All right. Good afternoon, everybody. Here with our last fireside chat of the day are the team from Lennox. If there's something else to talk about besides HVAC, I'm unaware of it. We're gonna keep the train going with that, no pun intended. We're joined today on stage by Alok Maskara, Lennox's new CEO, and their Chief Financial Officer, Joe Reitmeier. Guys, thanks for making the time. Pleasure to see you as always.
Thanks, Josh. Always a pleasure to be here.
Appreciate it. Just as a reminder for everybody, you've heard this a few times now. Research disclosures, check the website or talk to your salesperson. We'll keep it brief 'cause you've heard it 10 times today. Alok, new in the seat, clearly a very dynamic environment. Maybe just spend a few minutes kinda on, early observations across the business and what you're focused on today.
Great. Excited to be here. Been in the role four months. Alok Maskara. Came from Luxfer, small-cap company. First of all, beautiful weather. I hope you guys got to enjoy the beach or the sunshine. I took a coffee break, and I did FaceTime my wife, and I showed her the ocean, so that's the extent of it. Early days key observation on Lennox. I joined Lennox with three hypothesis, right? The first hypothesis was, it's a great industry, right? Second thing I talked about, it's a great company with solid foundation. Th e previous CEO generated 8x returns, so I'll be very happy with 8.5 or 9 times returns in my tenure, right? The third observation was like, I'm not sure if you'll have enough to do. I mean, it's such a well-run company.
I mean, do they have improvement potential? Maybe I'll get bored, so that's how it is. First two hypotheses, I think the first hypothesis, yep, great industry, proven. We can talk about the current environment, but irrespective, through the cycle, great industry. Great company. Strong foundation, great placement, love the direct-to-channel market, love the talent base we have, and really like our products and the leading edge of like, ESG footprint that we are working on. Then finally, on the last hypothesis, now I'm convinced I will not be bored. There's tons and tons of improvement opportunities. The beauty is, it's so much easier to take a company from a second quartile to first quartile, which is what we need to do, right? I mean, we are at just a great spot.
On the key things that I'm working on, Josh, is I think the first thing we have to do is make sure we have sufficient growth capacity. Like, one of the things you notice in the past five years, we have not grown share, and in fact, in most cases, we have lost share, mostly because our manufacturing output has not been sufficient to meet demand. At some point, it was because of the tornado, some point it was because of COVID, and most recently, Stuttgart is just like, our own missteps. So we gotta fix that. I won't call it low-hanging fruits, but it comes in a category of you must fix this, and that's necessary, but may not be sufficient to drive growth. So that's step one for us.
Step two, Josh, for us, is about very clearly looking at commercial excellence, restoring the commercial excellence. What does Lennox brand stand for? How do we get our salespeople motivated, who spent the past five years apologizing, to really go out and get growth, and truly using digital consumer interface SEO rankings to get growth, right? Third piece for us is true innovation. How do we get to have a winning portfolio that wins in heat pumps, that wins in mini splits, VRF, the highest COP rating? First one's all about getting the capacity, second's all about true commercial excellence, and third is all about innovation to get the right portfolio. Happy to answer question, but those are kind of, one, two, three focus for me right now.
Excellent. So maybe just to sort of level set us on what's going on near term. I mean, industry is, seems like it's in the process of maybe just starting to digest or, understand the growth that it's been through the last couple years. How would you say that's happened at Lennox, given that there's, crosscurrents and, not every OEM is experiencing it the same way?
Yeah. I mean, the past few years have been good for the industry. Whether you were in water heaters or whether you were in HVAC, I mean, just been good growth of anybody connected to residential home improvement. We had our fair share, so I think that growth has been good. As we go into these crosscurrents, I mean, there's clearly indicators, whether it's new housing starts, which we know are down, which mean it's gonna impact the industry next year probably, with a 9-12 months lag, as is typically the case with new housing starts. There's also data on consumer confidence, the recent HARDI data, everything else. I think as a industry, the timing is uncertain, right? Nobody knows whether it's gonna happen in August, September, October, or December, but everybody knows it's coming. It's more a matter for us to be prepared.
We can't predict the timing very well, but what we can do is focus heavily on how do we make the next 12 months, or 2023 in specific, to be a positive EBIT year irrespective of what happens on volume. 'Cause we don't know whether the volume is gonna be down 2%, 4%, 6%, I mean, whatever number you wanna choose. At this stage, it seems like just the new home construction will create a drag on the overall market, and I'm not sure replacements will offset that. I think that's sort of our base case that we are working on.
How do you view the state of the replacement market right now? I mean, if I look back throughout history, we appear to be replacing today at a level, I'll call it double-digit % above the best years of installation. I would imagine there's not a lot of people, replacing these things just 'cause they feel like they had a good year at work. Do you view that as sort of a drag in the future, or do you think these are levels that we can hold?
We like to hold these levels, like let's start with that. Now I understand your question, but I'm saying like, we like to hold these levels. These are good levels. There are some fundamental trends which support holding these levels. Like, replacements are winning over repairs for the past many years. I mean, that's a trend that's been going on. Recently, that trend has been a little bit more accelerated, and that's been largely driven by things like R22, difficult refrigerant to replace. 60% of the installed base has it today. The cost of labor and parts has been huge in terms of much higher than our, like, new equipment sales pricing. I mean, there's a huge shortage of just qualified labor to do the repair.
In parts, beyond the cost, there's just an inflationary environment that caused it, but also a huge shortage ? The number one complaints I get from consumers right now, my inbox is filled with that, is lead time for replacement parts. I mean, if you're given a choice, which economically is pretty close, but repair is a six-week lead time and replacement is two days, you probably choose replacement. I think those are multiple factors that we have to work through. Are we worried about that? Absolutely, yes, Josh. I mean, I think our goal is to try and maximize that, arm our dealers. The Inflation Reduction Act and some of the existing rebates help in that dynamic. 'Cause what we need to do is make sure that consumer is very informed on their choices on repair versus replace. Nobody knows the answer, right?
I mean, I think what it comes down to is as the consumer confidence changes, how many more consumers will choose to repair versus replace? We will be prepared for all different scenarios. We make money on repairs too. Obviously replacement, we believe often is a better choice for consumers because they get a new unit with warranty, they can get financing, they can qualify for rebate. If you repair, all you're doing is pushing off the problem for a few more years. That dynamic is in every industry that you can think of, whether it's washing machine or cars. It's. Replacement is taking more and more share versus repairs. Yeah, the past few years have been very accelerated. I hope it sticks. We're gonna do our best to make it stick. If it doesn't, we'll work through it and make sure.
The good news is these things come back pretty quickly, right? In our industry, very rarely has market been down more than one year. Once during the financial crisis, two years. We seem to work through that.
You touched on a few of the regulatory tailwinds that are starting to perk up here. We're heading into the SEER change. We have IRA now, not with a ton of clarity, but we're kinda getting in the right direction there. I guess, first on the SEER change front and for folks in the room who I've asked multiple people this question. I'm just trying to see how all the OEMs see it differently. But how do you think about the benefit from SEER transition in your business, understanding that, you have a certain percentage that'll be impacted. You have things like furnaces and, other products that don't really participate. What do you think sort of the net benefit to Lennox is in resi?
Joe, do you wanna take that?
Yeah, absolutely. Once again, just to sort of give everyone a little background, what's happening is minimum efficiency in the South is going from 14 to 15 SEER. In the North, it's going from 13 to 14, but it's different, the implementation's different. In the South, it's on the install date, so it has to be installed by the end of this year. Otherwise, you have to move to the new minimum efficiency. Up North, as long as the product is manufactured before December 31, you can sell it through any time. A little bit different dynamic. Takes a lot of risk around the inventory, pre-build that we may need to do to support this transition. We will just move the inventory to the North if we don't sell it in the South.
The benefits are in essence a bit of a price increase 'cause you're moving up literally through that SEER curve. It's about a 14%-15% price increase on top of the current minimum efficiency. Worst case, margin neutral and a bit of a mix lift for us. There's some benefits, not just us, but for the industry.
Got it. If I were to sort of net that out on stuff that's either already above minimum efficiency or not impacted, is that sort of a mid-single digit, kinda all-in number for you guys?
Yeah, I think so.
Okay. Got it. That's helpful. Then IRA, I know that, the ink is still pretty wet on that and , plenty that the states need to decide or maybe some more, ndustry lobbying or clarification that's necessary. How do you guys think about it?
In general, we'll say the IRA is good for the industry. Like going back to the repair versus replacement, it will shift the dynamic more towards replacement versus repair. The extent of that is unclear. Where it'll happen is a little bit unclear, and all the details are to be worked out. We like the fact that when a consumer is making a decision, and they gotta choose between $500 for repair versus, I don't know, $3,500 for replacement, they might get qualified for a $1,000 rebate. I know it's high numbers as well, hence the lower end. To make that difference between repair and replacement narrower, no matter what extent we look at, I mean, that's a dynamic we like. Heat pumps are a big part of IRA, at least from the way it's written currently, and that's good for us.
We lead out in the Cold Climate Heat Pump Challenge, as you saw that. That helps us. A lot of the North is under-penetrated in heat pumps. The new technology helps us do that, and the IRA will do that for us as well. We look at this as an opportunity for introducing more higher efficiency products, and we'll work closely with the government and the regulatory bodies to shape the actual implementation to make sure that it benefits all the products that are more energy efficient and are better for the environment.
I think, in its kinda most punitive form with a tax credit, not a rebate, you get the $2,000, and maybe there's an efficiency kicker to that that makes it a little more challenging. How does that compare to a typical price between a cooling system versus a heat pump. Like, my understanding is it's not too far off of $2,000 either.
Yeah, it's pretty close. In some cases, by the way, it could be a little bit lower, depending on which part of the country you are, the size of your house. Like, what efficiency you're going with or replacing. Often, what else needs to be replaced. Is it an air handler that's broken or can be replaced? Lots of dynamics, but yeah, it's in that range. That could switch the consumer from going one to the other. If you're in the northern area, where heat pump may not be able to use all 12 months, we can also put a hybrid system. You put a system that uses gas in the super cold days and uses electric heat pump in less colder days, and you still get the benefit of the government rebates.
I think we can work through that as well.
Is there a cannibalization factor on the furnace side? 'Cause you sort of mentioned it, that, like, in most cases, you'd probably run the heat pump, but you can envision a scenario where you wouldn't. I suspect that means that no one's throwing out their perfectly working furnace to take advantage of this. Is there some sort of, kind of, limit to what happens on the furnace side or headwind to there as a function of this?
I think if you take northern U.S., like Minnesota, Wisconsin, any of those places, furnaces are there to stay, right? Now, I make that statement as the next 50 years, not sort of far, like, maybe beyond that it may not. It's a bit of a technology challenge for these heat pumps to work at negative 15, 20 degrees. Now, they could move to more a hybrid system. In the south, I see heat pumps growing and could probably be half the market in the next 10 years. Yes, in those cases, people may switch from a gas furnace to air handler, which has got electric strip heating. That's why, like, it's hard to answer the question cannibalization. I mean, in all cases, you still need a unit inside your home that is still circulating.
It still has a fan, it still has a strip heater, maybe based on electric versus gas. In strict basis, is it gonna cannibalize the gas furnace a bit? Yeah. Will the total ticket size actually go up? Yeah. Is the unit that you're gonna put inside the house gonna look like a furnace, but have electrical strip heating for backup purposes? Yeah. There's lots of pieces in there. It's not straightforward. We embrace it. I mean, we think this is good for the environment. It's good for our consumer to have options in technology. We make good margins on both.
Is there a technical or production consideration that we need to keep in mind in terms of either your capacity or supply chain or something else? I know heat pumps are pretty similar to cooling systems, but for a few extra parts like valves and electronics. Are those the sort of things that are, easily remedied? Is this a major investment to up for this?
I think these are easily remedied. I know all the key players have been making heat pumps for quite a few years, so I don't think there's any major supply chain or manufacturing. The key barrier, again, is to make sure the heat pumps work well, even in colder climate. I mean, that's where we're gonna put disproportionate amount of our investments, so.
Then when you think about, the conversation at the kitchen table, being closer to the customer by owning your own distribution probably helps with that education process. How do dealers typically handle this level of complexity? I mean, at the end of the day, I don't know a lot of HVAC contractors who are also CPAs. Like, is that, is that a limiting factor, just, market ignorance? Historically, that works for the industry, right? 'Cause people don't know what these things should cost. Does it work against the complexity of maybe some of these proposals or not proposals, laws?
That's what our job becomes is to educate those dealers. I mean, we have LennoxPros, which is a really cool tool that helps them do that. When they're at a kitchen table, with a few clicks, they can come back with a good, better, best option for the homeowner and also build in all the rebates, all the differentiation, all the technologies. They might come back like, "Okay, here's a really basic 15 SEER or 14 SEER unit, along with, like, no rebate, nothing here. But if you go medium, you qualify for the government rebate, better warranty, and we'll put electric heat pump, which is better for the environment and will lower your gas cost, right?
Here's a premium unit which makes you better. Most people, when given the choice, they'll end up taking the medium or the high-end, right? If you present it properly. I think that's what our goal becomes, is to train those dealers. We do a pretty effective job in training the dealers to pull that together. Now, is there more to be done? Absolutely. We run a lot of training programs on educating people on the benefit of heat pumps and electrification. We also wanna make sure that people understand heat pump's not solution to every issue, right? I mean, it's some cases, a gas furnace, which we make at 99% efficiency, the highest in the industry, is a better solution. It just comes down to the type of home, which climate they are in, so.
Switching over to share gain, you mentioned some of this in your opening remarks in terms of that being an opportunity. If I think about the last 10-15 years at Lennox, maybe excluding the last 5, where there's share left on the table, expanding the PartsPlus store base and kinda having, more geographic coverage and a bit wider price point range. I think there was some product at the low end that got filled in along the way. You mentioned capacity, but is there anything else sort of either commercially or product centric or, the way you're approaching the customer that also plays into it?
Sure. I think each of those things that you mentioned, so more geographical coverage, different price points, multi-channel approach, all of those are true. We can maintain our technology lead in terms of the highest SEER products, the most efficient, like, we talk about ours is the quietest product in the neighborhood. I mean, those things still all remain true. Technological. What we have to do is make sure that model applies going forward. The past 5 years, which is where you said we have left some share on the table, the industry has changed, right? Our competition has become more focused. The trend in these 3-5 years for dealers not to come into our stores versus we do digital fulfillment. We can deliver the product to them. Physical stores, people couldn't walk in because of COVID.
They were sort of closed, but we could deliver products to them, or they could pick it up in the back. Focus shifted a lot more digital versus physical footprint on those. In addition, the consumer have become more environmentally aware across the board. ESG has become a bigger factor. Finally, the way our salespeople work and the way our field dealers work has also changed. Like, the whole digital has gone through a step change. What we are doing is, of course, keeping all of those, but upgrading them or training them to fit for the next generation. Under the commercial excellence program, we also gonna look at the brand. Like, what does Lennox brand stand for?
Does it appeal to all customers, including some of the dealers nowadays who are culturally different than what some of our historical dealer base had been? There's a lot of work to be done, but the core thesis holds. We have huge opportunity to expand geographically. We have a huge opportunity to expand in the multiple price points. We also have a big opportunity to go after the smaller to middle-sized dealers, 'cause historically, our strength has been the larger dealers. Putting it all together along with the products, we are pretty excited about the share gain opportunities. Capacity is sort of necessary but not sufficient. Like, we need to address that. All of the previous efforts failed and has failed because we didn't have enough capacity.
In the supply chain and broader, labor-constrained environment that we're in, is it hard to sort of push forward on those initiatives? Sounds like capacity needs to come first, but any of them sort of require material and people or are we at a point where you can move forward on that, or we need the air to clear a little bit?
Sure. I mean,
Yeah, I think we're ready to move forward. Once again, we need to make those investments in the business to continue to propel it forward. We're making those investments, not just because we have a problem at Stuttgart, but, we need additional capacity really across the enterprise to support demand. That's a high-quality problem, so we can solve that.
This is a new normal, and we are ready, yeah.
Yep.
On the sourcing front, I know the industry is, mostly comprised of source material from other folks. I think Lennox got $30 million-$40 million, give or take, a year every year for like the past decade, if I remember the December analyst meetings correctly.
Yeah.
Which added up are big numbers. I guess in a world where it's much harder to source, especially if you wanna go farther away, is some of that sort of clawed back on? There are other considerations besides price, and we're actually gonna have to cede some of that, but we'll get more availability and, thus, regain share or take share. Like, how do you guys think about sourcing in this new environment?
Sure. On sourcing, we have a huge opportunity in front of us. First is like, we single source too many of our products. 75% of our spend is single source, which puts us in the back foot when it comes to any supply chain issues. We need to flip that, and we need to get to, like, 80% of our products being dual sourced, just to give you, like, a structural answer to that. At the same time, I believe when I look at actually net cost reductions and not gross, right? I mean, think of net cost, true cost of ownership. We have an opportunity to improve that well and put more to the bottom line.
'Cause when you have two sources, when you have them closer to you, and when you don't miss out on a single sale because you don't have the $5 part, you're gonna win for shareholders overall. I'm actually very confident that building supply chain resiliency comes hand in hand with increasing our bottom line and top line and gets us overall savings. That's the path that we are on. It's similar to what we have done, but with more focus on true cost of ownership and truly looking at what's the net bottom line impact versus what's the gross material productivity.
Got it. That's helpful. I guess flipping over to the commercial side of the business, you talked a little bit about, some of the issues you guys have had at Stuttgart and the investments that need to be made. I guess over what timeframe do you think you can remedy that, and how should we expect that to trend in the second half here?
John, do you want?
Once again, it's been a bit of a bumpy ride in our commercial business. Once again, the clouds are parting. We've solved the issue in the manufacturing facility around headcount. We've got adequate headcount in the plant. Now it's a matter of just getting them productive. Trained and productive typically is a 90-day window, and we continue to, be challenged with the supply chain. As Alok mentioned, building that resiliency into the supply chain will help alleviate some of that.
As we look for opportunities to buffer the supply chain, we may make some investments in inventory as we finish out the year here to give us a little bit more ability to produce product a little bit more predictably than what we have in the past 'cause these supply chain issues change, so it's not always the same issue. Just the variation and the volatility it creates in the manufacturing facility is something that we're obviously very motivated to solve. What it all translates into is a $100 million opportunity over the next three years for us to reinflate that business to, the margins that we would expect, which would be between 18% and 20%.
Is that a linear relationship? 'Cause it seems like with headcount solved and, these folks getting more productive-
Yeah.
Maybe by the end of the year, like, is that a bigger step function move sooner than something that sort of takes the full duration to get to that range?
No, I think the way that I would think about it now is it's probably gonna be equally distributed over the next three years, once again, contingent upon what happens in 2023, but we're building that into the plan.
Got it. That's helpful.
We hope to do better, but that's a good assumption.
Right.
Fair enough. On the price cost front, I mean, something that's very topical right now for everyone that buys any metals, HVAC industry certainly being, big in that. How should we think about sort of the cost deflation potential here based on what we've seen with things like spot rates? I mean, on one hand, raws are not the majority of your purchases, so you get some relief there. You have a big pool of costs that is probably still, flat to maybe, up materially, kind of depending on what it is.
Does that net out to a, kind of a net deflation, or is that something where you're still gonna have to sorta enforce price, pretty materially over the next kinda 6-12 months just to keep where you're at?
Yeah, I think, net-net, I'll give you the punchline first. Net-net, we're gonna be more price cost positive in 2023 than we were in 2022. That's with commodities where they are today. Now, things change, and we've learned that things can change quickly. But our expectation would be is we have a very nice carryover price benefit in 2023, and we'll institute new price increases as we embark on 2023, with the magnitude of those increases contingent upon how component costs and commodities are behaving.
Terrific. I know we have a couple minutes left. Any questions from the room? Great. One more from me, kind of sticking on the pricing front. I mean, the industry has been pretty crazy on price in terms of how much you've been able to take collectively, not just Lennox, but everybody. Are we at a point today where you need more price based on what you see today? I mean, I know the industry sorta asks for more every year 'cause they ask for more every year.
Right.
Going through what we've had the last kinda 9-12 months in terms of really torrid price increases, are we kinda hitting our stride for maybe the short to medium term on needing more?
Sure, I'll take that. I don't think so. I mean, if you think about it, there are lots of changes happening in the industry, and all of that require a lot of investment. But if you go down to the bottom line, our ROS hasn't expanded dramatically despite all the price actions we are taking. That's true for the industry overall, as well. Sometimes you have margin expansion because of self-help stories, but not because of price cost dynamics. I mean, all these changes, whether it's the new refrigerants coming up in 2025, more heat pumps and all of that, all of that requires a different level of go forward and putting together manufacturing. Right now, price is keeping up with inflation this year.
I think next year we are looking at a situation where maybe there's some benefits if commodity goes back, but things are so unpredictable. What I like about the industry is that, look at the top four or five players, we fight on innovation, we fight on availability, we fight on branding, and we realize that fighting on price is useless.
Right.
Like, that's not gonna let anybody benefit.
Perfect. Well, I see we're coming up to time. Alok, Joe, really appreciate your time. Thanks for joining us here.
Thank you.
In person, thanks to you, to everyone in the room for a good first day of the conference.
Okay. Thank you.
All right. Take care.
Appreciate it.