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

All right. So we're going to continue the day with a presentation by Lennox. Same situation here, fireside chat. We have Alok Maskara, CEO. He's been with the company since May, prior to which he served as CEO of Luxfer Holdings, and before that, nearly a decade as President of several different business units at Pentair. So I think Alok has a few opening comments that he'd like to make, and then we'll get the fireside chat started. For anyone in the room, please feel free to raise your hand, get my attention, I'll kick it over to you, and you can ask your questions. If you're listening via webcast, feel free to e-mail me any questions that you have. So with that, Alok?

Great. Thank you, Nicole. Great to be here. Thanks for having us over. And I hope you guys, if you were in the room previous to this, asked all the difficult question to nVent and Sara, because Sara and I worked together at Pentair, and I wanted to [ second ] ask also some difficult questions, but let you pay me back in kind. So anyway, this is for Lennox. Thanks for joining. My CFO, Joe Reitmeier, could not be here. So apologies. He's dealing with some medical challenges related to COVID, but is recovering just fine, and everything is all good. I want to say that just so that there's no rumors starting. When the CFO is missing, people start rumors. I've been with the company 6 months, which means I'm done with my probation period now. So if you have any more difficult questions, we can go through that. From a company perspective, we are doing well. As we have previously mentioned, we are looking towards a good close to the year. Q4, as you know, is seasonally our weakest quarter, and we are taking the opportunity to work through all sorts of CEO transition challenges, both from a factory and inventory and all of that, but no changes compared to where we were in the past. And we are excited about 2023. From a '23 perspective, we do expect Residential volume to be down year-over-year, primarily driven by new home construction slowdown, but also possibly somewhat related to consumer confidence and renovations and everything else that you read about in the Wall Street Journal and other places. Our goal as a company is to deliver revenue growth, EBIT growth and EPS growth despite the volume challenge that I just mentioned. So we are looking forward to giving you guys more details and a guidance range when we host our December 14 Annual Investor Day. So a little advertisement, so come listen to us on the Investor Day on December 14, right here in New York. Beyond that, the first 6 months have gone in like a whirlwind tour, tour of all our facilities, tour of all our investors, meeting some of our dealers. And the 3 things that I wanted to summarize on my learnings for the first 6 months is, first of all, this is a great industry. I really appreciate being in this industry. It's a growth industry. We continuously innovate. It's a disciplined industry, strong competition but disciplined competition, and the tailwind from macro are with us and will remain with us. So first thing we really want to emphasize, a great industry. Second, for Lennox, we have significant upside. Being one of the smaller players among the larger 4, 5 players as you measure the industry, we look at significant upside, upside from a market share perspective, upside from innovation perspective, and upside from a margin perspective, margin perspective because we are primarily North America based. So we should have better margin than our competition who may have dilutive margins when they focus more on some of the global markets. And finally, the third message for us is, coming back to as we look at it, we are well set from a regulatory transition perspective, from a change and innovation perspective for the next decade or so. So while each quarter is hard for us to predict and give you guidance on, I feel more confident telling you how we're going to do in '24 and '25 versus what I feel in '23. So as an industry, as a company, our strategy is well set. There's not going to be massive changes that you should expect from a new CEO. But there are going to be tweaks. There are going to be modifications. There's going to be things that will ensure that we meet our goal. I'm only the sixth CEO in a company that's been around 127 years, and each of us as a CEO had one simple goal, which is going to be to leave the company better for the next generation, and that will be my goal as well. So with those opening comments, happy to take any questions.

Perfect. So maybe let's start with a little something around supply chain and then we'll kind of move on to each of the businesses in succession. So with respect to supply chain, can you just talk through the situation in a bit more detail? Are you seeing any signs of improvement? And maybe from a component perspective, where are you seeing the worst bottlenecks and where are things maybe improving a little bit?

Sure. Supply chain right now is like playing a game of whack-a-mole. Every time we think we have addressed the issue, something else pops up. But if I take a broader view and say, pre-COVID, out of our 3,000 or so parts, maybe 30 would be on critical escalation at any given point, which means that those 30 were critical for production tomorrow, production next week. So were in that situation. During the worst of COVID supply chain, that number used to be around 200. So there'll be 200 parts that we would be shut off, and if we didn't get within a week or a few days, we would have to stop production. That number has come down from 200 to like 120 or so. So it's moving in the right direction. We're nowhere close to 30, which is what was the number pre-COVID. But we're trending in the right direction. We are making progress. If there are component shortages, it's moving away from some of the semiconductor and microchips. Kind of those, we have done a good job of working through for the past 12 to 18 months, building backup plans, having secondary suppliers. Now it's moved towards things such as inverters, some [indiscernible] variable speed motors, drives, things like that. So we are working through all of those, but it's like whack-a-mole. I wish whatever answer I give you today on what we are short of, I know it will be a different part tomorrow, so.

Understood. So back to the hot topic of residential HVAC volumes, everyone's favorite topic at the moment. So you acknowledge that it's quite possible that volumes are down in 2023. I think most people in this room would agree. If we kind of look back into the history of the industry, the normal outcome is kind of a mid-single-digit decline in a bad year for resi HVAC. Do you think there's a scenario where it's worse than that because of this element of potential COVID pull-forward of replacement demand?

I don't think the pull-forward of COVID demand even existed. And even if it existed, I don't think it changes the demand tomorrow or next year or the year after. What happened during COVID is units were running 25% to 30% more. So all it did is if you're a 17-year life unit and if you're running more, you became a 16-year life unit. So even if you pull forward demand from '23 to '22, we also pulled forward demand from '24 to '23 and '25 to '24. So don't expect a steep drop next year, right? And by the time we are done with the lifespan of the unit, given the huge curve that we have in there, it would not be an issue. So from that -- now units are still running about 10% to 15% more than they ran pre-COVID. So that 30% hasn't gone down to 0. Partly, there is a lot more work from home still going on. And there's also just warmer temperature. I mean temperatures have been warm. I mean, this summer was extraordinary hot in most of the regions. So the pull-forward, I put it aside as there's going to be some impact, but that's more about life cycle getting shorter. I don't think anybody whose unit was going to break next year decided, oh, let's replace it now. Our favorite saying is, nobody wakes up on Sunday morning and says, "honey, let's get a new HVAC unit today," right? Most people don't even know what HVAC they have at home. So that's one part. Second, if I go to the main part of your question, yes, I do think units are going to be down next year, mostly driven by new home construction. So we break our demand into RNC and replacement. New home construction is 20%, 25% of industry sales. If that's down 20%, you can do the math, we should be down 3% to 5%, depending on your exposure. The replacement demand holds pretty steady even during a downturn like the financial crisis. There's going to be some people who will choose repair over replacement. So that's the piece we watch out for. So I think the units are going to be down. I don't think it's -- based on what we see today, I don't think it's going to be catastrophically down and is similar to what we have seen in the past, mid-single digits.

Okay. Okay. That's clear. And with the repair versus replace dynamic, have you started to see any of that come through with the weaker consumer confidence? Or is that something that you're expecting to see as we go through 2023?

We haven't seen any signs of that yet, but we constantly watch out for it, along with the rest of the industry. It could happen. It's very much a possibility. It's usually a small portion of the replacement because if you had a major component failure like a coil or a compressor, the dealer will do a good job convincing you that even if you replace the item for $2,000, you'll be back in the market for the full unit within a few years, so I think that's it. Second thing, keep in mind, the cost of repair has gone up higher than the cost of new units because of labor and parts. And finally, with the new units, you get a warranty, you get financing. In many cases, you're going to get a government incentive like the IRA rebates, things like that, which you will not get in repair. So those things should shift more towards replacement. There'll be some shift that's going to happen, and that's the one we are going to watch out for.

Okay. And I guess what complicates this even further is the SEER standard change that's coming. So I guess how does that factor into your thinking with respect to industry volumes? And does it change seasonality? Does it change the way you approach stocking the dealers? Any comments there?

I don't think it changes the industry volume, the SEER change, because most consumers don't think of the SEER change as part of the decision factor. I think things are going to be different in 2025 when we go through the reference rate change. But let me stick to the SEER change, Nicole. From a SEER change perspective, what's going to happen most likely is you're going to see a mix benefit because everything is higher SEER. So there's going to be price/mix benefit of that. We don't go as much through distribution channel, but there probably could be some inventory challenges. There may be too much inventory at the beginning of the year. It impacts us less, but I can see that happening because everybody want to make sure they are prepared for the SEER challenge. And that's normal, the typical rips of the supply chain that you might see. But net-net, for volume for the full year, I think the impact is going to be minimal. But in Q1 or so, there may be some inventory or sales disconnects as people work through the excess inventory or move things from south to not or bring their inventory back to normal level, expecting demand to be what it's going to be in '23, so.

Okay. But Lennox feels good about your channel inventory positions until you have more control, right?

We do, since we go directly to the dealer. Our dealers, at best, may have one garage full of inventory. I mean none of them have big warehouses to keep inventory on. So at the best, the garage might be full, but that's the extent of it. We do have Allied business, which goes to 2 steps. So we do monitor that. And if there is a pullback, we think it will be some time next year. But for us, the impact is going to be minimal.

Okay. With respect to pricing, so could you possibly give us a sense of the carryover pricing impact in 2023 from the actions that you've already taken throughout 2022? Let's start there.

Sure. So on a broader level, I think the 3 price impacts we'll see, Nicole, next year, one is carryover pricing. One is the impact of mix or price, whatever you will call it, because of the SEER change, and then just a typical annual price increase. So I think those will be the 3 impact. From the carryover, hard to give an exact number because it varies by commercial versus residential. But on the residential basis, it should be a low to mid-single digits carryover. A lot of the price increases went through midyear, some went through early in the year. And that will obviously start off with a higher number in the beginning of the year and then come down towards the tail end, but I think it's going to be low to mid-single digits on the carryover pricing. On the SEER change, I expect, again, a low to mid-single-digit benefit of the mix change pricing. We still have to work through some details on that. And then finally, I would expect a low single-digit benefit on just the annual price increases. A lot to unpack and put it all together. In some cases, they kind of overlap each other. It would be hard to pull that together.

No, that's super helpful, though, to help us frame it. A lot of moving pieces next year, of course. When you look at your own P&L, have you started to benefit from falling commodity costs? Or is that still to come?

It's still to come. Before that, I do want to go back on the SEER change. I said mid-single digits, but realize that the units for higher SEER, they're going to be priced about 10% to 15% higher. And that benefit to the P&L will be lower because of how many units we sell at what different pricing. I just want to clarify that because in the past, we have said and -- that we would expect 10% to 15% price increases every unit that's on higher SEER. On the commodities versus components and overall, it's yet to come. We have seen commodities starting to come down, but the components are still inflationary because often our contract for components is indexed back and it's backward looking for up to a year in some cases. So if you pull that together, I would expect it starts next year.and accelerates -- the benefit accelerates towards the second half when both components and commodities should be favorable to us. The beginning of the year, components would be inflationary, commodities would be deflationary.

Okay. Okay. Got it. And what about things like labor and freight?

Hourly labor is now getting flattish. So I think we had stopped seeing the huge inflation we saw in 2020 and 2021. Salary, we would still expect low single digits going up, similar to everybody else. And freight, I think, becomes a tailwind. So I think labor overall will be slight inflation and still going on. Freight should start becoming a tailwind for us. We are seeing freights come down, both from regular lane rates, but also from avoiding air freight. So I think there should be 2 benefits on that, so.

Okay. Okay. Perfect. Just want to shift to margins within resi HVAC. So that was probably the biggest piece of surprise in 3Q, I think, relative to expectations, margins a bit weaker. Can we just talk through what happened? And then understanding that how you're kind of thinking about the fourth quarter for resi margins?

Yes. Q3 margins were not normal, and we don't expect those margins to remain over the mature resi business in the long term. Few different things drove it, right? First of all, we remain short on high-end products like the Dave Lennox Signature Series. So product mix was negative. Second was from a customer mix perspective, we had more residential new construction sales. We were working through the backlog of RNC sales. So customer mix was a little negative as well. Finally, we had lots of high-priced components that we had spot purchase in Q1 or Q2, chips and micro [ in AHU ware ], those costs were hung up on the balance sheet. So as we sold those units, they are flushing out of the system, which is a very technical accounting reason, but that's the way it works, unfortunately. Good thing is, all of these things are infinitely predictable. We should have good insights, and we do. So we know that starting next year, that starts turning to be in a better situation. Most of these inefficiencies and mix impacts will wash out in Q4. So there is impact in Q4, but starting next year, we don't have any.

Okay. Okay. Got it. Putting all of this together, your thoughts on potential volume decline, but then you have pricing tailwinds. We've got the SEER standard change that factors into all of that. It seems to me that if I take a step back, you could still deliver resi HVAC segment margin expansion even with falling volumes. Is that a crazy assumption?

It's not a crazy assumption, but I also want you guys to come listen to our Investor Day on December 14. I don't want to give away all the secrets right now. I think if I take a step back, for Lennox overall, besides the resi, the Commercial margin improvement is also important to us. So today, we feel like between resi and commercial as a portfolio, we would have greater revenue, greater EPS and greater EBIT next year. So I think from that perspective, if you -- the resi versus commercial dynamics, we're still flushing through. I think as we go through October, November, putting all the results together, we should have them. It's not a crazy thought, but I can't comment to that either right now. I think we just need to work through the extra 3, 4 weeks we have, see where we are and better understanding of how Q1 is going to shift for us.

Okay. Totally fair. I'm going to get to resi in a second. I do want to ask you about that, but a couple more on resi before we move on to Commercial. So I guess how many points of share do you think the resi HVAC business has lost over the past several years? And what's the plan to turn that in the other direction?

Yes. So in this industry, shares are hard to move, as you know. But we have lost, starting with the Marshalltown tornado, share, which is very disappointing and we need to work through it. I won't give you an exact basis point or exact number because it does vary by how you measure it, what units include that. But let's just say our sales would have been 8% to 10% higher if we had not lost that share, right? So I want to plug it back to us in terms of what sales number we could have expected from a volume perspective. So if you have not lost the share starting the Marshalltown tornado, you would have had probably 10% more resi sales today than we have right now. I think that's the way I think about it. The plan to get it back is multi-step. A, it won't happen overnight. So just to set expectations, just like it's hard to lose share, it's hard to gain share as well. We would go back to some of the things we have done really well, which is expand geographic coverage. Our coverage in the South is still quite low. It may or may not depend on just storefront opening. It's more about how do I get the dealers, the product within a few hours. That could be done through milk runs, that could be done through distribution outlets and it could be done through physical outlets. But I think you're moving more towards digital plus physical in how do we optimize the network. Because we did train our dealers not to come into the store during COVID. So I think that's something we got to take appropriate consideration for. So that's going to be the first part, geographical. Second for us is heat pumps. And the new heat pump technology allows us to sell more heat pumps in the north, which is where we have greater share. So having that technology and being underpenetrated in heat pump, given our sales footprint in the north, and I put heat pumps along with like mini splits and all the other products. We just have under penetration there. So getting that up to the industry standard and slightly better, that's a whole product category for us to truly get share because we can be underpenetrated in the categories that are growing better. And now we have the technology to do that, right? And finally for us is going to be the combination of residential and commercial and getting our dealer loyalty back end. Since the tornado and otherwise, our dealers have had to often buy units from others because we didn't have them in stock. So getting that loyalty back and going back to what we've always done best, to serve our dealers and serve them with the appropriate support, the program, the digital footprint, getting them the ability to win and grow their own profits, so I think that's going to be a reemphasis on our -- cultivating our dealer network. So geographical, product and focusing again on our dealers with appropriate service levels.

Got it. Okay. Clear plan. Heat pumps, I did want to hit on that a little bit. Obviously, a big topic right now. Any thoughts on quantifying the potential opportunity, especially with IRA implementation? And just, I guess, do you feel good about your product offering now? Or is there more work to do?

We feel better about our product offering right now. Now some of the products which we talked about, they're going to be launched next year. That's an all-climate heat pump. So we are working through that. Industry is growing rapidly. If you see the recent AHRI data that just came out, heat pumps are growing 25%, 27%. So we're actually growing with the industry rate on that. What we do have to do is catch up for what we didn't grow in the past. So I think we caught up to the industry growth rate. We just tie with a smaller base compared to others. So we feel good about our product offering. In some cases, it's going to be moving our production capabilities. We need to make less furnaces and more heat pumps. I think that's just a manufacturing dynamic that we need to work through. I think the potential is huge. I won't give you a number, but in the South, 30% of the units sold today have heat pumps. At some stage, it's going to be closer to 80% to 100%. Now that could be a decade or 2 decades away. But remember, Lennox has a strong history of innovation. We started with oil fields furnaces being made in Marshalltown 127 years ago. These were cast iron furnaces, right, to where we now have the most efficient gas furnace with 99% efficiency, [ 20th CRA ] provisioning, and we are fully prepared to go through the transition. We are now working with hybrid systems on heat pumps, where if you are in the northern cold climate, in spring and fall, you can still use the heat pump, but in cold winter where heat pumps don't work, you still have a gas furnace back up. So I think we're going to go through that step transition. So we feel good. We don't feel great yet. I think we'll feel great when our numbers start showing better, so.

Okay. Fair enough. I'm just going to pause. Any questions from the audience? Okay. So continuing on with Commercial. Can we just maybe talk through the actions that you're taking to improve the profitability of the segment, Alok? I know that's been something that you've talked about as a key focus.

Sure. I think Commercial, I won't go into how we got here, but that's -- was not how Lennox operates. This whole setback in commercial should never happen again. The fourth step process to improve our commercial operation, first for us is fix our factory in Stuttgart. Labor was a big challenge. Now we are up to the labor levels we need. Our attrition has gone down. Our hiring has picked up. So we are pretty stable. We've added 35% more people. Just to give you context, that's hired 700 people in a small town, Arkansas over the past 4, 5 months. So we have done that, and we feel like we have reached the optimum labor level. What we have not done is increased production to the same amount. Our production is up only 10% to 15%. So think of that 20% is just inefficiencies in the factory that we need to resolve. So that's the first step of our production improvement, right, if you go through that. Second, beyond the labor inefficiencies, we still have inefficiency related to supply chains and just process deficiencies that have remained since past few years. Going back to everything like having dual supply, making sure we appropriate lean processes are there, quality. Some of our lines were running at a first-time-right quality rate of 15%, 20% versus the 90%, 95% we should be. So just working through process improvement and supply chain and factory good operations, so that kind of step-through. Third for us is share/revenue because today, our backlog is higher than our annual capacity. So I think that's the reason we look at the new factory. But just working through that, and additional volume, of course, drops through well for us. And the fourth factor is the new factory, which won't be fully online until '25. So we start in '24, but it will be ramping up and '25% when we start seeing the production capacity. That's why the 3-year plan, to get through each of those 4 steps. Let's fix our labor productivity issue. Let's get the factory from truly supply chain and efficiency perspective. Let's win back share. And I haven't counted all the share win-back immediately. So we just counted some. And then finally, the new factory, which is going to have 80% lower cost than the current one. So that's kind of the 4-step process to fix Commercial productivity.

Okay. Okay. Very clear. And I guess, thinking about your stated target of getting back to 18% to 20% margins in that 3-year time frame, is it kind of a linear progression that you're expecting with -- or is it more back-end loaded because of when the new factory opens, share gain, et cetera?

It's not back-end loaded. I think we should assume linear, and let's hope it's front-end loaded. So that's why I tell my Board that I want us to tell you guys say, okay, let's assume linear. We can promise you it's not back-end loaded. But let's see if we can make it front-end loaded, so.

Okay, I like it. We all like front-end loaded in this room, that's for sure. So that's pretty much all I had on Commercial. We're running short on time, so I want to keep moving along. Just maybe to touch on Refrigeration, quickly. Segment margins are -- have actually been really strong in Refrigeration, nice year-on-year improvement. We think that they're likely to return to prior peak [ levels ] in 2022. Is there further upside potential to refrigeration margins?

Yes, there is. I mean if you think about Refrigeration, there are a couple of questions that we addressed, right? And so I always start by saying, what's our entitlement margin? And as a company, we should be much higher margin and Refrigeration becomes a drag. So if you look at it from Refrigeration, there are 2 aspects to it. One is the Refrigeration business in U.S, and what is the Refrigeration business outside the U.S., right? I think our margins in the U.S. are actually much better, and we have sort of, I think, improved that. The margin in Europe are also improving, but not as much. In the U.S., we are #1 in the area we saw. In Europe, we have small niche positions and the scale there is a bit challenging for us. So we look at Refrigeration overall as significant room for improvement, but we do look at it as a tale of 2 halves and where we can improve more. The team has done a great job. I mean I applaud the team for getting the appropriate pricing, the factory. If you go to versus a few years or a few months ago, is continuous improvement mindset. Our customers appreciate our technology and our support. So I think there's a lot of upside here still to come.

Okay. And when you were talking about Europe having a niche position there, it just kind of struck me. Is that a business that Lennox needs to play in with a niche position? Or is there a potential for it to become more than a niche position?

There's still work to be done there to try and understand. And within that there, there's lots of different optionalities we'll be looking at. I think if you take a step back, so 95% of our revenue and near 100% of profits come from North America. So we know where we need to focus to win. I think I always look at this from the [indiscernible] aspect as we're a very focused company. We are more focused than most and we will continue playing where we have higher chances to win.

Okay. Okay. Fair enough. On the topic of recession playbook. So let's say things are worse than expected. Volumes are down across your businesses, more like a traditional global recession. If that takes place, you're new in the CFO -- CEO role, what's your plan?

I think that, first of all, in those cases, I lived through the housing crisis of 2007 and '08 in the Residential business where volume dropped 30% almost overnight. And at that point, I shut about 30% of our factories. Later, there were days where we laid off 1,000 people on a single day. So that's not going to be inconsistent with what our playbook here is going to be. First of all, we don't have to shut factories because we have really large factories. This way, it's pretty straightforward. But our playbook would be to manage the decremental. We need to hold the decremental to about 1/3. I may not be able to do it on a same-quarter basis. But within a few quarters, the key is to get the decrementals down. Majority of our costs are variable, anything from material and labor. And so -- and then we got to appropriately adjust the fixed costs. We just also have to be careful that we don't get in a situation that happened at COVID where us and everybody else went and laid off 20%, 25% of the people and then, for the next 2 years, struggled to get even 10% of them back. So I think that's going to be the balance. But we have a bias towards action and we are biased towards taking cost out immediately.

Okay. Okay. Clear. Just shifting a little bit to free cash capital allocation. Every company in this space has struggled with working capital this year. What are your thoughts on the path to working capital reduction in the coming quarters?

I think we are getting healthy on working capital. So last year, we generated more cash because our working capital went down, our inventory was low, and that hurt us. That hurt us from an availability perspective. Now ideally, you want low inventory and high availability. But absent that, you definitely want [indiscernible] maintain availability. So I think level now is an adequate position. I don't expect us a significant pullback in inventory. There will be some adjustments where our raw material inventory should go down. Our finished goods are probably going to go up, especially on the high end units. So we should be back to a standard -- over a 2- to 3-year period, we actually back to where we at least had 1 year of extra cash flow generation as we didn't have enough inventory. And this year, we had low cash generation as we build back our inventory. The other piece you have to keep in mind is we are investing $125 million, $150 million in a factory. That's CapEx, and I [ don't question ] working capital. That will impact our free cash flow for the next couple of years as we put that investment forward. But as a company, we convert 100% of our net income into cash, and we'll continue doing that. When these big investment opportunities come in, we'll be upfront with our shareholders, let you guys know where it is. So the next 2 years, of course, is going to be less than 100%

Okay. Okay. Clear. Last question for you. How should we think about capital allocation priorities? Any changes with you at the helm?

No, the strategy remains the same. It's going to be no changes. We will not be sitting on balance sheet. We will not be doing any big acquisitions, but we will probably want to put more emphasis on bolt-on acquisitions. If the economy softens and -- which we all do and if the valuations are more appropriate. We have a healthy balance sheet. We have a good cash flow situation. So we will always evaluate it versus share buyback. We'll always evaluate it on what's the right thing for the shareholders. And we'll always look at it, does it further our stated goals, which are let's gain more market share; let's focus more on North America; let's get bigger in the growth areas, whether it's heat pumps and mini splits and things like that. So we look at all of that. These are going to be more bolt-on nature. So we like to do more, but there's nothing imminent. Don't wait for announcement anytime soon either. Just want to signal that we'll be open to it and look for more, especially if the market and the valuations turn favorable.

Sure. Okay. Well, we'll go ahead and stop there. Alok, thank you so much for your time today. It's great to have you here.

Thanks, Nicole. Really appreciate it.

Thanks.

Thanks.