Lennox International Inc (LII) 2002 Q1 法說會逐字稿

Ladies and gentlemen, thank you for standing by, and welcome to the Lennox International first quarter 2002 earnings conference call. At the request of your host, all lines are in a listen-only mode. There will be a question-and-answer session at the end of the presentation. As a reminder, this conference call is being recorded. I would now like to turn the conference over to Mr. Bill Moltner, Vice President of Investor Relations.

Mr. Moltner, you may begin.

Thank you,

.

Good morning, and thank you for joining us for Lennox International's first quarter 2002 earnings conference call. If you did not receive a copy of our first quarter earnings release that we issued after the close yesterday or would like to be added to our distribution list for future releases, please call us at 972-497-6670.

We are broadcasting today's call live on the Internet, and there's a direct link to the Webcast on our corporate Web site at www.lennoxinternational.com. This call will be archived and available for replay through May 1st.

Reviewing our company's performance this morning are Bob Schjerven, our chief executive officer, and Rick Smith, the CFO of LII. Bob will begin with comments on the consolidated company's progress and performance and provide an overview of our recently announced heat transfer joint venture with Outokumpu. Rick will follow with an operating performance review by business segment and address some key income statement and balance sheet items. We'll wrap up the call as we usually do with a Q&A session.

I'd like to remind everyone that in the course of this call to give you a better understanding of our performance we will be making certain forward-looking statements. These forward-looking statements are subject to risks and uncertainties, a list of which are included in our publicly available filings with the SEC, which could cause our actual results to differ materially from those we expressed this morning.

That said, I'd now like to turn the call over to Bob Schjerven.

Thank you

. I too would like to thank you for taking the time to join us this morning.

In the first quarter of this year Lennox International made significant progress improving our operating performance. Despite the continued toughness in the end market demand and the fact that Q1 is typically the seasonally weakest quarter for us, our financial results improved both sequentially and on a year over year basis. Furthermore it is worth noting that the operating improvement was not isolated as the many cost controlled programs that we initiated last year began to gain traction, segment operating income and margins improved in all but one of our business segments. Additionally, our strong brands, quality products and services and established customer relationships have insulated our margins in a very competitive marketplace. Now given the difficult environment that we're competing in, we are pleased with Lennox International's start for 2002.

Now before I review our financial results let me take a minute to recap some of the important events that occurred in the first quarter. During the first quarter we launched the day Lennox signature series of residential home comfort equipment. This premium line features the quietest air conditioners and the quietest furnaces available in the market today and this addresses a growing consumer need for reduced noise in and around the home. The day Lennox signature series reinforces our reputation as an innovation leader in the climate control business and is being promoted through a national advertising program.

In this past quarter we also launched pure air, the most effective home purification system on the market according to independent test results. Pure air uses a revolutionary combination of ultraviolet light and

oxidation technology to capture and destroy 75 percent of the particles and 60 percent of the bio-aerosols as small as three tenths of a micron and the system removes 50 percent of odor and chemical content in a home in a 24-hour period.

And as a further investment in our commitment to consumer health and indoor air quality, our Lennox Industries unit has entered into an educational cooperative with the Allergy and Asthma Foundation of America and also a sponsorship of the Indoor Air Quality Association.

Last month, we unveiled a new corporate identity for Lennox International, an identity that is distinctive from its subsidiaries. The new logo addresses our overall corporate identity, not our product brand

. The previous Lennox International logo had become associated with our Lennox brand of heating and cooling products and actually dates from the 1950s. A key element in the new logo is a graphic, LII, the acronym for Lennox International Inc. The logo's simple and direct visual style reflects our focus on business basics and the underlying integrity that has been a permanent and recognized part of our culture since 1895.

Also during the first quarter, we continued to effectively execute the restructuring program that we outlined in the fourth quarter of last year to improve the utilization of manufacturing and distribution assets and to pare back underperforming product lines. We also successfully negotiated a four-year labor contract at our Armstrong unit's Bellevue, Ohio, facility. This contract uses a flexible seniority system that optimizes the use of employee talent and supports the continued implementation of lean manufacturing techniques.

And finally, two days ago, we announced that LII has entered into a joint venture with Outokumpu of Finland, the world's second largest producer of copper and copper alloy products. Outokumpu will purchase a 55 percent interest in LII's heat transfer business segment for $55 million, with LII retaining 45 percent ownership. The agreement, which has been approved by the board of directors of both companies and is contingent upon regulatory approvals, is expected to be completed in the year 2002, mid-year.

This joint venture brings together the resources and the reach of two highly respected global businesses, both of which are leaders in their respective technologies. Merging together these two adjacent links in the supply chain will drive unparalleled efficiencies and customer service and in working capital reduction. This partnership allows LII to focus on strengthening our branded finished goods business and improving our effectiveness in providing value added products and services in our core heating, cooling, and refrigeration markets.

Additionally the alliance supports our stated commitment to generate cash to strengthen our balance sheet and to allow investment in the growth of our core businesses. While our reported revenues will decline by approximately $90 million in the second half of this year as a result of this joint venture, we do not project it to have a material impact on our earnings per share or free cash flow for 2002.

Now we've evened the first quarter of 2002. Lennox International's total company revenues decreased six percent to $676 million from 716 million in the same quarter of last year and accounts and currencies company wide sales were down five percent. International sales, that is those outside the U.S. and Canada, generated 13 percent of total revenues.

Quarterly operating income for the consolidated company before our $700,000 in pre-tax restructuring charges for the previously announced program was $9 million, which is up substantially from an operating loss of $4 million last year. Operating income as a percent of sales was 1.4 percent compared with the six tenths percent loss in the prior year.

EBITDA increased 46 pectin to $25 million from 17 million in the same quarter a year ago.

Net income for the quarter before restructuring and good will impairment was $1 million compared with a net loss of $10 million in the year ago period.

Diluted earnings per share for the first quarter were two cents contrasted with a loss per share of 18 cents for the same quarter last year. Foreign exchange did not have a material impact on earnings per share in this quarter.

Had the

142 accounting rule eliminated the amortization of good will, had it been in place in 2001 the operating income in the first quarter of last year would have been $4.4 million higher and the loss per share would have been 11 cents.

We've completed an independent review of the fair value of our operations which have good will and as a result recorded an after tax non-cash good will impairment charge of $249 million in the first quarter of 2002. This charge relates primarily to our retail and North American residential segments.

On a gap basis after accounting for good will impairment our reported net loss per share in the first quarter was $4.38.

Also in the first quarter, we realized an additional week of revenue in our retail unit when compared with the same quarter last year. Due to the decentralized nature of our retail operations, historically, our reporting of retail results in the first quarter lagged our other operations by one week. However, now, with the

IT system in place and the resulting improvement that we've experienced on our financial control and reporting of this operation, we are able to reconcile the timing of our retail results with our other operations. Accounting for the additional week added $12 million of revenue and 2.3 million in operating income to our retail segment results during the first quarter.

We are continuing the very successful focus on free cash flow that we initiated last year. Our free cash flow, which we define as cash from operations less cap ex before dividends and restructuring expenses and excluding the impact of asset securitizations, was very strong in the first quarter, at a positive $8 million compared with a use of 26 million in the same quarter of last year.

Now, before Rick Smith, our CFO, takes you through the segment results, allow me to comment on our outlook for the rest of 2002. Due to the seasonal nature of many of our businesses and the uncertainty in the strength and timing of economic recovery, it is quite difficult to forecast the year's results based on performance of only the first quarter. We are, however, encouraged by the operating improvements that we realized during this first quarter, and we are confident that the first quarter was a turning point for the company. With continued improvements from process centering, lean manufacturing and cost control initiatives that are in place, we believe that we are solidly on the road to improved performance.

For the two the full year of 2002, assuming the heat transfer joint venture is completed in the second quarter, we anticipate reported company revenues will decline by about five percent. Based on the strength of our first quarter results, we now expect our earnings will be at the upper end of our previously issued 80 to 90 cents earnings per share guidance range, excluding restructuring and goodwill impairment charges, of course. We continue to project our free cash flow for the year to be approximately $50 million.

At this point now, I'd like to turn the call over to Rick Smith to take you through the business segment operating results. Rick?

Thank you, Bob.

Continued economic weakness reduced market demand for us, resulting in volume declines in four out of our five business segments, but the actions we took last year, 2001, to reduce cost structure, they are taking hold, and operating income increased and margins expanded in four of the five segments.

By comments on our segment performance in Q1 this year exclude the $700,000 in restructuring charges related to the decisions taken in 2001 and they exclude the good will impairment charge that Bob identified earlier. We've got a lot of numbers here and on the face of the income statement we do have a operating income by segment as adjusted a schedule for you but I'll try to talk about the numbers before and after the good will accounting change.

Looking at the North American residential segment, industry shipments of furnaces, air conditioners and heat pumps were relatively flat for the first two months of the year. We don't have the March data yet and that compares with a relatively weak year ago period as well but in this segment our revenues decreased two percent in the first quarter this year to 275 million and that was largely due to lower sales of

products. Segment operating income for the quarter increased 26 percent to 15.5 million from 12.3 million last year with that accounting standard 142 contributing seven tenths of a million to the $3.2 million year over year operating income improvement. Margins expanded 120 basis points to 5.6 percent due primarily to cost control programs and improved factory performance and we did see some mix favoring higher margin, high value added premium products.

In our retail segment service experts revenues declined eight percent to 205 million. We did have a number of centers a year ago that were not in the first quarter numbers this year so on what we call a same store basis net adjust for those centers that were sold or closed, sales were down nine percent. Despite that lower revenue base, service experts is beginning to see the benefit from the significant progress that has been made addressing labor productivity with a focus on right sizing the organization for the current level of demand and economic climate.

The segment operating loss shrank from $10 million the first quarter a year ago to $2.8 million this year with that accounting change effecting this segment most of any of our five. That was in effect contributing 3.3 million to the $7.2 million year over year improvement. Operating margins for the quarter were minus 1.4 percent compared with minus 4.5 last year and that extra week of business that was booked this year that Bob touched on, excluding the benefit from that, operating margins would have been minus 2.5 percent, again two points better than the minus four five last year.

, head of

, has worked closely with

management team to instill a culture of accountability and a commitment to improved performance. With that service center rationalization that we talked about, the implementation of the

IT system and higher than usual levels of center general manager turnover behind us, this business, we think, is well positioned for improved performance. Management's intensified its focus on sales generation initiatives to leverage that lower cost structure, and we're also looking at our procurement processes to reduce our equipment, material, and other costs.

In the commercial HVAC segments, industry shipments were down approximately 15 percent in the first two months of the year, and despite that market weakness, we continue to make notable progress. We outperformed the market, primarily due to strong performance in our domestic national accounts business. Our revenues did decline seven percent to $87 million.

Operating performance improved, with the segment operating loss decreasing to near break-even, minus two-tenths of a million from 1.8 million of a loss last year. Segment operating margins in Q1 this year were minus two-tenths of a percent, a 170-basis-point improvement from the prior year, and that again was driven primarily by cost reductions in the U.S. operations.

The commercial refrigeration segment, revenues in Q1 were essentially flat with last year at $85 million, but were up three percent when adjusted for foreign exchange rates. We're encouraged to see a strengthening in the order rate for commercial refrigeration equipment, and we're seeing this both in our U.S. and our European operations.

The segment operating income here is a very positive story. It increased 33 percent to $8.3 million, and there was a small goodwill accounting change effect that was two-tenths of a million as part of the year-over-year improvement. The margins expanded to 9.7 percent, up significantly from 7.3 percent in the first quarter of last year. And, as I said, the very little of that was due to the accounting change. And the other piece of good news around that is that all of our geographic regions benefitted from the cost control initiatives taken in 2001.

Heat transfer, the fifth segment, Bob talked about the joint venture there, but looking at this on a consolidated basis, in the first quarter, the demand for heat transfer surfaces remains soft, and the segment sales decreased 16 percent to $49 million in the first quarter. With this kind of volume erosion we saw a segment operating loss. It was $800,000 in Q1 compared with operating income of $1.8 million the previous year. That operating income in 2001 would have been two tenths of a million higher if the new accounting standard had been in place a year ago and operating margins were minus 1.6 percent this year compared to positive three one last year.

A quarter ago we did report this heat craft heat transfer division had entered into an alliance with

climate control division whereby this business will serve as a major provider of coils to

for its U.S., Mexican and Canadian operations. We are ahead of schedule. We've established a new facility in Mexico to produce these coils and the agreement is on track to bring $11 million in incremental revenues to this business in 2002.

Turning to the some of the key income statement and balance sheet items, interest expense in the quarter decreased by $4.9 million to 7.9 million. That reflected reduced debt levels and lower interest rates. Our progress of

the balance sheet which in 2001 was significant continues in the quarter. Total debt at March 31 this year was $524 million. That was $147 million lower than it was at the same time the previous year.

The good will impairment charge we took in the first quarter did significantly alter our capital structure and our leverage target has been adjusted accordingly. To go through some of those numbers, at the end of the first quarter our total debt to capital was 56.5 percent, which compared favorably with that same ratio a year ago adjusted for financial accounting standard 142 of almost 60 percent. We would like to get that ratio down to 50 percent on the new accounting basis. That would be the mid points of a policy range we would see in the 40 to 60 percent area and we have revised that range as I said for the incorporation of the new accounting.

As Bob shared with you, we were free cash flow positive by $8 million in the first quarter. That was due primarily to continued improvements in working capital and tight controls on capital expenditures. Over the past year our working capital and we measure this as a percentage of sales on a trailing 12-month basis to take some of the noise out. That has improve 220 basis points and is now running at about 22 percent of sales.

The capital expenditure figure that I touched on was $5 million in the first quarter this year. That was just about flat with the same quarter a year ago.

And so at this point, Bob and I would be pleased to address any question that you may have.

Thank you. If you have a question at this time, please press the one key on your touch- tone telephone. If your question has been answered or you wish to remove yourself from the queue, please press the pound key. One moment for questions.

Our first question is from

of

.

Good morning, gentlemen.

Good morning. How are you doing?

Great. Sounds like you all are pretty excited about some of those new products.

Well, indeed we are.

Is there any initial shipment numbers to give any guidance as to how the first signs of acceptance in the marketplace is going for either of those two the Signature or PureAir?

Well, there's no numbers that we would share, but I will tell you this: in both the PureAir product line as well as the Signature products, we have had a very full order book written by our independent dealers, which of course, are the mainstay of the Lennox piece of it. We have always, during the first quarter of the year, a number of regional sales meetings where we get a chance to touch and talk to literally all 7,000 of the independent dealers, and I'll just tell you, they're very, very excited, and the order rate is showing that.

OK. On your debt, can you comment a little bit more? Just as a shareholder, I think having a target as high as 60 percent seems pretty high for a typically cyclical business. Can you just go into a little bit of your philosophy about this broad range of 40 to 60 percent, and also comment about currently the composition of your debt? How much of it floats? If interest rates are going to go up from here, how much of your debt load would be affected by higher interest rates? And then your pre-cash flow, would that be devoted primarily towards paying debt going forward, or would you consider share buybacks and acquisitions as well? Hope you can remember all that.

, I'll give it a try. Thanks. This is Rick Smith. Yeah, on the debt question, again, I do want to point out that that 40 to 60 percent range is certainly high by historical standards. The accounting change does take a big whack. We think it's about 10 percentage points. So I'd like to say that in our frame of reference, that's more like a 30 to 50 percent policy range on an apples-to-apples basis.

And that is a range that we would typically consider over an economic cycle. At this point in the cycle, as I said, we're not comfortable with where we are. We do want to take that debt level down. We think we can with this cash flow free cash flow goal that we've got Bob touched on - $50 million for this year. And with the heat transfer joint venture that was announced earlier this week we think we can just about hit that 50 percent number so that's a 2002 goal. That cash flow is going to go to debt reduction in other words and I would see that number actually depending on the strength of the cycle, I can see us considering a 2003 target actually somewhat less aggressive than that as well but we did feel we had to adjust that policy range because of the accounting delta.

On the debt composition question, right now we are primarily floating. We might have some 40 percent of our debt in fixed rate and some 60 and floating. We're looking at a couple of alternatives this year to basically extend the duration and take some of that rate risk out of our debt structure, nothing to really talk about at this point but that is also a goal of ours to let's say improve the flexibility that we've got in our balance sheet.

I'm not sure I hit all the questions but if you need a follow up let's come back at it.

Great. Thanks for your time.

Our next question is from

of UBS

.

Good morning gentlemen.

Good morning

.

Nice to see us moving in the right direction.

Amen.

A couple of questions, one has to do with getting some tail wind behind us. You know it sounded like the markets were not obviously buoyant through the first couple of months but you did comment on some signs of better orders in the refrigeration business. I wondered whether there was any other kind of glimmers of hope that any of the other markets were turning the corner.

I'll just - I think Bob's got a lot more color on this but maybe just to talk about top line numbers, I think in the quarter the, as we've said, the refrigeration numbers were the most encouraging. It's still a tough market away from that but the one piece of good news that we saw was that February felt a little better than January and March felt a little bit better than February. So from a pacing standpoint although again as you look at the overall quarter numbers they are not robust but we feel that there is improvement building.

Bob, did you want to talk about some of the specifics segments?

Yeah and I appreciate your comment about color. The - there are a couple of things there that I think may seem to be a bit redundant but are worth mentioning and that is that I believe other people in the industry have commented on as well is particularly through the two step residential HVAC piece we continue to see very careful

on the part of everybody who was in that distribution chain to prevent run ups in inventories and in fact as a result we do see a little bit of a difference in terms of overall volume performance in the two step business versus the more traditional for us one-step business.

In answering a question that

had asked a little bit earlier

to the strength of sales on the back of the new technology. There is a great deal of excitement around that as well. If you look at the heat transfer piece, certainly that falloff is continues to be disheartening but not unexpected when you look at all the people in the customer chain who comprise OEM sales. So that piece of it, while a bit disappointing, is certainly understandable.

Generally, what we're seeing, if you get off the domestic piece, is that we're seeing some strength in the order rates for products that we have in Europe, both across air conditioning as well as refrigeration. So to try to pull all that together and also flavor the comment domestically with the fact that I think everyone in the HVAC industry would say that, particularly in residential, there's a fair amount of pent up demand that's got to be out there. You know, we feel that this could be, as the year unfolds through the second quarter, a nice improvement over last year.

We certainly have a cautious but a different outlook and frame of reference than we did, let's say, third quarter of last year.

Bob, is it fair to say that the inventory contraction in the two-step area is pretty much behind us, or is that still going on?

Well, I think that we've seen the most of it, because certainly the levels are at historical lows. But again, if we compare activity in, well, let's say the last couple months, through people that we know in the distribution network on two-step versus what we see on the one-step, which is closer to consumer demand of course, we do think that we saw, through the last two months of the quarter, still a continuing of very tight control. You see distributors walking by certain

programs and stuff that are traditionally taken advantage of again because of the concern around the economy and so forth.

And we're rooting for a hot summer, I'm sure.

.

Another question. You know, looking now over the last maybe four quarters with the improvement in the first quarter, how many of the retail branches are now operating I guess what you might consider at satisfactory levels maybe as defined in terms of, you know, double-digit margins?

Well, I guess the if you talk about

margins that are in excess of double- digit, we have almost a quarter of those at the current time. And that's certainly been steadily up, but I think the more important thing that I have seen, just to give you a perspective from maybe 10,000 feet, is that throughout that organization a number of the steps and including the elimination of over 1,000 personnel has really strengthened and infiltrated itself the operating style of each one of the centers, an approach that makes them closer coupled to the realities of the local economy and let's call that the marketplace so that they are now a lot more responsive than they perhaps have been over the past two years so changes in that market.

I feel that when you look at the things that

has done not just in cost control but across procurement and other places where we're driving cost that we have not seriously impaired the ability of that organization to meet increased demand that we all expect to see here as we get into the second quarter but at the same time to do that in a way that will show operating efficiencies that we've not seen before.

How many branches are we down to now?

Total number is about 196 throughout North America, which would be above Canada and the U.S.

Last question Bob, there were you know a number of I guess what I'd call manufacturing issues last year. I know we were working on

products and some rationalization in Europe in a couple plants in the U.S. I guess were

transition/start up mode but can you kind of walk us through the big kind of events on the manufacturing front and where those things stand in terms of where they were a year ago and where you'd like them to be, you know and where they are today?

Well there are several things. First of all when you looked at the manufacturing front we have in major plants for

products in Union City a new contract that was forged last year in the fourth quarter, a multi-year contract that gives us a good solid outlook and which the length of the contract that has just been settled in Boise, Ohio infiltrates necessary rule changes and flexibility to allow remanufacturing and demand

technology to be pursued with vigor and

of effectiveness.

We have seen that turnaround. Say you walk into a number of these factories today and compare them with the snapshot you may have seen just 12 months ago and the contrast is absolutely I mean it just blows your mind. What we see

we have gotten through and just about completed the closure of that Canadian manufacturing operation that we talked about on the last phone call. We also have migrated into the

startup plant a number of the product lines, both cooling and heating down in

, South Carolina where we have moved some lower productivity latent products that we had up in the Ohio operations and that group of people well trained with tremendous support from the state of South Carolina on the training side is performing very, very well.

Just up the road from there in Blackville, South Carolina, we similarly have inculcated lean manufacturing, and that factory's turned around with high productivity, and they're beating our numbers compared to our plan through the first quarter of this year. That plant, as you may recall, if you

manufacturing, is primarily producing the

line of products that we have several brands placed upon.

If you look at the overall level of operations in both the commercial air conditioning as well as in the large Marshalltown operations, people are operating very effectively. We see inventories continue to be decreased as lean manufacturing is embraced in more and more parts of those operations.

So I guess, if I were to quantify where we are, let's say, on a scale of one to 10, with all of the manufacturing initiatives that we had talked about last year, I guess I would think that we are a good three-quarters of the way through that. Similarly, we've got

that has been occurring in Europe, as you had touched upon, and that is underway during the first and second quarter of this year.

Great. Thanks, Bob.

OK,

. Nice talking with you.

Again, if you have a question, please press the one key on your touch-tone telephone. One moment for questions.

Our next question is from Robert Marshall of Wachovia Securities.

Nice quarter, guys.

Good morning, Rob. Thank you.

Can you comment on pricing and promotional activity in the in the two-step channel, and whether you see that kind of tapering off at this point, or is it still fairly acute?

Well, first let me ask the question are you talking about as an overall, multi-year trend, or as specific to the first quarter of this year?

Specific to the first quarter, and then maybe taking it back and looking back over 12 months.

I am, I think, ill prepared to get deep into the detail. And the statement that I made before, I know from and anecdotal information certainly is less value I try to stay away from it a bit, Rick's comments about

notwithstanding earlier in the conversation.

The fact is, it has been traditional on the two-step market and, to a certain extent, in the one-step market as well, that Lennox has always been, to encourage building up the inventory pipelines, particularly during the first quarter of the year. The

trend, of course, that we have seen I've seen in this company since 1995, and I know other people in the marketplace are being successful as well, is developing the kind of flexibility and turnaround capability in manufacturing operations that make a lot of the historical buildup that we had seen that has always been traditional

somewhat suspect even unnecessary. It's sort of the - almost a paradox we see. I think other companies would state this well.

We see improved inventory turns throughout our company both in finished goods and in the manufacturing area at the same time being able to produce, to ship products precisely as required by the marketplace at a much shorter timeframe with all the specificity that would be ordered by both distributors and dealers. So as a general comment what we have done as an industry which I think is good for the overall industry is we have demonstrated the ability to be a lot more responsive, an ability to take care of the peaks and seasonal demand and in doing that we have solely along with all the other economic issues that have confronted distributors, we've trained them that in fact they do not need to take advantage of as many of these programs as what perhaps they did historically.

In terms of pricing promotion and in terms of things done at the top line, there certainly is less of that in my view and again this is anecdotal 10,000 foot information

might have been four or five years ago. So our general comment I made earlier about the fact that we've been able particularly on the premium side to hold margin levels and to hold pricing has been correct.

OK.

So I think maybe as a summary, most ties of that equation are slowly taking backwards steps away from the traditional view of how you load products into the pipeline during the first quarter.

OK. Thank you very much.

Thank you

This concludes the question and answer session. Mr. Schjerven, please continue with any closing remarks.

OK. Thank you.

You know on our last conference call we told you that we took many of the actions in the year 2001 to position us for improved performance this year, 2002. In the first quarter of this year we began to see these efforts pay off. In a very difficult market environment our management team was effectively focused on cost control and the generation of free cash flow ultimately driving shareholder value and as we indicated earlier, we now expect our earnings for 2002 excluding restructuring and good will impairment charges will be at the upper end of our previously issued 80 to 90 cents earnings per share guidance range.

I want to personally thank you for taking the time to be with us today. Good-bye.

Ladies and gentlemen, this concludes today's conference call. Thank you for your participation. You may disconnect at this time and have a good day.