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

[Audio Gap] William Blair's research department. Before I begin, I need to remind you that a complete list of disclosures and conflicts of interest is available on our website. With us today is Alok Maskara, CEO; and Michael Quenzer, CFO. Lennox makes and distributes residential and commercial HVAC equipment. Products include air conditioners, furnaces, heat pumps and controls. Lennox has long history of share gains and margin expansion, driven by investments in products, distribution and technology. We're going to have Alok do 10 minutes overview, and then we're going to move into a fireside chat. Alok?

Thanks, Ryan. Thanks for having us over. Appreciate it. Delighted to be here. This was one of the first conference I did when I started as a CEO 2 years ago and very pleased to be back here. As Ryan said, we'll do 10 minutes of just overview presentation, and then we'll go into a fireside chat mode. We start all our presentations with our values and sometimes with a safety moment because this is what defines who we are. And for us, integrity, respect, excellence, our 3 core values are not just mere words. The guiding behaviors that support that, that's how we get evaluated, that's how we hire employees. And that's what we keep in the center of our strategy. A couple of ones I would highlight, which we are trying hard to get better at. One is customer experience. As we look back over the past few years, we had a tornado a while ago in our factory. And since then, our customer experience has been lagging behind, and we are working really hard to improve our customer experience. Second thing we just want to highlight for us is overall positive engagement. As we look at engaging with our dealers, engaging with our employees, engaging with our investors, we are finally making the switch to becoming more positive, putting some of the disruptions behind us and truly looking at growth and the results that matter all come because we are positively engaged with our dealers. Our dealers are our core asset as a company. From a financial perspective, Ryan mentioned some of these before. I'm not going to dwell on these. Very proud of our fiscal '23 results, which, as you can see, is a rare year where we had green across the board, 6% revenue growth, 300 basis point margin expansion, 27% growth in earnings per share, and more importantly, $434 million increase in our cash flow as we often remind our employees, the only 2 things that matter is the cash that we bring to our shareholders and the products or services we deliver to our customer. So very excited about the results that we delivered last year and had a strong start to 2024 as well. We operate in 2 segments, a very simple company, building Climate Solutions, previously earlier known as the commercial segment, and home comfort solutions, previously known as the residential. And you can see right now from a revenue perspective, residential is larger, but commercial is definitely catching up as we look at from a growth potential and profitability perspective. Not going to spend tons of time on this. You can see our ROIC is industry-leading. We do convert a majority of our income into cash. We don't believe a lot in adjusted and non-adjusted. Starting Q1, we actually made or adjusted and non-adjusted financials to be the same. And from a cash flow perspective, we are going through a period of investment right now as we start up a new factory in Mexico to serve our commercial HVAC products. But beyond that, we remain committed to returning all the cash back to our shareholders. Our long-term targets, which we increased. So when I was here a few years ago, we had talked about 2025 long-term targets. As we switch to 2026, we had to increase them given we made faster-than-anticipated progress on our 2025 targets and the numbers that we increase are both our revenue, now we're talking about $5.4 billion to $6 billion in revenue, and more importantly, ROS, return on sales, we are now talking about 19% to 21% ROS. I'm pleased to report that we are well on track and we already touched cash flow in the previous slide. The 2 things that are going to make a big difference in achieving those numbers. First is becoming a better distributor and this slide calls it is strengthening our distribution network. We are a manufacturing company. But as I said, our dealers are our core strength. And about half our revenue comes from distribution that we own and operate ourselves, but we need to do better. We admire companies, companies like Watsco, companies like POOLCORP. And we have been trying to be a better distributor by role models that I mentioned earlier, looking at them, benchmarking ourselves against them. The 3 things we need to do better is have more of a decentralized organization, which is the first bucket that goes everything from accountability, incentive plans, pricing because distribution is a very local business, and we were running it very centrally. Second for us is just infrastructure, both digital infrastructure and physical infrastructure. We run really good ERPs, but now we are getting into really good WMS systems as well. We are finally catching up and putting the investment and required to get digital. 45% of our sales in our direct to dealer business comes digitally. That number should be close to 100%. We are working through that. And then finally, harnessing the customer loyalty to sell more non-Lennox branded products. We sell 85% of our products sold through the system are Lennox and Lennox manufactured. The remaining number of 15% should be at least double that over the next few years. Other companies like Watsco and POOLCORP, they sell 30%, 40% products from parts and accessories. That's a big growth opportunity for us. One of the ways we are going to sell more Lennox -- non-Lennox manufactured products is something we announced last week is our partnership with Samsung. We have now a joint venture with Samsung where their mini split VRF or heat pump products going to be sold through our distribution channel. And that's something we are super excited that will help us close the gap between us and our competition on heat pump penetration in the U.S. So super excited about our partnership with that as one of the many examples on how we would be a better distributor. Putting it all together, we continue to believe that Lennox is a good, attractive investment opportunity for 5 reasons. And this is an acronym that we would use GREAT, as we go along the peacock feathers, G stands for growth acceleration. We have growth end markets. We need to accelerate our growth through share gain. Our resilient margins, you've seen the expansion recently. That will continue to be the case and will deliver resilient margins. You should count on us for execution consistency. At the end of the day, this industry is very good. The companies that execute the best win and you should be able to count us on execution and consistency. We serve our customers through advanced technology, advanced technology through our dealer network, whether it's technology to serve the dealers or heat pump technology or now really using machine learning to serve better our own pricing models and help our dealer convert better leads. And finally, talent and culture, that's where we started with our core values. That shapes us, our pay-for-performance shapes us. And we believe we remain a very attractive investment opportunity. That is kind of the prepared questions. I'll take a seat back and we'll move to a fireside chat format.

Here we go. Thanks, Alok. That was great. So the first question I want to ask is on the Samsung joint venture. Just why that changed? And then what share does Samsung have in the U.S. for heat pumps?

Sure. We started on this joint venture path about 2 years ago when I started. When we realized that about 10% of the U.S. market is mini-split VRF in that product category. And you need a partner from Asia to succeed in that. We were sourcing products from China and selling it, but we were not being very successful. We evaluated all the existing players. So the manufacturers from China, from Japan, from Korea, from India. And as we went through it, we tested the products, we looked at the reputation, and we looked at Samsung as being the best partner. We sort of finalized a partnership last year, signed the MOU last year. We announced it now simply because this is the time we got to start converting dealers, start working through inventory transition. Samsung has very low share in U.S. right now. So to answer your question, they have much bigger share outside the U.S., and they were looking for a U.S. partner to work through it. Just like Mitsubishi has Trane. Hitachi has York, Fujitsu has RIM, Dyke and Goodman are obviously together now. So Samsung was like one of the last remaining good players that was unaffiliated, we were the last remaining U.S. player that was unaffiliated. So it was kind of a perfect partnership. They have aspirations to be #1 in HVAC market globally, and they can't do that unless they are a strong partner in U.S. So mini-split VRF, 10% of the market, Samsung aspires to be #1 in that, and we will do our utmost to get them that share over the next multiple years. Super excited about it.

Got it. Well, Samsung is a great brand. So look forward to that. Maybe stepping back, what's your view on the consumer and the state of the HVAC industry?

Sure. We are pleasantly surprised by the resiliency of the consumer when it comes to HVAC. We all expected interest rates, the state of the economy and all to have potentially a negative impact. But so far, we haven't seen that. We see demand being steady and this is about replacements. It's a nondiscretionary spend at the end of the day and the cost of repair has gone up significantly more than the cost of new unit. In fact, the shortage of skilled labor required to repair has also moved people more towards replacement that takes much higher skilled labor to replace the unit, effectively adding to the cost. We find the consumer when they don't have a choice, which is like when AC breaks or the furnace breaks, you have to do something. They continue to choose more replacement versus repair. We don't see a shift in that coming up soon. Part of the reason is also people feel that they're stuck in their home, they have low interest rate mortgage that they are not going to get if they move their home. So they're willing to make the investment in something that's going to last 10, 15 years versus the repair in the last 2 to 4 years. We do see more people looking for financing. So we do see that. We do see interest rates higher on those financings. We do see some people trading down. So where they're getting the lower CR unit versus a higher CR unit. But lower CR is majority of the market. So it really doesn't impact the financials. But we haven't seen any further degradation in demand. We called this year to be flat to down in units, and that still holds and the down part is mostly because destocking continued in the first half. That does not reflect the health of the consumer, which remains about the same.

Right. Well, that leads into my next question, which is the outlook for residential in '24. I think the guidance is for flat units and then mid-single-digit price. Just talk through the assumptions there.

Yes. And I think we were being appropriate in looking at the stocking, destocking and pulling it all that together on saying, yes, it's going to be about flat unit. And remember, we are also coming off -- last year was pretty good from a record heat perspective. But it seems like you're having those record heat every year. The pricing comes down to a couple of things, right? I mean we talked 2 years on '23 that over 2 years, we'll get about 15% price benefit because of the transition. This was first year, hence, the mid-single-digit pricing. We get the regular industry pricing benefit and we have internal self-help pricing because we had quite a few key accounts and big accounts where we were not appropriately priced. EG price way below market. So we are catching up to those. We've been able to reprice many of those contracts. So we'll get the regular industry pricing of 1% to 3% plus on top, we'll get our own self-help pricing benefit. So we still feel very comfortable on the full year outlook.

Okay. And then same question for commercial. Just talk about the outlook for '24. And I recall on the last conference call, you mentioned production challenges, but improving and then you mentioned new construction could be delayed. Where do we stand on some of that?

Sure. So on commercial, the broader picture is we remain supply constrained versus demand constrained. So all our constraints today is around not having enough supply. If we could manufacture more, we would sell more. So that's kind of the first statement I want to make. That's true now. It'll probably be true until the end of this year when a second factory really starts getting online and starts getting out work, right? So that's one. The pent-up demand on the replacement side remains as steady and stronger than before. Average life of a rooftop unit on top of a flat rooftop like Lowe's, Walmart, Home Depot, Chick-fil-A, McDonald's is higher than it has been simply because the whole industry has been supply constrained since COVID and some folks have decided to wait until our 454 or the new refrigerant comes into place. So we see no softness coming on the replacement side. Our comment on new construction is true. That impacts less than 10% of our business. And in that portion, we are seeing projects shift to the right, whether it's a multifamily housing, office buildings, things like that. We do see that demand shift to the right. And we've seen some hesitancy in new builds around other types of investment, but really, we remain supply constrained versus demand constrained. And any project shift to the right has not really impacted our sales nor do we expect them to. Because our exposure to multifamily is just much smaller. Our exposure to office complexes is much smaller than the rest of the industry.

And you mentioned the shift to the new refrigerant. And a big question that a lot of investors have is, what will be the price increase for the new A2L equipment in '25. And I think you may sell some of it this year, talk about both.

That's right. On the residential side, we see a minimum 10% price increase, and 10% to 15% is a range, but we look at 10% minimum price increase across all the equipment base. Now it doesn't impact -- our furnaces don't have A2L. So you've got a do some mathematic gymnastics to get to a real number, but all equipment that has new refrigerant gets a minimum 10% price increase. That's why the costs are also going up. The new refringent require sensors, requires more efficient compressors, require greater heat exchange area. So the cost will go up too. I mean that's just required for us. On the commercial side, the number will be a little less than 10% because the costs are going up less than that. And I think we did significant price increase in commercial over the past 2 years, not so much in residential. So putting it all together, we think from a price perspective, this 10% gives enough revenue growth tailwind for us for the next year or two. Next year, about 65% of the products will be new refrigerant, 35% old, following year, I mean in the next few years, that 65% goes up to 100%, so I think that tailwind continues on the revenue side and the unit growth we already talked about.

Why 30% next year being R-410A because others think it could be as low as 10% or 20%.

And if we are wrong on the conservative side, this wouldn't be the first time. We like being wrong on the conservative side if we are. I think the way we looked at it is it's uncertain of how much prebuild there will be. We'd sort of find out in Q3, Q4. If there is less prebuild, then I think the number would be closer to 10%, 20%, and that's good for us overall. And I think it's a bit of a game theory driven situation for us and others there. In reality, none of the -- we, as the manufacturers do not want to make 410A. It creates manufacturing inefficiencies. We think it's bad for the consumer because price of 410A will go up and the repair cost would be more in the future, even at the upfront cost is. And we will price 410A accordingly. So ideally, we would like 410A be lower. And we'll work with our dealers to provide the right training. We had some dealers who came and said,Alok, in good conscious, I will not sell a 410A equipment next year because my consumer will have to pay more for repair 5, 6 years down the road, substantially more, I would rather have them convert to a 454B unit. So I just need more of those dealers to drive that behavior.

And when will you start shipping the new A2L equipment, there's some concern out there that some OEMs may screw up this transition and not have enough product. Where do you stand on that?

We are very confident -- first of all, we have a strong history of doing this well. We are very confident we are going to do this year well as well. We are starting to ship in Q3, but the numbers are going to be small and meaningless. We're going to do only the highest end units in Q3. Then Q4, again, we're going to go to the mid-tier. And honestly, the bottom tier units will effectively happen in first quarter 2025 right at the deadline. And that's because that's where the demand pattern is, right? The people who prefer the higher CR units are willing to pay the extra to go to new refrigerants sooner. So that's the way it will be. Listen, somebody will -- out of the 7 player, somebody will stumble and those are share gain opportunities for us. Same thing happened in SEER change. Last year, we gained more share than ever in the history of Lennox because 2 of the players tumbled. So I think from that perspective, we are not counting on it, but if that happens, we'll be fully prepared.

Good to hear. You mentioned the new plant in Mexico, and that's for commercial. Just talk about, is that still on track? And then what's the goal of the plan? I think it's to get back share in emergency replacement.

Yes, that's right. We are on track. It should start production essentially next month, so in Q3. It will trickle, right? The production start will be a trickle versus a flood. We just want to make sure we produce the right quality product, test the production out, it's all new labor, right, new equipment. For -- within the next 12 months, so let's say, mid next year, we hope to increase capacity by about 20%. That's the goal, [indiscernible] goal. If demand continues and share gain continues, we would obviously have the capability to do more, but I think of it as we have enough square footage to double our current capacity in commercial. We're going to do it in 5 steps, right, 20% at a time just because we want to be prudent with our capital and want to make sure we derisk the startup. So that's where we are. We used to have market shares in the mid-teens and now we are in the low teens. That's the share capture we are talking about for us over the next year. It's all in emergency replacement. That's a market we walked away from when we had production constrained. We are making sufficient and significant investments in our front-end sales force, training our dealers, making sure we have the inventory physically dispersed in the right location and at the appropriate coating capabilities. So we are putting a lot of effort in our SG&A side to be prepared for this. We have added about 20% more salespeople on our commercial side to be able to deal with this new extra demand that we are going to generate. So think of the demand generation investment that we are making in parallel to pull it all together it. So we are like prudent, share gain is never easy, but we're taking all the right steps to get it back. Emergency replacement is easier to win back versus key accounts, and that's what we are banking on.

And then let's stick with commercial. I want to ask about margins because your margins got as low as, I think, 12%. And last quarter, I think we were around 20%. So you've made a bunch of improvement, but I think there's still more to go. Talk about the key drivers of taking the commercial margin higher over time.

Sure. Michael, do you want to take that?

Sure. Yes. We're really pleased with the margin expansion we saw last year. We had about a 10-point margin expansion in the commercial business. It was predominantly around 2 things, getting back in pricing excellence, we had some longer-term contracts that we needed to reprice. And then also, we had a regulatory change shift within commercial. So we saw some mix up there as well. So that was a good catalyst last year on getting some of the margins up, but we have a lot more to do. Really going forward, we're going to be focused on kind of 3 things to get our margin expansion up. First, it's recapturing that emergency replacement share. Think of 35% incrementals as we start to win back that emergency replacement share. There will be another regulatory transition change starting in commercial next year. Again, that should be a catalyst for more positive mix to expand the margins. And then finally, we're still really focused on getting our supply out. So a lot of costs we've added to the system to try to make sure that the customer experience is as good as we can for customers. So as we get the 2 factories up and running, we're going to be able to step back and look at some of the costs that we have not been able to take out of system over the next couple of years as well as the factory that we're going to be putting down in Mexico is a bit of a lower cost solution to for cost. And so lots of opportunity to continue our margin expansion on commercial.

Great. And then can I ask about cold climate heat pumps? I know that's really important to you given your big presence in the Midwest and the Northeast, which is a lot of gas furnaces. Talk about what products do you have? What are you launching? And how do you see cold climate heat pumps playing out?

Sure. So I'll frame it as broader, Ryan, in terms of -- let's say, the heat pumps are about 35% of U.S. market. Our share is about 25%. So there's a 10-point delta between our share versus where the market is. It was driven by 2 factors. One is cold climate because our market share in the north is higher than our market share in the south. And second was lack of a mini-split VRF product line, which we get from Samsung. So I think that's one part of it. On the cold climate side, as we launch the new refrigerant products, we're going to be launching our first cold climate or colder climate, I should call it, colder climate heat pump line. And that's going to help us get into new markets, whether that's Illinois or Wisconsin or Michigan, areas where previously the technology didn't work. We're going to pay that with hybrid. So in some areas, if you're in Northern Minnesota, you can still have a heat pump and qualify for rebates. But you'll still have a furnace that will take care of the extremely cold days when the temperature is below freezing because before that, you can still have heat pump. We, today, have a strong line of heat pump, but it's not as good as competition lineup. Next year, as we go into like completing our 454 lined up, we are going to increase many more SKUs, many more tiers to qualify for different rebate levels and we believe between our new products that we are launching with cold climate, but remember, we won the cold climate heat pump challenge. So we think our technology is far superior to others. Plus the Samsung product is actually already very good with the R32 refrigerants and their cold climate technology. We think that gives us the winning portfolio to be able to start penetrating this in colder climate and gain our 10-point delta and make it 0. So that's what we'll be shooting for over the next few years.

It's exciting. It's higher ASP, and it's also a higher margin.

That's both true.

Both true. Let me ask about distribution, which as a distribution analyst that's post a hard for me. I want to leave the room with sort of the upside potential. So today, I think your distribution business is breakeven. I think 500 basis points of expansion is in the cards. First just is that right? And over what time frame, you talked about some of the investments you're making, but bottom line it for us.

Yes. So First of all, I don't want to acknowledge the exact number, but yes, I mean, we openly talked about we admired companies like Watsco. And one reason we like come at this conference is because you are also distribution focused, right? Today, we don't make Carrier plus Watsco type margins. I mean we admire both those companies, both are very good. And that's a natural math that somebody would come to, and I think that's fine. But it's not an overnight journey, I mean this is a lot of changes. The pieces that we need to get done, which we -- just to recap is we got to organize more like a distribution, like now our Head of the Distribution business come from legacy Carrier Enterprise and Watsco, the head of our physical distribution, the actual logistics one comes from Amazon. We have hired people from others. We have got consultants working on putting that together. And as we look at overall like relationships like Samsung, expect more of those so we can sell more non Lennox products, especially on parts and accessories. That's a 5-year journey, Ryan. I mean, that's not a -- we don't need to do that to hit our 2026 targets, right? Those are beyond our 2026 targets to be able to get there. And obviously, this is a large ship that will take us time to steer in the right direction. But early signs are very positive. I think the new talent that we are putting together, the new org structures, the new incentive plans haven't even gone into effect yet because a large part of it is going to be around the new incentive plans. We're going to get that into effect middle of this year. So the impact on all is going to be over multiple years. But that's what makes it a very exciting place for us to be is continue to excel in what we do in manufacturing. There's a clear link between manufacturing and distribution, but continue to be better distributors. The biggest benefit of that is also going to just come from the fact that being a better distributor means higher fill rate, which means higher loyalty and automatically higher market share. So the best way for us to get market share is to have higher fill rate. And I can tell you my fill rate at one point was 10 points, not 10 basis points, 10 points below what I would call acceptable and probably 12, 14 points below world-class. So just those kind of things, I'm super excited about.

Yes. A lot of potential. The other question I want to ask today was on M&A. What's your appetite? And how would you describe the criteria for what you're looking at?

Sure. Michael, do you want to take that?

Sure. So first, what we do is we have a bolt-on acquisition strategy. So we did our first acquisition last year, the first one we've done in 10 years where we bought a company called AES. It's a company that does service for commercial national accounts, helps increase the stickiness. We like those type of acquisitions. We continue to look at things like that in the commercial service space, applications on the commercial side as well as being a better distributor. So definitely focused on kind of these more bolt-on specific acquisitions. And then opportunistically, as things open up in the industry for either horizontal or other acquisitions, we continue to evaluate them. But they need to have the right strategy for us as well as the right economics for these things to materialize.

Yes. Well, just in the last 2 minutes, Alok, you've been at Lennox now 3-plus years, and you came from outside of the HVAC industry. Just for the audience, why is HVAC such an attractive market? And has it been everything that you thought it would be?

It's actually much better than what I thought it would be. And I remember being here 2 years ago, when I say, hey, it's a good market. Now I say, it's a great market, right? I mean few things that work in our favor, right? The replacement rate of , especially in U.S., is pretty good. I mean there's a noise around COVID and stocking and destocking. If you ignore all of that, you get about 4% in unit growth every year on the replacement side. Add the new housing portion to it, it goes up and down a little bit, great market, so growth. And the reason it's growing is simple. The temperature extremes are getting worse. And the more the temperature extremes are, the more the unit has to run and the higher the failure rate, simple, there are more explanation to it. So that's one. Second is the industry is pretty disciplined. Top 4 players make up 85% of the industry, let's go look at other attractive industries like what are 8 or 3 players make up that percent, right? So we're not that far off and it's going to continue consolidating. I mean, a lot of what we hear on M&A on the transaction side is continued consolidation because I think skill benefits exist. All these are very good competition that compete on the basis of technology, in pace of fill rate, in terms of service, not raised to the bottom dollar. So I think that is other piece. Finally, the piece that really excites me is we're going through a transition, just like the EV to electric, I mean EV to internal combustion engine, the whole heat pump transition is often underestimated. In U.S., it's not even 100% driven by government incentives and actually driven by technology, cost to install and has other benefits. And I think that itself will create significant tailwind and I'll build into that the regulatory transition that is happening every 2 to 3 years, each of those increases the barrier to entry. Each of those makes it more important for a professional installer to install it versus the DIY big box. And each of those gives us a price mix benefit going forward. So if you put it all together, I think it's a very attractive industry. I mean I came from other industry, which were also attractive like the water industry, but I find this to be much more attractive than the water industry.

Great. Well, we're out of time. Thank you very much.

Thanks, Ryan. Appreciate it.