Welcome to the Lennox International Fourth Quarter 2022 Earnings Conference Call. All lines are currently in a listen only mode, and there will be a question and answer session at the end of the presentation [Operator Instructions]. As a reminder, this call is being recorded. I would now like to turn the conference over to Alok Maskara, CEO. Alok, please go ahead.

Thank you, Ashley. Good morning, and welcome. I hope everyone is having a good start to 2023. It was nice to meet many of you face-to-face during the Investor Day on December 14th. Thanks for attending and sharing your feedback. Turning to Slide 2, a reminder that during today's call, we will be making certain forward-looking statements that are subject to numerous risks and uncertainties, as outlined on this page. Please refer to our SEC filings available on our Web site for additional details. Before we begin, I want to express my gratitude and appreciation to all of our employees who enabled us to deliver record financial results in 2022. Last year, our dedicated employees improved our customer experience while facing significant supply chain disruptions. This enabled us to reestablish our cadence of gaining residential market share. I want to take this opportunity to also thank our dealers and customers for their loyalty to Lennox. We will continue to improve our service levels while maintaining the best HVACR products and solution in North America so that we can continue gaining share in the future. Now please turn to Slide 3 where I want to highlight four key messages. First, we are proud to report solid fourth quarter results that capped off another record year for Lennox. Q4 revenues of $1.1 billion and full year revenues of $4.7 billion were both up 13% year-over-year. Strong price execution and continued volume growth enabled us to set new records for both quarterly and full year revenues. Q4 adjusted earnings per share of $2.63 and full year EPS of $14.07 both grew 12%, establishing a new record of full year EPS. Second, we successfully transitioned our product portfolio to meet the new minimum regional efficiency regulation that went into effect on January 1, 2023.…

Thank you, Alok. Good morning, everyone. Please turn to Slide 5. Looking at the quarter for Lennox overall, the company posted strong revenue and profit growth. Revenue was a record $1.1 billion, up 13% as reported and up 14% at constant currency, with the growth driven by volume and price. Total segment profit increased $30 million or 30% versus prior year as pricing gains more than offset cost inflation, and all three segments contributed to profit growth. Total segment margin was 12.1%, up 150 basis points as price gains outpaced cost inflation and Commercial margins improved due to higher factory output. GAAP EPS of $2.65 was up 17% and adjusted EPS rose 12% to $2.63. Regarding special items, the company had an $800,000 adjustment for the fourth quarter and $6.6 million for the full year. Corporate expenses were $34 million in the fourth quarter and $91 million for the full year. Overall, SG&A was $155 million in the fourth quarter or 14.2% of revenue, down from 15.7% in the prior year quarter. And for the full year, SG&A was $627 million or 13.3% of revenue, down from 14.3% in the prior year. Our full year 2022 income tax rate was 19.3%, which was up from the 17.2% last year, the result of higher tax benefits from share based compensation and the finalization of our prior year tax obligations with taxing authorities. For 2022, the company generated cash from operations of $302 million compared to $516 million in the prior year. The reduction in cash flow was primarily due to inventory cost inflation and investments to both minimize supply chain disruptions and prepare for the minimum efficiency regulatory change that took effect January 1, 2023. Capital expenditures were approximately $101 million for the full year compared to $107 million in the…

Thanks, Joe. Summarizing our financial results and providing an update on the assumptions behind our 2023 fiscal guidance. Please turn to Slide 11 for the key success factors for Lennox this year that are summarized on this page. While we have little control over the industry unit shipments in 2023 that are still expected to decline year-over-year. Given that, we are focusing our effort on the three controllable factors to grow our revenues and expand our margins. First, to offset inflation, we are maintaining and expanding our pricing initiatives. We have already implemented price increases for 2023 and are confident in our ability to offset cost inflation with pricing. Second, on the heel of a strong Q4 performance, we continue to maintain focus on commercial profit recovery. As Joe mentioned earlier, staffing levels are stable and the Stuttgart plant has switched over to the 2023 SEER standards while simplifying our product portfolio. Our new commercial product lineup provides greater value to our customers and we intend to share part of that value through pricing and contract negotiations. Third, Lennox is now well positioned to start gaining share again. As you may recall, our service levels suffered after the Marshalltown tornado in 2018 and we were unable to fully restore the service levels during the COVID years. Now, the Marshalltown reconstruction is complete, our finished good inventory levels have been replenished, Saltillo continues to add capacity, and our commercial lead times are approaching competitive levels. The improved service levels, along with recently introduced new products, put us in a strong position to relaunch our share gain programs. Even during a period of economic uncertainty, our confidence in executing on the three controllable key success factors makes us cautiously optimistic for 2023. Again, I want to thank our employees who are working hard to sustain and improve our customer service levels. Now please turn to Slide 12 for some final thoughts before Q&A. I would like to close our prepared remarks by summarizing why I believe LII is an attractive investment opportunity. Lennox is narrowly focused leader in energy efficient, environmentally friendly climate controlled solutions. We operate in high growth end markets with strong replacement demand that provides us with resiliency even during periods of economic uncertainty. The company has a unique direct to dealer network, which creates a sustainable competitive advantage. And finally, we have a history of robust execution with disciplined capital allocation. Thank you for listening. Joe and I will be happy to take your questions. Ashley, let's go to Q&A.

[Operator Instructions] We'll take our first question from Julian Mitchell with Barclays. We'll go next to Gautam Khanna with Cowen.

It's Gautam here. I was just curious if you could elaborate on your opening remarks about seeing some channel or seeing some pressure on volumes. Just if you could talk about the Allied versus the Lennox brand, if you're seeing -- what you're seeing in terms of destocking, if any? And how -- maybe you think it's just maybe an early read on Q1 based on what you're seeing on resi.

So I guess, first of all, as you know, majority of our sales are direct to dealers. And we highlighted Allied, ADP and Heatcraft as the three business units that do go through two step distribution model. Each of them are in a different cycle stage on distributor inventory levels. For something like Heatcraft, we saw some destocking already occur and we might be back to more normal levels. For Allied and ADP, as we talk to our channel partners, we believe there's some destocking that's going to occur this year, which frankly puts our Lennox brand in a strong position. That all is baked into our guidance as we look at 0% to 4% revenue growth. While we don't give quarterly guidance, Gautam, as you know, I mean, so far, I mean, as we said, the Q1 order rates are consistent with our expectations. And I don't see anything falling off a cliff or so, but we do see gradual slowdown that we have talked about in the past.

And then if you could just comment on the recovery on the high end product, Lennox products. Sort of where are we in that journey, and do you expect to be a full participant in the summer selling season with that product line that was impacted last year?

Yes, Gautam, now since Marshalltown tornado, this would be the year, 2023, we have all the inventory levels needed to launch our programs, to recapture our position on the high end, especially as we look at some of the new products like the Dave Lennox Signature series heat pumps and the new higher efficiency furnaces. So we feel good going into the year to be able to capture our fair share of market and higher than growth in 2022 on the higher end products.

We'll take our next question from Nigel Coe with Wolfe Research.

So I was a little bit late joining the call. So I just wondered, could you give any color in terms of the order activity in 1Q? I'm guessing not, but if it did, it'd be helpful to hear that. But just my broader question is, how has the SEER transition from a market perspective and obviously, asset, how has that gone versus expectations and has it caused any sort of air pocket post the year end?

So we didn't give any numbers on Q1 but we did talk about that January order rates were consistent with our expectations and outlook. So no change, it went as we expected. On the SEER change, overall, I think it went fine for the industry. The industry has gotten used to these changes. You know we think our design has got the winning formula in terms of -- we talked about in the last call, we don't need to change some of the indoor units. We can only change the outdoor unit. So we think we did quite well and we'll wait for some of the industry numbers to compare our share. But in general, I think the industry is used to it. I think us and majority of other industry players had a seamless SEER transition. Some of the smaller players may have had hiccups. But overall, I think it went as good or better than expected for the industry.

And then my follow-on is on inventories. You built inventory into 4Q versus 3Q, quite unusual from a [seasonal] perspective. But I'm curious, was that planned or were there some issues that caused that build?

I think the inventory build was very planned. We wanted to make sure of two things. One is that we have sufficient high end products in stock, even though that's not selling until the summer season given the challenges we had. Second is given the SEER change, we wanted to make sure that we have sufficient inventory of the new SEER product as we went into the new year. So I think that was planned. I think where we fell short, honestly, was more appropriate forecasting and where we landed up on some of the raw material side where I think our supply chains normalize, we should have opportunity to convert more of that inventory into cash. So [Indiscernible] at this stage been complete with inventory build.

[Operator Instructions] And we'll go next to Joe Ritchie with Goldman Sachs.

Alok, can we just maybe just talk about the Commercial business for a second? It sounded like pretty positive comments on the hiring front. I guess just where does production stand relative to normal levels? And then maybe just talk about how you're seeing that business from a share gain perspective. It sounds like you're starting to recover some gains or recovering some share that you may have lost previously.

So first of all, we are pleased with the recovery in Commercial and remain committed to $100 million EBIT improvement in Commercial over the planning period. We had a strong Q4, as you saw from numbers slightly better than expected, and that was kind of the prime driver of why we came to the higher end of our guidance. The recovery was driven by very stable levels of staffing. I mean at this stage, we're hiring as much as we are losing and that's kind of back to normal levels. I think the team has done a good job making sure that the output has come back up compared to the lows of the year, but we are still not back to normal. I would say we are probably still about 20% below normal on factory output where we could get there just with this factory even before the next factory comes online. So we remain pleased with the efforts in Q4. Q1, that's going to go through SEER transition. And obviously, that's something we are very excited about given the change in product lineup. So net-net, excited about the new Commercial segment. We will continue delivering and focusing. And even as we take a step into '24, '25, the new factory will give us more productivity, more capacity. And the last question you have is, yes, we did lose share in Commercial despite all the things I said earlier. Most of that was earlier in the year. Towards the end of the year, we started recovering shares and we did a little better. And we think that trend will continue because the industry lead times remain extended and ours are now getting to very competitive levels within the industry.

And just to elaborate a little bit on what Alok mentioned, where we lost share was in the emergency replacement segment of the market. And as productivity and output improves, it'll enable us to replenish our distribution channels with that stockable product and then you should really see the share gain gain traction. Once again, we're able to reengage in the emergency replacement side of the market.

I guess my one follow-up question. Residential volumes are continuing to stay positive, I know that you're expecting a decline in the year, and I know that you don't give quarterly guidance. But I guess just based on what you see with inventory levels today, I mean, are you expecting things to turn negative at the start of the year? Is that something that maybe happens later on in the year? I'm just -- any color that you can give on like the seasonality as we progress through 2023 would be helpful.

First of all, there’s significant uncertainty remains and at some stage, your guess is going to be as good as ours. January met expectations. Because majority of our business is dealer direct, the impact of channel destocking would be minimal. But for the industry, I do saw it happening more in the first half versus the second half. So I think the industry will see some decline in sales to distributors that distributors pull back orders, just to get the inventory rightsized. I think the seasonality, as we typically expect as in the summer seasonality, still remains. So I would say, yes, there's going to be some channel destocking impact in the industry in the first half. It's going to impact us less. But beyond that, it's going to be watching all the numbers that you would watch, consumer confidence, interest rates, new home starts and see where we come up. Because the new home starts that fell in second half of 2022 will have an impact in 2023 at those come up for completion, because our new home business did well in Q4 that's lower margin, as you know. But going into '23, we expect that to slow down for sure.

We'll take our next question from Tusa Steve with JPMorgan.

So just on the Allied side, what was the growth rate, the difference between Allied and your -- the Lennox brands in the fourth quarter?

I don't have it in front of me, and I think it was pretty consistent…

I'll be honest with you, Steve, I don't think it was radically different than what we saw in the direct to dealer business because we had a [really solid] and we had a record year in our Allied business, they did a tremendous job. They gained more than 100 basis points of share, along with our Lennox business. So it was a pretty good quarter for both businesses.

So when you kind of roll forward into the first half, and you talk about some destocking, what kind of split would you expect here in the -- how is it trending in January? And then what kind of split would you expect as this destock cycle move into the first half?

Yes, in the Allied business, we would expect a slower start because, as Joe said, I mean, they had a good year. I mean in Q4, they grew very well, Lennox grew well as well. Allied grew faster than Lennox in Q4. And as we take this forward, I would expect 20% of our business, which is on through two step distribution to have a slower start to the year versus the rest of our business, which is dealer direct.

Can you just provide a little bit of color on that? So is it like -- is it a 10% difference, at 20%? I mean there's there's just a lot of moving parts here, so it'd be helpful to figure out just roughly what kind of split you would expect there between -- effectively between sell through and sell in we're asking for the industry, if you even want to put it that way.

I think that's a fair question and we are wondering the same questions in that. I mean, 30 days in, we haven't noticed a huge difference between the two. So like time will tell. Some of it also comes down to how distributors are thinking of the year and what kind of signals and tea leaves they are reading about demand this year. But sometimes when these air pockets come in, in the two step model, they last a few weeks. We haven't started experiencing that yet. We're just prepared to experience that. Unfortunately, we don't have any numbers. And your guess is going to be as good as mine, Steve.

And then one last one. What was the actual, like -- just what were the inefficiencies from this year changeover, what exactly was that?

Quite a bit, I mean when we -- so I guess get three different areas, right? First is in our factories, we had to turn over different lines, which means there was work stoppage at different lines at different times. We did that on a rotating basis. But clearly, there was labor inefficiency and underutilization as we went through that. Second, we had to air freight and look at some prebuy of components at elevated prices just to make sure we met all the deadlines and pull that together. And I think finally, within our own distribution network, we have to spend extra because we had to manage old SEER, new SEER, different freights, move it around. So I mean those would be the three different things that we looked at, right, is just air freight and component costs, factory and efficiency and then additional distribution cost.

And we'll take our next question from Julian Mitchell with Barclays.

I wanted to check on the Commercial business, not so much the sort of internal self help initiatives. We can see that clear green light on Slide 11 for that, but more just on the sort of the market as you see it. Classically, there was a lag, but a relationship from Residential trends to light Commercial unitary, just wondered how you see that dynamic playing out this time, if you have seen any more kind of choppiness in project activity or so forth amidst higher interest rates and weaker housing starts activity.

So Julian, you're right. Historically, there has been a lag with the correlation. If there is one this time, I think it's going to be extended because the industry has such long lead times, and there's still a pent-up demand because of number of replacements that were converted into repair over the past few years. So if a unit broke, historically, they could have replaced it, but they chose to repair it. So when we talk to our larger customers, we don't notice any change in their replacement plans, their spend plan, their capital. Now that could change. But so far, we haven't noticed that. We see a lot of customers still talking about 2025 and how they plan to significantly upgrade their facilities and HVAC system with the low GWP refrigerants to meet their carbon footprint goals and get better ESG values out of it. So we have not noticed anything in the short term. The lead times are still anything from 24 to 52 weeks. And then we start hitting 2025, which we do expect a lot of the key accounts to start ordering more and planning for 2025 replacement. But we're watching it closely, the same data that you would look at, Julian, from -- everything from ABI to other indexes. But so far, it's more lead time and supply constrained, not demand constrained.

And then just looking at Slide 10, you laid out some of those moving pieces below the top line around the net material cost inflation. So I noticed, I think the components headwind that you expect went up a bit from what you'd said in December, any more color around that? And when you're looking at that net material cost inflation of sort of minus $35 million, what are the latest thoughts on how that headwind is weighted sort of first half versus second half? Are you getting a good tailwind in the back half or it's closer to flat?

We get some tailwind in the back half. I mean, it's right now heavily weighted but at the same time, we haven't locked in the commodities for the second half yet. So some variability still exist in that. The component piece is higher and we wanted to be upfront. It’s higher than what we thought. But some of the items such as compressors, variable speed motor, given the supply constraints that everybody is facing, I think vendors have decided to charge higher, and we clearly had to play a part in that. So yes, the component costs are higher and that just puts more onus to get pricing. That's why you see pricing, we increase our range and talk about 1.50 to 1.75 versus just a flat number of 1.50. So different moving pieces. We'll remain committed to offsetting material costs with pricing and keep doing our best to bring components down. And if commodities ease in the second half, the number could get better.

[Operator Instructions] We'll go next to Jeff Hammond with KeyBanc.

So really just want to dig in a little bit more on kind of share gain momentum. One, on the Commercial, I think you said you're kind of getting back into that emergency replacement. I'm just wondering, one, how easy it is to kind of gain back share and kind of gain dealer distributor trust? And then on the Residential side, I think you mentioned like you're -- for the first time in a while, you're positioned for share gain. Just maybe elaborate a little bit around, is it just kind of having everything together organizationally and with the plants or is it, hey, you think you got better products, better availability, et cetera?

Yes, I think on the emergency replacement side, Jeff, I think it's very difficult to distinguish. Where you compete there is on availability and price and we've got the distribution network, we've got the people who sell it. In 2022, we're just short of product. So it's a matter of once again, I'm just replenishing those distribution channels such that we have the product available, and we feel we're back in the game on emergency replacement and we expect that to happen over the course of 2023.

And if I could just answer the Residential piece, Jeff. We have been constrained in '18 on the appropriate product mix, the appropriate inventory. And we are excited about the new leadership there. We're excited about being back with fully stocked warehouses. We are -- I think put some specific efforts around sales excellence. I mean all of those efforts are coming to fruition. So historically, as we go back through regulatory transitions, we do always win more share because at least we believe that our products are superior and our current design is going to lead us to greater benefits. So I think that's what gives us confidence on the Residential side.

And then I don't know if I missed this. But any kind of update on the noncore divestiture and when you think that might be complete?

Jeff, we just kicked off a process literally this week, the teasers went out. So we're waiting for, once again, the NDAs to flow in and engagement to take place with potential suitors. We should have more news for you on the first quarter call, but we're out of the gate with the process. And we're excited about what lies in front of us with the portfolio of businesses that we have in 2023.

There are no further questions, and this concludes Lennox fourth quarter and full year 2022 earnings call. The earnings release with GAAP to non-GAAP reconciliations, today's presentation slides and the webcast link for today's call are available on our Web site at www.lennoxinternational.com. This webcast also will be archived on the site for replay. Thank you for joining us today.