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

Good morning, everybody. I'm Tommy Moll, analyst here at Stephens. We appreciate everyone's interest in our conference. Appreciate everyone's interest in Lennox this morning, where I'm delighted to be joined by the CEO, Alok Maskara, as well as Senior Manager of Investor Relations, Chelsey Pulcheon. Alok, Chelsey, thanks for your time, and thanks for coming.

Thanks, Tommy. Always a pleasure to be here, and thanks for arranging some really lively scenes last night. Sorry that I missed them all as was preparing for being the first one in the conference. Thanks for [ accommodating ]. I'll start with some prepared slides and remarks and then we'll go into a Q&A mode. So if you can start with the first slide, please. Lennox is a really good company. And as you can see from this, I've been in the company now a little over 18 months -- okay, sorry, I got to get closer to the mic. I've been to the company around 18 months and really excited to be here, really excited about the company's future. And while we have done really well over the past 12, 18 months, One thing I remain convinced is that our best days are ahead of us. And hopefully, that's what you will take away from this presentation. So if you go to the next slide, just to give you kind of talk in terms of where we are. What changes have we driven over the past 18 months. And I think one of the biggest one that you can measure in financials or numbers is reinforcing the company culture. We have 3 core values that have been around for decades, right, think of 100 years. As new employees were coming in, it wasn't really clear what integrity, respect and excellence means. So we didn't change our core values. We kept our core values. What we did is came up with guiding behaviors, and those guiding behaviors is how we communicate to all our employees. That's how every meeting at Lennox starts with is with this slide. While I'm not going through the 9 of them, I'll tell you some of the big changes we have done and things like accountability. We have come to a position where for whatever reason in the past 5 years, COVID, tornado, CEO transition, we lost our historical focus there, and now we are kind of back on that. The other thing we're driving very heavily is customer experience. I mean I strongly believe the better we serve our customer, the more market share we get and the more we grow. And we are making lots of improvements, changes, investments in improving our customer experience. And finally, I will touch on innovation under excellence because as we look at innovation, that's important to us. We do make the world's highest efficient air conditioner, the most efficient furnace. And we obviously win regulatory transitions that we did in 2023 as we went through the regional Sears standard, and we expect to do the same thing next year. So that's kind of we always start all meetings, I thought I'll start this one with that as well. And if you go to the next slide, just a quick one, just to kind of talk about numbers. We're very proud of our ROIC. Some of it's the fact that we haven't done acquisitions so we have not got tons of goodwill in our balance sheet. But it also shows we run the company well, half of our performance shares or west based on ROIC. So it's an important metric for the management team. On the left-hand side, you would essentially look at all the numbers, you get more details in your model. What I would highlight is how simple we are, which is what the graph show at the bottom, right? Two segments appropriately named residential, commercial, by the way, I don't like those names. We'll come back with better names in the next year or 2. But it's simple, right? That's what the whole thing is. And if you look at it historically, commercial owned less than their profit expectations. And one thing we are very proud of is now the revenue and the EBIT from the 2 segments are roughly equal. Otherwise, residential used to be a large portion of revenue and almost all the profits, and I think that's becoming more balanced. And the last graph on the right-hand side just shows that replacements is our business, right? I mean we do some new home construction, and that's cyclical based on number of housing starts and all that, but majority of our business is replacement. That gives us a really good perspective as we head into uncertain economic times. So those are kind of things I have to highlight here. If you go to the next slide, we talked about ROIC, and we talked about acquisitions and the fact we hadn't done many. But we did one in Q3, so we wanted to highlight that. A small bolt-on acquisition, kind of a dream type acquisition, $90 million in purchase price, $100 million in revenue. What it does, it fills a void in our portfolio around commercial service. We have talked in the past about commercial service being a smaller portion of our revenue versus where our entitlement is versus where some of our peers are. So this kind of [indiscernible] fits in like a hand-glove type situation, a really nice fit. So we could go to a large customer, let's assume, it's a large retailer that we already have. And now we can sell them the equipment, we can install them, which we couldn't do before. So we install it using AES. We do preventive maintenance, which we do based on our existing -- then we could recycle the overall refrigerants and the equipment at the end of life. And we sell more accessories like core adapters. So we are really excited about this acquisition and got a good value. And the reason we did it the way it is, no bankers, no private equity, the founder really wanted a good place for the employees, and we identified with the values. And that's the reason we did this acquisition on a purely one-on-one negotiation basis. So that's just an example of kind of things we like to do. Not ruling out any acquisitions, nor am I saying that all acquisitions will be as good as this, but this is really good, and we are happy with that. If you go to the next slide. I did say our -- as I started, that our best days are ahead of us. This slide is essentially just says that in with 5 -- and I think those are the simple 5 factors. We are in a very attractive industry, good growth market. And if you think about people talk about European business, all that, I mean, it's all good. We are very North America focused, but we like the growth prospects in North America as the industry continues to grow above GDP, and we are convinced it's going to grow much above GDP with regulatory transition, temperature extremes, life cycle changes, growth of heat pump, many, many factors. I'm not going to go through the other 4. You can read it. You've probably seen these slides in the past. But just to say, super excited to be here and remain convinced that our best days are ahead of us. With that, Tommy, over to you.

Yes. Thank you a lot for the introduction. And just a formatting note for those in the audience. These meetings run 45 minutes. So I've got questions prepared to keep us busy for the entire 45. With that said, I'll run about 20, 25 minutes and then start looking up to answer or rather to call on anyone who'd like to raise a hand and ask directly. So we'll definitely reserve a healthy portion of the session for audience participation. But just to kick us off and Alok you hit on some of these introductory themes already. But I want to drill down a bit in terms of well, an important part of context here, this being a generalist conference, there will be a number of folks in the audience who may not have a ton of familiarity with HVAC or Lennox. And so if you had to boil it down, why an investor should consider allocating capital to HVAC broadly defined? And what is the core distinction of Lennox within that space? How would you frame it?

Sure. No, that's a great question. Sometimes forget those basics, I mean that's almost come back to why did I join Lennox and why did I move? I've worked at different industries, different companies. But let me start as -- and I tell my children this as they look for jobs. I say join good industries. That's important because sometimes you could be the best executor in a poor industry and your results still suffer. HVAC is a good industry. So first of all, in North America, which is where our focus is, few large players, very disciplined, who are getting more disciplined, essentially make up the whole industry. it's a very large industry, too. I mean if you think about number of households multiplied by the replacement cycle, multiplied by average ticket price, which is going up significantly. So it's a large industry. It's a profitable industry, profitable because of the structure. I mean these are very capital-intensive businesses and barrier to entry for manufacturing is very high. And if you don't believe that, just come to one of our factories, you will see why. Then if you go to the next stage on that, the future of this industry -- this is one industry which actually benefits from climate change. Now we are not pro or against climate change. We simply say that as temperature extremes come in, we are here to provide comfort to our customers and make sure that we can do it in the most energy-efficient, more [ environmentally ] friendly way. So I think that's there. And the reason the growth is going to be above GDP is our replacement cycle is shrinking. So historically, an equipment would last for 20 years. Furnace is to last for 20 years. But as technology changes and the furnaces are being replaced by heat pumps, heat pumps last 10 to 12 years. So if you think about the heat pumps we are putting in the ground versus furnaces we're putting in ground 20 years later, that's the reason the industry grows above GDP -- substantially above GDP as the technology changes. And then, of course, there's regulatory changes, which makes refrigerants more expensive and the race towards zero global warming potential refrigerant. So that's on the industry side. Lennox is unique, unique because of the 5 things we have in here, but let me just go -- expand on a few. We are the ones who are direct to our dealers. So the industry structure is, think of 6 to 8 manufacturers in the North American industry, think of about 1,000 distributors, think of about 10,000-plus dealers. So we go directly to the dealers. 70% of our sales are directly to the dealer. We are unique in that, right? So we are belly-to-belly with these dealers and skip the distributor level. And that's our brand value proposition right 100 years ago and even today. That gives us some unique advantages and puts us in a position where we can innovate faster. We are closer to the dealer, so we actually have more insights and the loyalty, dealers love working directly with the manufacturer. And there's no brand confusion, there's no digital platform confusion. We have one ERP. This would be a dream company to run, by the way, one ERP. Just let me absorb that. one ERP, one digital platform, one DotCMS platform, e-commerce makes up 50% of our revenue now. So 50% of our orders come directly through in dealers app or their website, not fax -- sorry phone calls, right? So I mean just thinking from that perspective, that's where the direct connectivity of the dealer matters. So super exciting franchise, a great company to work for.

And Alok, regarding your tenure specifically, you joined the company in spring of 2022. You talked to some of the cultural points of emphasis that you've really focused on. But again, if you kind of had to tie it all together in terms of the culture and the strategy that you've shifted under your -- as CEO, what would you frame for folks?

I think we have done well from productivity perspective in the past. We have done well from share buybacks in the past. We have done well having a culture that's very execution focused. So we need to keep all of that and we will. As we go forward, where we did get a bit distracted was just operations, which were far flung and not adding value, like a European business, just numbers itself showed that we should have it. So we have divested that. And now we're 100% focused in North America. By the way, profits were always 100% focused on North America. It's only a revenue that was not. So we moved out of that and just focused. Second thing as we come back is we have put more emphasis on profitable growth, which comes down to a simple focus on if we are the manufacturer and the distributors, we should make margin for both. We should not be satisfied with just the manufacturer's margin. And that's a big shift in our mindset and thinking as we look at saying price and costs don't have to be related all the time. And let's really make margins that are manufacturers plus distributor. And that's taken a lot of cultural change, reorganization. As part of that, we also have to acknowledge that we are the second largest HVAC distributor in North America. So if you think about the 1,000 distributors we mentioned, right, we have 250 of our own outlets. So we need to leverage that and to be able to pump more parts, more supplies, more spares, more services through that network and pull that together. And finally, we're going to round up our portfolio as needed through acquisitions and be a more active player than we have been. So that's on the strategy. Culturally, I'll just go back to the values. We got to serve our customers better. We often lose a dealer because we didn't have the high fill rate. We don't have high fill rate because we didn't have enough manufacturing capacity. And I'm not giving that as an example. I'm giving that as a root cause of why we did not grow. We didn't have manufacturing capacity. Our commercial business has been supply constrained for over 5 years. So we are now making the necessary investment to double capacity in commercial, increase capacity in residential, so that we can continue growing.

And Alok, we'll dive into residential and commercial dynamics specifically here in a minute, but for the last of our opening questions. And this could be specific to HVAC or just in general, what you see in the marketplace. But how would you characterize where we sit in this economic cycle? And if you just -- you think about some of the big topics that come up over and over, inflation, supply chain, channel inventory dynamics, what is your dashboard telling you on some of these items right now?

My dashboard is better than I expected. If you'd asked me this 12 months ago, I would have expected a lot more yellows and reds, and I have a lot more greens and yellows on the dashboard right now, just in the overall picture. The health of consumer in the U.S. is better than most of us expected. Every banker that I've spoken to in the past 18 months, they have been predicting a recession 6 months out, right? We're still predicting a recession 6 months out. So I think from that perspective, I'm just so glad that it's forever going to be 6 months out. Now if we are wrong, we know how to deal with it, and we'll work through that. So I think that's one. We have seen interest rates make a difference. Of course, it does, right? More people are like looking to finance the houses, and we see a lot of our promotions, which were on cash promotions are now shifted to interest rate buy-down or points by down. We haven't seen dramatic changes in approvals, which is what we saw during banking crisis. So we know we are not at least there in terms of any dramatic changes. What we also found is because of interest rates, a lot more people feel stuck in their current house because they have got a 30-year mortgage at 3% and they can't move. So they're more willing to spend money on big ticket items. Earlier the conversation could be, oh, let's just repair it, Honey. We don't know how long we're going to be in this house. Now they're like, wow, we are stuck here for a decade or 2, [indiscernible] get a new air conditioning system. So I think that's changed from a mindset perspective. But the state of the economy is good. In 2023, to your last question, Tommy, the largest change that happened was channel destocking for us. That's the one that everybody did not predict accurately, and we should have, right? Supply chains always go through the whipsaw effect. If you had to book the goal, you know how that works, right? I mean there's a whole whipsaw effect. We should have all seen that. We expected it, it's a little more dramatic than we expected, but we are delighted that there's no replacement cliff. All this says is that about 1 million units in '22 and 0.5 million units in '21 that were counted as sales really were just stuck in the channel inventory, and that's not all coming back, which means the industry is actually pretty normal and boring. It just grows at 4% to 6% units per year, and this is just abnormal year. So we are pretty pleased with where we are, which the word cautiously optimistic is the right word, right? We still want to be cautious given all the news out there.

So let's move to a discussion on residential in a little more detail, and you touched on the destocking issue. On your recent earnings call, you framed the outlook for next year is, one, where there would be growth in units unlike this year where there's been significant declines. But specific to your direct-to-dealer channel where there's less of a destocking impact, what gives you that visibility today?

It's very much a book-to-ship business. So I can tell you, analytically, there's nothing I can give you in terms of numbers to say that's going to be true, right? What we just watch for is trends, like trends on repair versus replacement, trends on consumer financing, trends on lead generation and lead conversion. And all of that is holding steady. Now I think there was a -- '21/'22, there was [indiscernible] times and those things were much better. So there's definitely a shade lower than where we were in '21/'22, but they're not getting worse on a daily basis or weekly basis. So from that perspective, we see some stabilization in that. The other thing we constantly look at is the age of the units in the field, right? So I mean I think what happened is during COVID and other times, a lot of the demand accelerated. All it means is units ran longer. Our data shows they're still running longer, not as long as during COVID, but people are still spending a day or 2 at home versus 5 days at home. So I think that continues. And we do like the government incentive schemes to encourage replacement such as -- sometimes related to IRA, sometimes independent of IRA, but replacement that drives heat pump is good for us because it's replacement. So I think from that perspective, we feel good. Listen, I'm not saying next year is going to be gangbuster growth. But the channel correction is going to be complete this year. That automatically helps the manufacturers because we -- this year, we are selling -- our distributors are selling more than they're buying, which means we are building less than we are selling. Last few years was different. So productivity comes back. So we're going to be cautiously optimistic with a close eye out on consumer, just like all of you would be doing a close eye on consumer health.

So let's talk a little bit about some of the regulations that are coming down the pike here. There are a couple on the refrigerant side, one where there will be a supply curtailment for the existing refrigerant, the 410, and then a phasing in of equipment built for use of the 454. And again, maybe before we go into the technical discussion about pricing and cost, et cetera, just frame what those 2 coming changes are going to look like.

Sure. So I think both of those are driven by Kigali agreement overall global push towards using global warming potential that is lower with each successive generation of product. So if you go back and look at Golden old days, we used to use Freon. Now Freon was highly stable. The issue was even when it leaked to the atmosphere, it was so stable that it damaged the ozone layer. Some of you may remember, the younger people in the crowd probably don't even know what I'm talking about, what was this Ozone layer. So the next version of that is coming in January 1, 2025, where we all must switch to a new refrigerant that's going to have 70% less global warming potential. And as part of that, EPA has cut down the quota for current refrigerants being manufactured, which is 410A. The new refrigerant that we are using is we call 454B, great technical term, doesn't really matter. All it matters is the current refrigerants going to be phased out, the new refrigerants going to come in starting 2025. We all have to do a lot of work. All our products have to be redesigned to include safety sensors and to be able to handle new refrigerants. We got to retool our manufacturing lines. Between now and then, 90% to 100% of our engineering capacity is going to be working on this is to make sure the transition goes successful. As the 410A quota cut down and that's intentional, the price of 410A is going up substantially. So what price we paid for the old refrigerants in '23 is going to be lower than what we are going to pay in '24, 25% is going to be higher, 26% is going to be higher, and that's to curtail the use government's driving that, which means next year, we will have to pay more for the 410A refrigerants and recover that in price. The following year, 454, that requires a lot more safety sensors in the systems, a lot more electronics, a lot more controls and even the compressors and all have to be upgraded to maintain the same efficiency. So again, our costs are going to go up, which again, we have to recover based on price. So that's kind of the overall. Now is it good for the environment, I'm not going to debate that because most of us will say, yes, some will say no, but it doesn't matter. But I can tell you it's good for the industry. There is no debate on that from our perspective. Again, it shortens the replacement cycle. It gives the products to be more value-add, it makes sure this will never become a DIY business. I mean nobody can be able to -- you need a license to be able to handle these type of refrigerants. So we know it's good for the industry, and we know it's going to be good for Lennox because we work directly with dealers and we handle these transitions much better than others because there's no intermediary in between.

And on that point about transition, Alok, do you start to phase in some of the new 454 product in advance of the official date in January of 2025? Or what does that transition look like?

Yes. I mean there's a cutoff, it says at January 1, 2025, you need to stop making the products unless you're selling it to Canada or unless you're using for some replacement, so think of 10%. We -- since you make like 1 million units a year, just to give you rough numbers, we can do it overnight. So we will be starting to introduce the new refrigerant products starting next year. We will start with the high end first. That's where we see consumers more willing to go for those safety sensors and then slowly ramp it down. So by 1st January 2025, we are making very few, if any, units of the older refrigerants as allowed by the law. And that's going to be across the board, everybody would be doing something similar. I don't think it gives anybody a competitive advantage one way or the other. I think the competitive advantage comes from how well do you execute on it. You make sure there's no product shortages. Because if you have a shortage of a product, dealers don't wait for you to recover, right? They sold a unit that they're going to install tomorrow, no matter what you use then. If it's not your unit, they'll install somebody's. So we just have to make sure our inventory always remains full.

Now moving to the pricing or price mix impact of all this, Alok. You have framed the cumulative impact over the next couple of years in the 15% range. Can you unpack for us what some of the building blocks are of that 15%? And then if we look up in a couple of years, do you think it's more likely we overshoot that bogey or undershoot?

I'd like us to overshoot, of course. But let's unpack it as you requested, Tommy. First of all, it's over 2 years. So it's not over 1 year, right? So just keep that in mind. It's starting today until January 2025. First aspect of that is going to be the 410A refrigerant cost going up. And you will see everybody in the industry has to do price increases unless they want margin degradation, which I don't think this industry would do. Next is the 454B units, which will have significantly higher cost. We talked about sensors, electronics, [ boards ], all of those. So those are the 2 factors, plus add regular inflation, right? So I'd remind people, inflation is down. It's not 0. I mean just look at wages, UAW contracts, if you look at anything else, I mean, inflation is not down to 0. It's just lower than before. And the industry has historically been good at getting 2% to 3% price every year. So that should continue. And if inflation is more, we would get more. In addition to that, now you've got to think about the impact of mix in this as we look at the units sold and where it impacts, last year, when we went from 13 SEER to 14 SEER, we had significant mix benefits. That's reflected in our margins and most of competition margin. You would see that similar mix trend come in because now you suddenly see our units are all going to gear towards higher efficiencies, and we will take all the pain and the benefits of trying to get to a higher mix. Finally, for us, internally, we are driving a huge pricing excellence program, and that's got multiple aspects to it. One being just looking at how should we operate as a distributor. So we're giving more autonomy to our local districts to manage pricing. But of course, that comes with more accountability as well. And that ensures alignment overall is profitable growth. I would rather lose $1 million of sales at 10% margin and gain a $300,000 account at 35% margin because it will be better off. And I think that's the mindset that the alignment we are driving across the board. But so far, we think we'll do both. So I think those are elements of pricing, right? Just 410, 454, regular inflation and then our pricing excellence effort.

Moving on to commercial, Alok, and then we'll get to Q&A from the audience if there is any. I guess just to start, there's been a swift recovery in the profitability for that segment under your leadership. And so for those who have not been on your recent earnings calls to follow all the progress, what is the before versus after look like there?

Sure. I'll just add, it's not just my leadership. I think I do very little in the company. There are a lot of other people who have worked much harder for that. So my gratitude goes to Joe Nassab and others and the team who have driven this. The before picture was we had a factory in Stuttgart, Arkansas that went into crisis mode. We woke up one fine day and realized half of our labor force was gone. So what [indiscernible] make? So that was kind of the existential crisis. Now that should have never happened, but anyway, it's easy to play Monday morning quarterback. And that met our productivity was down, our output was down, our pricing was all messed up because if you not be able to deliver products, how do you go talk to a customer about pricing. The customer -- I'll give you price, if you ever give me product, right? So that's where we were stuck about 2 years ago. Where we are today is we have solved the labor problem, we decided to overpay. So we actually, in one fine day, I gave people like 30% increases across the board. So we went from $14 an hour to $20 an hour. That has solved the labor issue. There's literally being capitalist world, it's easy. Now we have a line of people waiting outside who would like to get a job there and we get really high-quality workers. We have taken significant steps towards dual sourcing our supply base, that was our next big problem. And then finally, we've been able to get the fair pricing that we deserve right from the beginning because our supply has improved, our commitment level has gone up. Our Net Promoter Score is back to a normal level. I mean that's the way I look at progress, and that helps us get pricing. In addition, we are building a new factory in Mexico. So we will, over years, not immediately, be able to double our capacity, and that's given our customers and the dealers, huge level of confidence. Yes, Lennox is actually investing in it. So even if there's some short-term pain right now, which there is because we are still supply constrained, not demand constrained. People have the confidence that we are putting the right investments in the ground to make it happen. So we are pleased with where we are, but there's still a lot of work ahead. I mean, next year is going to be difficult as we ramp up a factory, which means for 6 months or so, we'll have a fully equipped factory with no output. So we're not declaring victory. We still have a lot of hard work ahead.

So to double-click on the investment in Mexico, it's about $150 million for the greenfield project there. What do you want to make sure folks understand about the 2 plant strategy, about how that ties into the emergency replacement market reentry. And in particular, on that market reentry, what gives you the confidence that once the new plant is up and running, you can recapture all that lost market share?

Sure. Tommy, great questions. Let me start by the first one is the 2 factories are going to be very focused. We believe in very focused factories. So the factory in Mexico is going to be standard products. These are typically smaller products as well, shipped by the truckload and focused on emergency replacement. So that's our factory in Mexico. The factory in Stuttgart, which is again a great factory now, we'll continue and will focus on configured products, focus on key accounts and they're typically larger products, they often ship on flatbed. So I just want to separate, while we use the word commercial together that very different product categories. And that gives us the confidence that Stuttgart is going to be much more engineered products. And it is really going to -- and it historically has competed with companies like Aon, and versus if you go down and look at the Saltillo, that compete more with companies like Goodman and Carrier, so that's the 2 extremes. So they are very focused factories on that. As we look at what to expect going forward on each of those. I mean next year, there's going to be a bunch of, obviously, start-up costs, start-up distribution. No factory startup is perfect. I haven't found one, but we're going to try and get as close to perfect, will still mean it will be inefficient as we build that together. And we are very keen to be able to reenter the emergency replacement market. We are not taking the build it and they will come approach. So let me just assure you of that. I mean we have actually spent a lot of time retooling our front-end because our front-end has forgotten how to sell emergency replacement products. They haven't sold any for 4, 5 years. So how would they remember. So we've put a lot of effort in there. We are adding about 25% more salespeople. We are putting in new sales force-based automated tools. We are really revamping our districts. We have supply chain efforts because for emergency replacement, you have to have the product locally in stock to be able to do it. So take it as we are going to reenter it and we're going to enter in a thoughtful way. We're going to make the necessary investment. We're going to gain the productivity and it's not a build it and you will come. So that just doesn't happen. There's no competitor waiting to say, all right, Alok, you can have that share. Nobody's going to give it back to us like that.

Right. Last question for you on commercial, Alok. From the outside, it's been interesting to follow the evolution of the cycle there. There's a big backlog component, but if you think about the real underlying demand or whatever leading indicators you follow, where does it feel like we sit today on the commercial side?

A fair question. And each commercial business is a little different. Let me describe what our commercial business is, and then going to come back into, right? Our commercial business is very focused on, I would call, single-story buildings all over U.S.A. That typically means retail, foodservice, schools and businesses like that. Our exposure to things like office complexes is close to 0, if not exactly 0, because we don't -- we can do multistory. If you're more than 3 stories or even 2 stories, you would not be using our products. And there are very few single-story office complexes. So I think with that, our exposure to data center is also very low to 0. The reason I mentioned is of having low exposure to office space helps us having low exposure to data center hurts us. Net-net, we kind of come out even based on our exposure on where we are. Now data center, the reason we're now there is because I think to get in requires an acquisition, and I think everybody is kind of chasing that market. So if things ever calm down, we'll look at it differently. We have not seen any massive change in demand because these are typically key accounts, think of Lowe's, Walmart, Home Depot, Chick-fil-A, all of these would be customers. And they look at this from a productivity perspective, from reliability and the average age of equipment is much higher than what it was, and the demand has not come back to even pre-COVID level because post-COVID those year or 2 frozen in there. So we remain cautiously optimistic, but we are very cautious in this as well, right? We obviously have productivity actions that we'll take in case market softens. But so far, this is holding as we would have expected. And we still see a lot of people who have waited for a while will jump on this low GWP effort and put in units that gives them more green points are more energy efficient. And they will often get a payback of 2 to 3 years when they replace all the units on their roof. So it's a good economic and a good green decision for them.

Last question from me, Alok, and then we'll turn it to the audience for any questions. At your Investor Day last year, you rolled out some targets for 2026, $5 billion to $5.5 billion of revenue with an 18% to 20% EBIT margin. If you look at the current consensus forecast, you'll hit into both of those ranges next year, which would be 2 years early. But if you think even longer term in terms of margin entitlement, you've started to sketch some of the opportunities there today specifically around the distribution value that's not currently reflected in your margin. But what do you -- what is that long-term aspiration or entitlement? Or if you can't quantify it, what are the big building blocks yet to come?

It's a great time to be here in a way, right? A year ago, when we gave long-term targets, I felt that we were universally ignored by the buy side and sell side. Nobody moved their consensus and nobody looked at it. So the next few conferences, I would go to, I would take a 1 page printed only my long-term targets and just randomly hand out to people saying, we are committing to this. So in a year now, people still don't believe us, but now they believe that we'll far exceed that number. So I would rather have this problem versus the previous one. But listen, we -- consensus, we can't control. What we have to be careful is to not take 1-year success and draw a steep straight line. As I said, next year, we'll have cost -- extra cost for factory ramp-up, extra cost for 454B. And again, not counted consensus. But at the same time, I'll admit, we are ahead of schedule, especially when it comes to commercial recovery and residential margin. Once we have hit the target, and I mean, Tommy, the high end of the target, not the low end of the target, we'll be happy to give new targets. I've always believed we do internal strategic planning, and we will give new targets at that stage. But to your question, our best days are ahead of us. We believe on commercial, we should be best-in-class industry margins, and we are not right now. The others who have done better margins than us. We are really strong believer in our 2 factory, 2 segment model on commercial, that's going to help us. On residential, I mean, we literally should make OEM margins and distributor margins, and we are reorganizing around that framework to be able to do both to drive that successfully. So first, we will hit the high end of our previously communicated numbers, then we would go out and give a new set of numbers. But we are not done. I mean, I think as long as [indiscernible] year will probably never be done. I mean the only question is going to be, what's the basis point margin expansion we are going to get which year? I can tell you, next year's margin expansion will be less than this year's margin expansion and just to manage expectations. But it will be margin expansion.

Thank you, Alok. I want to make sure to give everyone in the audience a chance to ask a question. So please raise your hand if you have one, don't be shy. We have a microphone, Max, do you mind to carry the mic around?

How do you think about prioritizing M&A over the next couple of years in regards to your most recent acquisition?

We have a pipeline -- I shouldn't call it a pipeline. We have a target list of about 30 companies or so, all bottoms-up generated by our team and to fill gaps. M&A is not going to be a strategy for us, and M&A is not a strategy. M&A is simply a way to fill the strategic gaps that we have in our portfolio to get scale where we don't have scale, to get capabilities where we don't have capabilities, get technology where we don't have technology. I put M&A as it's a really good thing to do. If we can do it well and we get the right targets. Also, I was one of the consultant at McKinsey, who looked at this and say 60% of them destroy volume, right? So I want to be -- make sure I'm on the 40% side, not the 60% side. So we would do it cautiously. The pipeline is there. But all of these are private small companies that we need to have are owned by multi industrials that we need to think through and work through it. So we have a team. We are learning how to integrate. I want to make sure we integrate this well, absorb this well, build some muscles behind it. But this would be more often takes two to tango, whenever the other side is willing to tango, we would look at it.

Could you talk about kind of scenario planning as it relates to margin, just given -- obviously, there's so many factors that go into it, and you talk about there's this natural pricing and then all of a sudden, you've got these regulatory uplifts. And then you walk into a consumer environment that's uncertain. I mean just the scenarios you think about as it relates to consumer behavior facing price increases related to regulatory things like how they might react, how you think about that playing into the margin progression?

Sure. No, that's a good point. Let's look at the industry structure for a minute. So your manufacturers, then you have distributors and then you have dealers and then you have the consumer at the other end, right? The price that the consumer sees is completely disconnected from the price manufacturers charged to distributors. Over the past 3 years, distributor margins have expanded substantially because there was a shortage. Dealer margins have expanded substantially, especially with all the private equity money going in and how they negotiate and put it all together. Manufacturer margins have actually come down. right? And the consumer prices has gone up substantially. I'm not defending that. So I think part of it is going to be for us to work through the industry chain and make sure the profit pool is more fairly distributed. I, for one, think the profit pool over the past few years have become unfairly distributed. That doesn't mean the consumer price has to go up or down. That's up to the other folks in the channel and how they look at it from that perspective. A consumer when they change the HVAC system, that's probably make that decision once or twice in their life. Some will never make it. So they only will do it if they have been in a house that's got a system that's 14 to 16 years old. And most people will make it once or twice in their lifetime. They have no price reference. They -- I have no idea when the last time they changed what the price was. And the technology is different. The product is different. I mean it's just -- it's totally different. They're taking on an old Mercury or Honeywell thermostat and putting something digital on the wall. I mean, this is like totally different. Consumers have no price reference. It's more their affordability, their need on where they are, and they're all aware of the temperature extremes and how the new systems are more comfortable. And we want to help them with that, like, I mean, we really believe the indoor air quality is a big part of that. So for us, being a manufacturer, we are more focused on, let's do the fair thing. Let's have the profit pool be equal. The backlash from consumer on something like this doesn't exist because they have no frame of reference in this. Going back to price potential, there are companies we admire a lot like A. O. Smith, right? I mean it's a different type of products in a similar industry. I look at their margins. And I'm like Kevin, Ajita, great job, I need to learn from you guys, so we can work through that. The companies we admire, like Aon, they've got some good margins in there. I want to look at others who are publicly-traded manufacturers and distributors and look at their margins together. I take that to my team every day. I said, "So why is our margin less? What are we doing wrong, right?" I mean that's the kind of discussion we would have, but I would separate it from the consumer aspect.

Going once, going twice. We got a couple of minutes left. I'll ask one more, but please jump in if you'd like to. All right. So last one for me, Alok, and then we'll be at the 45-minute mark. This has come up a number of times the captive distribution you have for 3 quarters of your residential business. What do you see as the key benefit of that in terms of market share capture vis-a-vis the other OEMs you compete against?

Sure. I mean, that's a great question. And I don't think we have fully leveraged the value of that, right? But if you think about Lennox used to be a much smaller company. We had very few outlets. We started as PartsPlus and now they've truly become more of a distributor. When we executed very well, and we do it well. We just need to go from well to very well. With the benefits we would see the following, right, our stickiness with the dealer would be higher than others because we have no intermediaries in between. I mean at the end of the day, this industry works on dealers, how many dealers did you add and how many did you lose? If you just take that math and improve it, you double your shareholder value. I mean just like it's a very crazy industry from just math perspective. And I think we should have higher stickiness, and we haven't had that in the past few years because of supply disruptions that we face. So that's one. Second is, as you introduce new technology, whether it's about smart thermostats that drive predictive, preventive maintenance. We bring the value proposition that a dealer could know what's wrong with the system even before they get there because we have 1 single integrated system. The place that they order the product is the same place they have a dealer dashboard. They can see what's wrong with the equipment. And in some cases, do their diagnostic on their own even before coming there. So I think that's a huge. So technology-wise, this chain wins, right? Because you don't have to fight with a distributor who wants to introduce their own software versus dealer trying to do something. This is just one software, that whole thing. And it's seamless, completely interconnected. Dealer can take a QR code, scan it at the basement and know exactly what spare parts they need, and they know whether their local store has it in stock or we can deliver it overnight to them. I mean that seamless supply chain. Oh, by the way, we'll do warranty processing from manufacturers as well. Nobody else can do that. I mean, dealers just love that fundamentally on that, right? And finally, to be able to pump more through that, like our sales from parts and supplies is much lower than everybody else. And I think that's an opportunity we have is to take other people's products and truly get one-stop shop for dealer or share a wallet for the dealer, no matter what buzzwords you want to use, we can be able to do that. And best of all, we can put it all together and look at a business model where using our smart thermostats, AI tools, we can start looking at what are the recurring ways where we not just get dealer loyalty but also consumer loyalty on the brand and service filter changes. I mean just potential there is huge. We just need to capture it.

We'll end here. We're at the 45-minute mark. So again, I want to thank everyone for joining the meeting today. Alok, thank you for that great overview. I know you've got a busy day of one on ones. So we'll let you get to it.

Thanks, Tommy. Appreciate it. Thank you.