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

Good to see everyone. Thanks for joining us at the 11th Annual Laguna Conference. Really great to see everybody's faces, and I'm welcome -- happy to welcome on stage, the team from Lennox. Good to start off with. But I think it's been a good story here, especially over the last year or 2 with all the changes that have happened and all the improvements. I'm joined on stage by the Lennox team's, CFO, Joe Reitmeier; Chief Technology Officer, Prakash Bedapudi; and from Investor Relations and Corporate Finance, we have Michael Quenzer. Team, thanks for joining us.

Thanks for having us.

Joe, maybe just to start off, kind of tell us what you guys are up to, what you're seeing out there. Certainly, a lot to dive into and a lot of nuance in the resi HVAC industry right now, especially, but maybe just give us the overview of what you guys are seeing and focused on?

It's been busy. We're off to a record-setting start. And for me, the most encouraging thing is we're setting records for revenue and margins and earnings with our largest business being in a down market. So residential volume was expected to be down this year largely because of residential reconstruction. That's amplified a little bit with selling and distribution, and destocking is taking place. So setting all that aside, once again, revenue will be up low single digits in our residential business, even with volumes being down. That's an encouraging sign. On the commercial front, we had some challenges due to COVID supply chain, et cetera, that we're powering through now, and that business is on a nice trajectory getting back to record-setting margins. And once again, on track to hit our long-range targets between 19% and 21% by 2026. So we're in great shape there. All in, once again, it's been a challenging year, but a good year. We had regulatory change that we needed to get through. We've got some on the horizon in 2025 that will be more disruptive to the industry. So we have Prakash here to shed some light on that today. So that will be interesting. But all in, we're in a very good place. Once again, we're back in the share gain. So once again, we are crippled by a tornado, some struggles in our commercial factory once again, that we're powering through. But it's really setting the table for us to do what we've always wanted to do, and that's maintained focus on unitary HVAC and commercial refrigeration here in North America. And the table is well set. Once again, first half record-setting results, we expect to either exceed the guidance we have out there currently, and the markets are showing signs of cooperating more residential side. So all in, we're in great shape.

Excellent. So I guess coming through the first part of the season, obviously, weather was you were tending to say, to say the least. Inventory is also running a little high. I think [ the channel ] obviously not as relevant for Lennox given that a lot of that company owned. But maybe just snap the line on how this pickup in heat and where we are on destocking sort of what innings we are on those?

Yes. We're thriving the extremes, as you know. So it was a situation where we got some hot weather, but it came late in the second quarter and really didn't affect the second quarter at all. Normally, it would get hot earlier, and we see that benefit through June, but we didn't see that. We did see a lift as we got into the third quarter with hotter warmer weather really in the Midwest. It was more sporadic there, but more consistent in the South and Southeast. So that's been helping us once again here in the third quarter, but not so much in the second and then we'll see where it goes from there. But once again, demand remains steady, we expect a lift in residential demand here in the second half. Volume on the commercial side of the house, the industry itself is still product constrained. So we still have this bow wave of demand that we're continuing to fight every day to satisfied, but that's a high-quality problem.

Of course. On the inventory front, maybe give us a sense for if there's anything that you would point out either regionally, product line, anything that stands out on that front? I think you guys said that you were going to be done with this either third quarter or early fourth quarter. That's still quite gets the case.

It does. We had some destocking that was taking place where distributors were carrying much higher levels of inventory than historically necessary to meet end market demand just to make sure that they have product available because that was a challenge during cold and even lingering a little bit longer after that due to component shortages, limiting production. And that affected commercial more heavily, but it also affected residential to an extent. So we're through most of that. The destocking and the distributor channel, we think, will carry through most likely the third quarter in the early fourth quarter before that's complete. [ Legal ] direct to dealer sort of less affected by that. In fact, we benefit from that when the destocking takes place from a share perspective. So that's exciting to see. And once again, I think we're just well positioned strategically. We're focused. We've got the right power the right strategy. And once again, I think you're seeing that bear fruit in even challenging market conditions today. Once again, we're going to have a record year, and then we'll be off to the races. So we're excited about what we see today and what we have in front of us.

And then maybe just one finer point and perhaps one that you don't have to grapple with as much given the mix of business. But higher interest rates, I would think would be a pressure on inventories for anyone who sells through distribution. It seems like underlying demand and sort of working off the COVID excess has a lot to do with this. But is there sort of a toggle there that those folks are pulling along the lines of just higher interest rate, higher carrying costs?

No, it's a situation, I think, once again, it was the supply chain shortages of letting the product limitations where distributors didn't want to be [ sold out by ] a product. So they quoted inventory. Even us as a distributor, we need conscious decisions to go out and procure material inventory that was necessary. And where we could, we are carrying higher levels of finished goods inventory just to make sure that once again, we can meet end market demand. So once again, it's affecting us less than some of our competitors, but once again, I'm just really excited about what's in front of us.

Then I want to pivot over to what's really been kind of the surprise, the positive surprise of the year on the commercial side. How should I think about the savings or the opportunity still in front of you? Obviously, margins have just kind of blown away everyone's expectations, perhaps even what you guys said internally relative to that original 3-year expectation. But where do we go from here? What are the opportunities you still see in front of you on cost?

I think we're well positioned when it comes to our core of the business, which is our national account business. They tend to be consumers with more highly engineered product, more configured to order product, more sophisticated product. We wanted to preserve that where we have the opportunity in commercial and emergency replacement, which is roughly 40% of the market. There's no barriers to compete there. It's low first cost and product availability that will be in that game. There's no real differentiation to an extent on brand. So once again, that -- you kind of push the side. So that remains the biggest opportunity for us. And then running out the efficiencies really across the enterprise that we had incurred during the supply chain challenges and COVID still remains an opportunity from a margin perspective, not just in commercial, but also in residential as well. But once again, we're powering through the challenges in commercial. We're going to get that business back to peak margins here shortly.

Anything that happened either in the first half or second quarter, which was particularly exceptional that you would call kind of a more temporary or trained to getting good guy, and that we have maybe a step forward before -- or step back before we take the next 2 steps forward?

Yes. I think there's a couple of things. One is price and mix. Because of the regulatory change, the minimum efficiency also affected the commercial side of the house. So I think we got a lift from mix. We went out with additional price increases. They were targeted in nature, but I think that gave us some lift in the first half. So the first half story was price mix. Second half is going to be also volume. So once again, we'll get a lift there from just that pent-up demand in that bow wave that we came into the year with and as our manufacturing facilities increase their output, specifically in commercial facility and enables us, once again, to drive more volume across those assets and grow margins.

Got it. That's helpful. And then you mentioned the commercial emergency replacement business. I think it's roughly a 0 today just given the preservation of the national account base. I recall this being like almost 40% of the business at peak.

It was probably less than 40%, but it's 40% of the overall market. But we had just about 10% market share, if not more, and that went almost 0. So we're clawing that back now once again, as product becomes more and more available. And we won't be fully in the emergency replacement game until we get our second factory stood up, which will be in mid 2024 and 2025 -- [ end of 2024 ].

I'm assuming there's a progressive ramp that happens along the way and that would sort this all at once. How difficult will it be to win back some of those customers? It sounds like the end customer sort of is brand agnostic, so maybe those folks aren't as relevant. But from a contractor perspective or sort of that reliability of, "Hey, I need a product and I call Lennox, will they have it? Is that something that also are forgiven fairly quickly? Or does it take some time in the marketplace?

I think with the National Account customers, that's where you have the long courtship with the customer, and we need to retain that and maintain that over time with the emergency replacement, it's not so much. And we're fortunate that we have Michael here, who's been close to that business for a while. So I'll let him some color.

So first, when we use market share in any space, it's not industry. So I don't want to discount how easy it is to win the market share, but this is a highly fragmented share spread across thousands of contractors. Many contractors that want to do business directly with the OEMs so it's an advantage that we have, as Joe talked about, it's about product availability, which we're going to have when we get the second factory up and running. And it's about pricing. currently, we're pricing the product in line with market. We expect to continue to do that and there's still attractive margins. So it's a space that we want to continue to go after. And the way you win it is you forward deploy inventory, you have awareness of the product as we start to invest in our sales force and get awareness of the inventories back out there again. And then when we get calls, you have to quote within 2 hours and you have to ship within 24 hours. It's something we think we can do, and we can get market share into the mid-teens, if not upper teens. So it's really the focus for the next couple of years is that opportunity to grow that share.

Is -- how do you -- would you characterize the mix around that? It sounds like it's a little bit less beneficial than what you would have on the national accounts side, but is it so wide apart that we would see margins [ degrade ] on that?

No, I'd say, actually, the margins right now are similar to the national accounts as a percentage of margin percentage. The average sales prices are obviously left, but less when you sell more units than you do a larger national account rooftop, but we think volume growth should be significant, but margins are really attractive still in the business.

Yes. And the product that we go to market with on the emergency replacement we design for lowest first cost. So once again, we go on with the intent that's going to be the lowest cost unit in the industry. And we caution this team do an excellent job of helping us reengineer products, once again, to minimize cost [ debtors ], et cetera. And once we're fortunate we've got a great engineering team that helps us support that initiative.

Excellent. I do want to bring in Prakash to talk a little bit about all the changes that are coming in, in '24 and '25. And I'm...

So Josh is saying he wants to get to the [ good deal ].

We'll bring it all together. But I do think that it's sort of a unique opportunity to have like the CTO involved in what is a super technical point in time in the market. So I think into next year, the big refrigerant production cap stepped down and then obviously our 454B transition in '25. Maybe just to start off here, Prakash, how do you see that reduction in 410A next year as sort of a market impact? And how are you thinking about that relative to the business?

It is a significant reduction, as you know. So what you have to do, work closely with the refrigerant OEMs, manufacturers of refrigerants like Kenmores and/or Kmarts have a strategic relation so that you get your volume quota that you need. We feel very good about where we are in that journey. We have ample supply of 410A that we need as we transition out of 410A, go to 454B, we have contracts in place. So we're not concerned about refrigerant to sell the product. So we feel good about that. From a product design, redesign testing perspective, we're exactly where we need to be. I think we'll have all the testing, validation done, certifications done, all the mitigation, leak detections, sensors and controls, all of that in place, and we'll start launching the products in 2024. By January 1st -- we'll be in with full compliance by January 1st of 2025. So a lot of work, mountain of work. I don't want to underwhelm it, but we've got a great team like Joe said, we've got all the facilities we need to -- it's heavy testing burden. We need to get through all the various models, all the testing done and certified at the time.

So how much -- and maybe, Joe, this is a question for you as well, given that inflation on refrigerant next year will be pretty extreme, is that something that will be detectable in your price to the street? I mean, a 30% cut. I mean I know the refrigerant is not the dominant component here, but it's got to be worth something.

Well, it's 1 of those commoditized inputs that influences price absolutely. So we'll be a variable. I don't know if it will drive the pricing decision because the new units will be higher priced relative to where they are today simply because of all reengineering effort and some higher costs that need to be employed. But we're going to have a better unit on the other side. And once again, we're fortunate that we've got great engineers on the Lennox team both here and on our technology center in India that we leverage and give us best-in-class industry-leading claims on product, and we expect to sustain that. So once again, the pricing will line with wherever the commodities fall because we're all affected by that. So I don't think we'll be an outlier when it comes to pricing, but it will be a situation where it will be higher priced.

But it will be noticeable, right? This just points to price [indiscernible].

Yes. Probably high single digits is where I believe it will be at the end of the day.

For the entire unit goes up high single digits?

Yes.

Pretty high. Then I guess this transition looks different than maybe some of the other ones we had. I think the industry was particularly disappointed by the whole dry charge phenomenon when we went through the last one of these with R-22. It seems like instead of a pull forward or a prebuy that we're actually moving in the other direction that folks don't want to install something that maybe has service issues down the road and refrigerants more scarce. How are you guys thinking about managing that transition. I mean the homeowner doesn't know, but a contractors out there are like, "Hey, 7, 8 years from now, this could be really expensive to maintain. How are they threading that needle? How are you helping them thread that needle?

Well, I think part of it is a consistency of educating other contractors. I think that's the first point as we need to make sure that they're pulled up on the new technology, what it takes to install it and then more importantly, the implications of some of the regulatory changes that are coming in place with R-410A being rationed, et cetera, and then the escalating costs that will occur there. So it's going to be a bit of a dilemma for a contractor who has 410 product available that's on the brink of this new transition, where they know the repairs on the other side for the homeowner is going to be significantly higher -- more expensive than the 454B units that will be in the field. So it will be a situation where, once again, it starts with educating the contractor and then more broadly, I think, the consumer base. But most folks don't really wake up on a Sunday morning, go shopping for HVAC equipment per se. So it's going to be the catastrophic failure that will lead to the replacement on the residential side. So it will be a situation where that will be something that we're going to prepare the dealers to effectively manage. Would you guys have anything different?

I would say the initial cost of the new unit is going to be higher, the low GWP unit in 2025, so there may be enough people buying and people deferring. So on the balance, it's a wash, I think.

Is -- I think, past transitions for whatever reason, maybe just the industry likes these round numbers, kind of fall in this 10% to 15% range. Is that probably the right ZIP code for R-54B? That seems like what we've socialized so far.

Yes. What I'd add is that it's going to be over 2-years journey for the first year. Next year is going to be about the refrigerant cost increase. We're going to focus on that next year. Joe talked a little bit about the magnitude we think that, that could do next year, including just normal inflationary effects. And then in 2025, there'll be another cost and price increases. We have to add sensors, you have depreciation through the factories. We've made significant capital investments as well, as there's some efficiency loss that we need to come up with for the new refrigerant. All of that will be an additional price increase in 2025. So over a 2-year period, 15-ish percent sounds about right.

And then I know when we went through the last transition, the concept of match systems was very important and maybe even led to some of the loopholes that people were trying to exploit. I don't know that the installed base of 410 is big enough to where we went away from that system. But is that a phenomenon that is going to show up or kind of move the needle at the margin.

This is a real technical question, and I'm going to head off to my friends.

I'm going to [indiscernible] back to Prakash. Just wonder what I do. So yes, [ I'd go ] down the route [indiscernible].

Is your question kind of mix and match?

Well, it sounds like you can't mix and match, but are there enough purchases today that are just the condenser to where you actually see in your business? "Oh, We were selling -- 20% of our business was just condensers, replacement only, the indoor unit wasn't being replaced, now we have to do everything again. Or are most of your system sales today are already matched?

I think most of the systems are already matched today, it's just the coil. Maybe we would not replace the furnace, but typically AC furnace unit. So coils are replaced when we went from 22 to 410A or, et cetera. So I think same thing will continue when you go to 454, leave the furnace section alone or air handler you have to replace the whole thing. Yes. We'll see that continuing with the new refrigerant, match systems.

Got it. And then anything on the warranty front that should be unusual? It just seems like these are more technically complicated unit?

I think they're just more technically complicated. And once again, it requires us to redesign all of our products as most folks in the industry, maybe if not everyone. So it's a situation where we're all making that same level of investment. So...

Got it. And then I guess the other phenomenon happening here in the background amid all these industry changes is the government incentives around IRA. So a lot of initial work done on that last year, maybe too premature relative to where the [ states ] are. But we got a little bit more information sitting here a year later. How do you guys think about some of the incentives there? Because obviously, a lot of slicing and dicing that could happen on who lives were and what's their income and how many heat pumps do they want. But how do you guys think about it at a high level in terms of the amount of the market that should just convert to heat pump with the incentives you have?

Yes, it's opportunity for us. Yes. So we're excited about the regulatory improvements for -- or for the incentives for the IRA. We'll rollout over the next couple of years. It's still to be determined with some of the local income requirements that have to get through. But there's also existing tax incentives out there. Both these 2 help the homeowner buy down the replacement system costs, which helps from the repair and replace dynamic. So it's something we think is favorable in our industry. It helps us generally because what the consumer will do is they'll mix up and they'll generally buy a higher efficient product to get to maximize rebate. So we see that heat pump systems generally have a little bit better margins on a traditional air conditioning system with furnace. So it's a mix of benefit for us. We think the incentives are big enough to have a shift from a traditional system in areas where heat pumps are already prevalent into a heat pump. In the colder areas, we're going to still see the technology advance. It will take several years before that technology really improves and you get full adoption in some of the colder spaces, but the technology is improving. So it's going to be something that will happen over the next 3 to 5 years, but Prakash also is heading into the heat-pump technology and the cold climate side of it.

Yes, we'll launch our highest end cold climate heat pumps along with the low GWP refrigerant, and they'll probably get into the meat of the product line shortly thereafter. So we'll have cold climate down to minus 10, minus 20-degree Fahrenheit, almost near flat capacity, heating capacity. So yes, that's pretty exciting. So that will address universally all the geographies where we offer today. That should drive the conversion of heat pump a lot more than anything else.

And then the duration of the incentives is literally a decade, which is [indiscernible], if not more, what typically the incentives are for. So I think that will help sustain some of the -- some help sustain the offset to a homeowner of the increased cost of the more involved technologies.

So I think at a minimum, putting aside things like rebate where maybe people get a free heat pump, I think at a minimum, you get [ $2,000 ] per unit, and you can kind of refresh that annually, so multiple units you can navigate that. Is $2,000 enough to basically jump from cooling to heat pump across most lines? It seems like it would be pretty close.

I think it's enticing enough to get people to listen. And then once again, if you mix up even more, there's more benefits for the taxpayer. So I think it's $2,000 to begin with, and then it's $2,000 plus, depending on what your system ends up being designed and looks like.

I mean, is there a situation where 3, 4, 5 years from now, that straight cooling split system is sort of a dinosaur relative to a market that's all heat pumped.

I don't know, about 3 to 5 years. It's going to be a longer adoption than that. But there is -- we're seeing shifts in it. And we think that overall with incentives, there's local utility incentives, there's tax incentives, there's IRA. All of these help buy down the system cost. And generally, they's more focused on the heat pump than they are in traditional systems. So that should help the transition over the next 5-plus years.

And then part of our efforts, I talked about educating and training dealers, part of that education is making sure that they optimize these financial incentives for the homeowner as well.

When you think about Lennox's legacy as a furnace company, I can still picture Dave Lennox in Marshalltown, Iowa, in the factory.

Although I do think we also created the first heat pump early in the [ '65 ].

That's right.

Okay. Fair enough.

Now we've updated the design since.

I would hope so. I hear there's been some refrigerant changes.

There has been.

On the furnace side though, I mean, clearly, a good share position there where heat pump would naturally erode some of that. How do you think about the economics of that or what the cannibalization rate looks like? Because I think to Prakash's point, if you live in Minnesota, you're probably not ditching the furnace right away. And you might not even be replacing all these things at the same time. So there's probably a long tail. Like is that neutral positive? Like what happens is furnace shrinks and heat pump grows?

I think longer term, I'm going to invite Michael to dive deeper in the economics, but I'll paint the corners initially. It's opportunistic. Once again, from a margin perspective, it's more attractive. From a margin dollar perspective, it's a little bit less but it's also a situation where heat pumps have a shorter life. So once again, we -- over time, we will be selling more heat pumps. So once again, it's encouraging from those perspectives, but from more of an economic perspective, I'll let Michael...

As I mentioned earlier, the system margins on a heat pump basically are slightly more than that of a traditional system with a gas mostly because you move up in efficiency because I was trying to maximize the rebates on them. So we think it's a good business, and we'll continue to expand margins. But overall, the cannibalization doesn't hurt us too much, yes.

Got it. And then I guess on the useful life because these things are now running 10, 11 months out of the year instead of just 6, is that sort of proportional to the decline in useful life? I think you guys have talked about sort of, okay, it was 14 years and then maybe about 16. Like are we going to 10?

Yes. I think for a heat pump, it probably is closer to 10 than the 15, as a result of what you just mentioned, you're going to be running it more often than your typical air conditioner because of the heating capabilities.

The life is proportional to the run time. So heat pump runs 50% longer correspond reduction -- corresponding reduction in life. The temperature stress is nonlinear. So rather than running at a 90 degree a day if you're on a 100 degree a day, then it goes -- life goes down significantly more.

And I'm assuming the same thing on the low end, right, a negative 10 is pretty brutal on the system.

Yes, it is.

Got it. Just zooming out on the residential market as a whole, I think there are -- a lot of us certainly myself included, who try to run this useful life math, call it, 4, 5 years ago when the industry hadn't yet kind of kicked that extra gear for COVID, but we're replacing it sort of astoundingly high rates. And I think maybe with kind of a postmortem on COVID is there's a few things that we can try to explain a way. But like what do you guys think about this? Because replacement demand went pretty high pretty quickly. And I don't think it's because everyone was just stuck home running their systems more because I think there had been more to it.

Yes, I think when we looked at the run time data that we have access to. We notice systems are running 15%, 20% more. As Prakash mentioned, it has a finite life there. And then secondly, I think there's just much more attention-focused indoor air quality. So I think that leads itself maybe to situations where they want more air purification, dehumidification all those things factor into it as well. When they're making that replacement decision there won't be a catalyst for that decision. But when they're making that decision, there are now other bells and whistles that they want in their systems that maybe they didn't want before and that lends itself to more of a mix benefit longer term.

Got it. And then when we think about where the margins can go in residential, Lennox is in a unique position of being able to say, okay, we're the OEM, but we also the distributor. And I think we can all see what at least some distributor margins look like and maybe those are extended, maybe they're not. But is there an environment or a situation where you could get to OEM plus distributor. And I guess if not, or if there's some leakage in there, where does that leakage come from?

Yes, I think that's the opportunity in front of us. Michael, do you want to...

Yes. So first what we do is we look at Carrier and Watsco. If you combine the 2 margins, you could get to mid-20s. It's a long journey that we're focused on. Most of the improvement we think we have is on the distribution front, and really it's going to start with us kind of aligning our sales incentives, both for the selling group and the distribution group. So we're starting that journey now. We're going to have to make some investments into the distribution processes and the distribution systems, which Prakash definitely leads. And then -- because you really have to have strong fulfillment rates to be a really great distributor. So we're really focused on the system side of it. And then it's about picking the right products to have through our distribution so that you get the revenue per square footage up, we aspirationally want to get from about 15% to 20% of our residential sales of service in parts -- or parts and supplies to about 30%. And that's the longer-term journey that will get us to the combined margins in the mid-20s.

And Josh, what I'll say is when we had 100 stores and we were adding 20 a year, it was about the next 20 stores. When we have 250 plus, it's about what can we do with that asset that we're not doing today. So there are other things that HVAC contractors have an appetite to sell in its different bright region. We want to make sure that we make those things available to them. As Michael said, our goal is to get an attachment rate with parts and supplies. That's more in line with the broader industry, which is closer to 35%, 40%. And we're probably half of that today.

Got it. So there's -- that's not something that you're sort of giving back to the market in terms of price. This is an efficiency thing.

Yes, this is an efficiency, productivity and how do we get more revenue across that distribution footprint. That's what we're looking for.

Got it. And over what time frame is that sort of...

As a longer-term commitment we're looking at. Once we are 3, 5 years out, we want to be in this 35% mix of parts and supplies. And that is achievable. We're on the trajectory to do that. There's some fine-tuning that we need to do as far as the inventory mix and what needs to be carried in certain stores, et cetera. Some stores have light commercial. So we'll need more light commercial. So it just depends, but we're going through that exercise now and flushing all those opportunities out.

Excellent. I know we have a little bit of time left we think in the room. Excellent. Gentlemen, really appreciate the time. Always a pleasure and always very helpful conversation.

Thank you, Josh.

Thank you, appreciate it.