If these early reports and reactions are any indication, it’s going to be an interesting earnings season. Sandvik (OTCPK:SDVKY) reports pretty lackluster results in its SMS division and the market responds with “don’t worry, you’ll get ’em next time!” and Lennox (LII) has a very strong quarter and the market responds with “yeah … I dunno.”
Now, to be fair, not only are the addressed markets very different but so too are also the valuations, with HVAC companies like Lennox trading at quite high multiples going into the quarter. Still, I think the market is likely overestimating the risk to continued residential HVAC growth in 2021 (and beyond) while still being a bit too casual about the risk of weaker commercial new-builds (offset, though, by opportunities in energy efficiency and air quality retrofits).
I thought Lennox was pricey after second quarter results, and with the shares having largely tracked the industrial sector since then (dipping below with the post-earnings sell-off), I don’t feel any different. I appreciate the strengths and appeal of the HVAC market, but not at these multiples and I’d still prefer Daikin (OTCPK:DKILY) in the HVAC space.
Strong Results Across The Board
Although actual line-by-line results were certainly mixed in the third quarter, relative to expectations, Lennox had a very strong quarter at pretty much every line. Revenue beat the sell-side by 6%, with every segment beating by 5% or more, and segment earnings were $0.41 ahead of expectations, with each segment beating expectations.
Revenue rose 2% in organic terms, with the core residential business up 13% (5% better than expected). Residential replacement grew low double digits, while new construction was up mid-teens. Commercial HVAC revenue declined 18% (a 5% beat) on a 20% decline in equipment sales that was partly offset by a low double-digit decline in service revenue. Refrigeration revenue declined 14% (a 14% beat), with North America down by a high-teens rate and Europe down high single-digits.
Gross margin was a stronger-than-expected 30.6%, improving 170bp from the prior year. Segment income improved 6%, with margin up 70bp. Residential profits rose 21% (a $0.33/share beat), with margin up 140bp, while commercial profits fell 18% (a $0.07/share beat) with margin up slightly. Refrigeration profits fell 34% (a $0.02/share beat) on weaker operating leverage, and margin declined 360bp.
Between Lennox’s third quarter, an update from Daikin earlier in the month and Carrier’s (CARR) recent positive guidance, there’s ongoing strength across the HVAC sector, with residential, in particular, driving that strength.
A Less Certain Outlook?
Despite the strong quarter, Lennox shares were down about 3%. It would seem that concerns about the sustainability of the strong residential market are a significant concern at this point. Indeed, management did note that growth in the residential business moderated throughout the quarter.
One of the bearish arguments on Lennox is “peak replacement cycle”, with some analysts pointing to a decade-plus uplift in residential HVAC from replacement installations. That’s fair to a point, and given what happened to the housing market after the global financial crisis, I would expect some softening in replacement demand. On the other hand, new construction has been below sustainable trends and I believe there could be a “stronger for longer” uplift from new construction. Demographics also play into this, as new construction has been increasingly skewed to warmer climates, which should drive stronger HVAC demand.
On the commercial side, I’ve expressed my view before that new builds are going to be softer than the Street expects in 2021 and 2022. On the other hand, I do expect to see increasing demand for energy efficiency and indoor air quality retrofits. Lennox is not particularly well-placed as a player in commercial efficiency retrofits, but the company has launched its “Building Better Air” air quality initiative, which includes third-party UV components and LII-manufactured controls and components for ventilation, humidification, and so on.
I’ve seen a wide range of estimates for the opportunity in indoor air quality (from $10 billion to over $30 billion), with a lot of the spread driven by the adoption rate in institutional buildings like schools. While Lennox does stand to benefit from this, I believe Carrier, Daikin, Johnson Controls (JCI), and Trane (TT) will likely see a bigger benefit from wide-scale adoption of indoor air quality systems.
I think bearishness on residential HVAC demand is perhaps a little overdone, but given the recent investor enthusiasm and momentum in the HVAC sector, high expectations go with the territory. While I’ve made some modeling adjustments, the end result isn’t all that dramatic – I’m still looking for long-term revenue growth around 4% and high single-digit FCF growth with FCF margins in the low double digits.
The Bottom Line
Even in a near-zero rate environment, Lennox’s valuation looks high to me, with the shares well ahead of historical norms on cash flow and margin/return-driven EV/EBITDA. There are plenty of investors who pay little attention to valuation and invest on the basis of momentum/growth and secular cycles. If that’s your strategy and Lennox still works within that, great. For me, though, I’m still a valuation-driven investor and despite my generally bullish view on HVAC, these shares don’t work for me at this price.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.