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

Welcome to the Lennox 2026 Second Quarter Earnings Call. [Operator Instructions] As a reminder, this call is being recorded. I will now turn the call over to Chelsey Pulcheon from Lennox Investor Relations. Chelsey, please go ahead.

Thank you, Madison. Good morning, everyone. Thank you for joining us as we share our 2026 second quarter results. Joining me today is CEO, Alok Maskara; and CFO, Michael Quenzer. Each will share their prepared remarks before we move to the Q&A session. Turning to Slide 2. A reminder that during today's call, we will be making certain forward-looking statements, which are subject to numerous risks and uncertainties as outlined on this page. We may also refer to certain non-GAAP financial measures that management considers relevant indicators of underlying business performance. Please refer to our SEC filings available on our Investor Relations website for additional details, including a reconciliation of GAAP to non-GAAP measures. The earnings release, today's presentation and the webcast archived link for today's call are available on our Investor Relations website at investor.lennox.com. Now please turn to Slide 3 as I turn the call over to our CEO, Alok Maskara.

Thank you, Chelsey. Good morning, everyone, and thank you for joining us today. Please turn to Slide 3. The second quarter demonstrated the strength of our direct-to-dealer business model, our dedicated talent and proactive actions taken to manage the current operating environment. I want to thank our employees for improving our customers' experience through enhanced digital and distribution capabilities. I also want to thank our customers and channel partners while navigating a dynamic market environment alongside us. Lennox delivered a solid second quarter. Revenue increased 3% to $1.5 billion. Total segment profit increased 2% to $355 million and adjusted earnings per share were flat at $7.72. Within Home Comfort Solutions, year-over-year quarterly performance improved sequentially, though the pace of end market recovery remains muted. Elevated market rates, inflationary pressures and historically low consumer confidence are constraining underlying demand. Looking ahead, channel confidence is continuing to grow, and consumer confidence is starting to rebound which supports our positive long-term outlook for the market. Building Climate Solutions once again performed exceptionally well. We are seeing signs of progress across commercial end markets, momentum in emergency replacement and strong execution in the field to gain share and grow margins. Taking together, the results from the two segments demonstrate the value of our portfolio and the balance it provides across market cycles. Our long-term demand outlook remains unchanged, even though the residential demand recovery has been slower than anticipated. As a result, we now expect the most meaningful recovery benefits to extend into 2027 rather than occur in the back half of this year. While we are reducing our earnings outlook, several key elements of our 2026 financial framework, such as revenue and free cash conversion have not changed. Our balance sheet remains healthy, and we remain on track with our inventory reduction plans. The combined strength and the industry's long-term outlook provides us with the confidence to continue investing in the business, advancing strategic initiatives and strengthening our competitive position. Now please turn to Slide 4. Let me spend a minute on our recently completed acquisition of the Comfort Air, Century and Costar Air brands. This acquisition is an excellent example of our disciplined bolt-on M&A approach. The acquisition expands our reach into small and midsized distributed channel and broadens our product offering allowing us to further accelerate growth. We also sharpened our focus on customer experience by enabling One order, one invoice and one shipment towards distribution and contractor partners for most HVACR, equipment, accessories and parts. Finally, we see meaningful opportunities to drive margin improvement through product integration, logistics synergies and streamline SG&A through the application of the Lennox unified management system and expect the business to be accretive to our EPS in 2027. The strategic bolt-on acquisition, along with DuroDyne and SubCo acquisition completed in 2025 and the AES acquisition completed in 2023, reinforced our disciplined capital deployment strategy. Now let's turn to Slide 5 and discuss the current demand environment and how we are positioning the business for growth acceleration. The factors affecting residential demand today including affordability pressures, weather variability, softer consumer sentiment and suppress new construction activity are in our view, temporarily. We believe that much of the shift from replace to repair represents deferred replacements and the underlying demand profile remains unchanged. Our focus remains on controlling the controllables. We continue to invest in innovative heat pumps, emergency placement capabilities and our direct-to-dealer model to make it easier for customers to work with Leveraging our successful acquisitions, we are expanding our parts, accessories and service offerings, thus creating additional touch points with customers. At the same time, we are leaning into initiatives that strengthen our long-term competitive position including distribution network optimization and partnerships like Samsung and Arista to grow share of wallet. Rather than getting weighed down by short-term market fluctuations, we are executing our strategy and investing in the capabilities that matter most when demand returns. With that, I will turn it over to Michael to review our financials.

Thank you, Alok. Good morning, everyone. Please turn to Slide 6. The quarter reflected a mixed operating environment across the portfolio. Residential demand is still challenging, while strong commercial execution and contributions from recent acquisitions helped support overall performance. We continue to navigate cost inflation and factory absorption pressures associated with lower residential production models. These headwinds were partially offset by pricing actions and the timing of certain tariff refunds. Cash generation and a disciplined focus on the working capital management support a strong cash flow performance during the quarter. Against that backdrop, let's turn to Home Comfort Solutions on Slide 7. Residential market conditions remained challenging during the second quarter, although year-over-year demand trends improved compared to the first quarter. Compared to the prior year period, revenue declined 7%, driven primarily by a 12% decline in unit volumes. Favorable mix and pricing contributed 3% growth, while acquisitions added another 2%, partially offsetting the volume decline. While volumes were down year-over-year again, this represented a meaningful improvement from the 21% decline experienced in the first quarter. Performance varied across channels. Two-step volumes were relatively flat compared to the prior year, while one-step volumes declined in the mid-teens, driven largely by continued weakness in residential new construction, but revenues were down approximately 30% during the quarter. Segment profit declined $30 million. Lower sales volumes created approximately $50 million of EBIT headwinds during the quarter. Mix and price were favorable and mostly offset cost pressures, including ongoing inflation and approximately $10 million of factory absorption headwinds as we align inventory levels with market demand. Product costs also benefited from approximately $25 million of tariff refunds that we had originally expected later in the year. Let's move to Slide 8 and discuss our Building Climate Solutions segment. While strong growth in the first quarter, Building Climate Solutions maintained its momentum in the second quarter, supported by improving commercial end markets and continued execution on our growth initiatives. Revenue increased 24%, with organic sales up 12%. Growth was driven by success with national account customers and an increase in emergency replacement activity. Our service business also grew as customers increasingly leverage our combined equipment and service capabilities. Mix and price contributed 3%, while acquisitions added 9% primarily from DuroDyne. Segment profit also increased, benefiting from higher volumes and favorable mix and price. Product costs reflected inflationary and production cost pressures and were partially offset by approximately $5 million of tariff refunds. Within other costs, DuroDyne contributed approximately $11 billion (sic) [ million ] of M&A accretion, offset in part by investments in customer-facing digital capabilities and innovation. Now let's turn to Slide 9 to review cash flow and capital deployment. We generated $172 million of operating cash flow in the second quarter and delivered 92% trailing 12-month free cash flow conversion, reflecting disciplined working capital execution and progress on inventory reduction. While inventory dollars were flat to December due to inflation and tariff-related cost increases, unit inventory levels continue to decline, and we remain on track to achieve our full year inventory reduction implied in our full year free cash flow guidance. Our balance sheet is strong with net debt to adjusted EBITDA of 1.3x at quarter end. During Q2, we repurchased approximately $130 million of shares in -- After quarter end, we completed the acquisition of the Comfort Air and Century brands using approximately $200 million of debt. We are also refining our full year capital expenditure outlook to approximately $225 million down from $250 million. The change reflects project timing, but our key investment priorities are unchanged. With that, let's turn to Slide 10 and discuss our updated financial guidance. As Alok outlined, we are updating our full year adjusted EPS guidance range to $23 to $24. While our overall revenue growth outlook holds at approximately 8%, the composition of that growth has evolved since our prior guidance. At the segment level, we now expect Home Comfort Solutions revenue growth of approximately 1% compared to our prior expectation of 4%. Building Climate Solutions revenue growth is now expected to be approximately 20% compared to our prior expectation of 16%. These changes reflect lower expected residential volumes, stronger commercial demand and approximately 1 point of enterprise revenue growth from the Comfort Air and Century Brands acquisition. This acquisition adds approximately 2 points within ACS. Reduction in our EPS outlook is primarily driven by lower net volume expectations that stronger commercial demand is more than offset by lower expected residential bonds. We now expect approximately $60 million of productivity versus our prior expectation of $75 million, reflecting ongoing absorption headwinds from lower residential volumes and the delayed timing of some material cost reduction initiatives as resources were shifted to tariff mitigation. Interest expense is expected to increase to approximately $70 million and M&A amortization to approximately $25 million following the Comfort Air and Century brand acquisition. Importantly, our free cash flow outlook remains unchanged at $750 million to $850 million, reflecting confidence in our inventory reduction plans and working capital execution. Other guidance assumptions including inflation, investments, tax rate and share count have not changed. While residential demand is still below our expectations, the strength of our commercial business and continued cash generation position us well for the balance of the year profit growth. With that, I'll turn the call back to Alok.

Thanks, Michael. As we close, I want to reemphasize that while current market conditions are dynamic, I believe the long-term growth trajectory of the industry is very attractive. What gives me confidence is the performance of our portfolio, the durability of our cash generation and our ability to continue investing towards growth. We are committed to innovation and operational excellence, while continuing to allocate capital to expand our capabilities and improve our customer offerings. Most importantly, the dedication of our employees and the values that define our culture continue to drive excellent at Lennox. Our fundamentals are strong, our strategy is clear, and our best days are still ahead of us. Thank you. We are happy to answer your questions now. Madison, let's go to Q&A.

[Operator Instructions] And we will take our first question from Ryan Merkel with William Blair.

I wanted to start on the resi revenues. The down 12% for the one step is surprising. What are the key issues, Alok? And then any steps you're taking to improve the results?

Sure. Ryan, majority of the decline was due to residential new construction, where we talked earlier about, we walked away from really low margin business. And a large portion of that impact is beet in Q2 due to seasonality. That doesn't mask that the underlying sell-through also remains weak, but is improving both sequentially and as we look at this going forward. So that's really we kind of look at the negative 20%. And we have internally done a lot of analysis and feel confident that, that starts improving because we lapped some of the residential low-margin loss in the second half and the comps get easier even on the overall market dynamics.

Got it. Okay. That's helpful. And then on the guidance cut, it sounds like you had included the refunds some tariffs in the guide. So just confirm that for us. And then it looks like resi, you're going to have weaker margins in the second half. Is that just the fixed cost absorption on the lower volumes? Or is there anything else in there that's pressuring the margins?

That's correct. On the tariff guidance, we had built an inflation assumption of 5%. That includes the net impact of all increases within the 232 tariffs that we saw earlier in the year. And the IEPA refunds that we expected initially in the second half of the year that we've now gotten most of them in the second quarter now.

And there's nothing else based on the second question, Ryan. It is just simply an impact of lower volume and the absorption impact related to that.

And we'll move next to Tommy Moll with Stephens.

Alok, first question for you on the one-step trends for resi. Noted that there's the new construction headwind. Some of that relates to business you've -- low-margin business you've walked away from. I'm more interested on the replacement side there. What's your view on how market share has progressed? Have you seen any evolution or pressure there?

Yes. On replacement, we have seen the small market share gain, while in new construction, we have seen a significant loss as we talked about earlier. And we continue to build our distribution network efficiencies, continue investing in the sales team, but we are pleased with our market share position in the replacement, which has actually picked up over the past 12 months.

Related question for you on pricing, Alok, specific to resi. It seems like there have been some different strategies year-to-date. Some have raised and then lowered depending on differing tariff assumptions. Others have been slower to move. Just characterize for us what the Lennox strategy has been there and what you've seen across the market. There's just been a lot of volatility on that point?

Sure. Putting residential new construction aside because that's a different story. We continue to see higher inflation being offset by pricing action across the wide spectrum. We continue to remain focused and do price competitively. A large portion of the 232 tariff pricing is going to get into effect on 1st July, which is consistent with how some of the other competitors have done. And we feel good about where we are in the replacement side of the business on the residential portion. And obviously, we continue monitoring it. We want to be fair with our channel. Some of the early arrival of tariff reforms also impacted how we thought about pricing and how we're going to take this going forward. So we were able to delay some of the pricing actions because of the early arrival of the tariff refunds.

We'll move next to Noah Kaye with Oppenheimer.

I guess just to make sure that we've got it then on the revised guide, two points. One, so I think you contemplated resi volumes down mid-single digits for the year, does that sort of shift now to down high single digit, down 10%. Is that -- can you give us a finer point on that? And guidance on inflation expectations remaining unchanged with the 232 partial REPREVE. Was there an offset to some of that goodness to keep the inflation guide intact?

Sure. Noah, I'll give you a little bit of insights on that, yes. So within the HCS volume guidance, it now is high single digits. We expect most of the balance of year growth to happen within the direct channel as you have a favorable comp year-over-year. On the direct channel, we expect balance of the year to be down kind of low single digits or so within the direct channel and the balance of the year. . And then within the inflation, we still expect to be 5%. There's a little bit of benefit that we saw with the adjustment to the 232s, but then we continue to see inflation on commodities, fuel, memory, those mostly offset that benefit.

Okay. And then when we look at the two segments and the demand trends juxtaposed, I mean, really, it is seemingly a tale of 2 markets. is a little unusual to have such bifurcation. But can you talk a little bit about the drivers of the light commercial strength? You mentioned some nice wins. Clearly, national accounts, emergency replacement. But how much of this is sort of underlying versus Lennox share gains?

I think there is significant like share gain that I want to give credit to the team. As we build a new factory, we have focused a lot more on emergency replacement, and that's clearly playing out as we expected, maybe slightly better than we expected. At the same time, the extra capacity is helping us win back the national accounts. But also from an end market perspective, remember, this is the end market that was from data down continuously for like 17, 18 months in a row and now is finally turning around the corner. But I would say, among the improvement, a large portion is share gain and then there's definitely a benefit of the market not declining anymore and showing some signs of life.

And we will move next to Jeff Hammond with KeyBanc Capital Markets.

So just back, it looks like your HCS, you're bringing down 5 points on a core basis. Like is that just all sell-through demand weakness? Or is like this RNC walk away a bigger number? Or is there some other nuance in there? And then just my second one would be just repair, replace. A lot of people are saying like it's normalizing, exiting and this canister issue, and just what are you seeing there?

Sure. So the answer to first is it is all one-step. Two-step, we continue to see good growth, and we are forecasting like the lack of destocking leading to good growth in the second half as well. So but to said One-step the R&C loss is within the 1 step. So I think that's why those two numbers overlap. I would say the large part of the decline in Q2 and one-step was driven by RNC and that's a heavy quarter for RNC you know. And then even a reduction in the second half is primarily to that. Now we do see some underlying demand recovery that's been delayed. But we think from our perspective, the repair versus replace trend has stabilized. We see the channel confidence, which was impacted last year because of has returned fully. And we all know that the consumer confidence is sort of bouncing along based on the end of the pieces. But a short answer to your question, Jeff, is that a large portion of the one-step decline is residential new construction, low-margin business that we walked away from.

Yes. But I guess my question is, is that walkaway number bigger now than you thought? Or you knew that was there and your revisions really all underlying replacement weaker?

It is bigger than what we had originally looked at. That market remains extremely competitive and the margins were there were just not acceptable. So it was a little more than what we had originally thought and talked about.

And we will move next to Jeff Sprague with Vertical Research. .

I just wanted to get some insight into how to think about sort of margins for HCS into the back half. So we got some absorption issues, right, but we're walking away from lower-margin business. I guess you have some time for price to catch up a bit. So can you just give us some insight on how you think margins progress over the balance of the year in HCS, maybe relative to what we posted here in Q2 or relative to last year, certainly would be helpful.

Yes, Jeff, we expect the margin headwind year-over-year in the second half to be better than the first half, even after you adjust for some of the tariff refunds, mostly driven by the volume growth that we expect now up low single digits balance of the year to get to 35% incrementals on that. Also, we had a much heavier first half absorption headwind, and then we're going to pick up a point or two of price in the second half versus the first half, some of the new pricing initiatives that Alok mentioned in -- starting in July come in. So better margin performance in the second half as the volumes start to come back.

And, Jeff, to your earlier point, I want to add that our product mix is positive right now because of walking away from loss-making accounts. That's just masked by the other factors that Michael mentioned because of all the noise around absorption and the pieces. But the underlying mix is positive for us given our decision to not compete on those lower margin, negative margin accounts.

Is it overly optimistic to think that HTS margins are up on a year-over-year basis in the back half?

Well, you're going to get some headwind from the M&A that dilutive. -- price cost is a bit dilutive. That's the volumes accretive. So all of that still might lend to slightly negative.

So I think overall question is, we think it's pretty balanced, Jeff. We don't think it's optimistic, nor do we think it's super conservative. We're trying to put a very balanced picture forward.

Right. But something around sort of flattish to slightly down margins in the back half, I think, is what you're indicating if I read that right?

Yes. That's basically within the guide, that's approximately .

In a range, Jeff.

And what do you actually think industry volumes were in Q2?

The June AHRI data and everything else that we looked at continues to show us continued difference between sell-in and sell-through. That's obviously going to become a much longer conversation, Jeff. But we think the sell-in has obviously improved substantially, and we see that in our numbers. And I think the sell-through, we still have to get more data and see how everybody comes through. And I think that still remains under pressure.