Good morning, everybody. I'm Tim Wojs. I cover building products here at Baird, and we're delighted to have Lennox International join us again this year at our Global Industrial Conference. Lennox is a global leader in residential and commercial HVAC and refrigeration equipment. From the company, we have CEO Alok Maskara, we have CFO Michael Quenzer, and then Chelsey Pulcheon, who is in IR, is in the audience. We're going to start off with a few prepared remarks from Alok, and then we'll hop into Q&A. The floor is yours.
Great. Thanks, Tim. Thanks for having us over. I just want to start by a few slides and highlighting what Lennox is for those who are new to the story. As you see from this slide, we are a very healthy company, go into two segments, Home Comfort Solutions and Building Climate Solutions segments. Home Comfort Solutions is a little larger than Building Climate Solutions, and Building Climate Solutions has had spectacular performance over the past four years and has grown substantially. From application perspective, most of our revenue comes from replacement, which makes us resilient during different economic cycles. One unique thing about us is 75% of our revenue comes from going directly to a contractor.
We typically will skip the distribution channel and sell all Lennox-branded products directly to a customer in retail, direct to a contractor in Home Comfort Solutions, and bypassing the standard two-step model helps us stay closer to the customer and deliver good new products and good value. Our free cash conversion remains strong despite some of the challenges we have had in financials on the residential segment. Our differentiation compared to any other company, as I said earlier, is that we are close to over 10,000 contractors in U.S. and Canada. We are very focused. Almost everything we do is in U.S. and Canada. We are a North American company, again, very close to all our contractors. We own 250 outlets of our own. These are Lennox-branded. They sell parts. They serve as equipment pickup points. Half of our sales in this now goes through e-commerce.
We have our own channel called LennoxPros. LennoxPros continues to get better with AI, continues to get better with interacting with new field service management software, and that's the digital platform that I believe will continue strengthening our position. As technology evolves, the direct-to-contractor model is something we bank on and we are very proud of. We have had some challenges recently, especially when it comes to residential. On the left-hand side of the page, you would see we had almost a perfect storm in the past couple of quarters. We got hit by the Section 232 derivative tariffs, a bit unexpectedly. Last year was the first set of tariffs. Then these new set of tariffs hit us disproportionately as we manufacture a lot in Mexico. This happened mid-year, and we were unable to recover that in pricing in mid-year.
What you saw in Q3 was the impact of all the tariff flowing through our P&L and us not being able to capture pricing middle of the year. In addition, what we have seen is the consumer remains soft. While the industry has nicely recovered from destocking, the consumer remains tough, new housing still sluggish, interest rates, so that does impact our residential business. The number of units in the industry, depending on what numbers you look at, is down 10%-20% from its peak. It is getting better, but it is still down 10%-20% from its peak. We are focused on four key actions to make sure we can return back to normalcy, return back to continuous margin expansion. The first is just pricing.
When we went out and tried to get pricing because of the additional tariff, we lost some market share, and now we are at a stage where we are using a more dynamic pricing approach, less rigid, more flexible, and all going with all our business units, going with price increase at the end of the year so we can start getting back to normalcy. End of the year is important milestone. Quite a few contracts allow us to do price increases at the beginning of the year every year, and it is harder to do that in middle of the year. End of the year is also important because we see a lot more folks are getting impacted by steel increase, copper increase, compressor increases, and the diesel increase impacts everybody as well.
I think there is just a higher inflationary environment that we get to reset the bar beginning of the year. We are also retweaking our portfolio. We are the premium branded player in HVAC. We have always been at the top of the highest SEER, quietest product, and now we are introducing a lot more lower-tier products as well. These are not margin dilutive, but they do come with lower ASPs. This includes our side discharge products. This includes our lower-tier Merit products. This includes our mini-split products through the Samsung JV. And of course, we are giving our dealers the option to sell water heaters as part of expanding the portfolio. We are doubling down on productivity, especially as a lot of our engineers who are working on regulatory transition now have more time to work on material cost reductions.
We are working on productivity to offset a lot of the tariff. It is hard to offset tariffs within a quarter or a month, but over longer periods, we can move supply chains, and we are moving supply chains to offset the impact of tariff. And finally, we need a lot more promoters. Our Net Promoter Score across all our business units is increased substantially over the past four years. We have had some trouble spots that we are working through, but we just continue to work on getting more and more promoters by serving our customers well. In the long term, we remain convinced that we have a superior business model. We have lots of remaining opportunity for long-term margin expansion, and we believe that as we switch into 2027, we are going to see a mixed picture. I think price inflation is going to remain challenging for everybody.
None of us can predict where diesel's going to go, or steel's going to go, or where copper's going to go. But we do see the sales volume starting to neutralize. We are done with destocking. We are done with sort of the repair versus replace dynamics. We are done with some of the fears that was plaguing the HVAC industry. And we are expecting significant amount of cost productivity as we can truly get behind our material cost reduction effort. We can truly accelerate our tariff mitigation efforts and continue to get distribution productivity based on the investments we have recently made. As a company, we remain bullish about the industry's future, we remain bullish about our future, and we believe that we'll continue to enhance value for the shareholders, despite the sharp results we had in Q3 and this year.
With that, happy to take questions and move to the next phase.
Yeah. Great. Thank you for that overview. If anybody has any questions, you can raise your hand or you can email session4@rwbaird.com. Maybe Alok, just kind of circling back to what you were talking about in terms of kind of the issues that kind of popped up this year. How much of it do you think was just tariffs, and just your inability to kind of get a mid-year, or the industry's inability to get a mid-year price increase versus something else?
I think inflation was the primary cause, and the primary driver of within inflation was tariff. I think we paid about $50 million in tariffs in Q3. Think about this $50 million is not something that was part of our long-range plan or anything else. Now, historically, we have been able to mitigate quite a few of that, but that supply chain shifts takes a while for us to happen. You got to move compressor supply, you got to buy different types of steels, you got to move production from factory in Mexico to U.S. And sometime when you're serving Canada, you got to move production from your U.S. factory to Mexico, so you can escape tariffs going to Canada. All those moves just take a lot of time. But yeah, I would say tariff was the number one factor in inflation.
Yes, we were unable to offset it because everybody gets impacted by tariff differently. For those of us who have a higher footprint in Mexico, we got impacted more and more suddenly, and that is what we were not able to offset. I think if you were to ask me the one primary cause of what happened to Q3, that is a $50 million impact.
Okay. Okay. I guess on pricing, just why did not it stick in 2026? I mean, I guess there are two schools of thought. I guess the first is, if you go back to pre-COVID, it was hard for the industry to get a mid-year price increase. The other side of it is, maybe the market is just telling you there is just no more price. I guess kind of where do you kind of fall on that?
I think it is more the traditional, it is hard to get a mid-year price increase. I mean, if you think about the past few years, the number of price increases that have gone into effect, SEER transition, first Liberation Day tariffs, the recent inflationary pressures, people have been doing surcharges. I just think because not everybody got impacted by tariffs at the same time, people felt inflation, some people felt the secondary impact of tariffs, we just could not stick a mid-year price increase. I do not see the industry fundamentally changing. I mean, there are number of entrants in the industry are about the same. The number of players are fewer than what they were in before, and I talk about OEM. So I am pretty convinced that this was just a mid-year timing issue.
Okay. It sounds like from a pricing perspective, the right way for us to think about it is, productivity is actually going to be maybe a bigger offset to some of the tariffs than actual unit price will be.
No, I think that both would be. We will get price. Everybody's, we've been announced some already, and we will definitely get price. I think productivity offsets tariffs. Sometime it's just supply chain move that are not natural, but we have to based on the regulations. I think that both will play an equal part in that.
Okay. Okay. I guess when we kind of step back and you think about kind of volumes this year, how much of the underperformance was just kind of one-off items? I know there's a builder contract that didn't get renewed, and maybe a little bit of fallout from that. I guess, is it kind of a one-off issue that you kind of see, or is it something more underlying that we should-
In volume, besides the industry trends, which you guys are all experts in by now, right? I mean, I think our unique feature was the loss of two residential new construction contract, which happens every few years. It's kind of goes back and forth. That starts lapping itself as we get into early next year. From our perspective, that unique to us. Now, low margin business, and you can see the impact in our business. You can also see the impact in other folks in the industry. From our perspective, we made those choices. We are now going to look at this in a very different way. If you're going to win it back, we're going to win it back in a smarter way, looking at truly coming up with a lower cost, lower price product, much more entry level that we can go in.
These are standard vertical discharge products that we're going to work through it. I would say on our volume side, that's the one that uniquely impacted Lennox this year.
Okay.
Overall from industry, we are pleased with the repair versus replace dynamics stabilizing or getting better. We are pleased with destocking getting over. We are quite pleased with the way our dealer base has adapted to all the consumer softness through better financing, different type of sales techniques. We think the industry remains pretty healthy.
Okay. When you think about the entry-level product, I think the industry, for at least for the last 10 or 15 years that I have covered it, most of the industry has operated at minimum efficiency.
Yeah.
I guess it is a higher level now, but what is kind of happening on this entry level, and what is kind of driving Could you just kind of explain kind of what is going on with kind of more popularity of the entry-level products?
Yeah. So I think if you take within the lowest tier, so let us just start with the regulatory required 13 or 14 tier, the lowest tier. Within that, you could have multiple good, better, best as well.
Okay.
And I think where our portfolio has probably not been as robust is on the good category in that. These are not bad quality products. They will have lesser warranty. We will use probably compressors that are overseas sourced, and that gives us a tariff benefits. The visible look of the unit is going to be different, so they do not have the metal shroud in front of that anymore, or if they do, not on all four sides. They will have different type of valves and connections. So it is just different. In some cases, we are going to flip it around, and we call it side discharge, so it can be fit in California zero lot lines and save some metal in through that. And for us, it is also how the cost to serve works in that.
We are very high service, but some of the new builders, they do not really care about that service aspect. So we will look at how do we replenish their orders, how do we pull that together. So it is more of an entire supply chain effort. I think it is just our attempt to help the consumer who is stressed, our attempt to make sure our dealer wins on the kitchen table every time. We used to have with the good, better, best type product. Now I think I call it you need four tiers. You need value, good, better, best. And it is the value piece that we are reinforcing given how stressed the consumer is right now.
Okay. And your point would be the value piece is, A, that is not an area you have played in historically, so you need to develop the product, roll that out. And then two, it is a little bit more of a cyclical dynamic just because of the stress versus something where the value range becomes a large portion of the industry.
It is. So first of all, we ran a pilot in Florida, and that went very well. We are releasing it in Q1. So these are, by the way, not new product development. They are kind of new configurations per se. So easier to do. So we are already talking to our contractors, going to get released to the whole portfolio in Q1. And yes, it is a bit of cyclical. Everybody in times of stress on consumer tries to make it easier for them to replace. And this honestly is a great battle on a repair versus replace dynamic, on how we make sure that the replacement continues winning, which is a better economic choice for the consumer. But yes, Lennox being a premium brand, we did not play in this tier as some of the other players have.
That's now our way of saying, "Yeah, we're going to get there too.
Okay. You've mentioned it a couple times just with repair versus replace, but just kind of where do you think you are in that? Do you think that's kind of peaked? I think if you go back to prior refrigeration changes, you've kind of had a similar dynamic to some extent play out. So, how much would you chalk up to just the refrigerant change last year creating a lot of kind of dislocation in the market versus that kind of stressed consumer?
I think it was both. I would probably give it a 60% refrigerant change dynamic. Remember the whole canister shortage and lots of different things that were going around with R454B. All that's behind us. The dealer training and confidence is behind us. So I think if you think about, maybe I'll call it the dip, right, in sort of the peak, we are coming out of the dip now. So replacement is back to normal at this stage. I don't see our dealers getting stressed about it. Repair is very hard. To get a trained technician who can open up a unit and replace a compressor, that's a rare commodity these days. Those skill sets are no longer existing in the today's trade environment. So I think we are beyond that.
Any questions from the audience?
On your replacements, are people replacing from premium to value, or are they doing premium for premium?
Usually it goes premium to premium, because again, within the consumer, the high-end consumer is not suffering, right? Our premium business is doing quite well. So, that has stayed steady, and they never went more in the replacement. It is more in the they are going from good to value. So somebody who was buying a ML14 is now looking for ML14 value series. It is that consumer who is stressed, and that is what we are looking at it. But I think the repair versus replacement dynamic at this stage is no longer a concern. From our perspective, that was a temporary phenomena by all the different factors.
How quickly do you think R410A is going to be out of the system?
From a units perspective, some of us still have E&O, but we are working through it. At the end of this year, we will be left with very little. The channel will be left very little. And if it is, it is odds and ends, because they do not match the system, right? It is a coil that does not match the outdoor unit or vice versa. So I think, to me, that is a thing of the past.
Question.
Just maybe one question coming back to the price-cost issue. So when you look at Lennox and its history, for the last several years, price-cost was always positive. Pricing was always a positive driver of profits and margin, margins and profits.
Yeah.
Price-cost is not positive anymore, which is a rare occasion when you look at Lennox.
Yeah.
It's said to explain it's mostly tariffs, but I'm not sure whether there's not also a market share element to it, tougher competition.
Just repeat.
Is that also part of the explanation, and why should that then get better next year?
Yeah, so maybe
Just repeat the question.
Yeah, so the question is, Lennox has historically had price-cost positive in the past few years, and recently it has not been the case. Although our explanation has been tariff, the question is it really just tariff, or is it a broader industry phenomena or something else? I will tell you the sequence of events from moving to the answer. We got hit with tariffs. Some folks did, some did not. We went out with a price increase. That caused share pressure, so we backed off on that. I think that is kind of the sequencing of the events, right? Because I mean, nothing is immune to zero share. So it was not that we were losing share, hence it did that. It is like we withdrew our price increases because we were losing share.
Going forward, listen, I am not going to say that we are going to get 400 basis points of margin expansion that we did in the past few years. I mean, right now, first is let us stabilize margin and then start growing back again 30, 50 basis points a year going forward. Our long-term target still envision that. It is no longer talking about like in a significant growth. The new price increases going into effect in early 2027 will help. Tariff mitigation effect is going to also help. We just got the perfect storm. When you wake up on a Thursday and you have to start paying millions in tariff on Monday, your hands are kind of constrained. There is not a whole lot you can do. Yes, on top of that, diesel doubles in price, and I could keep making excuses, but that is not the point.
The point is, what are we going to do about it? Which is, yes, we are going to go get price. Yes, we are going to offset much of the inflation with productivity, and we expect a healthier balance. Is it going to get better overnight? No. Hence, in our 2027, I still called out that in the red bar, right? I think it's going to be a fight. I don't see anything fundamental changing with the industry dynamic. We all look at from the inflation perspective, copper, aluminum, compressor, diesel, the cost basis for the industry remains the same. I think the ability of the homeowner when it's under challenge, we help them out with the lower entry tier price points. We help them with different aspects, financing, to take that forward.
Maybe just on your Lennox stores, if you could just kind of give us an update. I know that's been an area where you focused on cross-selling, you've been focused on improved profitability. Just kind of give us an update on where that's at.
Sure. So we, from a structural perspective, are making a lot of changes there. As you know, we opened up our DFW FDC, which is factory distribution centers, to do more of a replenishment that is based on consumption, so consumption-based replenishment, and that is going to remove a lot of wastage from the stores. At the same time, we are getting more products through our Ariston joint venture, Samsung joint venture, a lot more emphasis on parts, and we are starting a new parts distribution center early in Q1. While doing all of this, of course, when the market goes down, you'll end up having a bit of absorption challenge, which is what happened to us, right? So overall, our strategic progress is good. Our internal metrics on that are tracking well.
We, as we lost units like everybody else, we land up having a bit of absorption challenge, which means we got to rethink the productivity and double down on that. We're shrinking some of our footprint as the leases expire or we restructure those out. Those 250 stores are our core assets. I mean, they are the ones where we want to be within 20 minutes drive from any contractor that they can go pick up a spare part or a water heater or a mini-split, get some technical training, get all the literature, and get the warranty service parts. So that remains our core part of it. We're neither growing nor shrinking the number of stores as we continuously reevaluate and put our footprint in the best optimal location. So we are pleased with the progress.
The results are suffering from the volume, and we expect that to turn around as all the different pieces I mentioned on productivity turns around for us.
Okay. Hey, Mike. Just on, we'll bring you into the conversation, but just, is there a way to just quantify what the absorption kind of headwind has been for you guys over the last, I guess, destocking last year and then this year, kind of where that's at now?
Yeah. As we saw the industry destock, we also were impacted by that, and we've been reducing our inventory this year in addition to some of the inventory declines because of the residential new construction channel's been a little bit softer. So we've experienced about $25 million-$30 million of absorption headwind this year, as our production was lower than sales. As we look into next year, though, we expect our production to be in line with sales, and we'll be able to see a lot of that, the absorption benefit coming back. Part of that cost productivity initiative that Alok talked about of how we're going to narrow this price-cost gap, especially in the H1 , will be around absorption next year.
Okay. Okay, great. And then I guess just maybe on the commercial business.
Finally, some questions on commercial.
Where are you at? I mean, you've obviously rebuilt. You put a new factory in Mexico. You've kind of rebuilt some of your market share on the emergency replacement side. What inning are you in kind of recapturing that emergency replacement share, and how do we think of that kind of impacting the top line?
Sure. From in terms of investments made to get returns, we are probably in the seventh, eighth inning. We're done with the investment part of it. From a results perspective, we are probably in the third inning right now. I mean, for the first time at the end of this year, we'll have our inventory deployed in 70% of the locations that we want to deploy. Another 30% will happen next year. It's not just inventory deployment, right? Every deployment takes sales team deployment, local marketing efforts. We go region by region, and that's been doing well. So third inning on that one. It's a good part of our success story, and the way as we look at it on our HCS business, we're actually using the same tactics to get recovery in HCS with a slightly different challenge. In one case, we were short of capacity.
Here, we have a little too much capacity, but we are moving talent between the two businesses. We are using the same top of effort. Commercial, the service business is doing well with the AES acquisition. That's well integrated, a full value proposition. We have regained all the lost key accounts that had plagued our business because of our one place to do installation, one place to do MRO-type maintenance on a service contract, one place to do recycling, pulling all that together. The last part of our business, which is CORE, is refrigeration. It's a business at Lennox that has the highest Net Promoter Score, which always correlates. It also has the highest margin in the business and has got strong loyalty where we have got a lot of share. This is despite some of the regulatory back and forth that we had to deal with.
We feel very good about BCS, and now we are kind of making sure HCS gets back to the same level as well.
Okay. How about the planned replacement market? How is that kind of holding up for you guys?
It is holding out quite well. As we used to call about like deferred demand, right? There were so many rooftops on top of large, big DIY chains that were beyond their useful life. We started that CapEx coming out loose this year, and we think that is a multi-year trend. It started coming out loose. We are in good discussion with people. Nobody wanted to plan it when you had 52 weeks lead time, but now that the lead times are down to five to six-week level, we are seeing that demand come out to be planned and purposeful and over a multi-year horizon.
Okay.
We think that is doing well.
Okay. I don't know if this is the right day to ask it, but you mentioned last on your earnings call that the refrigeration business is kind of working on some things within the data center business. Any kind of color on kind of what you're working on there?
Yes. We'll give you the color. First of all, we're not trying to chase the CDU business or any of the cyclical things. I mean, that's not who we are. We do know that data center cooling is a big opportunity. We have invested in CORE technology, CORE showcase, to be able to use our refrigeration technology for the next generation data center cooling. This is going to be a two-phase or immersion-based cooling. This is going to be about higher efficiency. This is going to be about zero water usage. This is going to enable natural refrigerants such as CO2, and this is going to be about using all those technical skills to go to the next generation of data center technology. We're not expecting any revenue in 2027 based on what we are targeting is going to be the phase starting in 2028.
We're not putting this in any of our model, and I think it's a great way for us to show our innovation power and build a long-term healthy business. But no, we're not going to chase the CDU-type business, and given where we are, I think it's a good investment, but it's the same time, we don't want to do this data center up or down. This is going to be about the long-term health of a two-phase, water-free, 15%-20% energy-efficient solution compared to where the industry is today.
Okay. I guess just with the stock pullback over the last kind of year- to- date, I guess, is capital allocation going to really be kind of focused on buybacks at this point?
Yeah. Capital allocation for the past couple years has been really focused on two things, both on acquisitions and share repurchases. We've done two acquisitions. Both are performing extremely well. We had accretion within the first year. We see some synergies still coming out of those. But for the next year or so, we're going to continue to focus on some self-help initiatives within the residential space, driving a lot of free cash flow, near 100% of net income, and converting that free cash flow more into buybacks while still maintaining a healthy leverage. Our current leverage is about 1.5 x debt to EBITDA. Our target's somewhere between that 1.5x to 2 x. First, just generate a lot of cash flow, and then use that to deploy to share repurchases.
And then maybe just the last one. We're asking a bunch of companies this question here this year, but just when you think about AI, how has artificial intelligence changed internally for you guys over the last 12 months?
Sure. I think we woke up to the AI trend about three years ago, so maybe we were a bit slow. But when we woke up, we realized two things, right? First is, to truly harness AI, we got to have our data lakes very clean. So we set up a whole central data lake. Our ERPs are all our systems. They feed into a central secure data lake. Second, we realized we had to upgrade our tech stack. So our tech stack, you couldn't do it with old accounts payable, old websites. Both of those are complete now. Now we look at AI as three different benefit categories. First is general employee productivity. So all our employees are going through AI training.
Everybody has to have AI in their objectives, and we expect everybody to at least do 10% more in terms of free time or extra work to make it happen. Second for us is rewiring core processes. I'll highlight a few. SIOPs, so our inventory planning processes, customer experience, and our pricing. I mean, those are three. You can't do dynamic pricing unless you're using AI. And third is embedded in our products. So you can see whether it's a new thermostat or a new CORE controllers or the way we do prognostic, diagnostic monitoring, that's all encased. So we are building all three of those layers and working through to get to impact.
Awesome. We are out of time, so please join me in thanking the Lennox team for being here.