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

One of the covering analysts and very pleased to welcome Lennox International for this session. And we have 2 folks from Lennox here. Obviously, we have Alok Maskara, who's the CEO. And he's the CEO effective May 9, I believe. So fairly fresh in that role. Prior to that, he served for 5 years as CEO of Luxfer Holdings, an international industrial company focused on advanced materials. And prior to Luxfer, President of several global business units at Pentair plc and leadership positions at General Electric and McKinsey. He has a degree in Chemical Engineering and an MBA from Kellogg. And we have the Chief Financial Officer, Joe Reitmeier, who people probably do know who's been with Lennox, CFO, I think, since 2012, did I get that right? And I think he joined Lennox in 2005. So we have the experience and we have the fresh face as well. So thanks for joining.

That means difficult questions for him, easy questions for me.

When you're the boss, you get to decide who asks, answers which question.

So let's kick it off, Alok, if you don't mind. I'm always curious when we see these kind of CEO transitions. If you can start by talking about the process of joining Lennox and what attracted you to the opportunity. What did you learn in your due diligence that was encouraging? And as important, what's the low-hanging fruit for you in terms of things that you can bring to bear on Lennox?

Sure. So I think the process started, of course, with the Todd Bluedorn deciding to move on. And I think that decision was based on various personal factors. So the Board embarked on a full search, a traditional search, executive recruiting firm. And the first time they called me, the search firm, I said, no, thank you. Todd's run the company well. It's a great company. What am I going to do, right? I mean that was part of the thing. Then they called me back and said, there's a bunch of opportunities and why don't you meet the Board, and I did. And I really liked the Board, the values-based culture, and frankly, the improvement opportunities that still exist. So once I did due diligence, it was clear to me that's a very well-run company, solid, solid foundation, yet lots of upside, upside from a market share perspective, upside from a growth perspective, upside from future productivity perspective and continuation of some of the good things. So -- and then, of course, 6, 7 months later -- it was a long-drawn process, very disciplined, significant number of interviews and candidates. I think there were days and days of battery or personality tests. I managed to fake through all of them, by the way. So that's how I got here. What I really liked was the nature of the industry, and it's a very disciplined industry. 4, 5 top players make up 80% of the share. It's great to be in an industry that's price disciplined. It's great to have macro tailwinds. I mean every year, 70%, 80% of your sales are replacement sales. So it's great to have that steady piece. And I liked Lennox's position. We are direct to dealer in most cases. Having worked in 2-step distribution in the past when I was in Pentair, there's always a dynamics between the manufacturer and the distributor. And no matter how many nice things we used to say about each other in public, privately, there's always a tension on where to invest, how to invest, who gets most margin. And I really like Lennox's way of going to market. I like the market share position in terms of improvement opportunities. We saw that the company has lost some share in the past few years after the Marshalltown tornado, and I look forward to kind of improving that. And I like the productivity aspect. And I always believe 2% to 3% net productivity every year. And I think that was consistent with how Lennox has operated in the past. And Lennox, we talked about $20 million to $30 million of productivity. So I think putting the whole story together I was like, hey, this is an opportunity for maybe able to double the share price again. I mean that's what attracted me. Now, I'm not going to give you a time frame for if anybody ask me a question on that. But it just seemed like lots and lots of improvement opportunity and consistent with the value systems that I believe in.

Okay. That was obviously going to be my follow-up. So I guess I can't do that. But I'm guessing when you first got a call, one of your reactions might have been, gosh, do I really want to take this on after 2 months, 3 years in an industry where we may be looking at some sort of pullback? How did you -- maybe I'm wrong, feel free to correct me as always. But if that's true, how did you get comfortable that, that's not a big challenge that would be difficult?

Sure. So I think there were 2 aspects to a challenge. One was -- at that point, the share price was $320, an all-time high. I think if I looked at Todd Bluedorn's tenure, share had gone up 8x. So I remember the first into he say, "Hey, 8x increase in share price? What are the expectations out of a new CEO? Is that going to be hard?" And yes, the industry had gone through a boom, that significant. But this wasn't the only one, right? I also follow other industries, which is either could be water heaters, could be pool pumps and all of that. They are industries that have gone through that. So it was looked like I have -- clearly, you're getting into the peak. But I looked at it, I'm going to do this job for 10 to 12 years, right? This is not a 2- to 3-year job that I was looking at. And the goal is during that time, how much of that will carry over? And at least my analysis showed, and it still shows, that not much. I mean in terms of -- this wasn't a pull-forward demand. This was truly a demand that accelerated the replacement cycle, which means unit that were due to replace 3 years from now would now be due to replace 2 years from now. It's not that you're going to face an air pocket. So I looked at, okay, this was good. You had a onetime benefit, but there's no drag on it in the future. You sort of go back to the normal cycle. But I think that's true across all of the businesses that serve the residential market. In heavy goods like, we're not talking about toasters, we're talking about larger units such as HVAC, water heaters and things like that. So I looked at that and I also looked at, hey, what a phenomenal opportunity for Lennox to gain share because Lennox should have gained back the share we lost after the Marshalltown tornado. And we did because COVID hit and all the supply chain disruptions hit. So hey, huge upside. So this is at least one company had more upside than others in the industry.

Okay, great. So let's shift a little bit. You obviously mentioned the tornado and some share opportunities, but I think you also maybe have some share opportunities in your commercial product. Can you just talk a little bit about sort of where we are with that Stuttgart facility, what's -- sort of what has been achieved, what's still to be achieved and how we should think about that?

Sure. So first of all, I mean, Stuttgart facilities/our commercial business was a negative surprise and is a negative surprise, part of your earlier question that you asked. We stubbed our toe. And we started really bad, it hurts, but we didn't kind of damage our foot permanently. That's the way to think about it. We lost our manufacturing excellence in Stuttgart, and a lot of it was driven by significant numbers of retirement and attrition during COVID. As we take a step forward, I mean, there are 3 different phases we are working through. Phase 1 is just restoring our manufacturing capability. And on that, they are again 3 aspects within that. One is restoring the hourly labor, and we put a check to that now. So 3 months into it, I can confidently say that we are at or above the staffing level we need. So I think that part is done. Next for us is going to be truly about restoring the supply chain capabilities because our suppliers have got used to lower volume being purchased, and they need to ramp up with us. So I think we're giving ourselves a yellow there. We are working through it. It's going to take a few more months, but we're going to get there. And the final piece of that would be is to restore the manufacturing efficiency in the current facility because it's still very inefficient. New employees take a long time to get efficient. Some of our lines are running at very low first-time right rate, and we have a huge opportunity to do lean manufacturing there. So we have deployed some good talent. So that's kind of Phase 1 for that, right? Phase 2 for us is to recover the lost volume. So we have walked away from certain markets like emergency replacement, and we need to get back. And some of that is going to happen with availability, but we'll fight hard for it. I don't mean to imply that it's automatic. It's easier, but it's not automatic. So I think we've got to fight hard to restore the volume pieces. And then finally, to set up the business for long-term growth and share recapture, we'll have to stand up our other facility. This was [ DT ] years running out of thing. Now the good news is everything I talked about, it's kind of internal improvements that we need to drive. Structurally, we're in a good industry. We have some great products. We're going to introduce better products in January 2023 with the [ CO ] change. And that helps us from looking at margins, pricing and manufacturability. So I'm very optimistic. I still think it's a $100 million improvement opportunity for us from an EBIT perspective. And I feel confident that we'll be able to deliver that in the next 2 to 3 years.

And when you talk about, sort of, regaining the market share there, I guess that's in the emergency replacement area mostly. I believe -- and again, please correct me, but I think you -- when you actually recovered from the tornado, you allocated some extra marketing dollars to help regain some of that share. So do we need additional marketing dollars in commercial to regain that share?

In this case, no. I mean I think what happens is there, we had to attract dealers that have went away. Here, this is a matter of simply ensuring that we fulfill distributor demand. The other thing you keep in mind here, which is different than residential, the tornado only impacted us, right? So I mean we had to fight back where others were flushed with supply. Here we may have been impacted more than others, but every other player is also impacted by supply chain shortages, by production disruptions. And you can see this across the board on any of our competition. The public ones talk about in the earnings. And you will see that everybody was impacted. We were impacted more. I mean that's clear. But going back and kind of fighting back, I think this would be more done based on product availability, getting the right kind of technical support and the new products which are already in the pipeline and announced.

Great. And then finally, you mentioned maybe needing another facility at some point. What -- when do we make that decision and what type of cost are we thinking that could incur?

Between now and the end of the year, the teams -- this has been talked about even before. So this is not new, driven by like new leadership. This has been on the cards for a while. In some cases, in hindsight, maybe we should have done it sooner. But no later than the end of the year, we'll have a decision and we'll kind of frame it up with the appropriate dollars and capital and how it's going to flow through. Like we have done in the past, I mean, Lennox has put up new facilities ground up many times before. So this is not new. This is part of just muscle memory coming back, and we'll give you all the details back in December.

Okay. Fair enough. Maybe let's switch to residential. That's what everybody seems to be focused on for '23. And I guess I'm curious to think about how you're thinking about carryover pricing into '23. And I think there's 2 parts to that, right? There's whatever carryover from the raw price increases from this year and then there's the SEER change as well. And so how should we think broadly about kind of pricing in '23?

Maybe I'll have Joe answer that question. It's a difficult question, so Joe, will answer your question.

Right, sticking with the game plan. It's a situation where pricing is going to come through in really 3 different ways. One is the carryover pricing from price increases we've already instituted. Two will be price increases associated with new product introductions and the minimum efficiency change. And then thirdly, we, as a matter of habit, we'll go out annually with price increases, and the magnitude of those price increases will vary depending on how costs are behaving. So what we'll do is once we finalize our plans, you will know what that looks like here in December.

Okay. But the industry seems to be talking about sort of 10% to 15% on the SEER change. Is there any reason that would be different in your company?

No, I think it's SEER change, but that's 50% of what we sell. So you have to make sure you weight it appropriate. I wouldn't go with a 15% price increase, assuming you're done or already captured that one. You just have to make sure you weight it properly. And once again, we'll give more color after we sort of sharpen our pencils a bit and share that with you here in December.

And are there any price increases in the second half of '22 that you've announced and are going to be effective?