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

I think we're ready to get going with our next presenters. We're really excited to have Alok Maskara and Michael Quenzer from Lennox International here with us today. Thank you, both, for being with us here today. I really enjoy getting a chance to meet you, guys. I'd love to see you again.

Maybe let's get going with look, Alok, it's been about a year now that you've been CEO. You've done a lot in terms of simplifying the portfolio, working on the margin expansion opportunities, investing in the future. Maybe just talk to us a little bit about like what you're most excited about, what the team actually has accomplished and what's left.

Sure. Thanks. And great to see you, I think it's been quite a few years when I was at Accenture and learning about IR. And a tough act to follow after Johnson Control in this room, people I respect quite a lot. George Oliver used to be my boss back in the GE days. And Jim Lucas used to be the IR person. It's a small world. But delighted to be here. Thanks for hosting. I completed 1 year yesterday. I got an e-mail from the system, saying, congrats on 1 year. So all those who were shouting, saying the new CEO won't last a year, you were wrong, I did last 1 year. As I look back on 1 year, and if I look forward the next few years, the thing that I'm most excited about and the most proud of is driving a cultural change at Lennox. Lennox is a great company. we were a better company 5 years ago than we are today. The first 10 years of my predecessor, he did great things. In the past 5 years, we kind of got into pickles/internally driven quagmire that we're getting out of. We're driving a significant culture change at Lennox. That has 2 different aspects to it. The first aspect of that is truly reinforcing our culture with guiding behaviors, getting accountability to be one of our core guiding behavior, getting to a stage where digital customer experience is part of our core guiding behavior. And we mentioned that in the PowerPoint, but I just want to emphasize how important that is to us. Because internally, because we were very successful for the first 10 years, we became a bit complacent. We were good, and we let that become the enemy to becoming better. And we became very internally focused, and we are changing that. That is kind of a huge portion. Each and every employee at Lennox is going through training. We took our top 200 people through a whole session. But it's not just a session. It's about the tools that's going to be used for all our talent measurements going forward, that's in people's annual performance. And that's a significant portion of if you want to be with Lennox in the future, you must live our guiding behaviors. You must be accountable for what you do. You have to be customer-focused. You have to believe in sustainability, and that's who we hire and who we retain. Second aspect of that is an operating system. We have put a very disciplined operating system driven by scorecards, to think of the old balance score card-type methodology, given with the lean principles on truly how we operate factories. Michael has actually led that from our perspective, getting into very discipline. Every month, every quarter, every year, how do you put a very disciplined operating system at Lennox that will make sure that we're never ever surprised by things like Stuttgart. The fact that we didn't know about Stuttgart, we as in the corporate, and we lost -- those things will just not ever happen again. So those are the 2 things I'm super excited about. We are early innings in that journey, but the results are quite positive. We have a team that's super excited. And we have given everybody a choice. Either if you're not -- if you don't want to be on the bus and you've done great for 15 years, given our stock price has been good, we don't want you to sit on the office chair. We want you to sit on the beach somewhere and enjoy all the wealth you've created. But let's pick that choice, get on the bus, we are here to win.

That was a great answer. I'm curious on the people side. Has there been a lot of change at this juncture? It's been 12 months. I know that you're probably looking to see the type of talent that you have on board, but has there been much change from that standpoint yet?

There has been, as you can see, new CEO, we have 2 new segment leaders, both experienced and both fired up, both in this journey together. Residential new segment leader, Gary Bedard, he grew up in the Lennox residential area, has strong, strong relationship with the dealers. And these are the dealers who are upset at us. These are dealers who left us. These are smaller dealers who are higher margin and have been Lennox loyalist for decades. So Gary has 24 years of experience working with them. And having him as a segment leader is a refreshing thing, right? Our dealers are really, really excited about it. On commercial side, Joe Nassab is our new segment leader. He grew the Allied business from $200 million to $800 million while taking profitability from low single digits to one of the best in the company right now. He's really fired up about commercial. I mean, he really wants to do the same journey at commercial. He's the one who says, it's not about share or margin, it's both, right? The way we're going to do it is both together. So I think 2 leaders. If you go to our plant, essentially, except for one, maybe all our plant leaders are new now. We need plant leaders to really work on what customers need versus we had come to the stage we were selling what the plants could make. No, it's going to be other way around. They are going to be what the customer needs and that's what the plants will make not having the salespeople say, "Hey, this is what you can sell because this is all we can make. That's a huge cultural shift for us. And then take it across the thing, like we are putting new folks understanding pricing, so we can do pricing more sophisticated way instead of brute force pricing. We are -- on our go-to-market front, we have worked with outside help to do external benchmarking, and we are revamping that, both on the commercial and the residential side. How do we go to market? We've added more salespeople in residential in the past 6 months than we did in the past 6 years. And we are funding that through G&A reduction and making sure we take out wastes and administrative processes and add more feet on the street. So there is a whole transformation that's going on that's beyond the numbers that -- that's supporting all the numbers that you see. It's easy to talk about numbers in it, but I thought I'd take this opportunity to talk about the real transformation which is happening at the plant level, which is happening at the salespeople level. Opening stores is interesting. But if you don't have salespeople who are helping yourself, that doesn't matter. But now we're actually doing the hard part of adding salespeople who will bring traffic into the stores.

That's great to hear. And I'm sure everyone's going to want to talk about commercial recovery, but there are a couple of jumping off points there that I wanted to ask you about. So number one, in terms of getting some of the dealers that you lost, are you starting to see any traction at this point in bringing them back into the fold? So any color around that would be helpful.

We are. It's early stages. And it's easy to lose, it's hard to win back, we know that. But we are seeing traction. Many of these have been historical loyalists. And one reason we lost them is because we didn't have the Dave Lennox Signature series products. And our service levels were low, our inventory in the system was really low. Our service levels are back up over 90%. Our inventory position is all green now versus mostly red just about 12 months ago. So from that perspective, yes. But it's a long journey. Our value proposition to a high-end dealer remains superior and it's getting better. One big way that's being driven, Joe, is e-commerce. E-commerce has now become over 30% of our residential sales. Like over $1 billion in our sales are purely through e-commerce. These are people who are ordering on their app or the website. They're not coming to the store anymore. They are purely relying on that. They love the fact that they can scan the QR code and get prognostic diagnostic decisions and pulling that together. The way we lost it was poor service, not enough products in hand, not enough premium products. The way we're winning them back is digital capabilities, fully stocked products and, frankly, more feet on the street. Some of them left because they didn't have a salesperson to talk to. There was a dealer in the south of Atlanta who called me in my first week, saying, "I've been a lifelong Lennox dealer, but you got rid of my salesperson. My salesperson is now 2 hour north Rheem guys right next to me, I'm going to go to Rheem, right? I mean, just those are things we are addressing straight up. So yes, we're winning them back, it's a slow journey, but we are going to get there.

It's an interesting dichotomy, right? You've got your e-commerce sales now 30% of your business but you're adding more people locally to the stores. And I understand that you want to be closer to your customer. I guess maybe just help us understand like do you have the right amount of stores? Do you have to continue to expand your store presence? And what's the right like leverage model, like sales leverage model that you're getting in the stores versus where you were before?

Sure. Two things. We know when we open stores, we win share in that market. So that part has not changed. The time line to get there can be faster. We also know that our distribution right now does not have world-class operations and efficiency. Our sales per square foot is much lower than people who do it well, and I admire people like Watsco who do a really good job at this. The good news is we have role models. We know what good looks like for us to be able to see from the outside in and learn through that. So there are lots of opportunity. And you have to think of our salespeople not as people who take orders, but people who are the product specialists, who can go help the dealers with a product questions. They shouldn't be order takers and carry a notebook to take order. That all happens on the e-commerce. But they need to be able to train them on the latest, greatest heat pump technology. They need to be able to talk about Dave Lennox Series startups and how that's going to help them make more money. They are the ones who are calling new dealers and saying, "Hey, can you switch back?" E-commerce doesn't help me win back the dealers if the dealers don't know about it. Somebody needs to be knocking on dealers' doors and saying, "Hey, here's the new capability. Here's the new offering." That's what our salespeople do. They should not be transacting. If they are taking transaction orders, we got this model wrong. But that's part of the go-to-market revision that we talked about. We are revising how we go to market. Our dealers are no longer order taker, ordering through our salespeople. They order through the website. But they have the back support when they need to. And that's where we've got to make it easy for them to process warranties, easy for them to get training and get to the stage where we help them win because that's how we win. This is an interesting dichotomy, but it's the right division of labor for us.

And then outside of the Lennox stores and outside of your direct channel, it was interesting, the comments that you made around growing the Allied business and now that being one of the highest-margin businesses that you have. What's the ambition at this point with your independent distribution channel? I know it's not just Allied, but what's your ambition here?

Listen, our market share on direct and indirect in both is very low. I mean we are a smaller player in both those, and we have a huge opportunity to grow. So I'm not going to say I prefer one versus the other. We like both of them to grow. The reason indirect has become larger, Joe, is because direct stumbled and remained flat for a while, right? So they both should grow. Both have opportunity to grow. On the indirect side, it's going to be about adding more independent distributors. Our penetration is still very low and we have a long backlog that we can convert now that the product position is better. On the direct side, historically, it was about opening new stores. Now I talk about how do we make sure that we serve more dealers the same day or next day. I can serve them through local distribution centers. I can serve them by dropping a container in the parking lot. That is a VMI and it's got RFID technology so they can -- when they take products out, we automatically bill them. So there's a lot more technology that we're going to use going back to e-commerce to serve our dealers. It doesn't have to be of more stores. We need to make our current stores more efficient, for sure, right? They are not as efficient they could be. That's about having more parts and supplies. That's having more velocity through them. So that's what a good distributor would do. And we need to act more like a distributor when we run our stores but not be afraid of experimenting with smaller stores, continue drop-throughs and other pieces that we work through. So we are no longer going to talk about opening x number of stores per month. That led to some bad behavior, right? I mean we open stores without having a fully fledged plan of how we're going to make them profitable.

Makes a lot of sense. Let's switch gears. Commercial margin recovery, happening a lot faster than we anticipated. Maybe not what you anticipated internally, that's what you communicated externally. So talk about what's been better and what's happened faster? And what's the plan going forward?

Sure. I'll let Michael answer that question. He was the CFO of the Commercial division until last year when I pulled him to corporate and got him more of a G&A type role. And he's also helping us with the whole metrics-based system that we are using to drive the performance turnaround.

Yes. So first off, very pleased with the recovery in the commercial business. You can see in our Q1 results, we had operating profit up 800 basis points. So definitely good progress there. A couple of elements when you break down the recovery in that business. The first was that this time last year, we were seeing cost increases coming in significantly faster than pricing. Second half of the year, we had to go out and reprice a lot of our national account contracts, a lot of our backlog. You're starting to see that benefit come through in the first quarter. So definitely, the price/cost dynamic is coming a little bit faster than we expected. On top of that, we're also seeing in Q1 some favorable mix as we transition to the new minimum SEERproduct. We're starting to see some mix benefits as well in Q1. That's one element of the recovery. The second element of the recovery is predominantly around production, getting more output out of our factory in Arkansas. If we could get more production out right now, we would sell more products. So it's still definitely a journey in that space. I think it's going to be kind of a multiyear journey, but we think we're going to be building more in Q2 than we built in Q1 and more in Q3 than Q2. So by the end of the year, we should see volumes up in the commercial HVAC segment. That's after being down 6% in Q1. So overall, we're seeing really good progress there. Production is really the remaining element that we're working on.

Super helpful. And so Michael, maybe just a follow-on question for you. Where are you in terms of your production today? I think I remember a number of the 4Q, I think you were at 20%. Like where are you in terms of -- and what's the limiting factor? Is it still labor?

Yes, I mean, a little bit of distortion in Q1. We obviously had to transition nearly 70% of our product to the new minimum efficiency product. So we knew there was going to be a bit of a more ramp-up challenge in Q1. But we are seeing component shortages still. A lot of our competition is seeing those on some of the new components that are going into the product. But things are improving, and they're definitely getting better. We had 20 or 30 issues this time last year, we're down to 5 to 10 right now. So we're seeing that improve. It's predominantly a component issue. The labor issue in the factory is definitely solved at this point.

Okay. Great to hear.

And Joe, if I can just add on the commercial side, I want to paint the vision of where we are going there. So I think there's a brute-force $100 million. We talked about it. We are more than halfway through. We'll get it. It's all about blocking and tackling, right? But we have good role models on the commercial side. I mean I look at [ Aon ], that's what our Stuttgart business used to be; high-end products, configure-to-order, quick lead time, working with the key accounts and getting engineered, right? I think [ Aon ] has borrowed a lot of share from us, and we need to get Stuttgart back in that thing, right? On the other side, our future factory in Saltillo, that's targeted towards replacement, Carrier curbside, get to a stage where that product is in stock and available within the same day or the next day, locally delivered to you, made very efficiently because that's more competitive and both can be good margin business. That's the vision we are going towards. Now to get there, we had to first stop digging hole in Stuttgart, which we did. We have stabilized it. But there's a long way to go before we crawl out of that hole. Output at Stuttgart is still 20%, 25% lower than 2019. So all I'm saying is you're not in a demand-constrained world. But in future, we made a demand-constrained world, right? It happens in every industry. And when we get there, we are working with our go-to-market, with our sales team, with external help redoing our go-to-market. So we are clearly focused on one end, getting the [ Aon-type ] margin on serving that customer. The other end, getting the Carrier-type volume and pulling that together. That's where we went wrong. We tried to be all things to all people using 1 single model, and that didn't work for us. So we will fix our current issues. But future for us, we still believe we have margin for improvement on both sides much way beyond the $100 million we talked about.

And look, just maybe just as a reminder for everybody, the facility that you're building in Mexico, just talk a little bit about like your confidence on when it will be up and running. And then secondly, sometimes where companies misstep is in making sure that their supply chain is appropriately set for that specific facility. Talk to us about what you're doing to ensure that you're going to be in a good place when you're ready to produce.

Sure. So this is a new factory, commercial factory in Saltillo. As a reminder, we have 3 existing factories in Saltillo. So this would be our fourth factory in Saltillo. So we share a lot of infrastructure. So this is not -- it's kind of greenfield, but it's next to our existing factory, right? So I think that reduces our overall risk. Everything from sheet metal vendors to other places from the supply chain, we have a very good, well-established supply chain. They need to come up with different components and things like that, so that we are working through. The factory will be running next year. We have targeted it, so it gets online with a new low GWP. So we don't want this factory to go through a transition. So end of next year, along with the new low GWP product, it will be focused only on standard products, no configuration, made to stock. We have significant experience in building factories in Saltillo and have done it successfully. And we are making sure the supply chain, everything from corrugated boxes to [ skids ] to metal bending capabilities, are all leveraging our residential supply base. Some of our suppliers, core suppliers are actually coming up with operation next to us in there because that's become a new hot bed as we are reshoring, so was our supply chain, putting it all together. Never be 100% confident in this thing. I live paranoid every day. But so far, we are doing all the right steps and we remain very confident. We are at our ahead of schedule 6 months into that journey.

That's super helpful. I'm going to turn it over to the audience in 1 second. Just I'm sure top of mind for everybody is resi HVAC volumes. And you referenced the destocking in 1Q in teens but an expectation that things are going to get better from here. Just maybe talk about your visibility and your confidence in that. And maybe we'll start there, and we'll go from there.

So Michael, do you want to take that?

Yes. So in the residential markets, we're seeing definitely resiliency still on our 80% of our business that goes direct to contractors in Q1. We saw shipments about flat to prior year. In the other side of our business that ships into distributors, it's kind of 20% to 30% of the business. We definitely saw some volumes down kind of 15% to 20% in line with what the industry expected. So right now, we're seeing everything kind of behave as we went into the year. We think full year, our units would be down in the residential space mid-single digits. Definitely want to see the Q2 progress happen. But right now, it's all in line with the guide that we've given.

And there's -- you mentioned Watsco earlier, right? I think Watsco built inventory this quarter. How do you kind of think about like the disconnect between -- I mean, one public distributor, I get it, versus what you're seeing in your business?

And I don't -- I can't speak for Watsco. They are a very well-run company, I admire the amount of value they have created. And I think, [ e.g., in Aladdin. ] But it could also be driven by their negotiations with their manufacturers and how they operate and what's their year-end numbers, I don't know, right? The way I look at it overall, I'll keep the seasonality in mind, too, right? I mean a lot of people are going to be hesitant about inventory reduction going into the peak season. And you have the SEER transition. I mean, SEER transition left everybody with some inventory that was the older SEER. So there could be too many factors that went into Q1. Net-net, I think overall, the whole industry has opportunity to improve 1 or 2 turns of inventory compared to pre-COVID level, if there was any such normal. Same for us, we are working with our independent channels who all believe that they want to turn more inventory. But none of them are in a crisis more trying to reduce inventory either. They are committed, let's do in a disciplined fashion, let's do it in an organized way. Our distributors are reducing inventory because they have more confidence in our supply chain and our lead times. Our lead time in quite a few cases have been cut down to half compared to a year ago. So automatic calculation, they are reducing their safety stock and they've got more and more confidence. I think that's just -- to me, distributor inventory reflects the confidence that they have on the manufacturer's the ability to deliver or not deliver. So we're working to...

Assuming demand stays...