onurdongel
Writing about Lennox International (NYSE:LII) over a year ago, I wrote that I was more bullish on the short-term opportunities for the company than the Street, but found the valuation unappealing, and particularly so given some longer-term challenges. Since then, the company has indeed executed well on its residential HVAC opportunities, as well as refrigeration, but the shares are down about 20%, lagging the broader industrial group and most of its HVAC peers (Carrier (CARR) has done a little worse, Daikin (OTCPK:DKILY), Johnson Controls (JCI), and Trane (TT) have done better).
I do agree that the company is going into 2023 with price/cost tailwinds at its back, not to mention healthy ongoing trends in refrigeration, but I also still believe that the company’s lack of leverage to commercial HVAC (particularly outside the U.S.) is a meaningful headwind. Valuation is more reasonable now than before, but not what I’d call compelling yet.
Margin Misses Undermine Some Positive Trends In The Third Quarter
Looking back at Lennox’s third quarter, it was in some respects a “par for the course” quarter, with strong revenue growth, but not much stronger than expected, that was undermined by ongoing margin pressures. The HVAC companies remain some of the strongest organic growers for now, but I do expect a meaningful slowdown in the coming year.
Revenue rose almost 18% in organic terms in the third quarter, more or less meeting expectations, with the company benefitting from double-digit pricing (up around 13%) that was well ahead of industrial sector norms (an average close to 9%), with volume growth (up around 5%) that was likewise ahead of the industrial average (closer to 4%).
Residential HVAC revenue rose 18% on 11% price and 7% volume growth, with 16% growth in the direct business and 22% growth from dealers suggesting some inventory-stocking. Lennox outperformed both Trane (up a16%) and Carrier (up high single-digits) in the quarter.
Commercial HVAC revenue rose 20% on 9% price growth and 11% mix improvement (and flat volumes), and that compared well to low double-digit growth at Trane, 20%-plus growth at Carrier, and high single-digit growth at Johnson Controls. Weak volume is unimpressive, but it does seem that component shortages that limited shipments of higher-end models have eased up (leading to a richer mix).
Refrigeration revenue rose 21%, with pricing up 16%. Dover (DOV) didn’t break out its refrigeration business within the 19% growth of its Climate and Sustainability Technologies, but I would expect similar growth here, and demand from retail and food service remains healthy.
Although pricing has been significant, gross margin did decline 110bp in the quarter to 26.8%, with almost seven points of favorable pricing offset by higher commodity and component costs, LIFO inventory costs, manufacturing inefficiencies, and higher freight/distribution costs.
Operating income rose 15%, with margin down 30bp to 15.2%, while segment profits rose 14%, with margin down 60bp to 16.5%. Segment profits missed by about 5%, with HVAC missing and refrigeration beating. Residential profits rose 7%, with margin falling almost two points to 18.4%, while Commercial profits rose 31%, with margin rising a point to 11.7%. Refrigeration profits rose 54%, with margin up 370bp to 14.3%.
Lennox Can Ride A Residential Price/Cost Tailwind … But Then What?
Analysts have been fretting about the outlook for the residential HVAC market for some time, and it’s understandable. The pandemic drove an unprecedented wave of replacement demand and orders are starting to weaken as the replacement market seems satiated for the near term and new construction fades as the housing market rolls over.
As that business makes up about two-thirds of Lennox’s revenue mix, it’s understandable why that’s a headwind for Lennox. Management has argued for its leverage to higher SEER standards, but I believe they’re not positioned quite as advantageously from a geographic perspective relative to peers, and a shorter replacement cycle, but I still think that may be an optimistic outlook (and it won’t help 2023 either way). It is true that the new Inflation Reduction Act does incentivize replacement over repair, but again I don’t think replacement demand will be sufficient given the surge in new installations in recent years and how well covered those should be by warranties.
Price/cost, though, should be a tailwind at least into mid-year. Many input costs are already starting to ease off, and there should be some LIFO benefits as the company works down higher-cost inventories built to offset component shortages. How long pricing stays robust is a great question, and one that I don’t think has an easy answer. Many (if not most) companies are feeling their oats with respect to pricing, arguing that this is the new normal, but I suspect that when demand fades and capacity utilization shrinks, many will reverse course and then congratulate themselves for maintaining operating efficiency and preserving jobs.
Commercial HVAC is, unfortunately, not much of an offset or driver for Lennox. The company does have opportunities to benefit from improved mix as component availability improves and allows for more higher-end units to ship, and the company likewise has an opportunity to reverse serious margin erosion driven in large part by manufacturing inefficiencies (inadequate staffing, et al). On the other hand, the commercial HVAC building is tiny – about one-eighth to one-tenth the size of Carrier, Johnson Controls, and Trane – and Lennox doesn’t have all that much leverage to energy efficiency retrofits, indoor air quality, or automation relative to its peers.
The Outlook
Improved price/cost leverage in 2023 should help drive EBITDA margins back into the 16%’s, but further leverage beyond that could well be limited by weaker sales in the higher-margin residential business. Longer term, management has talked about looking to diversify its sourcing (around three-quarters of components are sole-sourced), and that could help drive some longer-term uplift in margin.
A strong 2022 has led me to raise my revenue expectations for this year, and lingering price leverage also leads to a higher 2023 revenue estimate, but I do see weaker volumes undermining revenue and my 2026 revenue estimate hasn’t changed all that much, and my longer-term revenue growth rate is in the 4%-5% range (more or less unchanged). Relative to its peers, Lennox has less upside leverage to commercial building automation/controls and the broader adoption of HVAC and heat pumps in Europe.
I do still expect Lennox to generate free cash flow margins in the low double-digits over time (against a long-term trailing average in the high single-digits), helping drive high single-digit FCF growth.
The Bottom Line
Discounted cash flow suggests a long-term annualized total return potential closer to 7% now (roughly on par with Trane), but I don’t find that particularly attractive now relative to other industrials. Likewise, while the share price decline has brought valuation down to a more reasonable level, the 14.5x forward EBITDA multiple supported by near-term margins and returns (ROIC, et al) doesn’t drive a particularly exciting near-term fair value.
The bull case for Lennox is that the price/cost mix lasts longer than expected and that pricing proves durable and helps offset weaker near-term volumes, while greater residential HVAC use drives a shorter replacement cycle and commercial margins improve. I can see some of those arguments as plausible, but I just don’t find the valuation all that compelling even after this correction.
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