Lennox International Inc. (NYSE:LII) Q3 2020 Earnings Conference Call October 19, 2020 9:30 AM ET

Company Participants

Steve Harrison – Vice President of Investor Relations

Todd Bluedorn – Chairman and Chief Executive Officer

Joe Reitmeier – Chief Financial Officer

Conference Call Participants

Julian Mitchell – Barclays

Ryan Merkel – William Blair

Jeff Hammond – KeyBanc Capital Markets

Joe Ritchie – Goldman Sachs

John Walsh – Credit Suisse

Deepa Raghavan – Wells Fargo Securities

Gautam Khanna – Cowen

Nicole DeBlase – Deutsche Bank

Nigel Coe – Wolfe Research

Steve Tusa – JPMorgan

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Lennox International Third Quarter Conference Call. [Operator Instructions] As a 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.

Steve Harrison

Good morning. Thank you for joining us for this review of Lennox International’s financial performance for the third quarter of 2020. I am here today with Chairman and CEO, Todd Bluedorn and CFO, Joe Reitmeier. Todd will review key points for the quarter and the outlook and Joe will take you through the company’s financial performance and guidance. To give everyone time to ask questions during the Q&A, please limit yourself to a couple of questions or follow-ups and re-queue for any additional questions.

In the earnings release we issued this morning, we have included the necessary reconciliation of the non-GAAP financial measures that will be discussed to GAAP measures. All comparisons mentioned today are against the prior year period. You can find a direct link to the webcast to today’s conference call on our website at www.lennoxinternational.com. The webcast will be archived on the site and available for replay.

I would like to remind everyone that in the course of this call, to give you a better understanding of our operations, we will be making certain forward-looking statements. These statements are subject to numerous risks and uncertainties that could cause actual results to differ materially from such statements. For information concerning these risks and uncertainties, see Lennox International’s publicly available filings with the SEC. The company disclaims any intention or obligation to update or revise any forward-looking statements whether as a result of new information, future events or otherwise.

Before I turn the call over to Todd, I would like to announce the date of our Annual Investment Committee Meeting. The event will be held the morning of Wednesday, December 16. The format will be virtual this year. Please mark your calendars, invitations and more details will follow.

Now, let me turn the call over to Chairman and CEO, Todd Bluedorn.

Todd Bluedorn

Thanks, Steve. Good morning, everyone and thank you for joining us. Let me start with a quick overview on the third quarter that continues to be impacted by COVID-19 pandemic and then discuss our updated 2020 outlook.

For the year, we are raising guidance for revenue, earnings and free cash flow driven by the continued strength in our residential business. Overall for the company in the third quarter, revenue was up 2% to $1.06 billion, the third quarter record. GAAP operating income was up 7% to a third quarter record of $167 million. GAAP EPS from continuing operations was up 16% to new high for any quarter of $3.42. Total adjusted segment profit was a third quarter record of $177 million, up 1% from the prior year quarter that included $16 million of insurance benefit. From an operational perspective, excluding the insurance benefit, total adjusted segment profit was up 11%. Total adjusted segment margin for the third quarter was 16.7% compared to 17% in the prior year quarter. From an operational perspective, excluding the insurance benefit in the third quarter last year, total adjusted segment margin was up 130 basis points. Adjusted EPS from continuing operations was up 6% to $3.53, a third quarter record.

On our residential segment in the third quarter, revenue was up 13% to a new high for any quarter of $722 million. Revenue from replacement business is up low double-digits. Revenue from new construction was up mid-teens. Residential segment profit set a new record – excuse me, set a new third quarter record at $153 million, up 21%. Segment margin expanded about 140 basis points to a third quarter record of 21.2%. On an operational basis, excluding the insurance benefit in the prior year quarter, segment profit rose 38% and segment margin expanded 390 basis points.

Our residential business benefited from continued strong market conditions and favorable hot weather in July and August. Consumers continue to replace units more than repair with equipment growth rate running multiples ahead of the parts growth rate. September turned significantly cooler, which continues to – which has continued to-date in October as contractors work towards winter and furnaces. Strength in the residential market continues and the team is executing well as it continues to take advantage of market opportunities to gain share.

Turning to our commercial-facing businesses, they continue to be more heavily impacted from the pandemic than residential as expected. In the commercial business segment, revenue and profit were down 18%. Segment margin expanded 10 basis points to 18.7%. National account equipment revenue was down nearly 30% and regional and local revenue was down mid-teens. Breaking down revenue another way, replacement was down high-teens and new construction was down high 20s. On the service side, Linux national accounts service revenue was down low double-digits. VRF revenue was down low double-digits. While overall commercial equipment revenue was down 20% in the third quarter, we continue to see signs of relative improvement in the business with commercial equipment backlog currently down mid-teens year-over-year and order rates reflecting gradual improvement as well.

Our commercial team continues to win new business decision for future growth. Commercial won 11 new national count customers in the third quarter, bringing the year-to-date total to 26. In addition, our commercial group has launched an initiative called Building Better Air that is focused on improving indoor air quality of commercial spaces. This initiative combines our innovative product line and industry leading building services to provide comprehensive IAQ solutions to commercial customers. We are helping business and building owners evaluate for HVAC systems recommend that comprehensive indoor air quality solution tailored to the building and identify a maintenance plan to ensure ongoing indoor air quality effectiveness.

Turning to our Refrigeration business segment, revenue was down 14% at constant currency. North America was down high-teens and Europe was down high single-digits. Segment profit was down 34% and segment margin contracts at 350 basis points to 10.4%. Refrigeration profitability was impacted by negative mix with Europe down less than the U.S. in the quarter as well as factory inefficiencies due to COVID-19. As in the commercial business, we are seeing signs in Refrigeration of relative year-over-year improvement from the third quarter with backlog up and order rates reflecting strong improvement.

A quick update on SG&A cost savings this year. Earlier this year, we enacted a $115 million SG&A savings program. Due to the improved performance of our end-markets and our strong operational performance, we have restored compensation and volume related SG&A costs. Several examples of what I am talking about are reinstituting pay for the temporary salary reduction, increase sales commissions and paying performance-based compensation. We are now planning for $65 million of SG&A savings this year, with 45% coming from discretionary spending, 40% from headcount reduction and the remaining 15% from paying incentives that return in 2021.

To wrap up with our updated guidance on 2020, we are raising revenue, adjusted EPS and free cash flow. Revenue is now expected to be down 5% to 9% for the full year. Adjusted EPS from continuing operations is now expected to be $9.05 to $9.65 and free cash flow is expected to be approximately $425 million. We continue to face highly uncertain economic conditions in the fourth quarter and remain cautious on the potential impact from the pandemic heading into the winter season, but Lennox has a seasoned team, experience in managing through downturns, while continuing to invest in advanced accounting for the future. We look forward to closing 2020 strong with momentum into 2021. Now, over to Joe.

Joe Reitmeier

Thank you, Todd and good morning everyone. I will provide some additional comments and financial details on business segments for the quarter starting with residential heating and cooling. In the third quarter, revenue from residential heating and cooling was a record $722 million, up 13%. Volume was up 11% and price and mix combined was up 2% and foreign exchange was neutral to revenue. Residential profit was a third quarter record of $153 million, up 21% as reported over the prior quarter that included $16 million of insurance benefit. Segment margin was a third quarter record of 21.2%, which was up 140 basis points as reported over the prior quarter with the insurance benefit. Segment profit was primarily impacted by higher volume, favorable price, lower material and other product cost, higher factory productivity and lower distribution and freight costs. Partial offsets included the year-over-year difference in insurance benefit, higher selling and incentive expenses and tariffs.

Turning to our commercial heating and cooling business, commercial revenue was $208 million, down 18%. Volume was down 16%. Price and mix combined was down 2% and price flat and mix down. Foreign exchange was neutral to revenue. Commercial segment profit was $39 million, down 18%. Segment margin ticked up 10 basis points to 18.7%. Segment profit was primarily impacted by lower volume driven by the COVID-19 pandemic and unfavorable mix. Partial offsets included lower material cost, higher factory productivity, lower distribution cost and lower SG&A expense.

In Refrigeration, third quarter revenue was $125 million, down 12%. Volume was down 16%, price and mix combined was up 2% and foreign exchange had a favorable 2% impact on revenue. Refrigeration segment profit was $13 million, down 34%. Segment margin was 10.4%, down 350 basis points. Segment profit was primarily impacted by lower volume and lower factory efficiency due to the COVID-19 pandemic and unfavorable mix. Partial offsets included favorable price, lower material costs, lower SF&A expense and favorable foreign exchange.

Regarding special items in the third quarter, the company had net after-tax charges totaling $4.4 million that included a $3.6 million loss from natural disasters net of insurance recoveries related to an August 2020 high-wind damage at the company’s manufacturing facility in Iowa, $2.2 million for personal protective equipment and facility deep cleaning expenses incurred due to the COVID-19 pandemic, a net charge of $1.4 million for various other items, and a benefit of $2.8 million for excess tax benefits from share-based compensation. Corporate expenses were $28 million in third quarter compared to $18 million in the prior year quarter as the company’s financial results in the third quarter triggered incentive compensation true-ups for performance year-to-date.

Overall, SG&A was $152 million, up 6% from the prior year quarter. And for the first 9 months, SG&A is down 7%. In the third quarter, the company generated $440 million dollars of cash from operations compared to $236 million in the prior year quarter. Capital expenditures were $12 million compared to approximately $25 million in the prior year quarter and free cash flow was $428 million in the quarter compared to $211 million in the prior year quarter. The company paid approximately $30 million in dividends in the quarter. Total debt was $1.01 billion at the end of the third quarter and we ended the quarter with a debt to EBITDA ratio of 1.8. Cash, cash equivalents and short-term investments were $59 million at the end of September.

Now, before I turn it over to Q&A, I will review our current market assumptions and guidance points for 2020. For the industry overall, we now expect North American residential HVAC shipments to be roughly flat this year. We now expect both commercial unitary shipments and refrigeration shipments to be down approximately 20% for the industry this year. Looking at the company’s performance year-to-date and outlook for the fourth quarter, we are raising our 2020 revenue guidance from a decline of 10% to 15% to a decline of 5% to 9% for the year. We are raising our guidance for GAAP EPS from continuing operations from a range of $7.31 to $8.11 to a new range of $8.35 to $8.95 for the year. We are raising our guidance for adjusted EPS from continuing operations from a range of $7.90 to $8.70 to a new range of $9.05 to $9.65 for the year.

Looking at the various puts and takes in our financial guidance for 2020 that we are updating commodities are not expected to be a $25 million benefit for the year compared to prior guidance of a $20 million benefit. We now expect a $25 million benefit from sourcing and engineering lead cost reductions compared to prior guidance of a $20 million benefit. Residential mix is expected to be a headwind of approximately $10 million for the full year as new construction has outperformed replacement business year-to-date. Earlier expectations were for new construction to slow and mix to be flat. We now expect corporate expense of approximately $90 million compared to prior guidance of $75 million primarily due to higher compensation expense related to the company’s performance. We now expect interest and pension expense of approximately $35 million compared to prior guidance of $40 million.

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We now expect an effective tax rate for the full year on an adjusted basis of 19% to 20% compared to the prior range of 21% to 22% due to the timing of certain tax benefits this year. And for 2021, we expect the effective tax rate to be back in the 21% to 22% range. Capital expenditures are now expected to be $100 million for this year from prior guidance of $120 million on the timing of some spending between 2020 and 2021. And our guidance for free cash flow is now approximately $425 million from the prior guidance of $340 million for the year. For our guidance points that are remaining the same, price is still expected to be a $25 million benefit for the year.

Residential factory productivity is still expected to be a $10 million headwind. We still expect tariffs to be neutral and we continue to expect freight to be a $10 million benefit. The weighted average diluted share count for the full year is still expected to be between 38 million to 39 million shares and our stock repurchase plans remain on hold after repurchasing $100 million of stock in the first quarter for the $400 million that was planned going into the year.

Now, with that, let’s go to Q&A.

Question-and-Answer Session

Operator

[Operator Instructions] And I will first go to line of Julian Mitchell with Barclays. Please go ahead.

Julian Mitchell

Hi, good morning.

Todd Bluedorn

Hey, Julian.

Julian Mitchell

Hi. Maybe just a first question on the top line, the guidance at the midpoint and even the high-end implies sort of step down in Q4 sequentially that’s much worse than normal. Is that just because of the uncertainty in the environment or is there anything sort of specific that you are calling out? And maybe related to that, just wondered on your latest assessments of the health of the resi market entering next year, I heard you say this year you are looking at a flattish market now, any thoughts on sort of fundamentals into next year?

Todd Bluedorn

Yes. On the first point, it’s a combination both of uncertainty in the fourth quarter, but also we had such a strong third quarter if you are looking at it sequentially, year-over-year, I mean, it’s a record third quarter for us. Our residential revenue was up 13% driven by hot weather so that helped. And so I think that’s part of it. In terms of looking into 2021, on markets, we continue to remain bullish on the residential markets. There is lots of moving pieces, but we called – we are calling for the market to be flat this year. And I think that’s an important perspective remember, I understand that some folks are wondering, did demand get pulled in to something from 2021 get pulled into the strong third quarter? Two points, I would make one overall, the market is going to be flat year-over-year in the middle of the pandemic. Second is just the behavior of a residential homeowner, even when there is not a pandemic, no one wants anyone into their house to replace the unit unless they have to and there is a catastrophic failure, they replace the unit. And especially in a pandemic, no one wants people coming into their houses and spending 2 or 3 days replacing the unit. So, these are being replaced when they break and they are not being repaired like they were during the financial crisis, but there has to be a proximate cause for them coming in and that’s not pulling forward demand. No one is sort of saying let’s replace it now rather than next summer. They are replacing it now when it breaks and they have no choice. And so we remain confident as we have talked before that we think there is another couple of years of this mid single-digit growth and for it to be flat in the middle of the pandemic shows the resiliency of this market. And so we remain confident in the resi market for 2021.

Julian Mitchell

Thank you. And then my second question just on the margin outlook perhaps clarify exactly, how much of that $65 million in the savings could reverse or come back into the P&L next year? And what are you thinking for sort of residential operating leverage as you look out now that the revenue line has returned to growth again?

Todd Bluedorn

I think the way I think about it is our new guide on the SG&A, take out $65 million. And then when you look at that $65 million, only 15% of it now is paying incentives, because so much came back into the P&L this year. So, the 15% that’s paying incentives that will bounce back next year. So, that’s whatever the math is, $7 million, $7.5 million, the balance of it, the 45% that’s discretion and 40% is headcount, we control those. And it depends on how the market is performing and the investments that we want to make in the business. But our sort of goal of having 30% incremental margins is plus or minus what our target will be for next year. So, previously, our guide was $115 million with a lot more tied to paying incentives, I think that risk is now off the table for next year. It comes with it bouncing back on us in a meaningful way.

Julian Mitchell

Great, thank you.

Todd Bluedorn

Thank you.

Operator

Our next question is from Ryan Merkel with William Blair. Please go ahead.

Ryan Merkel

Hey, good morning, guys.

Todd Bluedorn

Hi, Ryan.

Ryan Merkel

Hey, good morning. Can you just dive into some of the commercial end-market performance to give us a little more detail?

Todd Bluedorn

I think we have caught it up somewhat out on the call. We have seen national accounts sell more than our local and regional business and that’s what we would have expected just the way the market behaves that the planned replacement gets deferred as people sort through things. And so our planned replacement was down mid 20s versus a year ago, but in Q2 it was down over 40%. So the trend line on playing replacements going the right direction. And when you look at our order and backlog playing replacement as many companies are getting more comfortable in the current environment and some of our large customers are people like Home Depot, Lowe’s, BestBuy, who are doing pretty well, are getting more comfortable spending. Emergency replacement was down 10%ish in the quarter after being down 35% in the second quarter, so again heading the right direction. And then new construction is the one that goes the other way, because new construction of things that were in flights continue to be built, but that new business starts to go down and we saw that down near 30% in third quarter after only being down mid-teens in second quarter. And then as we mentioned on the call the order, excuse me, the backlog is down mid-teens and so the backlog is heading in the right direction. But when we think about the full year, we still think the markets will be down 20%, the one silver lining in all that is the comp gets a lot easier next year. And so when we think about 2021 sort of which the way the world looks now that we would expect that the commercial market, commercial unitary market would be up after such a hard hit 2020. And when you look back on history of the commercial unitary market whether it’s the 911 downturn or the financial crisis downturn, goes down hard comes back quickly.

Ryan Merkel

Okay, that’s helpful. And then secondly, you mentioned commercial IAQ initiatives, can you just talk about how big that business is today and then what is your outlook for the coming quarters?

Todd Bluedorn

Yes, I mean, we tend not to quantify the market. And again, I think you heard in a way I talked about it, we think about it as a facilitator to win the equipment business. And our Build Better Air initiative is leveraging off our store capabilities in indoor air quality and our relationships with the building owner. And we are an industry leader in indoor air quality in both residential and commercial markets as we have talked about indoor air quality as air purification, like builders and UV lights, ventilation and circulation and humidity control. Our residential pure air equipment is the best in the industry, as noted by consumer reports and then we talked about building better air and our advantages and our opportunities there.

Ryan Merkel

Great, thanks, Todd.

Todd Bluedorn

Thanks.

Operator

Our next question is from the line of Jeff Hammond with KeyBanc Capital Markets. Please go ahead.

Jeff Hammond

Hey, good morning, guys.

Joe Reitmeier

Hi, Jeff.

Todd Bluedorn

I just want to point out before your actual question that so many things changing in 2020, I personally have great comfort that the Pittsburgh Cleveland remains consistent over the decades.

Jeff Hammond

I knew that was coming.

Todd Bluedorn

Okay, go ahead.

Jeff Hammond

Okay. Can you just talk about your distribution based business versus direct sales in the quarter and then just talk about how you think inventories are in your channel and at independent and maybe speak to how the channel is thinking about furnace distribution build versus maybe how they managed the cooling side?

Todd Bluedorn

Yes. The performances of the businesses were relatively consistent. They were both up plus or minus 13%. So, there wasn’t one that outperformed the other. And then I read to note and I thought you raised valid questions around the AHRI numbers versus the HARDI numbers one being sell out, one being sell in and we take great comfort that our Lennox business performs very similar to our allied business, i.e., the sell-through or the sellout of our Lennox business directly to dealers to sell, the 13%, 14%, whatever the exact number was that and so that’s a good sign for our Lennox business. Our allied business also did well. I think the direct question – answer to your question is inventories that are low right now, which is normal coming out of such a hot summer. And then what happens is there is [indiscernible] of short memories or however you want to phrase that of dealers. And so they had trouble getting cooling product in the summer, which many did because our competitors had trouble delivering. Then they want to make sure their bars are full with furnaces and so we see that right now as people are loading up on furnaces.

Jeff Hammond

Okay. And then just on refrigeration, I think you said backlog was up maybe what’s differentiating the order trend there? And then I think you mentioned COVID disruption there, what’s unique about the facilities there versus the other businesses?

Todd Bluedorn

Yes, we got it both in our European business and in our Tifton, Georgia business. If you look at Tifton, Georgia on a map, it was in one of the hardest hit areas for COVID in the country. And so that has some impact on our businesses and so absenteeism and then actually, having had the factories shutdown for a bit in both locations impacted our productivity. When you look at the backlog of commercial, as you know we are more exposed to retail there than we are in refrigeration and that’s been a softer spot and then also in refrigeration, cold storage is one of our largest verticals and that’s been relatively strong given that people are building up a cold chain to support different consumer buying habits and buying food at home and also maybe a bit of preparing for the vaccine. And so we have seen strength in cold storage and that’s helped us.

Jeff Hammond

Okay, thanks for the color.

Todd Bluedorn

Thanks.

Operator

And next go to the line for Joe Ritchie with Goldman Sachs. Please go ahead.

Joe Ritchie

Thanks. Good morning, everyone.

Todd Bluedorn

Hey, good morning.

Joe Ritchie

Hey, Todd. Maybe just commenting a little bit on the resi HVAC monthly trend, obviously, you guys have told us what July was up I am just curious how the rest of the quarter went? And then as you are switching over to furnace, I am just curious whether you think there are any issues that may occur, just given how strong HVAC has been just from a manufacturing perspective, I am just wondering if there is any kind of like picking the Python type problem as you try to deliver on furnace sales?

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Todd Bluedorn

The trend line during the months July and August were up mid-teens as I talked about on the second quarter earnings call we saw in July and then September was up significantly, but up more low double-digits, high single-digits as sort of got away from hot summer selling season. We are positioned as well or better than anyone in the industry to meet both cooling demand and furnace demand. So, we think we are in good shape. I think some of our competitors may have issues. And again, I think it gets more pronounced as if you have independent distributors trying to get large orders from you all at once and maybe our competitors are seeing some of that, but we think we are in good position as well or better than anyone in the industry to meet the upcoming furnaces.

Joe Ritchie

Okay, great. And then my one follow-on as you think about 2021 and I know it’s probably a little too early, but I am just trying to think about how to think about the price costs dynamics in resi, you saw copper is up a lot, but you mentioned getting good price mix this quarter on the resi is back. So, any comments on just the dynamics heading into 2021 just given the increase we have seen in commodity costs?

Todd Bluedorn

Yes. I will broaden the question and just sort of talk a little bit about 2021 more broadly, obviously lots of moving pieces. There is always uncertainty in October when you are thinking about the following year, but maybe as much now as ever. And I talked a little bit about the end-markets earlier I repeat that we walk out or almost out 2020 with a clear understanding of the resiliency of the residential market and again it’s demand that’s being caused by the home failing and remodel all that we think there is another couple of years of that. So, we think mid single-digits next year for residential and new constructions remains strong. For commercial and refrigeration, as I talked earlier, more uncertainty there, but after being down 25% – 20% this year, we would expect some rebound in 2021. Directly to your question is we do expect some commodity headwind for next year, but I would also just mention, we have always historically said commodities that matter most to us are steel, copper, aluminum in that order. With all the work we have done on moving to aluminum and our heat exchangers across our business, it’s now steel, aluminum and copper that’s most important to us. And so while copper still matters, it matters significantly less than it did 4 or 5 years ago and aluminum I think is behaving more, nicely if you will, sound like the President with that terminology, but has behaved better. And so we expect some commodity headwind, we expect some freight headwind at the current point of time although that still has to be shaken out. And then if we talk about, we would expect a little bit of compensation bounce back given the takeout a reduction this year. But as always, we are going to be announcing a price increase here shortly. And we expect to get price next year just like we do every year. We are going to benefit from sourcing and engineering cost reductions. We talked about raising that number from $20 million to $25 million this year. And so that’s order of magnitude that we have done for the last decade $20 million to $30 million depending on the year. Factory productivity after not really having much of any factory productivity issue, because of all the disruptions because of COVID, we will get back on track there. And then as always, our target of 0.5 point of market share gain. So I know I haven’t quantified a lot of those, but it’s to send a signal that we think the setup for next year will be not dissimilar to the setup of prior years, where we have markets saw share gain, priced offset commodities and then continued productivity and material costs and factory productivity.

Joe Ritchie

Thanks. Appreciate the color.

Operator

Our next question is from the line of John Walsh with Credit Suisse. Please go ahead.

John Walsh

Hi, good morning.

Todd Bluedorn

Good morning

John Walsh

Maybe just a finer question on that commodity discussion we just had there, you took commodities and the sourcings combined up $10 million relative to where we were in Q3. Just how much of that falls through in Q4 versus how much has been realized kind of the year-to-date?

Todd Bluedorn

I am not sure to be honest with you, John. Maybe we can sort of guide that I think that the commodities, I think people are scrambling diligently to sort of find, I think the commodities can’t tamper down as we go through the year, where the material cost reduction starts, continues to increase as we go through the year. So, if I had to guess I would say commodities are around $20 million, $22 million year-to-date and then MCR, I think the raise is just confidence that we will continue to execute for the balance of the year.

John Walsh

Great, thank you for that. And then just I guess maybe you talked a little bit about 2021 just kind of to two questions on my mind. I mean, you just talked about your normal kind of market share gains. But as I understand it, one of your competitors, right, had factory disruption and so they might have not been able to fulfill orders and that arguably comes back online next year. So, does that make it harder to get that kind of normal market share gain that Lennox has been getting? And then maybe just on this replacement pull-forward question, I guess it depends on how you think we look from a work-from-home benefit next year, but wouldn’t because we were sheltering we would see more breakage this summer that needed replacement arguably that pulled from ‘21 into ‘22 or is that just not the right way to think about it? We would just like to get your perspective there.

Todd Bluedorn

I will answer the second question first and not as you, John, have heard others talk about that. I don’t think that’s how it works. And what I mean by that is I don’t think people set their thermostats to 85 when they go to work and then when they come home, they set it to 68. That I think the majority of people don’t even set their thermostats on a timer, it just sort of remains constant over time. And then I think people raise it, maybe to 78, 80 when they are gone and then 75 when they get back. So I don’t – in terms of usage that doesn’t drive a spike up where units all of a sudden have huge acceleration of use of breakage. And so I just step back and say the market is flat year-over-year in 2020, that doesn’t show pull forward to me, it’s flat and a hot summer. So, the market is flat and hot summer that doesn’t show pull forward to me that shows people were hesitant to spend money unless they had to, but when the unit breaks, they replace the unit rather than repaired it. I don’t think there is – I don’t think anything was pulled forward, because people were at home. Remind me what the first question was?

John Walsh

Just on the ability to kind of get your normal market share gains, I mean, I know its end of April right?

Todd Bluedorn

Yes, one give me personal privilege to just sort of observe that when we lost because of tornado everyone assumed we would never get it back and now that we have taken it from others, there is an assumption that maybe we won’t be able to hang on to it. I think a couple of things. I think haven’t been on the other end of it, we were cognizant the constrained supply environment to supply the dealers who we thought we had the best chance of keeping business to sellers. We weren’t selling arms to anybody. We were selling arms to our units to those dealers who we thought we had. We are already sort of in the conversations with and converting over and those are the ones we sold to. So, we may – we are not hang-on to all that we get, but we are going to hang on to a lot of it, a whole lot of it. And then we are also on the attack to gain more share. So, I remain confident that we will – we are gaining significant share this year and I am confident we will gain share.

John Walsh

Great. Thank you. That’s really helpful color.

Todd Bluedorn

Yes.

Operator

And next from the one line of Deepa Raghavan with Wells Fargo Securities. Please go ahead.

Deepa Raghavan

Hi. Good morning all.

Todd Bluedorn

Good morning, Deepa.

Deepa Raghavan

Todd, can you provide your thoughts on when you think you can resume share buybacks? Looks like you are starting to loosen up on some of the variable costs and getting comfortable given your strong cash outlook. So, will it be normal for us to assume buybacks return in 2021?

Todd Bluedorn

Yes. I will be more direct put it in your model. We are not going to start it up here in fourth quarter getting some of the uncertainty, but when we give the December guide for 2021, we will be back to a more normal stock repurchase program for 2021.

Deepa Raghavan

Great, thanks. Can you – how do we think about normal volume-driven leverage in 2021? I mean, you have – you are going to have all these costs in and out rollbacks more seems like more headwinds. I don’t know if price gets that much more incrementally better. So, should I think about your volume-driven leverage to be slightly below trend or should all those dynamics not impact just given that you probably should be able to price for them or take costs elsewhere?

Todd Bluedorn

Our variable gross margin is around 40%. So volume drops through it sort of a normal 40% either direction and then obviously in a year, where we are spending SG&A and doing other things then the incrementals, goes down. And so that, that’s how we end up with the 30% incremental that we are making investments into business building out distribution, driving productivity, but the third normal volume leverage is about 40%.

Deepa Raghavan

Got it. Thank you very much, Todd.

Operator

And next, we will go to Gautam Khanna with Cowen. Please go ahead.

Gautam Khanna

Hey, thanks. Good morning and great results.

Todd Bluedorn

Thanks, Gautam.

Gautam Khanna

I had a couple of questions. First, I was wondering if you could maybe frame the magnitude of the pricing opportunity for resi. You mentioned you are going to announce some price increases, just should ‘21 be a better net realization year than normal, any framework for that?

Todd Bluedorn

Yes, I mean I am going with hope what we will announce will be what we always announce publicly for the second quarter what the final number is going to be. So, we will announce price, but yes, I do think there is when we expect the market to be up after having been constrained the year before. That sort of leads you to believe you can get price in the marketplace as we spoke about when we are having challenge meeting demand as we did – as the whole industry did in 2020 wasn’t really the right time to raise price dynamically the middle of a season. When we go into next year, we will be looking to raise price and for a couple of reasons. One, we talked about commodities. COVID has added cost to our cost structure. We talked a little bit about what happened in our refrigeration margins because of it, but quite frankly, it’s impacting the entire business both on the SG&A side and we think we have to do to manage suppliers and manage our own business, absenteeism in our factories and then we think rate is going to be up. So, those are all reasons on why we are going to need to pass price on and I think our – in fact, I know our competitors see the same for us.

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Gautam Khanna

Thanks. That makes sense. And also could you just expand upon the IAQ opportunity level of engagement with customers does it drive like a much bigger revenue cycle, anything you can talk about that?

Todd Bluedorn

Yes, I mean – I maybe – I don’t know what the right phrase is, maybe more clear-eyed on IAQ. I don’t think its billions and billions and billions of dollars of opportunity at least in unitary, where we play and in residential. I think if you are showing $5,000 residential units, your indoor air quality component is $400 or $500. On commercial, it’s maybe less of a percentage. So, I don’t think it drives the overall ticket. I think what happens is you have to have knowledge and expertise in it for those customers who want it and you want to steer customers who wanted to be able to handle their questions. And so, commercial customers have Build Better Air, sit down with them, talk about what we have and we have everything, and then put it in place and then use our NAS, our national account service to measure and monitor the compliance. In our residential business, it’s our PureAir S, which has both passive filters and active UV lights that allows us to clean air and then also it’s digitized, so those part of our iComfort controller. You can measure and monitor what’s going on. And so I think it’s being an expert in the area that allows you to win the jobs and convert dealers and that’s where we are focused on.

Gautam Khanna

Thank you very much, guys.

Todd Bluedorn

Thanks.

Operator

And next, we’ll go to Nicole DeBlase with Deutsche Bank. Please go ahead.

Nicole DeBlase

Yes, thanks. Good morning, guys.

Todd Bluedorn

Good morning, Nicole.

Nicole DeBlase

We covered a lot of ground here. But I guess on the free cash flow guidance, it doesn’t really embed a whole lot of free cash flow in the four quarter. I am getting to something a little bit more than $30 million. So, just thoughts on – I am guessing that working capital is kind of the biggest swing factor there. So, any thoughts that you have about what we should expect for 4Q?

Todd Bluedorn

That’s the answer. I know the sequence of the quarter is different this year. By the way, they are going to be different next year and we will talk about that in December. But we are typically at this point in time driving down production levels and burning off inventory. But given the hot summer selling season and given that we expected the markets to be down, while we saw summer selling season was a burn off of inventory, burn off of receivables, payables and then what we see in Q4 is on a year-over-year basis the inflation of inventory and working capital. And so that’s why you see – we typically have the big cash quarter, fourth quarter. This year, we had the big cash quarter in third quarter.

Nicole DeBlase

Okay, totally makes sense. Got it. And then just one more on refrigeration, so I think you characterized you quantified a bit of what’s going on with order and backlog within commercial, could you just provide some detail around what you are seeing in refrigeration, Todd?

Todd Bluedorn

Yes, I mean, our backlog is up year-over-year, right now where we stand, and the order rates on a 3, 6, 9-week basis are all up in refrigeration. So, the trend lines are good. I think it’s both. In our North America business, there is distribution business where we sell through – about half of its distribution business we sell through large refrigeration wholesalers and that has bounced back from being down significantly in second quarter. And then the other business is project business or our cold storage. And that, as I mentioned earlier, has been relatively strong. Our Europe business has been strong. But we are a little, obviously, a little over-concerned about COVID and lockdowns in France and Spain and what the trend line is there. But again, on – for the last 3 or 4 months, our business in Europe are at the order rates and also trending the right direction.

Nicole DeBlase

And what – have you actually seen any slowdown in Europe or is that just reading the headlines and being concerned about what could materialize?

Todd Bluedorn

We are starting to see things slow down.

Nicole DeBlase

Got it. Okay, thanks. I will pass it on.

Todd Bluedorn

Thanks.

Operator

And we will go to Nigel Coe with Wolfe Research. Please go ahead.

Nigel Coe

Thanks. Good morning, everyone. Obviously, residential margins were exceptionally strong ex the prior year insurance benefit. I am just curious, can you – you think if volumes remain sort of high-single digit, low-double digits in the 4Q and maybe even ‘21, you can maintain above 40% incremental margins? And then within your commentary on the margins, I think you mentioned sourcing commodities actually now more the benefit than you expected last quarter. Is that mainly volume-related? And then, I am just surprised that freight isn’t turning into a – it’s more of a headwind. Can you just maybe just address what you are seeing on freight utilization?

Todd Bluedorn

Freight remains tailwind this year, and part of that we were aggressive on – we are managing freight like we have managed over the last year or two, we have invested in Freight management like we did in NCR 15 years ago. And so, we have a pretty sophisticated team. We now have the tools to measure it. And so, I think part of it’s just productivity on our side, regardless of what’s happening with the overall rate, and we expect to be a tailwind this year and a bit of a headwind next year. In terms of residential margins, I think you sort of see a peak out in the current environment, where we had volume, we had done aggressive SG&A cost reduction and we had invested in stores because of the tornado. I think on an ongoing basis, since residentials 60% of our business, we talk about 30% incrementals. I think that’s plus or minus what you should think about residential. I don’t think it remains 40%, because we are investing in SG&A. We are investing in stores and we will start to back up in 2021. And so, we will have the investment headwind, if you will, that feeds the engine on an ongoing basis. And then was there another question? Did I miss anything?

Nigel Coe

I think actually you covered that one. Just wanted to touch back on the buyback comments, you mentioned ‘21 would be obviously a more normal year on buybacks. I think normal for you, Todd, would be 350 to 400 would be sort of the run rate. Is there any catch-up from the ‘20 air pocket on buybacks, or are we back to the $350 million, $400 million?

Todd Bluedorn

I think the way to think about it is and you can run the model on your own, right, is we don’t want debt-to-EBITDA to go above 2, that’s sort of our peg point. And so, we will invest in the business with CapEx, we will do acquisitions, but we don’t. And then what’s left, we will pay dividends and share buyback. And so, I think you model all of that and I think we start to peg what we do. I don’t think this year we will do $600 million or $700 million, if that’s a direct question. But there maybe we do a little bit more, but it’s all going to come down to that formula.

Nigel Coe

Okay, thanks a lot.

Todd Bluedorn

Thanks.

Operator

Our final question will be from the line of Steve Tusa with JPMorgan. Please go ahead.

Steve Tusa

Hey, how is it going?

Todd Bluedorn

Hey, Steve. Good.

Steve Tusa

On tax rate, what’s kind of the go forward you guys – is this kind of 19% to 20% the right number, and have you guys kind of evaluated? Does that kind of revert if there is – I know you like to talk politics, if that – if there is a blue wave or buy-in, does that revert to a certain level, maybe not back to where it was, but what’s kind of the long-term view on the tax rate?

Todd Bluedorn

As Joe mentioned in the script, we – for ‘21, we think tax rate is going to be 20% to 21%, so it goes back to more normal rate as we got it this year. We had some discrete items this year that allowed us to take it down. But 20%, 21% is what we are seeing next year. And then beyond that, who knows. But we will react whatever is done and we will adjust accordingly.

Steve Tusa

Just going back to this kind of resi cycle discussion, so are you saying this year was kind of ended up being a normal year despite the pandemic, so there wasn’t really a push or pull in and out of this year? And I know you guys had had that housing echo boom chart out there, we are kind of a couple of years into that chart. So, are we still thinking that that’s the swing factor in this cycle? I mean, housing peaked in 5, 16-year useful life. I mean, is that still the way to think about it that ‘21 from an echo boom perspective is kind of a peak year or is there something that happened this year that kind of changes that profile?

Todd Bluedorn

I think I would answer 2020 this year is we had a warm summer, and we also had a pandemic. And I think broadly they offset each other and we have flat market. So, I think if we didn’t have a pandemic the market would have been up more. And I think if we hadn’t had a hot summer, the market would have been down. And I think – we think the right comment is, when you look at the AHRI numbers, I am doing this from memory, but through August it’s down about 3%. We think from a year-to-date basis, that’s close to flat when it all shakes out.

Steve Tusa

Right.

Todd Bluedorn

So, that’s our call. In terms of the market going forward, yes, I think we have been pretty consistent. I know we disagree, Steve, I know that. But we – when we model it and look at it, we still think we have another couple of years a mid single-digit growth, everything else maybe more. And if it’s a hot summer, maybe better; cold summer will do worst.

Steve Tusa

Is that echo boom analysis still in play or is there something else driving it?

Todd Bluedorn

No, it’s still in play.

Steve Tusa

Okay. And then one last…

Todd Bluedorn

I don’t think the pandemic pulled anything forward. If people are sort of saying there is another couple of years but it all got pulled in this year, I would say – no way, because it’s flat market. Hot summer doesn’t make any sense.

Steve Tusa

Right, absolutely. And then just one last one on free cash flow, you have bounced around a bit here in the last couple of years, what is kind of the normalized conversion rate for you guys? And again, just to reaffirm, that’s on a GAAP basis when you talk about conversion, right?

Todd Bluedorn

It is. I read a note, it said 90%. I think if you look at a longer horizon, it’s closer to a 100%, and that’s our number, 100%. And this year we are having strong cash flow and that’s obviously because – one, we performed EBIT wise, but obviously if you deflate working capital, you generate cash net. So, we did. And so, in the years where we were inflated working capital, we have more headwind in years where we were building Mexico, we have headwind and then tornado, so lots of moving pieces. But over a longer perspective, it’s a business that will generate 100% of net income.

Steve Tusa

Yes, I think [indiscernible] was talking about adjusted, to be clear, so that would be more close to 100% if it’s on a GAAP basis, so just to be clear on that one. Alright, cool. Thanks a lot, guys. I appreciate it.

Todd Bluedorn

Thanks. Thanks, everyone. To wrap up, the residential market remained strong entering the fourth quarter and commercial and refrigeration markets continued to improve. The Lennox team is executing well and taking advantage of market opportunities and share gains. We look forward to closing 2020 strong with momentum into 2021. And again, thanks everyone for joining us today.

Operator

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



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