Lennox International, Inc. (NYSE:LII)
Bank of America Merrill Lynch Global Industrials & Materials Conference Call
September 6, 2012 9:30 AM ET
Todd Bluedorn – Chairman and CEO
Let’s start, and welcome back, everyone. With us today from Lennox International is its CEO and Chairman, Todd Bluedorn. Lennox is a global leader in heating, air conditioning and refrigeration markets. Todd has been CEO since 2007. You were elected Chairman this year, I believe. And Todd has served numerous senior roles at UTX since 1995 prior to his role at Lennox.
So without further ado, I’ll hand over.
Great. Thanks. Why don’t we go ahead and get started. I’m going to make a few opening comments and then we’ll turn it over to Q&A. This is a chart I always like to lead with. For those of you who are new to the story; this talks about the investment thesis in the stock, really four points.
One is, we have and continue to reduce our cost structure. The last four or five years we’ve gone from 25 to 15 factories, have done significant material cost reduction as we’ve moved our component supply base from North America to Asia, significant reduction in SG&A. And as revenue flows back across our business, we’ll be able to leverage those cost reductions is SG&A. We’ve committed we’ll going to grow half the rate of revenue as our end markets and our revenue grow.
Second point is, even when we’ve been doing this aggressive cost reduction actions we’ve continued to invest in the business, research and development to differentiate our product, investments like our India Research Center. So continue to differentiate product, also making significant investments in our physical distribution, this is the business where having physical distribution on the ground, drives market share gains.
Some of you may have heard us talk about our residential distribution strategy where we’re increasing the number of physical distribution points doubling it over a three-year period. We ended the year at 75 of these. We’re going to end this year over 100 and we’ll be over 125 next year. Have a similar strategy on the commercial side of the business as we leverage the investments we’re making in residential to also grow physical distribution for our commercial business.
Third is, after four, five years of being in the absolute wrong place at the wrong time, being in North America, tied to housing is probably not a bad place to be. And so this pent-up demand that we talked about of people have been, on the replacement side of the business, have been repairing units rather than replacing them. We think that’s an opportunity going forward. We talked about macroeconomic conditions to support that unleashing in the pent-up demand as things like stabilization of existing home values, consumer confidence and unemployment.
I think home values have started to make the turn. The other two metrics, I think, are still flashing yellow, maybe red. First half of this year for the first time in a long time, we saw our equipment sales grow faster than our part sales. And we think that’s sort of positive sign, which is an early sign of sort of unwinding of some of this pent-up demand.
And then finally, we have been extremely disciplined with a focus on shareholder value and our free cash flow. We think about, one, investing in the business first to doing focused targeted M&A like we did with our Kysor/Warren deal, where we play in the businesses that we or spend in the businesses we know well. We’ll have dividends grow with earnings over time and then we give money back to shareholders with share buyback. Our target debt to EBITDA levels too and over the last five years, we’ve returned over $750 million to shareholders through share buyback.
Let me talk a little bit about the four businesses. This is a breakout in revenue and earnings of our four segments. Maybe let me talk a bit about each of them. First overall, we had a good first half of the year with revenue up 4% at constant FX, earnings up 11%. We also exited the Hearth business, which was a non-core business that we sold to private equity earlier in the year.
Our Residential business, revenue up 10% through the first half of the year, constant FX, earnings up 30%. We’re winning in the marketplace. Market’s not growing as fast as we are. I think that’s a couple things. One is we have more exposure to residential new construction than many of our peers. We have a strong share with the major homebuilders as well as regional homebuilders. And that segment of the market has grown faster than the replacement segment and so that sort of mix shift, if you will, has helped us.
The other is within each segment, both add-on and replacement and new construction, we think we’re winning in the marketplace. We think our investments that I talked about and our physical distribution parts plus, as well as our investments in a fuller product line, most namely a furnace line that we launched last year or finished last year, is helping us.
Mix has still been headwind this year for us. We talked last year a lot about a mix down that we saw last year and we said we’d have $15 million mix headwind this year. We still think that’s about right. In second quarter, we saw a continued trade down as customers are still buying more entry-level product, increasingly more entry-level product and premium product. But I think the one good sign that we saw through second quarter was R-22 as a percentage of our sales was flat where we thought it would be up year-over-year.
Again, those of you who know our story know that this issue of R-22 had an impact of where – if you’re replacing an outdoor unit on an R-22 system with this R-22 dry-charged, you just get the air conditioner. But if you can sell the whole 410A system, you get the furnace and the full system sale. And so, we think part of the reason our revenue is up is we’ve done a good job of sort of combating this R-22.
We had a solid July as the warm weather helped us. Growth rates in August slowed down a bit. As we get closer – as we now started the month of September, it’s quite frankly less about weather now. So that the hot weather that helped us in the summer is now behind us and it’s more about dealers having confidence going into the heating selling season and loading up on furnaces. And so sort of the broader economic situation in North America is more of a driver and the confidence levels of our dealer are a driver as we head in or as we complete the month. September is about a third of the residential revenue for the quarter.
And our Commercial and Refrigeration segments, and I’ll just combine them for ease of comments, our revenues through the first half of the year were up 3% at constant FX. Again, we think we’re winning in the marketplace with differentiated energy efficient equipment as well as being successful with integration of our Kysor/Warren acquisition.
We had headwinds in Australia during the first half of the year. That’s about a quarter of our refrigeration business and other than mining; the economic conditions in Australia are tough right now. What we saw though in the first half of the year was the deceleration as we went through the year, that revenue was up in first quarter 5%, 6% and then it was flat in second quarter.
On the second quarter call, we used the word solid to describe the order rate and backlog in our Commercial/Refrigeration business. I would say in July and August we saw a deterioration in that. So we saw order rates and backlogs start to shrink in both businesses and I think this reflects the toughening, or better stated the increasing uncertainty in the macroeconomic conditions globally and in the U.S.
Our final segment is Service Experts. We’ve seen weakness in this business through second quarter. Our revenue was down 13%. The disconnect between this business and our Residential Equipment business is Service Experts doesn’t participate in residential new construction in any meaningful way and so they missed that bump.
It’s also the dealers that are part of our Service Expert network have traditionally focused on premium product, the premium segment and that’s the segment of the market that is not growing and they haven’t been able to pivot as much as we would like to the entry-level products. We’re taking cost actions and we’re repositioning the business.
On the second quarter call, we gave new guidance. Revenue up or constant FX 3% to 6% and then adjusted earnings per share from continuing operations $2.35 to $2.65 with a midpoint of $2.50. I think the color that I’d give on that from a couple of months ago would be when we gave it as that’s still our guidance but the softening in the commercial and refrigeration markets are sort of hanging on that number a bit.
As we talk about sort of more broadly 2012, a couple updates on sort of components of things is material cost reduction. We continue to talk about $20 million to $25 million in material cost reduction this year, more the second half than the first half and more fourth quarter than third quarter. Restructuring tailwind of $10 million, volume growth which you’ve seen in the business. And then price, we’ve said we would get price to offset commodities and our call on commodities now are a headwind to $10 million to $15 million from a year ago.
On the right hand side, the negative, the macroeconomic uncertainty I think I’ve talked about as we’ve seen sort of the slowdown in our Commercial businesses over the last few months. Commodities, as I’ve said, $10 million to $15 million headwind. And then a variable SG&A that we’ve talked about of $20 million headwind as we reinflate incentive comp that we didn’t pay out last year. Final point on the guidance that I talked about earlier, so we reconfirmed.
So with that, I’ll open it up for questions that the audience may have.
You mentioned raw material cost and I think at your quarterly, you said you’re confident that you could get pricing to overcome that headwind. Is that still the case?
Yes. The industry has been disciplined in the fact that we’ve been able – we and the industry has been able to offset commodity increases with price over the full cycle and we’re confident that we’re going to do that this year.
Maybe I’ll just ask one more. Can you just comment on inventories and backlog? I’m not sure whether you’re able to do it at an industry or competitor level but...
Yeah. I mean we’ll – 80% of our distribution, we own ourselves and 20% we sell through independent distribution. And I think I would characterize independent distribution as cautiously optimistic, but then maybe underline the cautious part. And I guess my point would be is end-use demand, I think, will quickly be realized by us as our distributors are used to us supplying them as they need it. And so, there’s not a lot of inventory between us and our end customers. Yes?
In regards to your commercial customers in refrigeration and just kind of thinking of that sector in general, what’s your thought for the step-back at the commercial customers that you’re speaking to there?
I think our growth rate has been in planned replacement where customers are making investments to lower their operating cost by upgrading our equipment either on refrigeration side or on the HVAC side. And I think as we get closer to the end of the year on some of the uncertainties in the U.S. economy, I think some of the customers are sort of slowing down some of their spending decisions.
I think it’s a timing issue. I think these are all positive investments that our customers will continue to make. But I think there’s enough uncertainty in the U.S. economy right now that people are starting to slow down a bit.
All right. In regards to the R-22 units being sent out without refrigerating being loaded up in the field, how long does that continue for? When do we get to a point when something is bought and shipped out, it’s a fully package system?
Again, you know the economics of an end-use customer buying an R-22 dry-charged unit really only makes sense if they’re managing, in business jargon, for cash flows. So sort of, if you will, the breakeven of buying a full system versus an R-22 dry-charged in many areas is two years or less. And so, someone buys an R-22 dry-charged if they’re just trying to sort of get through a hot summer and make the system last a bit longer.
And there’s couple speed bumps, I think, along the way that stop it or slow it down. One has been regulatory changes by the EPA and DOE. EPA has reduced the supply curve of R-22 which has raised the price to 2.5 times what it was a year ago. So the increase in R-22 pricing, I think, is one of the reasons it’s flat year-over-year rather than the increase that we thought might happen.
I think another speed bump along the way is going to be a regulatory change in 2015 that goes for many parts of the country from a minimum of 13 SEER to 14 SEER and from a multitude of reasons for people to launch R-22 14 SEER unit is going to be difficult for them to do so the existing 13 SEER R-22 unit goes away. So I think there’s a – I think it would be a slope down over a multi-year period. I don’t think it’s a step function down. But I do think this is the high watermark this year.
If there are no more questions, we might –
If there’s no questions, okay.
– finish there.
Good. Thank you.
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