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

Hello everyone, and thanks for attending Deutsche Bank's Industrials Conference. We're back in Chicago. Excited to be here. Thanks to everyone in the room who's sitting in for Lennox fireside chat today. We've got Alok Maskara, CEO. And Jeff, please comment with your last name. I should have asked you before we started.

[indiscernible].

I would have butchered it. And Jeff is VP and GM of Lennox Commercial HVAC. So Alok.

I'm going to start with something kind of high level, and then we'll dig into the nitty great staff. So you've been CEO for 4 years now, which is really hard to believe, like times live. What are you most proud of in your time as Lex CEO? And where do you see the most opportunity for further improvement in your next 4 years?

Sure. At West in it's always a good time to reflect that. but you come to an anniversary. And also in your stock price, they are unforeseen decline -- so in that resonate things are most proud of, and we'll start with that. Like the first is our growth journey. I looked at it compared to 4 years ago. We have still grown like 30% 4 years despite some divestitures in Europe, some acquisitions. And almost all the growth is driven by building commercials solution for us. We have obviously faced a really tough residential market, but to be able to build. And that growth is driven by we have gate share in 5 of our 6 business units. One place that in residential, we have gain share in replacement and lost a new construction, kind of a mix. That's the 1 thing we're really proud of this growth and the momentum that's still get. Second is margin ask AI to do this for me and that had a Panaseer. -- due to 2022 versus Q2 26, we are up about 500 basis points in margins. as we talk about margin improvement and our entitlement to get both manufacturers margin and distribution model sorry progress we that beat our Investor Day target -- we obviously came up with a new set of targets. So very proud about the growth journey and the margin journey? What's most proud moment for me is the momentum that's behind all the future improvements that through. The investments we have made, whether it's emergency supplement commercial, distribution improvements in residential, we're relooking at our product portfolio with greater emphasis on heat pounds, parts the JVs we have done with Samsung and Ariston, We believe all of those momentum going to carry us forward for the next 4 years. We are early only innings almost all of those with the mission is to get some meaningful changes. It's a super exciting time. I think I'm more excited about the next 4 years because of the potential we have and given where we are, it's on the trough of the market, versus what was done in years ago.

Yes, that's a good one. Okay, got it. That was a great answer. So we got to talk about 2Q. It was tough. What surprised you the most? And how much conviction do you have in the new guidance range that you guys have set now? Let's start there?

Yes. Listen, it was tough. We obviously terrible about missing our consensus and guidance and lowering guidance is not something any company should take lightly within that but when you lower guidance, you only want to do it once. You never want to do it for a table time Yes, we put forward a fair guidance. We went with the real rates that we normally do. At this point, we would have gone with a 50 era, but we kept a $1 range because there's still uncertainty in the market. Changes in oil price, the inflation, tumor sentiment, repair versus replay panomics -- they're just a bunch of uncertainty. So we kept the dollar range to make sure that we don't fall out of the range. We have good conviction in the range can from that perspective. What we learned out of the whole Q2 big was, a, sometimes we are too transparent. I mean, I went back and looked at the feedback of around share and then we went back and what other companies said about their residential growth in Q2 last year. So what happens is when you're a sell-through business, you appear to be using share when restocking is going on, and you gain share with destocking is mine. So last year, almost all our larger corporation does not give the equal for us to look at. So last year, Q2, we had analyzed the number same way, it would look like we are gaining share. This year, it does look like we'll take share. In addition to the residential new home construction business that we walked away from. So I think we could have done a better job explaining that. we should have seen that coming, and we did not. From a market perspective, as we said in Q2, the overall reason for where we are is the residential recovery in HVAC is delayed. We said it's going to be the second half when we announced full year guidance in January and now we are saying it's going to be some time 2027 that's kind of the fundamental. Everything else is got bit picking and what we could have done. But from the outside human perspective and just changes, any big recovery in residential beyond inventory movements in stocking destocking it's likely to be 2027.

Okay. Okay. Understood. Yes, absolutely Okay. can we try to project a little bit more? And maybe we can turn our bodies this way Okay. Okay. So I mean that was an important point, a look that you made around the replacement volumes versus peers, I think there is a lot of perception among investors that you guys have lost share -- how do you get comfortable that it is just an inventory issue? Can you see data on sellout that compares more favorably to what fares are seeing? .

Yes, we do. Remember, AHRI data are well published. -- hard data sketchy, not so great. So yes, we analyze market share by Zip Co to dance, right? In those are getting even more competition. So we can see people prepared to the HI data. we would have gained share last quarter we lost this year, but it's essentially the same. I'll give you a bigger answer. So we went back and looked at share data for the past 12 years because we can do that too on the deal. Our share at the end of Q2 2020 is about the same as our share 4 years ago when it started going back to the 4-year ago analyst. This is despite the residential new construction business that we walked away from, which clearly show that we are gaining share in replacement just not enough to fully offset the residential new home construction loss, then we walked away because of lower pricing and margins. Yes, we look at share against competition, high zipcode by region by product category, and we can clearly see that trend that our share is good. We've lost a bit of new construction, gained a bit in replacement. And net-net, we are doing okay. good conviction.

Okay. Very clear. And I guess on the topic of that new construction share loss, which was -- you guys decided to do that, right? You want by yourselves. Is it just 1 contract? Is it a handful of contracts? And is this something that's going to remain a headwind to your volumes for several quarters? Or was it just a 1-quarter thing?

No, it's going to remain a headwind until probably 1 more quarter most of those bids come out in about Q3. There were 2 bids, both large new homebuilders. We walked away at a price was reasonable given our focus on profitable growth. Our competition went lower than that, which, at least in the earnings, you could hear that talk about negative impact on mix as the margins took a big dip on it. So you could see that in both manufacturing competition and the distribution competition. So you could see that -- it's not permanent. There are 2 more bids going on right now. We have large new builders. The only loyalty is it to low price and low cost. So those 2 is in the market, and we have another decision to make. Honestly, we don't like chasing that business. We have a strong value proposition. We provide good value to our contractors. -- on construction is a weight to fill of acids. And if we choose to do that, we will let you guys know. But our perspective, it was the right decision. I would rather work on factory efficiency and build our recurring revenue base through our most profitable and the most line contractor.

Makes sense. Are these like 1-year contracts that come off renewal every year? Or do they last a long time?

Maximum 2 years. But again, there is no guarantee it means anything before take you all an RFP anytime. But right now, there are 2 big RFPs going on. Last year, they were too big on -- last year, the depending side this year, we are on the open side.

Got it. Maybe let's move on to inventory. How would you characterize channel inventory study? Like I know most of what you do is through your own distribution. But I guess, if you're seeing anything out there from an inventory perspective with competition? And then in your own factories, how do you feel about inventory is still looks a bit elevated to me. Is that something that you're planning to work on through the rest of the year?

Be elevated, and that's because our Q2 sales was little softer than what we thought. But our inventory reduction is going as per plan, maybe lead better than planned. As you saw when we reduced guidance, we kept our cash flow guiding percent. That is why we are offsetting some of the lower earnings with higher cash from inventory liquidation. So our inventory position, we feel good about fill very well, which is almost more important for inventory. From a channel inventory perspective, I think clearly, destocking is behind us. We've started restocking in Q2, which gives you an artificial weird comparison. But we think channel inventory is a pretty heavy level. I won't say we are overstocked or under stock at this point. So we didn't we shouldn't expect come from restocking to continue or should we expect another destocking. I just hope we stopped talking about this by next year. So we just talk about sell-through and consumer and how we win share the good old fashion way.

That would be nice. Any comments on how July shaped up or August as we're getting through the hottest part of the summer selling season? It feels like what has gotten a lot hotter, cooling degree days are up ad for the business?

It's always -- when you do summer, it always seems it's too hard. But the middle of winter, it always seems it's to coal. I'll I tell you, we were 2 weeks into July when we put in our forecast forward on the consensus. -- we sort of took all that into account when we gave our guidance. So no further update. -- perspective, whether it does make a difference, we should acknowledge that we watch out for other things, mortgage rates, consumer confidence, interest rates new home construction, existing home sales. And I can tell you, none of those are flashing green. So while weather makes a difference, the repair versus we're going to continue shaping the rest of the year.

Okay. That's a nice segue. That was the next question on my list is what you're seeing with respect to repair versus replacement? And I guess, like repair doesn't defer replacement forever, right? It's kind of a Band-Aid. Does that mean that if we're seeing a lot of shift to repair today and tell me if still are, that 2, 3 years from now, there should be a surge in replacement demand from all these repaired units.

No, you're absolutely right. So we are seeing more repair work as we place them. In our view, with Big about 2 years, if you change a motor, if you fix a car and you change the compressor, maybe 3, but this is just deferred replacement because these units are fundamentally at a stage where something else will bring. 3 or 4 major components in a unit, and they all fail about the 10- to 15-year mark. And so that perspective to us, that just before replacement. And yes, it will come back. That has happened before. The parliament of the residential offer has not changed. There's extraordinary focus in the short term. And I know that's the upside downside of being a public company and where we are at different cycles the fundamental to residential industry remains a very attractive industry, 80% replacement. Replacement cycles are continuing to getting shorter, energy efficiency, drugoplacement at both commercial and some of the other applications. So yes, we remain very bullish on the state of the long-term prospect for as an intern industrial.

Not any. Assessment on reactivation points of the rooms on a basis in addition possible intermittent or maybe an achievement of a line artesian. .

We do will be a moderate price elasticity -- now 2 things. First of all, a switch from ducted to Douglas Norton is extremely rare. That doesn't happen and some people might use it for the kids dorms or retrofits and how that did not have air conditioning. But the cost of doing a ducted to ductless is just extremely rare and not feasible to put that sign -- you could go to more of a 5 discharge like one, you could go to more type units, those are cleaning down that we see. We will succeed in the repair versus deal from that perspective. What we have for the following: manufacturer price since COVID has gone up about 40%. The price of the consumer has gone up more than 100%, right? So if you think of that and -- as there is winter price elasticity, more and more consumers are getting 2 to 3 codes. After COVID you've got 1 card, somebody showed up and you were thrilled that somebody is coming to repay -- now people get it to INR 4 crores, and there is price compression between the contractor and the homeowner. The homeowners are very much smarter about it. They are shopping for and we're kind of trying to figure out what the private equity on contractor and what's kind of for it, typical residential home. We do see a lot more price contraction of price in that segment. And I think that will continue happening for the next few years, and we will see that dynamic happen. But the -- where you see the bismuth player versus replace or downgrade, unlikely to see substitution that moving to you. those are just charter fixes or more fixed.

Affordability has become a pretty well telegraphed issue here. Does that change at all the way Lennox thinks about approaching price over like a multiyear period versus, obviously, a lot of price has been taken because of inflation and refrigerant standard changes and all these things that have materialized in the post-quota era.

We do. So I think there are multiple things we are doing right now, right? First of all, we are making more units that are affordable. So in terms of less thousand or temper replacements. So there's a lot more demand for those that we are making those and making them very effectively so that's one. Second, we're running a lot more consumer promotions. So we should have given discounts to the contractor, we are ending consumer promotions. That could be a $2,000 Costco rebate for a partner in many cases or just efficiency rebates part to the whole order and we're trying to mitigate it that way. Third, we are -- and we have launched exact side discharge units which are more the box units, more affordable units. We obviously have a sense partnership to go to the mini split times. The site discharge units are very -- another very affordable options, especially if you're working in California with you don't discharge losses lines and things like that. So yes, we're continuously switching our portfolio to make sure we can provide consumers with an affordable option. And finally, we help with financial. So we have our own financing partners -- we will do financing promotions, 0% for 36 months, 0% for 48 months and/or help our dealers work with the finance to do that. So all of us have to be aware of where the economy is, where the consumer is and help on. And we see good traction with them. I think our contractors appreciate that. And at the end of the day, we know the new unit is a better financial decision for the achieve. If your current unit is more than 10 years old. -- comp warranty, efficiency, you where you want to 2,000 gain and certainly make sure that we get the message and put money where our mouth is by putting the warranty financing behind it.

Okay. Makes sense. We're all kind of waiting for recovery and demand to happen. What are you looking for look? Like what do you think would be the biggest helpful driver to actually cause a recovery? Is it rates? Is it existing home sales, like...

I think I'll start with consumer confidence. And if you go back to the eye Michigan confidence, it goes through a lot of it then that it's bouncing along the bottom. I would hope for a meaningful recovery there. That has all building products company, not just us or they're strong in your words. I think that's first about. Yes, we got obviously more existing home sales. So that's a catalyst for people to look at the HVAC system or innovation. Of course, we'd like to see more new home sales, that's often cascaded into existing home sales as we provide interest rates, both mortgage rates and truly borrowing rates for people who are doing more equity lower an -- and those are things we are watching out for. I tell you the oil price or inflation going up doesn't happen, we almost see a fairly bright correlation with consumer confidence and their willingness to change an ATC system and how stretched they are.

Sure. Okay. Makes sense. Just want to talk about key pumps a little bit. I think at the last Investor Day, you guys targeted 30% of sales from heat pumps over the long term. How has the customer response to the new heat pump offering been so far? Like maybe because demand isn't great. It's not the best time to ask this question, but any signs of like share wins yet?

Yes. As we talked about, we are winning share in the replacement market. A lot of that is coming from locks. So heat bonds. Let me first touch on the mini splits, which also heat PoPs in a way that answer piece. We launched it at a terrible time. When we launched it at when the market was crashing. So -- they get a tough time to launch, but now expect a momentum and it's doing well. What also is helping us with a lot of new products that we have launched. For example, we do bumps in the unit that worked in Florida because the units were too big. They were designed for Midwest. They won't fit in a carbonate in a condo in Florida. We launched that, whether it's called R2-D2. -- utmost for sapping, right? So it kind of fits in the closet. Those have certainly started making a big difference as our contractors have embraced that and goes through 1 of that. We have also now a whole full series of heat part different range here, so we can offered the entire spectrum. -- lye only had the really low end and the really high end, many other units in between. So good uptick good momentum, but you're right. When the market is down, everything filter -- so it's hard to kind of show the saving of underlying momentum when your headline numbers are down.

Yes. Okay. Understood. Good to hear that you're seeing some kind of momentum though, that's really good in this market. There's the other long-term growth drivers as well. Parts attachment, you touched on Douglas a little bit and water heaters. Can you just give us an update on how that's going so far?

Very exciting. In hindsight, I would plan the Teradyne Sabco acquisition was just brilliance because we bought it right before the repair versus replace they come down. but the seller private equity keeps. I don't know how you timed it so was because not nest wanted to go into parts and we bought at a good multiple at good time. That's doing very well for us as we went from more repairs getting more parts. So they're working through that. That's also helping us build our own internal momentum on how do you do more products. At the end of the day, our parts attachment rate is at about 15% -- it should be 30%. With the acquisition, we added a couple of points to that already. And next year, we'll be launching official what we call like parts distribution strategy because you realize finished good distribution and parts distribution of very different games. So next year, right about March, April time frame, we'll be launching completely revamped our distribution, which will have options for contractors, which would be -- got new options for our home outstore, direct ship overnight with our goal is -- you already buy a corporate from us to make it much, much easier for you to buy parts by giving you the right part at the right price at the right place. Next year, we'll kind of have a big launch on that and truly pick up more momentum but we remain very confident.

Okay. Does that launch for next year give you the ability to get to 30% parts attachment -- or do you have to do more inorganically or organically to get to that 30% attached met?

It's done with inorganic on this, right -- we had enough momentum -- so that will -- at the end, it's -- do we need more sourcing or as, of course, we can do that. I think very good shape with that. And that gives us what we need. And this is not a big CapEx. You won't even see it because these suites title that more internally part of our overall, which we're going to be a better distributor. We have addressed the equipment side with the Thales FTC, and so what we saw in the Investor Day, this will be addressing it through more of a parts distribution side. just getting more specialized in panel Ted, we are competing with companies like Johnstone Supply. We're not competing with train and caring. -- onsale supply Ranger and Forbes and Patton we got to build capabilities that are very thin than an OEM manufacturer.

Okay.

We talk about why you own have good positive take. -- that launch than expected. But that's a rare thing to say, especially when the markets are down, right? So that went very well. We are pleased with the momentum. We think this convergence is real. So convergence between plumbing and HVAC has put it on or together, so that will be very good. I just want to be clear, we're not going after make try to become #1. Our goal is to serve our channels better, but we have no desire or ability to become #1 in so I get a lot of it from my friends at ease to get another place I want to make back clearly. We're not going after us. I just want to show about channel better.

Okay, on record. Just wanting to move on to profitability within HCS. So -- your -- you said many times, below hat you think your margin entitlement is you put together the OE margin and the distribution margins since you guys are effectively doing both. What are the key factors that can unlock this over time?

A year ago, we had outlined the strategic factors remain the same. I mean the #1 us comes down to better distribution efficiency. You remember, 30% to 40% of our page was being wasted because we're moving things between our warehouses. So I think we're addressing that early innings with the Dallas at PCs have been us with that, right? Second is more dynamic pricing. We have done a lot of key account price in growth for -- now we are really investing in dynamic pricing all throughout our network system won't be live until mid next year, that kind of we are working through. So that's the second piece on unlocking that. Third is just more output from our stores to take parts, you take Samsung, you take Arista, put that through our 250 stores. Our stores start gaining more efficiency without having to add more square for us. The right now, a majority of our stores are very inefficient. So if you think about just distribution, logistics, dynamic pricing and getting more through our current stores, all those 3 lead us to the value on getting back to manufacturers, first distribution. And this in with our long-term targets, but we remain very confident in the long-term target. What you're seeing now is highly unprecedented changes we get tariff changes on Friday and we got to start paying on bundling. We get supply chain shocks about certain companies in China being part from sending products to U.S. and we get 1 day notice story after that. We see inflation on materials because of secondary impact of tariffs and other things that we hardly get any time to be active and then, of course, the absorption impact on our packs. So we understand the pressures this year. We are fighting hard, but it is -- in fact, it might be the worst and COVID in terms of the supply chain and the inflation in at except this time, there's a way to pay for it and make it less than. But we remain very confident in our long-term trajectory. We just have to fight through the current environment where everything is going up and down every -- I just wish there be 1 set of things published on Taro 1 set of trade restrictions, 1 set of NAFTA or USMCA agreement and just be done with it. So we can run the business as we can. That's probably causing the biggest and changes in our profitability labor.

Understood. Is there anything specific on supply chain that you guys are seeing? That's a challenge? Or is it just kind of like whack-a-mole like things kind of showing up in typical places on different days?