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

I'm under way with the second session this morning. It's my pleasure to have here Lennox International, Michael Quenzer, CFO; and Prakash Bedapudi, Chief Technology Officer. So thanks very much, both of you for being here.

Maybe what we'll do -- trying to do a balance of sort of business and technology questions. Maybe start off with some of the more cyclical demand type stuff, residential HVAC, inventories and destocking in the U.S. is endless source of fascination for investors the last year. Where do we stand on that today both at Lennox's own channel partners let us say, Lennox itself, and maybe the broader industry.

Yes, it's been a really popular question that we received over the past month or even over the past 6 months. Just give a little background on the residential business or the Home Comfort Solutions segment, we have about 25% of that business that goes into distribution and then on to the end contractors. So we have a little bit of insight into the destocking. I also want to add is that in 2023, we saw some significant destocking through this side of the business. Our volumes were down about 20%, in line with AHRI reported shipments. So we kind of held our own from a share perspective in 2023. If you turn the page and look to 2024, a couple of points I want to make is that first we still see a little bit of destocking occurring in Q1, although we think it's going to come to an end at the end of Q1. Couple of things give us an indication [how this] is going to come to an end. First, we have [ coils ] business that sells indoor coils to distributors. That was one of the first areas where we saw destocking occur. We're actually now starting to see some growth through that side of the business. So that's really positive indicator that we think that the destocking is starting to come to an end. Also, we have an allied brand, HVAC equipment that goes into distribution. We have a little bit of insight into some of our distributors, not the entire population, but we're seeing normalization, some inventory levels through that brand as well. And then finally, for distributors to succeed throughout the summer season, they're going to have to get back and buy some [ normal ] demand. You just can't get through the summer selling season [without] getting demand. So we think it's going to wrap up here in Q1. For the full year through distribution, we think the volumes are going to be up mid-single digits. On the other side of our business, which is about 75% that goes direct to contractors. In 2023, what we saw there its not as clear as an industry indicator as you could see on the [ sell-in ], but we saw the unit shipments on the sell-through were down mid-single digits. We performed a little bit better. We were about flat. So we won some share executed very well and the regulatory minimum efficiency standard change performed well there. We look to 2024 on this sell-through, we think that the volumes they are going to do a little bit better. It could be down low single digits compared to down kind of mid-single digits from an industry perspective in 2023. We'll know a lot more as we get through Q1 and see how the summer selling season is going to perform.

That's helpful. Thank you. And just if you think about sort of the -- it's always a seasonal business, HVAC, as you mentioned, with the kind of early summer selling season starting in a couple of months. I think you've said before that sort of first quarter is about 20% of the year's revenue this year. So I guess, sort of operating leverage and so on, is the earnings of Q1 sort of mid-teens share of the year or...

Yes. So I'll just expand on that. As we look to our seasonal revenue curve throughout the year, it's correct. We kind of expect it to be a bit of a normal season where you'll see about 20% of the revenue in Q1, 20% in Q4, see about 30% in Q2 and 30% in Q3. We think that's kind of the normal seasonality within our business, maybe a little bit of pre-buy at the end of the year depending on the 410A transition in Q4. But assuming 20% of revenue in Q1 and we've got full year operating margins of kind of 30 to 50 basis points, we see our margins expanding -- slightly expanding into Q1. A couple of points that we see within that, though is, talked a little bit about the residential volumes. We think are going to be down because of the destocking. The sell-through might be kind of flat to low single digits, a little bit of headwind there. But from a tailwind perspective, year-over-year, we're going to get the benefit of all of the transition to the minimum efficiency products. We're about 50% transition through Q1 last year to that product. Now we're going to be 100% Q1 this year. Our commercial volumes, we still had supply issues in Q1 last year. We think volumes are going to be up in Q1 this year -- its the factory that we had some supply challenges continue to [ deal ]. So we kind of look at all of those 2 things together, we're going to be making some investments as well to get our new factory ramped up. We still see some margin expansion in Q1, although it's going to be slight.

Perfect. And if you think about kind of the margin expansion for the full year. Maybe expand a little bit on that. You've got some volume leverage on the distributor part of the business, growing the commercial business, growing -- so maybe flesh out some of the other aspects, price cost, the new plant in Mexico. How do those play into that 40 to 50 bps?

Yes. So first off, in 2022, we had really good margin expansion. We expanded our margins 300 basis points. A lot of that was related to pricing recovery that we did within our commercial, really good performances. We actually even saw our margin expand on the residential, our Home Comfort Solutions segment, which is a pretty good improvement, especially when I talked about those end markets being down at 2023. So 300 basis points improvement in 2023 is a really good performance. We think in 2024 its going to be more of a normal performance, while we target again this 40 to kind of 50 basis points of margin, you mentioned. That's some pretty good expansion, especially when we expect residential end markets to be flat. As Julian mentioned, we're going to get a little bit of tailwind from the commercial volumes being up, kind of low single digits. We're going to get a little bit of that mix benefit predominantly Q1 as we transition all to the new minimums here. And then from a price/cost perspective, we are still seeing inflation. Our component costs are going up. We're seeing the cost of 410A refrigerant going up. So we're focused on pricing to maintain our gross margins of at least 30%. Those are some of the tailwinds. From a headwind perspective, we're going to be ramping up the second factory. We've got about a $10 million headwind there to ramp up this new factory for commercial. A little bit of inefficiency as well as we trended our residential factories over to the new low GWP refrigerant products with some headwind there. Outside of that, its just going to be some normal SG&A inflation as well as investments. So we're making a lot of investments in sales force, customer experience, [ information technology ] and Prakash probably talk a lot about some of the information technology investments we're making, making investments and distribution as well. But right now, it feels good kind of 40 to 50 basis point margin expansion with the variables that we can control.

And on that commercial HVAC piece, I think some of the peers have been a bit more cautious there because of the tough comp in 2023, maybe some softness in pockets of the end market. You're guiding for growth, as you said. Maybe help us understand the drivers of that in commercial.

Sure. Yes. We don't publish our backlog, but we have a backlog that normally looks within the quarter, maybe a little bit out a quarter. I know some of our competition has applied product where they can kind of see a full year. So we have a little bit of visibility to the year already. What looks like is that when we exited 2023, we had a strong backlog. The backlog was up, and that's even up with being lead times going down. So demand still remains solid within the verticals that we participate in. Especially when you look at our national account customers, I think kind of big box retail customers. We do a lot of service work for this national account customers and the age of the equipment continues to age and there's a multiyear refresh that's going to accrue. We have regular discussions with them that may not be in the backlog, but what we call pipeline that they expect to do capital expenditures throughout this year and even into the next several years to refresh the rooftops that are on the roof. Talk a little bit about maybe some air pocket at the end of the year as we start to transition our commercial products into the new low GWP products. Maybe there will be some projects that here were delayed and they're like, all right, well, I could just wait a few more months to get new low GWP products. That's mostly going to be a Q4 dynamic. Don't have clear insight into it yet, but generally, all the verticals we play in, which are pretty much big box for retail, quick-serve restaurants, schools there performed well.

Got it. And there's been some noise from different parts of the consumer world about maybe consumers trying to push back on price increases. How do you feel about the pricing environment elasticity of demand, kind of the appetite of consumers and customers that see to get that price/mix tail?

Yes, definitely concern, but what I'm also just as concerned about inflation. We're still seeing inflation come into our business, so I need to protect our margins. So we're pricing to protect our gross margins right now. That's our focus for doing. Talked about inflation coming through components in our 410A, and I think competition is going to have similar cost pressures. But if you even look to the whole value chain within HVAC, there's an OEM margin, there's a distributor margin, there's a contractor margin. There's a lot of contraction that could happen within the margins. But right now, we're focused on executing our pricing initiatives that are controllable. On our Home Comfort Solutions, we've had several large national account customers that have had long-term pricing contracts. So that's controllable price that we're resetting some of that pricing on. We've announced price increases up to 10% on the residential side starting in February. We just started to see that come in. And so far, prices has been -- it's coming in. But again, summer season is coming. And then finally, at the end of the year, we're going to be launching the new low GWP product, which is going to have another 10% price increase on top of it, significant investments we've had to make for that product, significant cost increases. So we still see that come in kind of at the end of the year as well as we launch these new products.

On the refrigerant point, I guess a couple of things. One, perhaps, kind of Prakash around R32 versus 54. How do you see kind of the merit for that some of the OEMs take a different path on that front? And also, I suppose the rules themselves to a degree, still some question marks through the [EPA]. When do you think we get sort of a resolution of some of those lingering question marks?

First on R32 versus R454B, both are equally good refrigerant product performance with respect to the place R410A. We've studied both exhaustively. We've done lot of system validation testing. In the final analysis, we chose our R54B for 2 reasons. One it is much more reliable -- from an overall system reliability perspective. We've seen some oil returning issues under certain running conditions with R32. Also given the -- without getting too technical, all the flow rate differences between the 2 refrigerant system, you'd have to force the consumers and dealers to replace line sets [ against ] all this, which is a huge cost. So that's why we chose R54B. We're largely done with our product development and now going through the phase in, phase out. So we're very comfortable with our choice. It's no accident that the big -- all the other major players, us and [ Trane, Carrier and Geson ] they all landed on R54B. So we're very comfortable with our choice and that's the right [ opportunity ] for the next 10 years going forward.

And then from [EPA]

Yes, in the EPA, there is some clarity. We've given the clarity so that they can sell through the -- we can sell through in this, we can sell through the [ R410A ] units before the end of this year to the end of next year, end of 2025. There's still some clarification we're awaiting right now, HVAC can still do a component replacement not the system replacement, just the condenser only [indiscernible]. We're hoping to get some more clarity around that. Michael, did you hear that.

No, that's exactly [indiscernible].

And I think on this point of sort of technology upgrades and new standards, in the past, there have been some concern among investors, did Lennox under invested capital to do catch-up spending? How do you see that as CTO? And also sort of on the capital side from pure technology, where do we stand on that?

Probably a fair criticism on the manufacturing capacity. We probably -- and the investor, he could argue, we could have -- should have build the second factory for commercial much sooner, hindsight 2020. Now, the good news is the factory is going to come online in the next few months, and we'll have good capacity to serve the [indiscernible] especially the emergency replacement market that we had to walk away from a couple of years ago. On the technology side, I've been at the company almost 16 years. I can tell you categorically, every year we invested more than the previous year in tech -- information technology and product technology, regardless of end markets. End marks are up, down, COVID, this and that, we did not cut our innovation and technology investments. So that's why we have a product portfolio that has the best efficiency. Won lot of accolades, and the design awards and things like that. So there's no truth to cutting investments in the product technology, information technology because we are not only OEM, we're also distributors of the products we distribute. So we've done enough investments into e-commerce platforms and house management, test with management systems to optimize our -- and have the right product at the right location all the time. So no, we've invested significantly to stay ahead of the pack in terms of product technology for distribution systems, manufacturing systems, I would say.

Perfect. Yes, I'll just add. You can see that within our CapEx figures in 2023, we had $250 million of CapEx. Our normal CapEx is about $100 million. Maybe a little bit higher in CapEx in 2024. But thereafter, we should get back to our kind of normal CapEx of kind of around $100 million as we can do some of these types of investments, predominantly, run manufacturing, for cost you mentioned.

Great. And then one technology or product category that people have talked about a lot for a year plus is the heat pumps. Lennox back in the day was maybe a little bit behind there versus [ earnings ] expertise and market share. And so how satisfied are you with Lennox's heat pump position today?

Great question. Again, I'll try to set the record straight here. Lennox, one of the first, if not the first OEMs launched, heat pump technology back in 1960s, long before I got to Lennox. The reason Lennox had less market share penetration in the heat pump not because we didn't have the best heat pumps. I would say, because of where we were strong in the Northeast markets before the sort of advantage of the core climate heat pump technology, heat pumps weren't doing so under the cold climate. So traditionally, we had the best furnace technologies, and we participate in those markets, and we had very good share. Now as you know, we won the DOE, Cold Climate Challenge before everybody else. We competed with 9 other OEMs, and we had the technology. We proved to DOE, we can do the cold climate heat pump technology. Couple of years ago. I am very comfortable with where we are in terms of technology, whether compression technology, whether [ variable ] speed drive technology and more technology all the key things seen in the technology. We've got very unique solutions that was enabled us to get to the heat pump technology challenge. We partner with the best compression technologists. We have our own in-house variable speed drive technology now where with the software, we can modulate outdoor fan, indoor [fragment] compressor in a way and you can do a whole bunch of intelligent [indiscernible]. We made a strategic choice 10, 15 years ago to own our controls, system controls. Now we are seeing the fruits of that labor and very comfortable. You will see later on this year with the new R454 represents cold climate heat pumps being commercialized, and they will be the best in the industry.

Great. And just wanted sort of perspectives on the growth of heat pumps versus the broader market in the U.S. kind of expectations on that? And also sort of similar question, VRF, which was put a lot of attention 10, 12 years ago. How do you see the growth rate of that and Lennox's satisfaction for this technology with VRF?

First, growth rates on VRF, yes, when sort of VRF gained momentum and everybody started talking about it 10 years ago, the CAGRs were 15% to 20% and the growth rate, it hasn't materialized. I think now we're at a much lower clip, and I think it's still growing faster than, I would say, adopted systems, but off of a small base. Many switching to VRF. So we see that, we participate in that market. And in terms of technology, again, whether it's Mitsubishi or Samsung or a bunch of players, and really work with [ Midea ] as a strategic partner we chose for many reasons. And 2015 is when we started 2016, I remember the first trip taken to [Midea] working with them. The product portfolio is significantly different compared to what they have, what we started with. Over the last 7, 8 years, we brought up that product technology controlling feature functionality, integration with various other systems. I think it's -- there's not a whole lot of differentiation between any products. If you think about they all use variable speed compression. They all -- sort of -- they're all inefficiency points very similar. So I mean, not a whole lot to [ brand those ] points versus another.

Obviously the IRA incentives are focused on electrification, that's going to also help drive that side a little faster than the traditional HVAC equipment.

And just a follow-up on that, I suppose, when -- there were disappointments around the VRF growth rate in the last decade. How do you feel kind of pump that growth rate playing out versus the market?

I think there are some advantages with some of their heating and cooling and the flexibility it offers. Overall, pump category is going to grow, ducted or ductless period, right? The mini split, VRF mini, VRF growth rate be higher than that probably, again, off of a small base. So I think with special growth [indiscernible] however it comes we'll take it of market share. By the way, 2023, our heat pump growth rate is phenomenal. We've done really well with heat pumps. We've launched some products, SL25, the highest efficient heat pump that's doing really well in the marketplace.

Great. And then, Michael, you mentioned stimulus briefly. I guess, 2 different questions on stimulus. I think one would be the specific sort of as a stimulus education, did seem to have a big impact driving K-12 HVAC investment. Sort of where are we on the budget -- it's left? And is there a risk -- does that comes off the sort of education revenue for Lennox and its peers goes down in a year or 2.

I mean it's hard to quantify truly the benefit. We think there was a benefit that we received. We predominantly play it kind of the Midwest schools that aren't applied systems to kind of think of HVAC rooftop systems that we play in. Kind of the Northeast and East has more applied products. Central and the United States product that we work with Texas and other school districts. But it's about 5% to 10% of our Building Climate Solutions segment. It's a good piece of the business. But we think there's regular demand and growth within that area even outside of this stimulus. But if you get the orders in, my understanding through the end of this year, you continue to ship them through 2025. So still should have a couple more years of tailwind there from any benefit we are seeing.

Great. And on kind of broader stimulus IRA in particular -- talk among investors if there's a change in administration, what does that mean for parts of Inflation Reduction Act and implications for HVAC demand. Have you seen much broad stimulus effect at all on HVAC demand though or?

Not through the IRA. There is a lot of local incentives out there through states or utilities. So you definitely see that side of the tax incentives are still out. But from the IRA, it still hasn't been, stood up in any states everything but these many few that are starting to get the administrative side of it done. We may see some benefit later in 2024. But if you look at our industry, most people don't go out kind of shop for preventative HVAC equipment on the weekend. They kind of wait for it to break, then they go through and then they figure out what are my options. So I don't think it's ever going to create a lot of demand, but it definitely helps to improve our mix as generally to get the higher rebates to have a higher efficiency. We think it's beneficial for the homeowner and us. Hopefully, the stimulus stays and this is kind of its later this year.

Right. And on the -- you mentioned briefly the distributor model, margins captured by that part of the value chain, the OEM part of the value chain. Let me just talk about why can't we get kind of both? So sort of when do you think Lennox may get to that point? How long will it take? And any sort of examples of other companies, other industries that you have seen that approach succeed?

Yes, it's a simple construct. I mean, if you think about the OEM margin, the distributor margin. If you do both, you should be able to have entitlement to both margins. I think what we'd say is we are really good at the OEM margin, the manufacturing margin, we do have distribution, kind of been more of a tool, the sales of our equipment than be a full-service distributor. It's a journey. It's an investment that we started to make this year, realigning some internal conflicts with our distribution and sales force that we're trying to overcome. We have some consultants coming in and guiding us of what we need to talk it's about fulfillment rate, it's about culture. So it's a long journey to be a good distributor, definitely still focused on the manufacturing side, getting that cost productivity. But it will be 3 to 4 years we think before we start to really see some big benefits there. It's a different culture that we have to run through distribution. And as I mentioned, it's really about fulfillment, having the right parts at the right spot at the right time, and we're focused on it and starting the journey.

Great. And then maybe on the sort of portfolio front. It's public with some assets that Johnson Controls may be available, know exactly clear which assets or when or how big somehow. But anyway, that sort of things that may come to market. With that broad sort of canvas in line, any thoughts around the appeal of U.S. residential HVAC assets and even anything outside the U.S., what's Lennox has advertised?

Yes. So we've always said there could be a lot of value creation. We're #4 in the industry. You combine with the #5, there could be a lot of synergies. You've talked a lot about the regulatory changes. There's a lot of cost for every, 3 to 4 years in transition through these regulatory challenges, a lot of efficiencies and economies of scale that could be gained. So we think there could be a lot of value creation. But Julian, you mentioned you have to understand the perimeter like what exactly is it, just to learn more about the asset? Does it make sense in the strategy that we've set focused North American business with ducted providers, we want to make sure it kind of fits into our overall strategy. So we need to learn more there. So more and more its about the economics, making sure we can do it with a good ROIC. And but we're trying to learn more and we think that there could be some value creation as we go through the valuation.

And 2 quick follow-ups on that. One would be, what kind of balance sheet leverage would Lennox be willing to go up to in any M&A scenario? And then two, the appetite for any U.S. deal?

Yes. From a leverage perspective, we want to maintain our investment-grade ratings, that would be 3 to 3.5x [indiscernible] want to delever pretty quickly, get back down to kind of 2-ish. So focus of the economics as we look at this potential transaction. International, I mean, Prakash talked a little bit about there's a blending of the ductless and the ducted product in the United States. So we have to kind of understand, again, the perimeter what is entailed in the assets. But we can serve both sides of the end market from the United States from both ducted and the ductless in the best way we can.

Perfect. Good way -- switching out to the audience response survey questions. So if we could bring up the first question and if people could use those handheld gray boxes or what have you. So the first question, do you currently own Lennox stock? I guess over market weight or underweight? [Voting]

All right. So fairly balanced, not at all. Second question is around general bias, positive, negative or neutral? [Voting]

Not many negatives out there. Third question is around sort of through cycle earnings growth for Lennox versus, let's say, the multi-industry average here would be the peer set, so above, in line or below? [Voting]

So generally viewed as a high-growth company. Fourth question is around excess cash usage. There's a menu of things there to look at. So spread. I guess the most popular is buybacks and its on the investments but it's pretty broad. Fifth question, PE multiple on 12 months earnings, actually, yes, should we market multiple or [indiscernible] I suppose. [Voting]

So generally, around the market actually despite the higher growth perception. And then the last question, number 6, what's the reason why you don't own shares or more shares of Lennox? Is it growth, margins, capital deployment or execution and strategy? [Voting]

So the biggest thing is sort of the core growth outlook. And maybe on that point, we have sort of 30 seconds or so. When we look at Lennox has those updated medium-term goals a few weeks ago. If you're looking at sort of the top line growth rates, maybe help us understand any composition of that price, volume share, what the classical kind of incremental margin of that revenue in the medium-term plan is.

So once you get through this short-term lumpiness in the end markets, we think the industry is going to grow to 3% to 4% a year, that's for about 10 years. We think it's going to get back to their normal growth. So you're going to get some tailwinds. And then we're going to get back focusing on 50 basis points of market share gain per year. That's really what we're focused on. You see a lot of the investments we're making, Prakash talked about it. But we're going to be focused on customer experience, on the residential side and distribution. And on the commercial side, getting back and emergency replacement and getting back on the offensive on national accounts, things we really haven't been able to do in our supply-constrained environment.

And then the sort of the leverage of that will be, what, 30% plus?

Yes, 30% incrementals on those, and then we think there's going to be some mixed [indiscernible] as well, electrifications and some of the trends in GWP product as well, that's going to be some form of driver. You get back in the cost productivity. We're going to get the second factory commercial and Prakash just seems to lot of material cost reduction as well, and that's going to be a driver of margin expansion. And we're going to have to reinvest some of the profit growth every year to keep growing our margins.

Fantastic. Thanks very much...

Thank you...

Michael and Prakash. Thank you.

Thank you.