CARR - Lennox Eases Some Concerns With Its Fourth Quarter Numbers

Summary

• Lennox missed on revenue and segment-level profits in the fourth quarter, but expectations were for a miss-and-lower result that was worse than what the company produced.
• Management is still expecting low levels of destocking in 2023, and I believe this remains an important risk factor as the residential market slows.
• Margins weren't impressive, including still-elevated input cost pressures, but Commercial margins should ramp from here.
• Lennox's valuation is okay (neither cheap nor expensive), but I still see risks from volume; sentiment is weak, though, so outperformance could drive bigger gains.

Low expectations can set the stage for outperformance, and that would seem to be the case for Lennox ( LII ) coming out of fourth quarter earnings. The fourth quarter report wasn’t particularly strong relative to expectations, but there’s been a lot of doubt as to whether the company could hit its targets and withstand a more challenging environment for residential HVAC. Even so, I think a greater negative from destocking remains a threat in 2023.

Even with a 6% pop after earnings, Lennox shares are down since my last update and down relative to other industrials (including other HVAC names like Carrier ( CARR ) and Trane ( TT )), and that’s largely true over the trailing 12 months as well. I don’t find Lennox particularly expensive now, but I do still see elevated volume/destocking risk in 2023. There’s a lot of negativity on this name, though, and if management can come through with better volumes in 2023, a more meaningful rerating could be in store.

A Modest Beat Versus Printed Estimates, But Expectations Were Worse

Lennox’s outperformance versus fourth quarter published estimates wasn’t so special, but the tone going into earnings was definitely skeptical (at least among sell-side analysts) and I think there was a wider expectation of a miss-and-lower quarter on weaker underlying volumes.

Revenue rose 13% as reported or 14% in organic terms, and that missed expectations by close to 3%. The miss was largely driven by Commercial, where 20% growth (including 3% volume growth) still drove a 12% miss. Refrigeration was also weaker than expected, with 10% growth (including 11% volume contraction) driving a 7% miss. The Residential business also missed, by only 1%, with revenue up 14% on 4% volume growth.

Cost pressures remain meaningful, driving gross margin down another 20bp yoy (and 70bp qoq) to 26.1%. Management noted several items tied to the SEER transition, including higher costs in manufacturing, logistics, and distribution. Operating income rose 35%, with margin up 140bp to 12%, while segment-level profits rose 19% (margin up 80bp to 15.2%). Operating profits beat by 4%, but this was driven largely by corporate costs, as segment profits missed by close to 4%.

By segment, Residential posted 8% profit growth (margin down 70bp to 16.9%), missing by 4%. Commercial profits rose 79% (margin up almost four points to 11.6%), missing by 8%. Refrigeration profits rose 42% (margin up 330bp to 12.5%), beating by 4%.

Margins And Volumes Still Open To Debate

The two main bull/bear arguments on Lennox for 2023 are the extent to which a slowdown in the housing market will drive meaningful destocking and weaker volumes and what will happen to margins as this all transpires.

Margins

On margins, I do find the results from the fourth quarter to be less encouraging. Price/cost is still a challenge, as healthy pricing/mix (up 10% in Resi, up 17% in Commercial, and up 21% in Refrigeration) wasn’t enough to drive gross margin improvement. Costs should start easing, but this is taking a little longer than I’d expected.

I’m also not really sure what to make of the costs management cited in relation to the SEER transition. It’s understandable that there would be friction from changing manufacturing lines and adjusting distribution, but management has been talking about this transition for some time, so I’m a little surprised that the transition wasn’t smoother.

On a more positive note, Commercial margins are picking up and the Arkansas plant is still around 20% below prior capacity utilization. Assuming more stability in labor (not seeing elevated employee churn and having to train new workers), margins here should have more room for upside (the business has generated high-teens to low-20%’s margins in the past).

Volumes

I’m still of the opinion that Lennox may be expecting too much in terms of residential volume growth beyond 2023. I don’t fully buy the notion that elevated work from home is going to drive excess wear-and-tear on AC units to a point where replacement cycles are meaningfully shorter. I am more bullish on the heat pump business, particularly with the launch of a new cold climate product in 2024, but I really wish Lennox had the ability to leverage this product/category in Europe (where I think heat pumps could be a significant growth opportunity).

In the shorter term, I’m concerned about weaker residential construction trends, but new construction is only about 25% of the business. What concerns me more is the risk of destocking. While management said there was limited destocking in the quarter, Sensata ( ST ), a manufacturer of sensors and electrical protection products that serves the HVAC market, saw mid-teens revenue contraction from its HVAC business and cited destocking as the culprit. It’s certainly possible that Sensata doesn’t do business with Lennox and/or that the declines were driven by other businesses, but I remain concerned about destocking risk.

Commercial volume growth of 3% was encouraging, as that was the first volume growth in over a year. While I do expect muted non-residential demand in 2023 for HVAC overall, Lennox could have some company-specific counter-cyclical opportunities here. Last and not least, while I haven’t seen any clean comps on Refrigeration, the 10% growth at Lennox isn’t particularly impressive next to the 27% organic growth that Dover ( DOV ) just reported in its DCST business segment – they’re not apples-to-apples comparable, but Lennox’s business is skewed more toward food retail/food service and I think it’s a relevant comp.

The Outlook

Adjusting for the divestiture of the European refrigeration business, I’m expecting around 1.5% revenue growth for Lennox in 2023 – a bit below management guidance, as again I do expect greater destocking pressure. Longer term, I expect annualized revenue growth of around 3% or closer to 4.5% on an adjusted pre-pandemic basis.

While this wasn’t a perfect quarter on margins by any means, I do expect the company to get close to pre-pandemic EBITDA margin this year, with progress toward 20% over the next couple of years. Longer term, I still expect free cash flow margins to improve into the low double-digits on a sustainable basis, driving long-term adjusted FCF growth in the high single-digits.

Valuation is mixed. Lennox doesn’t look especially cheap on discounted free cash flow, but the shares could still have some upside on a margin/return-driven EV/EBITDA basis.

The Bottom Line

Sentiment is tricky here. I think the market is going to start looking past near-term headwinds in residential and non-residential demand in 2023 to better results in 2024 and 2025, but there could still be near-term vulnerability for Lennox’s multiple/share price if destocking emerges as a bigger issue and/or price/cost remains a more significant factor for longer. All told, I’m not that bullish on this name at this point, but I do recognize that expectations and sentiment are still pretty weak, so outperform could be disproportionately rewarded.

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