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

Good morning, everybody. I'm Tim Wojs. I cover building products here at Baird. And we're very happy to have Lennox International join us again at our Global Industrial Conference this year. Lennox is a leading provider of HVAC equipment for the residential and light commercial markets here in North America. From the company, we have CEO, Alok Maskara. And then we have Steve Harrison, who runs IR, and I think he's in the audience up here. So we're going to start with a couple of prepared remarks from Alok, and then we'll hop in the queue. And if anybody has any questions, in the Q&A session, feel free to raise your hand or you can e-mail [email protected]. So with that, I'll turn the floor over to Alok.

Great. Thanks, Tim, and thanks for having me over. I just have 2 slides to kick it off and happy to take questions after that. First of all, from introductions, I'm Alok Maskara. I've been the CEO of Lennox for 6 months. So finally, get done with my probation period. And the reason my CFO, Joe Reitman, is not here, unfortunately tested positive for COVID. But if you have detailed financial question, I'm all prepared for that. Just a few things about Lennox. I see quite a few familiar faces, but I do see some new ones, so I'll just give you a background. Lennox, long legacy, great storied history, started in Marshalltown, Iowa, 127 years ago, and has been in the business constantly evolving started as an oil furnace maker, went to gas furnace. Today, we sell air conditioning, heat pumps on the top 3, 4 players in the HVAC industry in U.S. You can look at the financials. Over the past 4 years, as we look at it 5 years, you can see revenue has been up 5%. EBITDA has been up 5%. EPS has been up 13%. This is every year numbers. So a good strong financial performance. If you look at it from the size of the company and from -- we have 11,000 employees, mostly all in U.S. and Mexico, and strong ROIC. Again, our ROIC is something that we are very, very proud of, just shows disciplined use of capital on our part. From a business mix perspective, we report in 3 segments: Residential, Commercial and Refrigeration. You can see on the screen, the Residential is the largest, both from a revenue and profit perspective. And Commercial needs to do better, better from a profit perspective. And Refrigeration is just small, both from revenue and EBIT, but where we are. From an overall end markets, you can see we are primarily a U.S./Canada based company, a little bit of revenue from Europe, not consequential from EBIT or revenue perspective. And from an end market exposure, 75% of our revenue comes from replacement demand, which gives us a lot of confidence and should give you a lot of confidence as we go into more economic turbulence times next year, where people are concerned about sort of the economic impact on our units. So that is a quick one-page snapshot of who we are. As we look at a little bit more details, I look at our business fundamentally has made up of 7 different business units that we consolidate and report out externally as 3 segments. So let me just give you color behind these 7, starting from the top. So in Residential, the largest unit is what we call our Lennox unit. That's a direct go-to-market business, a unique value proposition compared to anybody else in the industry, which means we have our own 260 outlets. We don't have a distributor in between. We think it's a better business model and positions us for long-term growth. Especially in the digital age, we don't have an intermediary that we have to deal with. We deal with dealers direct. So strong value proposition, lots of opportunity for us to grow that franchise. Next one for us is Allied. Allied is our distribution-based business. This is where we do not use the Lennox brand. We would use a bunch of different brands, sort of competes with ICP of the carrier enterprises. And here we go and go to market through distributors and have about 1,000 different independent smaller distribution outlets. Very few of these are larger consolidated distributors. Most of these are smaller distributors, independent family-owned distributor type business. And then we have ADP, Advanced Distribution Product. This is essentially where we make coils, heat exchangers, typically used for people who are assembling units in the field or for replacement products. So think of this as our replacement type business and making independent nonbranded coils. We are the largest maker of these products, and we make it in Grenada, Mississippi and good business. So that kind of makes up our residential segment. Next one is Commercial. Within Commercial, we have sort of 2 business units. One that's struggling right now is the rooftop equipment business. We manufacture this in Stuttgart, Arkansas. If you don't know Stuttgart, Arkansas, it means you are not into duck hunting. If you were in duck hunting, you would know. The only reason the factory is probably there is because many years ago, somebody was a fan of duck hunting. It's very hard to get labor there, and that's been one of our challenges. We recently announced opening up a second factory for that in Saltillo, Mexico. And we have taking care of some of the labor issues there, where we are now fully stacked in that factory, lots of room for improvement there. Second portion within the Commercial reporting segment is our NAS business, our National Account Service. This is, again, a fantastic business, smaller than what we want it to be, but it's growing rapidly. The business has quadrupled over the past decade. We have 700 field technicians, where we go repair, install units for key national accounts. National accounts like Lowe's, Amazon, Walmart. We give them a one-stop shop where we'll sell them unit, we'll service the units, we'll maintain the units, we'll warranty the units, we'll guarantee that we'll be there within 4 hours if the equipment breaks and provide an end-to-end service, a strong, strong value proposition that nobody else can provide. It's a beautiful business for us. The last piece, Refrigeration, I look at that as 2 business units. One is Heatcraft. Heatcraft in North America, very strong business unit. We are #1 in the market. We do very well in this. We supply equipment, refrigeration equipment to OEMs manufacturers who might be doing a grocery store, freezer room, a restaurant freezer room and got some good synergies actually with our rooftop service businesses on the Commercial side. So that's kind of the Heatcraft. And then we have our European footprint, which is a mixture of 2, 3 small business units. And that's primarily focused on process cooling, some refrigeration and some European HVAC. So that's a little bit kind of pulling the covers on what makes up Lennox. Overall, a very strong portfolio, a very attractive business, and we are excited about 2023 and beyond. With that, happy to take questions, and Tim may have the prepared ones or if the audience sends any.

Yes. No, perfect. Thanks for that, Alok. [Operator Instructions] So Alok, you mentioned you've been with the -- I think, tomorrow is your 6-year anniversary?

That's right.

Or 6-month anniversary. So I guess any kind of -- now that you've had time to assess, I mean, any sort of kind of big strategic moves or any sort of things within the businesses that you think need to be changed?

I would say the strategy remains the same. So there's no big strategic shift. From our perspective, the capital deployment strategy remains the same. The business strategy remains the same. What we need to do is kind of fix some of the ills for the past 4, 5 years. The past 4, 5 years have not been good for their business. Starting with the tornado, then with COVID, supply chain issues, we have lost share. We have lost some margin potential, and we need to fix that. And to do that requires a lot of tweaks, I would call it, but there's no fundamental shift in strategy for us. We will maintain the strategy, get our operations to recover and do better, get our market share to recover. It's a great business, a strong foundation that can grow more, and that can grow faster. I think that's where we are focused on, Tim.

And when you talk about share, I mean, it's a -- what, there's 5 or 6 main players. You're, I think, third or fourth on the resi side. What are the kind of small kind of commercial initiatives that you've got out there to kind of regain the share? Because I know it doesn't come in big lumps, but it does come in these kind of blocking and tackling type field situation. So I guess where are you putting more incremental effort to kind of regain that share without defaulting to price or something?

Sure. First of all, we would never default to price. I think the whole industry is pretty price disciplined, and we are, too. So I think we won't. From a share gain perspective, and Residential and Commercial, they are 2 separate stories. So let me hit the Residential first in and then we'll come back, talk about Commercial. In residential, we don't cover U.S. fully today, just if you focus on the U.S. We have historically grown up in the Midwest, have a history of higher share in Midwest, not enough in the South. Our market share in Florida is much weaker than our market share in Iowa. And that's where heat pumps are growing. That's where air conditions are going. So we need to expand our footprint. We've talked a lot about number of outlets in the past, and we have been slow over the past 5 years, haven't opened as many you need to. But instead of talking about outlets, we are now very much focused on how do we get more dealers in those areas where our market shares are weaker. That could involve opening outlets. That could involve more strategy shift on truly getting to more regional distribution centers. For the past 5 years, we have trained our dealers not to come into the stores during COVID. And we have got better at doing milk runs, better at doing distribution, and we're going to work through that. So first is geographical penetration within U.S. and get into those areas. That requires us to relook at our territory managers and offices differently. So we are doing that. Second is -- which maybe I should have said first is, we got to fix our production issues. We have been having production issues for way too long. I mean, COVID was not a reason for us to do worse than our competition, but we did. Some of this is fundamental, that 75% of our product today is single sourced when we buy. And we need to flip that. 75% of our purchase should be dual sourced. So we just need to take that excuse away from salespeople and from us saying that's not going to within. And finally, the technology piece. I'm excited about things like coal climate heat pump because historically, heat pumps have not been big in Upper Midwest and in the North. And with the coal climate technology, we can bring that to life. So again, it comes on to geographical penetration; truly eliminating the production bottlenecks; and finally, new technologies such as heat pump, and that goes on the Residential side. On the Commercial side, it is very much about recovering the Stuttgart facility, but that doesn't automatically give us the share gain. It gives us the ability to find share gain. And there, we are relooking at our sales methods of sales methodology and trying to tie our services together with the equipment portion to reenter the emergency replacement market; reenergize our Lennox dealer, who do both residential and commercial more; and reenter markets with new products that we are launching. So similar things that we talked about in resi, but a different flavor on the Commercial side. We have at least another 6 months on Commercial before we catch up to the existing order backlog. So we are taking that 6 months to really get our sales team back in shape to go out fighting. They become the Chief Apology officers for the company, right? We've been apologizing for not having products. We have forgotten how to sell. So we need to kind of get them back in that mode.

And on the Commercial business, with share, I mean, obviously, if you don't have the emergency replacement product that goes somewhere else and you don't really get it back. But on the national account customers, I guess, how forgiving or how understanding have they been with some of the production challenges? And has that correlated to any sort of kind of long-term implications?

We've been mostly been able to hold our national account customers, and we prioritize that. And they have been pretty forgiving because, honestly, we openly talk about it, but the industry lead times are super extended for everybody. It's not just us. If they go to somebody else, they might get a similar lead time or similar challenge in terms of getting products. For national accounts, I think they are pretty well predicted. Historical relationship remains, and we have prioritized all our production towards them. So we are grateful for their business. I don't see that because, we haven't lost there either. So I don't see that as a critical thing. The question is when can we go on the aggressive front and start adding new accounts that we don't have today? And that will be middle of next year.

Maybe just switching up to the replacement cycle. So 80%, 85% of your Residential business is replacement. And I think 1 of the biggest questions now is if we do kind of go through a rougher patch of the economy, how do we think about the puts and takes to replacement? So new construction might be down, let's just say, 20%, 25% next year. So that has an implication to units. But as you've gone back over the business through the business over the last 20, 25 years, I mean, how resilient is replacement demand in a choppier macro?

Sure. So let me start on the new construction. If it's 20% of our business, for us is a little bit more. If it's down 20%, we know we'll be down 4% units next year. So we can range bound that and plan accordingly. I think all of us are in the industry. Then on the replacement cycle, if you go back and look at the history for the past 20 years, including during the financial crisis, the housing crisis and all that, that demand has held very steady. That demand doesn't go down 10%, 20%. Maybe it moves a point here and there as people make choices to either delay replacement or use more repair. But that, what we call the AOR or the replacement demand, that's been pretty steady. That doesn't move so much. So in our scenario modeling, we have baked some of that. We think we can manage that, along with the rest of the industry players. There's going to be benefits of the Inflation Reduction Act. This benefit of the R22 replacement units, because R20 has become super expensive. So we can -- the dynamics between repair and replacement is more towards replacement. And frankly, the cost of repair has gone up higher than the cost of replacement. And the lead times on the replacement spare parts is higher than lead time on new equipment. So we don't know for sure, but we are trying hard. And so far, we have seen no signs of people choosing more repairs or more replacement. It's not discretionary, unless in a small bracket in certain areas, you have to replace your unit when it breaks. So you got to do something with the unit when it breaks. So we feel, right now, based on what we see, reasonably confident that the replacements will hold the same level as they have been recently.

Okay. And I guess when you think about the replacement cycle, I mean, if you just kind of echo boom the last housing cycle, 15, 17 years, you're kind of at what would theoretically be kind of peak replacement. So -- but then you also have R22, you have IRA, you have SEER transitions. So I guess when you kind of do all the modeling around the replacement cycle, just structurally, where do you think like annual shipments need to kind of be over time in the replacement market?

I mean I -- so if you take the annual shipments and remove the new home construction piece, which we already talked about, I see a hard -- I have a hard time seeing that number going down or backwards. It is true that the housing boom was 17 years ago, but the replacement cycle is not a 17-year cliff, right? I mean it's a bell curve. And we have already been on that bell curve so long. So I don't think it changes on a certain day where every unit gets replaced exactly at 17 years, and we have been living through that bell curve replacement demand for a while. The R-22 is a dynamic. Yes, you can put different products, but those things are just really hard to get and really hard for a consumer to say, I'm going to repair the unit, pay more. I get no warranty. I get no financing, and it might break. Something else might break tomorrow. So I think with all those dynamics, I don't see a cliff coming, I guess, if that's a question because everything goes on this curve style. Could there be a decline? Yes, it's possible. I think it's unlikely, but I'm not worried about a cliff, especially given the new technology, the units are more efficient. And they're more environmentally friendly, too. It doesn't matter to all the consumers, but it does matter to a small segment of the consumers. The IRA, while there's a lot of details still to be figured out, that gives good rebates. And there are rebates already existing. There are more rebates coming. And I think it holds.

Okay. Okay. So there's a SEER transition coming up that kind of starts in 2023. I think several different OEMs have several different strategies. But could you maybe talk about what Lennox is doing to prepare for that transition? And then how that might compare to some of your peers?

Sure. First of all, I think it's good for the industry this SEER change. And I think overall, it is designed for the right purpose of reducing the overall global warming potential. So we have no complaints about it. Second thing I'll say is we are fully prepared. Our new units are ready. We are shipping new units at this stage, like dealers are preordering. So we are fully ready. Our factories on the Residential side have made the transition. On Commercial, we're going to do that in Q4. So we are fully prepared. Our strategy has been to come up with the new units with the lowest cost possible and of course, go with the industry price and to get sure that we get the price cost delta. We've also tried to minimize change for the consumer. Our units can achieve the new SEER standard without having to replace the indoor units. You can only replace the outdoor units and get the benefit. We think that's an advantage versus some other designs where you might have to replace both of them. We know the entire industry has to redesign all their products in 2025. And we will, too, because with the new GWP coming in. So at this stage, our focus was get the best cost-effective way to get the new units. We had redesigned our indoor units, and they are backwards compatible. So as we come up with the new units, we don't have to worry about that. So I think we are very well positioned. Ours a single stage, and I think that gives us the cost advantage and the maintenance advantage to take this forward. I don't want to speak for competition. There's a lot of noise on what everybody is doing. But honestly, I think the industry is very well prepared overall. I don't expect carrier, train, us, any of us to have a hiccup in this transition. I think all of us will go through just fine in this transition. It is good for the industry. The last thing we want is the industry to have a hiccup because that impacts everybody negatively.

Right. So we talked about swing factors, maybe a little bit on the top line. As you think about -- and I know you haven't given guidance for '23 and you'll have an Analyst Day in about a month, but as you think about '23 from a margin or a cost perspective, what are kind of the key buckets that we should kind of keep in mind?

Sure. So for '23, the different headwinds, tailwinds, right? I mean, I think from a headwind, we talked about for Residential, the number of units are likely to be down, right? We don't know. Everybody guesses. But I think at this stage, just based on new home construction, I think number of units are likely to be down. That's probably my biggest headwinds. Barring unknowns, like the supply chain should be improving. So I think that's going to be a tailwind. So manufacturing inefficiency should be going away. As number of units come down, my factories who are running really hard, lots of overtime, lots of other things, lots of air freight, so I think manufacturing and efficiency goes away. The mix benefit of SEER change translated into pricing, that's going to be a positive. The pricing carryover from this year should be a positive. New price changes, which is annual price change going into '23, that should be a positive. So if you take everything I mentioned on the tailwind, that should more than offset the impact of unit decline that comes in. In addition, the commodities are easing. The components are still seeing inflation by middle of next year. I expect that to start easing. So I think my inflation starts becoming a deflation next year. So I start seeing deflation, and that should add on to the benefits doing that. In addition, because all of these was Residential, on Commercial, we clearly have our self-help program, which should add quite a few millions to our bottom line on the Commercial side. And then Commercial had the same impact or actually even better impact on mix and pricing on the SEER change. So I think put that all together, we -- as of today, I still stick with the fact that we think '23 will be a revenue growth, EBIT growth and EPS growth for us.

Okay. And you mentioned on the last call, the Commercial business today and then talking about getting $100 million of EBIT there over the next, call it, few years. What are the key drivers getting there because that is a pretty meaningful swing factor on earnings?

It is, and it's just getting back to normal. I mean that business should make 20% return. I mean, shame on us that is not making 20% return, right? So we are starting with a low baseline, hence, $100 million. But if you think of the core factors, I put that in 4 key factors on that $100 million, right? One is just manufacturing inefficiency. I mean, in a Stuttgart plant in Arkansas, some of the lines are running at very low first time output. First time yield is very low. We just need to get more manufacturing productivity. We have 35% of the plant workers are new in the past 3 months. So we are trying to get them trained, get them efficient. So that's one big bucket. Second is just pricing benefits. We have been stuck in some old national contracts that, with the new SEER chain, gives us the opportunity to go back and renegotiate or come up with new pricing because these units are not covered with the previous contract. There's a general 20% inflation since the time we signed these contracts. Now we got some of it, but I think that gives us a huge benefit of getting that innings. Third for us is just things like airfreight and deflation. I mean, we have been spending -- our supply base has been constrained, and that has impacted us quite a bit. So I think that airfreight and all that, elimination of those inefficiencies away from the production inefficiency that I talked about. Actually, it's equally big-sized number from a supplier base and fixing that. Finally, the fourth one is the new factory that we talked about. Now I hope to get to $100 million without using the new factory benefit, because the new factory is still 2 years away. But that's kind of my cushion to come back and say, I still feel confident in the $100 million. I hope I can get over the first 3. There's a volume advantage in there, built into the first 3 as well. But I mean, that's the way I look at $100 million as we should be in pretty good shape.

Okay. And what gives you -- so historically, you've had more of your kind of lower-end residential business in Mexico, and now you've kind of started to move or you're going to move commercial down there to some extent. I mean what's the driving factor behind moving some of the more complicated equipment down to Mexico and kind of gives you the confidence that, that's the right strategy?

So our strategy in Commercial is similar to Residential. We are not moving the configured to order products, the complicated products. Those remain in U.S. What we are moving to Mexico are going to be a standard product line, the radar product line. These are our fighter product lines, goes into emergency replacement. There is zero configurations. These are standard ship to order. So it's similar to the Residentials, where it's our lower-tier products targeted towards emergency replacement that we'll make in Mexico. And we have also grown our expertise in Mexico substantially since the time we put up a first residential factory a decade ago. So we believe our team is more mature. Our supply chain is more mature. So we feel very confident. We broke ground last week on the new factory. We are clearing earth. We have digging holds, putting foundations. So I think it's going to go well.

Good. We've got a few more minutes, if there's any questions from the audience. Maybe just on distribution. So 75% of your distribution is kind of owned by yourself, but then you also have the Allied brands that go through third parties. So I guess if you look at that Allied business over the last 3 or 4 years, it's actually grown really nicely. And I guess, what are the -- what's the differences today between kind of going direct and kind of trying to expand that third-party distribution element?

Yes. Sure. Allied has done very well for us. It's grown more than the Lennox in terms of percentage, a few different factors. First of all, the Marshalltown tornado that happened impacted Allied the least because Marshalltown primarily supplies the Lennox branded product. So they didn't have the supply chain disruption that Lennox had. So I think that's been 1 factor because Lennox really, really suffered during the Marshalltown tornado. And here, we make our projects, products mostly in Orangeburg in South Carolina. So that's just a practical reason. Second, I think Allied has done a really good job of taking consumer for their -- like their independent distributors who have often felt left out. As some of the larger distributors got consolidated, they were not getting attention from the appropriate manufacturers. So Allied found the right pocket or the small independent distributor outlets and has been able to win them over with products that are very unique and specifically designed to them. So easier to install. We have a product called Magic-Pak that's great for multi-unit housing. So they just found the right niche and expanded on each of those. So we think it's still got lots of runway to grow. And that gives us the appropriate balance, direct to Lennox, 260 outlets, indirect through Allied 1,000 outlets gives us the appropriate coverage and sets up beautifully for continue to gain share on both sides.

Okay. And then just a little bit left here. I mean the technology aspect, I think, kind of flies under the radar. And just owning your own distribution gives you much more of a direct connection to that kind of end dealer. So could you just talk a little bit about Lennox's technology strategy? And kind of how that can differentiate you and help you with dealer share gains?

Sure. And then technology, which I mentioned is one of the aspects for Residential share gain, we all do heat pumps very well. We all do our higher SEER units well. Where we get the differentiation is our controls, our digital controls and how we can take it to the dealer direct without having to deal with the channel in between. So if a unit is having issues at somebody's home and they have our controls and technology, we can diagnose it, send an alert to the dealer and the homeowner and us and tell the dealer that, "Well, most likely, we think it's the fan blade or the motor fan is bearing that's bad. So please take a replacement of that when you go to the home of the consumer." If I can save that dealer 1 trip, so they already have the bearing inside -- by the way, we can also tell them, yes, it's -- we have it in stock at the local Lennox part stone. So go pick it up and take it home. That's a huge game changer for them, because it suddenly saved them hours and have got them more efficient and help the homeowner get this fixed faster. That others are unable to do because they've got to work through different channels. The dealer doesn't have to struggle with, do I use a distributor app, but I do use a manufacturer app. They know they're just going to use our app, and that's a benefit for us from a digital technology perspective.

Great. We're out of time. So please join me in thanking Alok and Lennox for being here today.

Thanks, Tim.