An endless source of fascination for investors the last year. You know, where do we stand on that today, both at Lennox's own channel partners, let's say Lennox itself, and maybe the broader industry?
Yeah, it's been a really popular question that we received over the past month, or even over the past six months. Just to give a little background, on a residential business or the Home Comfort Solutions segment, we have about 25% of that business that goes into distribution and then on to the end contractor. So we have a little bit of insight into the destocking. And what I'll add is that in 2023, we saw some significant destocking through this side of the business. Our volumes were down about 20%, in line with AHRI reported shipments. So we kind of held our own from a share perspective in 2023.
If we turn the page and look to 2024, a couple of points I want to make is that first, we still see a little bit of destocking occurring in Q1, although we think it's going to come to an end at the end of Q1. A couple of things give us that indication why we think it's going to come to an end. First, we have a coils business that sells indoor coils to distributors. That was one of the first areas where we saw destocking occur. We're actually now starting to see some growth through that side of the business. So that's a really positive indicator that we think that the destocking is starting to come to an end. Also, we have an Allied brand, HVAC equipment, that goes into distribution.
We have a little bit of insight into some of our distributors, not the entire population, but we're seeing normalization of some of the inventory levels through that brand as well. And then finally, for distributors to succeed throughout the summer season, they're going to have to get back and buy some normal demand. You just can't get through the summer selling seasons without getting demand. So we think it's going to wrap up here in Q1. For the full year through distribution, we think the volumes are going to be up mid-single digits. On the other side of our business, which is about 75% that goes direct to contractors, in 2023, what we saw there is not as clear as an industry indicator as we can see on the sell-in, but we saw that the unit shipments on the sell-through were down mid-single digits.
We performed a little bit better. We were about flat. So we won some share, executed very well in the regulatory minimum efficiency standard chains. We performed well there. We looked at 2024 on this sell-through. We think that volumes there are going to do a little bit better. It will be down low single digits compared to down kind of mid-single digits from an industry perspective in 2023. But we'll know a lot more as we get through Q1 to see how the summer selling seasons perform.
That's helpful. Thank you. Just if you think about sort of the it's always a seasonal business, HVAC, as you mentioned, with kind of early summer selling season starting in a couple of months. I think you've said before that sort of Q1' s about 20% of the year's revenue this year. So just with sort of operating leverage and so on, is the earnings Q1 sort of mid-teens share of the year, or?
Yeah, so I'll just expand on that. So as we look to our seasonal revenue curve throughout the year, it's correct. We kind of expect it to be a bit of a normal season, where you'll see about 20% of the revenue in Q1, 20% in Q4, give about 30% in Q2 and 30% in Q3. We think that's kind of a normal seasonality within our business, maybe a little bit of pre-buy at the end of the year, depending on this R-410A transition in Q4. But assuming 20% of revenue in Q1, and we've got full-year operating margins of kind of 40-50 basis points, we see our margins expanding, slightly expanding in Q1. A couple of points that we see within that, though, is talked a little bit about residential volumes. We think they're going to be down because of the destocking.
The sell-through might be kind of flat to low single digits. A little bit of headwind there. But from a tailwind perspective, year-over-year, we're going to get the benefit of all of the transition to the minimum efficiency product. We were about 50% transition through Q1 last year to that product. Now we're going to be 100% Q1 this year. Our commercial volumes, we still had supply issues in Q1 last year. We think volumes are going to be up in Q1 this year as the factory that we've had some supply challenges continue to heal. So we kind of look at all of those two things together. We're going to be making some investments as well to get our new factory ramped up. We still see some margin expansion in Q1, although it's going to be slight.
Perfect. And if we think about kind of the margin expansion for the full year, maybe expand a little bit on that. You've got some volume leverage on the distributor part of the business growing, the commercial business growing. So maybe flesh out some of the other aspects, price, cost, the new plant in Mexico. How do all those play into that 40-50 bips?
So first off, in 2023, we had really good margin expansion. We expanded our margins 300 basis points. A lot of that was related to pricing recovery that we did within our commercial business. Really good performance here. We actually even saw our margin expand on the residential or Home Comfort solutions segment, which is a pretty good improvement, especially when I talked about those end markets being down in 2023. So 300 basis points improvement in 2023 is really good performance. We think in 2024, it's going to be more of a normal performance, where we target, again, this 40 to kind of 50 basis points of margin expansion. And that's some pretty good expansion, especially when we expect the residential end markets to be flat. As Julian mentioned, we're going to get a little bit of tailwind from the commercial volumes being up, kind of low single digits.
We're going to get a little bit of that mixed benefit, predominantly Q1, as we transition all to the new minimums here. And then from a price-cost perspective, we are still seeing inflation. Our component costs are going up. We're seeing the cost of R-410A refrigerant going up. So we're focused on pricing to maintain our gross margins of at least 30%. Those are some of the tailwinds. From a headwind perspective, we're going to be ramping up this second factory. We've got about a $10 million headwind there to ramp up this new factory for commercial. A little bit of inefficiency as well as we transition our residential factories over to the new low GWP refrigerant products. So some headwind there. Then outside of that, it's just going to be some normal SG&A inflation as well as investments.
So we're making a lot of investments in Salesforce, customer experience, information technology. I know Prakash will probably talk a lot about some of the information technology investments we're making. We're making investments in distribution as well. But right now, it feels good, kind of 40-50 basis point margin expansion with the variables that we can control.
On that commercial HVAC piece, I think some of the peers have been a bit more cautious there because of the tough comps from 2023, maybe some softness in pockets of the end market. You're guiding for growth, as you said. Maybe help us understand the drivers of that in commercial?
Sure. Yeah, so we don't publish our backlog, but we have a backlog that normally looks within a quarter, maybe a little bit out a quarter. I know some of our competition has applied product where they can kind of see a full year. So we have a little bit of visibility into the year already. What I'll say is that when we exited 2023, we had a strong backlog. The backlog was up, and that's even up with lead times going down. So demand still remains solid within the verticals that we participate in. Especially when you look at our national account customers, think of kind of big box retail customers. We do a lot of service work for those national account customers. And the age of the equipment continues to age, and there's a multi-year refresh that's going to occur.
So we have regular discussions with them that may not be in the backlog, but what we call pipeline, that they expect to do capital expenditures throughout this year and even into the next several years to refresh the rooftops that are on the roof. Talked a little bit about maybe some air pocket at the end of the year as we start to transition our commercial product into the new low GWP products. Maybe there'll be some projects at the end of the year where they delay, and they're like, "All right, well, I could just wait a few more months to get the new low GWP products." That's mostly going to be a Q4 dynamic. Don't have clear insight into it yet, but generally, all the verticals we play in, which are pretty much big box retail, quick serve restaurants, schools, are performing well.
Got it. I think there's been some knowledge from different parts of the consumer world about maybe consumers trying to push back on price increases. How do you feel about the pricing environment, elasticity of demand, kind of the appetite of consumers and customers that view to get that price mix tailwinds?
Yeah, definitely concerned about it, but I'm also just as concerned about inflation. We're still seeing inflation come into our business, so I need to protect our margins. So we're pricing to protect our gross margins right now. That's our focus we're doing. Talked about inflation coming through components in our R-410A, and I think competition's going to have similar cost pressures. But if you even look to the whole value chain within HVAC, there's an OEM margin, there's a distributor margin, there's a contractor margin. There's a lot of contraction that could happen within the margins, but right now, we're focused on executing our pricing that are controllable. On our Home Comfort Solutions, we've had several large national account customers that have had long-term pricing contracts. So that's a controllable price that we're resetting some of that pricing on.
We've announced price increases up to 10% on the residential side starting in February. We've just started to see that come in, and so far, that price has been coming in good. But again, summer season's coming. And then finally, at the end of the year, we're going to be launching the new low GWP product, which is going to have another 10% price increase on top of it, significant investments we've had to make for that product, significant cost increases. So we still see that coming kind of at the end of the year as well as we launch these new products.
On the refrigerant point, I guess a couple of things. One, perhaps, Prakash, around R-32 versus R-454B. How do you see kind of the merits of that? Some of the OEMs taking a different path on that front. And also, I suppose, the rules themselves, to a degree, still some question marks from the EPA. When do you think we get sort of a resolution of some of those lingering question marks?
Yeah, first on the R-32 versus R-454B. Both are equally good refrigerants from a performance perspective to replace R-410A. We've studied both exhaustively. We've done a lot of system validation testing. In the final analysis, we chose R-454B for two reasons. One, it is much more reliable from an overall system reliability perspective. We've seen some oil return issues under certain running conditions with R-32. Also, given the without getting too technical, all the flow rate differences between the two refrigerant systems, you'd have to force the consumers and dealers to replace line sets in the install base, which is a huge cost. So that's why we chose R-454B. We're largely done with our product development and now going through the phase in, phase out. So we're very comfortable with our choice.
It's no accident that the other major players, us and Trane and Carrier and JCI, they all landed on R-454B. So we're very comfortable with our choice, and that's the right refrigerant for the next 10 years or so.
And then, do you want to go on the EPA?
Oh, yeah. In the EPA, there is some clarity. They've given the clarity so that we can sell through the industry. We can sell through the R-410A units still before the end of this year through end of next year, end of 2025. There's still some clarification we're awaiting. Right now, it says you can still do component replacement, not the system replacement, like just the condenser only R-410A beyond 2025. We're hoping to get some more clarity around that. Michael, anything on that?
No, that's exactly what I was going to say. And I think on this point of sort of technology upgrades and new standards, I think in the past, there have been some concern among investors. Did Lennox underinvest and was out to sort of do catch-up spending? How do you see that as CTO and also sort of on the capital side, aside from pure technology? Where do we stand on that?
Probably a fair criticism on the manufacturing capacity. We probably underinvested. We could argue we should have built the second factory for commercial much sooner, hindsight 2020. Now, the good news is the factory is going to come online in the next few months, and we'll have full capacity to serve the, especially the emergency replacement market that we had to walk away from a couple of years ago. On the technology side, I've been with the company almost 16 years. I can tell you categorically, every year, we invested more than the previous year in information technology and product technology, regardless of the end markets. End markets are up, down, COVID, this and that. We did not cut our innovation and technology investments. So that's why we have a product portfolio that has the best efficiency, won a lot of accolades, nailed design awards, and things like that.
So, no, there's no truth to cutting investments in the product or technology, information technology, because we are not only an OEM. We also distribute our products. We're distributing. So, we've done a ton of investment into e-commerce platforms and warehouse management, transportation management systems to optimize and have the right product at the right location all the time. So, no, we've invested significantly to stay ahead of the pack in terms of product technology for distribution systems, manufacturing systems, I would say.
Perfect.
Michael, anything?
Yeah, I'll just add. You can see that within our CapEx figures, so in 2023, we had $250 million of CapEx. Our normal CapEx was about $100 million. We're going to be a little bit higher in CapEx in 2024, but thereafter, we should get back to our kind of normal CapEx of kind of around $100 million because we can do some of these catch-up investments, predominantly around manufacturing, as Prakash mentioned.
Great. And then one technology or product category that people have talked about a lot for a year plus is heat pumps. Lennox, back in the day, was maybe a little bit behind there versus its furnace expertise and market share. So how satisfied are you with Lennox's heat pump position today?
Great question. Again, I'll try to set the record straight here. Lennox, one of the first if not the first OEMs launched heat pump technology back in the 1960s, long before I got to Lennox. The reason Lennox had less market share penetration in the heat pump, not because we didn't have the best heat pumps. I would say because of where we were strong in the Northeast markets before the sort of advent of the Cold Climate Heat Pump technology. Heat pumps weren't doing so well in the cold climate. So traditionally, we had the best furnace technology, and we participated in those markets, and we had a very good share. Now, as you know, we won the DOE Cold Climate Challenge before everybody else. We competed with nine other OEMs, and we had the technology.
We proved to DOE we can do the Cold Climate Heat Pump technology a couple of years ago. I'm very comfortable with where we are in terms of technology, whether compression technology, variable speed drive technology, and fan, motor technology, all the key things, heat exchanger technology. We've got very unique solutions that enabled us to get to the heat pump technology challenge. We partner with the best compressor technologies. We have our own in-house variable speed drive technology now where, with the software, we can modulate outdoor and indoor fan and compressor in a way, and it can do a whole bunch of intelligent algorithms. So we made the strategic choice 10, 15 years ago to own our control system controls. Now, we are seeing the fruits of that labor, and I'm very comfortable.
You will see later on this year with the new R-454B refrigerant cold climate heat pumps being commercialized, and they'll be the best in the industry.
Great. And just wanted sort of perspectives on the growth of heat pumps versus the broader market in the U.S. kind of expectations on that. And also sort of similar question for VRF, which got a lot of attention 10-12 years ago. How do you see the growth rate of that and Lennox's kind of satisfaction with its technology at VRF?
First, the growth rates on VRF, yes. When sort of VRF gained momentum and everybody started talking about it 10 years ago, the CAGRs were 15%-20% at a growth rate. It hasn't materialized. I think now we are at a much lower clip, and I think it's still growing faster than, I would say, ducted systems, but off of a small base, right, mini splits in VRFs. So we see that. We participate in that market. And in terms of technology, again, whether it's Mitsubishi or Samsung or a whole bunch of players, and we work with Midea as a strategic partner. We chose for many reasons. And 2015 is when we started. 2016, I remember the first trip taken to Midea, working with them. The product portfolio is significantly different now compared to what they had, what we started with.
Over the last seven-eight years, we brought up that product technology, controlling feature functionality, integration with various other systems. I think there's not a whole lot of differentiation between any products if you think about it. They all use variable speed compression. They all use sort of they all, in efficiency points, are very similar. So again, not a whole lot to brag about one system versus another.
I'll just add the IRA incentives are focused on electrification, so that's going to also help drive that side a little faster than traditional HVAC equipment.
Just a follow-up from that, I suppose, when there were disappointments around the VRF growth rate the last decade, how do you see kind of heat pump that growth rate playing out versus the market?
I think it has some advantages with some of the heating and cooling and the flexibility it offers. Overall, the pump category is going to grow, ducted or ductless, period, right? Will the mini split VRF, mini VRF growth rate be higher than ducted heating? Probably, again, off of a small base, right? So I think we'll participate in both, and however it comes, we'll take the market share. By the way, 2023, our heat pump growth rate is phenomenal. We've done really well with heat pumps. We launched some products, SL25, the highest efficient heat pump. That's doing really well in the marketplace.
Great. And then, Michael, you mentioned stimulus briefly. I guess two different questions on stimulus. I think one would be the specific sort of ESSER stimulus on education did seem to have a big impact driving K through 12 HVAC investment. Sort of, where are we on the budget that's left? And is there a risk that as that comes off, the sort of education revenue for Lennox and its peers goes down in a year or two?
I mean, it's hard to quantify truly the benefit. We think there was a benefit that we received. We predominantly play in kind of the Midwest schools that aren't applied systems. So kind of think of HVAC rooftop systems that we play in. Kind of the Northeast and East has more applied products. It's a Central United States product that we work with, Texas and other school districts. But it's about 5%-10% of our Building Climate Solutions segment. It's a good piece of the business, but we think there's regular demand and growth within that area, even outside of this stimulus that's coming through. But if you get the orders in, my understanding, through the end of this year, you can continue to ship them through 2025. So still should have a couple more years of tailwind there from any benefit we are seeing.
Great. And on kind of broader stimulus, IRA in particular, there's some talk among investors of, "Oh, if there's a change in administration, what does that mean for parts of the Inflation Reduction Act and implications for HVAC demand?" Have you seen much broad stimulus effect at all on HVAC demand, though, or?
Not through the IRA. There is a lot of local incentives out there through states or utilities. So you definitely see that side of the tax incentives that are still out there. But from the IRA, it still hasn't been. It's stood up in any states yet. We think there's only a few that are starting to get the administrative side of it done. We may see some benefit later in 2024. But if you look at our industry, most people don't go out and kind of shop for preventative HVAC equipment on the weekend.
Normally, they kind of wait for it to break, and then they go through, and then they figure out, "What are my options?" So I don't think it was ever going to create a lot of demand, but it definitely helps improve our mix as generally to get the higher rebate fee to have a higher efficient system. So we think it's beneficial for the homeowner and us. Hopefully, the stimulus stays, and we see some benefits later this year.
Great. And on the, you mentioned briefly the distributor model, the margins captured by that part of the value chain, the OEM part of the value chain. Lennox has talked about, "Well, why can't we get kind of both?" So sort of when do you think Lennox may get to that point? How long will it take? And any sort of examples of, I don't know, other companies, other industries where you've seen that approach succeed?
Yeah. I mean, it's a simple construct. I mean, if you think about it, there's an OEM margin, a distributor margin. If you do both, you should be able to have entitlement to both margins. I think what we'd say is we're really good at the OEM margin, the manufacturing margin. We do have distribution. It's kind of been more of a tool to sell to some of our equipment than be a full-service distributor. So it's a journey. It's an investment that we started to make this year, realigning some internal conflicts with our distribution and sales force that we're trying to overcome. We have some consultants coming in and guiding us on what we need to stock. It's about fulfillment rate. It's about culture. So it's a long journey to be a good distributor. Definitely still focused on the manufacturing side, getting that cost productivity.
It'll be three-four years, we think, before we start to really see some big benefits there. It's a different culture that we have to run through distribution. As I mentioned, it's really about fulfillment and having the right parts at the right spot at the right time. We're focused on it and starting the journey.
Great. And then maybe on the sort of portfolio front, it's public. There's some assets that Johnson Controls may be available. Not exactly clear which assets or when or how big somehow. But anyway, there's some things that may come to market. With that broad sort of canvas in mind, any thoughts around the appeal of U.S. residential HVAC assets and even anything outside the U.S.? What's Lennox's appetite?
So we've always said there could be a lot of value creation. We're number four in the industry. You combine it with the number five, there could be a lot of synergies. We've talked a lot about the regulatory changes. There's a lot of cost for every three-four years to transition through these regulatory changes. A lot of efficiencies and economies of scale that could be gained. So we think there could be a lot of value creation. But Julian, you mentioned we have to understand the perimeter. What exactly is it? Just to learn more about the asset. Does it make sense in the strategy that we've set? Focus North American business with ducted providers. We want to make sure it kind of fits into our overall strategies. We need to learn more there.
To learn more, then it's about the economics, making sure we can do it with a good ROIC. But we're trying to learn more, and we think that there could be some value creation as we go through the evaluation.
Two quick follow-ups on that. One would be what kind of balance sheet leverage would Lennox be willing to go up to in any M&A scenario? Then two, the appetite for any non-US deal?
Yeah. From a leverage perspective, we want to maintain our investment-grade ratings. So that would be three to kind of 3.5x initially, and then we want to deliver pretty quickly, get back down to kind of 2%. So that would be a focus of the economics as we look at this potential transaction. International, I mean, Prakash talked a little bit about there's a blending of the ductless and the ducted product in the United States. So we have to kind of understand, again, the perimeter, what is entailed in the assets that we can serve both sides of the end market from the United States, from both a ducted and a ductless, in the best way we can.
Perfect. Good. Well, I think time-wise, we'll switch now to the audience response survey questions. So if we could bring up the first question, and if people could use those handheld gray boxes or what have you. So the first question, do you currently own Lennox stock? There's, I guess, over market weight or underweight. All right. So fairly balanced, and not at all. Second question is around general bias, positive, negative, or neutral. So not many negatives out there. Third question is around sort of through-cycle earnings growth for Lennox versus, let's say, the multi-industry average. Here would be the peer set, so above, in line, or below. So generally viewed as a high-growth company. Fourth question is around excess cash usage. There's a menu of things there to look at. So a spread. I guess the most popular is buybacks and internal investment, but it's pretty broad.
Fifth question, PE multiple on next 12-month earnings. Actually, yes, should be a market multiple or a premium, I suppose. So generally around the market, actually, despite the high growth perception. And then the last question, number six, what's the reason why you don't own shares or more shares of Lennox? Is it growth margins, capital deployment, or execution and strategy? So the biggest thing is sort of the core growth outlook. And maybe on that point, while we have sort of 30 seconds or so, when we look at Lennox has those updated medium-term goals a few weeks ago. If you're looking at sort of the top-line growth rates, maybe help us understand any composition of that, price, volume, share, and what the classical kind of incremental margin off that revenue in our medium-term plan is.
So once we get through this short-term kind of bumpiness in the end markets, we think the industry is going to grow at the 3%-4% and grow there for about 10 years. We think it's going to get back to that normal growth. So we're going to get some tailwinds. And then we're going to get back to focusing on 50 basis points of market share gain per year. That's really what we're focused on. You see a lot of the investments we're making. Prakash talked about it from market systems. But we're going to be focused on customer experience on the residential side distribution and on the commercial side, getting back in emergency replacement and getting back on the offensive on National Accounts, two things we really haven't been able to do in our supply-constrained environment.
And then the sort of leverage off that would be what, 30% plus?
Yeah, 30% incrementals on those. And then we think it's going to be some mixed tailwinds as well, as the electrification and some of the transition to the new low-GWP product as well. That's going to be a top-line driver. We're going to get back into cost productivity. We're going to get to second factory and commercial. I know Prakash's team's doing a lot of material cost reduction as well, and that's going to be a driver of margin expansion. And we're going to have to reinvest some of that profit growth every year to keep growing our margins.
Fantastic. Well, thanks very much, Michael and Prakash.
You're welcome.
Thank you.