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

Good morning. We are going to start off the 9:00 a.m. session here with Lennox International. We have Alok Maskara, the CEO of the company as well as Gary Bedard, the EVP and President of the Residential Market. We have a few slides to start with in a little bit and then we'll jump into the discussion point.

Great. Thanks, Chirag. Appreciate it. We have Chelsey -- Chelsey Pulcheon, she is out there, our investor relations. Excited to be here. Thanks for joining us. About 5 slides and then we will get into some Q&A. Perfect. Let's start by the thing that makes everybody want to do business with Lennox, it's our values. Our dealers typically are extremely loyal. As you know, we go direct to market in most instances. And the reason the dealers want to do business with us is because of our values. Our values of integrity, respect, excellence, that's what founded the company and still goes on today. What we are doing is we are reinforcing these values, we are better defining it, and you will see 9 guiding behaviors, 3 under each of those values, and that's part of the culture we are building here at Lennox. Now this is important, especially being [indiscernible] I still strongly believe that culture will beat strategy and culture is beating strategy for us. I'm not going to go into each of the 9 guiding behaviors as you see in here today, but let me just highlight 2 in here. One, accountability. The past 5 years had been difficult for Lennox, and we lost some of the accountability that we should have had. But we are on the remedy, we are getting accountability back. We don't talk about the tornado. We don't talk about the COVID. We talk about growth going forward, talk about serving customers better. We talk about serving our customers better, which is under customer experience, middle row, top. That's very important to us. And as I complete a little over a year at Lennox, what I'm most proud of is our customer experience has improved. If you think about whether it's the residential segment or commercial segment what 10-point increase in customer satisfaction Net Promoter, CSAC, how are you going to look at it, and we are back to being in the top tier of our industry peers in customer satisfaction. Those are the lagging leading metrics that we care deeply about. Clearly, our results as what you guys see. But we see a lot of the underlying foundation that we are building and our values and guiding behavior are very important with us. Every meeting, we start with the values slide or a safety slide. That's kind of the 2 things we start with. For those who are not familiar, a quick glance at Lennox [Audio Gap] trailing 12 months numbers. So on a trailing 12-month basis, you would see $4.6 billion in revenue, $13.5 billion in market cap. The thing that hopefully strikes to you, comes out to you is that what a simple company. 2 segments, residential, commercial, earlier, commercial used to make less in terms of percentage of EBIT versus revenue. Now on a trailing 12 months basis, commercial has caught up, and we kind of have a 70-30 split. The other thing that should jump out at you is on the right-hand side, 75% of our business is replacement. So while new construction, whether it's residential or commercial makes sense, this is very steady through economic cycles, everything else, 75% is just replacement business, high-quality revenue for us. If I think of where we are today, since I measure -- mentioned the resiliency of our business, depending on your outlook [Audio Gap] just list all the factors that we're experiencing. On the residential on the positive side, the regulatory changes, ones that we recently completed on 1st January '23 and the one we are getting ready to complete on 1st January '25, are both positive changes for us and for the industry. After years of struggle, we are finally gaining share again. We used to do this pretty consistently. Now we are gaining again. And that's another big thing for us on the residential side. Commercial side, if you see from overall, there's still a huge pent-up demand. While the industry [Audio Gap], lot of runway ahead, because overall, demand is not at the pre-pandemic level. So I see commercial still has a lot of runway. On residential, all the worries that you read in Wall Street Journal about consumer confidence, interest rates, mortgage, new housing start, yes, we face that. Fortunately, it's a smaller portion of our business and new houses doing better than what we were expecting 1 year ago. So things are positive. Yes, there's always a fear that the market is going to turn around and to the softer side and things will slow down. But we haven't seen that happen yet. And partly because we are not exposed to offices. I think a lot of the commercial slowdown is in office and office buildings, and we don't have any exposure to that. So that's why we see there's a balance, but mostly a cautiously optimistic outlook. Over the past year or so, we have been on a transformation plan. Very simply, there are 3 phases of this transformation plan. Our 2026 targets that we unveiled last year December are kind of halfway through this transformation plan. So 2 messages in this slide, right? We're in a long journey to improve. 2026 targets are a signpost in a long journey. They're now destination for us. And we are very disciplined methodology currently in the self-help phase, commercial turnaround [Audio Gap] potential impact on commercial. You're going to start to see impact in residential very soon. Next phase for us is growth acceleration, getting back on the share gain mode, actually using the extra capacity that we are creating on commercial, building of a new factory in Mexico. And then finally, into true expansion, we have so much opportunity to leverage the fact that -- we are the top 3, probably most likely the second largest HVAC distributor in North America. We don't act like that. So how can we expand through that? So just our 3-phase transformation plan. And if I were to put it all together, I'm not sure whether you guys like it or not, but if you [like acronyms], I would say this is our slide to say we've always been a good company, and we are on our way to be a great company and the great in the acronym starts with, we are going to deliver growth acceleration, we are going to deliver resilient margins. We are truly going to talk about execution consistency [Audio Gap]. We are going to have an advanced technology portfolio. A lot of the portfolio [Audio Gap] we have announced, the divestitures, it's all about advanced technology. And then we are going to win through our talent and culture [Audio Gap] 2026 numbers that you see here. I just -- and this is what we internalize and this is how we operate. The operating system behind it, which goes into execution consistency has been one of the bigger changes that may not be transparent to you on how we have adopted a monthly rigor, balance [Audio Gap] to make sure that we look at underlying metrics from before the financial results. Which is what gives us confidence that we are on track or ahead of time to meet our 2026 targets. With that, Chirag, we will open up to questions.

Excellent. Let me start out with -- just trying to get a sense for as we exited the 2Q earnings period, what really stood out to you from there. And then talk a little bit about the price/cost dynamics that you're seeing in the quarter. And you had indicated a midyear [price increase] going to be impacting for tailwinds into the end of the year into 2024 even?

Sure. Good questions, all of them. So in Q2, the quarter that we recently completed. So first of all, we are pleased with our commercial performance like Commercial had been struggling. It was just good to see customers were more satisfied. Employees have been staying longer or, in fact, not quitting the way they were quitting a year ago. Price/cost dynamics turned positive as we were able to reprice many of our national account contracts that we were under water for many quarters. So I think that was really good. We were pleased with that, and we expect that to continue. The other thing that in the quarter, which I mentioned briefly in my presentation that we don't talk [Audio Gap] was increase in customer interaction across the board. Dealers who were fed up with Lennox for whatever reason, delivery shortage, commercial contractors, we restored a lot of their confidence back. I mentioned 10-point increase in customer satisfaction, big deal, across residential and commercial back to sort of the top 2 in the HVAC industry. So that was pleasing to see. Finally, just a fundamental momentum on residential, and Gary can talk about that more later. As it's been kind of 6 months since Gary came back and started running residential, we have built up a lot of momentum on about pricing. Go back to your midyear price increase question, Chirag. We have suffered over the past few years because we had signed these contracts post tornado to get some volume and didn't have the appropriate inflation clauses. And we didn't know that inflation could be this high. But as those contracts come up for renewal, I think we have significant momentum that's built up that's going to continue delivering results. Now on a sequential basis, you will see improvement [indiscernible] we did price increases last year as well. Midyear price increase has gone well, and we expect it to get the appropriate return.

Excellent. And then I guess I want to hit a little bit more on the commercial side of the business. What were the underlying dynamics there that really kind of prop things up? It wasn't just volume. There's also execution that was significant there. Can we talk a little bit about it.

Sure, it is. A lot of this comes down to execution discipline. Beginning of the year, end of last year, we rationalized 65% of our SKU. So 2/3 of the product we just stopped making. That allowed us to simplify our factory, simplify our sales effort, do less custom product versus more configured to order products and fundamentally change how we execute. I applaud the team for taking such bold decisions that also helped us serve our customers better. Our lead times, which last year were trending at about 40 weeks or so, now are down to like 16 to 20 weeks. We have cut our lead times down by more than half. We are at par or better than the industry lead time for our product category at this stage. And then going back to the pricing mix dynamic, the benefit of rationalizing [SKUs] we got improvement in price and mix. And we remember, because of SEER change, we launched a whole new series of products, which also helped us with overall pricing dynamics. So underlying dynamics such as employee retention in Stuttgart, very good. A year ago, we were struggling to hire. Today, there's a line out for people wanting to come and join us, like it used to be. So from that perspective, we have restored a lot of the commercial mojo. And remember, this is just a beginning. We're going to build a second factory, try and get into other market segments, restore back because we are very confident in our ability to serve and the industry's continued growth potential.

Thank you and then with Gary here, it's important that we kind of jump into residential in a little bit more detail here. I'm trying to get a sense for what are you currently seeing in the residential market right now? What are the current customer order trends looking like? We're through August now and what was supposed to be a cooler September apparently, but just a little bit about what's happening -- exactly.

Not New York. So our Q2 numbers with volume down mid- to high single digits, but we're very pleased with the price/mix. We did have a big regulatory change at the beginning of the year. And that, as I sat through some of the meetings with distributors, everyone's talking about the destock phenomenon. For the HVAC business, it was perhaps a little bit more pronounced because you had a regulatory change. So people were stocking up to prepare for that. Nonetheless, if you think about the residential markets, look, it's still a necessary product, and it still has a weather component. If we look at Q2, cooling degree days, they were down some mid-20% from previous years. So you're going to see a decline. Of course, the weather in Q3 is not a 20% decline. But we won't get into the specifics of the sales, but you know what the weather is.

Right, and I guess one of the things that was interesting about that destocking idea is that 75% of the business is your own distribution. So it looks like the majority of the decline was really in the independent channel. Can you talk a little bit about the different dynamics between the two?

Sure. So as you correctly stated, Lennox has both a direct-to-dealer business [Audio Gap]. And then we have the 2-step distributor volume is where you're seeing the decline. You're seeing the decline from destock. But then, of course, the distributors are also going to be impacted by Q2 versus the 1-step business is simply going to be impacted by the consumer pull-through of the demand. And so the difference would be, obviously, the 2-step is going to be down more than the single step.

And how would you classify that [independent] destocking at this point? Are we seeing a little bit of carry through?

We see some that we are beginning to -- we're at the beginning of the end or [tailing off] here in Q3. The expense for manufacturers were down [Audio Gap] through July. That's -- everyone knows that. And a big part of that is the [Audio Gap] but again, as we talk to our customers, as we look at the channel, we think that we're approaching the end of it.

Okay. And I think just to reinforce, we talked about [Audio Gap] we expect destocking to be largely over in Q3. Some of it will bleed into Q4 for furnaces and extra product category. And everything we're seeing is consistent with that outlook.

Excellent. And if we can move a little bit forward and move past the 2023 idea and just talk a little bit about the impact that you're going to be seeing from the IRA. What's the longer-term dynamics for your industry from some of the federal funding programs that are out there and things of that nature?

Sure. But there's 2 elements to the IRA. One of them is kind of a $4 billion plus pool of money for low income. If you do the math on that, that's not exactly the game changer for the industry because you just do the math on installations. It can't be any more than 300,000 units in a 14 million unit [Audio Gap].

How expensive is new product at the end of the day?

Sure. So the change from our 410A refrigerant to our 454B refrigerant which will occur by 2025. What we're -- the refrigerant itself is going to be a lot less expensive, but the safety is required and the control devices on the products will be more expensive. And so if you think through -- compared to today's number, you're probably talking somewhere in the 10 to mid-teens type of costing, pricing difference between the 2. However, the one thing that people have to bear in mind is [Audio Gap] is subject to a quota [Audio Gap] the global potential, the quota is about [Audio Gap]. So what that means is that the comparison is going to change because pricing is going to go at the beginning of 2024. What changes in 2025, in January of 2025, the quota reduction occurs in January of 2024. And so the 410A price is going to have -- there's going to be a lot of pressure on the 410A pricing, which, of course, the existing products have 410A in them. And so we have that dynamic as well.

I got you. Okay. With this changeover, will there be a little bit of prebuy in the industry? Do you see anything like that happening?

So there will clearly be some prebuy. There's always -- whenever you're talking about a change of this magnitude, there are always people that for either economic reasons or for reasons that prefer the old [Audio Gap] they're going to look to have some level of prebuy. However, the math on the prebuy is confounded by the refrigerant pricing. So you have a reduction in quota that is going over the course of time. And so again, what will likely occur is that people will kind of do the math, and there's only so much risk they want to take with bringing in the 410A products because the refrigerant for that is going to continue to escalate.

Okay. And then, I guess we talked about the refrigerant. Now one of the things I was looking at was just the technology. And as we're kind of thinking about, you were the first to complete the DOEs cold climate heat pump, I believe, a challenge. So what does this mean for the industry? What are you seeing as the heat pumps are being adopted a little bit more? What's kind of the dynamic there?

Sure. Again, I think it's a good thing, net-net, to see. Heat pumps can be more efficient in heating than furnaces. And so we do see a trend towards heat pumps coming into the industry, and that's great from an energy use perspective. From our perspective, we think it's a good thing as well. Anytime you have technology that you can kind of move forward. But also heat pumps actually don't last as long as air conditioners and furnaces. And so when you think about that from a long-term market point of view, as heat pumps come out in the market more and more, you're talking about something with a 12- to 14-year life versus furnace, which may have a 20-year life. And so clearly, you do the long run math and that's very favorable to the business.

And if I can just expand on that because what we have is a very good technology for heat pump. And as a cold climate heat pump, which is part of your question comes in, you would notice Lennox' penetration or revenue from heat pump will start climbing up more steadily. Because today, we are little underweight on heat pump. We might have 10% to 15% of sales. Others may say 20% to 30%. And the difference is we sell a lot more in the north and others sell a lot more in the South. But with that technology penetration, cold climate heat pumps will start giving the adoption rate higher in the north. We will see incrementally faster benefit than most of the other players in the industry. That's why we are super excited about cold climate heat pump. Because even on the commercial side, it could be a big deal. And the last thing to -- just to put it back all together, remember, IRA incentivized heat pump a lot more than it does other product lines

2000 versus 600.

Yes, exactly. So I think that's the piece you got to keep in mind is IRA promotes heat pumps. I mean, heat pump penetration would be much less if it wasn't for some of the government incentives.

Okay, and then I guess staying on the technology kind of front, just on the idea of the VRF product penetration, what are you seeing in mini splits? What's the residential market and the commercial market is looking for at this point?

Sure. So we are a little underweight in VRF and mini split compared to some of the other players. And part of it is, if you think about the global players, they have significant more scale. And by global players, I mean like LG, Midea, Samsung, Panasonic, Gree, these companies, right? I mean they have a lot more volume in mini split and VRF. So almost all the North American U.S. manufacturers have a partnership. We have a relationship. We don't have a strong partnership with any. And that's something that we are working through over the next planning period to make sure we are appropriately positioned. We like the VRF product. It's a good suite. It's growing very well for us on a percentage, but we are starting with smaller dollars. Mini split's the same thing. It's growing very well, but we're starting with a small dollar base. We think the potential to grow both of them is much higher, and we decided to work through like a lot of the internal and partnership questions to pull that together. At the end, what we do is give our customers [Audio Gap] and a full technology portfolio. You want a high efficiency [Audio Gap] pump, we have it. You want mini split, which is for renovations and add-ons, we have it; similarly for VRF. In some buildings, that makes sense. Other buildings are typical rooftop, RTUs make sense. So we want to be somewhat product-agnostic and give our customers the best we can, but a lot of work still to be done on getting that portfolio streamlined.

Excellent. And we have a couple of minutes here left, but I just wanted to talk a little bit about the divestment of Refrigeration from last week. Just any thoughts on that? Anything you can kind of provide from a timing standpoint or anything like that?

Sure. I think as we had mentioned earlier, which still remains the same. We expect the divestiture of the European business to be complete by end of the year. We have announced one definite agreement. It's one of multiple that we will be working through. There's some regulatory -- but I think they are customary regulatory, not like antitrust type. They are all very straightforward. We expect that to compete on time. The proceeds are not going to be material in the big scheme of things. Just as a reminder, it was about 5% of our revenue, essentially a breakeven business. We would appreciate the management focus that came out of it. That's our biggest gain, right? Instead of us -- Gary used to get on a plane to go to Europe. Now he does only to go drink wine, but not to go other places. From that perspective, if we all went to Florida and win more market share in Florida versus going to Europe, shareholders will benefit more. That's a bigger benefit.

Excellent. And then the final thing I had on my list here was just on the capital deployment. We said that the proceeds are going to be pretty small over there from the European acquisition. Any thoughts on potential acquisitions that can be considered. Any areas within your portfolio see yourself lacking or things of that nature?

Yes. Bolt-on acquisitions is an integral part of our strategy going forward. They're going to be very focused. Over the past year, we have done a great bottoms-up approach and developed a list of about like 30, [Audio Gap] opportunities. None of them came through bankers, none of them came through private equity. They are all kind of organic bottoms up from the field opportunities. But listen, it takes two to tango. None of those 35 may be willing to sell tomorrow, maybe 1 will break loose tomorrow. So from our perspective, that's our approach. There are enough opportunities. They'll all be focused in 2 or 3 distinct areas. One would be things that we can sell through our stores. because we have a good footprint. We just need to be able to sell more through it. Services in commercial, we are still lagging behind others. And then finally, technology gaps that we may have. I mean everything we do will be around those 3 specific areas. We're excited about the pipeline, but we are in no rush either.

Well, I think we're actually at time, so we'll have to cut it there. But thank you guys so much for taking the time and effort here. Chelsey, thank you guys, Alok, Gary.

Thank you. Appreciate it.