Well, it's my pleasure to have up next Lennox International, Alok Maskara, CEO, for almost one year now, and Michael Quenzer, VP of Investor Relations and Corporate Finance. Welcome both. I think it's your first time to this conference. We're delighted you can make it, and thanks for meeting with everyone here today. Alok, maybe, yeah, start off, please. You know, as I said, it's your first time at this conference. A warm welcome, and a couple of sort of introductory remarks.
Sure. Great. Thank you, Julian. Thanks for having us here. What a great place to have a conference. Hope you guys are taking some time to get out of the conference room, enjoy the beach and the beautiful weather. Let me start by having Michael introduce himself. Then I will talk about myself and some prepared remarks.
Good morning, everyone. My name is Michael Quenzer. I'm the vice president of corporate finance. I've been with Lennox International for nearly 20 years. Most notably, I've recently been in the commercial segment, leading the finance as a CFO for that segment for the past six years. Just moved in this role and excited to take on investor relations.
Great. Thanks, Michael, and welcome. I'm Alok Maskara. As Julian said, I've been in the role, coming up to almost a year, almost nine months. Still very excited about Lennox. Just a few things. As you know, we are one of the smaller players in the US HVAC industry. A few things that differentiates us: A, with our announced simplification and divestitures, we are now 100% focused in North America, so very excited about that. We are unique in that we have our own distribution channel that we use to sell direct to business. In our residential market, so 70% of our sales go through our own stores and our own distribution, 30% goes through third party, so that's unique. Gives us a lot more insight into end consumer behavior and channel trends and other pieces.
On the commercial side, where we have significant margin improvement opportunity, also, most of our sales do go direct, where we serve national accounts and smaller unitary customers direct to market. That's one big differentiating factor. In terms of where we are, obviously we gave a detailed update during our Investor Day in December, and our view has not shifted on any of those aspects since then. We still remain confident that this year we will have growth in revenue, growth in EPS, growth in ROS, and continue to make progress on our strategic initiatives. We see residential to be down mid-single digits in terms of volume, but likely up in terms of revenue due to benefit of price and mix.
We do expect commercial to improve their margins further as we go through the year, taking advantage of a good strong backlog and continued operational improvement. Excited to be here and happy to go into the fireside chat mode.
Thank you, Alok. Maybe firstly, you know, as you said, you're sort of guiding for low single-digit core sales growth for the year as a whole. You know, how is the year starting out? You know, we've had some questions around, you know, warm weather, for example, impacts on furnace sales, if any, not relevant for this neighborhood necessarily, but across your business in the U.S. You know, how would you characterize sort of how the year's playing out to date?
Yeah. Six weeks into it's playing exactly as we thought it would be. While we do like cold weather, and cold streaks, and we like really hot weather in summers, net-net, it's not like, you know, moving the needle either way for us. It's as expected. If there is some benefit from the cold streak that we are facing in some part of the country, it's too early to say whether it's gonna have impact on the full year.
Yeah.
As you know, summer is our peak season, and summer weather makes a bigger difference to us than the winter weather. Yeah, we welcome the current weather and the climate, but no change to our year outlook six weeks into it.
When we're thinking about, you know, that mid-single digit volume decline outlook for the residential market in aggregate and Lennox slightly better than that through outgrowth, you know, should we think about that down mid-single digit fairly level through the year?
I would think so. You know, I mean, we can try and get more precise, but that gets us in trouble, right? From a simplicity perspective, let's just think of it across the year. Everybody's gonna face some destocking during the year.
Yeah.
It's hard to quantify when i t's likely to be around Q2. Net-net, from an overall perspective, it's fair to say, just think of it pretty evenly spread out throughout the year.
That point on, you know, destocking in second quarter. You know, I think there's a lot of cross currents on residential HVAC on that topic of inventories, and we've heard, you know, different things from suppliers like Regal here or some of the other OEMs like Carrier and Trane. You know, maybe sort of flesh out, you know, why second quarter, how much destocking do you think needs to happen? You know, I understand inventories might be high, but pricing's high, demand has been high. Sort of putting inventory in the context of everything else around it, I think would be helpful.
Sure. I think the reason the inventories are high primarily is because the whole industry is working on long lead times for many years during the COVID period, and demand was high.
Yeah.
Everybody bulked up on inventory, including us. On an internal level, we have higher inventory than we would like. In addition, the whole SEER change, people wanted to make sure that nobody ran out of product. Us and the industry players, we all did that. That's still being brought down as we are still selling some of the older SEER products where we can, especially on the north. As we put it all together, as demand sort of moderates, as lead times normalize, I would expect all of us to pull down on inventory. We are planning to do that internally. Talking to our channel partners, which are more only 30% of our business, Allied and others, they all expect to pull down on inventory. I think people are gonna be disciplined around it.
Instead of a one big step down, it's probably gonna be gradual, working with the manufacturers and the distributors together, and likely gonna be Q2 timeframe, because people are still seeing how the demand is gonna evolve this year. People are still looking at clearing out some of the older SEER and building up the new SEER inventory. That's why I think it's gonna be Q2. Listen, I don't have a crystal ball. At the end of the day, we know for the full year the impact is gonna be small. We used to turn inventory eight-10 times a year. Now we are turning, like, six-eight. I like to get back to the eight-10, but it might be 12 months timeframe during which we do that.
I think everybody else is hopefully thinking the same way, so there's no sudden cliff drop. If and when the de-stocking happens, it's a matter of, like you know, six - 12 weeks, maybe six - 14 weeks timeframe.
That's very good context. You know, as you, as you said, the SEER change, sort of the formal date and the you've got the two regional nuances, but the formal date for both was seven weeks ago now. Any impact since then or pre-then that's surprised you or are people, distributors, competitors, suppliers, all in general, you know, behaving normally and they should 'cause this transition was extremely well telegraphed.
I would say, Julian, almost everybody executed well.
Yeah.
Throughout the SEER transition. There were no surprises. Industry's got used to this.
Yeah.
This is not the first SEER change we are going through, nor will it be last.
Yeah.
I think people executed well. I'm proud of our team. We executed very well.
Yeah.
Didn't have any hiccups, no product issues, no supply issues. More than normal, right? We always have some issues everywhere. I think the change went as expected. It was pretty smooth across the board. I think us and our competitors did a good job executing through the SEER change.
Agree with that. If we think about, you know, pricing and I think it's helpful you've sort of meshed price and mix together in one figure. How's price discipline? You know, I think a lot of people have pushed through price increases. We've heard that from other OEMs the last 36 hours. You know, what's your expectation for pricing this year? Do you see any sense of resistance or hesitation versus a year ago to price up?
No, we don't. I think the industry remains pricing disciplined, Julian. You know, there's always some noise in certain...
Yes.
pockets that some competition is cutting price. I put that in the fake news category. I think at the end of the day, every salespeople, when they lose an account, they like to blame the competitor's pricing. Sometimes they need to look in the mirror and see what they could have done differently. When my salespeople come and tell me that so and so is cutting price, I'm like, "Show me real proof. Show me some real data," which we don't ever get.
Yeah.
I think the industry pricing is holding well. We are not cutting pricing, nor does anybody else. I think that continues. At the end of the day, we will all take extra price versus extra share. If there's ever a trade-off, which I don't think this industry has.
Right.
I will take higher price versus higher share any day long. You know, game theory is well understood in this industry, and we would look at getting to a situation where we can at least at minimum offset inflation. You know, inflation is still there. We talked about $100 million in component inflation this year alone. We need that pricing.
You know, as you look out, we've gone through the SEER change, it was fairly uneventful for all the sort of hot air, you know, expelled on that topic for three years. The refrigerant change coming up in two years may be more meaningful. I think, you know, Lennox's commentary has suggested, look, you may need an investment surge now. There could be pre-buy from the channel in 2024. You know, maybe sort of flesh out some of your thoughts on why that transition you think could be more impactful or consequential for the industry and for.
Sure.
You know, Lennox.
It's a bigger change compared to the SEER change. As you change refrigerant, this is the first time the refrigerant has some flammability concerns, which means the way we transport the refrigerant, the way we store it in our factories, the way we test it in our labs, all needs to be re-looked at to make sure we adequate fire protection, sensors and controls, including in the units we sell. We'll have to put sensors, and we'll have to make sure that flammability concerns are fully addressed. I think it's a bigger change in that respect. At the same time, I do expect it to go as seamless as the SEER transition went.
Mm-hmm.
You know, us and our large competition, we are all kind of done with essentially the design phase.
Yeah.
We're all working through the implementation, the certification, the manufacturing phases of that. The investment that we mentioned, I think others are doing the same thing. We are smaller, sometimes we are more transparent when I say, "Okay, I gotta put X million more in capital to upgrade my factory lines." Others being larger, it may not show as clearly in them. I think we all are investing in making sure our manufacturing is up to speed. Our, like, you know, refrigerant storage and transport systems have been upgraded. Making sure that we really look at inventory and so that if there is a pull ahead in 2024, which I think there will be, we are prepared for that. I think from our perspective, we will do our best to make sure that the low GWP transition is as boring as the SEER transition was.
Yeah. In terms of sort of scale of units, you know, I think there was some scaremongering around, you know, units needed to be the size of a 747 or something with the refrigerant change. I think the sort of the scale of it is probably quite similar now, just the units.
The box size as we look at it should be exactly the same. Our box size is not gonna change. I'll be surprised if any of our competition box size change. A higher SEER unit is typically a bit larger anyway.
Sure.
Given all that dimension, the box size is unlikely to change. You know, we can get similar efficiency by just redesigning our coils, redesigning our venting system, but I'll be surprised if the box size changes dramatically.
I guess, you know, while we're on the sort of subject of HVAC technologies, you know, heat pump, always a lot of investor focus on that topic. Maybe clarify sort of Lennox's, you know, it's domestic clearly the focus now, as you highlighted at the beginning, but within sort of residential and commercial heat pump, you know, the positioning there, the exposure, at the company.
Sure. In heat pumps, we're not satisfied with our current position. I think there's a lot of room for improvement for us. Our penetration or sales from heat pumps is lower than some of our competitors. We accept that, acknowledge that. A lot of it's driven by geography because the market share in Northern U.S. is higher than our market share in Southern U.S., just based on history.
Mm-hmm.
In Northern U.S., the heat pump penetration is lower because of colder climate versus Southern. We have a lot of opportunity ahead, a lot of improvement potential. The new technology for cold climate heat pump, on which we are leading the charge right now, is going to help change that dynamics, increase our penetration of heat pump. Related to that, mini-splits and VRF is a product category which we are under-penetrated in.
Yeah.
We are working through with our partners to increase our penetration in mini-splits and VRF just because, again, similar technology.
Mm-hmm.
Often the technology is coming from overseas.
Yeah.
The U.S. is a small portion of that market. Because we are more US focused, our heat pump penetration is lower because in Europe, given the climate and other conditions, heat pump do have a high penetration. They're often air-to-water heat pumps versus ours being air-to-air. I'm not gonna bore you down with technology. All I'm gonna say is we have significant room to improve our heat pump, VRF and mini-split, and all of that is upside for us.
Can you do that sort of all organically? You know, you have the partnership clearly with, you know, in VRF to get that technology. You know, how satisfied are you with that partnership? You know, I know you have a fairly low net leverage goal
Yeah
From the Investor Day. You know, is there an argument to be made perhaps for, you know, doing more M&A to move ahead in VRF and/or heat pumps?
Not as core part of our strategy, Julian. If there is, there might be some small bolt on to fill in gaps. We do have the technology. I think from a technology perspective, we do have it. We do have the channel to market. A lot of these products are manufactured overseas.
Yeah.
We have good suppliers and good partners through that. We may need more than one. I think we are working through that. One thing that brings to the picture is if you think about most US HVAC players, Julian-
Yeah
... they have a strong tie-up with somebody else.
Yeah.
Now we are the only ones who don't have that strong tie-up.
Yep.
If you flip that, among the global players, anybody who wants to enter U.S., we are the only one left. We are the only unattached one. We have more people wanting to partner with us than us trying to go seek out new partners, if that makes any sense.
Yep.
'Cause there are many large players today who don't have presence in U.S. Mitsubishi does because of.
Yeah
There are others who do. You know, Toshiba does, the JCI. I think put that all together. We're in a very strong position here with a North America focus and open opportunity for us to do more. That doesn't require acquisition capital. That doesn't require much investment. It requires more strategic partnership. If there's investment, it's around training, sales presence, dealer ramp up and all of that, so.
You know, Okay, the point is that, you know, VRF, you are looking to move ahead there and partnerships are a very likely way of helping you with that.
That's right.
If we look at, you know, moving away from maybe from the technology side to sort of stimulus measures and so forth, you know, I guess a couple of different elements. Education stimulus, you know, how far do you think through that we are now? You know, how much benefit did Lennox get, say, last year on sort of K - 12 and higher education spending? Looking ahead, infrastructure, Inflation Reduction Act, kind of where are we around, you know, when Inflation Reduction Act could maybe feed into some of your revenue or orders?
Sure. In the education initiative or the incentive, we had an initiative which started, like, two years ago.
Mm-hmm.
We met our goals, and we got appropriate benefit as we came towards the end of that. In many cases, because there was a deadline there where the funding was firing-
Yeah
we prioritized education orders more.
Mm-hmm.
Now, if you think of our strength, Our strength is typically in single story buildings.
Yeah
-unitary system, and that's schools typically, right?
Yeah.
Very few schools have a multi-story building, especially if you look at suburbs. We did well in the education center and met all our goals.
Mm-hmm.
Nice job by the team. If there was any miss, it was because of industry supply chain issues. Everybody had the same issues towards the end. On the Inflation Reduction Act, we are bullish on it. It helps the industry, it helps us. A large part of the monetary impact is going to happen later in this year as all the rules cascade through the states and the utilities and start getting... It's going to impact mix more than core demand because people who are replacing HVAC might replace in higher end to a higher end because there's a government rebate associated with a higher efficiency unit and heat pump unit. We do see it impacting mix more positively, and we see that impact more in the second half of this year.
I see it not as a step function change. It's not that on 1st June we'll suddenly see a big step change.
Right.
I just think it's a gradual uptake which has already started. You know, some of the tax benefits and the tax credits have already started. I think that's a good benefit.
Great. You know, I suppose when you know, I think there's been some perception that, you know, has did Lennox, you know, maybe under invest a little bit in recent years in areas like that low GWP refrigerant technology or VRF. You know, is there some catch up needed? Commercial has had some issues sort of with plant operations. You know, do you see a substantial need for kind of stepped up investment from here or not necessarily?
Let me have Michael answer the question on the commercial.
Yeah.
I'll come back to your research question.
Sure.
Yeah. On the commercial, we definitely had some issues earlier this year with manufacturing. We think we solved that issue predominantly through labor.
Mm-hmm.
We do need more capacity as we enter back into the emergency replacement space over the next couple of years. We announced that we're gonna enter and build a second factory for the commercial segment in Mexico.
Yep.
That's definitely an investment we're gonna make in that segment. That'll happen over the next year or two. Thereafter, it should be more normal CapEx in that business.
Sure.
On the R&D side, that's just not true that we under invested. I mean, we have invested same and more. Sometimes we get more out of our R&D dollars than others.
Mm-hmm
... because we spread our R&D between here and our technology center in India.
Yeah.
Because we are small and focused, we are really very focused on things that matter. In low GWP, we don't need to worry about propane regulations in Europe, you know? We are very focused.
Mm-hmm
... on low GWP in U.S.
Mm-hmm.
Our investments are very focused, and they might appear to be low compared to some others who are trying to balance regulations in Europe and Asia and China and U.S., and we are only focused on one, right? No, I mean, we are fully invested. Our designs are done. We are moving ahead. We might even be a step ahead of others in terms of putting appropriate capital to get our manufacturing facility ready. To bigger point on investment, I don't see any change in our SG&A, which includes R&D.
Yeah
... as a % of sales going forward. Our CapEx is going through a spike this year based on what Michael described.
Sure.
$100 million-$125 million, really looking at a new commercial factory. Starting next year, we expect us to be back to normal, 90%-100% free cash generation.
Got it. Maybe Michael or Alok, you know, following up on that new plant, you know, in Mexico, I think it's maybe two years out, it'll be getting towards sort of full production rate. You know, maybe help us understand, you know, how much extra, I don't know, share or revenue are we expecting out of that plant at full production? Kind of qualitatively, you know, what output will it have differing from the existing US factory output?
Sure. We expect the factory to start to go live mid-2024, and we'll start to ramp up throughout 2024. By the end of the year, have all production going through there. We think the footprint of the factory will give us ability to double our capacity. We won't put all of the equipment in to double it immediately, but it will give that opportunity to double capacity, which is key as we enter back into the emergency replacement space. Definitely a big upside for capacity. We think about 50% of our production will come out of Mexico. The other 50 will be in the U.S. at our existing Stuttgart factory.
Just to build up on that, the Stuttgart factory.
Mm-hmm
... will be very focused on made to order, like, you know, configured products. The factory in Mexico would be very much into made to stock or standard products. That's the standard products are the ones that have higher share on the emergency replacement. They're gonna be two very focused factories, and that actually brings up our efficiency significantly. 'Cause doing both in the same factory, given the size of those units.
Yeah
was getting quite challenging.
I see. Alok, I think, you know, as you said, it's been almost a year in the role. You know, some big changes already. The commercial plant, being added in Mexico, the sort of withdrawal from Europe. You know, what else do you kind of think not trying to tell us here decisions, but what other focus areas do you have in mind? You know, again, you've got a couple of big things done already. What else are you kind of exploring or thinking, you know, we can change direction here or...
I was thinking of taking up golf, Julian, and doing some other things. No, in all seriousness, these changes that we have announced recently, some of them were planned for a while.
Yeah.
During the CEO transition, everybody gets a little leery.
Yeah.
The CEO transition took longer than it should have, right? People just got a little gun-shy during the transition. The commercial second factory, it was shovel-ready plan when I came in. I mean, it wasn't that we had to create a new plan. I mean, things were sort of ready in that. Lennox has been working towards simplifying. We divested out of Australia and China and-
Mm-hmm
... Latin America. I think this was the final step. A lot of this is continuation of our strategy. We wanna be a simpler company, focus on HVAC. Our next big thing going forward is making sure we deliver on our margin goals. Okay. Our margin goals of getting to 18% - 20% ROS across both segments by 2026 is very important to us. A large part was gonna happen because of pricing. You know, our pricing opportunity is higher because of some of the national accounts and how long it takes for some of that. A large part of that is gonna happen as volume recovers in commercial, and we get more efficiencies on that.
A large part of that's going to happen as we look at our corporate cost and bringing that down slowly to more a normal level, to better reflect the fact that we are simpler company, 100% focused in U.S. That's where I'm going to be spending most of my time now, is looking at that while making sure we have the appropriate partnerships to win in heat pumps, VRF and mini-splits. Those are kinda all in one category of products that are growing faster. You know, all of these are things that we would have been doing earlier as well. For us, the CEO change is behind us.
Yep.
The strategic decisions are behind us. The second factory decision behind us. It's time to execute. Time to execute, get some growth, win some share, and expand ROS. Those are the three priorities we talked about when we had the top 200 leaders of the company.
On the ROS point, you know, two segments now, so it's an easier discussion. You know, commercial is very clear. I think you've got the sort of, you know, 150 improvement over three years. Residential maybe, you know, focusing more on that then. I think flattish margin this year is sort of in the financial plan. Once you get maybe through this destock or soft patch or what have you know, what kind of core operating leverage should people expect in that residential business? Do you see any natural, you know, competitive anchors on the margin? Maybe just talk about that.
You know, one strategic way to look at it is if a manufacturer in our industry makes 14%- 15% margin and a distributor makes a 10% margin.
Yeah.
Lennox should make 24%, right? I mean, it's simple math. I don't know why I would complicate it any more than that. That's kind of a margin goal. We need to go back and analyze is either our pricing is messed up or if our distribution is inefficient or our manufacturing is inefficient, right? There's no other reason. I start with that aspect on an outside-in looking.
Yep.
I go back and look at it. I'm confident we're gonna get higher margin in residential. This year will be flat to up-
Yeah.
despite significant manufacturing down. Remember, this year we are gonna make less than we sell. Last year, we made more than we sell. From production perspective, we'll be down more than sales. Still, our margins will be flat to up. Pricing is gonna be a big part of that. We've talked about manufacturing efficiency or reduction of manufacturing inefficiencies, lower air freight, lower premium on parts, lower all that will be another part of it. Finally, on residential side, we gotta get our distribution to be more efficient. You know, our distribution just needs to be more efficient. Those will be the three factors on which the residential margin is gonna go up. I didn't talk about mix. Mix was a negative on the past few years. Now it's gonna turn positive.
That mix element is because of sort of new construction being pressure-.
New construction being
The technology changes.
New construction down, SEER change being a positive. Finally, we have premium products in stock. We didn't have premium products in stock during COVID, just like Dave Lennox Signature Collection. We actually finally aggressively going after premium products that we didn't do for the past two years.
Re-residential, you know, you could be into that sort of 20s margin, theoretically.
I would expect by 2026, both residential and commercial to be in 20s. Like 18%-20% is our guidance right now, so.
Good. Well, I think now we'll switch to the audience response survey, questions, please. The first one is just sort of current, positioning in the stock. Very low ownership
Good opportunity.
-at present. Absolutely. Next question is around sort of general bias, aside from, you know, ownership today. Very balanced. Third is around growth, you know, EPS growth. The peer set here is, you know, US Industrials or US M ulti-Industry, sort of broader than just HVAC. In line with just slightly above the average. Next question I think is around capital deployment. Yeah, not a lot of leverage the near future. Buybacks, the preferred use of cash. Next I think is on the valuation. You know, what P/E should Lennox trade at, you know, through cycle, really this one.
Clearly, the answer is six, right, Julian?
Let's see. High teens is where most people are shaking out. Next question is around sort of, you know, why is it high teens and not to Alok's point, you know, 20 something times, or what's the biggest concern people have if they had to pick just one? Organic growth, similar to Trane somehow. The next one or last one, really a new question this year around sort of ESG, and the role that that does or doesn't play at present. More ESG. Generally, most answer been 25% for number one, so it's double that for you, which I think makes a lot of sense with the HVAC drivers. With that, Alok, thanks so much.
Thanks, Julian. Pleasure.
Thank you very much. Thanks, Julian.