Lennox International, Inc. Q4 2007 Earnings Call Transcript

| About: Lennox International (LII)

Lennox International, Inc. (NYSE:LII)

Q4 FY07 Earnings Call

February 6, 2008, 10:30 AM ET

Executives

Karen Fugate - VP, IR

Todd M. Bluedorn - CEO

Susan K. Carter - CFO

Analysts

Curtis Woodworth - JP Morgan

Jeffrey Hammond - KeyBanc Capital Market

Michael Coleman - Sterne, Agee

Operator

Thank you. Ladies and gentlemen, thank you for standing by. Welcome to the Lennox International Q4 and Full Year 2007 Earnings Conference Call. At the request of your host, all lines are in a listen-only mode. There will be a question-and-answer session at the end of the presentation. As a reminder, this call is being recorded.

I would now like to turn the conference over to Karen Fugate, Vice President of Investor Relations. Please go ahead.

Karen Fugate - Vice President, Investor Relations

Good morning. Thank you for joining us for this review of Lennox International financial performance for the fourth quarter and full year. I am here today with Todd Bluedorn, our CEO; and Sue Carter, our CFO. Todd will review highlights for the quarter, and Sue will take you through the company's financial performance.

In the earnings release we issued this morning, we have included the necessary reconciliations and the financial metric that will be discussed to generally, accepted accounting principles. You can find a direct link to the webcast of today's conference call on our corporate website at www.lennoxinternational.com. We will archive the webcast on that site and make it available for replay.

I would also like to remind everyone that in the course of this call, to give you a better understand of our operations, we will be making certain forward-looking statements. These forward-looking statements are subject to risks and uncertainties. A list of these risks and uncertainties is included in our recent 10-K filing with the SEC, and includes the impact of higher raw material prices, our ability to implement price increases for our products and services, the impact of unfavorable weather and a possibility that a decline in new construction activity will depress demand for products and services. These risks and uncertainties could cause our actual results to differ materially from those we expressed to you today.

I will now turn the call over to Todd Bluedorn.

Todd M. Bluedorn - Chief Executive Officer

Good morning everyone. I will start today's call with an overview of our full-year results. Lennox International finished 2007 with strong financial performance. In fact, three of our businesses, Commercial, Service Experts, and Refrigeration had outstanding results with EBIT growth in double digits, and margin expansion. In the face of tough markets, our residential business took aggressive cost actions and ended the year with solid results.

Total company revenue was $3.7 billion, a growth of 1% over last year. EBIT rose to 7.4% was up 50 basis points. Earnings per share on an adjusted basis were $2.50, a growth of 15%. GAAP earnings per share were $2.43, a growth of 8%. Our focus on cost containment across the enterprise gained traction and approve point as the year-over-year improvement in corporate expenses up $13 million. But, this is just the beginning of our cost reduction efforts. We still have significant opportunities in front of us to drive margin expansion and to support growth into other segments of business.

We generated cash flow from operations of $238 million and invested $68 million in capital assets. Our free cash flow for the year was very strong in $170 million, a market improvement over last year's $126 million. We returned $282 million to our shareholders to stock buyback, up $247 million and a $35 million in the form of dividends. Our Board of Directors has increased the dividend in each of the last four years, resulting in a compound annual growth rate of over 10%.

We continue to buyback shares to our $500 million share repurchase program, and by year end over 40% of the program was complete, and we remain on track for third quarter's year 08 completion. Our balance sheet remains strong with the year end debt of $208 million for a debt-to-EBITDA ratio of 0.6. We continue to have significant capacity to utilize our balance sheet strength to expand and sustain our premium position.

Now, turning to the fourth quarter results. Revenues for total LII were $887 million, up 1%. Earnings per share on an adjusted basis were $0.55 for year-over-year growth of 20%. On a GAAP basis, earnings per share were $0.59, growth of 2%. 2007 was the year of unprecedented challenges in the North America residential market, but a year of solid execution for LII. We said in motion, many strategic priorities that will benefit the enterprise over the long-term.

Firstly, broke down our low-cost assembly factory in Saltillo, Mexico. This factory plays a critical role on our low-cost sourcing and manufacturing efforts, reducing our cost by over $20 million on an annual run rate basis by 2010. Manufacturing and sourcing excellence is a priority for LII and we have more opportunities in the pipeline.

Second, we made progress on our the factory rationalization efforts. We announced three factory closures in 2007. Although restructuring charges are incurred in the near term, we expect close to $10 million in annual savings on a run rate basis in 2010. We are looking across our businesses to evaluate further consolidation of our manufacturing footprint and reduction of manufacturing overhead.

Third, product innovation was at the forefront of 2007. Our new premium commercial rooftop unit Strategos is a first of its kind in the industry. Innovative products like our Healthy Climate air cleaner and ozone-free indoor air quality products are the best on the residential market. And on the refrigeration side, we introduced our inter-link EC motors, most energy efficient motor technology available for commercial refrigeration of operators. It's cutting edge projects...products like these that differentiate LII from the competition.

And lastly, expense reductions are an area of continued focus for us. Over the last several quarters, we have taken a bite out of corporate expenses and lowered SG&A as a percentage of sales. But, we have a long way to go before we are done.

Before I turn it over to Sue, I would like to briefly wrap up with our thoughts on 2008. First and foremost, we reaffirm our 2008 outlook provided at the December Analyst Meeting. That is adjusted earnings per share in the range of $2.85 to $3, and GAAP earnings per share in the range of $2.73 to $2.88. We expect financial performance during the first half of the year to be softer in second half, primarily due to the current market conditions in residential and new store retails openings being pushed out in commercial retail market. We will continue our focus on the cost side of equation and execute on our strategic priorities.

Now, I will turn it over to Sue.

Susan K. Carter - Chief Financial Officer

Thank You Todd. Good morning everyone. As you've heard from Todd this morning, LII finished the year with strong financial results. I'll provide some additional commentary on the business segments for the quarter and full year, starting with the residential heating and cooling.

For the fourth quarter, sales in the Residential business were $354 million, down 11% from prior year, primarily driven by lower sales volume of 16%, offset by favorable price and mix of 3% and 1% respectively. Currency was favorable by 1%. Segment profit in the quarter was $31 million, a margin of 9%, compared to $43 million and a margin of 11% in the year-ago quarter.

Full year sales in the residential segment reached $1.7 billion, a year-over-year decline of 10%. Sales volume was down 16%, while product mix and price improved 1% and 5% respectively. Segment profit for the year was $174 million, a margin of 10%, compared to profit of $212 million and a margin of 11% in 2006.

As you may recall, our residential segment includes our hearth business and our ADP coil business, which are disproportionately down a year-over-year due to their exposure to the RNC segment. The residential equipment business was able to maintain relatively flat segment margins for the year due to cost reductions and pricing actions.

Before I move on, let me just count non-recurring warranty gain in the fourth quarter. We made a change to the way we fulfill our warranty obligation on a Pulse furnace, which is product that was produced from 1982 to 1999. We worked with our dealer partners to focus on the customers to make an equitable change to our warranty process. This change resulted...this change in our warranty policy resulted in a one-time $17 million pre-tax reduction in the warranty reserve, which we excluded from our adjusted results.

Now, turning to our Commercial Heating and Cooling business. Our Commercial segment had an excellent quarter and a record breaking year. Sales in the fourth quarter reached $224 million, growth of 14% or 8% growth when adjusted for foreign exchange. Growth was the result of favorable product mix and pricing. Commercial segment profit in the fourth quarter grew 26% to $24 million, a margin of 11% and 100 basis points improvement over the last year. Earnings improvement is attributed to favorable product mix and cost containment.

Commercial sales for the full year were $875 million, year-over-year improvements of 16%. Favorable foreign exchange contributed 3% to that growth, and we realized price of 5% and favorable product mix and volume of 4% each. Total segment profit for the year increased 39% to reach $101 million. Margin improved by approximately 200 basis points to 12%. Favorable product mix shifts to our high-efficiency rooftop unit, profitability in Europe and cost reductions drove profitability improvements.

Moving to our Service Experts business. Sales in the fourth quarter were $169 million, 5% growth or 2% growth when adjusted for favorable foreign exchange. Segment profit in the quarter was $7 million, a margin of 4% versus $8 million, a margin of 5% in the year ago quarter. 2006 fourth quarter results include an incremental $2 million favorable adjustment to our causality insurance accrual.

For the full year, sales and service experts reached $681 million, year-over-year growth of 4% or 3% when adjusted for foreign exchange. Segment profit for the year was $25 million, a 4% margin. The strong performance was driven by a favorable mix shift to higher margin service and replacement business, geographic mix and cost reduction efforts.

In our Refrigeration segments, fourth quarter sales grew 17% to $158 million, or 6% when adjusted for foreign currency. Segment profit for the quarter was $15 million, a year-over-year improvements of 27%. Profit margin was 9% and 80 basis point improvement over the last year.

Sales from our Refrigeration segment for the full year topped $608 million, up 15%. This 15% increase consisted of 4% volume, 4% price, and a 7% benefit from foreign exchange. Segment profit was $62 million for the year, and 18% improvement over last year. Profit margin was 10%, a 30 basis point improvement.

LII had very strong cash results for the year. Our cash from operations at $238 million and free cash flow at $170 million were significant improvement over last year's results. Our free cash flow being equal to total company net income for the year is consistent with our long-term cash conversion goals. Our $282 million return to shareholders in the form of dividends or stock buybacks was facilitated by this excellent free cash flow and balance sheet leverage.

Our working capital ratio for the trailing 12 month average in 2007 of 18.3% and increased from our results in 2006, reflects the impact of caring higher inventory levels than anticipated through much of the year. However, our year end working capital ratio at 16.4%, which is roughly equal to the 2006 year end position, reflects the significant progress for the company in managing these issues through the latter part of the year.

Our total capital expenditures in 2007 were $68 million. We project our capital expenditures in 2008 will be approximately $90 million. These funds will be used to invest in new products, capacity and process improvement initiatives.

Before we go to Q&A, I'll briefly talk about our 2008 outlook. We don't provide outlook by business segment, but I will update the market assumptions, since we last spoke in December. On the residential side, the North America RNC market is expected to be down a bit further than the mid teens we talked about in December. The NAHB data now shows RNC down 20% for 2008, estimates for replacement remained same, down just slightly flat. Assuming the residential market is 70% replacement and 30% RNC, you get into a decline of mid-single digits for the total residential market.

Turning to the commercial side; as you know, a large portion of our commercial business comes from retailers, some of who have probably pushed out new stores. Therefore the backlog for our commercial business remain solid and we believe that 2008 looks a lot like 2007 with markets flat to up a few points.

So with that, let's turn the total company guidance. Our total company, we expect revenue of $3.8 billion to $3.9 billion, growth of 2% to 5%; core earnings per share of $2.85 to $3 per share, growth of 14% to 20%; GAAP earnings per share of $2.73 to $2.88, growth of 12% to 19%. Capital expenditures of approximately $90 million and a tax rate of 36% to 37%.

And with that, let's go to Q&A.

Question And Answer

Operator

[Operator Instructions]. And we will go first to the line of Curt Woodworth with J.P. Morgan. Please go ahead.

Curtis Woodworth - JP Morgan

Yeah. Hi, good morning

Todd M. Bluedorn - Chief Executive Officer

Hi, Curt. How are you?

Curtis Woodworth - JP Morgan

Good. How are you?

Todd M. Bluedorn - Chief Executive Officer

Good.

Curtis Woodworth - JP Morgan

In terms of thinking about sort of the distribution of growth and earnings for 2008, you made a comments similar to what you talked in the Analyst Day that the first half is going to be probably a little weaker than the second half. And I wonder if you can kind of just walk me through that a little bit more in terms how different do you think the growth rates could look first half to second half? Given some of the economic data that points a potential recession, what's the level of confidence that the market did accelerate in the back half of the year?

Todd M. Bluedorn - Chief Executive Officer

Well, Curt as you know, we don't provide quarterly guidance. But let me offer you a little bit of thinking on it and a lot of this you know which is, our businesses is clearly seasonal with Q1 being our lowest revenue and profit quarter followed by Q4, with Q2 and Q3 our largest quarters. And as I mentioned and as you just reiterated, we expect the first half to be a little slower than the second half, driven in part by the new construction and residential. Couple of numbers to give you, the North America home builders' data shows that the first...we're still predicting the first half of the year will be down about 30%, and the second half of the year will be down 15%, and part of that quite frankly is just comps get easier as we get to the second half of the year after what's happened in 07.

The second issue that I have talked about and Sue had mentioned during the first half of the year is some of our retail customers have pushed out some of their orders to second half of the year, the largest being Wal-Mart. But the balance of our commercial business, which is about 60%, our contractor customers remain optimistic for all of 2008. Their backlogs look strong and they are signaling that to us. And given the growth that we've had international accounts business, the 29 new accounts that we captured in 2007 in part with our Strategos unit, we feel confident on the balance of our commercial business. So really to me that the big risk or the big softness during the first half of the year has to do with the residential market. And I think our confirmation of guidance for full year sort of reflects that.

Curtis Woodworth - JP Morgan

Okay. Great, thank you. And then in terms of the gross margin for the company. A lot of significant improvement on SG&A and gross margin this year into the fourth quarter results despite very weak residential volumes was really impressive. So I am just wondering in terms of thinking about 08 in terms of getting kind of this annualized benefit of all the cost actions you took in 2007. It seems like it would be pretty fair to assume that gross margin on the flattish volume scenario should be up year-over-year in 2008?

Todd M. Bluedorn - Chief Executive Officer

Short answer is yes. But longer answer would be to talk about the guidance that I gave in December, and I talked about how we have an end the year at 7.4 EBIT rise, which we did and I talked about a 2010 target of 10%. We obviously need to be on that line in 2008. And so we are clearly focused on margin expansion on 2008.

Curtis Woodworth - JP Morgan

On both the growth and on the SG&A benefit line?

Todd M. Bluedorn - Chief Executive Officer

Correct, yes.

Curtis Woodworth - JP Morgan

Last question in terms of leverage. Even with the buyback they're going to be only about one turn debt-to-EBITDA. How high would you be willing to go and you have seen acquisition opportunities that would even foster that?

Todd M. Bluedorn - Chief Executive Officer

Let me answer the first question and then I will get to the second question. As we talked about in December, as you suggest we are going to end up about one debt-to-EBITDA as we go into 2008. When we look at where we think make sense for a company of our size and debt rating and competitive field. We think 2ish is sort of a reasonable place for us to be. And then...so if we are going to end at 1ish and 2ish is the place to be, then we look at where else can we go. As you suggest that it's either investments organically into business, it's acquisitions that can make sense in lieu of that to give the money back to the shareholders. In terms of acquisition, I don't... none of us talk about individual candidates, but this is clearly an industry that lends itself to consolidation. I think we were in a strong position to do that, given our market leading position and our strong balance sheet. The businesses that make sense to us are the businesses that we have strength in which is our north America residential business, our north Americana commercial business, our refrigeration businesses can make sense and as I talked about in December we like commercial service quite a bit and so growing that business to acquisition could also make sense.

Curtis Woodworth - JP Morgan

Great. And would you characterize the pipeline in terms of opportunity. Is this better than it was last year or the kind of given the market conditions, the buybacks, the priority near term in picking that?

Todd M. Bluedorn - Chief Executive Officer

As you know, acquisitions are often a long dance and so I think at any given time the pipeline or at least the conversations around the pipeline need to fallen, that's where we are focused on.

Curtis Woodworth - JP Morgan

Great, thanks a lot.

Todd M. Bluedorn - Chief Executive Officer

Great. Thanks, Curt.

Operator

: All right, thank you. Next we'll go to the line of Jeff Hammond with KeyBanc Capital Markets. Please go ahead.

Jeffrey Hammond - KeyBanc Capital Market

Hi Good morning.

Todd M. Bluedorn - Chief Executive Officer

Hi, Jeff. How are you?

Jeffrey Hammond - KeyBanc Capital Market

Good.Todd, just want to go...it seems like you lowered your new construction assumption, seems like you lowered your commercial at least slightly from a market perspective. In the revenue guidance is unchanged. So does that mean that you picked that up with share or your bias is maybe more towards the lower end or maybe just a little more color there?

Todd M. Bluedorn - Chief Executive Officer

I think you probably fair on the back end of your statement, which is probably biased towards the lower end right now. And then also I mean my inclination is to on the revenues guidance, let's get a quarter under our belt. As you know, first quarter is our lowest quarters; second and third quarters the really big drivers. So I think that's the short answer.

Jeffrey Hammond - KeyBanc Capital Market

Okay, and then looks like you drew down inventories substantially in the quarter. Can you just speak to the impact that had on absorption and just maybe characterize how you feel about your inventories and the inventories in the channel.

Todd M. Bluedorn - Chief Executive Officer

On the inventories on the channel as you know given that the majority...vast majority of our business is one step. We are typically not concerned about that in the same way that our competitors are, who have predominantly two steps. So we are as end use demand goes up our sales will fluctuate very quickly with that. In terms of the inventory drive down in the fourth quarter, yes, and that was good news as we helped generate cash with that. And we had absorption impacts, but overall we were able to a large degree off set those with cost reductions in the factory that helped protect our margins. So long answer...or short answer is we had inventory go down, we have some absorption we offset it to a large degree with cost reduction.

Jeffrey Hammond - KeyBanc Capital Market

Okay, great. And then just...you talked a little bit about restructuring benefits in the 2009-2010. Taken all the actions together to-date, do you give any material benefit in 08. And is that incorporated in the guidance?

Todd M. Bluedorn - Chief Executive Officer

No material benefit in 08. Really 09 is when we start to kick it in. In fact I don't have the exact math in front of me, I think it's neutral to a slight headwind on some of the period expenses that we are going be having in our face at the end of 2008. So, it's really an 09, 10 benefit on the factory reconsolidation. Some of the restructuring that we have done on our head count that you see in the corporate expanse line obviously we will see those benefits in 2008.

Jeffrey Hammond - KeyBanc Capital Market

Okay. And then just final question back to the acquisition discussions, maybe just to ask it a little bit different way; as you came in April, it seems like you are very focused internally on cost improvements and restructuring actions. I just want to get better sense of how the balance is shifting or not shifting internally versus externally. Are you more focused externally now than you were six to nine months ago?

Todd M. Bluedorn - Chief Executive Officer

I guess the way I think about it, is given the market conditions that we face there is no way me or anyone else in this organization has taken our eye off the internal focus restructuring margin expansion and cost reduction, we can't afford to. So we have not in anyway lessened the focus that we had on that when I first walked in the door, where zeroed in on that. It's taking time, we understand as I talked about in December that the future of this company is about growth. And so we are focused on...at the same time our new product development and then the third piece is industry consolidation, and so we are starting and have started trying to fill the pipeline with candidates that can make sense, but I don't want to convey that in some way we've taken our eye off the cost book, because we haven't.

Jeffrey Hammond - KeyBanc Capital Market

Okay. Great, thanks.

Todd M. Bluedorn - Chief Executive Officer

Thanks.

Operator

All right, thank you. [Operator Instructions]. And we'll go now to the line of Michael Coleman with Sterne Agee. Please go ahead.

Michael Coleman - Sterne, Agee

Hi, good morning.

Todd M. Bluedorn - Chief Executive Officer

Hi, Michel, how are you?

Michael Coleman - Sterne, Agee

Doing well. You picked up three points of price on your residential business in the fourth quarter. And if I go back, I think you picked up maybe highest single digits in the fourth quarter of 06, which was on top of price gains in the fourth quarter of 05. If you look out given the volume issues in the new residential construction and so forth. Do you see at some point, where you are not going to get price at least in the coming year?

Todd M. Bluedorn - Chief Executive Officer

I think the way I would answer it is, we have been very disciplined on offsetting the commodity increases in our business with price increases. And the volatility of the commodities will really drive what we think we can get on price in the marketplace. And so in the current market, as commodities go up, I think we will be capture more price and will drive to do that.

Michael Coleman - Sterne, Agee

Okay. And you seem to at least this year capture more price on the commercial side of the business than residential. Are you finding it not necessarily easier, but are you finding the commercial end market more receptive to price increases?

Todd M. Bluedorn - Chief Executive Officer

I think short supply and demand indicates that the market in commercial is strong. Third and fourth years of a strong, certain supports price as we announced a 5%...excuse me 8% to 5% increase in prices on our commercial product line December 1st of 2007. So we recently announced the price increase on commercial continue to push pricing the marketplace.

Michael Coleman - Sterne, Agee

Okay. And if you take an action on residential?

Todd M. Bluedorn - Chief Executive Officer

We have not announced recent price increase in residential, but as you know that's the deal-to-deal business, where we sort of push pricing as we go. So in any given market, we are fighting everyday for price, but haven't had a recent price announcement.

Michael Coleman - Sterne, Agee

Okay. In terms of the commercial the descriptions of commercial potential push outs in the first half. Relative to your comments in December, have you seen in acceleration in the kind of the push outs or the commercial deterioration in the last mid-December.

Todd M. Bluedorn - Chief Executive Officer

No, that's a good question, and the answer is no. In terms of the guidance that I gave in December, it's really consistent with my view there on the commercial market, which is the things I knew about the retail pushing out we knew in December, talked about it in the same comments that I gave on the broader 60% of our business, which is non retail the contractors remain optimistic and talk optimistic about the back log.

Michael Coleman - Sterne, Agee

Okay, great. Thank you.

Todd M. Bluedorn - Chief Executive Officer

Thanks.

Operator

Thank you. [Operator Instructions].

Todd M. Bluedorn - Chief Executive Officer

Okay, I would like to wrap up then. Couple of comments in closing. LII has strong results despite a very tough market, but with outstanding performance in the three of the four businesses strategic initiatives set in motion ensure LII is well positioned to expand its premium position and reduce costs across the enterprise. 2008 is about execution. And though the markets remain tough, we re-affirm the financial outlook we laid out in December and remain optimistic about this market and our position in it. Thank you all for your time. Thanks.

Operator

Ladies and gentlemen, that does conclude our conference for today. Thank you for your participation and for using AT&T Executive Teleconference service. You may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!