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

Well, it's my please to have up next, Lennox International, Alok Maskara, CEO for almost 1 year now; and Michael Quenzer, Investor Relations and VP of Corporate Finance. So welcome both. I think it's your first time to this conference. So we're delighted you can make it, and thanks for meeting with everyone here today. Alok, maybe, yes, start off, please, as I said it's your first time at this conference. So a warm welcome and a couple of sort of introductory remarks.

Sure. Great. Thank you, Julian. Thanks for having us here. What a great place to have a conference. Hope you guys are taking some time to get out of the conference room, enjoy the beach and the beautiful weather. Let me start by having Michael introduce himself, and then I will talk about myself and some prepared remarks.

Good morning, everyone. My name is Michael Quenzer, I'm the Vice President of Corporate Finance. I've been with Lennox International for nearly 20 years, most notably have recently been in the Commercial segment, leading the finance as a CFO for that segment for the past 6 years, just moved in this role and excited to take on Investor Relations.

Great. Thanks, Michael. And I'm Alok Maskara. As Julian said, I've been on the role coming up to almost a year, almost 9 months. Still very excited about Lennox. Just a few things. As you know, we are one of the smaller players in the U.S. HVAC industry. A few things that differentiates us, a, with our announced simplification and divestitures, we are now 100% focused in North America. So very excited about that. We are unique in that we have our own distribution channel that we used to sell direct to business. In our residential market, 70% of our sales go through our own stores and our own distribution, 30% goes through third party. So that's unique. It gives us a lot more insight into end consumer behavior and channel trends and other pieces. And on the commercial side, where we have significant margin improvement opportunity. Also, most of our sales do go direct where we serve national accounts and smaller unitary customers direct to market. So that's one big differentiating factor. In terms of where we are, obviously, we had, gave a detailed update during our Investor Day in December. And our view has not shifted on any of those aspects since then. So we still remain confident that this year, we will have growth in revenue, growth in EPS, growth in ROS and continue to make progress on our strategic initiatives. We're still residential to be down mid-single digits in terms of volume, but likely up in terms of revenue due to benefit of price and mix, and we do expect commercial to improve their margins further as we go through the year, taking advantage of a good strong backlog and continued operational improvement. So excited to be here and happy to go into the fireside chat mode.

Thank you, Alok. Maybe firstly, as you said, you're sort of guiding for low single-digit core sales growth for the year as a whole. How is the year starting out? We've had some questions around warm weather, for example, impacts on furnace sales, if any, not relevant for this neighborhood necessarily, but across your business in the U.S., how would you characterize sort of how the year is playing out to date?

Yes, 6 weeks into it, it's playing exactly as we thought it would be. While we do like cold weather and cold streaks and we like really hot weather in summers, net-net, it's not like moving the needle either way for us. It's as expected. And if there is some benefit from the cold streak that we are facing some part of the country, it's too early to say whether it's going to have an impact on the full year. As you know, summer is our peak season and summer, whether it makes a bigger difference to us on a winter weather. But yes, we welcome the current weather and the climate, but no change to our year outlook 6 weeks into it.

And when we're thinking about that mid-single-digit volume decline outlook for the residential market in aggregate and Lennox slightly better than that throughout growth. Should we think about that down mid-single digit fairly level through the year?

I would think so. I mean, we can try and get more precise, but that gets us in trouble, right, from a simplicity perspective, let's just think of it across the year. Everybody is going to face some destocking during the year. It's hard to quantify when. It's likely to be around Q2. But net-net, from an overall perspective, it's fair to say just think of it pretty evenly spread out throughout the year.

And that point on destocking in the second quarter, help -- I think there's a lot of crosscurrents on residential HVAC on that topic of inventories, and we've heard different things from suppliers like Regal here or some of the other OEMs like carrier and train. Maybe sort of flesh out why second quarter and how much destocking do you think needs to happen? I understand inventories might be high, but pricing is high, demand is -- has been high sort of putting inventory in the context of everything else around there, I think, would be helpful.

Sure. I think the reason the inventories are high, primarily is because the whole industry is working on long lead time for many years, having the COVID period and demand was high. So everybody bulked up on inventory, including us on an internal level, we have higher inventory than we would like. In addition, the whole SEER change, people want to make sure that nobody ran out of products, so us and the industry players, we all did that. And that's still being brought down as we are still selling some of the older SEER products where we can, especially on the north. So as we put it all together, as demand sort of moderates, as lead times normalize, I would expect all of us to pull down on inventory. We are planning to do that internally, talking to our channel partners, which are more only 30% of our business, Allied and others, they all expect to pull down in inventory. I think people are going to be disciplined around it. So instead of a one big step down, it's probably going to be gradual working with the manufacturers and the distributors together and likely going to be Q2 time frame because people are still seeing how the demand is going to evolve this year. People are still looking at clearing out some of the older SEER and building up the new SEER inventory. That's why I think it's going to be Q2. But listen, I don't have a crystal ball. At the end of the day, we know for the full year, the impact is going to be small. We used to turn inventory 8 to 10x a year. Now we are turning like 6 to 8 x, I'd like to get back to the 8 to 10x, but it might be 12 months' time frame during which we do that. And I think everybody else is hopefully thinking the same way. So there's no sudden cliff drop. But if and when the destocking happens, it's a matter of like 6 to 12 weeks, maybe 6 to 14 weeks' time frame.

That's very good context. And as you said, the SEER change sort of the formal date and you've got the 2 regional nuances, but the formal date for both was 7 weeks ago now. Any impact since then or pre then that surprised you or are people, distributors, competitors, suppliers, all in general, behaving normally, and they should because this transition was extremely well telegraphed?

I would say, Julian, almost everybody executed well throughout the SEER transition. There were no surprises. Industries got used to this. This is not the first SEER change we are going through, nor would it be last. I think people executed well. I'm proud of our team. We executed very well. Didn't have any hiccups, no product issues, no supply issues, more than normal, right? And we always have some issues everywhere. But I think the change went as expected, was pretty smooth across the board. I think us and our competitors did a good job executing through this SEER change.

Agree with that. And if we think about pricing, and I think it's helpful in sort of meshed price and mix together in one figure. How is price discipline? I think a lot of people have pushed through price increases. We've heard that from other OEMs, the last 36 hours. What's your expectation for pricing this year? Do you see any sense of resistance or hesitation versus a year ago to price up?

No, we don't. I think the industry remains pricing disciplined, Julian. There's always some noise in certain pockets that some competition is cutting price. I put that in the fake news category. I think at the end of the day, every salespeople when they lose an account, they like to blame the competitor's pricing. Sometimes they need to look in the mirror and say what they could have done differently. So when my sales people come and tell me that so and so is cutting price, I'm like show me real proof, show me some real data, which we don't ever get. So I think the industry pricing is holding well. We are not cutting pricing, nor is anybody else. I think that continues. At the end of the day, we will all take extra price versus extra share. If there's ever a trade-off, which I don't think this industry has, but I will take higher price versus higher share any day long. Game Curie is well understood in this industry, and we would look at getting to a situation where we can at least at minimum offset inflation. Inflation is still there. We talked about $100 million in component inflation this year alone. So we need that pricing.

And as you look out, we've gone through the SEER change, it was fairly uneventful for all the sort of hot air expelled on that topic for 3 years. The refrigerant change coming up in 2 years may be more meaningful. I think Lennox's commentary has suggested, look, you may need an investment surge now, there could be prebuy from the channel in 2024. Maybe sort of flesh out some of your thoughts on why that transition you think could be more impactful or consequential for the industry and for Lennox?

Sure. Yes. It's a bigger change compared to the SEER change. Have you changed refrigerant, this is the first time the refrigerants has some flammability concerns, which means the way we transport the refrigerant, the way we store it in our factories, the way we test it in our labs, all needs to be relooked at to make sure we adequate fire protection, sensors and controls. Including in the units we sell, we'll have to put sensors and we'll have to make sure that flammability concerns are fully addressed. So I think it's a bigger change in that respect. At the same time, I do expect it to go as seamless as the SEER transition went. Us and our large competition, we're all kind of done with essentially the design phase. We're all working through the implementation, the certification, the manufacturing phases of that. The investment that we mentioned, I think others are doing the same thing. Because we are smaller, sometimes you're more transparent when I say, okay, I got to put x million more in capital to upgrade my factory lines. Others being larger, you may not show as clearly in them. I think we all are investing in making sure our manufacturing is up to speed, our refrigerant storage and transport systems have been upgraded and making sure that we really look at inventory and so that if there is a pull ahead in '24, which I think there will be, we are prepared for that. So I think from our perspective, we will do our best to make sure that the low GWP transition is as boring as the SEER transition was.

Yes. And in terms of sort of scale of units, I think there was some scaremongering around units needed to be the size of a 747 or something with the refrigerant change. But I think the scale of it is probably quite similar, not just the units.

The box size, as we look at it, should be exactly the same. Our box size is not going to change. I'll be surprised if any of our competition box size change. Now a higher SEER unit is typically a bit larger anyway but given all that dimension, the box size is unlikely to change. We can get similar efficiency but just redesigning our coils, redesigning our venting system, but I'll be surprised the box size changes dramatically.

And then I guess while we're on a sort of subject of HVAC technologies, heat pump always a lot of investor focus on that topic, maybe clarify sort of Lennox's -- it's domestic. Clearly, the focus now, as you highlighted at the beginning, but within sort of residential and commercial heat pump, the positioning there, the exposure at the company?

Sure. So in heat pumps, we're not satisfied with our current position. I think there's a lot of room for improvement for us. Our penetration, our sales from heat pumps is lower than some of our competitors, and we accept that, acknowledge that. A lot of it is driven by geography because the market share in Northern U.S. is higher than our market share in Southern U.S. just based on history. And in Northern U.S., the heat pump penetration is lower because of colder climate versus Southern. So we have a lot of opportunity ahead, a lot of improvement potential. The new technology for core climate heat pump on which we are leading the charge right now is going to help change the dynamics, increase our penetration of heat pump. Related to that, mini splits and VRF is a product category, which we are underpenetrated in and we are working through with our partners to increase our penetration in mini splits and VRF, just because, again, similar technology. Often, the technology is coming from overseas. The U.S. is a small portion of that market. And because we are more U.S.-focused, our heat pump penetration is lower because in Europe, given the climate and other conditions, heat pump do have a higher penetration. But they often air to water heat pumps versus ours being air-to-air. So not going to bore you down with technology, all we're going to say is, we have significant room to improve our heat pump, VRF and mini splits, and all of that is upside for us.

And can you do that sort of organically? You have the partnership clearly with -- in VRF to get that technology. How is that -- how satisfied are you with that partnership and I know you have a fairly low net leverage goal from the Investor Day, but is there an argument to be made perhaps for doing more M&A to move ahead in VRF and/or heat pumps?

Not as core part of our strategy, Julian. If there is, it might be some small bolt-on to fill in gaps. We do have the technology. So I think from a technology perspective, we do have it. We do have the channel to market. A lot of these products are manufactured overseas. And we have good suppliers and good partners through that. We may need more than one. So I think we are working through that. One thing that brings to the picture is, if you think about most U.S. HVAC players, Julian, they have a strong tie up with somebody else. So now we are the only ones who don't have that strong tie up. If you flip that, among the global players, anybody who wants to enter U.S., we are the only one left. We are the only unattached one. So we have more people wanting to partner with us than us trying to go seek out new partners. That makes any sense for that because there are many large players today who don't have presence in U.S. Mitsubishi does because of train, there are others who do, Toshiba does. So they put that all together. So we're in a very strong position here with a North America focus and open opportunity for us to do more. But that doesn't require acquisition capital, that doesn't require much investment. It requires more strategic partnership. And if there's an investment, it's around training, sales presence, dealer ramp up and all of that so.

And so -- okay. So the point is that VRF, you are looking to move ahead there and partnerships are a very likely way of helping you with that.

That's right.

If we look at moving away from the technology side to sort of stimulus measures and so forth. I guess a couple of different elements, education stimulus, how far do you think through that we are now? How much benefit did Lennox get, say, last year on sort of K-12 and higher education spending? And then looking ahead, infrastructure, inflation reduction at kind of where are we around when inflation reduction at could maybe fit into some of your revenue or orders?

So my education initiative or the incentive, we had initiatives which started like 2 years ago, and we met our goals and we got appropriate benefit as we came towards the end of that. In many cases, because there was a deadline there, when the funnel was firing, we prioritized education orders more. Now if I think of our strength, we had -- our strength is typically in single-story building, unit resystem and that schools typically, right? Very few schools have a multistory especially if we live at suburb. So we did well in the education side and met all our goals. So a nice job by the team. If there was any miss, it was because of industry supply chain issues. So there are a lot of people but everybody had the same issues towards the end. On the inflation Reduction Act, I said, we are bullish on it. It helps the industry. It helps us. A large part of the monetary impact is going to happen later in this year as all the rules cascade through the states and the utilities and to start getting, it's going to impact mix more than core demand because people who were replacing HVAC might replace an higher end to an higher end because there's a government rebate associated with a higher efficiency unit and heat pump unit. So we do see it impacting mix more positively, and we see that impact more in the second half of this year. But I see it not as a step function change. It's not that on first June, we'll certainly see a big step change. I just think it's a gradual uptake, which has already started, some of the tax benefits and the tax credits have already started. I think that's a good benefit.

Great. And then I suppose when you -- I think there's been some perception that has -- did Lennox maybe underinvest a little bit in recent years in areas like that low refrigerant technology or VRF. Is there some catch-up needed, commercial has had some issues sort of with the plant operations. Do you see a substantial need for kind of stepped up investment from here or not necessarily?

Let me have Michael answer the question on the commercial, then I'll come back to your research question.

Yes. So on the commercial, we definitely had some issues earlier this year with manufacturing. We think we solved that issue predominantly through labor, but we do need more capacity as we enter back into the emergency replacement space over the next couple of years. We announced that we're going to enter and build a second factory for the commercial segment in Mexico. So that's definitely an investment we're going to make in that segment, but that will happen over the next year or 2. Thereafter, it should be more normal CapEx in that business.

Sure. And on the R&D side, that's just not true that we have underinvested. I mean we have invested same and more. Sometimes we get more out of our R&D dollars than others because we spread our R&D between here and our technology center in India. And because we are small and focused, we are really very focused on things that matter. But in low GWP, we don't need to worry about propane regulations in Europe. We are very focused on low GWP in U.S. Hence, our investments are very focused and they might appear to be low compared to some others who are trying to balance regulations in Europe and Asia, in China and U.S., and we are only focused on one, right? But no, I mean, we are fully invested. Our designs are done. We are moving ahead. We might even be a step ahead of others in terms of putting appropriate capital to get a manufacturing facility ready. The bigger part on investment, I don't see any change in our SG&A, which includes R&D as a percentage of sales going forward. Our CapEx is going through a spike this year based on what Michael described $100 million to $125 million really looking at a new commercial factory. But starting next year, we expect us to be back to normal 90% to 100% free cash generation.

Got it. And maybe, Michael or Alok, following up on that new plant in Mexico, I think it's maybe 2 years out or will be getting towards sort of full production rate. Maybe help us understand how much extra share or revenue are we expecting out of that plant at full production and kind of qualitatively what output will it have differing from the existing U.S. factory output?

Sure. So we expect the factory to start to go live mid-2024, and we'll start to ramp up throughout 2024 by the end of the year, have all production going through there. We think the footprint of the factory will give us ability to double our capacity. We want put all of the equipment into doublet immediately, but it will give that opportunity to double capacity, which is key as we enter back into the emergency replacement space. So definitely a big upside for capacity. We think about 50% of our production will come out of Mexico. The other 50% will be in the U.S. at our existing cutback factory.

And just to build up on that, the cutback factory in U.S. will be very focused on made to order, like configured products and the factory in Mexico would be very much into made-to-stock or standard products. And that's what's -- the standard products are the ones that have higher share of the emergency replacement. There are going to be two very focused factories, and that actually brings up our efficiency significantly because doing both in the same factory given the size of those units was getting quite challenging.

I see. And look, I think as you said, it's been almost a year in the role, some big changes already, the commercial plant being added in Mexico, sort of withdrawal from Europe. What else you kind of think -- not sorry, tell us here decisions, but what other focus areas do you have in mind? Again, you've got a couple of big things done already. What else are you kind of exploring or thinking that we can change direction here or...

I was thinking of taking a golf, Julian, and doing some other things. But in our seriousness, these changes that we have announced recently, some of them were planned for a while. During the CEO transition, everybody gets a little leery, CEO transition took longer than it should have, right? So people just got a little gun shy during the transition. The commercial second factory, it was shovel-ready plan when I came in. I mean it wasn't that we had to create a new plan. I mean things were sort of ready in that. Lennox has been working towards simplifying. We divested out of Australia and China and Latin America. So I think this was the final set. So a lot of this is continuation of our strategy. We want to be a simpler company, focus on HVAC. Our next big thing going forward is making sure we deliver on our margin goals. Our margin goals of getting to 18% to 20% ROS across both segments by 2026 is very important to us. A large part was going to happen because of pricing. Our pricing opportunity is higher because of some of the national accounts and how long it takes for some of that. A large part of that is going to happen as volume recovers in commercial and we get more efficiencies on that. A large part of that's going to happen as we look at our corporate cost and bringing that down slowly to more a normal level, to better reflect the fact that we are a simpler company, 100% focused in U.S. And that's where I'm going to be spending most of my time now is looking at that while making sure we have the appropriate partnerships to win in heat pumps, VRF and mini splits. And those are kind of all in one category of products that are growing faster. But all of these are things that we would have been doing earlier as well. And for us, the CEO change is behind us, the strategic decisions that are behind us. The second factory is behind us. It's time to execute, time to execute, get some growth, win some share and expand ROS. Those are the 3 priorities we talked about when we had the top 200 leaders of the company.

And on the ROS point, 2 segments now. So it's an easier discussion. Commercial is very clear. I think you've got the sort of 150 improvement over 3 years, Residential maybe focusing more on that then. I think flattish margin this year is sort of in the financial plan. Once you get maybe through this destock or soft patch or what have you, what kind of core operating leverage should people expect in that Residential business? You see any natural competitive anchors on the margin? Maybe just talk about that.

I mean one strategic way to look at it is if a manufacturer in our industry makes 14%, 15% margin and a distributor makes a 10% margin, Lennox should make 24%, right? I mean, it's simple math. I don't know why I would complicate it any more than that. So that's kind of a margin goal. Then we need to go back and analyze either our pricing is messed up or if a distribution is inefficient or manufacturing is inefficient, right? There's no other reason. So I start with that aspect on an outside in looking and then I go back and look at it. I'm confident we're going to get higher margin in Residential. This year would be flat to up despite significant manufacturing down because remember, this year, we are going to make less than we sell. Last year, we made more than we sell. From a production perspective, we'll be down more than sales. But still, our margins will be flat to up. Pricing is going to be a big part of that. We've talked about manufacturing efficiency, a reduction of manufacturing inefficiencies, lower air freight, lower premium on parts overall that would be another part of it. And then finally, on Residential side, we've got to get our distribution to be more efficient. Our distribution just needs to be more efficient. So those will be 3 factors on which the Residential margin is going to go up. I didn't talk about mix, but mix was a negative in the past few years. Now it's going to turn positive.

And that mix elements because of sort of new construction being pressured and the technology changes.

New construction down, SEER change being a positive. And finally, we have premium products in stock. We didn't have premium products in stock during COVID. It's got Dave Lennox Signature Series. So we're actually finally aggressively going after our premium products that we didn't do for the past 2 years.

And so Residential, you could be into that sort of 20s margin theoretically?

I would expect by 2026, both Residential and Commercial to be in 20s, right, 18% to 20% is our guidance right now so.

Good. Well, I think now we'll switch to the audience response survey questions, please. And the first one is your sort of current positioning in the stock, very low ownership.

Good opportunity.

Absolutely. Next question is around sort of general bias aside from ownership today. Very balanced. Third is around growth, EPS growth and the peer set here is U.S. industrials or U.S. multi-industry sort of broader than just HVAC. So in line which is slightly above the average. Next question, I think, is around capital deployment. Not a lot of leverage, the near future. But buybacks is the preferred use of cash. Next thing is on the valuation, what PE should Lennox trade at through cycle really this one?

Clearly, the answer is fixed, Julian.

Let's see. So high teens is where most people are shaking out. Next question is around sort of why is it high teens and not to Alok's point, 20-something times? Or what's the biggest concern will have if they had picked just one? So organic growth, similar to train somehow. And then the next one or last one, really, a new question this year around sort of ESG and the role that, that does or doesn't play present. So more ESG. Generally, most ones have been 25%, #1. So it's double that for you, which I think makes a lot of sense with HVAC drivers. And with that, Alok, thanks so much.

Thanks, Julian. Pleasure.

Thank you very much. Thanks for being here.

Thanks, Julian.