Our next fireside chat is with Lennox International, Alok Maskara, and Michael Quenzer, CEO and CFO. Guys, great to see you.
Same, yeah. Thanks for having us here.
Yeah, of course. I don't know if you wanted to start with some prepared remarks, if you want to just get right into it. It's totally up to you.
Sure. We have some slides, so if you want to go through some slides, we'll take a few minutes with that and then kick it off to questions. So, welcome. We're great to be here, right, on holiday season where Times Square looks great, Fifth Avenue looks great, and we can get some time to do shopping and holiday gifts. Thanks for hosting. You know, for Lennox, we always start all our presentations and discussion with our core values. And within core values, if you see, we have added what we call guiding behaviors. And what I want to talk about here is, over the past few years, we spent a lot of time reinforcing the guiding behavior of accountability, and that's been behind some of our successes.
Going forward, the two guiding behaviors that we are going to be very intently focused on would be improving our customers' experience and doing more innovative new products. Our financial summary: no new news here. You know, we are proud of being one of the highest ROIC companies in our industry. As you can see, we have significantly increased our margins. About two years ago, it was hovering around 14%. Now we are hovering about 19%. You know, significant improvement in our margins, almost trending to double-digit growth, which remains an aspiration for us, and strong financials. We are in two segments: Home Comfort Solutions and Building Climate Solutions. Both have growth potential, significant growth potential. And as we look at how we get to those growths, it is through some investments. We are making investments in two core organic areas. One is on the residential side.
We are focusing on being a better distributor, improving our profitability in distribution. On the commercial side, or BCS, we are heavily focused on the emergency replacement market segment, where the new factory has come online and is going to make a big difference on our ability to be no longer constrained by supply, and we continue to build a pipeline of bolt-on acquisitions. We did one about a year ago, and we are pleased with the success of that and continue to build the pipeline to do more in the future. Our long-term targets, which, if you remember, we actually released the long-term targets for the first time two years ago, and then, beginning of the year, we had to revise the targets up because of the strong progress, so this is the revised targets. I'll focus you on the middle of the chart: 19%-21% ROS.
like, you know, we are trending very good to achieve those targets. And keep in mind, these are still net of all the investments we talked about: investments in more salespeople, investments in a new factory, investment in more distribution capability. And we remain committed to strong free cash flow and make sure that we convert our earnings into cash without any funny adjustments and things like that. So that was kind of the quick snapshot of where we are, and happy to switch to questions.
Yeah, thanks, Alok. And yeah, we appreciate the non-funny adjustments. And look, you guys talked about the long-term targets. We're already trending towards the bottom end of that range this year. But before we get to that, it really has been a tremendous two and a half years. I want to acknowledge that, since you've been at the helm. As you think about the next, you know, 12 to 18 months, what are you most excited about, as given all the investments that you've been making in the business?
You know, I think our culture is still very much, as you know, ongoing improvement opportunity for us, ongoing reinforcement. We are 130 years old, and once you have been successful for that long, sometimes a bit of complacency sets in, and one of the big focuses to eliminate that complacency and focus more on the future. Our customer experience still lags behind some of our competition, whether that's around distribution fill rate, whether that's around Net Promoter Score, whether that's around market share. You know, we strongly believe that we have structural advantage in our business model by going direct to dealer. You know, that's where 70% of our sales are, and I keep asking the question, why shouldn't our market share be higher? That's the case, right? So I think that's one thing I'm super excited about. Second thing is around innovation.
You know, we lag behind on things like heat pump, which are growing more. And there's a huge opportunity for us, especially post all this A2L conversion and everything else, is to truly take our engineering resources and focus them on innovation versus focusing them on making the regulatory transition seamless for our dealers. So those are two areas I'm super going to be focused on as next couple of years. Let's improve customer experience. Let's have more innovative new products.
That's great. As you think about, you know, you mentioned A2L, and as you think about innovation and ultimately what that means in terms of, like, margin expansion over time, maybe just kind of put that into context. You're already, like, as I mentioned earlier, in both of your segments and at a portfolio level, you're already hitting the bottom end of that long-term 2026 margin framework this year. So how does the new product introduction, how does that all fit into driving higher margins over time for your business?
Sure. The margin target for us is more driven by the fact that we aspire to make manufacturers' margin plus distribution margin. We do do both activities, so why should we be satisfied with just one margin? It really does not depend on the new products, which is more of a share gain. So on our new products, just to kind of double-click on that, we have three focus areas. One is indoor air quality. One is controls, which includes, like, you know, service as part of controls. And the third is heat pumps, which is probably the largest, although I mentioned the third. All three of them are higher margin than our core products. All three of them have higher recurring revenues versus our core portfolio. But our long-term targets are not dependent on that.
There's enough significant improvement opportunities for us based on where we are on our three-phase transformation plan to get to our long-term margin targets. I mean, innovation, as you know, it doesn't happen overnight. It takes a lot of time. It takes us 12 to 18 months to introduce a new product. Then they got to gain traction. So I think that's beyond 2026, any margin expansion from innovation.
Got it. As you think about maybe some of them, you mentioned both manufacturing and distribution and the opportunities. You've been scaling up one of your businesses, in the, you know, building climate solutions segment to get after the emergency replacement market. Maybe just how does 2025 look from an investment standpoint versus actually starting to see, like, some of the benefits of the investments that you've already made, into your segments?
Sure. So in the BCS segment specifically, which is where your question is, I would call 2024 as the year of inefficiencies. We had inefficiencies related to the Saltillo startup. We had inefficiencies based on Stuttgart transformation. We had inefficiencies related to heavily underutilized growth investments that we made. I expect all of them to start flipping in 2025. 2026 full year, you'll start seeing them disappear completely. But in 2025, we start seeing that transition where those inefficiencies gradually go down to zero or even on the positive side. But 2026, all those efficiencies will go away. These three inefficiencies are fairly massive. I mean, the investments we have made have been a record for the company, and we're still at record margins. From that perspective, we feel very good where we are, and we have a very solid plan to eliminate those inefficiencies.
The Saltillo startup inefficiency sort of automatically disappears because now it's up and running. It's in production. The Stuttgart piece also will start disappearing or we can balance production between two sites. We were running Stuttgart a bit too hot, too much overtime, too much scrap, too much this, too much that. And then, as we gain share, our investments that we made in the growth, they start paying off. So we feel good about the margin trajectory there.
That's great to hear, and then, look, this year, there's been a lot of disruption. There's been a lot of weather disruption, really from, like, the August through October timeframe. Did you see any of the benefit this year, or was it in Saltillo for being able to, like, deliver into the emergency replacement market, or was it still fairly minimal because of the ramp-up that you were experiencing?
I would say it didn't move the needle in 2024.
Okay.
We did produce a bunch, but between production and sales, there's still a two months or so gap because we got to make sure these are locally stocked, put it together. So no, it did not move the needle in 2024.
Okay. But what we did do is we had a test market out there in Chicago. We had some early wins on the emergency replacements. We started to build back that capability. We started to deploy that inventory, and we started to see some wins this year. Awesome. Great. Let's transition to A2L. So, look, residential demand appears to be, you know, good GDP-plus growing business. We're seeing much better growth. You saw much better growth in the third quarter. You'll see much better growth in the fourth quarter. Just characterize what you see happening with this transition today and then ultimately how you think this plays out in 2025.
Sure. And Joe, you've been in the industry longer than I have. I sort of find this industry very strange where every year there's a massive disruption. We think it's coming, and it never happens. And the status quo just goes back to status quo. Last time we were here, we were talking about this big SEER transition and all the disruption. It came and went. Nothing happened, right? I think A2L would be something similar. The only thing that matters is companies who execute better seem to gain some share. And we have historically executed better just because we are very focused and because we have a direct relationship with 10,000 dealers. But from an A2L conversion perspective, the big benefit to us as manufacturers is going to be on the pricing side. You know, the costs are higher. The pricing is going to be higher.
Obviously, that may offset any volume pieces. The big benefit to us as a company will be from share gain. You know, we gained share in the SEER transition. We're gaining share now in the A2L. We'll continue doing that. But we are also the smallest of the top four players. So it doesn't change the overall industry dynamics. I think from a long-term perspective, given that there are more safety features built into the product, given that the refrigerant gets harder, it's good for the replacement versus repair dynamics. I mean, these products are more suited for replacement versus repair with the automation and control boards and everything else putting it together. So I look at it as an ongoing positive for the industry.
While we hate regulatory change when it happens, when we look back at it two to three years from now, this would be like the R-22 versus the 410A debate saying, "Hey, it's time to replace R-22 units with 410A," and it gives you another new cycle of replacement that comes through. But we are pleased with how we are performing during this price. We are pleased with how disciplined the industry has been around this. Have some players struggled and some gained? Yeah. We are happy to be on the gaining side.
That's great. Look, I described this earlier. We had one of the other OEMs that was here, this morning, and I described it as kind of game theory in terms of making sure you get your inventory levels right as you head into next year. What gives you the confidence that you guys are managing through the transition well enough?
Yeah.
and that you're not going to be disrupted from a sales perspective?
Yeah. Listen, it's really hard to say whether we are doing it right or not, and we'll only find out in hindsight, right? Hindsight is going to be 2020. But I'll tell you, a lot of the game theory that we started the year out with, that didn't turn out to be true because the industry just went really short on 410A capacity. So if I had plans to go with excess 410A inventory next year, we may have sold out of it this year already. So that kind of changed any of our game theory assumption because some players didn't have 410A products anymore. I don't know if we got it right, but we know we have done better than this. And net-net having less inventory carryover going into next year is better for the whole industry. So from that perspective, I think we've been positioned in good shape.
Everybody had a game theory, and nobody was correct in this. In this, at the end of the day, is the way I look at it.
Yeah.
Is because the industry just ran out of 410A capacity.
Yeah. That makes sense. From a pricing standpoint, just talk through the, you've been clear around, like, the gross pricing benefit from the transition into 454B. And for those that are unfamiliar with it, you've said 10+% pricing from a gross perspective. How do you see the pricing then playing out for your, both for your residential business and also for your light commercial business next year?
Michael, do you want to help me out with that?
Yeah. Yeah. So first off, still feel very confident in the 10% price increase that we're going to launch on our new products next year. The math on this will be in the HCS or the residential segment, about 70% of that product is refrigerant-based, and that will then convert at about a 65% conversion to the new 454B product, which will then get the 10% price increase. We've seen some really good wins on large national counts on the 10%, but we'll have to see how the street pricing behaves in the second quarter of next year to see how it overall sticks, but feel good right now on the HCS side. And then similar story on the BCS side, the commercial segment, about 50% of that segment has equipment that will be applicable to the 10%.
We're seeing some good price gains on large national counts there to the 10% as well. Yeah, and so this all kind of translates into, you know, 4%-5% type pricing.
On the residential side, a little less on the commercial since it's only 50% of that segment, and then that will then flow through at about 65% to the new product.
Okay. That makes sense. And what about for the, you're going to carry some 410A into next year. I guess one theory would be given that 454B is coming in at such a higher price point, you could actually potentially get better pricing on your 410A units into 2025. Is that a fair assessment?
Yeah. I think there'll definitely be some price increase on the legacy 410A, but you can't go up to 10% because then people will just buy the 454B. So there's a bit of a cap on how high we can go. But overall, I think a lot of it's going to depend on availability and how much pre-buys happened in December versus January to determine the inventory that we have next year.
Great. I'll turn it over to the audience in a second. But, you know, Alok, you mentioned earlier that you've been gaining share on the residential HVAC side. One of your peers has clearly been losing share. I know that you've only been in the industry for about two and a half years, but what's your sense on, you know, pricing discipline continuing, next year, just given the dynamics that occurred this year?
Sure. I mean, one thing that I'm really pleased, and again, being new to the industry, unit pricing for manufacturers really does not shift shares to any meaningful level. When we lost shares in the past, it was because of availability after the tornado. When people are losing share today, it's because of availability. Next year will be the same thing. It does come down to availability, inventory, dealer support, technical support, how we are positioning the dealers to win. Pricing does not really shift shares in the long term. Would some rebates, something kind of help incentivize people to go back to close to normal? Yeah, it does. But I'm pleased with the fact that small adjustments in pricing do not, and none of our margins are like 40%-50%, so none of us have lots of room to cut pricing either.
So from that perspective, I don't see pricing having any meaningful impact next year. You know, all of us have the same pressure. Costs are going up. I mean, the R-32 or 454B units, the costs are up. You can argue whether it's 10 or nine or 11, but it's in that range. So I don't see pricing changing. We're pleased with the industry price reaction so far.
Great. I'll turn it to the audience to see if there's any questions, or I can continue. Looks like we have a shy bunch this morning. Okay. I'll continue. So maybe just focus on the near term, right? So you put up mid-teens organic growth in the third quarter, on the HCS side of the business. Seems like the guidance, I mean, not nitpicking here, but the guidance kind of implies a little bit lower growth, still double digits, but a little bit lower growth in the fourth quarter. Just given this transition is happening that we've been short supply, why wouldn't growth be better in 4Q?
It could be. So listen, if you were not a public company, I would not publish Q4 results, and I would just take my Q4 and take my Q1 next year and draw a straight line, right? But we are a public company, so we will have to publish Q4 results. There is some pre-buy. There is something. Overall, I think what we got to look at is on an industry sell-through volume, this year has been flat to down. Next year is likely to be flattish, maybe slightly down, slightly up. And that's what we are focused on, and we are gaining share. Could this quarter be better? Yes. Could this be worse? Yes. But I do know successful companies have a highly optimistic CEO and a highly conservative CFO.
There you go.
Maybe you should ask the question to Michael.
Yeah. Well, maybe I was asking Michael. Yeah.
Thanks for the answer.
No. When you do these forecasts and new guides, you have to set a target out there. We want to make sure that we can confidently deliver against the financial commitment we have out there. But as Alok said, some of this is dependent on pre-buy does it happen in December versus January. Right now, things are trending well, but December is still a big month in the quarter, and we'll have to see kind of how that behaves. The next natural question is we're on the eve of 2025. So just any early thoughts on a framework on how to think about 2025 for you guys?
Yeah. Overall revenue growth for sure. I think end markets are kind of flat to slightly down, as Alok talked about, a little bit of share gain. We should definitely have some favorable cost carryover for some of the inefficiencies we had this year. And then pricing on the new product will be the big story. The big story on the margin expansion as well as the top line. It's going to be the biggest driver. But overall, we do expect more margin expansion next year. And looking forward to 2026 when things finally get back to normal in our industry, though.
Can you guys maybe double-click on the end market comments specifically around light commercial? There's some concern, you know, just given the starts data that we've seen this year that the light commercial markets, I want to say fall off a cliff, but they could be down, you know, mid-single digits or better next year. Just any thoughts around your business and what you're seeing there?
Sure. I'll give some comments. I mean, overall, we didn't see the same run-up that some of the industry had because of some of our supply chain issues. So we still continue to see healthy backlog with large national counts. We expect that to continue. But really on the BCS segment, the biggest opportunity there is the share gain. As we now get our second factory up and running, we think we're going to be able to get back into a large piece of the market that we haven't previously played in. That should help any end markets, but our backlog remains healthy right now. And on light commercial, you got to separate us out from some of the others because our exposure is mostly to retail, food service, distribution warehouses, big box retail type, schools.
It's really not that much on multifamily, office buildings, and others where we are seeing softness. So that's why we may not feel what others are feeling. The other is some others benefited from restocking because they go through two-step channel earlier in the year, and we don't because we go direct. I think that's why we may feel some different, but that's just where we are positioned.
Fair enough. I'd be remiss just given that we're only about a month removed from the election if we don't at least talk about potential implications. I think your manufacturing exposure in Mexico is roughly around 20%. I think ballpark, maybe it's a little bit more than that. But just help us understand how you're thinking about the new regime and potential implications to your business.
Sure. And first of all, there's lots of uncertainties. I still haven't set up my Truth Social account, but once I do that, I might be more up to speed on what's going on. But if I put that together and I say, as an industry, let's start with that, right? About 40% of the capacity on the products we compete is in Mexico. So if there are tariffs, I think it impacts the whole industry, and pricing would be first lever we would all default to, right? I think that's going to happen if the tariffs go into effect. Second, it'll come down to the nature of the tariff. Is it about net of import and export, or is it only on export? Because a lot of the raw materials, compressors, motors, they're still going from U.S. to Mexico, and the assembled goods coming back.
So I think that's going to be another factor we have to consider. Third, if over the long term this becomes an issue, remember, we all have capacity in the U.S. Like, you know, we have four plants in the U.S. right now and one in Brazil. Can we switch back and forth? Over a period of weeks, probably not, but over a period of years, we definitely can. So I don't see that as a big game changer. We will kind of obviously continue monitoring and do what we can, but not just our industry. So many other industries are dependent on that.
What we do take comfort in the fact that for China tariffs, if there are China tariffs that go up, we are very well positioned because when the first time tariffs went into effect and during the COVID supply chain, we have reduced our dependency on China significantly, and the switch we recently did to move to Samsung products for mini splits and VRF, that even further reduced our China exposure, so from that perspective, low China exposure and Mexico exposure kind of at par with some of the other industry players.
That's interesting. Did I have the exposure right on Mexico?
It's about right, yeah.
Yeah.
Resi is higher, commercial is close to zero, but commercial will go up as we start the new factory, so.
Sure. Okay. Great. And then that's interesting. I didn't fully appreciate that on the Samsung relationship. So maybe touch on that relationship, how you expect that to, you know, contribute to growth going forward.
Sure. In hindsight, I would say, like, you know, we knew there were tariffs coming, so that's why we moved, but that was not the reason we moved there. Samsung has a better product. They have a better brand name, and we are looking to compete against other larger premium brands. These are brands like Mitsubishi. These are brands like Daikin. So we are trying to move to that tier. And our share in mini splits and VRF is much, much lower than our shares in unitary products. Samsung, on the other hand, is a big global player and has very low share in the U.S. So it just made a natural sense for us to put up a joint venture and pool that. That increases our market share in heat pumps. As you know, mini splits, VRF are essentially all heat pumps based.
That has also a halo impact on our unitary share as well because Samsung is like the world's third most recognized brand. So as you go to a new home, our future vision would be the new home would be a Samsung Smart Home, Samsung SmartThings, right? And it'll have a system by Lennox for HVAC, a bunch of the appliances, their TVs. So there's a lot of upside potential that we are excited about. We haven't baked any of that in. In the short term, we are just excited that we have premium products, a really strong joint venture, two parties who are committed to winning in the U.S. HVAC market, and we're looking forward to the launch of product early next year.
Yes. You mentioned heat pumps. I've historically thought of your heat pump business as being, call it like roughly 15% of your sales. Some of your peers are closer to like about a third of their business. So is the play on heat pumps then Samsung, or are you also doing things on your own to try to drive like additional R&D, additional innovation on that side as well?
Both. So Samsung is one part of it. The other part is, remember, our market share in the south is lower, which is a higher heat pump market, so places like Florida. And our heat pump portfolio today is lagging behind some of our peers, especially when it comes to the southern heat pumps market. Now that we'll be done with the A2L conversion, finally, we can have engineers focusing on launching new products versus just regulatory conversion. So I think it's going to be a matter of getting the Samsung JV right, getting new heat pumps, and increasing market share in the south. But we are fully aware of the gap, 15-point or so, or maybe even 20-point gap. And that's part of our growth and the share plan that we were talking about earlier.
As you mentioned earlier, it takes time to narrow that gap. I mean, do you have any kind of time horizon for like how quickly you want to penetrate that market?
Personally, I like to do it much sooner, but I think realistically, that's a five-year journey, not a one, two-year journey.
Sure. Look, stock has done incredibly well. Just going to turn the conversation over to capital deployment at this point and priorities. So Michael, maybe just kind of talk through how you're thinking about the investments that you're making organically versus M&A versus, you know, potential buybacks.
Yeah. So maybe first what I'll do is just talk a little bit about our cash generation. So over the past several years, we've had free cash conversion below 90%. We're getting back on track to deliver 90% cash conversion. So over the next three years, we expect to deliver $2.5 billion of free cash. So when you couple that with our current net debt to EBITDA ratio below one, we have, you know, very strong balance sheet. And what we're going to do is, you know, politely increase our dividend to have the yield in line with kind of S&P 500 companies. And thereafter, really about focused bolt-on acquisitions in the North American space. Alok and I have a pipeline of 30 or so acquisitions. We had a slide up here earlier.
We talked about some of the focus areas that we're looking at, but we're going to be very disciplined here and be selective and make sure we're doing the right deals. We did one a year ago with AES was a really good deal, but we think we have, you know, some opportunity to do some more, and then we're also going to get back into share repurchases that we began in the third quarter, so we'll do more of that as well.
Got it, so broader question, you know, Alok, you know, we've said now you've been in the seat for about two and a half years. As you look at the portfolio today, clearly, yeah, you're doing incredibly well, gaining share both on the residential side of the business and light commercial side of the business. As you take a look at like the holistic portfolio, the obvious gap in your portfolio is that there's no applied business, right? And as you mentioned earlier, you know, where you're investing your dollars is in areas that have greater recurring revenues, greater service intensity. That's the benefit of one of the biggest benefits of having that applied business, right? It's a 20- to 30-year tail. Do you have aspirations at any point in time to have that be part of the portfolio, and you know, what thoughts have you put around that?
You know, there are pluses and minuses of applied business, and you accurately laid them out, right? I mean, it's got tails from long replacement. It's got service revenue. Typically, also lower margin. So I think if you think from that perspective, I would say we like where we are. We like our portfolio. We have enough runway. But, you know, opportunistically, if something comes by, this will have to be through an M&A, right? I mean, this won't happen organically. We're not going to go start a new applied business. But if something comes up that makes sense, and it makes sense, we have a very disciplined acquisition framework. We look at things like ROIC, being the highest ROIC players. We don't really spend time on things like multiples. It's more ROIC-driven metrics. If something comes up, we'll take a look at it.
But I think this year we'll be known for is the best deals we did this year were the ones we walked away from, right? I mean, those were our best deals. So if that continues, we'll do the same. So no aspirations to chase applied, but if it comes up, we will look at it.
The spirit of my question is, and you guys were very clear around, you know, some of the residential assets that came up, the JCI assets you passed on them, I think rightfully so for your business and where you're positioned. At the same time, you have, JCI is a good example, you have players within the space that are going through a transformation that ultimately you might end up with a standalone applied business, and so I guess TBD on whether that's something that makes sense in the future.
Yeah, TBD. I think it'll come down to is how do our shareholders benefit? How do our customers benefit? And can we generate returns better than others, right? Is it the right home for us?
Great. Look, unless there's any other questions from the audience, Alok, maybe I'll just kind of turn it over to you. Any last closing thoughts?
Sure. You know, I think if there's one takeaway I want you all to take is that I strongly believe, and the rest of the management team strongly believes, that the best days of Lennox are still ahead of us, right? Two years ago, we launched our three-phase transformation plan. We are barely finishing phase one of that, which is kind of the self-help. The second phase was all about growth acceleration, and that's where we are. Finally, we have the capacity that we needed on the commercial side. Finally, we'll be done with some of the regulatory transitions for a while. We are finally ending at a high market share, finally getting some benefits from the investments we made over the past two years.
And then there's still so much more potential for us to look at expanding, expanding geographically down to the southern U.S. where we don't have much share, expanding it with the bolt-on acquisitions. So we are very optimistic on where we stand, and we still strongly believe that our best days are still ahead of us.
Great. Alok, Michael, thank you for joining us today.
Appreciate it.