Lennox International Inc. (LII) Q3 2013 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by. Welcome to the Lennox International Q3 2013 Earnings Call. [Operator Instructions] And as a reminder, today's call is being recorded. With that being said, I'll turn the conference over to the Vice President of Investor Relations, Mr. Steve Harrison. Please go ahead, sir.

Good morning. Thank you for joining us for this review of Lennox International's financial performance for the third quarter of 2013. I'm here today with Chairman and CEO, Todd Bluedorn; and CFO, Joe Reitmeier. Todd will review key points for the quarter, and Joe will take you through the company's financial performance and outlook. Financial results in prior periods have been revised to reflect sold businesses in discontinued operations. In the earnings release we issued this morning, we have included the necessary reconciliation of the financial metrics that will be discussed to GAAP measures. You can find a direct link of the webcast of today's conference call on our website at www.lennoxinternational.com. We will archive the webcast on that site and make it available for replay. We like to remind everyone that in the course of this call, to give you a better understanding of our operations, we will be making certain forward-looking statements. These statements are subject to numerous risks and uncertainties that could cause actual results to differ materially from such statements. For information concerning these risks and uncertainties, see Lennox International's publicly available filings with the SEC. The company disclaims any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Before I turn the call over to Todd, I would like to announce the date of our Annual Investment Community Meeting. It will be the morning of Wednesday, December 18, in New York City. Please mark your calendars. Invitations and more details will follow. The event will also be webcast. Now let me turn the call over to Chairman and CEO, Todd Bluedorn.

Thanks, Steve. Good morning, everyone, and thanks for joining us. The company's strong business momentum continued in the third quarter with 8% revenue growth at constant currency and earnings per share from continuing operations up 34% from prior year quarter. Both adjusted and GAAP EPS from continuing operations were $1.30, which set a new record for GAAP EPS for Lennox International. Total segment profit margin expanded 190 basis points and also set a new record at 11.9%. The company's growth continue to be led by our Residential business, but we also saw an acceleration in our Commercial business in the third quarter, and Residential revenue is up 13% at constant currency and segment profit grew 51%. New construction revenue was up high-single digits. And for the second quarter in a row, we were pleased to see Replacement business grow even faster at 13%. As most of you know, Replacement business contributes more than 75% of Residential segment revenue and has a richer product mix than new construction. For a third quarter in a row, we saw a step up in 14-plus year shipments from the prior year quarter. These high-efficiency systems were 38% of Residential cooling product shipments in the third quarter, up 3 points from the third quarter a year ago. Within minimum efficiency 13 SEER equipment shipments, low-end R-22 equipment continued to trend down from a year ago. Replacement revenue growth was strong in the third quarter despite cooling degree days being down a double-digit percentage from last year in the key summer months of July and August. We continue to see some of the pent-up demand, built up over the last year, start to flow back and contribute to robust Residential growth. However, I would note that pent-up demand relates to cooling products as a result of elevated repair rates on compressor bearing units over recent years. Gas furnaces are typically replaced and not repaired. So we do not expect to see the same impact from pent-up demand in the winter months as we have seen in the summer months. What we do expect to see through the winter, however, is ongoing market share gains as we continue to win dealers over to Lennox with our expanded distribution network, innovative HVAC systems and controls, and strong dealer support. The fourth quarter is off to a solid start. In our Commercial business, revenue is up 8% at constant currency and profit was up 21%. Segment margin had a record 16.4%. In North America, revenue was up double digits at constant currency in the third quarter. As expected, we realized a pickup in National Account equipment revenue growth on the strength of new National Account business. We continue to win in the marketplace with 29 new National Accounts last year and 15 more so far this year, including 9 in the third quarter. Our Lennox National Account Services business continue to see a specially strong growth as we leverage our National Account relationships. In the emergency replacement market, we continue to see good momentum from our new product, Raider, as well as from our expanded distribution footprint as we attack this $1.4 billion market segment opportunity. In Europe, our Commercial HVAC business was up for the first time in a year, despite the soft market conditions still in that region. Revenue was up low-single digits at constant currency. In Refrigeration, revenue was down 2% at constant currency and profit was down 5%. Refrigeration continued to experience soft market conditions in Europe with revenue down mid-single digits at constant currency. In Australia, we have seen the economy slow in the third quarter. And after latest Australian election and government changeover, lawmakers have drafted legislation to repeal the carbon tax in that country. We have experienced a slowdown in our refrigeration wholesale business in that country, including in our refrigerant operations. Australia revenue was down low-double digits at constant currency in the third quarter. In North America, revenue was up slightly but continued to be negatively impacted by pushouts from supermarket customers. Previously, we expected a pickup in North America shipments in the second half of 2013, but we now expect this business to fall into 2014. In emerging markets for Refrigeration, we continue to see strong growth. South America revenue was up double digits and China was up well over 50% at constant currency. Before I turn it over to Joe, let me update you on a couple of our strategic initiatives. In Residential, we added 3 new Lennox PartsPlus stores to our distribution network in the third quarter and are on track with plans to add a total of 28 of these wholesale stores this year. We now have 130 PartsPlus stores and it continued to be one of the keys to the success we are seeing in our Residential business. Within these stores, about 3/4 of the sales are HVAC equipment and 1/4 of the sales are parts and supplies. In our commercial distribution expansion, we now have 31 regional and local distribution centers as we continue to invest to provide the high level of same day/next day delivery that customers require for emergency replacement. We are on track with our plans to have at least 32 commercial distribution centers in place by the end of this year. In addition, we are often leveraging PartsPlus stores for smaller commercial rooftop units like our new Raider product for the emergency replacement market. While it's still early, we are pleased with the momentum we're seeing with Raider in serving the emergency replacement market. In the third quarter, we continue to invest in the business, introducing new products and expand Residential and Commercial distribution, as well as return cash to shareholders. We paid $12 million in dividends and repurchased 33 million of stock in the quarter. Year-to-date, we have repurchased 66 million of stock. For the full year, we are raising our stock repurchase guidance from 100 million to 125 million, including plans to repurchase 59 million in the fourth quarter. Currently, we have 305 million remaining under our existing stock repurchase authorizations. Now I'll turn it over to Joe.

Thank you, Todd, good morning, everyone. I'll provide some additional financial details and comments on the business segments for the quarter starting with Residential Heating & Cooling. In the third quarter, revenue from Residential Heating & Cooling was $434 million, up 12%. Foreign exchange had a negative 1-point impact on revenue growth, volume was up 9%, combined price and mix was up 4%, with both price up and mix up. Residential profit in the third quarter was $57 million, up 51%. Segment profit margin was 13.1%, up 330 basis points from the prior year quarter. Residential results were positively impacted by higher volume, favorable price and mix and lower material costs with partial offsets from higher SG&A and investments in our distribution expansion. Commercial Heating & Cooling segment revenue in the third quarter was $239 million, up 9%. Foreign exchange had a positive 1-point impact on revenue growth, volume was up 8% and combined price and mix was flat. Commercial segment profit in the third quarter was $39 million, up 21%. Segment profit margin was a record 16.4%, up 160 basis points from the prior year quarter. Commercial results were positively impacted by higher volume and lower material costs, with partial offsets from higher SG&A and investments in our commercial distribution expansion. In our Refrigeration segment, revenue in the third quarter was $195 million, down 4% from the prior year quarter. Foreign exchange had a negative 2-point impact on revenue growth, volume was down 2% and combined price and mix was flat. Refrigeration segment profit was $24 million, down 5% from the prior year quarter. Segment profit margin was flat at 12.3%. Refrigeration results were impacted by lower volume and SG&A investments with partial offsets from lower material costs and productivity initiatives. Looking at special items after-tax in the third quarter, the company had $700,000 for the net change in unrealized gains on unsettled futures contracts and a gain of $100,000 for other items net, partially offset by a $500,000 special legal contingency charge. SG&A was $137 million in the third quarter compared to $126 million in the prior year quarter on higher selling expenses and higher incentive compensation expense. Corporate expense was $17 million in the third quarter, up from $14 million in the prior year quarter. Cash from operations was $153 million in the third quarter, up from $75 million in the prior year quarter. Capital spending was $18 million compared to $12 million in the prior year quarter. Free cash flow in the third quarter was $136 million, up from $63 million in the third quarter a year ago. Total debt was $435 million and our debt-to-EBITDA ratio was 1.3 ending the quarter within our targeted range of 1x to 2x. Cash and cash equivalents were $38 million at the end of September. Before I turn it over to Q&A, I'll review our current outlook for 2013. For the industry, we continue to expect North American Residential HVAC shipments to be up high-single digits for the full year. We still anticipate North America commercial unitary shipments to be up low-single digits for the industry in 2013. And we continue to expect Europe HVAC and Refrigeration markets -- market shipments to be down low-single digits for the full year. Obviously, we are in an environment of high political and economic uncertainty. But based on the company's performance year-to-date and current outlook, our guidance for 2013 revenue growth remains 6% to 8% with a neutral impact from foreign exchange on a full year basis. We now expect Residential product mix to be flat for the full year versus our prior year guidance of a negative $5 million. We now expect a $35 million benefit from price and lower commodity cost for the full year versus $30 million previously. However, these 2 favorable adjustments to guidance are largely being offset by the choppiness we are seeing in the Refrigeration markets, which is presenting more of a headwind than expected in our previous outlook. We continue to be on track for approximately $30 million material cost savings for the year through a combination of sourcing initiatives and engineering-led cost reductions, and we are still -- and we still expect corporate expenses of approximately $85 million for 2013. Incorporating third quarter results, we are raising the low end of our 2013 guidance for adjusted EPS from continuing operations from a range of $3.45 to $3.75 to a new range of $3.50 to $3.75. GAAP EPS from continuing operations guidance moves from a range of $3.38 to $3.68 to a range of $3.43 to $3.68. To wrap up with a few other guidance points for 2013, we continue to expect net interest expense of approximately $15 million for the full year. Our tax rate is still expected to be between 34% to 35% on a full year basis. Our fully diluted share count for 2013, overall, is still expected to be approximately 51 million shares. And for capital spending, we continue to target approximately $60 million in 2013. And with that, let's go to Q&A.

[Operator Instructions] And first we'll go to Keith Hughes with SunTrust.

A couple of questions. One, specifically within Commercial, where was the strength on renovation, was it new construction? And just any kind of details there. And also, in Residential, have you seen any changes in your business here in October in terms of the pace of growth given all the events that's been in the news in the last several weeks?

First, on Commercial. Our mix of business, as you know, Keith, is 2/3 Replacement and that was the trend that we saw in third quarter. So the growth is in planned Replacement. As well as in emergency replacement, we saw good growth with Raider and the investments we've made there, both in product and distribution, paid off. So it was Replacement growth. In terms of Q4, we continue to win in the marketplace and on Residential, and we're off to a solid start. As I mentioned in the call, pent-up demand is primarily an air conditioning, heat pump event, not a furnace event. And we sell, as a percentage of our mix, more of those in the summertime. So we won't see -- I don't think we'll see the same kind of pent-up demand unleashed in the fourth quarter, but we're off to a solid start.

Our next question is from Rich Kwas with Wells Fargo.

Just a question on price cost and as you think about commodity improvement next year. Just remind us where you are with your hedging activity? And then it seems like you haven't seen the full benefit from lower commodity costs that were realized earlier in the year. So I know it's early for '14 but just conceptually, how should we start thinking about that?

Our hedging program, as you know, Rich, is we are hedged on copper and aluminum, and we're hedged 50 -- about 50% for purchases 12 months out, this is the way to think about it. So yes, there's some lower cost hedges that are flowing through our books than there were this time a year ago. But I think at the same time, I would point out that steel pricing is trending up and we think that will be some headwind as we go into next year. In terms of sort of the broader price cost equation, this industry -- and we have done a good job over the last couple of years, most specifically this year, of being able to get price to offset commodity increases during the cycle. And we expect we'll do something very similar as we go into 2014, announce a price increase and pass on to customers to offset steel increases, freight increases, cost increases we have in our businesses.

And then -- so as you think about '14, I mean, with this level of the magnitude of the spread this year, is it fair to say that you're going to try to offset the higher costs depending on what steel does here going forward, but then there's going to be some benefit coming through. So net-net, something similar is potential for next year in terms of the spread benefit or is there -- is that just -- would that be too optimistic?

I think, we'll tighten up the guidance in December, I'm not trying to be too cute with you. But we'll sort of play that out a little bit as we get closer to the December on that particular point. I think, the message I would leave you with is we're committed to getting price in 2014 just like we did in 2013. Other things I'd put in the model is on our -- commodity cost to the side, our material cost reduction efforts, we're going to get plus or minus $30 million this year. I would use that as a placeholder for next year as our material cost reduction program continues to play out. The kind of mix benefits that we got this year, I'd expect us to continue to drive mix in 2014 with all the investments that we've made.

Okay. And then last quick one. Just on non-res, are you seeing any signs on the construction side of increased quoting activity? There's been some chatter out there amongst some companies that things have started to pick up. So just curious what you're seeing on your front?

Sort of on the margins, I mean, as I said to Keith earlier, I mean, at least in our Commercial business, we -- our Commercial business, as we've seen it in the Replacement side of the business, the new construction maybe percolating a bit but corporates are still, and many of our customers, most specifically in the grocery segment of Refrigeration, are a little cautious right now about new investments.

And next we'll go to Rob Wertheimer with Vertical Research Partners.

Quick question on the share buyback, which was up a little bit, especially a little bit of extra weighed into 4Q. Is that any kind of indicator as to your view on the attractiveness of the acquisition environment or is that just business as usual until and unless something were to happen?

The second, it's business as usual, something -- in case -- until something happens. I mean, in a more positive way, I would talk about it as we had a really good cash quarter. And so as we've said about we're -- I'm never embarrassed to give -- we're never embarrassed to give cash back to our owners, and so we thought it was just prudent and sort of almost housekeeping event of raising it sort of in line with what we over delivered in a very good summer quarter.

Great. And it was great quarter. One of the things we struggled to model a little bit is the corporate and other line, which has bounced a little bit around, it was down this quarter. I think the implied guide is up next quarter. Is there anything -- can you maybe explain the volatility in that line a little bit, I had thought maybe we stepped up to a higher level the last couple of quarters and then this one was lower.

I think we were still up year-over-year in third quarter. We may not have been as high as what you had in your model, but I think we are up. I mean, fourth quarter is going to be a big corporate expense quarter for us and if you sort of do the backward math, it's $25 million, $30 million in fourth quarter. And this is primarily related to higher incentive comp in our annual plans, as well as our long-term plans, and we're triggering higher incentive comp. Q4 tends to be a true up quarter for us. The honest answer is sort of year-over-year, it bounces around because of STI and LTI, or short-term incentive and long-term incentive. But full year, the guidance is $85 million, and I think that's consistent with what we said on the last call.

And next we'll go to Josh Pokrzywinski with MKM Partners.

Just back on the price cost and sourcing benefits for this year. I understand some of those are getting diluted by the Refrigeration headwinds, but I would have thought we would have seen a little bit more margin expansion, particularly in resi, off that growth this quarter. Is that somehow weighted more to 4Q or was there more investment in these PartsPlus stores kind of sequentially that was diluting that? I guess, just any color there or any timing there in for fourth quarter would be helpful as well.

No. I mean, I guess, I just struggle a little bit with the premise, Josh. I mean, I know maybe it didn't tie to your model, but we thought resi had a great quarter with earnings up 15% and margins up dramatically and commercial same-same. And then in Refrigeration, even in some tough end markets and revenue of constant FX down 2%, they had constant margins on a year-ago basis. So I'd argue that we're seeing the kind of incremental drop-through that people had expected and certainly what we'd committed to, and we saw that in third quarter. And I think if you project out our guidance, we'll see it in fourth quarter.

Okay. I guess, just the way I was looking at it though was versus 2Q in Residential, it looked like a normal seasonal progression in the margin kind of the step down quarter-to-quarter. And if I had remembered it right, it seemed like a lot of those benefits on sourcing and price cost were weighted to the second half. Is that true? Or did I miss something there?

I think you broadly had it. But again, I think we'll see some more of those material -- if that's your question, we'll see some more of those material cost reductions in fourth quarter. But yes, were still committed to the 30% -- $30 million sourcing cost reduction, where 2/3 of it or so in the second half of the year.

Okay. That's helpful. And as you guys think about the pricing environment heading into next year, I know fourth quarter is usually an announced price increase. Do you think the appetite for prices is still there in the market with commodities being flattish I think on net and demand, maybe on a macro basis, being a little anemic maybe outside of Residential markets. Do you still feel like you should prosecute price for '14?

As I said earlier, I think, well, let me wrestle you down on the premise. Our Commercial business was up 8%-ish in the third quarter so -- and we're sort of getting momentum on planned Replacement and the emergency replacements. I think the Commercial market's picking up a little bit, certainly the parts of the market we see in Residential strength, I think continues. Also on commodities, I think copper is probably a tailwind as we sit right now. But I think steel is definitely a headwind. And so, as I said earlier, yes, short answer is, we need to get price in 2014. And I think we'll play out in a similar way to what we did in '13 announced something going into the year and capture it. And I think the industry has done that in the past and we plan on doing it in 2014.

Okay. That's helpful. And then just one last one for me. You guys have talked in the past, I think, over the past several years about thinking about Lennox as a whole, as levering up with incremental margins kind of in the low-20s all in. With the sourcing benefits you've put in place and the PartsPlus expansion and certainly getting more of a market tailwind here, how should we think about that structurally today and over the next several years? Does that number shift more into the high-20s approaching 30 or are there other items that we should be thinking about?

Last December, when we gave a sort of a 3-year look on the business, the implied drop through was closer to 30 than it was to 20. And so I would have said a year ago in December when I talked, I would have said use 30% in any medium-term model. We'll give a updated view of that when we're together in December.

[Operator Instructions] And in the line of Walt Liptak with Global Hunter Securities.

I wanted to ask about the comment on the R-22 trending down. I wonder if you could talk about is it cost related or is it sales effort towards more system sales?

I think it's all of the above. The R-22 sale, really, is driven by -- or really driven to a consumer who just can't afford to do what's right for himself sort of on an MPV basis and are just managing short-term cash flow. And as consumer confidence has trended up and people are feeling better about the economy in 2013 than they did back in 2011, we've sort of seen the mix up and the system sales go together to help drive down R-22. And part of that is the market, part of that are clear actions that we have taken, as we talked about, 18 months ago that we were going to do around our marketing mix and how we position the product and how we sold them product. Things like introducing icomfort Wi-Fi our control system that ties together a whole system to really sort of drive system sales, is a big part of what we're doing. But also it's because R-22, as we get closer to the formal obsolescence of virgin production, it's harder and harder, I think, for dealers to make that sale to consumers. And so the -- and third quarter, it was under 10% and sort of heading down.

Okay. Great. And if I can switch gears and just ask about your outlook for Refrigeration in 2014. And I think you're looking for a pickup, what's that based in?

I think it's conversation with our customers, in some of our large grocery customers, and our dialogue and conversation with them of sort of pushing things out and moving into 2014. And when we get into the December call, we'll give a little bit more color on that. But I think more than anything, I'm sending a signal that -- on the last call I talked about being second half of '13, I think it's more likely the pickup is going to be '14.

The next question is from Jeff Hammond with KeyBanc Capital Markets.

This is James Picariello calling in for Jeff. Just a question about Europe. What you guys -- I know it's a smaller piece of the pie, but what you guys are seeing out of Europe? And also if you could just flesh out your comment on the choppiness in emerging markets, particularly what the cadence was in Europe from July through October or September, October?

First, I'll answer the second part of your question first. In emerging markets, we had great success, Brazil up double digits and China up over 50% for the quarter. So emerging markets, we did well. In Europe, it was sort of a story of 2 different businesses. And we're driven in Europe, given the size of our business and what we do there, often by larger orders. And in third quarter, Commercial HVAC was up low-single digits. Our Refrigeration business was down single digits. And again, we're focused -- our growth strategies are focused on Eastern Europe, North Africa, the Middle East, sort of what traditional Europe, France, Germany was sort of flattish to slightly down and just sort of continues to tread water is the way I would think about it.

And next go to Samuel Eisner with Goldman Sachs.

Just had a couple of questions on the Commercial business. It looks as though you mentioned that mix or price/mix was flat. I'm just curious how you're thinking about market share on the commercial product particularly given, I guess, the seemingly success of the Raider product?

I think we won share in the third quarter. I think we won it both in National Accounts and in emergency replacement. And the investments that we've made in both those segments on product are paying off. We traditionally had strength in National Accounts and a lot of the customers we won over the last 18 -- or some of the customers we won in the last 18 months are sort of picking up some of their buying habits second half of the year. And I think, clearly, in emergency replacement we picked up some share both in second and in third quarter.

That's great. And then just lastly on the Refrigeration business. You said that performance there is coming a little bit weaker than you had expected. Is that more from a regional standpoint that is coming in weaker-than-expected or is that just there's some product introductions that are a little bit weaker? Just help us understand a little bit more where the specific weakness is coming from.

I think it's driven by end markets. I think our business is performing well, both on the innovation of their products and even in a tough revenue environment, keeping their return on sales flat, what sort of demonstrates strong operational performance. I think what we're seeing is Australia, which is a meaningful part of our Refrigeration business 20%, 25% of what we do in our Refrigeration segment, we've seen pressure there. And we're a refrigeration wholesaler, and the government has pending legislation to eliminate a carbon tax and is often the case when there's regulatory change, the market tends to freeze up as people wait for clarity. And we're seeing some of that in the Australia business, and that's why revenue was down double digits for us there. And then in the U.S., we were up, but just a bit. And the segment there that we're seeing slowness in is the grocery segment, and I think our -- I think that's an industry phenomena. I think our team is doing well. I think it's just the customers are pushing out orders.

And we have a follow-up from Robert Wertheimer.

Just a real quick one. Is the Raider product a material portion of the commercial mix at this point? Is it additive or dilutive to margin if so?

It's consistent with margins, so it's sort of order of magnitude to same margin. And if material is defined as 10% or more, it's not material yet.

And we do have a question from Aditya Satghare with Lazard Capital Markets.

It's Aditya from Lazard here. Two questions. So can you talk about the high-efficiency 14 SEER plus shipments being up this quarter versus sort of last year. Do we expect to see any similar benefit in terms of consumer buying behavior going to the winter season?

Yes. I mean, we'll give guidance on '14 as we get a little -- at our December Analyst Day. But the investments we've made to mix up, I think, are paying off both in product and the way we've handled other elements of the marketing mix. But I also think the consumer is stronger than they certainly were a year ago. And we're going to do everything we can to continue that mix up in 2014 and we -- quite frankly, expect it.

Got it. Next question is on -- when we think about -- in the kind of grabbing share on Commercial, you did really well on the Residential side. But how do you think about potential competitive response in terms of the new product introductions or other competitors trying to expand the distribution channels and so on? Like how should we think about the potential competitor response here?

I mean sort of the old line, the other team is being coached too, right. So we certainly expect responses, we see responses. And the game is nothing that you do lasts more than a year or 2, and you have to continue to be adding to it. And so we continue to innovate on product and we'll continue to do that. We know we have to take costs out to be able compete, we continue to do that. I think distribution, adding distribution is tougher for our competitors to do. We're in a unique position, in our Lennox brands, that we own all our distribution. So we can sort of make our own decisions on what we want to do and what we don't want to do, and we've made the decision we want to grow it. Using independent distribution, it's more complicated on how you implement. So I think we have a unique opportunity, given our distribution strategy, and we're going to continue to grow it, and let's see how people respond. When they do, we'll respond to their responses.

And with no further questions in queue, I'll turn it back to the presenters for any closing comments.

Great. Thanks, operator. A few points I'm going to leave you with. We continue to see strong growth on our Residential business and we're now seeing pickup in our Commercial business as well. And we expect Refrigeration markets, most specifically in Australia and grocery in the U.S., to remain choppy for the balance of the year. Overall, the fourth quarter is off to a solid start and the company remains strategically well positioned to capitalize on growth in our major end markets and drive increased profitability through our operational initiatives. We look forward to our Investment Community Meeting on December 18, in Midtown. We hope to see you there as we discuss our outlook and plans for 2014 and beyond. Thank you, everyone, for joining us today.

Ladies and gentlemen, that does conclude your conference for today. Thank you for your participation. You may now disconnect.