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

Hello. I am Ryan Merkel from William Blair's Research Department. Before we begin, I need to remind you that a complete list of disclosures and conflicts of interest is available on our website at williamblair.com. With us today from the company is Alok Maskara, CEO. We also have Joe Reitmeier, CFO, in the audience. Lennox is the global leader in HVAC and refrigeration markets. The company has been a share gainer, driven by investments in products, distribution and technology. HVAC is one of the best markets that I cover due to a large installed base of equipment that's all going to break and you can't live without it. With that, let me turn it over to Alok.

Thanks, Ryan. Appreciate it. Good morning. Pleasure to be here. I've been the CEO for 30 days now. That means I'm a complete expert in the industry and the company. And keep that in mind, at the end, if there are any difficult questions, they go to Joe, our CFO, easy questions to me. So excited to be here. I was going to read through this in detail to waste 30 minutes, but we'll move to the [ Q&A thing ]. People ask me, why did I take this job? And one of the things I wanted to highlight is the values of Lennox. Lennox has a long history, 125 years, started in Marshalltown, Iowa, now is an operation all over U.S. And it's just a very good company. Our dealers like to do business with us because we have strong values. Our dealers have strong values. And our consumers trust this brand because we are innovative, we bring the right quality. And I do want to mention that is a big attraction for me to come into this company. And there's a lot of like anxiety when a new CEO comes in. And one thing I wanted to convey to the investors through this page is that we have a very good, stable, experienced team. Now don't go by these pictures, they were taken when they started. So if Joe looks much younger in the picture versus what you see him in the room here, that was 15 years ago. But lots of experience, people who have done very well in the industry and people who know the industry quite, quite nicely. And what the Board was looking for, for somebody who had experience in 2-step distribution, somebody who had public company experience, somebody who had a strong track record of driving growth. So all my previous experience kind of adds up to those things. The other thing that Lennox has, although we don't always talk about it, is very strong business processes. We have one of the best business processes to drive technology innovation. Joe and the team have done a phenomenal job in capital deployment on how we kind of really believe in giving money back to the shareholders. We really do a good job developing talent. It was only fortunate for me that Lennox had to go outside to get a CEO. And otherwise, most of our talent is homegrown or comes through the ranks in the company. So just really strong values and truly put together, but good business processes. And from an ESG perspective, we are the leaders when it comes to things like heat pumps. We are the leaders when it comes to truly looking at diversity in our ranks. We are the leaders in truly caring about the environment and reducing our CO2 footprint, CO2, water footprint. We don't do greenwashing. We don't make big proclamation about net 0 till the time we are confident that we can do that. So anything we publish in our reports, and new ones coming out soon, we do this annually. We really believe that sustainable way, the right kind of social, making impact to our communities and, of course, governance is rock solid for us. Governance, obviously, is also driven by the Board. We have a very good Board, a diverse Board, experienced Board. And one of the questions that always comes up when I talk about this is, why did the Board choose me versus many other competition? It's very rare for a well-run public company of this size to go outside. And as a recruiter told me, in his 20 years of search, this is like a very, very rare thing. Good for me. So I'm here. And the reason the Board chose me is our values align very well. I have always been part of well-run, high-value companies. What it also came down to is they wanted somebody who was very growth-focused, somebody who has a strong track record of developing growth, and finally, somebody who was just experienced in fixing problems if and when they arise such as what we are facing in Commercial, and we'll come back and talk about it in a few moments. But net-net, as I spent 30 days, and if you had to summarize it in what I have taken away in those 30 days, it's kind of 4 things, which are on this page, right? First is, we are the leader in direct-to-dealer network. Ryan mentioned earlier, HVAC is a beautiful industry, right? 4, 5 competition, all very disciplined, market is huge, replacement markets makes a majority of the sales. Lennox has the leading technology position when it comes to energy efficiency. Whether you measure it in terms of 28 SEERs or whether you measure it in terms of having the leading heat pump technology, we lead. And that's kind of on the left-hand side of the page. And that's current. In future, the long-term tailwinds that we have, from just macro perspective, it's beneficial to us. Replacement cycles are getting shorter. As more regulations come in, more people work from home and you need more energy-efficient units, that's going to be great for our industry. And for us, being one of the smaller players, right -- we're not the big gorilla in the HVAC space. We are the smaller player. The share gain opportunity for us is just massive. And I think that's going to continue. So if I take all of this and talk about just a little bit more about Lennox and where we are, we are one company. We're not a portfolio company. We have no intent of being a portfolio company. We are going to be focused on HVAC like we are today. And you can see, residential is big for us and, clearly, largest part of our profits. North America is our focus, and I already talked about replacements is majority of the business. That gives us comfort that there will be cycles in residential. We don't know exactly when they'll come and how [ they're down to lap ]. But hey, 75%, 80% is all replacement business for us. Strong track record in truly growing sales, earnings and cash flow. And of course, you guys know, we take all our free cash flow and deploy it towards share buybacks. We don't hold on to it. And I'll talk more about our capital deployment philosophy. But great track record. That is one reason not to take the job. How do you beat something like this? And then you look at the growth opportunity forward, and we'll talk about that in a moment. For those who are new to the story, a little bit more details on the segment. Residential is our largest, and you can see that, approaching 20% in ROS, strong growth. A lot of the recent growth is price. And the good thing is on the price versus inflation, we are keeping up or slightly making -- beating inflation with price. And you can see that from some disruption in the past, for people who don't know the weird yellow box, we had a tornado hit our factory in Marshalltown, Iowa, really difficult time for the company. The company came out through it very well, but we lost some share in the process. We couldn't gain it back fully. We gained most of it back because of COVID and other pieces. And I think now is the time to kind of get back and get those shares. You all will have questions about the residential market. You probably have answers that are more informed and better than us. What we look at it is this market grows, right? I mean there is -- growth could be bigger or smaller. This year, growth will be less than last year. We know that. Could it be lower than what we are predicting? It's all possible, depending on which analyst report [ you hear ]. We don't see it in our orders today. We don't see any slowdown. We are not demand-constrained right now. We are supply-constrained. And we look at things such as extended run hours during work from home, the replacements from refrigerants and the new efficiency standards coming in, all of that has positive impacts on the number of units in the residential markets that are going to continue selling. Switching to Commercial. A bit of a surprise when I joined, right? I mean the decline in ROS, which as you saw in Q1 got worse, that creates on a run rate basis a $100 million EBITDA improvement opportunity for us. This is a business that there's no reason for it not to be an 18%, 19% ROS business. And Q1 was 3.5%. A single factory where we stumbled, stubbed our toe a bit, but we know how to fix it. We will fix it. And that creates a huge upside opportunity. If Resi softens, this will kind of make sure that our margins and our EBITDA continues improving. You can see that this business had a tough time during COVID. Clearly, Commercial was the opposite spectrum of when people were working from home, not much going on in the commercial side, but it's kind of come back last year, and we still expect this business to continue growing. We have lost some share because of recent disruptions, but from new construction, positive price, that's going to continue gaining for us. We remain optimistic on this business. And remember, on Commercial, we are very focused. We don't go after a broad spectrum. We are focused on rooftops. We are focused on 25 tons or lower. And we go after the national chains. So customers are typically things like Target, Best Buy, any of the big national chains. That's what we serve. So we're very, very focused. Small and focused is the way you want to think about us on the Commercial. And then Refrigeration, Heatcraft, which as the picture shows, beautiful business, North America-focused, high margins. And the rest of the portfolio needs to come up to that. So I will leave that with Refrigeration. It is a good business, good secular tailwinds, but needs to improve. And we're going to keep working through those improvements. And the team has already done a good job on it. That's kind of the preamble. Now thinking through, so what do we need to do to grow? For a while, pre-tornado, we had a very simple formula. Every year, 30 to 50 basis point of share gain. Every year, 30 to 50 basis points of margin expansion. Take all the free cash, give it to shareholders. It's simple, right, not very complicated. And our goal is to get back to that now that, hopefully, COVID is almost behind us, supply chain disruptions are getting better. And the 4 things we are going to do to do that is kind of highlighted on this page. First one, service excellence to gain share. And there are 2 aspects to that, I'll come back to it. Environmentally friendly products and services. Our attachment rate with our units are lower than our competition. So if competition sells 30% parts and supplies, we will sell half than that. So huge opportunity to grow that. Operational efficiency. We have so much room still to get more operational efficiency through like production, more production in Mexico, through more material cost reduction. And finally, digital innovation, digital investment, great opportunity for us, especially because we skip the distribution channel and establish direct relationship with the dealers, our prime target. So let me go into some details on each of them. On service excellence, opening more Lennox stores and making sure for stores opened more than a year, we have appropriate year-over-year sales growth is a key part of our strategy. We didn't open many stores during COVID: a, because we didn't have enough supply; b, it was just harder to get physical new store openings. We are getting back on that. We expect to open 20 to 30 new stores this year. And our entitlement right now is around 350 stores. So you can see this will continue to gain us share, and then we'll get more efficient in each stores as well. On the Commercial side, national accounts. We are the leaders in national account. We have service, sales going directly to national accounts, and we have done very well. Even in today's disruption, this is the market we are protecting heavily. And I think that's going to be a key part of our growth drivers. I honestly believe our national account relationships have significant, significant room to grow, especially as we fix our operational issues in the Commercial segment. So those are the 2 things I want to talk about on the service side. Now moving to the innovation side, I truly look at eco-friendly products, indoor air quality, heat pumps, VRF units, splits, mini-splits. Our penetration on all of that is smaller than our competition today. The parts and supplies we sell, that's smaller than our competition today. It's huge opportunity for us. And we're going to do that through new products. And you can see on the right -- top right-hand side of this page, we have shown some of the new splits and mini-splits. On the left-hand side, you can see we have new IAQ sensors coming up. Our new thermostats have built in per room IAQ sensors that we can deploy, first ones in the industry. We continue to lead in sustainability, the highest SEER unit. So I'm really excited about actually making a difference, difference to the consumer, difference to the dealer and reducing the overall global warming and greenhouse emissions through our products while increasing sales for Lennox. On manufacturing efficiency, I was in Saltillo on Monday. What a great facility and so much room to grow that to truly drive manufacturing efficiency for us. Automation for our plants in U.S. remains a huge opportunity. During COVID, we couldn't do a whole lot of that just because we couldn't buy automation equipment. Those things were like lead time to extend it so much. But I look at this as beyond the $20 million gross productivity in 2022, continue that journey. You will see more of us in Mexico. You will look at us as continue to driving more automation. And I think we're just scratching the surface on continuing to drive more efficiencies throughout our chains. Historically, we have done a great job in material cost reduction is to have this mantra of $30 million in cost reduction. Recent years, a lot of that has got eaten up either because we paid too much for air freight or maybe materials, raw material like commodities went up. But I'm excited about getting back on that trend, truly looking at designing our costs out. For circuit boards, we are now skipping steps and going directly to getting our PCBs made ourselves. We had to do that because of the shortages, but that's a good part of our cost reductions as well. So there's a lot more room left for us here. And clearly, we are focusing on appropriately balancing supply chain resiliency with cost out because we remain in an environment where we're not demand-constrained, we are more supply-constrained. Digital is a huge part of our growth strategy, and I do believe we have an edge compared to our competition because we sell directly to our dealers. What that allows us to do is if a unit is about to fail and they have the appropriate unit, we get a signal, the homeowner gets a signal, and the dealer is informed or gets a signal. So the dealer can send their service truck with the right spare part so they can fix the unit even before it breaks and do it in one visit versus historically, it could take the dealer 2 to 3 visits. That's worth a lot to the dealer, saving a whole trip, having the spare part in stock and giving the homeowner the guarantee that we will see that this unit is about to fail. So we stop the unit from failing. Because an HVAC unit going bad in a house or commercial, it's just bad. Commercial, they may have to stop operations. Homeowners, it becomes very uncomfortable, in some cases, unsafe. That's the kind of digital investments we are making. It's not going to be about trying to compete with Nest on thermostats. We don't intend to do that. For us, digital really means how do we make the homeowner more comfortable, the dealer more productive and us gain more share. Of course, we'll use digital to get productivity in our factories, you can go see that. Of course, we will look at this as generating more leads for our dealers. Of course, we use digital so that dealer does not have to come inside the store. They order their products on an app because they scan a QR code on a unit, and they pick it up straight through. So that's all going to happen as well. But the greatest focus is going to be about preventive maintenance, predictive maintenance and gaining share out of these investments. Being a new CEO, it will be not fair for me not to touch on capital deployment. So a simple way to say it, that strategy remains the same. We like the debt-to-EBITDA ratio. Does it go up at the beginning of year and go down towards the end of the year with seasonality? Yes. But the debt-to-EBITDA ratio remains at around 2. We will continue doing share buyback. And in today's time, if there are gaps in our portfolio that we see through strategy, we will be open to doing bolt-on M&A. Some of the assets were very expensive in the past few years. So we would look at that in an open-minded way. But don't expect us to go into far adjacency to get scale or something like that. We don't need scale. We have good internal scale. And if we do M&A, there's a disciplined set of criteria that Joe has. We're going to be focusing on those criteria and make sure we always compare it versus share buyback. And lastly, 2024 targets. They remain the same, not going to change it because there's a new CEO. If it changes a year or 2 from now because macro has changed or something else, that would have happened irrespective, right? But the key message is the long-term targets don't change just because we have a new CEO. They remain the same. So it's the exact same slide that you've seen in the past. This basically says 80 basis point margin expansion every year, basically looks at this and there's a 6% revenue CAGR over the cycle. And I know pricing could make it go up or down a little bit, but that's our vision, and we will continue sticking with that. And that's the summary of my 30 days. 4 key messages. We are the leader in a very attractive industry. We have the leading technology position. The long-term secular tailwinds will remain with us. This is one of the presentation's beauty that I don't have to convince you guys, because I already know it's a beautiful industry and the long-term secular tailwinds remain with us. And we're going to get back to recover our share and gain share because we are the smaller player in the industry. We are hungrier. We are going to work harder. And we are going to fight for share without ever impacting price negatively. That's all the prepared things we have. I know we have a breakout, but we may have time for a few questions.

Yes. Yes, let me kick it off. There's 3 questions that are topical, and I'll just fire them off. So health of the consumer, you mentioned you haven't seen it slow down. But have you seen any trade down? That's the first question. Secondly, inflation is still rising. Are you seeing things peak? And then third, supply chain, you mentioned you're supply-constrained. How is product flowing. Is the worst over?

Sure. So on the first one, on the health of the consumer, we look at the same Wall Street data that you look at, right? We are monitoring everything. We have not seen any trade downs. We have not seen any slowdown. We don't have to worry about inventory in the channel usually. Because again, we own the relationship between us and the dealer. Our inventory, I would sure describe it as lean. If we had more production capacity, and we would put more inventory in our stores right now. So we have not seen any -- doesn't mean it's not coming, Ryan. It just means we haven't seen that. If it comes, we'll be prepared. Again, we're not good at predicting. We are good at reacting. So we'll work with everybody. Joe and the team, we monitor it. I think we get flash report every day on all of these factors, and we haven't seen it change. Maybe it's coming, maybe everybody else sees it before, but we will be prepared, right? So that's easy. Inflation versus pricing, every time I say that inflation is almost behind us, I turn out to be wrong, right? So far what we are seeing is we seem to be stabilizing a little bit more. I mean this year, we are going to get about $335 million in price. I mean a big number because that's what the inflation does. We've already done 2 price increases in certain sector. Commercial, we have done 1, we're about to go to do another one. So it's a very dynamic mode. The challenge on that we have is to train a bunch of our salespeople who have never lived in an inflationary environment, and we have done a good job with that. So from where we are, our goal is to make sure we cover it minimum, maybe a little bit more with pricing. So Q1, we saw, we were better in pricing versus inflation, and that will continue. So I just don't want to predict commodities because every time I do it, I'm wrong. I'm sure some of you guys are going to be better than that, right? Supply chain: a, we have just got used to the disruption, right? I no longer feel terrible about leasing an entire airplane because we need to get condensers from overseas, right? I mean it's $1 million, but we've been doing it for a year. So some of it, we're getting immune to it. But the situation is getting better in areas such as semiconductor chips. And I'm not sure the industry is getting better. We are getting better because we have redesigned our chips. We have skipped some of the manufacturers. We're getting our own PCBs printed. We have got 3 suppliers where we used to have 1. So we see an end in sight in those places. Now could something else happen again? We didn't see the war coming. We didn't see the Shanghai shutdown coming. There are lots of things we didn't see coming. But so far, what we're seeing, it's not getting worse, and we expect it to get better based on all the actions we have taken. So those are kind of the 3 macro things.

And then can you just talk about how the SEER change and maybe the refrigerant change can impact your business and how you're preparing for that?

Sure. So this -- both of those are positive for the industry, the SEER change and the refrigerant change. Both of those are positive for us. So let's start with that. I mean that's a part of what I said, it's a beautiful industry. The SEER change, first thing to remind you all is that going from SEER 13 to 14 is a much smaller change than what some of you may remember when we went from 10 to 13. That was like a 30% change. This is like a 7% change, right? The reason that's important is it's not as disruptive as the previous one was because many of you have that in mind of what happened a few years ago. Second thing I'd tell you is we are fully prepared. I think the whole industry is fully prepared. So I give credit to all my competition and our dealers and supply chain partners. What it would mean essentially is the price per unit would go up because it has to, our cost will go up. It will go up for everybody in the industry. I don't expect any significant pre-buys from anybody. And part of it is because everybody is a bit supply-constrained. It's not that we have extra capacity just waiting to do prebuy. What I do expect it to become a nonissue with -- they could ask all mixing up because 50% to 60% of our units are the lowest minimum efficiency units. That just mixes up as you go from 13 to 14. I won't drag you to the north versus south and all that details. You all already know that. It's good for the industry. It's good for Lennox. We are prepared. Industry is prepared. We will mix up. We'll cover it in price. So that's on the SEER change. Refrigerant change -- by the way, on the SEER change, the other thing I should mention. On the Commercial side, which is not your question, it's actually better for us and better for the industry because there's an opportunity to reset pricing here when you have national accounts because these are new products, right? The same efficiency standard applied to commercial means very new products, like more efficiency there. So I think Commercial is actually better for us versus everybody else. Refrigerant change, we're a few years out, right? Everybody is keeping their cards a little closer to their chest. We are 100% prepared, right? We believe our solution is going to be better than the competition. I'm sure competition thinks the same way that their solution is going to be better than us. Again, I think it's a good thing. What that does is older units, if they break and there's a leak, the dealer can go convince them that the cost of putting in the old refrigerant, which certainly becomes more expensive, is not worth it, they should replace the unit. So I think the replacement cycles get shorter. I think the refrigerant change, when it comes to it, will be an advantage to us because of our technology. I don't know what the competition has in store. Some are talking about the units getting bigger. Some are talking about doing other things. I think it's just going to be good for the industry. And we'll be fully prepared. But remember, it's 2, 3 years out, so.

Okay. In the last 2 minutes, can you just -- we'll go high level. Just talk about your growth algorithm to build up industry growth plus share gains and then how does that translate to earnings growth and then cash flow conversion.

Okay. The second part, I may need Joe's help because I did say difficult questions to Joe. I think the growth algorithm, first of all, at minimum, let's grow with the industry, right? In Joe's 6% number that he has there, we always take industry growth is about half of that, right, 3%? Could be different, but that's units-based. The other half, I think, is share gain/pockets that we talked about. We are still not geographically fully penetrated. Our parts and accessories are not fully penetrated. Commercial, this bigger opportunity. So think of our growth target being half from the industry, half from our own efforts/share gain. That could include new products as well, right? So that's a look at it. It drops down at, at least 30%, which I think was Joe's number. I hope in some cases, it's more, but it drops on at least at a 30% number. We do get fixed cost leverage. I mean our factories, when they make certain units, I mean, we do get advantage of that. We convert 80% to 100% of our net income into cash. And absent any good M&A opportunities, we give it back to shareholders. So that's kind of a longer way. Joe, anything to add to that?

No. I'm [indiscernible] already.

So that's my 30-day answer, but my CFO blesses it. So I think I did okay.

And just in the last 30 seconds, I continue to get asked why does Lennox own its own distribution, right, which is very different than everyone else in the industry? Just give us the 30 seconds on why that makes sense for you.

Dealer loyalty. Dealer loyalty, service to the dealer, it becomes more important in the future with the digital world connection. I don't have to worry about convincing the dealer that they choose my software versus a distributor software because distributors are all going with their own software and their own solution. My dealer has it simple. They work with us. We work with them. We don't have additional party in the chain.

All right. We're out of time. Thanks, everyone.

Thanks.