Please stand by. Your program is about to begin. Should you need audio assistance during today's program, please press star zero. Welcome to the Lennox First Quarter 2023 Earnings Conference Call. All lines are currently in a listen-only mode, and there will be a question-and-answer session at the end of the presentation. You may enter the queue to ask a question by pressing the star and one on your phone. To exit the queue, press star and two. As a reminder, this call is being recorded. I would now like to turn the conference over to Chelsey Pulcheon from Lennox Investor Relations Team. Chelsey, please go ahead.
Thank you, Brittany. Good morning, everyone, and thank you for joining us for Lennox's first quarter earnings results. I'm here today with CEO Alok Maskara, CFO Joe Reitmeier, and VP of Finance Michael Quenzer. Alok will discuss highlights for the quarter, and Joe will take you through the company's quarterly financial performance and our view on 2023 fiscal guidance. After that, we will have a Q&A session with Alok, Joe, and Michael. 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. Please refer to our SEC filings available on our website for additional details. All comparisons mentioned today are against the prior year period, unless otherwise noted.
Speakers may also refer to certain non-GAAP adjusted financial measures that management may consider to be relevant indicators of underlying business performance and trends. A reconciliation of all GAAP to non-GAAP measures is included in today's earnings press release, SEC filings, and in the appendix of this presentation. The earnings release, today's presentation slides, and the webcast archives link for today's call are available on our website at www.lennoxinternational.com. Now let me turn the call over to our CEO, Alok Maskara.
Thank you, Chelsey. Good morning and welcome, everyone. Allow me to start by sharing my appreciation for all of our employees whose hard work has enabled us to deliver exceptional performance this quarter, including record quarterly earnings per share. We take great pride in our team's effort to gain share, expand margin, and seamlessly transition our product portfolio to meet the new minimum energy efficiency regulations. This successful quarter reflects our company's product leadership, strong direct customer relationships, and advanced digital platforms. These factors will continue to fuel our share gain and margin expansion for the foreseeable future. I wanna also take this opportunity to thank our dealers and customers for their loyalty to Lennox as we improve our service levels while delivering the best HVACR products and solutions in North America. Please turn to Slide 3 , where I wanna highlight four key messages.
Lennox is proud to report another quarter with record financial results. First quarter 2023 core revenues grew 3%. Our margin expanded 210 basis points, resulting in our adjusted EPS increasing 15% to $2.83. Our free cash usage this quarter was $114 million, which is typical given the seasonality of our business. We are pleased with the pace of margin recovery in our commercial business segment. Our profits more than doubled compared to last year as manufacturing operations stabilized and the benefit of price and mix outpaced inflationary cost increases. We continue to help our dealers and customers succeed during the transition to the new minimum efficiency regulations that went into effect on January 1, 2023.
Our superior design and successful track record of executing during regulatory changes in conjunction with improved service inventory levels has put us in a strong position to gain share. Fourth, given the strong quarterly results, we remain comfortable with our previously issued full year financial guidance. We continue to closely monitor end market sentiments, track movements in commodity pricing, and execute countermeasures, including additional price increases. We are also optimizing our inventory levels given improved lead times and current sales outlook. Please turn to Slide 4 for our view on the current end market conditions. In the residential end market, we are experiencing destocking in our two-step distribution channel just as we had expected. We anticipate the destocking to continue through the beginning of second half of this year. Volume in our direct-to-dealer channel was flat in Q1.
We are expecting softness later in the year, driven by fewer new housing starts in 2022. We are closely monitoring consumer confidence for any changes that may impact the replacement versus repair decisions. We are also encouraged by the recent improvement in the new housing starts. There is no change in our full year outlook for mid-single digit decline in residential unit volumes. In commercial, our backlog is strong and our lead times have improved as the factory situation has stabilized. The industry lead time for commercial equipment remains extended due to the shortage of common components. We still believe that commercial sales will grow by high single digits this year. On the price versus inflation balance, we are price cost positive, but we are monitoring recent inflation in commodities such as steel and copper.
To offset the higher material cost, we have implemented a targeted residential price increase that will become effective on June 18th this year. Overall, we are well-positioned to gain share with our success in seamlessly transitioning to the new minimum efficiency standards and given our improved service inventory levels. We are strengthening our go-to-market organization by adding more field resources and offsetting those investments by driving back-office SG&A productivity. Please turn to Slide 5. To accelerate our profitable growth and to expand margins, we are investing in pricing excellence at Lennox. Over the past few years, we have managed to offset inflation with price, there remains a significant opportunity for us to refine our pricing strategy to derive greater benefits from both price and mix. We are strengthening our pricing infrastructure by increasing price analytics, engaging outside experts, and further developing our internal talent.
Recently, we have revised our company-wide contract signing authority to ensure appropriate scrutiny over key account pricing and have redirected new business development on higher margin channels and applications. We also plan to expand our rebate auditing process and take all the necessary steps to increase price netting. Another priority of ours is to work with our larger key accounts to optimize our cost to serve so that we can establish win-win partnerships. In summary, we know that pricing excellence is an important step towards Lennox regaining our competitive margin advantage, and thus, we are increasing our focus to meet or exceed our long-term margin goals. Later in the presentation, I will provide an update on our long-term goals. For now, I'm going to hand the call over to Joe Reitmeier, who will go through our first quarter financial performance.
Thank you, Alok. Good morning, everyone. Please turn to S lide 6. Looking at the quarter for Lennox overall, the company posted strong revenue and profit growth. Core revenue, which excludes our European operations, was a record $990 million, up 3% compared to prior year. Both our residential and commercial segments experienced sales volume declines, but price execution and favorable product mix more than offset the volume headwinds. Total adjusted segment profit increased $24 million or 20% versus prior year. Price and mix exceeded product cost inflation by $63 million, with partial offsets of $17 million from lower volume and $22 million for inflationary effects and investments in distribution and SG&A expenses. Total adjusted margin was 14.4%, up 210 basis points, with most of the margin expansion driven by performance in our commercial segment.
In the first quarter, corporate expenses increased $6 million to $19 million due to the timing of incentive compensation expenses. Moving on to net income and cash flow performance, starting on Slide 7. The first quarter not only achieved record levels of revenue and segment profit, but also marked record earnings per share, with GAAP earnings per share rising 20% to $2.75, and adjusted EPS growing by 15% to $2.83. Our first quarter adjusted net income included a 21.4% tax rate, and diluted shares outstanding were 35.6 million, compared to 36.4 million in the prior quarter. The company used $79 million of cash in operations compared to a use of $98 million in the prior year.
Working capital optimization is a priority, we remain on track to achieve our 2023 cash flow target. Capital expenditures were approximately $35 million for the quarter, an increase of $10 million compared to prior year. Capital investments will be higher this year as we fund growth and increase capacity, including a new factory for our commercial business. We used $114 million of free cash flow compared to a use of $123 million in the prior quarter. In the quarter, the company paid approximately $38 million in dividends. Total debt was $1.67 billion at the end of the quarter, and our debt-to-EBITDA ratio was 2.1. Cash, cash equivalents and short-term investments were $48 million at the end of the quarter.
Moving to the business segments, starting on Slide 8, where our residential segment delivered record first quarter revenue. Residential revenue was flat to prior year, where sales volume declines of 8% were offset with 4% favorable price, 5% favorable mix, and 1% unfavorable foreign exchange. Total sales, which go direct to dealer, represent about 70% of our segment revenue and were up mid-single digits. The remaining 30% of our revenue goes through distributors, where total revenues were down low teens, the result of expected industry destocking. Residential segment profit rose 3% to $111 million, a first quarter record. Segment margin expanded 50 basis points to 16.3% as continued pricing gains more than offset product cost inflation of our new minimum efficiency standard products drove favorable mix.
Partially offsetting these gains were $12 million of lower volumes and $16 million from inflationary headwinds on distribution and selling and administrative expenses where we've made investments to fuel growth. Turning to Slide 9 in our commercial business. As announced in our last earnings call, beginning in the first quarter of 2023, the commercial segment results will include our North American refrigeration operations. Our European operations will be reported in our corporate and other segment until we complete the divestiture of the European businesses. Revenue was $309 million in the quarter, up 10%. Combined price and mix were up 16% and volume was down 6%. Commercial segment profit was up 110% and segment margin expanded 770 basis points to 16.2%.
We are pleased with the profit recovery in our commercial segment, where price and favorable mix were the main contributors to profit growth early in the year. In the first quarter, we successfully transitioned our HVAC products to the new minimum efficiency standard, industry-wide supply chain challenges constrained production output and continue to limit sales volumes. Demand from customers remains robust with a solid order backlog. While supply chain challenges persist, lead times to our commercial customers are shortening and are competitive with the industry. Turning to Slide 10, let's review our 2023 full year guidance. Our outlook provided on our last conference call remains unchanged. As a reminder, I will reiterate a few guidance points.
We expect core revenue to be flat to up 4% for the full year and earnings per share of between a range of $14.25 per share to $15.25 per share. Free cash flow is targeted within a range of $250 million to $350 million. We are planning capital expenditures of $250 million. That includes investment in a second commercial factory and investments related to refrigerant transition to take effect in 2025. Price benefit, including price associated with the 2023 SEER transition, is now expected to be $175 million. We now expect net material cost to be a $45 million headwind in 2023.
The material cost headwind is driven by component cost inflation of $100 million, net of $30 million in savings from cost reduction initiatives, along with $25 million from commodity cost benefits. Corporate expenses are still targeted at $80 million. We will manage SG&A tightly while continuing to manage necessary investments in the businesses to support growth initiatives and drive productivity. Finally, we still expect the weighted average diluted share count for the full year to be between 35-36 million shares, which incorporates our plans to repurchase $100 million-$200 million of stock this year. With that, let's turn to Slide 11, and I'll turn it back to Alok.
Thanks, Joe. Please turn to page 11 for an update on the key initiatives reviewed during last year's Investor Day to deliver on our long-term targets. As a recap, our 2026 target is to deliver an ROS of 18%-20% with revenues over $5 billion. We believe that our laser-like focus on North America HVACR market, our direct-to-dealer business model, and our superior technology portfolio will ensure long-term success. We are executing six self-help strategic imperatives outlined on the right-hand side of this page to meet or exceed our 2026 goals. First, growth acceleration to drive share gain will be achieved by optimizing our go-to-market effectiveness, by improving our brand's customer experience, and by increasing growth capacity. Second, we will increase resilient margins through commercial recovery, productivity, and pricing excellence, which was highlighted earlier in the call today.
Third, to maintain execution consistency, we have introduced a balanced scorecard operating system. We are transitioning to a dual-source supply chain, and we are implementing lean digital processes like sales and inventory planning. Fourth, we are reconfirming our commitment to 90%-100% cash conversion and a healthy balance sheet while building a bolt-on M&A pipeline focused on North American HVACR. Fifth, we will enhance our technology leadership through the frequent regulatory transitions by winning in cold climate heat pump and investing in digital AI ML adoption across all our business functions. Sixth, and finally, we are reinforcing our high-performance talent and culture by rolling out guiding behaviors to support our core values.
In addition, we are undertaking succession planning and ensuring that our compensation scheme remains aligned with value creation. Once again, I would like to thank our employees who are working hard to successfully implement this self-help transformation plan. To close our prepared remarks, I would like to summarize on page 12 the reasons why I believe LII is an attractive investment opportunity. Lennox is a narrowly focused North American leader in the attractive industry of energy efficient, environmentally friendly HVACR solutions. We operate in high growth end markets with strong replacement demand that provides us with resiliency even during periods of economic uncertainty. The company has a unique direct to dealer network, which creates a sustainable competitive advantage, and we have a history of robust execution with disciplined capital allocation.
As I complete my first year at Lennox, I'm even more excited about Lennox's future and continue to believe that our best days are ahead of us. Thank you. Joe, Michael, and I will be happy to take your questions now. Brittany, let's go to Q&A.
At this time, if you would like to ask a question, please press the star and one on your touch-tone phone. You may remove yourself from the queue at any time by pressing star and two. Once again, that is star and one if you would like to ask a question. We'll take our first question from Joe O'Dea with Wells Fargo. Your line is now open.
Hi. Good morning, everyone.
Morning, Joe.
Just to start on the commercial margins, certainly some encouraging progress there. Anything that you can talk about that you would consider sort of non-repeat in the quarter versus just some of the progress that you were expecting maybe coming through a little bit faster, kinda weave that into, you know, how you're thinking about sort of the go forward from here as the supply chain continuing to improve and those margins continuing to improve sequentially?
Joe, on the commercial, we are pleased with the progress. We had talked about earlier that we think there's a reset coming in the first quarter of this year, given that many of our key accounts had to be repriced with the SEER change and the new product addition. You saw that loudly reflected in our P&L. That's consistent with what we expected. You know, we had also talked about almost like a little over under a year ago, $100 million in EBIT improvement. Over the past few quarters, we have already delivered 60 of that $100 million. Yeah, we are a little ahead of where we expected, and that's a good thing. We remain on that journey.
I think we are gonna get to that $100 million faster than what we had originally talked about, just given we are more than halfway through with that. With supply chains improving, demand remaining strong, we still expect high single digits growth this year, and we still expect margins to hold. No, there was nothing unusual in Q1. We would expect that performance trajectory to continue going forward.
Great. Thank you. On the resi side, can you talk a little bit about your sort of expectations for the year on the sort of direct to dealer versus to distributor kind of outline? You gave some color on the first quarter, but curious sort of how you think about that, you know, if you're able to talk at all about sort of your framework for the second quarter, thinking about that, and then just generally, for the full year, you know, how we should think about those varying trends?
Sure. I think let me start with the end consumer, right? Because that's how we look at it. I mean, the end consumer demand seems to be holding pretty well. From our perspective, as you know, this was not a great season from a heating perspective. You know, it was unseasonably warm in quite a few parts of the country. Despite that, we talk about that in our direct to dealer business. You know, we had flat revenue, units coming through. On our two-step model, we had declines, and that was largely destocking driven. From our perspective, the end consumer demand remains healthy. Like, you know, there's obviously slowdown in growth, but we don't see any declines coming up because the replacement business is holding pretty steady.
For the rest of the year, Joe, I will expect a decline in direct, mostly because of residential new construction. You know, that slowed last year, and that's gonna impact our demand now. On two-step, I think the declines get better, so I think in Q2 we'll see less destocking than we saw in Q1, and Q3 we'll probably see little to no destocking as that gets behind us. We're only in April. You know, May, June are bigger months for us than in April. Overall, we remain confident in the full year outlook of mid-single digit unit decline with 0-4% revenue growth for us as we look at all these factors combined together.
I appreciate it. Thanks.
Thanks, Joe.
We will take our next question from Nicole DeBlase with Deutsche Bank. Your line is open.
Yeah, thanks. Good morning, guys.
Morning, Nicole.
Maybe just going back to the commercial margins, obviously really strong this quarter. With respect to Joe's question, I mean, I think you usually see a step-up in margins seasonally in commercial from 1 Q to 2 Q, and then a smaller step-up in the third quarter. Would you say that it's possible that we could see, you know, a seasonal increase? It's just kind of hard to gauge since 1 Q was so strong. Thank you.
Yeah. I mean, commercial, listen, Over the long term, we expect that business to be a 20% ROS business. Q1 was good, but we are only at a 16%, so I think there's still room for improvement for us. I don't wanna accurately try and predict Q3, Q4, like, you know, or Q2. I mean, we don't have that level of precision. I would see no reason why our typical seasonality trend won't hold this quarter. 'Cause remember this quarter, we also had some inefficiencies related to the CEO transition as we completed those. Stay tuned. You know, I mean, I think we are starting at a good spot, and we expect, like, you know, to end in a few years at closer to 20%.
Thanks. That's really, really clear. Second question just on price cost, obviously a benefit to margins in the quarter. How does that phase through the year, especially given the new price actions that you talked about today? Thanks.
Yeah. The new price actions that we talked about are on the residential side. On commercial, we had a reset going into, like, you know, this year. I think the price cost benefit that you saw, we will see the levels remain the same, but obviously we start going through more difficult comps because we had done significant price increases. The year-over-year comps get difficult, but I think the levels on a as is basis remains. Where we have to do more pricing effort is on the residential side, and that's where we are putting a lot of our emphasis and focus. That's where the new price increase that we talked about goes into effect on June 18th.
Thanks. I'll pass it on.
We will take our next question from Tommy Moll with Stephens, Inc.. Your line is now open.
Good morning, thanks for taking my questions.
Hi, Tommy.
Hi, Tommy.
We appreciated the insight you provided on the pricing excellence strategy. I wanted to drill down on a couple of the items in there, specifically around the optimizing local versus central decision-making. Can you bring us in on what that involves? To what extent was that related to the mid-year price increase that you just announced on resi to us today? Was there some other factor driving that decision? Thanks.
You know, I think as we went through the tornado many years ago, as we went through COVID and significant inflation, we went into more of a command and control mode because we had to. Those were crises that we're managing. Historically, we have really good territory managers. We have really good branch leaders. We have really good folks. We have good field intelligence. We need to act accordingly, just like a distributor does. Because although we are a manufacturer, like, you know, our 250 outlets act more as distributor. As we are looking at it, we wanna give more input, more say to local pricing decisions versus looking at things doing more centrally. Obviously we wanna set our strategy centrally, but our local field force have a lot more market intelligence and look at every region behaving a little differently.
That was the comment was, you know, we are gonna optimize it, and that's a pretty typical thing for us to do, 'cause pricing in South Florida may be very different than pricing in North Dakota, and we need to make sure that we appropriately account for those differences.
Thanks, Alok. I appreciate the context there. As a follow-up, I wanted to look at the residential profit contribution versus the commercial side, which was quite robust this quarter. If we think about the full year trajectory there, your guidance does imply some growth and profitability year-over-year. Given the residential volume headwinds that you've articulated, should we assume that all or substantially all of the profit growth this year should come on the commercial side, or is that not the right way to think about it?
No, I think it'll be a balance between residential and commercial. Listen, commercial had a good start. I think residential has lots of room for improvement, with the price, with the mixing, with the inventory level coming down. I'm optimistic on residential, and we are driving that hard. Commercial did have easy comps too, compared to where we started in Q1 last year, right, Tommy, so we look at that. No, I think the overall profit increase for this year would be balanced between those two. As residential, the benefit of CR change also is gonna happen, a little slower than commercial, 'cause commercial we didn't have as much finished good inventory sitting around. In residential we sold quite a bit of the lower CR products in Q1 as we were finishing that inventory.
I think putting it all together, we are equally optimistic about residential improving for the rest of the year.
Appreciate it, Alok. I'll turn it back.
Thanks.
We will take our next question from Jeff Hammond with KeyBank. Your line is open.
Hey, good morning, guys.
Morning, Jeff.
Hi, Jeff.
Hey, just wanna come back on price. I guess first, you know, what's informing, you know, another price increase kinda around this June 18th? Then just, you know, as you talk to contractors and get feedback, Are you starting to see any pushback, or, you know, from contractors or fatigue from the consumer on kinda these multiple increases?
Yeah, I know. I mean, listen, costs keep going up. I mean, as you saw, steel's been up significantly. Copper started to go back up. What we also did is, like, you know, just like you would expect good companies too, we did a pricing benchmark on where we stand. I think the price increase in June is a targeted price increase. We targeted areas where we think we have greater opportunities. And that's because for the past 2 years, we were sort of doing brute force price increases versus what I would call sophisticated price increases. A lot of that is, you know, working with our own analytics and our teams to go through that and fully offset the inflation and make sure we remain competitive in the market and capture the adequate balance.
It's a lot of details and analytics behind it, Jeff, but we remain confident that the right thing to do and supports the industry pricing level. On the second part of your question, no, I mean, remember the equipment price is only a small portion or less than half of what the consumer pays or sees in there. We have seen no pullback because the repair versus replacement dynamics, in fact, still favors replacement given that repairs are more expensive. R22 units are very hard to repair, or the cost of R-22 has gone up. Cost of spare parts and labor has gone up more than the cost of equipment. We haven't seen any changes, and I think that's consistent with the industry.
obviously, you know, we remain closely aligned with 10,000 dealers, and we keep getting their feedback, and we'll adjust if anything changes.
Okay, great. You know, just as we look at it seems like you still have a lot of confidence in the resiliency of res. Seems like commercial is running ahead. What kind of precluded you from kind of moving the guide at this point?
Jeff, I think, you know, once again, first and fourth quarters are seasonally our lightest. You know, we've got, you know, a lot of, you know, the year still in front of us and just didn't really wanna. You know, once again, we approach it with conservative, you know, cautious optimism, I think is the right way to characterize it. We remain confident in our, you know, gauging the underlying markets, but just, you know, wanted to get into the peak season before we made a call on the full year.
Okay, thanks, guys.
Thanks, Jeff.
We'll take our next question from Julian Mitchell with Barclays. Your line is now open.
Hi, good morning.
Hi, Julian.
Good morning. Maybe I'll leave commercial margins in peace for the time being. Maybe just on the commercial kind of top line, you know, fully understand the excitement around the good margin performance. On the top line, maybe remind us of some of those main sort of end market exposures for the commercial piece in terms of kind of end market verticals. Obviously a lot of concern from people out there on things like office and retail and so forth in recent months. Have you seen any kind of shift in customer behaviors? You know, any color you could provide on sort of bookings or orders at all on the commercial side? Again, any sort of flavor you could give on how the end markets break out for the business.
Hey, Julian, this is Michael. Yeah, on the commercial side, the backlog still is healthy. We're seeing good demand across most of our verticals. New construction is kind of 15%-20% of that business. We're not seeing any credit issues yet, but the backlog is definitely still healthy reaching into Q3. We're really not seeing a pullback on the demand yet. Backlogs are extended a little bit because of some of the lead times in the factory, but from a demand perspective, it still looks healthy.
Thanks very much. Michael, any color you could give on sort of, you know, vertical splits, I don't know, education versus more commercial applications, anything like that?
Yep. We're seeing some good demand on the education side. That's predominantly a summer season though, when the schools are out of season and we can get in and do the replacement work. Schools are more of a Q2, kind of Q3 dynamic more than Q1. Right now it's still just executing our backlog that we've had for quite a while, and we're seeing a good demand across most of the channels.
You know, a few more things, Julian. You know, where we've, you know, put a concerted effort was preserving our national account customers. Once again, that strategy, I think, is paying off for us as, you know, once again, the order rates and backlog remain strong there. As we continue to reengage in the emergency replacement segment of the market, that should provide us additional upside, more in the second half than first half. You know, regardless of how the underlying vertical is performing, we still think given where our business is positioned today, we still have tremendous runway, particularly in the second half of the year.
That's helpful. Thank you. Then just my quick follow-up on going back to sort of residential volumes. You know, understand that maybe Q1's a bit noisy with the SEER transition just sort of happening and so forth. You had that, you know, and maybe some weather constraints. You've got the down 8 volumes in resi in the quarter just behind you. As we think about how that plays out through the year and what you've seen in April, albeit it's a very small month for the quarter, do we assume sort of second quarter's down about the same amount? Sort of volumes down high single digit in the second quarter, then, you know, by the fourth quarter you're probably growing volumes again.
Is that the way to think about the year for resi volume?
You know, I mean, it's hard to say in April. I mean, April doesn't really give a trend. I mean, if you think about the key drivers of the volume decline in Q1, almost all of it was destocking, right? I mean, if I take that destocking part, and I would say Q2 will see some more destocking. I don't know if it'll be as extensive as Q1, probably not, because Q1 was the most pullback as people completed SEER transitions and knew that they were in comfortable stock. That's what we expected. I think Q2 there'll be a little less destocking. Q3 will be minimal to zero, Q4 we should be done with destocking. I think that's the way to think about it. End user demand seems to be holding just fine.
I mean, there's no growth that we saw, like rapid growth that we saw during COVID and other places, but that demand seems to be holding just fine. RNC Residential New Construction, we can predict very well because the housing starts is what drive it. I think the volume declines moderates. It won't be 8% in Q2, Q3. In Q4, to your specific portion, I'm not sure if it'll return to growth because that'll depend on the Residential New Construction, which is looking better. You know, we started the year thinking it'll be down 20%. Right now, it's looked like it's closer to 10% from housing start perspective. We just need to watch and monitor that, Julian.
That's helpful. Thanks, Alok.
Thanks.
We will take our next question from Jeff Sprague with Vertical Research Partners. Your line is open.
Thank you. Good morning, everyone.
Good job.
Hey, I wanted to come back to kind of the Maybe it's on Slide 5 , kind of the pricing slide. Alok, can you dig a little deeper into maybe the opportunities? I guess, I'll call them non-price, price actions, right? Rebates, leakage, things like that. Is this an area where, you know, the firm once had discipline and lost it, or this is a new area of focus? Maybe you could give, you know, some color insight on, like how significant, you know, driving some of these, quote-unquote, "netting," actions might be.
Yeah, I guess having done pricing back in my consulting days, you know, I strongly believe that all three levers are important: setting, getting, and netting. I think it's important. In some of these cases, yes, we had strong discipline, and during COVID and other cases, we pulled back on non-critical activities. Like, you know, some of these just had to give, as we had to focus on other things such as recovery on COVID, looking at supporting the volume constraint. I think we have that muscle. We gotta kind of make sure we retrain it. We make sure we find it and deploy it. A lot of this is also around, you know, we have structural advantages when it comes to serving some of the large accounts, whether it's, we call it national accounts or key accounts.
It's gonna be for us to work jointly with our customers to find the lowest cost way to serve them and create win-win situations there. 'Cause we are direct, right? We can optimize a lot of freight, distribution, and make it win-win for us and these large growing, often, like, you know, sponsor-owned PE dealer network. We think that's a big opportunity where it's less about what the list price is, but it's more about what's margin on both sides, and we have an opportunity to optimize that. We used to do it very well. We lost some ground just because we had to focus on other areas. We are bringing that back, and we are excited about the structural advantage we have in going after larger accounts where the cost to serve will be lower on both sides.
Just on inventories. You know, you spoke to the channel destocking and the like. I just wonder if you could address your own inventories. You know, I guess we're up, you know, 30% year-over-year and 20% sequentially. It's not crazy given the inflation that's out there. But maybe just address where your inventories are vis-a-vis where you think they should be, any particular absorption or other issues, you know, embedded in the guide, as you work through that or anything else to be aware of there.
I think what you saw was our inventories definitely grew in Q1. That's normal with our seasonal nature of our business. We always grow inventory in the first quarter. We'll burn that off in Q2 and Q3. Built in, into the guide is that burn off of the inventory. We're gonna look to potentially do a little bit more. We think there may be some upside to exceed the free cash guide. It's normal to build inventory as we did in Q1.
If I can just jump on that, you know, I mean, if you go back again then few years ago, when we were turning inventory at five to six times a year, and we still had room for improvement there. I mean, right now we are turning it at three to four times. I think over the three-day year planning periods, you can expect us to go back to turning inventory at the historical levels, driven by finished goods optimization that Michael mentioned, but also raw material. You know, as supply chains became extended, we bulked up on raw material. We don't wanna do anything crazy here, but over the next two to three years, in a very disciplined manner, working with our suppliers and our customers, we are gonna drive our inventory turns to be better.
Great. Thanks a lot. Appreciate it.
We will take our next question from Josh Pokrzywinski from Morgan Stanley. Your line is open.
Hi, good morning, guys.
Hey, Josh.
Hey, Josh.
Alok, I wanna follow up on, I guess adjacent to price, but really about share gain. You know, if you think about where you see the biggest opportunity today, is it more on kind of the larger dealers, you know, bigger national accounts like home builders? Is it in the smaller guys? You know, maybe talk about where, you know, this kinda, you know, newer field autonomy is really, you know, designed to try to meet the market, between, you know, different customer types.
Sure. I mean, Josh, I think the simple answer is all of them. I mean, we have an opportunity with smaller dealers because we underserved them post the tornado. You know, when we were known for our Dave Lennox Signature Collection products, we had really good partnerships. Because we didn't have enough inventory or service levels, many of them were forced to look somewhere else. We need to win them back. I think that's where a lot of the local autonomy, the improved service levels, and all of that goes into, right? Second part of that is just geographic. Based on legacy and driven, I mean, our market share in South Florida is much lower than our market share in Marshalltown, Iowa, and that's been for years.
That's where a lot of the efforts we have done, including, you know, increasing our reach, investing in our distribution footprint, getting more heat pump coverage, all of that adds. I think second factor is geographic. Third, to come back to the national dealers or the larger dealers, you know, that's where we have a structural advantage, and it's a different, more sophisticated approach of working with them on trying to make sure that we create a win-win partnership. Josh, we have opportunities in all three areas. Don't forget at the same time, our indirect business, which is also doing very well. While I talked about our direct, on the indirect side is where we are targeting through Allied, our independent distribution network, and giving them a stronger, better value proposition. That works well. I think all four are important, right?
Smaller dealers that we lost, unfortunately, during and after the tornado. The truly looking at regional expansion. going into key accounts and getting to make sure we have a win-win value proposition. Finally, continuing to expand our two-step model as well, because we believe we have a unique value proposition. Those are kind of our four levers for market share gain.
Understood. Just shifting over to the product side and the 2025 transition coming up. You know, I know you're reiterating guidance today, but, you know, it does look like you have, you know, a little bit of padding to start the year. You know, good performance in commercial. Anything that you're able to pull forward on R&D, CapEx, anything else on, you know, getting set for 25?
Yeah. You know, Josh, you know, it's a situation where I think we're doing all that we can. Once again, our priorities are, you know, elevating our service levels with our customers, making sure we've got the right mix of product to meet end market demand, and then continuing to pull forward. We've done that to some extent, Josh. You'll notice that our capital expenditures are $250 million. $50 million of that is associated with staying ahead of the 2025 transition. We're making those investments, pulling, you know, ahead those activities that we can to deliver that value to our customers. Once again, much like we did with the minimum efficiency transition this year, seamlessly attack what's ahead of us in 2025.
Got it. Thanks for the color. Best of luck, guys.
Thanks.
We'll take our next question from Noah Kaye with Oppenheimer. Your line is now open.
Good morning. Good to be with you. Thanks. I guess to start with, you know, interested in the commentary around the SEER benefit to mix. Alok, I think you said actually it was a fairly small amount of SEER product sold through the resi channel in 1Q. Is it possible to quantify the SEER benefit to mix in the quarter, how you would think about that into the seasonal uptick and what's embedded for SEER specifically in the full-year guide?
Sure. Michael will answer that question, but let me just clarify. Maybe I didn't what I was saying is that not all our sales in Q1 were the new SEER products. About one-third of our sales in Q1 were still the older SEER products as you're going. No, majority of the sale in Q1 did shift to new SEER. Michael can actually break down the mix benefits for you.
Right. Yeah. In residential, we did see favorable mix. It's predominantly for the SEER transition. As we've talked about previously, it acts more as volume than price. Drop through at about a 30% drop through that we saw in residential. We should start to see that for the rest of the year at a similar 30% drop through on the benefit for the mix shift. A little bit higher margins on the drop through on the commercial as we're able to get some additional pricing on top of that. Should be about a 30% drop through that we see in residential.
Okay. Great. Then what did you see from the e-commerce channel this quarter? You know, I think to the question around share gains overall, just how did that channel factor in?
We don't break out e-commerce sales by quarter. Needless to say, you know, as we talked in the Investor Day, it's a very important channel for us. You know, we look at over a third of our sales, as we mentioned in Investor Day, go through e-commerce. We find that all of those are very sticky customers. That continues to grow. I think the numbers we disclosed in December still hold or are better. We don't break that out quarterly, nor do we think it's relevant to break it out quarterly. It's an important part of our growth strategy. What we're even more excited about is to be able to leverage those data and the relationship and using artificial intelligence and machine learning to make critical decisions.
Everything from inventory planning to pricing, to also looking at making it easier for our dealers from predictive maintenance perspective and others. It's a huge investment for us, very important for us. The quarterly breakdown of that is not something we think is relevant.
Yep. Appreciate the color. Thank you.
We'll take our next question from Ryan Merkel with William Blair. Your line is open.
Hey, everyone. Just a couple cleanups for me. Just going back to commercial, Alok, can you put a finer point on why you're so far ahead on the margin recovery? 'Cause I think before you thought it was a 3-year sort of linear progression, and now it looks like you might be there at the end of this year.
First of all, I'll say it really pays to have a conservative CFO. I think that would be the first start, point on that, Ryan.
That helps.
Listen, the... It definitely helps. When we said 3 years, we really looked at that being. you know, our external commitment. Internally, obviously, we were driving it to a faster pace. I think the SEER transition worked well for us, you know. I mean, as we looked at the factory converting over, the labor stabilizing, getting the new products, which I give full credit to the team as we were also able to rationalize our SKU. We have, like, 40% less SKU in the factories working through and simplifying. A lot of just the core discipline was restored. We make a step forward with SKU rationalization. We were able to work with our key accounts because these new SKUs were not covered by some of the legacy contracts. All of the...
I think we if there was a, like, an optimistic scenario and a conservative scenario, we were probably guiding you guys to the midpoint of that. Right now, we are firing on cylinders to hit closer to the optimistic, but it's within the range of what we thought, Ryan.
That's helpful. Thanks for that. Then just on resi, any differences in the quarter by geography? We obviously had some weather out West. Just curious there.
Not substantial. I mean, there is weather related, right? Because the winter was mild in certain cases, Northeast did not do well, but I think that's an industry-wide factor, not, southern states did well. I think it could also be because some of our competitors stumbled during the SEER transition, and we had inventory. I think some of the southern states we saw particular strength, but nothing that I could call out or give you an data-based answer on, Ryan.
Got it. Thank you.
We will take our next question from Nigel Coe with Wolfe Research. Your line is open.
Thanks. Good morning, guys.
Hey, Nigel.
Obviously, we covered a lot of ground already. Hi, guys. Just on that last point, obviously we saw a pretty significant share shift during the fourth quarter with the transition. Sounds like that continued, perhaps not as extreme, but that did continue in the first quarter. Is that fair, Alok?
Yeah, that's fair. I think these things typically, given the abrupt nature of the regulations, but the difference between north and south, like, you know, I think we all have got, I mean, all industry players have got sophisticated on starting to make them in Q4 and continue selling them through end of kind of Q2 to make sure the inventory doesn't become, like, you know, E&O type excess and obsolete. I think we have done a good job with that.
I think, you know, I think our direct to dealer strategy benefits us due to the destocking and the two-step channels. You know, once again, I think we were probably unjustly criticized for losing share as the two-step channel stocked up. You know, once again, as it destocks, we'll see some of that benefit in the form of additional share.
Yeah. That's, that's very fair. Going back to commercial margins, I know that, this has been well vetted, but, you know, if you think about the Arkansas facility, you know, where is labor and material productivity, you know, trending today relative to normal? I'll leave you to define normal. Where are you sort of, you know, with target on that, on that curve?
You know, I'm glad you're gonna leave us to define normal. I'm gonna leave it to somebody else. It's hard to define normal, but here's the thing, right? I mean, wages are not going back, so let's put it at that perspective. Our factories are still fairly inefficient. A lot of the inefficiencies that crept in, including expedited freight, including overtime, including line rates running below normal, those still persist. Q1 was actually a little bit worse on that because we had to go through SEER change. Imagine retooling all your lines and getting to new products, which were completely new design for us. Remember our 3 new models that we introduced the beginning of the year. I think there's still room for productivity improvements for us going forward. Our priority is still output there, right?
I mean, I think the more we can produce, the more we can sell. We're still limited by output. Getting the output up, getting manufacturing productivity, and working on the second factory. Remember, all of this is still based on the existing factory. Once we have two factories and can truly look at one being focused on made to stock, going after emergency replacement, you know, making standard products at very high velocity, very high efficiency, and the other being on made to order for key account specific. I mean, that's sort of our vision. That hasn't changed. We just got to the one factory improvement sooner.
Okay. Thanks, Alok. We'll leave it there.
We'll take our next question from Joe Ritchie with Goldman Sachs. Your line is open.
Guys. Good morning. Can you touch on just your visibility into the independent distribution channels? It looks like your Allied business was probably down. I'm guessing volumes are down like high teens this quarter. Just what kinda visibility do you actually have to destocking, you know, being pretty much behind you in 2Q?
Sure. When we say two step, we mean ADP and Allied, so combined together, and you're right. I mean, the volume was down in the range you mentioned. We have very good relationship with this channel, and we have good visibility. That's the reason we are kind of hinting at we would expect destocking to continue in Q2 and then beginning of Q3 or beginning of second half, we think that'll be behind us. It's hard to quantify because every distributor is different, right? I mean, nobody has, like, you know, the same exact operating rhythm as somebody else in a different state. The amount of excess inventory that the distributors are holding should be complete with destocking by beginning of Q3.
Got it. That's super helpful. I guess maybe just to follow on commercial, I know we've talked about it, congrats on being way ahead of plan on getting that $100 million back. It's probably unfair for me to even ask this question, how are you thinking about what, you know, where the margin improvement is gonna come, you know, post achieving the $100 million, which seems like it's gonna come a lot faster than you originally anticipated?
Yeah, I mean, I'll point out to a few different things, right? First of all, remember the $100 million we had said does not include the second factory benefit. I think we are still holding to that. The second factory, we've started construction. Things are moving along well. We expect to be under roof by the end of the year. We would expect production sometime next year. That will give a significant benefit as we have 2 factories, very focused, operating, like, you know, to serve our customers really well. That's gonna be one part. Second on that is, I think there's significant opportunity for us to continue looking at our service growth. You know, service is a very attractive business for us, and we were not fully focused on that given all the disruptions happening here.
Getting service and increasing our service focus, which is good margin, it's repeatable, it's predictable, and gives us great insight for our equipment sales. I think the service will really help as well. Finally, going back to the manufacturing inefficiencies, I don't wanna rule that out. I mean, we are in the early stages of working through manufacturing inefficiencies and getting all of those out of the system. You know, long term, we are committed to 20+% ROS across both the segments, and we are excited about all the steps. Those are sort of the things I mentioned in the last page, when I talked about the six key self-help initiatives we are working on. They kind of equally apply to both residential and commercial.
Makes sense. Great. Thanks, guys.
We'll take our next question from Brett Linzey with Mizuho. Your line is open.
Hi, good morning, all.
Hi, Brett.
Just, yeah, just wanted to come back to commercial briefly. You noted the backlog remains strong and order rates are solid. What degree of visibility on those orders converting do you have for this year? Is there anything specific of mix, whether it's national account versus other verticals that we should be aware of over the next 2, 3 quarters?
I'll take the second question first. On the mix side, no, I mean, we don't have large projects that funnel through the pipeline or anything, right? I mean, these are all projects and these are like products that we price accordingly. No, the margin in our backlog is no different than the margin we are expecting in Q1, if that's your question, right? We have good visibility into that margin, and it's all good. Nothing to worry about there. On the overall demand visibility, you know, it's everything from some key accounts who want to plan 2025 volume right now, post the low GWP, to people on emergency replacement who wants product tomorrow. Our backlog is healthy. I mean, the industry lead times remain stretched.
I mean, today, if somebody places an order, whether it's us or our competition, chances of getting a product this year is low. I mean, you would likely get into a queue for next year. I think there's some flexibility here and there, but that's kind of the demand visibility we have. It's pretty solid going forward, both from actual revenue sales and also margin perspective.
Okay, great. Just to follow up on the news this week with one of your peers making a portfolio move into European heat pumps, can maybe just speak to your appetite to compete internationally, you know, be it organically, be it inorganically, and then maybe just, you know, how much investment do you think is required to maybe reinvigorate that part of your portfolio?
You know, as you know, we made a decision last year to make a portfolio move, which includes divestment of our European operation. You know, we like being laser-like focused on North America HVACR business. You know, it's a very large industry. We have low share. I think our focus is gonna help us win. No, I think we are currently 100% committed to remaining a North America HVACR player. We still have lots of bolt-on opportunities here, whether it's about service or expanding our line card so our stores can be more efficient and looking at other opportunities. I think for us, never say never, but currently, we like our laser focus, and I think that'll help us win share. That will help us through the transition.
You know, everybody at Lennox gets up every morning and is focused on winning in North America HVACR. All our 11,000 employees focus in that direction. We are confident that's a winning formula for us. If you guys wanna diversify for other internationals, you can always buy shares in other international companies, you know.
All right. Thanks. Thanks a lot. Best of luck.
Thanks.
We'll take our next question from Steve Tusa with J.P. Morgan. Your line is open.
Hi, good morning. Thanks for squeezing me in.
Morning, Steve.
Morning, Steve.
I don't quite... I'm not sure I heard this before. Been a lot of calls this morning, but did you guys comment at all on how April is looking relative in resi to what you guys posted for the first quarter?
We didn't comment, specifically on April, but I'll tell you it's consistent with what we expected. April is a hard month given that most of the summer sales starts in kind of May and June. There's nothing in April that would have caused us to change our full year outlook.
Okay. I think you mentioned there were some production inefficiencies in the fourth quarter on new products coming up to speed. It was my understanding that you guys didn't really do like a major clean sheet kind of redesign for this SEER go around? I thought you were, you know, maybe taking a legacy product and, you know, you were talking about how you had the outdoor unit kind of advantage there. How can you maybe just explain how your product strategy, you know, kind of progressed through that?
Let's start with the two segments separately, right? On the commercial, we did redesign our product, and that's what we were referring to earlier. We launched three new models and replaced most of our legacy. That included significant SKU rationalization, more modular design and went more modern. Commercial, we did redesign our product line. On residential, we had to redesign our outdoor units just because those are air conditioning and heat pump, but that's what regulation does. We did not relaunch an indoor unit because our indoor units are still very new. They were launched just a year or so ago, and they're already very high efficiency and they're compatible.
We believe that gives us competitive advantage in the marketplace, is that our new higher SEER air conditioning and heat pump units are backwards compatible with our existing furnaces and air handlers indoor. That's the piece, I think, of the product strategy we had mentioned earlier.
Got it. One last one on this price increase. How much in total is the price increase? Can you just remind us of how that works, with your distribution channel? I mean, are you selling... Does that price increase go, you know, independent versus your captive? Like, is there a difference between what the contractor is seeing and what your independent, distributor is seeing?
Yeah, we call it a targeted price increase, Steve. I think a lot of the discussions with the customers are starting now. I'd rather not go into tons of details in that one. The answer is that, you know, we believe that this is the right step for us to be more competitively priced in the marketplace. From a consumer perspective, this is a small portion of the overall cost, and all we are doing is making sure we can offset inflation. You'll notice in our full-year guide, we now talk about $175 million in pricing benefits. Earlier, we'd given a range with the high-end at $175, and we took our commodity inflation up by offsetting $10 million. So that's kind of where we are on the numbers.
Got it. It's embedded in that $175 now, that Your realization, whatever you expect to get in June.
Yeah, we just remove the range and stuck with the high number.
Yeah. Okay, great. Thank you.
Thanks, Steve.
We'll take our next question from Chirag Patel with Jefferies. Your line is open.
Thanks. I just wanted to cover the Allied piece just in one more kind of a blush here. One, I was just kind of looking at what the opportunity kind of seems like for you guys over time. I know in the past, we've talked about the idea of share gains of $300 million or so to get to that 2026 target. How much of that is Allied? What do you kind of see the growth? Is there an acceleration opportunity in that? Is there an opportunity to partner with additional distribution channels to kind of expand that product? Just trying to get a little bit more sense for what you see as that particular piece of the business growing versus, you know, the core Lennox brand.
Sure. First of all, we're very proud of Allied. I mean, they have done great over the past, many years. I mean, the business has grown up 4x. I mean, the margins have expanded beautifully. I think Joe Nassab and the team have done a fabulous job taking that. At the same time, we don't think we're anywhere close to being done. We have significant room for improvement. I can easily see that business doubling again over the next five years as we continue to add distributors. Have a very focused product portfolio that wins a lot of awards, and we truly focus on best serving these independent distributors. Excited about Allied. We think there's a lot of growth potential ahead. At the same time, I don't wanna break down $300 million in opportunity between business A and B.
Ideally, both of them will get it, right? I mean, ideally, we both get the $300 million targets. We deliver more to the shareholders. Super excited about Allied. I think we have share gain opportunities on direct and in indirect. We will keep driving both of them.
Appreciate that. Would there be a mix shift if that were to grow a little bit faster, or slower, on the margin side, I just mean?
No. We don't break our margins. We remain committed to 20% margin on residential overall. It's hard to kind of break down margin artificially, 'cause remember, we share the same infrastructure for manufacturing, product development, and all of that.
That just becomes allocation game, right?
Okay. Thank you.
Thank you for joining us today. Since there are no further questions, this will conclude Lennox first quarter conference call. You may disconnect your lines at this time.