I said, we expect it to continue to grow at a multiple GDP.

Perfect. Great. Well, I'm afraid we're out of time. Please, if anyone has a minute, complete that audience survey. And thanks very much, Joe, for being here and for chatting with us.

Always a pleasure.

Thanks so much. Thank you.