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

Good morning, everybody. I hope everybody had a chance to mingle a bit before the start of the meeting. We'll have more opportunities to do that. Pleasure to welcome you all here. Thank you, everybody. Thanks for joining us. And I also want to extend my welcome to everybody who's joining us via our live webcast. I'm Alok Maskara. I'm the CEO of Lennox, and I'm pleased to be here, pleased to be here and share our story, share our strategy for winning, accelerating and optimizing profitable growth. Along with me, I do have our good looking, all of our executive staff. And also, we have a team of really high-performing talented business unit leaders. So you should have plenty of opportunity to meet us and get your questions answered. Let me start, as we normally do by a quick safety overview. This is for folks in this room. As you would notice, there are 2 exits, the front and the back, and you're going to use those 2 exits to leave the room in an emergency. There are no planned exercises, nor are there any tests going on. So if there is an alarm or an announcement over the PA, that's going to be real emergency. Please use one of these exits to leave the room and meet us in the courtyard, which is the meeting point for emergency evacuation. If you are joining us via our live webcast please familiarize yourself with the emergency evacuation procedures at your location. Before we begin, a reminder that throughout today's presentation, we would be making certain forward-looking statements, which are subject to numerous risks and uncertainties. For more information around our future risks and uncertainties, please see our SEC filings, which are also available on our website at lennoxinternational.com. We have a very full agenda for you today. My presentation will be followed by Gary Bedard, who is our newly appointed leader of the residential segment and then Joe Nassab will provide an overview of our commercial strategy. These presentations will be followed by a short Q&A and a break, during which you will have an opportunity to visit our showcases and freshen your coffee cup. After that, our Chief Technology Officer, Prakash Bedapudi; and our Chief Financial Officer, Joe Reitmeier will give the presentation before final round of Q&A and lunch. At lunch, you will have one final opportunity to meet our talented leader at our showcase booth. Now I'll ask our executive leadership team sitting here in the front row to introduce yourself. We'll start with Doug.

Good morning. I'm President of Residential on the way to [ retirement ].

Hello. Joe Nassab, I'm with the Commercial business. Good morning.

Joe Reitmeier, Chief Financial Officer.

Gary Bedard, President of Residential.

Good morning. Prakash Bedapudi, Chief Technology Officer.

Good morning. Dan Sessa, I lead the HR function for Lennox.

Good morning. I'm Jessica Smith, I'm the [indiscernible] in our organization.

Good morning. I'm John Torres, I'm the Chief Legal Officer of Lennox.

Good morning. [indiscernible], Marketing Communications.

Great. Thank you, team. I am privileged to work with you every day to introduce shareholder value at Lennox. I would like to take this opportunity to congratulate Doug Young on his decision to retire after 24 years at Lennox. Please join me in applauding Doug's lengthy service to Lennox. Congratulations, Doug. As I mentioned earlier, we are presenting 3 showcases designed by the talented leaders in our room. May I ask each of the leader to stand up and wave as I call their names. The growth excellence showcase is being led by Kuan Win, General Manager of our Lennox Direct business; and Angela Chapoy, the General Manager of our Allied business. The quality and operational excellence showcase is being led by Dave DeRoussel, Global VP Operations; Craig Farley, U.S. VP Residential Operations; and Miguel Gutierrez, VP Commercial Operations. Our innovation excellence showcase is being led by John Whinery, VP Product Management; Shailesh Manohar, VP Engineering; Keith Mori, VP of Control Engineering. Thank you all for taking time from your busy schedules to be with us here today. I know you are proud to share your story and what you do, and I look forward to you sharing that sense of pride with our investors. Now it's my turn to share why I am proud of being here and how Lennox's strategy will win, accelerate and optimize profitable growth. The 4 key messages that I want to emphasize today are, first, Lennox has an incredibly solid foundation to enhance value creation. We have a strong history, and we have a strong history of creating significant shareholder value, and we have significant runway ahead. Second, we are implementing near-term initiatives, which will simplify our company, streamline our portfolio and increase our margins. Third, we are establishing a robust growth operating system, which will sustain elevated performance while building our competitive advantage. And lastly, our purposeful capital deployment strategy will continue to create significant shareholder value. as we maintain robust free cash flow and maintain discipline in allocating that cash flow. Now let us go deeper into each of these 4 points. The information on this page shows that we have an extraordinary strong financial foundation. Our trailing 12-month ROIC of 41% is top-tier and reflects the strength of our portfolio, our balance sheet and our recent performance. 75% of our revenues comes from replacement which provides the company with resiliency and stability through economic cycles. The numbers on this page include our European operations and display our results in 3 operating segments. However, as we have previously announced, starting January 1, we will be reporting our results in 2 financial segments, and we intend to divest our European operations sometime next year. Our historical finances, restated for 2 future segments are in the appendix of today's presentation, and I will share more details regarding these changes in a few minutes. But before that, I want to talk to you about our core values, which remain unchanged. Integrity, respect and excellence, they are 3 simple words, but together, they represent everything that Lennox does and what we stand for. These 3 core values are supported by a set of 9 guiding behaviors, which are part of how we attract, retain and reward our talent. The value of integrity ensures that our stakeholders trust us and know that we are accountable for our commitments and that we will always positively engage with them. The value of respect means that we respect customers and talent, while sustainably impacting our communities and the environment where we live and work. The value of excellence means that to serve our customers and stakeholders, we strive for excellence in quality, innovation and superior results to win in everything we do. Our core values have been the bedrock of our foundation and provide us stability even during leadership transition. Another bedrock of our strength is our environmental, social and governance foundation as we continually improve our ESG footprint and the associated metrics. We are proud of our environmentally conscious operations and products as over 1/3 of our revenue comes from highly energy-efficient solutions and more than half of both our residential and commercial products meet the ENERGY STAR criteria. We are the leading manufacturer of the highest efficiency furnaces, highest [indiscernible] air conditioners and advanced heat pumps that work in cold climates. We remain committed to driving decarbonization by making our products more energy efficient, by promoting electrification and by ensuring that our operations continually reduce our carbon footprint. We lead and participate in industry's effort to reduce refrigerants and use newer refrigerants with low global warming potential to reduce the environmental impact of our products. We remain committed to workplace safety and strive continually to improve our world-class safety record. We positively engage with our communities and support them with volunteerism and conditions to strengthen the bond between our employees and our communities. Lastly, our governance record is impeccable. And over the past several years, we have added significant diversity to our Board to make our high-performing board even stronger. The high-performing Board continues overseeing the company with a strong 127-year-old history of innovation. As some of you may know, our innovation journey started back in 1895 when Dave Lennox founded the company, and it further accelerated when Lennox was the first company to introduce forced air furnaces in 1935 and also the first company to manufacture packaged rooftop units, for commercial HVAC in 1965. Our record of innovation accomplishments continued in 1984 when we were the first to introduce 15 SEER air conditioning products. And more recently, when we were the first to complete the Department of Energy's core climate heat pump challenge in 2022. Our innovation record of accomplishments has created multiple growth opportunities, fueled by sustainability, such as the recently launched S40 Thermostat with indoor air quality sensors and the colder climate heat pump to be launched in 2024. Our history of innovation has made us a top-tier participant in an attractive industry with good growth and good profitability. For the 10 years, between 2010 and 2020, the residential HVAC units have grown at compound annual growth rate of 4.6%, and the commercial industry units have grown at 1.7%. The actual revenue impact is higher due to inflation and price. Despite any near-term macro-related softness, we expect these industry growth rates to further accelerate during the next several decades, driven by new home construction and shorter replacement cycles. It is important to point out that we are but a small player in the larger North American HVAC products and services industry. This gives us a significant room to grow. Our growth strategy is focused on a $50 billion total addressable market, where we have less than 10% share. So we continue to have a lot of room to grow. Our growth will also be driven by favorable mega trends that will provide tailwinds for the industry. Mega trends like climate change, regulatory intervention, housing shortage and advancement in technology have all contributed to industry's growth, and we believe will continue driving industry growth above GDP for the foreseeable future. As a new leader in the HVAC industry, I am personally energized by how these megatrends will fuel growth for the HVAC industry. And I believe the replacement demand will continue to drive [ big ] resiliency for our revenues through economic cycles. It is good to be in a high-growth residential industry. Within the industry, we is very well positioned in the attractive end markets. We have sustainable competitive differentiators, which allow us to maintain our leadership position and further grow our share. The 4 pillars of our sustainable competitive differentiators are our: best-in-class products, our customer relationships, our digital technology and all enabled by our direct distribution network. Gary Bedard and Joe Nassab will both provide you with more details on how these competitive differentiators apply to their own business unit segment. So to summarize the first section, Lennox is driven by our values. We have a history rooted in innovation, and we have a strong ESG foundation. We are a top-tier performer in an attractive industry that benefits from megatrend, and we have sustainable competitive advantage that has enabled us to consistently deliver exceptional financial performance. Now let's talk about some of the actions that are driving near-term profitability at Lennox, including the recent announcement to simplify the company, generate efficiencies and increase our margins. The planned divestiture of our European operations will focus all our strength in winning and growing in North America, our core market. We believe that the European business is a benefit for another company that has a necessary scale to compete in the European market. Divesting our European business allows us to consolidate our high-performing Heatcraft North American business into the new commercial segment to simplify our internal reporting and our external reporting as well. These actions and the resulting $20 million in G&A savings will increase our EBIT margins by 100 basis points while facilitating greater management focus on growing North America share. We are confident that our new consolidated commercial segment with additional scale and talent is better positioned for success. As you are aware, recent margins in the Commercial segment have been challenged as our Stuttgart factory struggle with labor shortages and supply chain challenges. I want to take a few moments to highlight recent accomplishments and the planned improvements to fully restore the margins at our commercial segments. This year, our reinforced leadership team address the labor challenges, drove greater price realization and initiated a new construction of a commercial factory in Saltillo. We remain committed to delivering $100 million in incremental EBIT from the Commercial segment by 2025. And by increasing the labor and manufacturing efficiency at Stuttgart, recovering market share in emergency replacement, capturing the benefit of lower cost manufacturing in Saltillo. And I believe Joe Nassab and the team will make sure that these targets are met or exceeded over the next 3 years. He will provide more color and greater depth behind our commercial profit recovery plans. Similarly, the near-term macro-related headwinds in the Residential segments are being addressed by fully capturing the benefit of price driven by regulatory [ SEER ] change and ongoing component inflation. Our near-term results in Residential will also benefit from eliminating manufacturing inefficiencies as the supply chain normalizes. Government programs such as the Inflation Reduction Act, are also going to offset some of the macro-related headwinds by positively influencing the repair-versus-replacement dynamics with the help of tax incentives and rebates. Gary Bedard will provide more details and greater depth on how we plan to offset these short-term macro-related headwinds in our residential segment. So to summarize the second section, we are excited about the recent changes and the organizational focus going forward. We are the leading participant in both the residential and commercial HVACR industry with a proven innovative portfolio that sets new standard for energy efficiency to aid decarbonization. Our 2 narrowly focused segments, both with leading industry positions, are poised to accelerate growth and profitability. Our solid foundation and enhanced focus in North America will make our future even more attractive. Now I want to spend a few moments to switch gears and talk about long-term growth and how we are going to deliver long-term differentiated growth, implementing a growth operating system at Lennox. Our growth operating system is based on 6 of our guiding behaviors and gives us the required tool and the operating rigor to succeed. We will sustain elevated performance through excellence in quality, innovation and superior results to win in everything we do. We will build competitive advantage by building exceptional customer experience world-class talent and by supporting our communities and environment to impact long-term value creation. For the next few pages, I will provide some framework and examples behind our growth operating system. We have a robust strategy and talented leadership team to deliver growth results excellence. To strengthen our growth foundation, we are establishing standardized and digitized sales and marketing operations that will provide efficient support to our field resources who are best suited to make decentralized decisions closest to our customers. To transform ourselves, and to deliver more profitable accelerated growth, we are reinforcing our growth structure and making incremental investments to upgrade and strengthen our digital talent pool, our manufacturing capacity and our digital innovation capability. To further accelerating growth, we are expanding the use of revenue growth as our key metrics in our incentive plans starting in 2023. Two of our growth leaders, Kuan Win and Angela Chapoy are here with us today, and I encourage you to visit them during a break to get practical examples of how we are driving growth at Lennox. An example of successful growth is our national account service team. This is a beautiful business where we service large national accounts customers who trust us to manage their indoor air comfort and help them achieve their net zero targets by continuously providing them with highly energy-efficient solutions. Over the last 12 years, this business has doubled the number of locations while tripling its revenue and field service technicians. They have been able to do this by having a standard digitized sales and marketing operations while empowering their local leaders close to the customers to make growth decisions and control their own destiny. We look forward to continued growth of this team and adopt their best practices across Lennox. A critical part of our growth operating system is innovation excellence, which at Lennox means discovering with strong product life cycle management, defining with enviable talent and expertise, developing with global technology partnership and effectively deploying innovative solutions. For new products and solutions, our focus is going to be on growth products for electrification, decarbonization, high energy efficiency and increasing indoor air quality. To get more practical examples behind this, I encourage you to visit our innovations booth and meet Keith Mori, and Shailesh Manohar and John Whinery, who can provide you with insights into our innovation excellence and how we will drive at least 50% of our revenues from new products by 2026, even excluding products related to the low GWP transition. One example of innovation for us is our cold climate heat pump technology, which we expect to commercialize in 2024 with an overall goal of driving 25% to 30% of our revenues from product heat pump products by 2026. Again, Prakash will provide greater details later this morning regarding our heat pump technology and strategy. Another pillar behind our growth operating system is our quality and operational excellence discipline. Our disciplined efforts here have focused on increasing supply chain resiliency to ensure that 75% of our products are dual sourced by 2026. Jessica Smith, our supply chain leader is here with us, and you can get more details on this effort by visiting her during our break. As part of operational excellence, our factories are embracing lean automation as we invest in automation at our U.S. factories to mitigate labor shortages while we leverage our Mexico operations, to generate labor productivity and operations that are not cost efficient to automate. By 2026, we expect at least 50% of all earned labor hours across Lennox to be in Mexico. The final pillar of operational excellence is our digital enablement to manage our order to cash process including supply chain planning and factory floor visual management. I encourage you to visit Dave DeRoussel, Craig Farley and Miguel Gutierrez, at our solutions showcase, who are proud leaders at the forefront of operational excellence at Lennox. Our mostly behind-the-scenes effort at operational excellence is to support our endeavor to elevate our customer experience using a combination of our digital and physical footprint. As Gary Bedard will show you in a few minutes, we are the leader in own physical distribution and a leader in digital transactions with our customers. The combination of these 2 foundational strength will allow us to gain share by enacting a digital plus physical strategy to deliver consistent and seamless best-in-class customer experience. Success across all of these growth initiatives depends on our talent and high-performance, value-driven culture. We will continue to develop our talent, invest in our leadership, building greater bench strength and nurturing our high-performance culture. We have a robust courier development tool and multiple training program to train and develop our employees and leaders with a narrow focus on succession planning for the next few years. Our high-performance culture is also driven by our initiatives to support our people and communities through volunteering and contributions. We foster workplace inclusion through robust policies and practices to support diversity and inclusion. We support the communities where we work and live by programs such as Feel the Love program, where we partner with our dealers to provide no-cost HVAC systems to local heroes. This year alone, we proudly supported over 140 charitable equipment installations with our dealers to local heroes. To summarize our third section, we believe that the planned deployment of our growth operating system will increase our market share and accelerate our growth by giving our team the necessary capacity, tools and resources to deliver superior growth results and win. Now I'd like to turn to the last and the fourth section to highlight how we are investing in the future to enhance Lennox shareholder value. It starts with a disciplined capital deployment strategy, which has remained consistent over the past several years. Our core philosophies of maintaining a solid balance sheet, delivering strong cash flow conversion and competitively growing dividend remains intact. Although going forward, we will be targeting a debt-to-EBITDA ratio between 1x and 1.5x as we head into a potentially recessionary environment with higher interest rates. Joe Reitmeier will provide further details on this during his presentation. The new debt-to-EBITDA ratio will give us some additional flexibility in pursuing bolt-on acquisitions using the clear criteria highlighted here. We have sufficient scale to compete. And hence, we will focus our M&A efforts exclusively on the HVACR space to look for value-creating strategic opportunities that meet our strict financial criteria. For example, we will focus our acquisitions on areas that allow us to expand our geographical coverage in North America, increase our parts and supplies sales and expand our service offerings. To be even more specific, we will not be pursuing large adjacent acquisitions, and we will not pursue acquisitions simply to be a bigger company. We are pleased to highlight our 2023 guidance consistent with the press release this morning. While Joe will go into this in much greater depth, let me just say that as a team, we are proud to present a plan that will deliver growth in revenue, share, EBIT and EPS despite the expected decline in residential unit volume. We are also pleased to introduce our 2026 organic financial goals. While it had been customary to release 3-year financial goals, we chose to introduce 4-year financial goals given the potential industry volume uncertainties in 2024 and 2025, driven by the low GWP refrigerant change. Despite any potential volume shifts between 2024 and 2025, we remain confident and optimistic about the long-term growth prospects of Lennox and the industry, and that optimism is reflected in our 2026 financial guidance. Joe Reitmeier will provide more details behind these goals. I want to wrap up my presentation by reiterating the 4 key messages with which we started. We are building from an extremely solid foundation, implementing near-term initiatives while executing on a growth operating system with disciplined capital allocation to drive shareholder value at Lennox. Personally, I am confident that Lennox's best days are ahead of us. Thank you for listening. It's my pleasure to hand the stage over to Gary Bedard our newly appointed President of the Residential operating system.

Good morning, everyone. I'm excited to return to the business, and I know and love, the Residential business, and let me talk about some of the great opportunities ahead. Our residential business serves a very attractive market, which has some compelling long-term trends. Lennox has a unique structure, product offering and value proposition that positions us to gain incremental annual share over an extended period, while our operating and digital capabilities both support this growth story and help drive profitability. Let's start by taking a look at the segment, its composition and its performance over time. On the left side of the slide, you see the 3 business units that comprise LII's residential segment. The largest is our flagship Lennox residential business, selling Lennox-branded HVAC equipment through captive distribution. This business unit has allowed us to reliably build a leading brand with a direct-to-dealer relationship. Lennox can target footprint and sales force investment in any geography, and we provide a more uniform execution for a brand that consumers trust. Next, we have our Allied Air business, which services the 2-step HVAC equipment market through distributor partners. The Allied business works with independent wholesale distributors who invest in local markets typically targeting a different segment of the market than the Lennox brand. Finally, advanced distributor products or ADP offers flexible indoor HVAC options to help distributors meet unique application needs. Our ADP business helps Lennox International to hone our expertise on the indoor side of the home comfort market while delivering value to a much broader group of distributors than the Allied business. In total, about 75% of our revenue comes from the large replacement market, which has healthy long-term trends for growth. Now looking at the right side of the slide, you can see that our market focus has delivered consistent revenue growth over time despite setbacks from the 2018 tornado, which decimated our Iowa residential factory and then followed shortly by COVID-related supply chain issues. Our proven long-term formula for acquiring share remains intact, and I look forward to sharpening our execution focus in 2023 and beyond. The business is very profitable and we have a series of initiatives and actions that will help drive ROS improvements in the years ahead. The North American residential HVAC market is appealing with long-term growth rates above GDP. And I want to take a few moments to dissect how we look at this market and our view of the future growth trajectory and drivers. First, let's level set. Industry shipments are based upon manufacturer reported shipments to customers. For most of the industry, this means sale to wholesalers. For those with captive distribution channels like our Lennox brand, it means sales to contractors. Because much of our sales are direct to dealer there is minimal inventory buildup at the distributor level due to things like price increases, regulatory changes or supply chain issues causing inventories to rise to reflect lead times. In the short run, these types of channel effects impact how the overwhelming majority of the industry sees the market. For Lennox, our view is pure, mimicking the actual sell-through market more closely. Now in the long run, channel impact evens out to zero, but it can make the industry appear more volatile when disruptors like supply chain or regulatory changes occur. Our focus is always to understand underlying long-term consumer demand independent of channel effects. And we think these long-term trends are encouraging. The North American residential market remains attractive over the next 10 years or more. The market is broadly divided between those shipments intended for new construction, that's roughly 25%, with the other 75% focused on the much larger add-on replacement market. Historically, the new construction portion of the business experiences more volatility with the business cycle. The add-on replacement market is much steadier being impacted by weather and consumer confidence, but usually going up or down in a more steady and predictable fashion, always subject to the constant buildup in the housing stock over time. 80% of all sales in the replacement market are based upon failures of existing equipment. So the only choice consumers face is whether to repair or replace. Looking backward in time, you can see the market has delivered growth CAGRs between 4% and 5%. From 2010 through 2015, the CAGR was closer to 4% as a strong new construction rebound augmented a low single-digit replacement demand. Now since 2015, the CAGR was closer to 5% with surging replacement demand in the mid-single digits, keeping pace with similar new home growth. Going into 2023, the HVAC market faces some near-term volume headwinds. Over a longer horizon, however, the fundamentals for residential HVAC look strong. We model the long-term trajectory for the residential market that is new construction and replacement combined to remain in a 4% to 6% CAGR band over the next 10 years. Of course, long-term projections involve many variables, and ours is no different. In addition to the existing housing supply and key historical trends in the business, we account for both tailwinds and headwinds that face the industry. Key tailwinds include increasing unit run time, a significant population of less efficient R22 units, which are getting more expensive for consumers to run and repair; heat pump growth, given both their longer run time and their importance to electrification. And finally, the long-term housing deficit driving new construction. Although difficult to model, the Inflation Reduction Act is also a key volume tailwind in the near term and a high-end mix driver through 2032. When you couple these longer-term tailwinds with higher average prices due to efficiency regulations, you can see that the revenue growth potential in residential HVAC is strong. Despite the strength of the long-term trends, we still have near-term demand headwinds, Alok discussed. Helping us to overcome these headwinds and grow our top line in 2023 are several items. First, we have a regulatory change, which will boost the average revenue per unit. Lennox has a more simplified approach to this change than many of our competitors. Our cost-effective approach involves changes only to the outdoor system, driving simplicity at the distributor level, which makes our changeover cheaper and easier while improving Lennox fill rates to drive share. At the same time, disciplined and continuing price actions will help us to offset inflation and enhance profitability. And while we expect a modest downturn, we will continue with targeted growth initiative investments while driving productivity. Investors have asked us to explain the impact of the recently passed Inflation Reduction Act, the program affects the industry in 2 ways. The generation of unit volume from lower income consumers who might otherwise defer a purchase and a longer-term upward mix impact from higher income consumers who are incented to purchase higher efficiency products. The impact on volume comes from the high-efficiency electric home rebate program, abbreviated as shown. The program varies by income level with geography, and will be administered by the states. It's capped at a total of $4.3 billion, and this program incents lower-income homeowners to electrify their home and increase efficiency. The subsidies for qualifying consumers can cover up to 100% of the cost of installation, but other products like solar panels are also eligible for this limited funding. Based upon the current funding levels, the program could provide support for up to an extra 0.5 million units spread out over time. It is both a complicated program and an unprecedented one, so we will closely watch the impact and prepare our customers to capitalize upon it. The second part of the IRA is much more familiar and more important to Lennox. It expands the existing 25 C tax credit and moves its expiry out to 2032. Importantly, it has no cap on funding. To qualify, installed products must meet or exceed the highest efficiency performance tiers. Consumers essentially receive a tax credit to mix up to higher efficiency with a credit that often makes the move very attractive. In the past, Lennox has seen a significant mix benefit when 25 C credits are offered because more customers choose higher efficiency. Because this program will last 10 years, it will drive positive mix for years to come. Lennox serves a growing end market with proven unique advantages to keep us on a long-term share gain trajectory. Alok showed you this slide earlier, and I want to touch on the sustainable competitive differentiators and weave them into the residential growth strategy for Lennox. I will review in the coming slides. Our direct structure is unique in the industry, giving us uniform capabilities and a customer-centric culture. We use our deep knowledge of the market to find dealers and distributors who need best match our capabilities, and then we go about enhancing these capabilities through product line or distribution expansion to meet the requirements of a wider slice of the market. The lifeblood of Lennox is innovation, and we have a long history of industry first and comfort technology and efficiency. Our brand promise rests upon our ability to continually innovate and use our leading product line and customer-centric culture to attract and convert leading HVAC dealers and distributors. Lennox can meet customers where they are with an expansive and growing network of physical locations, 2-step distributor partners with our allied brands or an online e-commerce presence that ties into an expansive multi-echelon supply chain, delivering with same-day or next-day service. Finally, our digital footprint gives us not only leading e-commerce capabilities but delivers deep engagement with dealers and their employees while our factory operations provide the quality, productivity, capacity and reach to navigate these changing times. These 4 items are the basis of the Lennox share gain story. They function together to bring mutually supportive, unique competitive advantages. Our long-term goal remains to use these investments in all 4 of these areas to drive a 50 basis points or more increase in market share each year. Lennox has a structural advantage based upon our market approach. We use both the direct and indirect models through focused business units that are completely dedicated to that specific channel strategy. The Lennox brand was founded on direct-to-contractor distribution over 125 years ago. That model has kept us close to the market, allowed us to build and control the quality of a highly capable base of dealers and gives us a competitive advantage with national entities looking for uniform execution, like builders and retailers such as Costco, for example. To support the store expansion strategy that I will cover in a few moments, we built a multi-echelon integrated distribution network unmatched in the industry, and we linked it together with our leading e-commerce platform, LennoxPROs. In addition to our Lennox network, our Allied business enjoys strong partnerships with leading independent wholesalers who serve contractor segments more tailored to their specific go-to-market approach. The synergies of our LII product innovation, together with a determined focus upon distributor needs, has allowed our Allied Air business to continually add accretive distribution. It's a big market serving many different segments, so there's plenty of room to grow share using both approaches. Finally, our ADP business similarly sells indoor HVAC products through both our owned and partner distribution networks. Product. It's what we sell. Alok talked about innovation as a strategic pillar and our CTO, Prakash Bedapudi, will go into more detail later this morning. Innovation doesn't pay unless you can introduce and sell leadership products. The Lennox Direct model simply excels at bringing new technologies and new products to market, gaining traction with existing and new accounts in the process. Our leadership products include the SL 25 heat pump, the most precise and efficient heat pump you can buy. This product formed the basis for our ability to quickly meet the cold climate heat pump design sponsored by the U.S. Department of Energy. Our integrated residential solutions are second to none. Today, Lennox offers the Ultimate Home Comfort system, a collection of our best products that deliver unparalleled efficiency, comfort and indoor air quality. Each member of this product family boasts industry leadership and delivers the very best that consumers can find from the highest efficiency to the quietest. Our product line allows us to both grow high-end mix and acquire new dealers. One example is our PureAir air purification system, which is the most effective whole home device on the market, providing the highest efficiency filtration while also eliminating odors and chemicals without generating harmful ozone. Lennox has been able to build upon consumer interest and indoor air quality to grow the delivered value and increase the average revenue our dealers get from the residential installation. It's a clear example of how our product leadership strategy works: consumers win, dealers win and Lennox wins. And our product leadership extends to the digital front as well. Lennox smart thermostats deliver top-tier consumer engagement and comfort while also assisting contractors with installation, commissioning and servicing of the equipment. These products deliver improved consumer engagement while also ensuring all the elements of the system work together for maximum comfort, security and efficiency. Please take a few moments to look at the suite of our smart thermostats in the display area. Our research and development efforts go beyond product leadership. They also extended to the core of our product line to deliver cost-effective products that meet current and emerging regulatory needs. Since most of the industry shipments are at entry-level efficiency, it's important to get this right. In 2023, new regional standards for air conditioners and national standards for heat pumps go into effect -- our new products are cost optimized using lower cost components and existing indoor systems to ensure a complicated transition goes smoothly without burdening consumers, wholesalers and dealers with unnecessary change. The industry is also facing a refrigerant change beginning in 2025. Regulatory changes present challenges and opportunities. Lennox has always navigated them well and gained share during a transition. We will be ready for the change in 2025 with the exceptional products our customers expect from us. With leadership products, a unique distribution model and an industry where share is heavily correlated with outlets, Lennox successfully pursued a strategy of adding stores to underpenetrated markets. The Lennox brand remains underpenetrated from a distribution perspective, meaning we still have a long way to go to exhaust opportunity despite having quadrupled our footprint since 2010. At the same time, changes in dealer buying behavior over the pandemic with a focus on delivery services and online interaction have led us to refine the approach to simply growing our reach with investments and touch points. Stores, delivery capability closer to our customers and, of course, continuing to invest in our e-commerce capabilities. Now stores remain foundational to our strategy. Physical locations are important and Lennox uniquely within the industry needs no permission or acquisition to invest in attractive geographies. To select our store locations, we maintain a robust business development pipeline looking at best fit opportunities throughout North America where distribution presence would unlock account conversion. We rank order store possibilities based upon available dealer conversion opportunities, properties available, budget and execution bandwidth, then we adjust the supply chain as we switch into account conversion mode, typically seeing an 18-month breakeven and a 24- to 30-month payback. Our store expansion strategy is an integrated effort among many disciplines that drives incredible market value. Moving forward, we will focus on both same-store execution measured through equipment and parts growth along with a robust store build-out plan that exploits the very best opportunities for growth. This will usually be in the neighborhood of 10 to 15 stores each year, but it will vary based upon the next best opportunity for growth investment. As we have built out stores over the last 10 years, we've also needed to enhance the network that supports these stores, larger regional distribution centers and smaller local distribution centers. Along the way, our service capabilities have also improved. With the right transportation assets, our shipping locations are close enough to make it possible to reach 80% of the demand in the same day and fully 98% of the demand the next day. This capability will allow us to thoughtfully gain share of wallet with our customers who may source higher volume parts and supplies or even some types of equipment from suppliers with better delivery. As we do with our store process, we will use our opportunity management approach to ensure that capability additions are prioritized and accretive. The customer touch point that has grown the most in the last several years is our online LennoxPROs e-commerce site. I'll review the traffic and sales in a moment. but LennoxPROs allows dealers to order parts and equipment for pickup in our stores, delivery or it even allows orders to be collected from a dealer's distributed workforce all day and consolidated into a single delivered order. As we look at expanding our touch points, we will continue to make annual investments to improve this capability. Our Allied brand has its own path for gaining points of distribution by targeting independent wholesalers. The Allied distribution network typically targets a contractor base in the lower and mid-tier where local availability is paramount. The Lennox product line backbone provides them with a competitive advantage against many brands. When you couple these advantages with the deep customer-centric culture and dedicated wholesaler focus, it's clear why Allied has enjoyed such great success in the past several years. The Allied business is well positioned to address nontraditional growth vectors like private label products. When you consider the Allied distributor network alongside of the captive Lennox network, we have over 1,000 points of distribution serving the contractor community. I spoke about e-commerce a few moments ago as a customer touch point. It is that, but it's so much more. It drives customer engagement. Our e-commerce sales now make up over 40% of our Lennox-branded sales. LennoxPROs allows us to engage many of the most important employees of a contracting firm from purchasing to service to training, accounting and installation. LennoxPROs is more than an e-commerce site. Our vision is that this is our online community. Our LennoxPROs users are among the most loyal customers, and the tools and capabilities that it brings allows both our customers and Lennox to improve efficiency and interaction. It is truly one of our competitive advantages. Finally, let me talk about our focus on operational excellence, which supports our growth story, our profitability and our well-earned reputation for quality. Our residential operations footprint now sources about 60% of our product in Mexico. But we've developed the ability to build many of our products in multiple locations, improving the resiliency of our operations and bringing a renewed focus upon process discipline and quality as we replicate these lines. We've also moved upstream into the supply chain to build broader sourcing relationships and redundancy while always remaining focused upon cost and quality. Finally, we're working to improve the quality and delivery and schedule compliance by focusing on automation and our production planning, leveraging our closeness to the market to identify trends. Our operations team set and achieve annual productivity goals in excess of $20 million. Lean transformation is all about eliminating variation again and again and again. While we have a team that has proven they can deliver through some incredibly challenging times, we also know that we still have plenty of opportunity to get even better at what we do. To that end, we further build out our center of excellence that focuses on lean transformation to do just that. Automation has augmented our drive to create cost-effective productivity. We've long had significant automation in areas like sheet metal and brazing, but more and more, we are implementing solutions that are increasingly unique and tailored to specific tasks with a goal of not only improving the performance, but also developing the muscle to be able to flex on a broader scale in the future. In closing, I am happy to return to the residential business. Our market opportunity, unique value proposition and proven ability to execute shows that are best days ahead. I'll be followed by Joe Nassab, the President of our Commercial segment.

Thank you, Gary. Good morning, everybody. By way of introduction, I've been with Lennox for the last 12 years, leading the Allied Air Enterprises business. And 6 months into this assignment, I'm very encouraged by the progress that's been made. We're building businesses that deliver consistent growth, share and margin executed by great teams with rigorous plans and a rigorous operating system. Our playbook. Our playbook focuses on these 4 areas. First is manufacturing and quality excellence. No doubt, the pandemic has impacted everybody. And in many ways, for us, it exposed gaps in systems, in processes and in talent. With the benefits of learning and wisdom, we've implemented numerous changes. The Stuttgart transformation is well underway. And beyond that, we've shared news of standing up a new facility in Mexico. It's another integral piece of that puzzle. Second, from a customer perspective, we're very blessed with special relationships. The role that we play in our customers' day-to-day operations is vital, delivering comfort, lowering energy costs, helping achieve environmental goals. Our direct model provides a proud seat at their table from which we glean valuable insights. Part of our bargain then is to deliver a superior experience. It's one reason we've become the leader in commercial national accounts. Third, on the topic of growth, our vision is very clear on where to go, and how to get the job done. In some cases, it's reentering markets that we've been forced to step away from. Supply challenges made that necessary and one example would be the emergency replacement market. Beyond that, there are numerous customers, geographies and verticals to better serve and to better grow and that we will. And last but not least, is margin expansion, that $100 million of EBIT delivered over the next 3 years in roughly equal increments. I'll go a little bit deeper in each area. But first, what I'd like to do is give you an overview of the segment. We're composed of 3 businesses, 2 are equipment businesses and the other as a service company. And on the right-hand side, you see 4 years of history, flattish sales and a ROS decline. That erosion now has been well documented and well discussed and it was driven primarily by our Stuttgart operation, where the perfect storm for us materialize, inflation, scarcity of labor, material shortages, expedite expenses and everything you can imagine in between. But as it relates to factory stabilization, we've turned a corner and are seeing signs of improvement. So a few words on each of the businesses. Our commercial rooftop business operates in a $4 billion to $5 billion market with a lineup spanning 5 to 50 tons. We deliver comfort and air quality into a variety of environments from large national accounts to schools, grocery stores, retail outlets, warehouses, quick-serve restaurants, tens of thousands of locations and millions of systems on rooftops across North America. What we built -- what we build is essential to commerce into the economy and to our environment. Our Heatcraft business competes in the refrigeration space. Heatcraft has been around for well over 30 years with manufacturing in Georgia. This business designs and manufactures climate control solutions for the cold chain, keeping food fresh from harvest through distribution to stores and restaurants. We also provide climate control into other areas as well, including pharmaceutical industry and data centers. These are also mission-critical operations, applications essential to healthy everyday living. Third, our third business is Lennox National Account Services, and this company performs installations and repairs, preventive maintenance and ultimately, replacements for our national account customers, services, which span the complete life cycle. It's a business, as Alok said, that's as close to recession proof as they come. We love this business. Highly stable with a nice recurring revenue stream. Today, we employ about 725 technicians and operate out of 115 locations. So that's the segment in a nutshell. Looking forward, I am bullish on the market, and it's for many reasons. As you know, the rooftop industry is driven by replacements, accounting for 70% to 80% of shipments in any given year. The installed base is large, it's old and it's aging by the day, and there's significant pent-up demand to replace these less efficient systems, systems installed 15 years ago, 20 years ago and more. They're very costly to maintain and they're very costly to service. Beyond that, customers realize savings with more efficient equipment. So number one, replacements are often a smart economic decision. The industry also benefits from regulation. And on this front, much is coming and in rapid succession. New efficiency standards go live in January that will drive mix and 2 years later in 2025, the low GWP refrigerant transition will provide additional fuel for our market. The last refrigerant change was in 2010 as we moved away from R22. And here is reason #3. Many of our largest customers have made bold environmental and sustainability commitments. These commitments require replacing tens of thousands of units annually well into the next decade. Innovative solutions from Lennox, including high-efficiency heat pumps, create meaningful opportunities for us to gain share. Demand. Demand has rebounded from pandemic levels and will accelerate as we bring to market low GWP equipment. So you put it all together, put it all together, and we see plenty of room for both meaningful and sustained growth. Alok touched on this earlier, so did Gary, and what I'd like to do is emphasize 2 elements of our value proposition. Number one is the direct model. Being the industry's only manufacturer, distributor and servicer affords unique customer exposure and access. It is a closeness that our competitors cannot replicate. Our direct model delivers enormous value, speed, efficiency, consistency, ease, turnkey support. Our ability to provide complete control from manufacturing to the job site ensures that equipment is ordered, built and delivered to meet store openings and planned replacement schedules. This is one of the top KPIs for this customer segment. The model also demands constant communication and on-site presence. And through this, keener insights are derived. We use these insights to develop tailored solutions, equipment and services designed for building owners and for contractors and for service technicians, all 3 of those constituent groups in our mind. It is because of our direct model and it is because of these unique competencies that Lennox is the preferred partner to many of the largest companies in North America. Shifting gears to Stuttgart, a few statistics for those who may not be as familiar. The factory -- the factory opened in 1974. It's been expanded 3 times since and it's about 750,000 square feet. We operate 15 assembly lines and employ approximately 1,500 people. After a few challenging years, a very special transformation is underway. I am there often, and I see it and I feel it. We're building a performance culture with a lean mindset. Now as is true in many cases, it begins with leadership. We've made significant talent additions and one I'd like to highlight is our Vice President of Operations, Miguel Gutierrez, sitting to my left. Miguel is a seasoned operator and a strong leader who comes to us from running our residential factory in Marshalltown, Iowa. He is with us, and I encourage you to spend some time with Miguel during one of the breaks. Since our low point in March, staffing levels are up 35%. Staffing had been a major roadblock to production. It is not anymore. We are fully staffed. Production, too, has been steadily improving. Output in Q3 was up 30% from the first half. Now we still experience material challenges, supplier shortages, but big picture, things are improving. Looking forward, looking forward, I expect consecutive years of capacity increases. Our output next year will be up in the 15% to 20% range. We have much more to do in Stuttgart and no victory laps are being taken. But that said, we do see light at the end of the tunnel. In October, we announced plans to build a second factory, bringing with it additional capacity and diversification. Happy to report that site prep has already begun, began on November 4, and we're purchasing long lead time equipment as I speak. It is $125 million to $150 million investment. And from a timing perspective, the majority of that spend will go next year. The factory will be in Saltillo, Mexico, close to our residential campus, and we chose that site for many reasons. First, for the availability and cost of labor. Also for the ability to share resources and talent as it makes sense. And beyond that, a robust local supply base has been developed, which we will be using. Now from a portfolio standpoint, Stuttgart will build our premium high-efficiency rooftops, and it will remain our configure-to-order factory. Saltillo. Saltillo will manufacture high-volume, low variation equipment, -- this product, among other things, will serve the emergency replacement market extremely well. We will be in production in the back half of 2024, ready for that low GWP transition. On to products. Lennox has a proud history as you've heard, and we'll hear again, a proud history of innovation and leadership. And here, I offer a few examples. Model L is the industry's most efficient commercial rooftop. It provides the lowest total cost of ownership for national account customers and building owners. And we strive, we strive to lead in these categories, efficiency and total cost of ownership. We're also focused on controls leadership. Our goal here is to provide open and flexible solutions. And here are 2 of them. The Core Controller features an industry first. It's an app-based interface which speeds up installations and service, and it seamlessly integrates with third-party building automation systems. Unlike the competition, we provide customers with the ability to use the enterprise management system of their choice. On the Refrigeration side, the Intelligent Controller delivers unparalleled ease of use and assistance with installation and commissioning. And it also provides business owners with the ability to lower operating costs by up to 30% by better managing energy-intensive defrost cycles. Lennox Solutions, developed with and developed for building owners and contractors and service technicians. Many years running. We've earned more design awards than the competition, I assure you, this is not something that happens by luck or by chance. Shifting to market share. Share growth in 2023 and beyond will come in many ways. It will come from additional capacity. It will come from an assortment of new products. It will come from different market segments. And it will come from specific customers. Two products I highlight. Heat pumps are becoming a larger part of the industry, as you know, driven by the electrification trends. Our newest offering, the high efficiency in-light system was designed to support national account customers and their environmental goals. More broadly, more broadly, it opens access to large markets and customers where high-efficiency heat pumps are growing, and that includes California and Arizona. A bundled variable refrigerant flow, rooftop offering is another. Many applications require a mix of ducted and ductless systems, and our bundle hits the mark. And when engineers specify Lennox as a basis of design, blocks out the competition. The VRF market, as you know, has been growing double digit for many years. Now still -- while still relatively small, this is the fastest-growing part of our portfolio. We have ambitious goals, ambitious goals around the emergency replacement market. And here, we will grow with the right product assortment, with local inventory and rapid response. I expect this will contribute up to [ 1 ] point of share each year for many to come. Beyond products, we're systematically investing in large underpenetrated geographies. One way is with additional feet on the street, sales and support. And last but not least, that expanded capacity will enable us to quote and compete on more opportunities with more customers in applications like schools and quick-serve restaurants, DIY centers and grocery stores and warehouses. These are segments that we know very well in segments that we serve very well. So as you see numerous opportunities and numerous avenues to multiply. And it's this combination of things that set us up for meaningful and sustained growth. I'll close with margin expansion. That $100 million of EBIT will be generated from these 3 buckets. First, from cost efficiencies. Alok spoke earlier about the impact of segment consolidation. I believe Joe will talk a little bit more about it when he speaks. Our factory in Mexico will boost productivity with labor costs 80% lower than Stuttgart. Saltillo begins contributing through volume and share in 2024. And in 2025, we realized productivity as the operation ramps up. But before that, my expectation is that new leadership, lean discipline, healing supply chains will enable year-on-year output and efficiency increases in Stuttgart. Material cost reduction also plays a role. This, after several years of inflation and supply chain disruptions. We'll realize a positive impact next year more in 2024, even more in 2025. Second is price and mix, regulations and sustainability. Those trends help a lot. Beyond that, we're committed to ensuring that price gains more than offset cost. We executed this well in Q3, and we will execute each and every quarter moving forward. And last, from volume, consistent year-on-year share improvements from those areas that I just discussed. So in many ways, in many ways, it's getting back to the basics -- it's executing the fundamentals. There are no silver bullets nor are there any moonshots. It's executing these 4 pillars, that's our plan. And that's our commitment, too. So we have lots to do. We know it. We have lots to look forward to. I'm very confident that we will deliver, and I'm excited by what's to come. Thanks a lot. And I think with that, I'll bring Alok up to the stage for the first round of Q&A. Alok?

As you saw in the agenda, we have two opportunities for Q&A. So this one is more about me, Joe and Gary being able to answer questions or anything else in your mind. After that, short break, and then we'll get to Prakash and Joe Reitmeier's presentation. So you can keep the difficult questions for Joe Reitmeier towards the end of the session, but I'll take any of the easy questions right now. Yes. And there's Ashley, and patience with mics. We'll bring you mics as you raise your hand.

Maybe a first question just on the sort of guidance. Just trying to understand for this year, are you sort of reiterating like the midpoint of the guide, sort of any flavor on current business dynamics at Lennox for the fourth quarter whether on resi or commercial or overall?

We are -- on 15th December, I mean, I've just found it best not to talk about the quarter during the quarter. So I guess we have no update to the previously issued guidance for this year.

And then when we look at next year, the commercial business, how much of that sort of medium-term plan on EBIT recovery do we get in 2023? Just trying to understand the slope of the margin jump in commercial next year based on everything we just heard.

I think Joe Nassab mentioned that in his presentation. I would just expect a linear margin change. So think of that $100 million spread over 3 years. If we do better, which we'd all hope we do, we'll see that. But for planning purposes, just assume a straight line. Thanks.

Yes. Just coming back to the commercial business, specifically with the share gain assumption for next year. Could you just talk about what's embedded in that share recapture opportunity? I would think the bigger opportunity would be in '24, but maybe speak to where you're getting better footing there. And then I have a follow-up.

Sure. I mean on the share gain, as Joe Nassab mentioned earlier, it's a combination of factors. In the short-term, it's just capacity. Right now, we have more demand than we can supply. So in the near term, it's going to be just driven by more manufacturing capacity. And as that comes online and we continue improving, we would look to reenter the replacement market and that we would expect towards the tail end of '23 and the beginning of '24. But let me just pause. Joe, anything you would add to that? Okay.

Yes. And just one follow-up. You didn't spend a lot of time on the PartsPlus expansion years past. You put a lot of detail on slides related to that. Could you just speak to the priority and the urgency on PartsPlus expansion and where you see that going in '23 and '24?

Sure. Yes. I think Gary mentioned and I highlighted, for us, it's important to not think of this as a digital plus physical footprint. During COVID, a lot of the buying behaviors have changed. So I think it's more important for the dealer to make sure that we can get them the product within four hours, the same day, the next day, and we can do that with a digital and physical footprint. Our physical footprint, which is a PartsPlus store remains very important to us. And I think we will continue expanding those. But at this stage, I think the true success is going to be measured by both the combination of digital and physical. And I don't want to get into the same situation we have been in the past, we would give you a number every year and then maybe miss it. I think it's just important to continue looking at our growth and see how we get to that, you know, end goal. Needless to say, we remain underpenetrated, and physical store expansion is critical for our growth. Out there in the back.

Could you give us some color on the exit of Europe, the European exit? How that was -- how that decision was brought about?

Sure. So being a new CEO, one of the mandatory obligatory things to do is the entire portfolio review, and we did. The classic review on where we are best positioned to succeed, where we can drive the highest return for our shareholder capital and where somebody else might be a better owner of that valuable asset. And Europe stood out for us as an asset there. We did not have the scale to compete. We think it's a good business, and there's probably a better owner for that business. But it was a comprehensive portfolio review, which should give you some confidence that we love all the remaining portfolio of the businesses. Out here?

Wondering just on resi, if you could give us a little bit more color on kind of the mix effect in revenues embedded in the revenue guide for resi. You told us $150 million price, that's 3 points of price across the organization, whether that's level loaded against resi, I'd be curious. But just maybe how do you see the SEER change really playing out from a mix standpoint on the top line?

Sure. So yes, the $150 million price, I mean, that's obviously carryover price plus new pricing to clarify that. And as we look at the mix, there's probably a 3-point of impact from just the SEER change because I think that impacts about 1/4 of our revenue. We have talked about, it's about a 15% uplift on that 1/4 point. So give or take, like it's about a 3-point of that. Now the biggest uncertainty we all have right now is what's going to be the industry growth rate or industry unit shipment next year. But that's kind of the building blocks of our assumption right now.

And could you then also give us your kind of early gut on how you think the refrigerant change does play out. It looks like you're preparing for maybe a repeat of R-22 with some prebuild and particular noise in the channel. How much does the unit costs go up? What would be the incentive to prebuild? Do you have the ability to kind of police your dealers and not let them prebuild, so to speak, to minimize disruption, which seems to have been accomplished with the SEER change anyhow?

Sure. So I think right now, obviously, we are focused on ensuring a seamless SEER change. The teams are working hard. That's still ongoing. There's a lot of uncertainty still about SEER change that we have been able to put behind us. If I take the next 2 years because we still have 2 years before the actual low GWP refrigerant change happens. We got to work through those uncertainties. There's probably going to be similar dynamics that has what happened in the past. We really don't want to be the police to the dealers or distributors. We obviously want to make sure we serve our consumers and not hinder any of their abilities to grow. So a lot of uncertainties, but I would expect some pull ahead into '24 versus '25, which was like something that happened when we had the R-22 change as well. So I would expect '24 volumes to be artificially higher and perhaps '25 volume to be artificially lower. But listen, we still have '23 to run through lots of uncertainties in '23 on the industry shipments. So I think I have a better answer for you next year at this stage versus I have now. Okay. Another one right there.

Just a follow-up to that question. You talked about this changeover just being the outside unit. Where are you in the continuum of investing for the system for '25? I understand it's a little bit of a more of a technological leap and some companies have decided to refresh their product lines at one -- in one bang basically for SEER. How are you guys approaching that? And kind of how ready are you for '25? You said there's a lot of uncertainty. So how much wood is there to chop between now and then for your entire product line?

We are very confident that we have a winning approach. We have a solid approach. But to get you more details, I'm going to ask Prakash to answer that question, our Chief Technology Officer.

So the way we look at DOE minimum efficiency change versus the 2025, those are mutually exclusive. Some of the competitors are catching up with the heat exchanger design. We've been in a smaller volume diameter tube forever. We've migrated to aluminum coil ahead of rest of the competition. So we're well positioned, plus our air handlers and furnaces have been designed for a higher static capability. That's traditionally who we are. That's what we've done. Some of the dealers, tongue-in-cheek, say Lennox build stiff air handlers and furnaces. What it means is our product can work with higher static capability to overcome the duct losses. And as you go to 2023 DOE minimum efficiency, one of the requirements is, SEER point is measured a higher static capability. So since we had traditionally stronger product line on that metric, we didn't have to change indoor, just the outdoor change will get us there. Others who didn't have the capability, they have to redesign everything, right? So that's 2023. 2025 is complete redesign of refrigeration system, compressor, coil, expansion device, new refrigerant and lubricant, all of the above, right, compatibility. So that is equal for everybody just because somebody did the entire design for 2023 compliance doesn't give them advantage or a pass to meet 2025. It's kind of like a car with a new powertrain, new engine, new transmission, what's remaining is the windows and the seat, if you will, right? So that's really between -- common between 2023 and 2025. So from that perspective, I've read the reports I don't know what they're talking about. Maybe they know. But certainly, it's new refrigerant system design for 2025 with a brand-new refrigerant. A lot of validation, a lot of qualification, everybody has to do.

[indiscernible] a lot of challenge to get there between now and [indiscernible]

That's no different than anybody else. Everybody has to go through a new compressor, a new [indiscernible] exchange, a new control, there's a safety critical control too, right? And we've invested quite a bit in the controls over the last dozen years. We have the full capability to design and qualify our safety critical control, which is essential. Without that, you can't ship the product.

Can you just talk about the guide for next year, how you look at that kind of first half or first quarter, second quarter, just the seasonality you expect and how that unit volume forecast looks over that time period to down 5%, how you start the year end in the year?

Yes. So let me just summarize the previous question, right? I think Prakash said it well. We are on equal or better footing compared to any of our competitors. We had redesigned our products recently. So we are very prepared and ready. Everybody still has to test their compressors, the new refrigerants and everything else. So we will have to do the same, just like anybody else. On your questions on the first half versus second half. Listen, economic outlook is still uncertain. We don't know that fully. We are putting our best foot forward in terms of what we know. I think needless to say, we would expect component inflation to start easing in the second half of the year and be stronger in the first half. Commodities we'll watch, just like you guys would. And from a revenue perspective, we know what the new house construction looks like for us at the beginning of the year. we'll closely watch some of the metrics over the next few months to see how it looks in the second half of the year because housing that starts in second half of '22 impacts our sale in the first half of '23. So lots of moving pieces. But at this point, what it looks like components, we would expect to become more -- less inflationary in the second half. Jeff?

Just on the mid-single-digit decline. Can you just clarify, is that more reference to sell out or sell-through or kind of the HR versus the HARDI data? And then what your expectations are built in? I know your channel situation is different around kind of destock from an industry perspective?

Sure. So for us, it's obviously sales to our dealers. So there's no like sell-through versus sell-to concept for us. For us, it's all sell-through to the final dealer. Allied, which is our 2-step distribution model, when we look at that, there's potential for destocking in that, but that's built into our expectations for going in there. It's a smaller portion of our sales, as you know. But from where we look at the channel, we think the channel inventory levels are pretty healthy right now. If future volumes come down, the consumer sell-through, then we would expect some pullback in the channel, but we bake that in as we look at the mid-single design. It's a big range, Jeff. From our perspective, things will become more clear early next year, but that's what we look at based on a combination of new housing starts and replacement. But we are looking at beyond the channel effect, just effect on us.

Okay. Perfect. And then just as you look at your heat pump share versus kind of the traditional HVAC market and your -- the competitive landscape, maybe just talk about whether you're kind of punching above or below your weight on heat pump market share? And what maybe you think is most differentiated in your heat pump offering to kind of drive share gain as that becomes a bigger part of the market?

Sure. First of all, on heat pump, we are very proud of our technology, our product, our offering. Those are all best-in-class for us. However, as a market share, we underpenetrated. So we are below where we should be. It's mostly driven by geography. Our market share in the north is higher than our market share in the South, heat pump penetration in the south is higher than the heat pump penetration in the north. So kind of put that mathematically and now we are underweight in heat pumps. That gives us a huge opportunity, though, Jeff. As we look at the cold climate heat pump technology, as we look at how that progresses over the next 3, 5 years, because we have superior technology there and because we are underpenetrated, I think it fuels our growth more than the industry going forward. So that's the exciting part. And that's why we made the indication of the commitment that we think it's going to be 25% to 30% of our sales by 2026, a big change on how we have been in the past. And it's all because technology will allow heat pumps to increase their penetration up in the colder climate area. Tony or Ashley?

On the resi outlook, can you just talk about kind of one standard deviation ranges around how you're thinking about...

I thought I'm done with my statistics class. That was a nightmarish class, my friend.

We'll call it rough. It doesn't need to be fully accurate. I'm just trying to think how you're thinking about the range of outcomes around new construction and replacement relative to when you're saying down mid-single digit, and if you can think about the volumes, both in the new construction and replacement. And just how you're thinking about how much that could vary over the course of the year relative to your sort of guidance?

First of all, I can tell you, we are as good or as bad at predicting industry volume as everybody else in the industry. The mid-single-digit, fortunately, for engineers like us, I think it's a very broad range, right? I mean you can go from the extremes and still be within the standard deviation. So I would say the midpoint of the mid-single digits is where we are and within the range. I mean it's -- let's just say the standard deviation is about two points each way right now. But I wish we could be more precise or there could be better visibility. A lot of it just comes down to is where is the consumer confidence and where does replacements shake out? We have gone back in history and looked at even during the financial crisis, the replacement volumes held pretty well. And if that holds true, we would be on the lower end of the mid-single-digit decline, and that's where we have left ourselves enough cushion and room. But historically, we have rarely come across a situation where replacement volumes went down substantially. And if it does, it's usually 1 or 2 quarters, not longer than that.

And just what you currently have in there in terms of new construction and replacement?

New construction, we have taken 15% to 20% down just because that was recent numbers. Now I hope it improves next year.

And then maybe this is for Joe later on, but just given the items that we have for the guide right now, it seems to get to a number sort of nicely above the midpoint of the EPS range that you're providing. So any other sort of cost items that aren't detailed on those slides that we should be thinking about for headwinds?

I will let Joe answer that towards the end. But I was told, successful companies means -- if you look at them, 80% of them have an optimistic CEO and a pessimistic CFO. And I think Joe and I make a good team that way. So let him answer that question, so -- out here, Patience?

With your 4% to 6% long-term guidance, I was wondering how that breaks out roughly between units and pricing and how that might differ from the 4.6% CAGR in 2010 through 2020.

If it's okay, I'll have Gary answer that question. Gary, is that okay?

Sure. The 4% to 6% is units. That's not price.

And I think price for us, the industry is really good at offsetting inflation with -- so we would just add that. But if somebody told me Fed's targeting 2% inflation in the future, like well, they targeted that in the past as well. So we just don't know. Okay. All right. So I think that's great for the first round of questions. I would encourage you all to visit our talented leaders on the other side of the room as you go get a coffee refresh, and we will restart in 10:45. So we'll give you the bell and all the different alarms to get you back here. Thanks, everybody. [Break]

Well, good morning, and welcome back from the break. Again, Prakash Bedapudi, I lead the technology function of the company. I've been with Lennox International about 15 years in my current role. I'm very excited to be here today to share the progress we are making and out-innovating the competition and in commercializing the most energy-efficient, sustainable and cost-effective products and solutions in the HVAC industry. In my view, the key ingredients to out-innovate the competition are talent, capability and capacity, innovation, culture and process, investment and relentless focus on developing innovative technologies, both in good and bad economic times. Let me walk you through what we have done and what we are planning to do over the strategic horizon to continue to accelerate innovation at Lennox. As you heard for the past 127 years since the inception of the company, innovation has been truly the lifeblood of Lennox. We have truly pioneered the art of HVAC and has brought many firsts in the HVAC solutions to the world. Building on that heritage, we are further enhancing capacity and capability to accelerate the pace of innovation and bringing HVAC solutions to the market. Another unique thing about Lennox being the best-of-breed climate technologies company with very similar products across our business segments, we are uniquely positioned to develop common technology building blocks centrally once and deploy rapidly across multiple product lines. Our relentless focus and the progress we are making on developing technologies that directly correlate to mega HVAC industry trends will enable us to gain meaningful share. As you know, in our industry, great products are necessary but not sufficient to win in the end markets. Hence, we are investing heavily in the areas of digital technologies to create deep relationships with our customers and make it easy to do business with us. To give you a bit more insight into our innovation capability and capacity, we have engaged more than 1,300 best minds with unique capabilities around the world. Our technology team footprint includes half a dozen major locations in North America. Larger centers being in Dallas, Texas and Atlanta, Georgia. And two major locations in Asia, the largest technology center being located in Chennai, India. In the last 5 years alone, we have grown our innovation resource capacity by 65%, while the investment dollars have gone up by 30%. This leverage in R&D dollars is due to the outstanding resources, we were able to add at Lennox India Technology Center very cost effectively. To keep up the pace with our velocity of innovation, we've also increased focus on intellectual property protection in the last decade. We have filed for many offensive and defensive patents in several key technology areas to protect our freedom to operate. As a direct result of our innovation capacity expansion, our product totality index has risen to 48%, an all-time high. Product vitality is defined as a percentage of sales derived from new products launched in the last 3 years. While we are very proud of our heritage and legacy of innovation that began with riveted steel furnace in 1895, we have introduced many first HVAC industries since then. Just to name a few: first two-speed hermetic compressor in 1970s; first high-efficiency gas furnace in 1980s; first whole-house air cleaning purification technology, Pure Air S in 2018; first high-efficiency rooftop unit, highest efficiency rooftop unit Model L in 2021 that Joe Nassab mentioned earlier. Most recently, we were the first company in the industry to win the Department of Energy, core climate heat pump challenge, beating 8 other HVAC OEMs, both domestic and international. In the last couple of years alone, we have launched many industry-leading products, just to name a few: world's highest efficiency air conditioner, Dave Lennox Signature series at 28 SEER; highest efficiency gas furnace, again, Dave Lennox Signature series SLP99, clocks in at 99% efficiency; high-efficiency cold climate heat pump SL25. Apart from these product launches we've already accomplished, this innovation machine we've built has put us in a position to flawlessly launch products that meet 2023 Department of Energy minimum efficiency standards as well as 2025 low GWP. That's global warming potential refrigeration standards as well as position us to win the race for electrification, decarbonization with our proprietary called climate heat pump technology. So while we are excited about the progress we've made in launching innovative products over the last several years, we are honored and humbled that our innovative products have garnered many accolades from our customers and truly unbiased awards presented by HVAC dealers that is the Dealer Design Awards. Our products have won about 30 Dealer Design Awards in the recent years. That is 3x more than any of our competitors. So not only our products, our digital, e-commerce and internet of things solutions won many awards and accolades as well. As I alluded to earlier, Lennox truly has an advantage when it comes to developing common technology building blocks and rapidly deploying across multiple product lines. Shown here are some of the key technology building blocks that we are truly pioneering through a combination of organic in-house innovation and exclusive partnership with leading technology companies. The proprietary variable speed drive technology you see on the chart, both the hardware and software are fully developed in-house. Exclusive rotary scroll compression technology that powers our 28 SEER product is developed through a co-development agreement with a technology partner. Exclusive Bluetooth low energy, BLE wireless mesh technology stacks also developed with a technology partner; and the photocatalytic oxidation, air purification technologies, proprietary to ours as well. So these are some of the examples of common technology building blocks that enable us to commercialize industry-leading products. Now let's take a look at some of these products that we commercialize using these technology building blocks. The DLSC 28 SEER uses the rotary scroll compression technology that's exclusive to us. The high-efficiency heat pump uses variable speed rotary scroll, advanced blower technology and heat exchangers. The Pure Air S using photocatalytic oxidation technology -- and the Model L uses, again, variable speed compression and Bluetooth wireless mesh technology. The 99% efficiency furnace, it uses a very proprietary heat exchanger and the combustion system design. Each of these products represent the best in the industry with undisputed leadership claims. Now I want to shift gears and talk about another essential capability we've built over the last several years. Essential part of accelerating innovation at Lennox, whether it is for rapidly launching new products or delivering the product material cost reduction to the bottom line is the ability to rapidly qualify key components. We have been focused on this for at least the last several years. We've developed proprietary highly accelerated life test protocols, and we built test facilities to execute these protocols. We have modeled physics of failure -- physics of failure models and develop the test recipes to replicate real-world failures in a matter of days in the lab that would typically take 5 to 10 years to manifest in-field failures. This capability enabled us to qualify multiple sources for microprocessors, motors and other key components to mitigate the supply chain shortages during the last couple of years of COVID-driven supply chain disruptions. This capability also has been instrumental for us to increase the velocity of our innovation pipeline to reach 48% product vitality index without compromising quality and reliability of new products. We've been able to get it right the first time in terms of product quality, reliability over and over again. Now our relentless focus on game-changing technology building blocks and our demonstrated ability to commercialize industry-leading products using these technologies really bode well as we look at the future megatrends. We have consistently met and exceeded either Department of Energy or Environmental Protection Agency regulations ahead of the industry. And that ability is increasingly important as the industry prepares for the low GWP refrigerant exchange that impacts 100% of the air conditioner and heat pump products in 2025. And also as the focus on energy efficiency and reducing carbon footprint increases, we are excited that we have the highest efficiency and lowest carbon footing products now and we will continue to offer them in the future as we execute our product road maps. As the electrification and decarbonization megatrend takes hold, we have the most advanced cold climate heat pump technology building block that enable us to have the best product to capitalize on this opportunity. When it comes to digitization and e-commerce platforms, given our predominantly one-step distribution scale and leverage, we continue to invest significantly to differentiate from our competition. Now lots of discussion, lots of commentary around heat pump technology and heat pumps. Let me walk you through a little bit more about the heat pump technology from our perspective. Lennox introduced the first heat pump system way back in 1958. And we've been constantly improving the technology building -- improving the technology. Building on that innovation legacy, we've launched the high-efficiency residential cold climate heat pump system earlier this year. Heat pump technology building blocks we've been perfecting for decades have enabled us to meet the Department of Energy, Cold Climate Heat Pump Challenge during June of this year, again, a first in the industry, amongst 8 OEMs have competed. The Cold Climate Heat Pump Technology developed by us to meet the challenge included these major technology building blocks. First, the exclusive variable speed rotary compression technology, rotary scroll compression technology, I should say, electronic expansion well for the flow control, vapor and/or liquid refrigerant injection. That's a significant technology and the proprietary control algorithms. All of these make Lennox to be very well positioned to lead the industry as the industry migrates to sustainable heat from technology. Now shifting gears, talking about our controls innovation our residential homeowners' desire and value uniform comfort throughout the space and better indoor air quality with minimum energy consumption. This is a good example of the latest innovation Lennox has brought to the world in the ultra-smart thermostat category to meet these requirements. Our S40 thermostat has many truly industry-leading features, just to name a few, easiest installation with wireless mesh technology. No wires to run through put the zone sensors. Wireless on averaging sensors for the best comfort, even in a non-zoned application. And we also have a wireless indoor quality sensor that activates air circulation, ventilation and purification technologies that are already part of a Lennox premium HVAC system on demand to make the air quality perfect in people's homes. Another example on our sustainability -- leadership in sustainability. This is a commercial rooftop unit used to provide comfort for a small format commercial buildings such as a convenience store or a food retail establishment. This is another example of a key technology building block enabling us to launch one of the most environmentally friendly product from both energy consumption and refrigerant usage perspective. Using Environ microchannel heat exchanger technology, this rooftop unit can meet and exceed customer needs with 70%, I repeat, 70% lower refrigerant compared to industry standard product. The reduction represent 70% -- reduces the direct carbon footprint by 70% at the end of the day. In addition, this sustainable product design reduces the number of coil brace joints by 90%, reduces the leak opportunities, reduce the overall product weight and improve the quality of reliability. This is one of those win, win, win across the board. Now shifting gears from product technology and investments in digital technologies and e-commerce investments that Gary mentioned about LennoxPROs, for example, during his presentation. LennoxPROs for our residential customers and Heatcraft hub for our commercial customers have been very important e-commerce platforms. We've made significant investments also in our, what I call, to build out the most comprehensive internet of things platform on the cloud to provide seamless experience to our customers whether they're controlling their building from their homes or halfway around the world or anywhere in the world for that matter. So the best way to describe how our customers value our e-commerce platform is to just take a look at this testimonial from one of our key customers. [Presentation]

So now that we all learned Lennox HVAC industry could be sexy, let me conclude my remarks where I began by reiterating the key themes of innovation at clinic as it stands today and well into the future. Again, the key themes are relentless focus on bringing innovative and environmentally sustainable solutions. Our focus on development and deployment of common technology building blocks puts us in a uniquely competitive position to accelerate the launch of industry-leading products. Our innovative leadership product and technologies are garnering external recognition accolades. We continue to focus on 360-degree customer experience, not just with great products, but also through digital investments. Thank you for your time. Now it's my pleasure to invite next speaker, Joe Reitmeier onto the stage.

Team and Prakash are going to be a tough act to follow, but I'll give it a shot. So thank you, Prakash. It's good to be with you here again in person. Once again, it's been way too long. I'd like to start off with a few key messages that captures all that we shared with you throughout the morning. Over the last several years, we've made changes to our portfolio that permits us to focus and dedicate resources to our core businesses that support our long-term strategy. As our strategy has evolved, it's really necessitated further change. So in November, we announced our intent to explore strategic options for our European operations and our desire to intensify our focus on the more attractive North American end markets. This will result in a change to our operating structure as we consolidate our North American Heatcraft Refrigeration business into our commercial segment, which is a natural fit given the similarities of these commercial-facing businesses. Beginning in 2023, Lennox will now operate in two segments focused on driving profitable growth in the more attractive North American end markets, along with capturing market share, by leveraging our advancements in innovative technologies and capabilities that will deliver profitable growth. Our business will enhance profitability by continuing to deliver superior value to our customers and driving productivity through the value chain, which will lead Lennox back to delivering best-in-class margins. We remain a shareholder-focused company with a disciplined capital allocation philosophy that allows us to optimize the balance between investments necessary to fuel our businesses for growth and rewarding our shareholders with attractive returns for their trust and all of us across Lennox. Now for a quick look at our historical results. This chart summarizes our financial performance over a 5-year horizon, including our 2022 outlook. And while it's been a turbulent 5 years, which began with the tornado in mid-2018, which we recovered from operationally at the end of 2019, only then face the onset of the pandemic. And through all the challenges, we've redeemed our trajectory of delivering record earnings. As we close out 2022, which will be a record year for both revenue and earnings. We are also making necessary investments and taking the appropriate steps to position our businesses for long-term success. We are adding manufacturing and distribution capacity, continuing to advance differentiating technologies and funding necessary working capital all to propel our businesses forward. In addition, we believe we have best-in-class returns on invested capital. This results from a sound strategy, coupled with a disciplined capital allocation philosophy that optimizes returns. And while we are proud of our accomplishments, we are even more excited about the opportunities that we have in front of us and we've outlined for you today. Now let's take a look at what our businesses are planning for in 2023, beginning with our residential segment. Gary provided a lot of insight into the residential end markets, which have proven to be resilient over time. From 2010 to 2020, the residential end markets grew roughly at a multiple GDP, and we believe remains poised to continue that trajectory of growth over the next decade, similar to the past, as you see on the chart. In 2023, while we all expect volumes to decline, we will benefit from price increases in the form of 2022 carryover pricing and new pricing actions announced for 2023. The new minimum efficiency regulations taking effect January 1, will boost the top line with incremental price for the higher efficiency units and will provide a mix benefit as the minimum efficiency ratings increases. Over the last several years, whether it be a tornado or pandemic, which was compounded by supply chain challenges, all caused significant disruptions in manufacturing. There have been significant drags on productivity over the last several years. So as we make that turn into 2023, it really offers us the opportunity to begin to wing those inefficiencies out of the system and reduce our costs. With distribution channels healthier than a year ago, we are now poised to gain share and product availability should no longer stifle new business development. With respect to headwinds in 2023, I don't think anything listed as a surprise. As Gary mentioned, residential new construction is expected to be down, we think, about 20%, resulting in industry unit volumes declining. Inflation continues to be a pressure on the business. However, we do expect inflation to ease in the second half of 2023, along with supply chains continue to get healthier. Despite residential industry volumes being under pressure, our residential segment will grow the top line in a down market, seize market share and enhance profitability. Now let's turn to our Commercial segment. Joe outlined our bullish outlook for the commercial end markets and describe the dynamics that are presenting the opportunity for us to deliver meaningful, sustained growth in our commercial segment. During 2022, we saw lead times for the industry expand to unprecedented levels as key commercial specific components remained in short supply. Industry production could not fulfill the market's demand for commercial rooftop units. And this has resulted in elevated backlogs as we enter 2023, along with a bow wave of pent-up demand that cannot be fulfilled in 2022 and will benefit 2023. As we've mentioned, we were plagued in 2022 by the limited production output at our sole commercial factory, which severely impacted our ability to serve our customers, particularly in the emergency replacement market. Joe gave you color on the continued improvement of the factory in Stuttgart and the production output continues to increase. And as output increases, we are replenishing our distribution channels with emergency replacement units and we'll be back on the offensive in the emergency replacement market very soon. We continue to develop and deliver industry-leading advancements in our commercial HVAC and refrigeration businesses that enable us to offer the most efficient products in the industry, providing our customers with optimal solutions when it comes to meeting their goals on sustainability and energy conservation. Our innovative solutions position us to seize market opportunities as our commercial customers seek environmentally friendly ways and solutions that optimize their return on investments. And over time, as we look how we can serve these customers, we have been and continue to be their best option. Our Commercial segment will benefit from the continued progress toward the $100 million EBIT opportunity over the next 3 years. And despite macroeconomic headwinds that will impact the industry next year, we are well positioned to gain market share and outperform the commercial market for quite some time. Let's now turn to Lennox's capital allocation priorities. On the left side of the chart, we have our year-end leverage ratios. Historically, we've managed our leverage between 1.5x and 2x EBITDA, and we achieved those desired targets. We are now targeting a leverage ratio between 1x and 1.5x EBITDA over our long-range plan as interest rates escalate and to provide financial flexibility for inorganic growth for both on acquisitions that complement our businesses and the initiatives that the team has shared with you throughout the morning. Our capital allocation priorities remain consistent, and those priorities are to invest in the business to sustain industry-leading claims on efficiency, to advance our digital strategy, introduce new innovative technologies like the Cold Climate Heat Pump, along with productivity initiatives that all collectively contribute to better serving our customers while enhancing profitability. In addition to fueling our business for growth, we will continue to efficiently return cash to shareholders with a steadily growing dividend, coupled with share repurchases. Our distributions to shareholders has increased appreciably over time. Our dividend has grown 18% annually over the last decade. Our last dividend increase last May was 15%, and our dividend payout ratio was 30%, and our yield is 1.7%, both are competitive with our HVAC peers and other mid-cap industrials. As I mentioned, we have and will continue to supplement a steadily growing dividend with share repurchases. We have returned $3 billion to shareholders over the last decade via share repurchases at an average price of $172. Strong free cash flow and disciplined capital deployment provides us with the desired flexibility I mentioned. We target free cash flow that approximates net income, and we have a history of strong free cash flow generation, and this enables us to efficiently fund operational investments, and we are continually evaluating the capital needs of the businesses and balancing our uses of cash. I guess it helps you to put the right slide on. In 2022, given the supply chain challenges that have adversely impacted product availability across the industry and a stifled growth for Lennox, we have elected to invest in higher levels of raw materials to buffer the supply chain and the buy ahead of 2023 price increases. In addition, we are making investments to ensure our distribution network is replenished with finished goods back to more normal levels so we can effectively support end market demand. Absent those necessary inventory investments, our 2022 cash flow generation will be more in line with net income. Over the last 5 years, we have generated $3 billion in cash with over 80% distributed to shareholders. As we enter 2023, we are investing in new technologies, expanding manufacturing capacity, and preparing for more regulatory change that takes place in 2025. So the prior years will remain the same, but will require elevated short-term levels of investment in our businesses to support profitable growth. Let's take a closer look at our 2023 guide that Alok previously introduced. The macroeconomic environment is expected to be challenging, and that's no secret. But as Alok mentioned, there are megatrends benefiting the industry that will drive healthy demand and opportunities for Lennox long-term. However, in the short-term, given cyclical economic conditions, residential industry unit volume is predicted to decline. As Gary explained, we expect the unit volume declines impact on revenue to be more than offset by product price increases and a richer product mix due to the minimum efficiency changes that take effect January 1. As a result, and boiling it all down, we plan on residential revenue to be flat to up low single digits in 2023 despite the unit volume decline. Now on the flip side, as Joe illustrated, we expect commercial end markets to be more robust. This will provide some resiliency from the tempered residential new construction demand, and our commercial-facing equipment businesses are entering next year with elevated backlogs and are serving markets with significant pent-up demand. And as we've mentioned throughout the morning, our commercial business is on pace to achieve the $100 million in earnings improvement over the next 3 years. Considering all these variables, we plan for the commercial top line to grow high single to low double digits next year. Collectively, for the enterprise, price will deliver $150 million to the top line with $50 million of that coming from new price increases to take effect in early 2023. On the material cost front, Commodities will be a $35 million benefit predominantly in the second half of the year. Component cost inflation will affect the first half of the year and is expected to ease in the second half of the year, but stay tuned as supply chains and the linkages throughout remain unpredictable. We will save $30 million in product cost reduction projects next year to be generated through our sourcing and engineering-led cost reduction efforts as they begin to regain traction. Now let's take a -- now let's look longer-term and turn to our long-range targets. Alok also shared with you our long-range targets for 2026. We are targeting revenue between $5 billion to $5.5 billion with targeted margins for all of Lennox within a range of 18% to 20%. Our target margins for our residential and commercial segments are the same for each segment which are 19% to 21%. In addition, we plan to generate free cash flow that will approximate net income on average over our long-range plan horizon, which is consistent with our historical performance. We have a clear path to achieve our long-range targets. This illustrates our path to our target revenues in 2026. The European divestitures will remove approximately $250 million of revenue for those businesses that are essentially breakeven today. We shared with you our outlook for the end markets, the mega trends, coupled with competitive position as a premium player with industry-leading technologies, which Prakash gave you some insight on earlier this morning, presents sizable opportunities for Lennox long-term. Electrification and decarbonization will play a more prominent role in our customers' decisions and affords us the opportunity to deploy our innovation to aid our customers in the achievement of their ESG goals and objectives. End market growth will be complemented with share gains and each will contribute equally. Share gains are targeted at approximately 50 basis points annually over the next 4 years. Our commercial business recovery has targeted initiatives in place to drive growth and margin expansion. And as we get that business back to peak performance. And the benefits of price and mix, mostly benefiting 2023 in our long-range plan complete our path to our long-range revenue targets of $5 billion to $5.5 billion by the end of 2026. Let's now look at the path to achieve our target margins. Our path to achieve our target margins of 18% to 20% look like this. The divestiture of the European footprint will lift margins 100 basis points as we shed those businesses. Growth in the form of market and share gains will each add 200 basis points and will be driven by strategies and initiatives that we've shared with you today. The commercial business recovery and their incremental $100 million in earnings will provide another 200 basis point lift and productivity initiatives will contribute significantly and will be generated from; first, bringing out inefficiencies incurred the last few years due to the pandemic and related supply chain disruptions; secondly, by regaining traction in our sourcing and engineering-led cost reduction efforts to further reduce our product cost; and by leveraging SG&A and other fixed costs, including the benefits of the segment consolidation that Alok mentioned earlier. That is the primary path for Lennox to reclaim best-in-class margins. And I will wrap up with the key messages that I began with. While the macroeconomic horizon is a bit cloudy, Lennox is well positioned to capitalize on the robust and resilient North American HVAC and refrigeration end markets. Our continued investments in industry-leading products and capabilities will enable us to seize market share as we optimally serve our customers and delivering on productivity and goals will contribute to enhancing profitability, permitting us to continue to provide attractive returns to our shareholders. The strategy is clear. The opportunities are identified and the plans are in place. In addition, the team is prepared and energized by what we have in front of us. We are excited about the future where the best is yet to come. Thank you all for your attention, and I'd like to invite Alok back up for a few final remarks before we get to the final Q&A.

It's been exciting to be here and share the messages along with our top 30 leaders at Lennox. We were joined together with over 150 people who joined us virtually today to join this session. In my closing remarks, I want to reiterate the same 4 points that we started with. Without the script, it is just real exciting to join a company that has a very solid foundation, a strong track record of success with significant runway ahead for continued value creation. We are implementing short-term initiatives, some -- just as we finished our portfolio review, some potentially preparing for a recessionary environment, quite a few to make sure that we win during the upcoming low GWP transition as we think we are winning during the current SEER transition. But beyond that, we are also implementing a growth operating system, an operating system that will give our frontline the tools, the resources, the support necessary to go fight for share every day, to go win in the marketplace every day so we can deliver even better returns than what we have. In the short-term, as Joe said, we are not afraid to make the investments necessary in organic growth, in our capital so that we can get the necessary manufacturing capacity, the necessary capital needed, the necessary technology investment to ensure we win all of those. I'm proud to be part of a winning company, and we'll take questions in a few moments. But before the questions, just a few housekeeping reminders and a few additional items I want to cover. First of all, we appreciate feedback. Internally, feedback is a great way for us to develop talent, and we like feedback from our investors as well. So for those who are in the room, you have a little QR codes in front of you. On the right-hand side QR code, if you scan that with your phone, you will be able to give us feedback. It's a quick 5-question. I should take you a few minutes. If you can do that during the break or before you leave. If not, we promise to haunt you with e-mails asking you for your feedback again. So you won't escape even if you do that. Similarly, for folks who are joining us online, we would be sending you an e-mail request, so we'll appreciate feedback about today and what we can do better. Secondly, I just want to thank all the folks who work behind the scene to make today possible. I want to especially thank Ashley Clayborn, Patience Hall, Sue Manno and Steve Harrison for making this day possible. So thank you.

With that, I would like to open the room to Q&A. But before that, just one final reminder, after Q&A, we do have lunch and one last opportunity for you to go visit our talented leader and get detailed answers on everything that we talked about here. Happy to take Q&A. We have two folks with mics out here in the front.

I don't know if these questions are better for Joe or for you, but both equally qualified. But -- so I guess one question people have had is sort of solving for the fiddly bits and pieces in the EBIT bridge. There's some headwinds maybe that are not called out in there for 2023, maybe just flesh out what those are? Is it sort of distribution costs going up? How big is that? Is there just some contingency embedded?

If we gave you all the pieces to the puzzle, we would have nothing to talk about. So it's a situation where when you think about -- we're continuing to make investments in certain areas. One is for the distribution initiatives that we talked about. And then there are some other things that we continue to look for ways to drive productivity, and those require some investment for long-term benefit. Those are woven in there as well. And then we have some hedge in the number as well. Once again, we're embarking on some rather uncertain times in front of us. So I think we want to be cautiously optimistic but also appropriately conservative. And I think that's where I would characterize our guidance.

That's great. And then just my follow-up on the cash flow, as you said, the sort of conversion on cash has been under pressure from working capital this year. That's kind of common to every industrial -- but I guess as you look out the next 2 years, there's some Lennox or HVAC specific cash items, the sort of capital spending for the new plant and maybe working capital sort of build dynamics for the refrigerant change. So maybe just help us understand, I think, '23 and then even '24, how those 2 pieces, working capital and CapEx.

Yes, what I would expect -- so breaking down our 2023 CapEx guide, it's [ $250 million ]. Our routine or normal run rate on CapEx is roughly $100 million. We've got roughly $100 million in there for the new commercial factory. There will be another $25 million to $50 million in 2024 for that. And then we're also making some investments to ready our R&D folks and our factories for the low GWP refrigerant transition in 2025. So it's going to take a little bit of a while and a little bit of advanced investment to prepare for that. And that's what you see in 2023. There will be a little bit more of that in 2024 in the form of additional CapEx, along with a little bit more working capital as we prebuild some inventory to prepare for that transition at the end of 2025.

I think I just want to end that with saying over the long term, let's be clear that we continue to be aiming for 100% cash conversion to net income. We simply wanted to call out the short-term investments that we think are necessary. And consistent with our previous announcement, where we did talk about the new factory costing us $125 million to $150 million in capital. Question there?

Sorry, Joe, just another one to follow up on Julian's. The 2% revenue growth off of $4.5 billion is about $90 million. You've got $150 million in price, plus $90 million in residential mix. So you kind of subtract all that, you're getting the volume impact on revenue of about $150 million, but your total volume decline in resi looks like it's $150 million. So how much price are you getting in commercial? And is there commercial volume embedded? And then maybe a question for the commercial guys. What is your current lead time in light commercial? We're hearing in the industry, it's still like 40 to 50 weeks. Is that about in line with where you guys are?

Yes, there is -- Steve, when I think about the price, it's $150 million for 2023, it's almost equitably distributed between the 2 businesses. As you know, there's a longer tail on the realization of commercial price over time. So in addition to that, there is commercial volume in that number as well. So commercial -- the market is expected to be up high single digits because of, once again, elevated backlog and pent-up demand going into 2023. We also have price -- once again, the price I mentioned, and then also, there'll be share gains for the businesses as well. So it's getting us a little bit above the market.

And the mid-single-digit in resi, is that market or is that you guys?

Mid-single digit, are you talking the decline?

Volume decline.

Volume decline, that's the industry. That's the industry unit volume decline.

Would you expect to be above that or in line with that?

We expect to be above that simply because, once again, share gain, price and mix will get us to low to mid-single-digit growth in the residential business. Once again, all predicated on how the residential new construction market behaves.

Got it. And then just on the lead times in commercial?

Yes. Our lead times have gotten a little bit better, and I think we're in the -- depending upon product and configuration, 20 to 30, 35 weeks.

Could we maybe just try to unpack heat pump a little bit more in terms of how it actually plays out on your revenues and maybe it's kind of a 2- or 3-year question that dust settles and the like. But my question is, obviously, you've got an important furnace business. You had an [indiscernible] business. You might be selling less furnaces, more heat pumps. Is this actually a net revenue add in your opinion, over the next 2 or 3 years as you work through kind of that substitution bias that might be happening? And then kind of separate from the revenue question, what's the margin impact of that shift?

Sure. I'll take that just to start with, but happy to get going. So first of all, there's a lot still to be unpacked here and the transition is still going. But to confirm our original message, right, today, heat pumps are about 10% to 15% of our revenue. We are calling it to be 25% to 30% of revenue in 2026. So that's taking the mix. Overall, keep in mind that furnaces have a longer life cycle and heat pumps have a shorter life cycle. So from a replacement perspective, heat pumps come up for replacement faster because I want to put that context out there before I answer your question. So if I come back and look at it from a revenue perspective, we would expect this to be about flattish if we put the appropriate exchange. Now there's more complicated answer where we have to talk about mix whether it's a high-end furnace versus a low-end heat pump, but let's just see from a revenue perspective that is going to be. From a margin perspective, we don't really break down margin by product, but we are confident that as we work towards our technology leadership in heat pump, that around margin, it will be pretty neutral for us as well on putting that together. So net-net, if your revenue and margin neutral, what it does is, overall, as replacement cycles for heat pumps are faster or the time line is shorter, it's good for us and good for the industry. And that's the kind of way to look at it. We also look at it, it's a must do for us. Like heat pumps are growing faster than furnace, and it is a must do for us to make sure we capture that growth. Did I get your question, right? Jeff?

So just on the leverage -- lowering the leverage target. One, is that kind of short term around recession and interest costs? Or is that something we should think about longer term? And then -- it seems like you're a little -- maybe a little more focused on bolt-on acquisitions than prior management. And just talk about rebuilding the muscle or kind of what's already there in terms of cultivating that bolt-on opportunity?

Sure. Yes, I mean, definitely more focused on bolt-on. But as we've been clear, it's really just bolt-on. Don't look at big transformative acquisition, not going to look at adjacencies. And to me, bolt-on, Jeff, are all about furthering our strategy. Can I get more sales through our PartsPlus or Lennox stores because our accessory penetration is low. How do we get more service, more service footprint, more service revenues through that? And those are just examples of where we would focus on the bolt-on acquisitions. And yes, we have to build that muscle, Jeff. I mean we are starting. We are doing some work, but we have to build that muscle. There are some pockets where we have this trend, and we can bolt on quickly or those we need to build muscle on. So that's kind of an evolving dynamic. On your leverage ratio question, it's driven by interest rates. It's driven by flexibility that we want for bolt-on. We have always talked about we would like to be less than 2. We used to give a broad range of between 1 and 2. We are just narrowing that range to the lower end, looking at interest rates and where the current environment is. We'll reevaluate 2 to 3 years from now, we'll still stick to less than 2, but we might adjust the range within that. But for now, for the planning period for the next 3 years or so, we think that's the number, and we're going to slowly work towards that, while continuing to deploy $100 million to $200 million in share buyback next year and higher number in future years as still we remain very good in cash generation and deploying that back towards dividends and share buyback. Joe, anything to add to that?

No. Once again, I think our priorities shift as the businesses need shift. And once again, our overall objective is to make sure that we reward our shareholders. And the one way that we can do that more than anything is to invest in our businesses.

Okay. Great. And then just if I do the math on long-term targets, it seems like the incrementals are bumping north of 40. And historically, you kind of talked about 30. I don't know if there's anything more to it than commercial recovery and maybe catching up on price cost, but help us kind of bridge the gap to that higher incremental.

Those are the exactly 2 points, Jeff, that you mentioned, it's a commercial recovery because we tried to break that $100 million separate because overall commercial would grow more than the [ 100% ], but we just tried to break that out separate. And then, of course, catching up on price cost. I mean this year, we did well. But next year, as we go into an environment where we are getting price cost to be more positive, those are the 2 mix on going from 30 to 40. But I think that's a very accurate observation.

[indiscernible] I just want to circle back on the $100 million of EBIT target. And if you could talk about the buckets a little bit more in terms of when we think about cost efficiencies, price mix, share. If you could talk about kind of the relative importance of those and really just sort of that confidence in why this is linear, why it maybe doesn't accelerate faster than that if we're going to see a lot better performance out of the factory in near term?

Sure. Well, what I tell, Miguel and Joe, that it should not be linear and it should be faster. So I would join you in putting that together. But as a planning assumption and to make sure like we appropriately put conservatism because we don't know what the supply chain is going to be doing. We were bad in predicting COVID. We were bad in predicting the Ukraine war. I don't know what the next shoe is going to drop, right? But to answer your question, we think it's made up of 4 factors, Joe, and we have kind of roughly talked about that. The first part on that is just more productivity in [indiscernible]. Joe talked about earlier that we have added sort of 30%, 35% labor, our output is going up, but needs to go up more. So we're going to get just more productivity in the factory itself for us. Second part for that is just price cost dynamic. I think Joe and the team are doing a really good job finally catching up on the price cost. And some of the key accounts, it takes a while to get through the pricing dynamic. So we expect the price cost dynamic to get there. Third for us is reentering the emergency replacement market and getting our share back, which I mean our own dealers have been forced to use not our products in commercial because we didn't have them. The fourth factor, which we hope not to use at all. I hope to get the $100 million from the first 3 factors, Joe, would be the factory, the new factory in Salto, which has significantly lower labor cost than our current factory in [indiscernible]. So think of those first 3 as the one we want to use and fourth sort of a backup if one of the other ones don't go as well as plan. So collectively, we're very confident in getting the $100 million, hope to get with the first 3. And I think linear is just a nice easy way for us to think about it. If we do better, we both benefit together.

Can you talk about historically what your mix of emergency replace was? How bad that got in 2022? And maybe where you are kind of today to just understand how much better position you are today to serve that market?

It varies year-to-year because obviously, of economy and everything else. But let's just say it was about 1/3 of our volume that went down to zero during the absolute worst of our production in Stuttgart because we focus everything towards our national accounts and walked away from the emergency replacement. So it was a significant chunk of our business, Jon.

But today, how well can you serve that?

Joe, how would you answer that? Joe Nassab?

Yes. We're in a situation right now where the productivity out of the factory is improving. But once again, our focus right now is on the national account customers, we expect in 2023 to have more of that product available. I mentioned, once again, making sure our distribution channels are full with stockable product. That will be through the course of 2023. So we're still at near zero when it comes to emergency replacement, but quite frankly, that's a tremendous opportunity for us going forward. And once again, it's a situation, too, where you understand what it takes to compete in that. It's product availability at the lowest cost. So once again, we just need the product. We've got the distribution footprint. We've got all the other capabilities. Once again, once we solve for product, we're back in the game.

Any other questions?

As it relates to the Mexican facility, I was wondering if you could just help us understand the return -- expected return on invested capital for that investment?

Sure. We don't make our ROIC for individual investment. But like overall, we look at a payback and is it a 2-year payback or a 3-year payback. And from our perspective, like it's within our expected range, and it's not going to be dilutive. But yes, it's -- we don't give individual payback for investments, Joe, do we?

No. No, we haven't historically, but this is a situation, too, where this is necessary capacity to support a growing industry. And it will bring some cost benefits. But once again, this is more about capacity and derisking the manufacturing footprint in commercial.

It's got a good payback. I just -- we don't declare it publicly, so Okay. Steve, anything online?

No, no online questions.

Okay. Great. Well, I appreciate all of your time. Again, great to meet you in person, great to do the event in person. We do have lunch outside. And of course, our talented leaders are very happy to answer your question. So are Joe and I and the executive staff. So I encourage you to again visit our leaders to learn more about innovation, sales and operational excellence. And again, once again, thank you. Appreciate it.