Lennox International Inc. (NYSE:LII) Q4 2023 Earnings Call Transcript

Lennox International Inc. (NYSE:LII) Q4 2023 Earnings Call Transcript January 31, 2024

Lennox International Inc. beats earnings expectations. Reported EPS is $3.63, expectations were $3.46. LII isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Welcome to the Lennox Fourth Quarter and Full Year 2023 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. [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, Shelby. Good morning, everyone. Thank you for joining us this morning as we share yet another quarter of outstanding performance. With me today is CEO, Alok Maskara, our new CFO, Michael Quenzer; and our outgoing CFO, Joe Reitmeier. Alok, Michael and Joe 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 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. Now please turn to Slide 3 as I turn the call over to our CEO, Alok Maskara.

Alok Maskara: Thank you, Chelsey. Good morning, and welcome. I’m proud to represent our 13,000 employees as we delivered another full year of record results. We are pleased with our 2023 growth, margin expansion and more important cash generation. Our strong results were noteworthy, given the unprecedented destocking faced by residential HVAC manufacturers last year. I’m deeply grateful for our employees and our customers whose hard work, loyalty and dedication drove the results that we will be discussing today. I would like to begin by highlighting 4 key messages on Slide 3. First, we delivered $3.63 in adjusted EPS for Q4, an increase of 41% year-over-year. Adjusted EPS for the full year was $17.96, a 27% increase year-over-year.

Our 2023 full year results were also notable for 6% core revenue growth, 300 basis point expansion in adjusted segment margin. In addition, our operating cash flow more than doubled compared to prior year. Second, we continue to invest wisely in manufacturing capacity, distribution optimization, technology transitions and growth initiatives while maintaining our industry-leading ROIC of 44%. Third, while end market uncertainties linger, our transformation momentum sets a strong foundation and gives us confidence in our 2024 EPS guidance range of $18.50 to $20. Fourth, given the robust progress on the self-help transformation plan, we are pleased to increase our previously announced 2026 financial goals. Now please turn to Slide 4 for more details at 2023 self-help accomplishments.

In 2023, Lennox experienced significant success during the first phase of our self-help transformation plan. Our strategic initiatives allowed us to effectively navigate the destocking challenges, which demonstrated our resilience and exceptional execution. This phase laid a solid foundation for future growth and positioned us to capitalize on further growth opportunities. We accelerated growth by strengthening our distribution muscle to better serve our existing customers, attract new customers and increase our share of wallet from HVAC dealers. We are investing in our sales and stores teams to create greater alignment, accountability and autonomy for improving the customer experience. To ensure resiliency we implemented pricing excellence initiatives to recover margins from previously depressed levels as many long-term key account contracts which were signed before the recent inflationary period came up for renewal.

We also achieved higher factory output, enhanced productivity and optimize product mix. Together, these measures contributed to the overall margin expansion and strengthened our margin resiliency. Finally, to ensure consistent execution, we implemented a balanced core card-based operating system, which we refer to as Lennox unified management system. This system was instrumental in driving accountability and ensuring alignment with our strategic goals to accelerate revenue growth and expand margins. We also simplified our portfolio with the sale of the European businesses and improved our total life cycle value proposition with the recent AES acquisition. On the next slide, I will share more about how we fine-tuned our internal engine to ensure success of the transformation plan and accelerate growth throughout the journey.

Slide 5 shows the 5 components that fueled Lennox’s success in 2023 and are building momentum that will continue to power Lennox’s bright future. At the heart of our transformation is our unwavering commitment to our vision and mission. These set the true north direction for everything we do, aligning our efforts towards a shared goal. Moving outward, the strategy to great will deliver accelerated growth, resilient margins, execution consistency, advanced technology portfolio and talent and culture that help us win every day. Next is the commitment to our customer charters, emphasizing our dedication to always being a partner of choice by delivering exceptional customer experience and quality solutions. Another crucial element to our outstanding performance was the implementation of our Lennox unified management systems.

We are utilizing balance scorecard to drive accountability, integrating standard processes and best practices and aligning operating cadence for efficiency. This represents our commitment to a unified approach that enables Lennox to shift into a higher gear and outperform competition. Lastly, our core values and guiding behaviors serve as a foundation of our high-performance growth culture with a passion for improving the customer experience. Last year, we rolled out 9 guiding behaviors that improved the team’s focus on critical behaviors such as positive engagement and sustainability. These 5 components not only helped us build momentum on our self-help transformation this year, but also act as a spring boom to continue our long-term journey of growth and expansion.

Before we move into the detailed financial section, allow me a few moments to express my gratitude to our outgoing CFO, Joe Reitmeier. I am thankful for Joe’s years of service to Lennox, and I’m especially grateful that stayed with us to train me, the new CEO, and to oversee a smooth transition to our new CFO, Michael Quenzer. Now for the last time on an earnings call, let me hand the call over to Joe.

Joe Reitmeier : Thank you, Alok, and greetings to everyone joining us this morning as we announce Lennox’s record-setting performance and outlook. I’ve had the pleasure and privilege of serving as Lennox’s Chief Financial Officer during a period of transformation and record-setting achievements. Portfolio changes enable a more intense focus on our key North American end markets, the team introduced new and innovative solutions. We delivered on initiatives that drove significant increases in profitability and that coupled with efficient capital allocation resulted in industry-leading returns on invested capital. We fortified the balance sheet and most significantly, we generated exponential increases in returns for our shareholders.

Now before I hand it off to Michael, I’d like to reflect briefly on 2023. It was another year of exceptional performance while strengthening the foundation for the future by investing in our people, sustaining industry-leading innovation and enhancing our capabilities to better serve our customers. Now while I’m extremely proud of my time with such a great organization that has accomplished so much. I take even greater pride knowing that I’m leaving an extremely talented and seasoned team that is very well positioned both strategically and financially for long-term success. I’d like to wrap up my comments with a sincere thank you to all Lennox employees, our valued customers, the investment community and other stakeholders for your partnerships over the years.

I’ll now hand it over to Michael, who will take you through the details of Lennox’s financial performance and outlook. Michael, take it away.

Michael Quenzer : Thank you, Joe. Good morning to everyone. Please turn to Slide 6. As Alok mentioned earlier, 2023 has been a record year in the fourth quarter with no exception. Core revenue, which excludes our revenue operations was $1.1 billion, up 7% as price and mix drove the year-over-year improvement. Adjusted segment profit increased $44 million at $69 million of price and mix benefits were partially offset by inflation and investment in SG&A and distribution. Total adjusted segment margin was 15.9%, up 320 basis points versus prior year. For the fourth quarter, corporate expenses were $30 million, a decrease of $3 million. Our fourth quarter tax rate was 20% and diluted shares outstanding were $35.8 million compared to $35.6 million in the prior year quarter.

The fourth quarter achieved record levels of revenue, segment profit and adjusted earnings per share, which grew by 41% to $3.63. Let’s shift our focus to Slide 7 and review the financial results of our Home Comfort Solutions segment formerly referred to as a residential segment. The left graph shows revenue grew 1% to a record $709 million in the fourth quarter. The segment benefited from favorable mix of higher efficiency products and effective pricing execution. This was partially offset by volume declines. Although unit sales volumes for the segment declined by 5%, our direct-to-contractor sales volumes remained stable, signaling a resilient consumer demand landscape. Unit sales volumes through independent distribution channels declined more than 20% driven by continued industry destocking.

Home Comfort Solutions profit decreased approximately 4% to $115 million, and segment margin also experienced a decline of 70 basis points to 16.2%. The decrease was attributed to a $9 million decrease in sales volumes and $25 million impact from inflation and investments in distribution and selling. Moving on to Slide 8. We will now review the performance of our Building Climate Solutions segment, formerly referred to as the commercial segment. The segment continues to consistently deliver outsize performance each quarter, resulting in another quarter of record revenue and profit. Revenue was $390 million in the quarter, up 19%. Combined price and mix were up 11% and volume was up 5%. Building Climate Solutions profit was $91 million or up 98% and segment margin expanded 930 basis points to 23.2%.

These results were primarily driven by price and sales volume gains. The team’s execution on several self-help initiatives aided in the recovery of previously depressed profit margins. These initiatives include price corrections, enhanced factory productivity and strengthened supply chain resiliency. The AES acquisition also played a role in the growth during the quarter. The integration is progressing smoothly with existing Lennox customers showing interest in the AES full life cycle value proposition. Ultimately, the fourth quarter continued the year’s momentum and resulted in a strong finish to 2023. If you will now turn to Slide 9, I will recap the full year Lennox results. For full year 2023, core revenue, excluding European operations, was $4.7 billion, up 6%.

Adjusted segment profit increased $180 million as $348 million of price and mix benefits were partially offset by Home Comfort Solutions sales volume declines as well as inflation and investment in SG&A and distribution. Total adjusted segment margin was 17.9%, up 300 basis points versus prior year. Despite facing volume challenges in the residential end markets, inflationary pressures and ongoing investments, the Home Comfort Solutions segment achieved revenue and profit growth through successful execution of strategic pricing initiatives and the seamless transition to the new minimum SEER standard. The Building Climate Solutions segment also achieved impressive results in 2023. Healing supply chains and factory productivity played a key role in growing volumes in the second half of the year, and pricing execution helped the segment recover previously depressed profit margins from years of higher supply chain and production costs.

Exceptional execution by both segments resulted in adjusted earnings per share growing to $17.96, setting a new record and representing a 27% increase compared to the prior year. Moving on to cash flow and capital deployment on Slide 10. Operating cash flow for the quarter was $306 million compared to $132 million in the prior year quarter. Capital expenditures were $125 million for the quarter, an increase of $91 million compared to the prior year. Net debt to adjusted EBITDA was 1.3x, down from 2x in prior year. Our approach to capital deployment remains consistent. We will prioritize organic growth investments with strong returns, grow dividends with earnings and continue to explore M&A opportunities and to supplement with share repurchases when necessary.

Lennox’s industry-leading ROIC of 44% reflects our dedication to delivering value to our stakeholders through strategic and targeted investments. We not only aim to maintain our high ROIC, but also aimed to make necessary investments to elevate our performance and competitiveness in the marketplace. We anticipate the successful completion of our upcoming commercial HVAC factory and production is slated to begin midyear. While overhead and ramp-up expenses posed known challenges in the first half of 2024, we anticipate the factory will realize productivity benefits in 2025. This facility plays a pivotal role in our sustained growth, enhancing our commercial production capacity by 25% by the end of 2024. It will allow us to better address consumer demand and recapture market share in emergency replacement market.

Now let’s transition to Slide 11. Here, I will provide an overview of our full year financial guidance for 2024. We anticipating another year of profitable growth, the chart on the left provides key growth drivers with revenue expected to increase by approximately 7%. Alok will provide additional comments on end markets later in the presentation, but sales volumes are expected to remain relatively flat with a slight upward trend from Building Climate Solutions growth and stable Home Comfort solutions end markets. The combination of price and mix is anticipated to contribute to a mid-single-digit growth in revenue, price increases will sustain margins amid continued cost inflation and a slight favorable mix is expected due to the 2023 minimum efficiency regulatory change.

In addition to the profit drivers from revenue, we have listed key costs and investment assumptions on the right side of the slide. Component cost inflation is expected to be up mid-single digits, including large increases in our cost to acquire our 410A refrigerant. We expect this to be partially offset by material cost reduction programs. We anticipate ramp-up costs of approximately $10 million for the new commercial HVAC factory along with additional costs associated with the refrigerant transition across our Home Comfort solutions manufacturing facilities. We will continue to invest in information system advancements, distribution growth initiatives and projects to improve customer service. Additionally, we expect to support growth initiatives by making investments in both sales and marketing.

While we continue to focus on managing SG&A expenses, we do expect moderate inflation area pressure in 2024. Our guidance for capital expenditures is approximately $175 million. This includes final spending for the new commercial HVAC factory and the 2025 low GWP refrigerant transition. Interest expense is expected to be approximately $50 million and tax rate is estimated to be between 20% and 21%. Incorporating all of these guidance items, we expect earnings per share to be within the range of $18.50 per share and $20 per share. Finally, we expect free cash flow to be within the range of $500 million to $600 million. With that, please turn to Slide 12, and I’ll turn it back over to Alok for an overview of 2024 business conditions.

Alok Maskara : Thanks, Michael. As we look forward to the coming year, it is important to recognize that while our transformation momentum has yielded positive results, we are still facing challenges in the end market. Within our Home Comfort Solutions segment, the health of the consumer will remain a significant driver of demand and greatly influence the repair versus replace dynamic. We are mindful of consumer sentiment, especially in an election year, and we’ll continue to track macro data for early indicators. It is important to point out, we have not yet noticed any meaningful shift from replace to repair. EPA rulings have also introduced an element of uncertainty regarding industry inventory levels. Ahead of the R454B transition, we do not anticipate a large pre-buy due to inventory fatigue in the tunnel and the increased cost of carrying inventories.

However, we do expect distributors to normalize inventory levels this year as the channel returns to its usual ordering patterns. We also expect ongoing benefits of the strategic pricing initiatives and potential share opportunity as Lennox historically win share during regulatory transitions. Turning our attention to building Climate Solutions, we predict solid demand in 2024. With the data we have from our National Account Services business, we know that rooftop units are aged past historical averages and will need to be replaced soon. 2024 demand may be impacted if key accounts delay installs pending new R454B product availability. End markets may also face challenges related to softening commercial new construction and project delays. Ultimately, our outlook for 2024 remains cautiously optimistic, though we acknowledge the complexities of the market conditions in the coming years.

We trust that our proactive strategies focused on driving top line growth, expanding our margins and consistently executing on initiatives will continue to propel Linux towards enhancing customer experience and shareholder value. On the next slide, I will go into more depth on each of the strategies as it relates to 2024. On Slide 13, I want to take a moment to revisit our self-funded transformation plan, which has been steering our current success. As a reminder, this plan is structured around 3 phases over the next several years. Now let’s dive into the specifics of our actions for 2024, where we will transition from the initial phase to the growth acceleration phase. This year is pivotal as it sets the stage for the next wave of growth through strategic investments and focused actions.

First, we are investing in our sales force to expand customer touch points, enhancing the overall customer experience through digital innovations and anticipating improved output from our new commercial HVAC factory. Additionally, we aim to increase the attachment rate for parts and accessories, ensuring the holistic experience for our customers. Second, we are committed to driving resilient margins. This involves maintaining pricing excellence, leveraging greater productivity from volume recovery, realizing material cost reduction and reaping the mix benefits of transitioning to the new R454B product. These actions collectively fortify our financial position and solidify our sustainable competitive advantage. Lastly, we will leverage the Lennox unified management system to streamline our operations and set clear priorities.

Our focused strategy, investment in heat pump growth and enhancement to our distribution network further exemplify our commitment to consistent management execution. 2024 is a year of purposeful actions that will propel us into the growth acceleration phase and lay the groundwork for our journey into the expansion phase. I am confident that with our collective dedication and strategic approach, we are not just following a plan, we are shaping our future success. Now please turn to Slide 14 for an update on our long-term financial goals. It has been just over a year since we introduced our 2026 goals and are confident that our execution is ahead of schedule, even though market uncertainties persist. We are pleased that Building Climate Solutions has achieved record margins and that Home Comfort solutions demonstrated margin resiliency, even while facing significant volume headwinds.

With this year’s achievements, we recognize the need to adjust our long-term goals to better reflect our current positions. For 2026 we are now targeting revenue of $5.4 billion to $6 billion, with total company target margin range of 19% to 21%. Our free cash flow conversion target is approximately 90% as we complete the necessary investments to support our growth. We are increasing the long-term target for Home Comfort solutions to a range of 20% to 22% ROS and building Climate Solutions to a range of 22% to 24% ROS. Now for a wrap up, please turn to Slide 15 for the reasons I continue to believe that Lennox is a great investment opportunity. Lennox operates in growth end markets has resilient margins demonstrates execution consistency and serves its customers through advanced technology and high-performance talent.

The 5 reasons we remain confident in our ability to deliver strong results are: first, we will continue to make strategic growth investments to improve our go-to-market effectiveness and support consumer demand. Second, our margins remain a focus as we continue to evaluate our pricing strategy, implement innovative solutions to increase productivity and optimize our direct-to-dealer network. Third, while leveraging the Lennox unified management systems, our teams will be able to streamline processes, leverage best practices and consistently deliver strong results. The fourth aspect reflects our continued technology advancements that ensure Lennox will remain at the forefront of innovative solutions for our customers. Finally, the introduction of our guiding behavior enhances our team’s focus on core values and fortified our high-performance culture.

Our refreshed pay-for-performance incentive structure further aligns the talents of our team and the interest of our stakeholders. Allow me to wrap up by saying thank you to each of our dedicated employees and valued customers. I am proud for what we were able to accomplish this past year, and I’m looking forward to the promising future that lies ahead of Lennox as our best days are still ahead of us. Thank you. We will now be happy to take questions. Easy questions can go to Michael and I and the harder questions should go to Joe Reitmeier. Operator, let’s go to Q&A.

See also 15 Best Dividend Paying Stocks To Buy Now and 35 Most Congested Cities in the World.

Q&A Session

Operator: [Operator Instructions] And we’ll take our first question from Jeff Hammond with KeyBanc Capital Markets.

Jeff Hammond : Joe, look forward to seeing you in Cleveland, look me up. Just on margins, I’m just trying to think about the puts and takes. You’ve got some profit incrementals on the left of Slide 11 and then you talk about a number of headwinds. I’m just wondering if you could put a finer point on just overall incrementals embedded in the guide and maybe how to think more five point. Much of this refrigerant inflation, manufacturing efficiencies are going to cost similar to how you did for the factory ramp-up costs?

Joe Reitmeier: Yes. So on the left-hand side, you can see our contribution margins. And on the right-hand side is the increase related to rate for costs as well as investments. So you have to join those two together see the full impact. But we do expect some margin improvement for the enterprise next year when you look at the combined. Our component costs are a big piece of our cost of goods sold are nearly 45% and then refrigerants also going to go up significantly. So most of that pricing should be there to maintain our current gross margins and then we’ll get a bit of leverage on the volume and a little bit of leverage on the acquisition as well. But overall, we do expect margins to be up just not 300 basis points like we saw in 2023.

Jeff Hammond : Okay. And then can you just talk about your inventory destock process with respect to your company-owned distribution? And just on the independent channel, where are you at? Or what are they telling you in terms of how much more to go on destock?

Alok Maskara: Sure. I’ll take that, Jeff. On our own internal — I mean I always think we can get more working capital improvements, but I think we are reaching a level, especially given the upcoming A2L transition, but I think the levels are going to be relatively flat. We might have to build up some towards the second half of 2024, and that’s embedded in the guide just to ensure a smooth transition. On the independent China, I mean, honestly, the destocking in Q4 was more than we expected. And we do think there’s going to be some destocking happening in Q1, especially on product line eases whether that’s impact of weather and all, we don’t know. But I think from overall, we do expect some destocking bleeding into Q1, but remain confident that by second half or Q2, independent channel distribution destocking would be largely behind us, especially as the distributors get ready for a A2L transition and the EPA ruling allows them some sell-through in 2024 as well.

So lots of moving pieces, but we’ve embedded all of that in the guide, Jeff.

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

Nigel Coe : Congratulations, Joe. Enjoy your retirement. So I’m not sure whether it’s a tough question or not. But just on the — I think maybe on the back of Jeff’s kind of question about incrementals. You’ve got price mix as a 90% incremental margin. So just wondering how that plays into the mid-single-digit component inflation math. So maybe I’m just asking Jeff’s question again, but if you just see mid-single-digit contribution from price mix with the incremental, you get to sort of a $3 to $4 EPS tailwind. Is that how you’re thinking about it?

Joe Reitmeier: Yes. I mean what we have to do is look, it’s predominantly price, price drops through to 100%. There’s a little bit of mix that we’ll get from the carryover benefit from the minimus year transition. So that will kind of drop through at 30%. When you blend the 2 together, you kind of get to the 90, but then that then covers some of the cost inflations we have on the right-hand side where we think our components are going to be up significantly, both from the normal inflation, mid-single digits as well as the refrigerant. So that kind of sets a lot of that, which maintains your gross margins. And then thereafter, we start to make investments in distribution and SG&A. And we still see overall operating margins improving think of it maybe a little less than 50 basis points within the guide.

Nigel Coe : Okay.

Alok Maskara: And I think if I could add to that, Nigel, keep in mind, the factory inefficiency both for the start-up in Saltillo or the commercial factory and for the A2L conversion, but that’s fairly massive transformation we have to do. Every line has to be redone. We’ll have tiers of factory shutdown. So we bake in all of that — so I understand your question. It’s just we got to — we baked in all of those inefficiencies in our guide.

Nigel Coe : I get it. I understand that now. And then just on the component inflation of mid-single digits. We talked to some of the motor manufacturers, some heat exchange suppliers. And it doesn’t feel like they’re targeting mid-single-digit price increases in 2024. So just curious where you’re seeing that mid-single-digit price inflation. And maybe just talk about the 410A, what your expectations are in terms of that commodity inflation in 2024.

Alok Maskara: Sure. First of all, you should give me the list of all those people that were telling you that. So we can go and negotiate, use their work on that. I’d love to get that Nigel. But no, more seriously, some of it comes down to the starting point. In some cases, on components, we did have long-term contracts that are coming up for renewal. So we may have like escaped some of the inflation in the past. The other thing you’ve got to see in the 410A, I mean, the spot pricing, the contract pricing and where we are still a lot of moving pieces. But based on the production quota reduction from EPA, we fully expect and have baked in inflation on 410A. And overall, I mean inflation is lower than before, but it’s not gone away, whether it’s SG&A or NAV factors. So we’ve built all of that in as we looked at what’s going to happen in 2024 for us. but we do continue to see inflation in components, especially if our long-term contracts come up for renewal.