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

All right. Good afternoon, everybody. Here with our last fireside chat of the day are the team from Lennox. If there's something else to talk about besides HVAC, I'm unaware of it. So we're going to keep the train going with that, no pun intended. And we're joined today on stage by Alok Maskara, Lennox's new CEO; and the Chief Financial Officer, Joe Reitmeier. Guys, thanks for making the time. Pleasure to see you as always.

Thanks. Always a pleasure to be here.

Appreciate it. Just as a reminder for everybody, we've heard this a few times now. Research disclosures, check the website or talk to your salesperson. We'll keep it brief because you've heard it 10 times today.

So well, new in the seat, clearly, a very dynamic environment. Maybe just spend a few minutes kind of on early observations across the business and what you're focused on today.

Great. Excited to be here. Been in the role 4 months, Alok Maskara. Came from Luxfer, a small-cap company. First of all, beautiful weather. I hope you guys get to enjoy the beach and the sunshine. I took a coffee break and had a FaceTime with my wife, and I showed her the ocean. So that's the extent of it. Early days key observation on Lennox. I joined Lennox with 3 hypothesis, right? The first hypothesis well, it's a great industry, right? Second thing I talked about, it's a great company with a solid, solid foundation. The previous CEO generated 8x returns, so I'll be very happy with 8.5 or 9x returns in my tenure. And the third observation was, like, I'm not sure if I'll have enough to do at such a well-run company. I mean do they have improvement potential? Maybe I'll get bored. So that's the third thing. So first 2 hypotheses, I think the first hypothesis, yes, great industry. Proven. We can talk about the current environment, but irrespective, through the cycle, great industry. Great company. A strong, strong foundation, great placement. We love the direct-to-China market. Love the talent base we have. And really like our products and the leading edge ESG footprint that we are working on. And then, finally, on the last hypothesis, now I'm convinced I will not be bored. There's tons and tons of improvement opportunities. And the beauty is it's so much easier to take a company from a second quartile to first quartile, which is what we need to do, right? I mean we are just a great spot. On the key things that I'm working on, Josh, is I think the fourth thing we have to do is make sure we have sufficient growth capacity. Like one of the things you noticed in the past 5 years, we have not grown share. And in fact, in most cases, we have lost share mostly because our manufacturing output has not been sufficient to meet demand. At some point, it was because of the tornado, at some point it was because of COVID. And most recently, Stuttgart is just like in our own missteps. So we've got to fix that. I wouldn't call it low-hanging fruit, but it comes in the category of you must fix this. And that's necessary, but may not be sufficient to drive growth. So that's step 1 for us. Step 2, Josh, for us is about very clearly looking at commercial excellence, restoring the commercial excellence. What does Lennox brand stand for? How do we get our sales people motivated, who spent the past 5 years apologizing to really go out and get growth and truly using digital consumer interface, SEO rankings to get growth, right? Third piece for us is through innovation. How do we get to have a winning portfolio that wins in heat pumps, that wins in mini splits, VRF, the highest SEO rating? So first, we thought about getting the capacity. Second is all about true commercial excellence. And third is all about innovation to get the right portfolio. So happy to answer the question, but those are kind of 1, 2, 3 focus for me right now.

Excellent. So maybe just to sort of level set us on what's going on near term. I mean industry seems like it's in the process of maybe just starting to digest or understand the growth that it's been through the last couple of years. How would you say that's happened at Lennox given that there's cross currents and not every OEM is experiencing it the same way?

Yes. I mean the past few years have been good for the industry, whether you are in water heaters or whether you are in HVAC, it's just been good growth of anybody connected to residential home improvements. And we had our fair share, so I think that growth has been good. As we go into these crosscurrents, I mean there's clearly indicators, whether it's new housing starts, which we know are down, which means it's going to impact the industry next year probably with a 9- to 12-month lag, as is typically the case with new housing starts. There's also data on consumer confidence, the recent HARDI data, everything else. I think as the industry -- the timing is uncertain, right? Nobody knows whether it's going to happen in August, September, October or December, but everybody knows it's kind of coming. So it's more a matter for us to be prepared. We can't predict the timing very well, but what we can do is focus heavily on how do we make the next 12 months or 2023, in specific, to be a positive EBIT year irrespective of what happens on volume? Because we don't know whether the volume is going to be down 2%, 4%, 6%, I mean whatever number you want to choose. But at this stage, it seems like just the new home construction will create a drag on the overall market, and I'm not sure replacements will offset that, so I think that's sort of our base case that we are working on.

And how do you view kind of the state of the replacement market right now? I mean if I look back through our history, we appear to be replacing today at a level, I'll call it, double-digit percentage above the best years of installation. So I would imagine there's not a lot of people replacing these things just because they feel like they had a good year at work. Do you view that as sort of a drag in the future? Or do you think these are levels that we can hold?

We'd like to hold these levels. Like let's start with that. No, I understand your question, but I'm saying like we like to hold these levels, these are good levels. There are some fundamental trends, which support holding these levels. Like replacements are winning over repairs for the past many years. I mean that's a trend that's been going on. Recently, that trend has been a little bit more accelerated, and that's been largely driven by things like R-22 difficult refrigerant to replace. 60% of the installed base has it today. The cost of labor and parts has been huge in terms of much higher than our new equipment sales pricing. I mean that's just -- there's a huge shortage of just qualified labor to do the repair. And in parts beyond the cost, there's just an inflationary environment that caused it, but also a huge shortage. The #1 complaint I get from consumers right now, my inbox is filled with that, is lead time for replacement part. I mean if given a choice which economically is pretty close, but repair is a 6-week lead time and replacement is 2 days. You'd probably choose replacement. So I think those are multiple factors that we have to work through. Are we worried about that? Absolutely, yes, Josh. I mean I think our goal is to try and maximize that, or more dealers, the inflation reduction act and some of the existing rebates help in that dynamic. Because what we need to do is make sure that consumer is very informed on their choices on repair versus replace. Nobody knows the answer, right? I mean I think what it comes down to is as the consumer confidence changes, how much more consumers will choose to repair versus replace? We're going to be prepared for all different scenarios. We make money on repairs, too. But obviously, replacement, we believe, often is a better choice for consumers because they get a new unit with warranty. They can get financing. They can qualify for rebate. And if you repair, all you're doing is pushing up the problem for a few more years. That dynamic is in every industry that you can think of, whether it's washing machine or cars. Replacement is taking more and more share versus repairs. But yes, the past few years has been very accelerated. I hope it sticks. We're going to do our best to make it stick. But if it doesn't, we work through it and make sure -- the good news is these things come back pretty quickly. In our industry, very rarely has market been down more than 1 year. Once during the financial crisis, 2 years. We seem to work through that.

You touched on a few of the regulatory tailwinds that are starting to perk up here. We're heading into the SEER change. We have IRA now, not with a ton of clarity, but we're kind of getting in the right direction there. I guess first on the SEER change front. And for folks in the room who -- I've asked multiple people this question. I'm just trying to see how all the OEMs see it differently. But how do you think about the benefit from SEER transition in your business? Understanding that you have a certain percentage that will be impacted, things like furnaces and other products that don't really participate. What do you think sort of the net benefit to Lennox is?

Joe, do you want to do that?

Yes, absolutely. Once again, just to sort of give everyone a little background, what's happening is minimum efficiency in the south is going from 14 to 15 SEER. In the north, it's going from 13 to 14. But it's different. The implementation is different. In the south, it's on the installed base, so it has to be installed by the end of this year. Otherwise, you have to move to the new minimum efficiency. And then up north, as long as the product is manufactured before December 31, you can sell through any time. So a little bit different dynamics. So it takes a lot of risk around the inventory prebuild that we may need to support this transition. So we will just move the inventory to the north. We don't sell it in the south. But the benefits are, in essence, a bit of a price increase because you're moving up literally through that SEER curve. So it's about a 14% to 15% price increase on top of the current minimum efficiency. Worst case, margin neutral and a bit of a mix lift for us. So there's some benefits, not just us, but for the industry.

Got it. And if I were to sort of net that out on stuff that's either already above minimum efficiency or not impacted that sort of a mid-single-digit kind of all-in number for you guys?

Yes, I think so.

Okay. Got it. That's helpful. And then IRA, know that the ink is still pretty wet on that and pointing to the states' need to decide or maybe some more industry lobbying or clarification that's necessary. But how do you guys think about it?

In general, we'll say the IRA is good for the industry. Going back to the repair versus replacement, it will shift the dynamic more towards replacement versus repair. The extent of that is unclear. Where it will happen is a little bit unclear, and all the details to work out. We like the fact that when a consumer is making a decision, and they got to choose between $500 for repair versus, I don't know, $3,500 for replacement, they might get qualified for $1,000 rebate. I know it's high numbers as well in terms of lower end, to make that difference between repair and replacement in IRA. No matter what extent we look at, I mean that's a dynamic we like. Heat pumps are a big part of IRA, at least on the ways written correctly, and that's good for us. We lead out in the Cold Climate Heat Pump Challenge as you saw that. That helps us. A lot of the north is underpenetrated in heat pumps. The new technology helps us do that, and the IRA will do that for us as well. And we look at this as an opportunity for introducing more higher efficiency products. And we'll work closely with the government and the regulatory bodies to shape the actual implementation, to make sure that it benefits all the products that are more energy-efficient and better for the environment.

So I think in its kind of most punitive form with a tax credit, not a rebate, you get the $2,000, and maybe there's an efficiency kicker to that, that makes it a little more challenging. But how does that compare to a typical price between a cooling system versus a heat pump? Like my understanding is that it's not too far off the $2,000 either.

Yes, it's pretty close, in some cases. By the way, it could be a little bit lower depending on which part of the country you are, what's the size of your house, like what kind of efficiency you're going without replacing. And often, what else needs to be replaced. Is it an air handler that's broken that can be -- so lots of dynamics, but yes, it's in that range. That could switch the consumer from going one to the other. If you're in the northern area in which where heat pump may not be able to use all 12 months, we can also put a hybrid system. So you put a system that uses gas in the super cold days and uses the electric heat pump in less colder days. And you still get the benefit of the government. I think we can work through that as well.

Is there a cannibalization factor on the furnace side? Because you sort of mentioned it like in most cases, you'd probably run the heat pump, but you can envision a scenario where you wouldn't. So I suspect that means that no one's throwing out their perfectly working furnace to take advantage of this. But is there some sort of kind of limit to what happens on the furnace side or headwind to there as a function of this?

I think if you take Northern U.S., like Minnesota, Wisconsin, any of those places, furnaces are there to stay, right? Now I make that statement as the next 5-0, 50 years, not for the file, maybe beyond that, it may not. It's a bit of a technology challenge for these heat pumps to work at negative 15, 20 degrees. Now they could move to more a hybrid system. In the south, I see heat pump growing and could probably be half the market in the next 10 years. And yes, in those cases, people may switch from a gas furnace to air handler, which has got electric strip heating. So that's why it's hard to answer the question on cannibalization. I mean in all cases, you still need a unit inside your home that is still circulating, it still has a fan. It still has a strip heater, maybe based on electric versus gas. So in a strict basis, is it going to cannibalize the gas furnace a bit? Yes. Would the total ticket size actually go up? Yes. Is the unit that they're going to put inside the house, is that going to be look like a furnace but have electrical strip heating for backup purposes? Yes. So there's lots of pieces in there. It's not straightforward. We embrace them. I mean we think that this is good for the environment. It's good for our consumer to have options in technology. We make good margins on both.

Is there a technical or production consideration that we need to keep in mind in terms of either your capacity or supply chain or something else? I know heat pumps are pretty similar to cooling systems, but for a few extra parts like valves and electronics. But are those the sort of things that are kind of easily remedied? Or is this a major investment to hope for?

I think these are easily remedied. And then all of us -- all the key players have been making heat pumps for quite a few years, so I don't think there's any major supply chain or manufacturing. The key barrier again is to make sure the heat pumps work well even in colder climate. I mean that's where we're going to put disproportionate amount of our investments.

And then when you think about the conversation at the kitchen table, being closer to the customer by owning your own distribution probably helps with that education process. But how do dealers typically handle this level of complexity? I mean at the end of the day, I don't know a lot of HVAC contractors who are also CPAs. So like is that a limiting factor just kind of market ignorance? And historically, that works for the industry, right? People don't know what these things should cost. But does it work against kind of the complexity of maybe some of these proposals or not proposal as well?

And that's what our job becomes, is to educate those dealers. I mean we have LennoxPROS, which is a really cool tool that helps them do that. So when they're at the kitchen table, with a few clicks, they can come back with a good, better, best option for the homeowner and also build in all the rebates, all the differentiation, all the technology. So they might come back, okay, here's a really basic 15 SEER, 14 SEER unit along with no rebate, nothing here. Whether they go medium, you qualify for the government rebates, better warranties and we put electric heat pump which is better for the environment and will lower your gas costs, right? And here's the premium unit, which makes you -- and most people when given the choice, they'll end up taking the medium or the high end, right, if you present it properly. I think that's what our goal becomes, is to train those dealers, and we do a pretty effective job in training the dealers to pull that together. Now is there more to be done? Absolutely. We've done a lot of training programs on educating people on the benefit of heat pumps and electrification. But we also want to make sure that people understand heat pump is not a solution to every issue, right? I mean it's in some cases, a gas furnace, which we make at 99% efficiency, the highest in the industry, is a better solution. It just comes down to the type of home, which climate they are in, so.

Switching over to share gain. You mentioned some of this in your opening remarks in terms of that being an opportunity. If I think about kind of the last 10 to 15 years at Lennox, maybe excluding kind of the last 5, where share left on the table, expanding the PartsPlus store base and kind of having more geographic coverage and a bit wider price point range, I think there are some products at the low end that got filled in along the way. You mentioned capacity. But is there anything else sort of either commercially or product-centric or the way you're approaching the customer that also plays into it?

Sure. I think each of those things that you mentioned, so more geographical coverage, different price points, multichannel approach, all of those are true. And we can maintain our technology lead in terms of the highest SEER products, the most efficient. And in most cases, like we talk about, ours is the quietest product in the neighborhood. I mean those things still all remain true in the technology. What we have to do is make sure that model applies going forward. The past 5 years, which is where you said we had left some share on the table, the industry has changed, right? Our competition has become more focused. We trained in the 3, 5 years for dealers not to come into our stores versus we do digital fulfillment. We can deliver the product to them. Physical stores, people couldn't walk in because of COVID, because the stores were closed, but we could deliver products to them or they could pick it up in the back. So focus shifted a lot more digital versus physical footprint on those. In addition, the consumer have become more environmentally aware across the board. ESG has become a bigger factor. And finally, the way our salespeople work and the way our dealers work has also changed. The whole digital has gone through a step change. So what we are doing is, of course, keeping all of those but upgrading them or changing them to fit for the next generation. Under the commercial excellence program, we're also going to look at the brand. What does the Lennox brand stands for? Does it appeal to all consumers, including some of the dealers nowadays, who are culturally different than what some of our historical dealer base had been? So there's a lot of work to be done, but the core thesis holds. We have a huge opportunity to expand geographically. We have a huge opportunity to expand in the multiple price points. We also have a big opportunity to go after the smaller- to middle-sized dealers because, historically, our strength has been the larger dealer. Putting it all together, along with the products, we are pretty excited about the share gain opportunities. But capacity is sort of necessary but not sufficient. We need to address that. All of the previous efforts failed and has failed because we didn't have enough capacity.

In the supply chain and kind of broader labor-constrained environment that we're in, is it hard to sort of push forward on those initiatives? It sounds like capacity needs to come first. But any of them sort of require material and people? Are we kind of at a point where you can move forward on that? Or do we need the air to clear a little bit?

Sure. I mean I think we're ready to move forward. Once again, we need to make those investments in the business to continue to propel it forward. We're making those investments not just because we have a problem at Stuttgart, but we need additional capacity really across the enterprise to support demand. That's a high-quality problem, so we can solve that.

This is a new normal, and we are ready, yes.

On the sourcing front, and I know the industry is mostly comprised of source material from other folks. I think Lennox got $30 million to $40 million, give or take, a year every year for the past decade, if I remember the December analyst meetings correctly, which added up for big numbers. I guess in a world where it's much harder to source, especially if you want to go farther away, is some of that sort of clawed back on? There are other considerations besides price, and we're actually going to have to see some of that, but we'll get more availability, and thus kind of regain share or take share. Like how do you guys think about sourcing kind of in this new environment?

Sure. On sourcing, we have a huge opportunity in front of us. First is like we single-source to many of our products. 75% of our spend is single source, which puts us in the back foot when it comes to any supply chain issues. So we need to flip that, and we need to get to like 80% of our products being dual sourced, just to give you like a structural answer to that. At the same time, I believe when I look at actually net cost reductions, they're not growth, right? I mean I think on net cost, true cost of ownership. We have an opportunity to improve that well and put more to the bottom line. Because when you have 2 sources, when you have them closer to you and when you don't miss out on a single fail because you didn't have the $5 part, you're going to win for shareholders overall. I'm actually very confident that building supply chain resiliency comes hand in hand within cruising our bottom line and top line and get to the overall savings. So that's a path that we are on. It's similar to what we have done, but we're more focused on true cost of ownership and truly looking at what's the net bottom line impact versus what the gross material productivity.

Got it. That's helpful. And I guess, flipping over to the commercial side of the business. You talked a little bit about some of the issues you guys have got at Stuttgart and the investments that need to be made. I guess over what time frame do you think you can remedy that? And how should we expect that to trend in the second half here?

Yes. Once again, it's been a bit of a bumpy ride in our commercial business. But once again, the clouds are parting, so we've solved the issue in the manufacturing facility around headcount. So we've got adequate headcount in the plant. Now it's a matter of just getting them productive. So train to productive typically is a 90-day window, and we continue to be challenged with the supply chain. But as Alok mentioned, building that resilience seen in the supply chain will help alleviate some of that. As we look for opportunities to buffer the supply chain, we may make some investments in inventory as we finish off the year here to give us a little bit more ability to produce product a little bit more predictably than what we have in the past because the supply chain issues change, so it's not always the same issue. And just the variation and the volatility it creates in the manufacturing facility is something that we're obviously very motivated to solve. And what it all translates into is a $100 million opportunity over the next 3 years for us to reinflate that business to the margins that we would expect, which would be between 18% and 20%.

Is that a linear relationship? Because it seems like with headcount solved and these folks getting more productive maybe by the end of the year, like is that a bigger step function move sooner than something that sort of takes the full duration to get to that rate?

No, I think the way that I would think about it now is it's probably going to be equally distributed over the next 3 years. Once again, contingent upon what happens in 2023, but we're building that into the plan.

Got it. That's helpful.

We hope to do better, but that's a good assumption.

Right. Fair enough. On the price cost front, I mean something that's very topical right now for everyone that buys any metals, HVAC industry is certainly being big in that. How should we think about sort of the cost deflation potential here based on what we've seen with things like spot rates? I mean on one hand, raws are not the majority of your purchases. So you get some relief there, but you have a big pool of cost that is probably still flat to maybe up materially depending on what it is. Does that net out to kind of a net deflation? Or is that something where you're still going to have to sort of enforce price pretty materially over the next kind of 6, 12 months just to keep where you're at?

Yes. I think net-net -- I'll give you the punchline first. Net-net, we're going to be more price cost positive in 2023 than we were in 2022. That's with commodities where they are today. Now things change, and we learned that things can change quickly. But our expectation would be is we have a very nice carryover price benefit in 2023, and we'll institute new price increases as we embark on 2023 with the magnitude of those increases contingent upon how component costs and commodities are behaving.

Terrific. I know we have a couple of minutes left. Any questions from the room? Great. So one more from me, kind of sticking on the pricing front. I mean the industry has been pretty crazy on price in terms of how much you've been able to take collectively, not just Lennox, but everybody. Are we at a point today where you need more price based on what you see today? I mean I know the industry sort of asked for more every year because they ask for more every year. But going through what we've had the last kind of 9, 12 months in terms of really toward price increases, are we kind of hitting our stride for maybe the short to medium term on needing more?

Sure. I'll take that. I don't think so. I mean if you think about it, there are lots of changes happening in the industry, and all of that requires a lot of investment. But if you go down to the bottom line, our ROS hasn't expanded dramatically despite all the price actions we are taking. So -- and that's true for the industry overall as I said as well. Sometimes even margin expansion because of self-help stories but not because of price cost dynamics. I mean all these changes, whether it's the new references coming up in 2025, more heat pumps and all of that, all of that requires a different level of go forward and putting together manufacturing. So right now, price is keeping up with inflation this year. I think next year, we are looking at a situation where maybe there's some benefits of commodity goes back, but things are so unpredictable. What I like about the industry is that in the top 4, 5 players, we fight on innovation. We fight on availability. We fight on branding, and we realize that fighting a price is useless. That's not going to let anybody benefit.

Perfect. Well, I see we're coming up to time. Alok, Joe, really appreciate the time. Thanks for joining us here in person, and thanks to everyone in the room for a good first day of the conference.

Great. Thank you.

Thank you. I appreciate it.