Lennox International Inc. (NYSE:LII) Q4 2022 Earnings Call Transcript

Lennox International Inc. (NYSE:LII) Q4 2022 Earnings Call Transcript January 31, 2023

Operator: Welcome to the Lennox International Fourth Quarter 2022 Earnings Conference 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 . As a reminder, this call is being recorded. I would now like to turn the conference over to Alok Maskara, CEO. Alok, please go ahead.

Alok Maskara: Thank you, Ashley. Good morning, and welcome. I hope everyone is having a good start to 2023. It was nice to meet many of you face-to-face during the Investor Day on December 14th. Thanks for attending and sharing your feedback. Turning to Slide 2, a reminder that during today’s call, we will be making certain forward-looking statements that are subject to numerous risks and uncertainties, as outlined on this page. Please refer to our SEC filings available on our Web site for additional details. Before we begin, I want to express my gratitude and appreciation to all of our employees who enabled us to deliver record financial results in 2022. Last year, our dedicated employees improved our customer experience while facing significant supply chain disruptions.

This enabled us to reestablish our cadence of gaining residential market share. I want to take this opportunity to also thank our dealers and customers for their loyalty to Lennox. We will continue to improve our service levels while maintaining the best HVACR products and solution in North America so that we can continue gaining share in the future. Now please turn to Slide 3 where I want to highlight four key messages. First, we are proud to report solid fourth quarter results that capped off another record year for Lennox. Q4 revenues of $1.1 billion and full year revenues of $4.7 billion were both up 13% year-over-year. Strong price execution and continued volume growth enabled us to set new records for both quarterly and full year revenues.

Q4 adjusted earnings per share of $2.63 and full year EPS of $14.07 both grew 12%, establishing a new record of full year EPS. Second, we successfully transitioned our product portfolio to meet the new minimum regional efficiency regulation that went into effect on January 1, 2023. We believe that our superior design and solid execution has put us in a strong position to win share during and after the transition. Third, we ended the year with fully replenished finished goods inventory levels to support our customers through the SEER transition. In addition, we are also carrying higher level of raw material safety stock to mitigate the impact of ongoing supply chain disruptions. Given this, our 2022 free cash flow was $203 million, which was below our expectations.

We are undertaking countermeasures to improve our cash flow forecasting and remain committed to converting 90% to 100% of our net income into free cash over the long term. Fourth, our 2023 full year outlook remains unchanged, and we still expect revenue growth of 0% to 4% and an EPS range of $14.25 to $15.25. Now please turn to Slide 4 to discuss business updates as a follow-up to our dialogue during the Investor Day. In terms of end market update, as we approach February, our order rates remain consistent with our prior expectations. While we are noticing signs of a slowdown, we remain confident in our dealer networks’ ability to continue driving both replacement and new construction sales, especially as equipment lead times normalize. We do anticipate some channel destocking in our two step distribution businesses like Allied Air, ADP and Heatcraft.

We are maintaining solid communication with our distribution partners to effectively manage channel inventory levels. In addition to successful execution during the SEER transition, we are pleased to report that we remain on track to transition our portfolio to comply with the upcoming 2025 low GWP regulation. In terms of order updates on our innovation road map, we recently launched our next generation thermostat controller, the Lennox S40, which has built-in indoor air quality monitoring capabilities and improved connectivity to further improve the experience of our customers and our dealers. We also continue to make progress on accelerating our heat pump growth, and we’re a proud recipient of the good design award for our Dave Lennox signature series collection heat pump.

Switching gears. As part of our commercial recovery effort, the construction of our new commercial factory in Saltillo has started and will be complete by the end of 2024. Lastly, on this page, the formal process for divesting our European assets has started and our internal segment consolidation is complete. We expect to close the European divestiture sometime this year. With that, let me hand the call over to Joe, who will provide you a more detailed view of our financial performance.

Joe Reitmeier: Thank you, Alok. Good morning, everyone. Please turn to Slide 5. Looking at the quarter for Lennox overall, the company posted strong revenue and profit growth. Revenue was a record $1.1 billion, up 13% as reported and up 14% at constant currency, with the growth driven by volume and price. Total segment profit increased $30 million or 30% versus prior year as pricing gains more than offset cost inflation, and all three segments contributed to profit growth. Total segment margin was 12.1%, up 150 basis points as price gains outpaced cost inflation and Commercial margins improved due to higher factory output. GAAP EPS of $2.65 was up 17% and adjusted EPS rose 12% to $2.63. Regarding special items, the company had an $800,000 adjustment for the fourth quarter and $6.6 million for the full year.

Corporate expenses were $34 million in the fourth quarter and $91 million for the full year. Overall, SG&A was $155 million in the fourth quarter or 14.2% of revenue, down from 15.7% in the prior year quarter. And for the full year, SG&A was $627 million or 13.3% of revenue, down from 14.3% in the prior year. Our full year 2022 income tax rate was 19.3%, which was up from the 17.2% last year, the result of higher tax benefits from share based compensation and the finalization of our prior year tax obligations with taxing authorities. For 2022, the company generated cash from operations of $302 million compared to $516 million in the prior year. The reduction in cash flow was primarily due to inventory cost inflation and investments to both minimize supply chain disruptions and prepare for the minimum efficiency regulatory change that took effect January 1, 2023.

Capital expenditures were approximately $101 million for the full year compared to $107 million in the prior year. Free cash flow was $203 million for the year compared to $410 million in the prior year. In 2022, the company paid approximately $142 million in dividends and repurchased $300 million of the company’s stock. Total debt was $1.5 billion at the end of the fourth quarter and we ended the year with a debt to EBITDA ratio of 2.1. Cash, cash equivalents and short term investments were $61 million at the end of the year. Moving to the business segments, starting on Slide 6. Our Residential segment delivered record fourth quarter revenue and profit. Residential revenue grew 13% to $703 million, vwolume was up 5%, price and mix were up 9% and foreign exchange had a negative 1% impact.

Photo by Guillaume Bolduc on Unsplash

Residential segment profit rose 8% to $119 million. Segment margin contracted 90 basis points to 16.9%, primarily due to incremental costs associated with supply chain disruptions and the factory changeover for the new 2023 minimum efficiency standard products. For the full year, Residential segment revenue was a record $3.2 billion, up 15%. Volume was up 4%, price was up 11% and product mix was flat for the full year. For the full year, Residential profit was a record $597 million, up 10%. Segment margin was 18.7%, down 80 basis points, primarily the result of supply chain challenges, which drove manufacturing inefficiencies and unfavorable product mix with reduced production output for higher end products. Now turning to Slide 7 and our Commercial business.

Revenue was $241 million in the quarter, which was up 19%. Commercial price and mix was up 17%. Volume was up 3%, and foreign exchange had an unfavorable 1% impact. Commercial segment profit was up 79%, and segment margin expanded 390 basis points to 11.6%. Commercial demand and backlog remains solid, and our Arkansas factory recovery is progressing well. Staffing in the plant is at our desired levels with productivity progressing and production output increasing. For the full year, Commercial revenue was $901 million, up 4%. Price and mix were up 13% and volume was down 9%. For the full year, segment profit was $81 million, down 27%. Segment margin was 9%, down 380 basis points. Looking at our Refrigeration business on Slide 8. Revenue was $150 million for the fourth quarter, up 5% as reported and up 10% at constant currency.

Price and mix were up 21%, volume down 11% and foreign exchange had a negative 5% impact. Revenue growth was led by our North American business with price and mix, which was up more than 20%. Europe revenue was up 9% as reported and up 22% at constant currency. Overall, the Refrigeration segment profit rose 42% to $19 million and segment margin expanded 330 basis points to 12.5%. Refrigeration demand, order rates and backlog remain strong. For the full year, Refrigeration revenue was $619 million, up 12%. Volume was up 3%, price and mix was up 14% and foreign exchange had an unfavorable 5% impact. Segment profit was $79 million, which was up 60% and segment profit was 12.7%, up 380 basis points. Turning to Slide 9 for a free cash flow update.

Free cash flow was $203 million and was impacted by inventory replenishment to get our distribution network back to effective levels to serve our customers, along with inventory investment to buffer the supply chain to support demand for the new minimum efficiency standards that became effective January 1st. As we look to 2023 and free cash flow, we expect cash from operations to increase as we work to optimize inventory levels while we prepare for the next regulatory change to take effect in 2025 for the new low GWP refrigerants and minimize supply chain disruptions. Our capital expenditures in 2023 will be approximately $250 million and includes investments for a second commercial factory and investments necessary to prepare us for the 2025 refrigerant change.

Free cash flow in 2023 is planned within a range of $250 million to $350 million, including increased capital spending to support regulatory change and growth initiatives, including factory capacity. Free cash flow in 2023 is planned within a range of $250 million to $350 million, including increased capital spending to support regulatory and growth initiatives, including factory capacity. Now turning to Slide 10. Let’s review our 2023 full year guidance. Our outlook collectively for the end markets we serve remains unchanged. We expect revenue to be flat to up 4% for the year. There is no change to our EPS guidance of $14.25 to $15.25 that we shared with you during our Analyst Day. Free cash flow is targeted within the range of $250 million to $350 million, as I mentioned.

And we are planning capital expenditures of $250 million that includes the necessary investments in a second factory, as I mentioned, and investments related to the refrigerant transition that take effect in 2025. Price benefit, including price associated with the 2023 SEER transition is now expected to be within a range of $150 million to $175 million. Now turning to the cost side of the equation. We expect net material cost to be a $35 million headwind in 2023. That material cost headwind is driven by component cost inflation of $100 million, net of $30 million in savings from sourcing and engineering initiatives, along with a $35 million commodity cost benefit. Corporate expenses are still targeted at $80 million. We will manage SG&A tightly while continuing to make the necessary investments in the businesses to support growth initiatives and to drive productivity.

And finally, we expect the weighted average diluted share count for the full year to be between 35 million to 36 million shares, which incorporates our plans to repurchase $100 million to $200 million of the company’s stock this year. With that, let’s turn to Slide 11, and I’ll hand it back over to Alok.

Alok Maskara: Thanks, Joe. Summarizing our financial results and providing an update on the assumptions behind our 2023 fiscal guidance. Please turn to Slide 11 for the key success factors for Lennox this year that are summarized on this page. While we have little control over the industry unit shipments in 2023 that are still expected to decline year-over-year. Given that, we are focusing our effort on the three controllable factors to grow our revenues and expand our margins. First, to offset inflation, we are maintaining and expanding our pricing initiatives. We have already implemented price increases for 2023 and are confident in our ability to offset cost inflation with pricing. Second, on the heel of a strong Q4 performance, we continue to maintain focus on commercial profit recovery.

As Joe mentioned earlier, staffing levels are stable and the Stuttgart plant has switched over to the 2023 SEER standards while simplifying our product portfolio. Our new commercial product lineup provides greater value to our customers and we intend to share part of that value through pricing and contract negotiations. Third, Lennox is now well positioned to start gaining share again. As you may recall, our service levels suffered after the Marshalltown tornado in 2018 and we were unable to fully restore the service levels during the COVID years. Now, the Marshalltown reconstruction is complete, our finished good inventory levels have been replenished, Saltillo continues to add capacity, and our commercial lead times are approaching competitive levels.

The improved service levels, along with recently introduced new products, put us in a strong position to relaunch our share gain programs. Even during a period of economic uncertainty, our confidence in executing on the three controllable key success factors makes us cautiously optimistic for 2023. Again, I want to thank our employees who are working hard to sustain and improve our customer service levels. Now please turn to Slide 12 for some final thoughts before Q&A. I would like to close our prepared remarks by summarizing why I believe LII is an attractive investment opportunity. Lennox is narrowly focused leader in energy efficient, environmentally friendly climate controlled solutions. We operate in high growth end markets with strong replacement demand that provides us with resiliency even during periods of economic uncertainty.

The company has a unique direct to dealer network, which creates a sustainable competitive advantage. And finally, we have a history of robust execution with disciplined capital allocation. Thank you for listening. Joe and I will be happy to take your questions. Ashley, let’s go to Q&A.

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Q&A Session

Operator: We’ll take our first question from Julian Mitchell with Barclays. We’ll go next to Gautam Khanna with Cowen.

Gautam Khanna: It’s Gautam here. I was just curious if you could elaborate on your opening remarks about seeing some channel or seeing some pressure on volumes. Just if you could talk about the Allied versus the Lennox brand, if you’re seeing — what you’re seeing in terms of destocking, if any? And how — maybe you think it’s just maybe an early read on Q1 based on what you’re seeing on resi.

Alok Maskara: So I guess, first of all, as you know, majority of our sales are direct to dealers. And we highlighted Allied, ADP and Heatcraft as the three business units that do go through two step distribution model. Each of them are in a different cycle stage on distributor inventory levels. For something like Heatcraft, we saw some destocking already occur and we might be back to more normal levels. For Allied and ADP, as we talk to our channel partners, we believe there’s some destocking that’s going to occur this year, which frankly puts our Lennox brand in a strong position. That all is baked into our guidance as we look at 0% to 4% revenue growth. While we don’t give quarterly guidance, Gautam, as you know, I mean, so far, I mean, as we said, the Q1 order rates are consistent with our expectations. And I don’t see anything falling off a cliff or so, but we do see gradual slowdown that we have talked about in the past.

Gautam Khanna: And then if you could just comment on the recovery on the high end product, Lennox products. Sort of where are we in that journey, and do you expect to be a full participant in the summer selling season with that product line that was impacted last year?

Alok Maskara: Yes, Gautam, now since Marshalltown tornado, this would be the year, 2023, we have all the inventory levels needed to launch our programs, to recapture our position on the high end, especially as we look at some of the new products like the Dave Lennox Signature series heat pumps and the new higher efficiency furnaces. So we feel good going into the year to be able to capture our fair share of market and higher than growth in 2022 on the higher end products.

Operator: We’ll take our next question from Nigel Coe with Wolfe Research.

Nigel Coe: So I was a little bit late joining the call. So I just wondered, could you give any color in terms of the order activity in 1Q? I’m guessing not, but if it did, it’d be helpful to hear that. But just my broader question is, how has the SEER transition from a market perspective and obviously, asset, how has that gone versus expectations and has it caused any sort of air pocket post the year end?

Gautam Khanna: So we didn’t give any numbers on Q1 but we did talk about that January order rates were consistent with our expectations and outlook. So no change, it went as we expected. On the SEER change, overall, I think it went fine for the industry. The industry has gotten used to these changes. You know we think our design has got the winning formula in terms of — we talked about in the last call, we don’t need to change some of the indoor units. We can only change the outdoor unit. So we think we did quite well and we’ll wait for some of the industry numbers to compare our share. But in general, I think the industry is used to it. I think us and majority of other industry players had a seamless SEER transition. Some of the smaller players may have had hiccups. But overall, I think it went as good or better than expected for the industry.