Lennox International Inc. (NYSE:LII) Q3 2023 Earnings Call Transcript

Lennox International Inc. (NYSE:LII) Q3 2023 Earnings Call Transcript October 26, 2023

Lennox International Inc. beats earnings expectations. Reported EPS is $5.37, expectations were $4.7.

Operator: Welcome to the Lennox Third Quarter 2023 Earnings Call. All lines are currently in a listen-only mode and there will be a question-and-answer session at the end of the presentation. [Operator Instructions] As a reminder, this call is being recorded. I would now like to turn the conference over to Chelsey Pulcheon from the Lennox Investor Relations team. Chelsey, please go ahead.

Chelsey Pulcheon: Thank you, Gary. Good morning, everyone. We have had an exciting quarter, and we are looking forward to discussing the details with all of you this morning. With me today is CEO, Alok Maskara; CFO, Joe Reitmeier; and VP of Finance, Michael Quenzer. Alok will take you through some quarter highlights as well as some preliminary perspective on the year ahead. Joe will go into depth on the Company’s quarterly financial results as well as our revised guidance for fiscal 2023. At the end of the call, we will move to our 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.

An engineer wearing a hardhat inspecting a newly-installed air conditioner system.

We may also refer to certain non-GAAP financial measures that management considers to be 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 all GAAP to non-GAAP measures. The earnings release, today’s presentation and the webcast archive link for today’s call are available on our Investor Relations website at investor.lennox.com. You can also find the press releases for our CFO transition and AES acquisition on the Investor Relations website. Now please turn to Slide 3, I then turn the call over to our CEO, Alok Maskara.

Alok Maskara: Thank you, Chelsey. Good morning, everyone. I am proud to report that this has been another record quarter for Lennox with results that truly speak to our commitment towards delivering growth acceleration and resilient margin expansion. The record revenue, profit and earnings that we are sharing today reflect the transformative impact of our self-help initiatives put in place last year. These results were made possible by the hard work of Lennox’s 13,000 employees as well as the unwavering loyalty of our dealers and customers. I deeply appreciate the tireless efforts of everyone who played a part in delivering these exceptional results. I also extend my appreciation to our dealers and customers for entrusting Lennox to provide top-tier innovative products and solutions.

Now let me transition into an overview of this quarter’s highlights. Lennox’s core revenue grew 10% and our adjusted segment margin expanded 334 basis points to 19.3%, resulting in our adjusted earnings per share increasing 30% to $5.37. Our operating cash flow of $313 million was up 83% year-over-year. Additionally, earlier this morning, we announced Joe Reitmeier decision to retire and the appointment of Michael Quenzer as our new CFO. We are excited for both Joe and Michael as we complete this planned transition. Additionally, we also announced the strategic acquisition of Architectural Engineering Services, or AES this morning. The acquisition is consistent with our bolt-on acquisition strategy and is a clear strategic fit that will accelerate growth, unlock operational synergies and enhance our service offerings to create incremental shareholder value.

Now please turn to Slide 4 for more details on our CFO transition. Announced earlier this morning, Joe Reitmeier has decided to retire, and I’d like to express my sincere gratitude for his remarkable 18-year tenure at Lennox. Under his leadership, the Company achieved many significant milestones, including 7x earnings per share growth and 12x increase in market cap. Beyond his financial stewardship, Joe has cultivated a talented dynamic finance organization here at Lennox. With that strong foundation and robust succession plan, we expect a smooth transition as Michael Quenzer takes on the role of Chief Financial Officer, effective January 1, 2024. Michael joined Lennox in 2004 and has been a key contributor to Lennox’s strong financial performance.

He has a proven track record of driving operational excellence developing talent and creating shareholder value. Michael’s experience as the segment CFO during the commercial turnaround and most recently as VP Finance and Investor Relations, equips him with a solid foundation for his new role. I’m very happy for Joe, as he looks forward to his well-owned retirement, and I am excited to work with Michael in his new capacity. Please join me in congratulating both Joe and Michael. Now please turn to Slide 5 for an overview of the ADS acquisition. We are pleased to welcome AES customers and employees to the Lennox family. This strategic bolt-on acquisition is in line with our overall capital deployment strategy and provides clear benefits to our customers, employees and shareholders.

As you may know, Lennox’s existing national account service team is focused on preventative maintenance and energy monitoring services. Our new acquisition is centered on turnkey installation accessories as well as refrigerant, reclaim and recycling. The combined portfolio will allow us to serve our customers more holistically, ensuring that all their needs are met by Lennox. Additionally, it enhances our cross-selling opportunities as we can now offer a broader range of services and solutions to our client base. This will strengthen our relationship with our customers and positions us for a comprehensive lifecycle provider in this fragmented light commercial service industry. AES also provides new services to facilitate product life commissioning, including refrigerant reclamation and material recycling.

For example, a commercial customer can purchase rooftop equipment from Lennox, utilize AES installation services, use us for maintenance and monitoring and leverage our reclaim and recycling services at the end of equipment life. By offering these services, we not only align with the evolving environmental needs and regulations but also create a new revenue stream for our business, ensuring that we remain at the forefront of sustainable innovations. Another compelling aspect of this acquisition is the vertical integration into parts and accessories, specifically in core adapters. By manufacturing and core adapters in-house, we will be able to generate cost efficiencies, increase profitability and build a stronger competitive edge in the marketplace.

Ultimately, this strategic bolt-on acquisition addresses several critical execution needs in our growth strategy. It adds installation capabilities to our industry-leading preventative maintenance services, provides new services such as refrigerant reclaimer and material recycling to support product lifecycle decommissioning and increases the sales of parts and access fees. Now, let me hand the call over to Joe, who will take us through the details of our Q3 financial performance.

Joe Reitmeier: Thank you, Alok, and good morning, everyone. Please turn to Slide 6. As Alok mentioned earlier, the Company posted strong revenue and earnings growth. Our core revenue, which excludes our European operations, was a record $1.3 billion, up 10% where price and mix drove significant year-over-year improvement. Adjusted segment profit increased $62 million as $97 million of price and mix benefits were partially offset by inflationary impacts on SG&A and distribution costs. Total adjusted segment margin was 19.3%, up 334 basis points versus prior year. And for the quarter, corporate expenses were $27 million, an increase of $11 million as a result of higher incentive compensation and wage inflation. In the third quarter — or the third quarter, achieved record levels of revenue, segment profit and adjusted earnings per share.

Adjusted earnings per share grew by 30% to $5.37. Our third quarter tax rate of 25.6% and diluted shares outstanding were $35.7 million compared to $35.5 million in the prior year quarter. Turning to our residential results on Slide 7. The chart shows revenue growth of 7% to a record $896 million in third quarter. The segment benefited from new minimum efficiency standards and a richer mix of higher efficiency products. We also noticed the positive impact from the strategic price increase in June. Although unit sales volumes for the segment declined by 2%, our direct-to-contractor sales volume increased mid-single digits, reflecting healthy end markets and ongoing market share gains. Unit sales volumes through independent distribution channels declined mid-teens, primarily due to continued industry de-stocking, which decelerated during the quarter.

Residential segment profit increased 18% to $181 million, and segment margin improved by 183 basis points to 20.2%, driven primarily by price and mix and partially offset with lower volume, higher incentive compensation and inflationary effects on wages and distribution. Turning to Slide 8 and our commercial business that continues to deliver strong results. Revenue was $406 million in the quarter, up 15%. Combined price and mix were up 13%, and volume was up 2%. Commercial segment profit was $97 million or up 86%, and segment margin expanded 912 basis points to 24%. These results were driven by price and mix for a total for the total of a $47 million increase in profit for the quarter. Increased factory productivity has offset inflation and we have made significant progress on our new factory construction, which will support growth and productivity.

Moving on to cash flow performance and our net debt to EBITDA starting on Slide 9. Operating cash flow for the quarter was $313 million compared to $171 million orders in the prior year quarter. Capital expenditures were $40 million for the quarter, an increase of $20 million compared to prior year. Our capital deployment priorities remain consistent, supporting organic growth investments like our new commercial manufacturing facility in Mexico, driving industry-leading innovation and exploring potential bolt-on acquisitions like AES. In the quarter, the Company paid approximately $78 million in dividends. Total debt was approximately $1.5 billion at the end of the quarter, and our net debt-to-EBITDA ratio was 1.7x. Cash, cash equivalents and short-term investments were $141.6 million at the end of the quarter.

Construction on the new commercial factory is also coming along nicely with first production anticipated mid-2024. We do anticipate some P&L inefficiencies and temporary working capital build as the factory ramps up. By the second half of 2025, however, we expect the factory will be fully ramped, and we will begin realizing productivity gains. Now turning to Slide 10, I’ll review our revised 2023 full year guidance. As a result of our strong execution on driving growth and expanding margins, we are increasing our full year outlook. We estimate core revenue to be up approximately 5% for the year and earnings per share of $17.25 per share to $17.75 per share. We are also increasing our free cash flow target to a range of $350 million to $400 million.

Our guidance for capital expenditures is unchanged from our prior guide at $250 million, and this includes our investment in the new Saltillo factory and refrigerant transition-related investments. Pricing cost benefit are now expected to be $325 million, and net material costs are expected to be flat for 2023. We revised our corporate expense estimate to be $100 million attributable to higher incentive compensation expenses. We will remain diligent on managing SG&A expense while also making necessary investments in the business to support growth, promote the development of our innovative products and solutions, improve overall productivity. And finally, we still expect our weighted average diluted share count for the full year to be approximately 35.5 million shares.

With that, let’s turn to Slide 11, and I’ll hand it back over to Alok.

Alok Maskara: Thanks, Joe. In addition to delivering impressed results, we are also making significant progress towards streamlining our portfolio. Last year, we announced a plan to divest — we announced the plan to divest our European operations aligning with Lennox’s strategic concentration on the North American market, where we are well positioned to accelerate growth and expand resilient margins. In the third quarter, we reached exclusive agreements for the sale of our European commercial HVAC businesses as well as our European process cooling businesses. Based on these agreements, we recorded $63 million noncash impairment this quarter. We expect both transactions to be completed before the end of the year. We also made strides in simplifying our already strong balance sheet.

In September, we issued $500 million of senior unsecured five-year notes, which will replace the $350 million note maturing in November of this year. In order to retire all secured debt, we increased our revolving credit facility and introduced a commercial paper program. With these changes, we have lowered our financing cost and created additional liquidity. Now please turn to Slide 12, where I will provide an initial assessment of 2024 business conditions. 2024 will be another transformative year for Lennox as we ramp up the new commercial factory transition to low GWP refrigerant and continue our transformation plan. Our strategic management and execution discipline will allow us to navigate ongoing macroeconomic and regulatory uncertainties.

On the left-hand side of this slide, we have laid out several tailwinds and headwinds that are likely to impact industry demand. We anticipate channel de-stocking to end in 2023, which will lead to favorable volume trends in 2024 as channel returns to its usual ordering patterns. Additionally, the IRA, tax credits and other local incentives aimed at promoting energy-efficient at grades will encourage consumers to replace versus repair as well as the boost the sales of higher efficiency products. Also, as supply chains continue to heal and lead times normalize, pent-up demand for commercial products will drive growth. We continue to monitor demand changes related to the impending refrigerant regulatory transition in 2025. There is likely to be demand disruptions as distributors are going to adjust inventory levels to mitigate supply chain risks, gain possible price advantage and prepare to meet regulatory deadlines.

In terms of headwinds, the most significant source of uncertainty stems from macroeconomic factors. These include 2024 as an election year, fluctuations in consumer confidence influenced by geopolitical concerns and the impact of elevated interest rates on residential new homes and large commercial construction projects. On the right-hand side of the slide, we have identified several profit drivers. We believe that end market demand and normalization of channel inventory will drive improved volume with consistent incremental profits. We also expect the ongoing benefits of the strategic pricing initiatives and additional pricing opportunity driven by the increase in the cost of 410 refrigerants. Towards the end of 2024, we’ll start experiencing additional price and mix benefits, driven by the higher cost of 454B units that require new sensors, control boards and more for advanced heat exchangers to maintain energy efficiency ratings.

We forecast additional manufacturing productivity due to higher absorption and fuel for supply chain constraints. These drivers will be partially offset by ongoing inflation, ramp-up costs for the new commercial factory in Saltillo and costs associated with the refrigerant transitions. Regarding cash flow, we anticipate cash conversion to be impacted by a temporary increase in working capital as well as capital investment to complete the new commercial factory and to meet the 2025 refrigerant transition requirements. Ultimately, our outlook on 2024 is cautiously optimistic. Our strategy remains focused on consistent execution, driving top line growth and expanding our margins. We plan to provide our 2024 financial guidance when we report our fourth quarter earnings early next year.

With that, please turn to Slide 13. Allow me to summarize some of the factors that lead me to believe Lennox is poised to continue delivering great results. First, we are making the necessary investments to enhance our go-to-market effectiveness to meet the attractive long-term industry demand. Second, our unique direct-to-dealer model enables us to deliver sustainable and resilient higher margins by leveraging both our manufacturing and distribution network to optimize profitability. Third, we deliver consistent execution through utilization of our balanced scorecard-based operating system, dual source supply chain and lean digital processes. Our capital deployment remains disciplined as we prioritize organic growth investments, developments, acquisitions and share repurchases.

The fourth pillar is our advanced technology portfolio that allows us to address mega-trends and provide innovative solutions to our customers. Finally, we live by our core values and embody our guiding principles to strengthen our high-performance culture. Our pay-for-performance incentive structure also ensures close alignment of talent and stakeholder interest. I would like to conclude by expressing my appreciation to all of our employees and customers. I also want to thank Joe Reitmeier for his dedication over the years and congratulate Michael Quenzer on his new role as CFO. Finally, I would like to welcome all of the 280 AES employees to the Lennox family. I am excited about what the future holds for Lennox as our best days are still ahead of us.

Thank you. Joe, Michael and I will be happy to take your questions now. Kerry, let’s go to Q&A.

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Q&A Session

Operator: [Operator Instructions] And we’ll take our first question from the line of Jeff Sprague with Vertical Research Partners. Please go ahead.

Jeff Sprague: Thank you. Good morning, everyone. Joe, we’re going to miss you. I think it was you, me and LeBron from Akron. So, we’re going to be down to two now, but…

Joe Reitmeier: I appreciate you.

Jeff Sprague: Thanks for all the help over the years. Look, thanks for the early view into 2024. I wonder if we could just drill a little bit more into the transition itself. And just thinking about the timing of all this, should we expect, say, kind of cost burdens early in the year that are then kind of recaptured in higher selling prices later in the year? Just kind of thinking about the progression of this through your P&L as you prepare and then ultimately sell on the other side?

Michael Quenzer: Jeff, this is Michael. Yes, I’ll speak specifically to the commercial factory. What you’ll see in the first half of next year is that we’ll ramp that factory up specifically on the head count and some of the training needed to start the production kind of late into Q2. So, you’ll see some costs in the first half with no production output. And then in the second half, we’ll start to get some production output, but that also still won’t be at full efficiency. It will take a bit of time before we get the efficiency, but the second half will at least start to get some more production out and let us start to get back into the inventory levels that we need to get into emergency replacement. So, most first half of the year is going to be kind of the cost and efficiency getting better in the second half.

Alok Maskara: And Jeff, the same would be true on the refrigerant transition. So I think you’re right to assume that the first half, there would be cost burdens as we start converting lines, ordering more spare parts. And then second half is where we start getting the price mix benefits. Most of the price mix benefits for refrigerant transition is likely to be 2025, but we’ll start seeing some of that towards the tail end of next year.

Jeff Sprague: And maybe just as a follow-on comment here. Just thinking about the commercial margins, obviously, just a very positive story here in 2023 looks like you are still expecting kind of a significant step down in Q4. Obviously, there’s some seasonality, but maybe just give us some color on what you’d expect in Q4 in commercial price/cost mix and how the bridges to a margin expectation there?

Joe Ritchie: Yes. Naturally, our Q4 has a little less volume in it seasonally. It drops down a little bit. But — as we look to our backlog, the margin and the backlog still this supports margins that we saw in Q3. So pricing still remains to hold there well as well as the mix dynamic is positive. So, we see that continuing into next year. I mean after several years of being behind on the price/cost dynamic, we’ve kind of gotten back to where we think we have normal margins. Now, it’s involved maintaining those margins going forward as we start to see costs for refrigerants and some of the new 454B cost additions that we need to do.

Alok Maskara: I think, Jeff, on the guide perspective, I mean, I just want to remind that like we are still heavily volume-constrained. And even in Q3, if we had more capacity, we would have sold more. So I just want to remind that like we made good progress in the factory. There are still — are paying back a more some time with supply chain with production output. We wanted to make sure that we didn’t get too far ahead of ourselves as to giving guidance for the rest of the year.

Operator: And we’ll take our next question from the line of Chirag Patel with Jefferies. Please go ahead.

Chirag Patel: Thank you. Just wanted to also thank Joe for his time and patience with us over the years, and Michael I look forward to your continued insights in the new role, congratulations. One thing I wanted to kind of hit on was on the acquisition side. Any sort of thoughts on seasonality of that business, if there is something that doesn’t match up with where commercial is currently? And then we talked about being accretive to earnings. Just wanted to also get a sense for how that margin profile kind of works. Will it be at the similar levels that we’re seeing here in commercial currently? Or is there maybe a little bit of a dilution to that in the near term?

Alok Maskara: Sure. Thanks, Chirag. Let me start on that. So first of all, very excited about the acquisition, very consistent with our stated goal of how we look at bolt-on and areas such as service parts and accessories so super excited on what that brings. In terms of seasonality I mean given that it’s installation and services, it’s going to be very similar to the rest of the Lennox business, so I wouldn’t expect anything materially different compared to the rest of the business. The same comment also holds on the margin. The margin on par would be same as the rest of Lennox, neither accretive nor dilutive to us as we embark on 2024. So, a great fit for us, it kind of from a revenue perspective and margin perspective would be similar dynamics to the rest of Lennox’s business. I mean the fit is like hand in a glove fit for us on how well this business fits with our existing portfolio.

Chirag Patel: And then I guess on the commercial side, we talked about the idea of being able to sell more if we had more volume capacity currently. But just digging a little bit deeper into the actual end markets themselves, are you seeing any sort of softness or weakness in any of the various markets you serve? Is there a specific area that may be moderating just given the current macro environment that’s out there, anything that you can help us within understanding that a little bit better?

Alok Maskara: Where we have seen some softness is like large office complexes and others. The good news is our exposure to that market is very small. Our primary exposure, as you know, is in flat single-story buildings like retail, restaurants, schools and all of them have been doing very well. So we haven’t seen any significant change. Now we do see backlog, which is not like big for us, going back to more normal levels as lead times are going back to more normal levels. But from a core demand perspective, we’re not noticing any noticeable differences, except in the small pocket where we don’t have much exposure that’s large office buildings and office complexes.

Operator: And we’ll take our next question from the line of Nigel Coe with Wolfe Research. Please go ahead.

Nigel Coe: Nice quarter. So, the net material inflation now, I think, looks flat. So I think prior, you’re looking for, I think, commodity costs, $35 million of deflation offset by component inflation of, I think, 90, if I’m not mistaken. How does — if you break out that flat between the components and the commodities, how does that look? Is it mainly steel price the facing coming through on the commodities? I was just curious how that bucket looks?