Q3 2022 Lennox International Inc Earnings Call
Ladies and gentlemen, thank you for standing by welcome to the Lennox International third quarter earnings Conference call at the request of your House all lines are currently in a listen only mode.
Will be a question and answer session at the end of the presentation. You may enter the queue to ask a question by pressing star and the number one on your phone and pressing star and the number two exits the queue.
Reminder, this call is being recorded I would now like to turn the conference over to Steve Harrison Vice President of Investor Relations. Please go ahead.
Good morning, Thank you for joining us I'm here today with CEO elope, Mascara and CFO , Joe Reitmeier local will discuss highlights for the quarter and Joe will take you through the company's quarterly financial performance and guidance for 2022.
After that and Luke will discuss our current view on 2023 before Q&A.
To give everyone time to ask questions. During the Q&A. Please limit yourself to two questions or follow ups and re queue for any additional questions.
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 website at Www Dot Lennox International Dot com.
The webcast also will be archived on the site for replay.
All comparisons mentioned today are against the prior year period, unless otherwise noted.
Turning to slide two I would like to remind everyone that in the course of this call we will be making certain forward looking statements, which are subject to numerous risks and uncertainties for information concerning these risks and uncertainties see Lennox International's publicly available filings with the SEC.
Before I turn the call over do look let me remind everyone of our upcoming annual Investor Day on Wednesday December 14th when we will discuss specific guidance for 2023, and our three year outlook as well as provide an update on our strategy now.
Now, let me turn the call over to CEO elope Mascara.
Good morning, and welcome everyone.
I Wanna stock by thanking all our employees, who are working exceptionally hard given the ongoing supply chain disruptions to better serve our customers.
As a result of their efforts.
<unk> was able to deliver another record quarter, while improving our customer service level.
On slide three I want to start by highlighting four key messages.
First.
Our record third quarter financial results, including double digit revenue growth in all three of our business segments.
Overall company revenues were up 17%.
Third quarter record of $1 $44 billion.
Adjusted earnings grew 21% to a third quarter record of $4 10.
Second we are prepared for the upcoming minimum efficiency regulation to be effective on January one 2023.
As part of the preparation we are replenishing inventory levels, which will also help us increase supply chain resiliency.
Given an inventory burn cash from operations was $171 million in the quarter down $51 million from a year ago.
Third.
The recovery in our commercial business segment is progressing well and the daily output from our factory in Stuttgart is steadily increasing.
Third quarter commercial segment profit was up 72% sequentially and up 31% year over year.
Today, we're also announcing investment in a second commercial factory to be built in Mexico. The two.
Total capital required for the new commercial factory is expected to be in the range of $125 million to $150 million over the next two years.
The new commercial factory will provide us the much needed additional manufacturing capacity, while enabling margin expansion.
Sport, given persistent supply chain inefficiencies and the adverse mix impact driven by shortage of components for high end residential products.
Our revising our full year EPS guidance range to the lower end of the prior range.
Now please turn to slide four to discuss our preparedness for the minimum efficiency regulatory changes.
In our residential and commercial end markets in the U S and Canada, the new required minimum cooling efficiency level for air conditioners heat pumps and rooftop units is increasing on January one 2023.
For air Conditioners in the South and southwest regions. The changes based on date of installation.
While for air conditioners, and the north regions and for all heat pumps and rooftop products the changes based on data manufacturer.
While the new 2023 compliant units, we expect a double digit benefit of price and mix to more than offset the higher cost of the units.
Our residential products our competitive designed include single stage compression.
More efficient aluminum cars, and then optimize external footprint.
This design approach achieved higher efficiency standards without having to change into units, making our solution better for dealers and end users.
<unk> historically has done very well competitively during these minimum efficiency transitions and we believe we are well positioned to do so again.
Now please turn to slide five for an update on our commercial profit recovery efforts.
At our existing Arkansas manufacturing facility.
We have met our targets for hiring and retaining talent, resulting in staffing levels, reaching normalcy, which is up 30% since April .
Since achieving normal staffing levels, we are systematically increasing our daily output, which is now up 15% since April .
Higher output is improving service for our customers, who have been mostly understanding of our challenges given industry wide supply shortages.
We are grateful for our customers' loyalty and patients and want to assure them that we are doing our utmost to increase capacity and reduce lead times.
We are deploying additional talent and working closely with our suppliers to satisfy current demand levels and remain committed to delivering additional manufacturing output and productivity from the existing factory.
However, in the fourth quarter, we are expecting sequentially lower manufacturing efficiency and output as we transition our product lines to build our newly launched in light and Zion products that meet or exceed the new minimum efficiency standards.
Similar to residential price positioning of the higher efficiency commercial products.
Enable us to more than offset the associated higher cost.
Looking ahead, we have decided to invest in our second commercial factory in <unk> Mexico.
Here, our existing residential operations.
The new factory will increase our capacity to support our customers' forecasted demand and it will also position us to regain lost share, especially in the emergency replacement market.
We expect an 80% lower hourly labor cost at this new facility.
Although some of those savings will be offset by higher freight cost.
Overall as commercial production continues to recover we expect.
Hundred million dollar segment profit improvement within the next three years.
With that I.
How is the call over to Joe on slide six to discuss full quarter financials and guidance for the full year.
Thank you Luke and good morning, everyone.
Looking at the quarter for Lennox International overall, the company posted record third quarter revenue and profit.
Revenue was $1 $2 4 billion up.
Up 17% as reported and up 18% at constant currency, primarily driven by volume growth and price.
GAAP operating income was a third quarter record $186 million up 14% and in the chart you see the total segment profit rose, 15% to a third quarter record $189 million.
Total segment margin was 15, 2% down 30 basis points, primarily due to supply chain inefficiencies and lower mix driven by manufacturing constraints at the higher end products.
GAAP EPS was up 17% to a third quarter record $3 99, and adjusted EPS Rose, 21% to a third quarter record $4 10.
Now moving to the business segments, starting on slide seven you see a record third quarter for residential and revenue and profit.
Residential revenue grew 17% to $835 million.
Volume was up 7% price was up 10% in the quarter.
Residential replacement and new construction sales were both up high teens with new construction growing faster.
Residential segment profit rose, 7% to $154 million segment margin contracted 190 basis points to 18, 4% due to lower mix as we were unable to increase coupled with the higher than units due to the component shortages.
Regarding Lennox stores, we opened four new locations in the third quarter to bring our total store count to 239, we expect to end the year with approximately 245 stores.
Now turning to slide eight and our commercial business.
Revenue was $253 million in the quarter up 20% led by strong growth in National account business commercial price was up 9% and mix was up 11% <unk>.
Commercial segment profit was up 31% and segment margin expanded 100 basis points to 11, 7%.
Commercial demand and backlog remains strong and our Arkansas factory recovery continues to progress well.
We have recruited and hired the number of employees, we need for the factory. The daily output is increasing and we continue to make progress on improving processes and productivity.
Now turning to slide nine and our refrigeration business.
Revenue was $157 million for the third quarter up 14% as reported and up 21% at constant currency.
Price was up 16% volume was up 5% foreign exchange had a negative negative 7% impact.
Revenue growth was led by North America up more than 20% Europe revenue was up 2% as reported and up 20% at constant currency.
Overall for the refrigeration segment profit rose, 54% to $22 million and segment margin expanded 370 basis points to 14, 3%.
Refrigeration demand and backlogs remained strong.
Turning to slide 10, let's review, our 2022 full year guidance.
We now expect revenue growth for the full year of 12% to 15% compared to the prior range of 10% to 15%.
For the industry, we continue to assume low single digit shipment growth in North American residential markets and mid single digit shipment growth in North American commercial unitary and refrigeration markets.
We are updating our guidance for GAAP and adjusted EPS for the full year to a range of $13 80.
Compared to the prior range of $13 80.
To $14 50.
Now looking at the puts and takes that are changing.
<unk> is now expected to be a $425 million benefit for the year, a yield of 10%, which is up $25 million from our prior guide of $400 million.
The mixed headwind is attributable to the shortage of higher end products is supply chain constraints continue to limit production of our Dave Lennox signature series.
Commodity cost inflation is now expected to be $120 million down $10 million from our prior guidance of $130 million.
However, we are still seeing inflationary pressures on components and other materials and now expect $120 million headwind compared to prior guidance of 100 million dollar headwinds.
Supply related factory disruptions are now expected to be a 25 million dollar headwind compared to prior guidance of a $15 million headwind.
Interest and pension expense guidance is now $40 million up from our prior guidance of $35 million.
And as we invest more in inventory for supply chain resiliency buying ahead of continued component price increases in the minimum efficiency regulatory transition free cash flow is now expected to be approximately $300 million for the year compared to prior guidance of $400 million and stock repurchase guidance is now 300.
For the year, which has been completed compared to our prior guidance of $400 million.
The effective tax rate will be approximately 19% for the full year.
Now for the guidance points that are not changing.
Freight costs are still expected to be a 20 million dollar headwind.
We still expect corporate expenses to be $95 million.
We are still planning for $125 million of capital spending and.
And we still expect a weighted average diluted share count of approximately 36 million shares for the full year.
And with that let's turn to slide 11, and I'll turn it back over to Luke to talk to you about our thoughts on 2023 at this time.
Thank you Joe.
While we will be giving specific guidance on 2023 at our Investor day in mid December .
Wanted to spend a few minutes today on the different headwinds and tailwind that are guiding our 2023 outlook.
On the headwind side, we are prepared for a decline in residential unit shipments due to the downturn in single family New housing starts as well as possible impact on the replacement units from rising interest rate environment and broader economic slowdown.
On the cost headwind side, we expect the first half of 2023 to continue seeing component inflation and we also expect some of the current supply chain disruptions to persist in the first half of 2023.
Okay.
For the 2022 tail winds.
Expect to see a price and mix benefits from minimum efficiency regulatory increase in both residential and commercial.
We also see significant carryover and annual price increase benefit.
Our 2023 margins will also be favorably impacted by commercial manufacturing recovery and easing commodity cost.
In addition, our material cost reduction pipeline will provide meaningful savings as we expect that most of the supply chain inefficiencies will be behind us by the middle of the year.
Our commercial and refrigeration businesses have strong demand and backlog into 2023, and all our businesses have share gain opportunities ahead of us.
Bottom line, even if residential units are down on new construction and macroeconomic softness we still expect revenue margin and EPS growth for NII in 2023.
Please turn to slide 12 for some final thoughts before Q&A.
I would like to close our prepared remarks by summarizing why I joined Lenox and why I believe <unk> is an attractive investment opportunity.
Linux is narrowly focused leader.
Leader in energy efficient environmentally friendly climate control solutions.
Our innovative products.
Continually reduce global warming potential.
We operate in high growth end markets with strong replacement demand that provides us resiliency even during economic uncertainties.
The company has a unique direct to dealer network, providing a strong sustainable competitive advantage.
And we have a history of robust execution with disciplined capital deployment.
In summary, I believe allied.
<unk> is a compelling investment opportunity as we look at 2023 and beyond.
And that our best days are ahead.
Thank you Julia and I will be happy to take your questions now operator, let's go to Q&A.
At this time, if you would like to ask a question. Please press the star and the number one on your Touchtone phone you may remove yourself from the queue by pressing star to once again that is star and the number one to ask a question.
We will take our first question from Gautam Khanna. Please go ahead.
Yes, Hey, thank you guys.
Yes.
Couple of questions first I was wondering on the commercial side.
As you think about supply chain and get to root cause for questions.
What's happening there is there any evidence of.
Well, hey is it getting better.
And likewise on the on the high end residential product and B are you seeing anything where.
Maybe you guys aren't getting.
As strong an allocation from certain suppliers relative to some of your competitors is there any evidence of that and then lastly, if you could just talk about.
The capex required to build.
The new commercial facility and the timeline.
Sure Gautam good morning.
So on the supply chain side, both for residential and commercial yes. It is getting better but you know I've said this a few times and then something hits like Covid hit once in the Ukraine crisis hedge funds, but so far everything that we're seeing things are getting better maybe not fast enough.
Second no we have no concerns or have no evidence to show that their allocation issue is impacting <unk>.
Our supply chain performance.
Long lengthy relationship with our core suppliers and we believe that the rollout of the challenges we are facing are.
Exactly the same as other industry players. So we're not concerned about any of the allegations.
On the capital spend we highlighted for the new factory, it's about $125 million to $150 million. We worked for now planning purposes assume that to be.
Evenly split between the two years, but we can give you more guidance on that when we are together for the Investor day on December 14th.
Thank you.
Our next question will come from Jeff Hammond with Keybanc. Please go ahead.
Hey, good morning, guys.
Good morning, Jeff.
Just back on on the residential supply chain like you kind of commented that it's getting better but it feels like it's getting worse and I'm just wondering.
If theres anything with how you use your supply chain and a little bit more sourcing from from Asia is creating a little bit of a lag or just wanted to understand because it just seems like across the board people are saying things are getting better and this seems kind of seemed worse.
I think I would separate the supply chain situation with the Q3 residential margins because if you look purely at the margins year over year, you could reach a conclusion that it's getting worse.
But frankly, there are like in a few decisions we made in Q3 to expedite materials and spot buy to make sure that we could serve our customers well.
And I wouldn't look at our Q3 margins as an indicator, especially the euro or your change in Q3 margin as I indicated on supply chain.
Our inventory levels are getting healthier our lead times are improving there is pockets of challenges remaining especially on the high end products, which are more dependent on micro electronics and semiconductors, but overall things are getting better and I think our guide implies that our Q.
Q4 margins on a year over year basis would be down less.
Significantly less than what we saw in Q3.
So I look at Q3 as a one time impact of multiple different factors.
So I would come back and reiterate Geoff that Noah supply chains are getting better.
Unless another shoe drops that we are aware of we would expect most of the supply chain inefficiencies to be behind US no later than.
Mid next year.
Okay helpful and then.
We're starting to hear kind of about the pricing change changes associated with the regulatory change can you just speak to.
What youre seeing there and then just as we look at headwinds and tailwind into next year, just seems like the tail ones are much more meaningful than.
And then the kind of lingering headwinds, maybe just give us a better frame for you know if that's the right way to look at it.
Sure so on the pricing for the new minimum efficiency products, you know I mean, we talked about a double digit benefit.
And clearly we are going to do our best to do.
To make sure that we get the appropriate price benefits.
Currently we remain very confident that will more than recover the additional costs associated with that.
Clearly there are nuances, which I won't get into in a call on which products GDS at work.
But we remain confident that it's going to be a double digit increase and thats consistent with the higher cost and what we are hearing.
They can make acceptable levels from our customers and channel partners.
On the second side.
Yeah, I mean, that's.
A good takeaway I thought if I put three bullets on the headwind and it bullets on the tailwind I would naturally drive everybody to that conclusion that there are more tailwind that headwinds.
The biggest unknown there Jeff that we've talked about in the past is.
How well is the replacement demand going to hold.
Do you think it's going to hold well, we think the replacement versus repair equation.
Going to tilt more towards replacement given the various dynamics, including higher labor cost for repair and including the inflation reduction Act and other pieces.
It really drive people towards replacement.
Yeah, we'll give you more details in December , but I think thats, a fair way to interpret what we said.
Okay, great color. Thank you.
Thanks, Jeff.
We will take our next question from Nicole <unk> from Deutsche Bank. Please go ahead.
Yeah. Thanks, good morning, guys.
We're having the critical.
Maybe we could start with pricing question, so maybe putting a finer point on it.
Tempting to loosely quantify the pricing tailwind in 2023, Hello can you talk about like when you combine the impact of the double digit improvement due to see your standard change and then think about just the price carryover from the actions that you guys took about 2022 that bleed into 2023, that's that is annualized.
Is there a sense of how much of a pricing benefit that can be in percentage terms for next year.
From a percentage terms, we can probably give you a lot more color in December as we finished launching all the higher seer product change.
But I mean, we do expect that number to be meaningful in the first half of the year. We obviously will have a significant carryover benefit.
On pricing that comes through and for the full year, there will be annual price increases and they will be done.
Mix and price benefits from regulatory changes.
But at this point, Nicole I would say I think it's best for us to wait until December before we can give you like a range of price number.
Okay. So what we are indicating is that it'll be more than any volume decline that we're expecting at this stage, yes. The residential side also added that Nicole we expect to be.
More price cost positive than we were here in 2022.
Okay got it that's really helpful.
And then maybe just anything you guys are seeing with respect to channel inventory dynamics, obviously theres a lot of questions about this from investors.
And I think that it's especially tough to understand the level of inventory in the channel right now with what's going on with the Seer standard change. So how do you guys feel about where inventory is in your own distribution as well as allied thanks.
Sure so in our own distribution, which is where the majority of our sales come from you know I think the inventory level is getting healthier, but we are still short on some of the higher end products and.
If we could we would actually maintained more inventory to ensure that we have all the products that our customers need as they go into the CEO change, which does make it messy.
The independent distribution, which majority of the industry uses we think inventory levels are getting healthier in those areas.
You worry about an air pocket sometime in the near future driven by lead time improvements.
And driven by sort of a ranking of the post minimum efficiency change people may try and right size the inventory but.
But I think that's not something we are experiencing now and that air pocket is probably going to be in.
Particularly early next year as most people are being cautious and we want to keep inventory sufficient inventory for the CEO change.
Just to make one more point.
Air Pocket is more attributable to those that go through two step distribution versus our direct to dealer model.
So we think that impact is where youre looking right.
Okay, Alright, Thank you guys I'll pass it on.
Thanks Nicole.
We will take our next question from Julian Mitchell from Barclays. Please go ahead.
Thanks, Good morning.
And Hey, I just wanted to start off with a sort of a question about fourth quarter. So just wanted to understand is is the sort of assumption at the midpoint that you've got.
Mid high teens sales growth in Q4, I'm not too different total or across the segments than what you saw in Q3.
And then it's kind of a flattish margin year on year in the fourth quarter.
So a little bit better year on year, and that's because of race is that the right way to think about it in kind of still single digit growth in resi volumes in Q4.
Yeah, when I sort of step away and look at things year over year, particularly in the fourth quarter I think what we're going to see is more of an impact on the commercial business in fourth quarter margins.
Had better margins last year in the fourth quarter and because of the challenge that we have in that business, that's going to be the biggest drag in the fourth quarter on margins.
The challenges in the residential business we.
<unk>.
Intentionally made some investments to procure inventory to make sure. We can serve our customers and thats simply came at a higher cost, which we don't expect to repeat in the fourth quarter at the same degree and then our refrigeration business continues to do very well net net we expect margins for the fourth quarter, even though we typically don't give guidance.
I'll give you a little bit of insight here flattish to up slightly in the fourth quarter.
Thanks, very much Joe and then maybe my follow up would be around kind of cash flow and cash usage. So I think this year, you're running at about 60% free cash flow conversion from adjusted net and understood. It's because of the supply chain constraints.
And then you have the sort of the Capex for the new plant. The next couple of years. So now we're thinking it's cash.
Cash flow conversion headline wise, probably doesn't get back to 100%.
Two or three years, just wanted to check that that's that's the right way to think about it and also any context as to the.
Reduction in the buyback guide thank you.
Yes, I'll start with the reduction in the buyback at what we did in the over the last few months is continuing to evaluate what we need production wise to meet end market demand and continue to look for opportunities to create slack in our supply chain and also fend off component price increases that will stick.
Daniel where he first so we made additional investments in inventory and lose share repurchases to make sure that we had adequate supply to support our customers going into critically important time in 2023.
So that's the trade off there.
And we'll continue to do things with the share repurchases to target our desired leverage points out between one wanted to.
We've talked historically.
About targeting between one five and two I think we want to be closer to the midpoint as we embark on 2023.
With respect to free cash flow conversion going forward the way that I would do with Julian is start with the assumption that we're going to deliver free cash flow that approximates net income and then take the incremental spend.
The new manufacturing facility for commercial and adjusted cash flow Accordingly for that and that should give you a pretty good proxy of what the next year's cash flow looks like.
That's very helpful. Thank you.
Well take our next question from Jeff Sprague with vertical research partners. Please go ahead.
Thanks, Good morning all.
Good morning, Jeff Good morning, I'll look maybe first on the new commercial plant can.
Can you give us some sense of.
The increase in productive capacity that comes with this plant.
In terms of.
Other its square footage or potential revenue output something to kind of frame the size of this increase relative to the current base.
Yeah I think.
Listen we are working through all the details and what we did is work backwards from our customers' forecast and looked at how much capacity we would need.
Five years from now 10 years from now and work backwards to that so the plant may start out with lower capacity, but it'll be very much matched to the customers' demand other thing remember in Stuttgart, we are running much lower than nameplate capacity given the local challenges in the labor availability. So at this stage I don't want to give a number.
But if it's sufficient to say at this plant will give us capacity at least for the next five to 10 years to keep serving our customers with their forecast they need Custer.
Customers than us.
And pretty optimistic about commercial replacement demand, especially as they go to.
The new regulations come in and the ESG benefits that our customers receive.
But given a lot of sensitivities around construction timelines and the impact on our existing facilities I would rather not give exact details.
But rest assured we have thank you.
Fairly detailed plan that will execute on within the next two years to make sure we can ramp and start production by the end of 2024.
The new facility.
Yes.
Understood and then just thinking about the seer change again.
The.
The mix impacts.
As you as you exit 'twenty two what what what percent of the business was at minimums sheer levels across the country in 2022.
Therefore subject to the mandatory step up.
We've always talked about is more than 50% I mean, the industry number typically how was about $60 65, and we are in a similar range.
That number's, probably a little higher in 'twenty, two just because the higher end products used more microelectronics and they remain in somewhat short supply, but how would you use a number of around 60%, which is the industry average and that will apply to us as well.
Great and then.
Maybe just one last one just the comment about higher N componentry and the like.
Is that causing any friction on the new seer units or you're talking more 18, 20, seer kind of up in there, where you're having kind of component supply issues.
'twenty 'twenty four 'twenty eight I mean, remember, we make the highest year units and a very well known for Dallas and those typically go as part of our signature series products, that's where we are seeing shortages, which unfortunately like you know forces a dealer not to be able to upsell I mean, our dealers are really good at upselling.
And getting customers more energy efficient products and we have just been constrained on that but we do see that easing as well as we get into 2023.
Great. Thanks for the color.
We will take our next question from Ryan Merkel with William Blair. Please go ahead.
Hey, good morning, and thanks for taking the questions first off you mentioned being prepared good morning, you mentioned being prepared for this year changed how does your equipment lineup look competitively with the other brands.
Ryan as a CEO I always believe we have the best in this right. So.
Listen a lot of the changes are still being unveiled we believe that our design with it keeps the bauxite is the same so the footprint remains optimized we believe as we have put a single stage technology that gives us competitive advantage, we believe our aluminium.
Exchangers are better, but I think the most important difference is that for our products.
A dealer does not have to change the indoor unit and just by tuning the outdoor unit. They can meet the higher efficiency standards for many of our competitors theyre going to change the indoor unit and the outdoor unit.
So listen I'm biased, but I think we've got a great solution I.
I think our dealers and end users are going to be well positioned.
Looking forward to gaining some share through the transition.
Got it thanks for that and then a nice job on commercial I'm curious what inning are we in for increasing production and then did you say that in mid 'twenty three you'd be at full production for commercial.
While if you follow cricket that we had in the first inning. If you follow baseball we are probably in the second or third inning on that one.
Listen we had early innings.
Labor was a big challenge, we got that but we are still nowhere close to meeting our customers' full demand, although natural lead time.
At minimum they cannot production should go up another 15% to 20% in the near future.
And improving our manufacturing processes is a big deal I mean, this is not acceptable level of productivity.
And finally, you know now our suppliers have to ramp up with us.
These often smaller suppliers that we have let down in the past few years. So we are working through that but early innings.
Robert Lee the second or third inning on a baseball terminology.
Very helpful. Thank you.
We will take our next question from Tommy Moll with Stephens Inc. Please go ahead.
And thanks for taking my questions.
Alright, Tony.
The 2023 early peak was helpful.
Wanted to follow up on one of the comments that you made around the resi replacement for next year.
Specifically, where you talked about the potential for some volume pressure there in the context of an economic slowdown.
How much of that.
In your mind as a just a repair versus replace dynamic or are you also hinting at some <unk>.
Discretion with respect to the timing of when a homeowner decides to spend like for example in the context of our existing home sale.
No I think pretty much all of it is balanced between repair and replacement. We continue to believe that this is a non discretionary spend.
Would there be a small percentage.
People would choose to live with the broken air Conditioner that always there, but I think that's negligible.
I think it's purely a repair versus replacement.
We're still working through the analysis, we have looked at.
Although recessions and economic uncertain environments in the past.
And we think this time around if there is a softness.
There versus replacement.
Stood 10 more favorably towards replacement. So I think we continue to believe it's all non discretionary.
And.
And so that nobody knows and we just have scenarios around it is how much of repairs.
Versus replacement tradeoff.
The change in a time of economic uncertainty.
And we'll do our best to driving more towards replacement.
Okay.
I think all servers.
There is also some other variables in play that will point things toward more towards the replacement versus repair scenario what is the art 22 dynamic.
There is still a significant number of R 22 units installed where it's going to be difficult if not punitive to find that refrigerant.
Should that be necessary repair.
Secondly, the minimum efficiency change so I think that will help us a little bit and then also incentives for heat pumps electrification and all of that with government incentives I think all of that points towards maybe a lower price tag for replacement scenario.
Compare tied to escalating costs.
And our repair situations. So I think those dynamics are more closely aligned than they were in previously economic tough times.
One of your analysts with an R 22 system I'm keenly aware of these dynamics.
All the context there.
Take care.
We can point.
Lennox dealer in your area.
We'll circle back after the call there for sure.
Joe I did want to ask about interest expense for next year I know some of your debt is floating rate is there any way that you could frame based on the information you have now or maybe the rate curve what the headwind.
In terms of interest expense might look like next year.
I'm going to wait until December to clarify that for you. If you don't mind, we still have a lot of work to do on our plant etcetera and all of that so there's lots of moving pieces various scenarios that we're whittling down at this time. So I don't think it'll be significantly different that wanted to stay it will be higher but it wont be significantly higher than that.
It is today.
Yes.
We will talk to you in December and thanks for everything I will turn it back.
You bet.
We will take our next question from Joe O'dea with Wells Fargo. Please go ahead.
Hi, good morning.
I wanted to start on the on the cost side Hi.
And if I if I heard you correctly I think part of inventory investment might've been sort of in anticipation of seeing component costs go up but maybe you can clarify that.
And then related to that when you think about sort of the within.
Within Cogs, the raw materials versus the.
Sort of source components exposure that you have.
Kind of the balance of that so I mean likely seeing I guess raw materials come down, but you know what is your anticipation in terms of some of the sourced components do you think you see price coming down there or would you expect that to sort of be flat or even moving higher as we move forward.
Sure. So let me start with the inventory.
As you know.
I mean as we go forward I mean, we will probably shift that makes it a little bit so we'll have more fixed.
More final finished goods and less raw material right now we have higher raw materials, given the supply chain lead times, our own supply chain lead times. So I think that's going to shift a little bit, but overall, reaching fairly normal inventory levels. So I think the majority of the buildup that we have.
Half was returning back to normal finished good level.
And in future, we would see that trailing in the same way.
Thank you Don and my factories, we always challenge them to say, hey, I have less raw material and.
Warehouses need more finished goods to serve our customers better, but I don't think we break it out historically and we won't do that right now.
The second one on the component cost side.
We are expecting inflation and we will continue expecting inflation for a few months.
Always like commodities and our supply team in some cases has negotiated some excellent contracts, which means that the sort of pricing for next year, maybe index to commodity pricing this year.
Not always.
<unk>, it's a six to 12 months lag.
And I think based on dock, we would expect component to continue being inflationary.
But if you take components commodities, our material cost reduction initiatives put it altogether next year that would be a positive versus a negative. This year. So this year that was a net negative in terms of.
Headwind to us next year, putting the whole package together will be a tailwind to us and we'll break that out for you in December .
That's all really helpful.
And then I wanted to circle back on minimum efficiency pricing and just so that we kind of do the right math in terms of how much of the portfolio that applies to so can you talked about.
What percentage of the air conditioning, and heat pumps would would be at the minimum efficiency level, but if we think about sort of total <unk>.
I don't know that the right math is to just say, 60% is going up 10% to 15%, maybe just kind of help us step through that a little bit.
Yes, it's a little more complicated than that given.
The way the transition has particularly in residential where you can still sell thirteenths here in the North you just have to be manufactured by December 31 of this year. So I think that's something that we'll scale that number back a bit I.
I'm not going to give you the math on it because I'm not certain of it.
So I'm not going to lay it on the table, but.
I just want to play those dynamics back sheet, because once again it is a very difficult thing to get our hands around roughly 50% of the revenue 60% of the units are minimum efficiency. So you start there and then like I said you need to consider the timing of the transition and the way that it's laid out north north versus south, particularly on the residential side to come up with us a tighter number.
Round that we.
We may give you more color around that in December , but I'm not prepared to do that at this time.
Got it thanks very much.
We will take our next question from Josh <unk> from Morgan Stanley . Please go ahead.
Hi, good morning, guys.
Good morning, Josh.
Yeah look on the on the commercial.
Startup here with the CEO and then you mentioned you kind of hit a few milestones.
Stuck or what should we think about as sort of the incremental along the way to restoring that $100 million of profitability you talked about because I think on one hand.
Reasons that you guys decided for what drove the reduction sound like they've been remedied.
So I'm sort of wondering like what's the next thing to watch in.
Are there any sort of buckets of profit restoration, you would think about is correlated with that.
Yeah, right before the call I might join us off our president and CEO of commercial and he said, we got to strike a balance.
So I'm going to use his words on making sure we are demonstrating and celebrating progress, but acknowledging that we have lots and lots of hard work still ahead of us.
The improvements on $100 million is still going to be spread over the next two to three years.
Lot of that is going to come with higher output because that outflow, there's still way below nameplate capacity at Stuttgart a lot.
That's going to come from just manufacturing efficiency I mean, just a number of shows that we have increased staffing by 30%, but output only about 15%. So we should be able to make 15% more products without adding any labor just simple math on that and then there's a lot more benefit that comes from improving our manufacturing processes.
Yes.
Don't get too the state we got in April .
Robust manufacturing processes, so we need to establish those processes.
And then finally as we take the step forward towards the or change the price mix benefit that we talked about in residential also applies to commercial where some of our national account contract artificially constrained us on our pricing levels.
Put it altogether I mean, we are confident of the $100 million.
We think it's.
It's going to be in three years or less I hope to deliver it into what we commit to delivering it in at least three.
Got it that's helpful and then.
I apologize if you covered this earlier I cut out a couple of times during the prepared remarks, but I'll.
On.
And some of the heat pump points to watch I think you guys, probably leaning a little bit more towards furnace than some of your peers out there I would imagine that comes at the expense of heat pump on the other hand here.
Pumps I think in terms of the incremental technology benefit might help you a little bit more in the north than what they would have historically I guess, how do you think about both.
Both product and channel positioning to maybe kind.
To.
Execute on that opportunity here.
Sure. So you're correct that our heat pump exposure is less than some of our peers, mostly because we saw a higher share in the north versus the south I look at it as a huge opportunity for us.
To increase heat pump penetration.
Had strong growth this quarter, just like previous few quarters in heat pumps.
Our new core climate heat pump technology gives us an edge over our competition as heat pump penetration.
Those from South to North and I believe inflation reduction act is going to make a meaningful difference for us to increase heat pump penetration and often.
Use the inflation reduction to go with dual fuel system, where you have a heat pump and a furnace in areas where people may not work in the cordis few months, but work very well for the remaining.
Nine to 10 months. So there are a lot more opportunities ahead for us love to talk.
Show more of some of these points during the Investor day.
But pretty exciting opportunity for us and the rest of the industry.
It gives us more favorable benefit given our low penetration and our cold climate heap of technology.
Do you think youll be able to quantify.
Or are we still sort of ring fence the opportunity at Investor day.
It was hot.
Potentially going to still remain very hard part of it is it needs to Florida two states on each of the states come up with their own broker regulation, we know it's positive.
I don't know if any of US all startup viewers couldn't give you actual quantification.
We can probably point to teams and I'm looking at jewelry and he's got a nodding it has.
I think it's going to be hard to quantify the exact impact just because it hasnt flown down to states and utilities and how it's actually going to be implemented.
Got it understood I appreciate it.
We'll take our next question from Steve Tusa with Jpmorgan. Please go ahead.
Hey, good morning, guys how are you.
Perspective.
So first of all what was the independent channel how did that perform for you in the quarter I know it was up pretty big last quarter in.
<unk>.
We as you know we serve mostly through their direct on the Linux and then with Allied and heat craft. We do go through the independent channel I would say the growth was similar across the board. We historically don't break it out but right now the growth was similar across the board.
I think you guys break it out in your 10-Q now or is that now you are not going to disclose that anymore.
That we do break it out in the 10-Q, what it looks talking about it in our formal presentation and prepared remarks that you know that's what you prefer.
So yeah.
And to <unk> point, I think both channels performed almost on par with each other this quarter, okay, okay, not meaningful enough for us to punch it out here.
Great and then just just one follow up question.
So I guess what everybody in the industry is now saying is that there is basically.
Zero elasticity in the residential HVAC market.
<unk> prices are up 30% to 35%.
Relative to a couple of years ago Youre going to get another you know kind of artificial price increase.
With basically zero return for the consumer and spending that much money.
And everybody is generally replacing today versus repairing so you're just saying just market is kind of like fundamentally bulletproof from Nols that elasticity perspective is that kind of what I'm hearing on residential no I don't I don't think we said that the market is price inelastic.
I think what we have to do with industry players is make sure that we serve our customers best.
With the right solution, the repair versus replacement dynamics, I'm, not saying there'll be no shift in fact earlier in the call. We did talk about that there may be a potential shift in what we're doing is preparing for that.
I don't think any market ever 100% price inelastic.
But the current dynamics do favor more replacement versus repair given some of the factors. We've talked about I don't think the <unk> pricing is artificial I mean, I think that's a real there's real costs associated with that Theres real benefits associated with it it's driven by regulation that impacts the whole industry.
But there are a lot of unknowns.
Our job as leaders is to be prepared for those unknowns and react in the best interest of our shareholders as those different factors play out Steve.
Yeah, I guess, what I was just saying was that.
The consumer doesn't really care about regulation or any of that so for them. That's just another 10% price increase that hot.
And they're not worried about your increase in cost and there's really not a payback.
Associated with it. So you just one more question for you what is the what kind of the new efficiency systems. What what is the average cost of install to replace one of these things now in your view.
In the channel, it's a five year average as you look across your fleet.
If I'm, a consumer and I'm, replacing what is that average now cost.
So first of all let me thanks for bringing up the cost of install because to a consumer the cost of equipment is often less than the cost of install but that obviously it depends on whether you are in.
Topeka, Kansas or whether you are in New York City, I mean that obviously very substantially based on the cost of labor, but the cost of equipment on average is less than half of the total cost to the consumer given the cost of installing and supplies an enabler and other pieces that are put onto that.
We don't have a number because it does vary so much.
To give you in terms of what's the average cost of installed from the industry data that you can I'm sure well aware off but in our view that has gone up substantially as well over the past few years and.
Last thing I would say there is a benefit to the consumer with higher seer changes as lower electricity cost most consumers may not see that on their daily Bose I may not be fully aware of it but there is a benefit to the consumer in terms of lower energy consumption that is meaningful when energy prices are at a record high sometimes.
Great. Thanks for the call I really appreciate it.
Thanks, Steve.
We will take our next question from Nigel Coe with Wolfe Research. Please go ahead.
Good morning Nigel.
So look I think that you you raised the point about the R 22 pricing as a driver of you know.
Smith for Pat I think I think this is a really important debate because it's something that we hear a lot of debate about you know in the field.
We're all dropping refrigerants are like awful with four O seven a full 38 et cetera that can replace all 22 at much lower prices and half performance very similar or are we not seeing that happening I mean, you you haven't got a pay all 20 prices at this point I'm. Just wondering you know what the views on that.
Specifically to the R. 22 units you have to consider the cost of refrigerant along with many other factors such as the age of the equipment.
The potential life left in the compressors and motors, so you're right I mean, it's not just that I mean, we look at that as a significant installed base.
Tom's of rebates. So I think it's a whole package you got to look together, yes. There is.
A huge debate and be a part of that debate in terms of repair versus replacement.
I think you would have talked about before they could nobody knows the answer there are different models and our goal is.
As a team to drive it towards replacement, that's beneficial to the consumer but be prepared towards any possibilities.
If the consumer chooses repair you want to make sure we provide them with the repair parts and then we'll talk if we see shifts in that dynamic will come and talk to you all about the shift we are seeing.
Right right and then just a quick one on you are a repeat this one to death, but.
You alluded a lot this is.
Don't hold your breath you know this is government thing the Cogs 10 slowly.
Hum.
Thinking here. This is more of a 'twenty 'twenty four I mean, certainly if you look at the data.
<unk> and the budgets are C. D O predictions, it's much more 'twenty four 'twenty three but when do you think your contractors and dealers can go out and actually stopped selling customers on these benefits.
I think it starts in some states next year and then some of the states, which are faster to roll this out and I do expect along the coast or you might see it sooner.
Some of it will be in 2024.
I mean, it is a good.
Fees for our dealers to be able to start talking about it now I mean, if you see from press releases from us and all our competition, it's already being used and there are already some rebates available with utilities and states that are not tied to irate, but because this gives us an opportunity to go talk to consumers about the rebate that may already be.
Existing.
But the actual impact of Iot I think it starts in 'twenty, three and goes into 'twenty four.
Just hard to quantify without knowing for details on that.
Great well, thanks, a lot I appreciate them.
Our next question will come from Joe Ritchie with Goldman Sachs. Please go ahead.
Okay.
Hey, good morning, guys and thanks for fitting me in.
Hi, Joe Good morning, Joe.
Sure.
And my I might have missed this earlier, but just can you parse out the commercial growth this quarter, how much pricing came through this quarter versus volume.
If there's any commentary on commercial orders that'd be helpful.
Yes, I think we mentioned in the script that the pricing for commercial was 9%. The total growth was 20%. So you think of 11 from core unit volume and nine from pricing.
We don't typically breakout order information, but I mean orders remain healthy and currently are at or above our sales rate. So our backlog continues to build.
And in addition to the backlog on our book.
Also anticipated demand as many of the key customers are working with us.
<unk> planned replacements here as they need to meet their ESG criteria.
And at least here there is a very sophisticated decision about repair versus replacement because through our national account service.
We have huge insights into potential breakdown the replacements coming up so it's all positive in terms of I think pricing is picking up volumes holding strong and we have good insights into orders on the book and future orders beyond what's in the book.
Got it that's helpful. And then it was nice to see the margin expansion this quarter, both sequentially and on a year over year basis in commercial I.
I know that there is some seasonality in the business of <unk> and <unk> tend to be seasonally lower quarters I'm, just curious as you're kind of thinking through.
The margin progression from here are these margins margins that can hold.
Or do you expect the margins kind of stay.
Take a step back at least from an absolute level sequentially because of the seasonality in the business.
So a couple of things right.
Overall for Lennox, our margins are going to go up in the future. So I think the current margins level are lower than what I expect a year from now two years from now three years from now.
And we'll talk more about that on the Investor day.
Q4, specifically Youre right, Mike know margins are seasonally low and quite a few of our manufacturing lines are going to go through a transition as we shift to minimum efficiency brought out, especially on the commercial side.
Hence we hinted that in Q4, the commercial margins may take a step back, but that's planned changeover.
Factories lines need to be just re will be shut down to support the new products.
But overall on margins listen we would win.
Disappointed with the resi margins this quarter, but we understand some of the onetime factors in the mix impact.
We are cautiously guarded for.
Q4.
But we're optimistic about margins in the future as we look at 2023 and beyond.
Got it. Thank you one more quick one just on the commercial facility that's coming online that you expect to be fully operational by I think you said 2024.
Right now commercial end markets to your point the orders are strong who knows where we're going to be in 2020 for I guess the question I have for you. If you are adding capacity in that facility.
How much.
The leeway or are you going to are you going to have to basically.
Just to maybe changes in the market dynamics that you can point to.
If we're in a much different place on nonresidential construction or commercial HVAC in 2024, what will you be able to do to kind of adjust your capacity to ensure that you're not taking significantly high decremental margins if the market were to turn.
Yeah, I know that that was part of the concern in the equation. We went through I mean, there may be a short term softness.
Two years from now it's none of US would know first of all I think the new facility gives us a lot of flexibility.
Mentioned in my script that.
The hourly labor costs of the new facility would be 80% lower than our hourly labor cost at our current facility.
Also the new facility is.
Those two are residential facility, which gives us flexibility moving labor around if we need to between and optimizing it collectively as Lennox International. So yes, I think we will have significant flexibility to react as we have done in the past.
In terms of ensuring that margin degradation is minimal as we go through any volume decline based on external factors.
Having two facility will give us a lot more flexibility than if we only had one.
When.
Things like it'll bounce out economically.
And it is interesting that also remind you I think everyone knows this our variable costs are roughly 85% variable when it comes to product cost. So it's not a high capital intensive business, where it would be catastrophic to.
Decremental margins should volume decline.
Okay. Thank you.
We have reached our allotted time for Q&A.
Our last question that concludes today's presentation. Thank you for your participation and you may now disconnect.
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