Lennox International Inc. (LII) Earnings Call Transcript

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

Thank you, Cory. Good morning, everyone, and thank you for joining us as we share our 20,263rd quarter results. Joining me today is CEO, Alok Maskara; CFO, Michael Quenzer. Each will share their prepared remarks before we move to the Q&A session. Turning to Slide 2, a reminder that during today's call, we will be making certain forward-looking statements, which are subject to numerous risks and uncertainties as outlined on this page. We may also refer to certain non-GAAP financial measures that management considers relevant indicators of underlying business performance. Please refer to our SEC filings available on our Investor Relations website for additional details, including a reconciliation of GAAP to non-GAAP measures. The earnings release, today's presentation and the webcast archived link for today's call are available on our Investor Relations website at investor.lenox.com. Now please turn to Slide 3 as I turn the call over to our CEO, Alok Maskara.

Thank you, Chelsey. Good morning, everyone, and thank you for joining us today. Let me start with our third quarter results on Slide 3. Third quarter revenue grew 10.2% to $1.6 billion while total segment profit declined approximately 2% to $323 million. Adjusted earnings per share declined 7% to $6.84. Double-digit revenue growth was driven by continued outperformance in Building Climate Solutions, contributions from acquisition and improving residential sales volumes. Profitability, however, fell short of our expectations. In response to the competitive environment, we adopted a more dynamic pricing approach to defend and stabilize our residential market share position. We are encouraged by the early results from these actions, but the trade-off was lower price realization at a time when tariff and inflationary pressures continue to increase. Within Home Comfort Solutions, organic sales improved meaningfully from the second quarter and our share position began to stabilize. At the same time, underlying demand remains constrained by homeowner affordability, elevated mortgage rates and broader consumer uncertainty. Building Climate Solutions delivered another quarter of double-digit growth with revenue up 24%. Margins remained healthy, although higher tariff and inflationary costs were not fully offset by pricing during the quarter. Given our third quarter performance and expectations for the remainder of the year, we are reducing our full year earnings outlook. Our focus now is not only delivering a strong finish to 2026, but also on retooling the business to target consistent growth and revenue, profit and EPS in 2027. Now please turn to Slide 4. We have launched a recovery plan focused on regaining share and restoring margins. While the near-term environment has changed, we remain confident in our long-term strategy. Our recovery plan is centered on 4 actions, and we are moving with urgency on each of them. First, pricing. We are rewiring our pricing approach to be more dynamic in current competitive conditions. This means being more responsive and targeted by region and customer segment, particularly where a competitive price cap affects our ability to win or retain business. The objective is to defend our existing position and recapture share where we have lost it while remaining disciplined about the economics of our business. Second, productivity. We are rightsizing the residential business for current market conditions and accelerating productivity across manufacturing, distribution and SG&A. With the A2 conclusion behind us, we are able to dedicate more resources to productivity, which is expected to play a larger role in restoring margins. Third, portfolio. Affordability has become increasingly important for homeowners and entry tier products have gained more relevance in the market, we are refreshing our entry-tier portfolio with new products, including additional site discharge offerings. More accessible price points will also strengthen our product portfolio for new construction. We are pleased with the heat controller acquisition and early performance is in line with our expectations. Strategically, it has provided new insights and capabilities in the entry tier market and broaden the portfolio available to us. We see additional opportunities across parts and accessories to broaden how we serve our contractors and distributors. Finally, promoters. As evidenced in our Net Promoter Score Insights, we have a strong base of promoters across our traditional residential and commercial contractors as well as our commercial national account. Within residential national accounts, particularly private equity-backed contractor groups and residential new construction, we see an opportunity to deepen relationships and create more promoters. To capture the opportunity, we are updating our value proposition and expanding our capabilities to better meet the evolving needs of these customers. We also continue to strengthen the relationships that has made us successful across our traditional contractors and commercial national accounts. These are actions within our control and execution is already underway. The near-term objective is to stabilize share and improve profitability. Over time, a stronger portfolio, a more advantageous cost structure and deeper customer relationships position us to return to consistent growth and margin comments. With that, I'll turn it over to Michael to walk through the third quarter financial results in more detail.

Thank you, Alok. Good morning, everyone. Please turn to Slide 5. Third quarter revenue increased 10% driven by continued volume growth in commercial equipment and services along with contributions from M&A. Recent acquisitions are performing well, delivering approximately $20 million of operating profit accretion in the quarter. That growth helped offset higher tariffs and other costs. However, competitive pressures, limited price realization and total segment profit declined 2%. Our immediate priority is turning to revenue growth into improved profitability. Alongside the product and pricing actions Alok outlined, we are accelerating cost productivity across manufacturing distribution and SG&A, including restructuring where appropriate. Restructuring actions are already underway with associated charges included in GAAP net income and excluded from adjusted results. Against that backdrop, let's take a closer look at our segment results, starting with Home Comfort Solutions on Slide 6. Home Comfort Solutions revenue increased 3% in the third quarter with organic revenue down 1% compared with the 9% decline in Q2. direct-to-contractor sales declined 6%, improving from a 12% decline in Q2, while 2 step, organic sales increased 13%, benefiting from last year's industry destocking comparison. Sales trends are improving, though we are not yet seeing a broad recovery in underlying demand. Acquisitions contributed $39 million in revenue and $6 million in segment profit, performing in line with expectations. Despite improving sales trends, organic segment profit declined $46 million. Favorable mix and price provided $13 million of benefit. However, tariffs and related inflation net of cost productivity savings drove $47 million in cost headwinds. We expected the price increase we introduced in late Q2 to cover more of the cost headwinds, but homeowner affordability pressures, softer demand and increased competition limited realization. With current competitive conditions, we are placing greater emphasis on cost productivity across manufacturing, distribution and SG&A to support margins in the near term and position us for stronger margin expansion as volumes recover. Let's turn to Slide 7 and review Building Climate Solutions. Building Climate Solutions revenue increased 24% in the third quarter, including 15% organic growth. Acquisitions contributed 9% to revenue growth and approximately $13 million in segment profit. Our investments in factories and sales coverage are improving quoting speed and product availability, helping us win more emergency replacement business. We also continue to grow with national accounts through our full life cycle equipment and service offerings with new heat pump product offerings, further expanding our opportunities. Together, these capabilities position us for continued growth in both channels over the next several years. Higher sales volumes drove organic segment profit growth, but margins declined as pricing did not fully offset higher tariffs and inflation. Price increases take longer to implement under large national account contracts while competitive pressures limited realization with local contractors. We are focused on narrowing the price cost gap through additional productivity, while we expect continued volume growth will provide further margin leverage. Let's now turn to Slide 8 to review cash flow and capital deployment. We generated $395 million of operating cash flow in the third quarter, up $95 million from last year, with trailing 12 months free cash flow conversion reaching 108%. We continued to reduce inventory, with organic inventory units down more than 15% from last year. Inventory dollars were slightly higher as acquisitions added approximately $100 million of inventory and inflation further increased inventory costs. Net debt to adjusted EBITDA increased to approximately 1.4x, reflecting in part the $200 million acquisition of the Comfort Air and Century brands completed in Q3. We also repurchased approximately $151 million of shares during the quarter. Looking ahead, our capital deployment will place greater emphasis on opportunistic share repurchases when our shares trade below our assessment of intrinsic value while maintaining a disciplined net debt to adjusted EBITDA ratio. We continue to expect approximately $225 million in capital expenditures this year to support our entry tier product launch in early 2027, new contractor training facilities innovation labs for data center cooling applications and AI tools to drive growth and productivity. With that, let's turn to Slide 9 and discuss our updated financial guidance. As Alok outlined, we are updating our full year adjusted EPS guidance range to $21 to $21.50. Lower price realization and expected tax rate of 21% compared with 20% in our prior guidance are the primary drivers of the reduction. Sales trends are improving in HDS and growth remained strong in BTS. However, competitive conditions have limited our ability to realize the pricing we expected to offset higher tariffs and inflation. Our updated outlook assumes these pressures continue through the remainder of the year. We now expect revenue growth of approximately 6% compared with 8% previously. This primarily reflects a lower contribution from price and mix, which we now expect to deliver low single-digit growth compared with mid-single-digit growth in our prior guidance. Our overall volume outlook is also modestly lower, although we continue to expect a low single-digit decline. Stronger BCS volumes partially offset lower volume expectations in ACS. At the segment level, we now expect BCS revenue growth of approximately 23%, up from 20% and while HCS revenue is expected to decline approximately 4% compared with our prior expectation for 1% growth. Consistent with the lower net income outlook, or reduced free cash flow guidance to $700 million to $750 million from $750 million to $850 million. We remain focused on reducing inventory and sustaining our progress in cash conversion. Looking ahead, improved residential sales trends and continued growth supported by our commercial investments provide opportunities to build momentum. Entry-level product introductions and cost productivity actions also provide opportunities to improve profitability but relying solely on an end market recovery. With that, I'll turn the call back to Alok.

Thanks, Michael. Before we close, I want to share some early perspective on our 2027 outlook. Please note that we are not providing 2027 guidance today, but we will discuss several assumptions that are shaping our planning. Starting with price and cost, we expect inflationary pressures to continue, particularly from tariffs, components and commodities. As we reset the business, the first half of 2027 will be more challenging as we work through year-over-year are headwinds. Our pricing approach will be responsive to competitive conditions while productivity will play an increasingly important role in balancing the price cost gap. Successful execution of our recovery plan is expected to drive sales, EBIT and EPS growth in 2027 and with momentum building as the year progresses. Importantly, our plan does not depend on a significant market recovery. We are planning around muted industry volumes with resilient replacement demand and continued softness in new construction. Instead, our growth opportunities are largely driven by actions within our control. In HCS, that means recapturing share expanding our entry-tier offering and growing penetration of parts, water heater and [ Dukas. ] In BCS, it means continuing the momentum with national accounts, emergency placement and services. The third tier and the 1 more directly within our control is productivity. We have meaningful opportunities for material cost reductions, manufacturing productivity, and further efficiencies across distribution and logistics. Improved volumes should also provide factory absorption benefits. We will provide our DTA 2027 guidance with our fourth quarter results, but the actions underway are intended to reset the stage for continuous growth and productivity for 2027 and beyond. Let me close on Slide 11. While we are clearly not satisfied with our profitability this quarter, the short-term challenges we are addressing do not change the long-term value proposition of Lennox. We operate in attractive markets with significant replacement demand. We have strong brands, differentiated technology and a direct-to-dealer model that creates close relationship with our customers. Over the last several years, we have also expanded the business through investments in capacity, innovation, acquisitions and joint ventures, thus creating additional avenues for growth. The near-term priority is translating those trends into better financial performance. That means restoring share in residential and improving profitability by closing the gap between price and inflation, while maintaining the momentum we have built in our commercial businesses. We are proud of our talented team and winning culture and grateful for the loyalty of our customers. Our long-term strategy remains intact and we are confident in Lennox's ability to deliver sustainable value, strong margins and high cash conversion. I truly believe that our best days are still ahead. Thank you. Michael and I are happy to take your questions now. Cory, let's go to Q&A.

[Operator Instructions]. We'll take our first question from Jeffrey Hammond with KeyBanc Capital Markets.

I'm really just trying to unpack the level of margin degradation in HCS. I mean I understand kind of the more competitive dynamic and kind of the res new construction walk away. But just help me a little bit better understand what else is going on to drive kind of the margin degradation.

Sure. Jeff, I think it's pretty simple. We were expecting to go out with the price increase that with a higher realization. And as you know, we talked about doing that towards the end of Q2. At the same time, we faced a tariff and other inflation and most of the tariff impact started coming through with the 232 derivative tariffs in Q3. And I just believe there's a short-term mismatch between our pricing realization, which was very low and inflation and tariff that came through. That's kind of the one and only change since we talked last on why the margin at HCS were lower.

And the pricing realization being lower is a function of the competitive dynamic?

It is a function of corporate dynamics. It's also some pricing fatigue. I mean we have done so many price increases with the ever-changing tariff environment. I mean, at this stage, we are planning to go out with a price increase for 2027, which I think works better for our national accounts, better for our contractors and we expect that to offset inflation as we work through the year. We just couldn't stick a midyear price increase.

Okay. That's helpful. And then it looks like your inventories are still kind of stubbornly high. Just wondering where you think you're at in the destock, you need to destock more.

Yes. Actually, our inventory progress we're making some really good progress. The units are down 15%. Some of it is up because of acquisitions. We'll continue to see some decline go into the fourth quarter seasonal decline, but most of the absorption headwind that we've seen is already behind us. As we look into next year, we have some additional productivity initiatives around reducing inventory around raw materials, some of our sourced products, but those won't impact our absorption. So think the inventory will continue to go down support our free cash flow guidance, and we're in a good spot on that.

We'll move next to Ryan Merkel with William Blair.

I wanted to start with the actions to regain share. Can you just talk about where the share loss occurred and if the price adjustments you've made, has that helped you regain share? Or is there a lot more to go?

We don't think that's a good clarification. I mean, we have talked in the past about our share loss in RNG, and we are now in a state where within the next quarter or so, that will be lapping itself and we get back to more of a normalized year-over-year comparison. In addition, when we talk about share, we didn't talk about share loss as much as we talked about defending our share. And we had to essentially go to a much lower price realization in Q3 as we look to defend our share in the remaining portion of the business. So there's no incremental share loss beyond what we talked about, but just to defend our share and not lose any more share, we had to go to the dynamic pricing approach, which meant we couldn't cover the steep tariff impact and inflation in Q3. I just want to clarify, there's no additional share loss that we're talking about. We are clearly gaining share in BCS, gaining share in commercial and the only share loss that's noticeable and evident is the ones we have talked about in the past.

Got it. Okay. And then on the HCS revenue guide for 26, it's going to be down 4% now. Can you give some color on one-step first 2 step there and then is the biggest factor for the negative revision just the increased competitive dynamics? Or is it equally residential new construction is a little bit worse?

No, overall, what we expect is in the 1 step to be down on the full year low double digits 2 steps. We expect to be up kind of low low single digits. This is total organic sales. And it's pretty much in line with our previous guidance with the expectation that maybe a little bit softer on the 1 step as mentioned in the fourth quarter. Most of the revenue decline, though in the guide was related to second half pricing actions.

We will take our next question from Noah Kaye with Oppenheimer.

Maybe talk a little bit about the competitive pressures you're seeing. How much of this is coming from the incumbents versus kind of smaller entrants non-U.S.-based players? And then a lot, what do you think you need to do to the cost structure at this point to kind of put the operating costs on a more equal footing given those competitive pressures?

Sure. So yes, let me first answer the competitive question. The company pressure is just in the industry in general, I mean we are a competitive industry. We have had some new entrants. I think the lower-tier products typically come for more of those new entrants and a comp pressure for the rest of the portfolio is typically from incumbents. But those lines are blending. As we look at lots of people partnering with 1 another, but net-net, it remains competitive, and the lower-tier offering is definitely in response to some of the overseas new competition coming in because we want to make sure we remain competitive in the very long term. So that's where it is. From a cost structure perspective, we are very good with cost structure, as you know. We have done this successfully many times. The large portion of the cost structure, and I would say about half of that is going to come from our distribution network. We've been retooling our distribution network. We added the FTC earlier this year, as you saw. And the second part of that is obviously now retrenching and taking out capacity from the regions, which makes a distribution network overall more efficient, we come up with lower cost when it comes to intra network freight. We've talked about millions of savings opportunity there. We can exit some leases in different locations, including as we retool our stores network and then, of course, there's group for SG&A, and we do start getting the productivity benefit from non-negative absorption. It's sorry, that's double negative, but we do start getting the benefit of absorption back in the picture. So it's a broad-based effort on our part of the cost structure and not including in this the lower cost of new products or the new tier products. I just want to say that is separate because we just look at that as a new offering, realizing that there will be some cannibalization from the current offering. Our aim is to maintain our margin percentage which is lower cost products, which will be lower cost and lower price with similar margin that we're experiencing today.

I guess you did mention in terms of the CapEx guide, some allocation of spending to innovative data center cooling, Again, I know that this is very preliminary, but can you share some color on those efforts and how you see your opportunity why it makes sense to invest at this point?

So the investments are all in our refrigeration business where we do have the core technology to address large-scale cooling requirement, what we are working on is an innovation lab, which has got proof of concept and offering. It's on the two-phase cooling technology, so the technology which is 18 months away perhaps from the current state technology. And we have seen some good early results, good early momentum. But at the same time, that's not baked into any of our plans. We are not going to bake it into our 2027 plan. I mean from our perspective, that's just maintaining the health of the business going forward. And if there's any upside that comes in, in terms of large orders, we'll let you guys know. But at this stage, just the investment to make sure that our technology keeps up to date and showcase our 2 face cooling technology, which we're already very good at.

We'll take our next question from Tommy Moll with Stephens, Inc.

Alok, I want to start on the topic of the entry tier product you expect to launch early next year. This is not the first time it's been mentioned, but it does seem to have a increased level of importance now. And I'm curious if there's something you've observed over the last quarter that's escalated that up the list of priorities for you?

Tom, thanks for the question. No, you are right. This is not the first time we're talking about it. Thomsa, this is not the last time we'll talk about it either. As we look at overall consumer affordability challenges, as we look at overseas competition coming in, we did a full study, which we had started before Q3 on just tearing apart all the products, looking at our product costs versus other product costs, and given that we are direct to business, direct to contractors, we know we have an inherent advantage in the supply chain and how we do this. So we ran some pilots in Florida, where we went after like the whole market, including overseas competition. We launched the site discharge earlier in the year at our trade show. And now we are putting it all together to come back with a whole set of SKUs, including the many splits that we launched last year. And the pilot we did in Florida was around a unitary product, that would go head on with unitary product from anybody, including overseas competition. So those all design efforts are now at a stage where we can talk about that being inherent part of our portfolio with a full launch coming up in Q1 2027. We just think it's helped consumers with the affordability concerns. It helps our loyal contractor fight off any overseas competition, whether it's uniquely or site discharge or mini split and gives us offering to defend our share in other areas, including R&C and [ EOR, ] so we just think it's an ongoing effort that now we have reached a stage in a maturation that we can talk about it publicly and start offering to our customers.

I wanted to ask a follow-up on HCS volumes. Making what I think are some reasonable assumptions about the fourth quarter on price mix and the other line items there, it looks like we have to assume a double-digit decline in those HCS volumes for Q4, which if you look at the compare from last year is rather favorable. So I just want to see if your math is aligned with mine and what would drive the big decline there in Q4.

Yes, Michael will answer that question. I'll just tee it off by saying our focus this year at this stage is to make sure we are set up for success in 2027 and beyond. I mean it's a small quarter, obviously, we've got lots of puts and takes, but we want to make sure that 2027 is set up for full success, and we take all the actions the actions we've outlined on the paid and drive success through that. With that, I'll hand it over to Mike to actually answer your numbers question.

Yes, Tommy, it's a smaller quarter. The quarter is off to a bit of a softer start with warm weather in the Midwest as we're focused on kind of first is in that region. Overall, the guide assumes a mid-single-digit total sales decline for the fourth quarter organically, better obviously on the indirect for some of the comparisons and less on the one step, but -- we feel it's a good guidance and it looks that we're focused on closing out the year strong and moving on to 2027.

And as you do the math, I would suggest you also look at sales per day as a factor versus sale for the full quarter.

We'll take our next question from Nigel Coe with Wolfe Research.

Appreciate all the color guys. This is really helpful. I want to take another crack Mike, at the implied 4Q math since we warmed up on that on the revenues. On the margins, I mean, just doing a similar kind of implied math, it looks like I don't know, ACS margins down in the low double digits sort of I just want to make sure that's correct. And then how do we think about the confidence in margin expansion in 2027, it sounds like first half down, second half up. Any more color around that would be helpful.

I'll take the second part of the question, and then Michael will come back and address the margin thing. I think it's too early to talk about 2027 that level of detail. I mean what we did see and we feel confident about is that 2027 will have higher sales, will have higher EPS and higher EBIT dollars and you need to give us some time, so that when we come back in January, we can break that out. I mean our intent is to go with a price increase that goes into effect like early, early beginning of 2027, and that will reverse a lot of the margin pressures we are having. But let us work through all of the math, and we laid out for you at the beginning of 2027. For Q4 margins, let me hand it back to Michael.

Sure. So implied in our financial guidance for the full year is about 200 basis points of margin decline at the enterprise. We break that down by segment, BTS full year margins, we think, are approximately going to be flat. So we're getting volume leverage with some price cost headwinds going against that. And within ACS in the full year, we expect about 350 basis points of margin contraction, mostly driven by volume declines in the step as well as some price cost headwinds that we've seen during the year.

Okay. No, that's really helpful. And then just coming back to inventories. I think, again, Mike, I think you quantified $100 million of impact. I think that's a year-over-year impact I think when we look at the acquisition you closed in the third quarter, that's maybe, I don't know, 30 or so, is the high inventory balance intentional to kind of get ahead of some of this inflation that's been coming through the pipeline? Or is it just a function of weaker demands or combination of both? I'm just wondering what the policy is in terms of that inventory going forward?

And I mentioned, I think we are making some really good progress on the unit decline, down 50%. We do see $100 million increase from the acquisitions we completed one in the fourth quarter of last year, and then we've also completed one in the third quarter of this year. So that added on top of it. just kind of reiterate, we do see some opportunities still in raw materials and source products are kind of higher than what we would like, and we're going to continue to drive some of that down. That won't have an absorption impact. We think the absorption impact is really negligible in the third quarter. We don't see a lot of that headwind going into the fourth quarter, and it actually should turn into a tailwind as we look to increase production levels in 2027 versus 2026.

And just to specifically answer your hypothesis, no, we are not building up inventory to get ahead of inflation or anything else. Our organic volumes of inventory of Microsite is down 15%. And and we feel comfortable with where our overall finished goods inventory is yet in the spirit of continuous improvement and lean that we live in, we'll keep pushing on that, but there's no big step change coming.

We'll move next to Steve Volkman with Jefferies.

Michael, I think you mentioned some restructuring that was running through the P&L. Any details there on what that might look like in terms of saving benefits.