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

Getting back to that $100 million run rate. Great transition because I think you have a lot to say and investors are very curious around the distribution growth strategy. And I guess I would start by framing it this way. You highlighted the opportunity to realize OEM plus distributor margin on sales, just starting with your direct channel strength. Can you maybe help us quantify this opportunity? And then what your strategy is to go after that margin?

Sure. And I think from our perspective, we find ourselves in a unique position to be able to do both. As you know, we have 250 outlets across the corporation. We distribute our own 70% of products. But as we took it a different view and find that we are in the top 2 HVAC distributor in North America, Watsco being one, us being #2, maybe Ferguson is 3 or maybe we are #3, maybe definitely in the top train. We need to learn how to be a better distributor and Michael refers to that. And the 3 core aspects that we are focused on that is, one is just culture, talent, pay for performance, the whole people aspect of it. How do we get people who know how to be a good distributor? How do we give local flexibility to do the local pricing decision? But more importantly, local assortment decision, like your retailers learned that the long way that if you give store managers the flexibility of keeping what sells in the store, they sell more of it. We were still doing things centrally to pay for performance. Second big bucket is I would just say our physical network optimization. We are not very efficient in moving boxes from our factories to our stores. We have a very over-antiquated system, and we need to get better. And we need to be able to leverage our commercial sales better as well. There's quite a bit of just efficiency there because we have not updated everything from our WMS systems to technology behind it. And finally, the last piece that comes down to is 80% of our sales, maybe even 85% of our sales through these are products made by Lennox versus a good distributor like Watsco or SiteOne. I mean they sell 40% parts and supplies, maybe 50%. So we should be able to flip that number from 15% parts and supplies to 30%, 40%, 50%, some number higher than that. So if you go back, think through it, like we're trying to build a better pipe as a distributor. We need to put more products through the pipe and when we have better processes and culture to manage that pipe. All 3 together gets a significant improvement in our margins and accelerates our growth as well. So we are super excited about it. It's a long journey, though, Noah. This is not going to be 3 months or 1-year journey. I mean these are long-term changes that will take us 3 to 5 years to get to the end goal here.

Where are you so far in that journey? Maybe talk through those 3 different elements you identified? And can you give us a sense of what's been going on with the company?

Early, early innings. So just to give you a reference, I mean, some of the leadership changes, like 5 regional P&Ls. We announced that last year. It gets fully operational by the end of this year. Some of the incentive comp changes, we are making the first phase of that in midyear this year and then second fees would be beginning of '25. Very early innings. I mean physical distribution network, we got 2 new RDCs that we have announced and moved. We have many more of those to go through. And going back to -- it links back to some of the emergency replacement Michael mentioned as well. So moving commercial products on the same freight lane as we move our residential products and the warehouses, all of that is kind of all you need. So very early innings on that, Noah. I think we have a strong vision. We have got some really good talent. We are working through technology investments, which are critical, critical part of this, to link all the technology back to our consumer and customer and how it makes a difference. So very early innings. I mean if we land up having an Investor Day next year, that would be this topic will need to be flushed out more. We are no way close to getting results here.

It's something for us to look forward to. Certainly, the prospect of bringing in parts -- non-Lennox parts, that would presumably require some key partnerships, right? And so maybe talk through a little bit what that could look like, the types of parts, I mean sort of talking about things like compressors, et cetera, but just how you would sort of frame up that opportunity and what that ecosystem could look like?

Sure. I think it starts by having the [indiscernible], which we now have finalized and strategy. We are putting some processes and talent in place. We've created a new group that's focused on this. We call it the sourced products group, going after some stuff what GE used to do very well and just doing that and putting that together. And yes, I would expect quite a few partnerships in the near future on key products, everything from motors to ductwork, to controls, to mini-splits. I mean, those are all different categories that we're exploring to get partnerships and do that. So I would expect all of that. And some of it going to be big partnerships. Some are just going to be sourcing arrangements. The way you buy motors and compressors has become pretty commoditized. So those may or may not be partnership, just good sourcing arrangements.

And again, I'm sorry, I feel like we're asking for information that you're going to give us more in a year or so. But just as we think about the actual technologies that can help improve distribution and visibility into operations, it would seem to be things to me like tracking SKUs, inventory management. Maybe talk to what you have in place today and maybe what some of the gaps are that you'd like to address?

Sure. We overall are in good spots. I mean not in a bad spot, but we could be in much better spot. We are just finishing up updating our WMS, warehouse management system, right? So a lot of investment went into that to get something more modern and up to date. Next step for us is obviously fixing our [ SI ] process or demand. I mean if we fix our demand forecasting process, which using a lot of AI tools to be able to do that, our fill rate needs to go up much closer to 98% compared to last year, we were in the 80s. And a lot of that's going to be on demand planning deployment. Often, we have inventory, we just don't have it in the store that demands it, right? Talking with our dealers and they say, look, as so many air conditioning in stock because none in my store, so it doesn't matter to me Alok. So we've got to fix our really technology to use that. Finally, the last piece is connected all back to the dealer and consumer. Remember, LennoxPROs, our star flagship, 50% of our sales now are going through all digital. Now when somebody grows and buys a unit, a pop-in comes in and we have these accessories in stock for you at your local store, would you like to add that in the car, new AI capabilities to be able to do that and link it back to diagnostic, prognostic, I'm saying, hey, you got an alert, so and so consumer's unit is not working very well. Chances are, you need this new motor. By the way, we have this motor in stock at the Lennox store. Do you want to pick that up before you go to the consumer house for a repair? Putting the entire ecosystem together, we are the only ones who can do this because, again, we manufacture our own product. We make our own thermostat. We put this system together. We don't have to worry about compatibility of different manufacturers. So all 3 levels down to physically moving the goods, actually getting the demand right and making sure the right product at the right store and finally, the consumer aspect of it so that the dealer really benefits and gains out of it. We believe our technology footprint in this area is second to none and is getting better as we keep making this invested and link it all together.

It's very helpful. In terms of putting the entire ecosystem together, you mentioned a number of different offerings. I want to talk a little bit about service and how you plan to utilize ServiceTitan partnership to better align with dealers and end users. Can you speak to that?

Sure. What we want is LennoxPROs to become the platform through which our dealers live and die by, right? But they also use other offering, ServiceTitan is one. So what we are creating is a new digital ecosystem where we are creating APIs. So our product will have APIs that goes with key partners like ServiceTitan, and there are many others to come so that our dealers can rely on our information, our products and use other software that's compatible to them. So that's what the whole ServiceTitan is. I think ServiceTitan has features that we would never have such as telephone, such as CRM, which we won't be able to do cost effectively in our own platform. So that's a good example of the type of partnerships we'll be doing on the digital thing because it's becoming an ecosystem for the dealer. We want to make it very easy for our dealers to sell Lennox products, to quote Lennox products, to service Lennox product and, at the same time, do the billing, invoicing, CRM with whatever platform they choose. So happy with the ServiceTitan partnership, but we'll do more of those to make sure we are part of the dealer's ecosystem -- the primary part of dealers ecosystem.

I want to ask you about M&A, and I think you were very clear that you do not need to be positive to drive shareholder value creation. And I would say in light of everything you just discussed around the distribution opportunity and organic growth and around commercial that's very clear. But with all that said, just talk about how you're evaluating opportunities, certainly related to the JCI HVAC assets. And maybe you can just speak more broadly to market and technology-related opportunities and certainly, how you might think about managing international exposure following recent...

Sure. Let's start with international exposure, right? Because we left some of our international businesses last year. And in the town hall yesterday some employee asked me about getting to air conditioning in Dubai, and I said, no, we are not going to enter that market, right? We don't bring anything to the table and I've been a fundamentally different market. So our appetite for large broad international expansion is low, very low. Our appetite for leveraging international technologies such as heat pump technologies, such as compressor technologies, such as mini-split technology, VRF technology, that is high. So I think that's kind of we have to look at is because that component market is pretty global, and the technology is pretty global. So that's the real answer on our international exposure is we want the technology. We would like more say in those components, and we want to have those packaged units appropriately available to our dealers. That's our appetite internationally. It's not a geographical appetite, it's a product or technology appetite for us. On broader M&A, listen, the industry has got 7 players. We talked about this earlier. It is going to consolidate. I think the smaller players no longer have the scale to compete, especially with the regulatory environment is becoming more frequent, these changes becoming more frequent. When you go through regulatory changes, whether you sell 1 million unit or 3 million units, you will spend the same amount of R&D dollars and testing and capabilities, so bigger scale up. We have sufficient scale to compete. And if smaller players come up on the market to sell their assets, we clearly should take a look at it. We should take a look at it in a disciplined fashion with strong financial guardrails, which Michael has established and done a good job on and with a clear view towards what's a better way to create shareholder value. Executing on our current organic path and leveraging share buyback or doing something different. And as long as we do this in open mind, simple calculation and remind ourselves that the goal is not to get bigger, the goal is to generate more shareholder value. I'm confident we'll make the right decision for our shareholders on any acquisitions that we look at.

It's a great answer, and I would like to drill into it a little bit more. The opportunity to gain that product exposure, whether it's the ductless or other technologies that are more abundant internationally, maybe making their way here. What could that look like if not through like the JCI happened to? Could it be a JV of some sort? How are you thinking about those opportunities? Because you do have obviously some arrangements in place right now, some partnership.

We do. Internally, we talk about, we are the last pretty girl left at the dance, right? I mean if you think about Goodman is with Daikin, Trane is with Mitsubishi, Carrier is with Toshiba, VRF, JCI is with Hitachi, Rheem is with Fujitsu, so listen, we're going to make the right decision for our shareholders, realizing that we are one last pretty girl at the dance. The number of international players who want to enter the U.S. market and bring mini split offerings is more than the fingers on my arm, it is like Bosch, LG, Samsung, Midea, Hisense and they can keep going on and on. So we make the right decision. It could be by supply. It could be a JV. It could be something different. The key is how do I serve my dealers better. How do I create the right value for my shareholders, and we will address both of them simultaneously.

And so where else might you have an M&A appetite, if not for sort of large product? I think we talked about distribution. It seems like you've been kind of keeping your level of actual stores fairly flattish. What do you see as a pipeline of opportunities to go out for inorganic growth?

Sure. I'll tell you the level of store is flattish in the short term. It is going to go back in a growth mode. Right now, we're doing a lot more pruning because we have some -- like we don't want to store number to be a target. We want the profitability with target. So we're doing some pruning, but that will grow more, gives us a couple of years, and we'll come back and talk about that. But the 3 areas of M&A that I'll focus on, to answer your question, Noah, first is go back to the core being a better distributor. Are they part supplies, pieces that we can sell through our stores/our distribution network. We already sell coils. We already sell air handlers. Are there other businesses that we can buy and put through that? And these are small typical one who don't have the distribution reach that we do. So that's one category for us, right? Second is switch to commercial for a moment. If I'm at a food service place, Chick-fil-A, and I'm trying to sell them a rooftop unit, what else can I sell them along with that? So we can actually take care of the entire HVAC ecosystem. So that's like a second category of things that you've got to think through. I just used Chick-fil-A as an example, but just think of any of our customers and the third is service. We are still highly underpenetrated in service. We did one acquisition last year, which, by the way, is turning out to be great. Everything is green on the scorecard. There are many more opportunities that we could do on service. Think of those 3 categories, along with technology, I mean if there's cool technology that comes in, usually, we think partnership gets us there. But if not, we'll be looking to participate in that as well. So 3 core areas, plus anything new technology that could come in, especially around indoor air quality, especially around controls, especially around like some of the dealer sticky pieces would be the areas we would focus on. In the end, I would add anything around acquisition by saying, for us, acquisition is not a strategy. We have a strategy and we use acquisition to fill gaps into it.

Last question for you. I think by broad metrics, the company has really made a lot of progress since the last leadership transition, whether it's on the commercial side with pricing, pick your initiative. And so with all that said, why aren't you satisfied with where you're at? What does the future hold for Lennox in terms of opportunities where you think investors should really be focused. We've obviously talked about distribution. That's going to be a big one. What do you think is still underappreciated about the opportunity facing the company today?

That's interesting because I actually don't think we have made as much progress as I want it to. I feel like I'm behind. I feel like a lot more opportunities here that we are working on that are either delayed or did not reach full potential. I'm not going to go back to the distribution piece because that just one example. We have such a price jam with a unique go-to-business model, with direct connection to our dealer. Our dealer base is probably a most valuable asset that's still highly under leverage. I mean, could we be selling more products to them? Could we be looking at more commercial emergency replacement products through them? That's just the beginning. On productivity, we lost our way over the past few years and didn't get through because of COVID and supply chain, so much more productivity initiatives we could get to. And finally, as we look at -- we are not done with pricing, at pricing, we're starting the journey. I mean there's so much more sophisticated pricing. The Pricing Excellence book by [ Mike Mard ] and my McKinsey colleagues in there is something that's still close, dear to my heart. I keep giving that book to every new pricing person we hire. And there's so much more we can do. We haven't even done proper micro-segmentation in pricing to get only the benefit. We are taking the low-hanging fruits of key account contracts. That's not what pricing excellence is. The pricing excellence is a much deeper level. So we have so much more -- and our multiples are still below other industry players. I mean, from all of that perspective, I don't feel satisfied with where I am. I actually feel like we have a lot more potential ahead than where we came from.

You focus on that pricing productivity and margin performance that multiple will sort of sell out. So...

I'm sure it will. We pay the least attention to that.

We appreciate the thoughtful discussion, as always. We hope everyone has a great remaining day and several days at the conference. We look forward to additional meetings with the company. And thank you all. Thank you for the time here today.

Thanks, Noah.

Thanks.