Lennox International Inc (LII) 2002 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by. Welcome to the Lennox International Inc. Q3 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 is being recorded. I would now like to turn the conference over to Bill Moltner, Director of Investor Relations. Please go ahead.

Thank you. Good morning and thank you for joining us. On the call today, Robert Schjerven, CEO and Director, and Rick Smith, Executive VP, CFO, Treasurer will take you through the financial results for the Q3. Bob will start with commentary on the initiatives we have taken to improve the focus of our company. And the implication that focus has on the financial reporting structure. He will address our progression and performance in Q3 and provide an outlook for the balance of this year. Rick will follow Bob with business segment operating review detail and address key income statements and balance sheet items. We will wrap up the call with a question-and-answer session. Today's call is being broadcast live on the Internet. You can find a link to that website at our corporate website.

On the call today, we will make forward-looking statements. These are subject to risks and uncertainties, a list of which are included in the publicly available filings with the S.E.C., which could cause our actual results to differ materially from those expressed today.

I will turn the call over to Robert Schjerven.

Thank you, Bill. Good morning. And thanks for taking the time to be with us for this review of Lennox International Inc.'s Q3 financial performance.

The Q3 was the third consecutive quarter of year-over-year improvement. Despite continued softness in the top line, our margins and profitability are up substantially, and we continue to deliver strong, free cash flow performance and the debt level on the balance sheet has been reduced to its lowest point since we did our IPO more than three years ago. But before I discuss the details of the progress we made in the quarter, I would like to take a minute to talk about the strategic focus that undergirds that performance. Lennox International Inc. grew rapidly and that was primarily through acquisition in the late 1990s and in the year 2000. In fact, our revenues more than doubled over that period of time. Over the past two years, we have been following a strategic course of action to concentrate our resources on those key businesses that are central to our long-term success. We have taken significant action to align ourselves in accordance with that plan. Our three core businesses are: heating and cooling, service experts, and refrigeration. These three businesses are all related to our central focus, and that is providing climate control solutions, and, therefore, offer many synergies across them. The adaptation of technology and the bundling of equipment, and services for key customers who are players in more than one segment.

These are businesses in which we have strong core competencies and they are built upon a solid experience base that provide us with meaningful competitive advantages. These are businesses in which nurturing strong brands and trusted customer relationships, things that we do well add value. These are businesses in which we can continue our strategy of focusing on the downstream links and the supply chain. So as to access multiple distribution channels. And these are all businesses that we believe offer solid, profitability growth potential for our shareholders.

In our last conference call, I told you that LII continues to clear the decks. This is our way of saying that we are focusing our resources to improve effectiveness in providing value-added products and services in these important heating, cooling and refrigeration markets. The restructuring programs that we initiated in the past 18 months have allowed us to shed non-core and underperforming businesses. And the restructuring initiatives have improved the cross-structure in our core businesses by allowing us to rationalize manufacturing footprint where we have excess capacity. Now, consistent with our strategic focus, we streamlined and simplify the our reporting structure beginning with the Q3. We will begin reporting our results in these three key business segments.

Let me quickly review the operations that comprise each segment. First the heating and cooling segment is the sum of our previously reported northern residential products and commercial air-conditioning segments. This includes our Lennox, Armstrong, Ducane and manufacturing operations. Our products unit as well as our European commercial air-conditioning business. The second segment is service experts. Which consists of the approximately 200 company-owned dealer service centers across the U.S. and Canada that sell, install, service and maintain H-VAC equipment.

The final segment, is refrigeration. Which is the segment with the greatest global potential for this company. This segment consists of our domestic heat graft refrigerated products division, as well as international commercial refrigeration operations located in Europe, Brazil, Mexico and the Asia-Pacific region.

Now, turning to the Q3 results, Lennox International Inc.'s total revenues decreased by 1% to $819 million from 825 million same quarter last year. The foreign exchange benefited revenues by less than 1% during the quarter. While favorable weather supported our residential businesses, the end market for commercial H-VAC equipment remains quite soft, and the demand in the commercial refrigeration sector is strag inability, mostly going sideways. Our GAAP net income for the quarter rose sharply to $28 million. A jump of more than 80%, from $15 million in the year-ago period. GAAP earnings per share were 46 cents per share contrasted with the 27 cents per share same quarter last year.

Foreign exchange did not have a material impact on EPS in the quarter, of course. Reporting operating income, it grew 28% to 53 million dollar with operating margins expanding 140 basis points to 6.4%. Add the FAS 142 accounting rule, eliminating goodwill amortization beneficial last year 2001, operating income in the Q3 of last year would have been $5 million higher and EPS for that year would have been 35 cents per share. In the Q3, we realized that $12.5 million pre-tax gain on the sale of 55% of our heat transfer business to Outokumpu, Finland, as part of the activity we discussed with the heat transfer. This gain was almost entirely offset by charging incurred in the quarter related to our efforts to clear the decks. Rick Smith will reconcile these charges with you in a moment.

Quarterly earnings benefited from an adjustment to our prior year tax provisions reducing our tax expense in the Q3 by $3 million, adding about 5 cents a share to earnings. I am particularly pleased with the pace of our improvement in strengthening the balance sheet. During the Q3, Lennox International Inc. generated $62 million in free cash flow, which was used primarily to reduce debt. As of September 30th, our total debt was $410 million, down $157 million from one year ago. Our debt-to-total capital ratio improved to 46.7%. And now while this is better than our target of 50%, we do feel that in the current environment, continued debt reduction is for us a prudent course of action.

Before Rick gives you additional detail by business segment, I would like to comment on our outlook for the rest of 2002. For full-year 2002, we continue to expect revenues from continuing businesses will be down about 2%. Reported company revenues are expected to decline by about 5%, which includes a drop in revenue from the heat transfer joint venture, which in the future, will no longer be reported in our financial statements. Based upon our earnings in the first nine months of this year, we expect our diluted EPS for the full-year 2002, excluding gains, restructuring, goodwill impairment, and other nonrecurring items will be in the range of 90 cents to a dollar consistent with our previously issued guidance. We also project that we are going to exceed our previous cash flow estimate of approximately $75 million, again based on the strength of our performance year-to-date.

At this point, I would like to turn the call over to our chief financial officer, Rick Smith so he can take you through our business segment results.

Thank you, Bob.

Before I go through the segment operating performance, as Bob said, there were several nonrecurring events that did affect the Q3 earnings. I would like to take you through these factors in detail to help reconcile our reported generally accepted accounting principles earnings, the headline number with our core performance. First and large evidence of those items as Bob mentioned is the sale of 55% of our heat transfer business to Outokumpu at the end of August. We realized a pre-tax gain of $12.5 million on that transaction. 7 million after-tax. This gain was almost entirely offset by charges related to that process Bob described of narrowing our focus to the three core business segments.

First, we did have a pre-tax charge of $3.6 million, a million two after-tax, to write off the investment we had in a joint venture in Argentina as we exited the H-VAC business in that very difficult and volatile market. We also took a charge of $2.1 million in the quarter as part of the restructuring initiative we announced in 2001's Q4, as most of you on the call know, the accounting rules did require us, as we implement those decisions, to take some of those costs on a pay as you go basis. This particular item was to close a commercial refrigeration equipment factory in Europe eliminating some excess capacity we had there.

And finally we did have to begin the wind down process of a residual piece of our heat transfer business, a piece that was not included in the joint venture transaction with Outokumpu. This wind-down initiative resulted in a restructuring charge of $4.7 million pre-tax, 3.3 million after-tax, in the Q3, here in 2002. This business manufacturing capital assets. It does not fit with our strategic focus, as Bob has described it. It has got relatively long lead times in terms of the orders that it has in-house and so the wind-down process will entail additional restructuring charges over the next two or three quarters, which we would estimate today at about a million dollars pre-tax. During the wind-down period, the revenue from this stub piece of the heat transfer business and its operating results will be reported in the corporate and other line item on the face of our PNL.

In cents per share terms, the gain on the sale of the heat transfer business added about 12 cents to the GAAP earnings. The combined restructuring programs that I just went through reduced reported earnings by 11 cents, and we did have, as Bob mentioned, a nonrecurring favorable adjustment to our prior-year tax provisions. That benefited tax expense by 3 million, or 5 cents a share. If you take all these nonrecurring one-time items together, our EPS on a core basis for Q3 would be 41 cents compared with the GAAP EPS of 46 cents we reported.

Moving on now to the segment performance, in my comments to make that comparison of operating performance this year versus last, in a more meaningful way, these segment operating earnings have been adjusted to eliminate the impact of those nonrecurring items, and the impact of the FAS 142 accounting for goodwill amortization. There is a reconciliation of these amounts by segment in a table in our earnings release for those of you that have got access to that release. In the heating and cooling segment, revenues increased 4% to $469 million. Shipments of residential equipment were the strength in that line of business, up by about 8% in the quarter. We certainly had favorable weather this year in most of north America during the important cooling season, and low inventory levels in the supply chain, which helped across the board. The north American commercial HV shipments declined modestly, about 3%. We think we did the better than the market. All the intelligence we have indicates that industry shipments experienced double digit declines. So we feel that this business, again the commercial part performed well in an environment where construction activity remains depressed and price competition is as stiff as ever.

In Europe, shipments of commercial H-VAC equipment was up about 1%. All in all the heating and cooling segment operating income for the quarter increased 4% to $41 million, and operating margins were flat year-over-year at 8.8%. Higher volumes and cost reduction initiatives improved margins in the North American business, and essentially offset declines in Europe. We also had a modest impact with the floods in eastern Europe, temporarily interrupting operations at our factory in the Czech republic which had a negative effect on the manufacturing productivity. At service experts, the retail business segment, we had a third straight quarter with substantially improved operating profitability. Segment operating profit jumped 76% to $13 million. With operating margins expanding to 5.2 from 3.8% a year ago in the same quarter. We continue to realize operational improvements in this business, gross margins were up 240 basis points, and SG&A expenses continue to run below last year both at the segment headquarters level and at the individual centers.

We are leveraging our network of 200 centers by consolidating a lot of the back office, for example accounting functions, at the regional level. We have implemented a new company-wide fleet management program, and we continue to emphasize our preferred vendor relationships in order to leverage our purchases of equipment, parts and supplies. And maybe as importantly as any of these steps, we continue to make progress spreading a performance-oriented culture throughout the organization. We are, however, aware that the top line remains a challenge in this segment. Revenues declined 6% to $252 million in the Q3. On a same-store basis and as adjusting for service centers that have been sold or closed in the intervening year, our Q3 sales are down about 5%. Our priority in that business remains operational execution, before we look at putting this business on to a growth track, but the management at service experts, they are thinking ahead and they continue to implement numerous marketing and business development initiatives, which are going to pay dividends on the top line.

The refrigeration segment had another excellent quarter. Building on the strength, they have shown on a year-to-date basis, revenues in the Q3 were up 7% to $93 million. Segment operating income increased 19% to $9 million, and operating margins expanded about a hundred basis points to just shy of double digit. Our domestic operation continues very solid record of performance with EBIT margins above that segment average. We feel they have increased market share in the period as well. As I mentioned earlier, we closed a production facility in France in this segment and we have successfully relocated production coming out of that facility to the other European locations of refrigeration.

To move on to some of the items below the operating income line and the balance sheet, interest expense in the quarter decreased by 1.4 million, to 8.9. That reflected both the reduced debt levels Bob talked about as well as lower average interest rates,. As was mentioned at the top of the call, our progress in deleveraging the balance sheet has been particularly pleasing. Debt at the end of September was $410 million. That is debt on the balance sheet, down 157 million from the same time the previous year. And at the end of the quarter our debt-to-total capitalization ratio was 46.7%. If we adjust the ratio a year ago for the FAS 142 goodwill treatment, our end of quarter debt in 2002 compares very favorably to the 54.8% ratio of a year ago. We generated $62 million of free cash flow in the Q3, and that brings the year-to-date number to $79 million. Working capital, and we measure this as a percent of sales on a trailing 12-months basis, continued to improve, let by higher inventory turnover and quality receivable portfolios, working capital, the way we measure it now has declined to 20.2% from 23.5% last year.

We do have, as I think most of you are aware, an accounts receivable securitization program still in effect. Not on the balance sheet. The amount of securitization at the independent of the Q3 was $160 million, down from 174 million same quarter of last year. By the way, the change in that securitization, being a nonoperating transaction, is not included in those free cash flow calculations that I went through just a moment ago. Finally, capital expenditures for the Q3 were some $7 million, compared to 5 million same-quarter last year. Our outlook now for total capital spending for the year will be that it is approximately $30 million.

That does complete the presentation of the quarter's results. Bob and I would now be pleased to address any questions that you may have. Thank you.

Thank you. Ladies and gentlemen, if you do wish to ask a question, please depress 1 on your touch-tone phone. You will hear a tone indicating you have been placed in queue. You may remove yourself from queue at any time by depressing the pound key. If you are using a speaker phone, please pick up the hand set before pressing any numbers. Again, ladies and gentlemen, if you do have a question, please press 1 at this time. We have a question from the line of Michael Reagan with CS First Boston. Please go ahead. Mr. Reagan, do you wish to ask a question? We will go on to the next question from Paul Domiko with the National Bank Financial.

Hi, gentlemen.

The business is a smaller portion, but you guys won awards that I have seen. I know you are giving it some attention. Can you comment on how the business do in the quarter year-over-year? If you don't want to quantify it, just up, down, flat, roughly.

The performance is improving. Quite frankly for the year, that business still is not quite achieved a break-even point. We have continued work at rationalization on both the products as well as the manufacturing locations which I believe we talked about the last couple of quarters. The new president, operating officer, for that business, Dan seaman, and his team have made a number of changes. Not the least of which was a significant restructure to dramatically reduce the break-even point and solidify the basis from which this thing is going to grow going forward. He is running very much on his individual plan, and while certainly this business has distressed us a bit in terms of the time it has taken to fashion it into the business that we have known it could be, the fact of the matter is he is very much, his plan is doing all the right things. For that reason, while it certainly -- if you look at the averages in the overall segment, has, you know, created a certain amount of drag on the segment results, the fact is that the restructuring things he has done took out about 17% of his overhead just in the month of August. Just to quantify for you how significantly that restructuring and the rationalization has improved the operating ratios.

Are you given any indication in terms of when you anticipate that portion of the business to be profitable? Are well talking 2003?

Oh, sure. No, it will go through. It is hard sometimes to pin the inflection point. For example, one of the things that impacted that whole industry has not been just the economy, but if you look at where you normally focus on your early season sales of not just fireplaces but particularly stove, appliances, that type of thing, we have seen pre-mild winter weather across the market area and that has created some head wind for everybody in the market. So while that change in the market may affect it a little bit. The fact is we are well on course to pass that inflection point sometime early next year.

Aside from the operational aspect of it, was the topline, can you comment on that, what happened to the top line for that business?

Well, it is not what we wanted it to be. It is down a bit. But of course it is nestled inside the entire segment so we don't break them out piece by piece.

Low single digits was the decline in revenue?

Oh, yeah, I would say so.

All right. Last question, sorry, guys, last question. In terms of the consumer market, are you guys seeing a lot of Chinese imports with respect to air-conditioners?

I know wham you are referring to. We certainly see no evidence of that yet. That is a relatively new development. But, you know, one of the things that has confronted this type of product for many years is the difficulty of shipping these type of products, when you think of central air-conditioning equipment, you know, great distances. But certainly I am sure they have got probably a labor cost tail wind and so forth that is baked into their pro formas, but quite frankly we haven't seen evidence of it yet.

Thank you, gentlemen.

Sure, Paul, thank you.

We do have a question from the line of Michael Reagan with CS First Boston. Please go ahead.

Sorry about not being able to get on the line earlier. Bob, on -- in the Q2, there was lots of excitement over the size of the improvement in the service experts' margins, year-over-year they were up 8.4% versus being up 3.1% in year-over-year margin change in the Q1. That decelerated in the Q3, they were up 3.8% year-over-year in the Q3, I am wondering -- that is despite kind of the same comparison. I am wondering what happened in the Q3, you know, in that service experts business, why did we see a decelerating improvement in their margins?

Michael, we are glad you made it. First of all, and let me see if I can address the question, because it is a good one. First of all, we reported that the revenue line, and also the fact is the variable margin line, because of pricing-type activities, have been an interesting challenge in that particular segment. And I don't think that -- I know for sure in fact that that would not be a service experts' only phenomenon. In our plan, our internal business plan, which of course has baked in the kind of improvement we have talked about all year, we had indicated, as well, that the Q3 would diminish a little bit in terms of improvement. And there's a couple of reasons for that. Probably the most significant piece of that would be the fact that you go through a period of a relatively short period of time where labor management, as you shift from summer into the winter demand, there is a lull in demand. And so we try and quite properly to acknowledge the fact that that would be a bit of a challenge. But having said that, if you look at the year-to-date figures, and you note that we have in the year-to-date figures a combination of effects to revenue line, and what that means as far as variable margin dollars both in terms of the volume as well as you factor the pricing activity, if you eliminate that, what you find internally compared to the plan that we have established for this business, is you are on an operating basis you have run nearly a hundred basis points at the ebit line if you eliminate those. To better understand -- of course this is the challenge -- to better understand how those improvement processes down inside the organization are really paying off. So from an operating standpoint, and in terms of measuring the efficacy of the changes made, we are running ahead of plan. A couple of the pieces of that pie that are difficult for example, when you look at the top line, would be the commercial business. The commercial business has got challenges not only because of what we all know the commercial market this year, but also because this is a business that requires substantial experience and talent in terms of job management, understanding costs, and so forth, in that particular respect. One of the changes that we made recently by Dennis submit, the president of service experts, has been the inclusion and the management staff of George Ramras, George accepted the position of Vice President Commercial Operations recently. He comes to us with over 25 years' experience in the commercial construction market. He came to us from TYCO, and he served in a number of pretty responsible positions, most recently as their western region vice president and before that vice president of field operations for SIMplex [ phonetic ]. This is a man who understands the challenges and brings with him the skillsets we need to make that important piece of the overall pie work better for us. So a number of things have been included to increase the momentum of the improvement of this business. And while I certainly acknowledge the fact that we have got a bit of disappointment over the fact that we a little bit behind our plan in terms of the top line and the variable margin line, the fact of the matter is, you know, we have focus, and this I think is the correct sequence, very diligently on making permanent process organizational changes to make this thing perform as we said it would. And they have begun, we have talked in past phone calls, about things we have done on a national scale that has brought primarily more service and support business for other national accounts like the Cinemark theater chains and others. The fact is attention to the top line continues as we have in the past quarter, spent additional funds in the marketing side and so forth to accelerate the segment of the business which of course is higher margin which is the repair service replacement. It is a lot of words in answer to a very direct question. I guess --.

I am afraid to ask another one, Bob.

That wasn't my intent. But I think the important fact here, and of course this is the win we looked at hard, there is a challenge at the top. In terms of the fundamental improvement of the business, that improvement continues and in fact it is running at pace that nearly a hundred basis points better than the internal plan we had for it.

Don't misunderstand the question. You guys are doing a very solid job there in the performance as the improving performance is obvious. The nature of the question is just simply in the Q2 conference call, I think everybody got a little bit whipped up by the fact that you did 6.3% margins, and you got drawn into talking about getting double digit margins in the retail business at some point in the future. While that might be a plan, it is just inconceivable to me how the current business model of a service experts' kind of business gets anything better than sort of mid- to high single digit margins. Can you -- in a brief period of time, can you just walk us through how you get there?

Well, there are a couple of pieces to it without getting bogged down in great detail. First of all, a number of the processes that have gone into place, and which continue to go in place this year, addresses the very important factor associated with the labor deployment. Certainly, we have already made moves and there is a number of more to go in the area of consolidation of a number of functions, both at the metro level as well as at the regional corporate level. That activity is just underway, so we have not netted those benefits. Benefits out of fleet management, for example, those type of changes occur over a period of time, but in fact they have been put into place. I think something we must not lose sight of which of course is the primary driver of profitability, so you have -- this is the intrinsic profitability at the center level. Currently, almost 30% of our centers are earning double digit ebit at the center level. The number of centers that continue that type of improvement in their operation continues to increase on a monthly basis. So while I suppose the long conversation might change your -- the word inconceivable, the fact is that we are very comfortable with our assessment that this is clearly a double digit ebit business. But share this sentiment and with someone we talked about at length, that this does take time to put these kind of changes in place.

Thank you very much.

Sure, Michael. Thank you.

Again, ladies and gentlemen, if you do have a question, please press 1 at this time. We do have a question from the line of Jay Glassman with McMahon Securities. Please go ahead.

Yes, good morning. Just a couple of questions. If you could give us a September current bank revolver outstanding balance as well as your availability, and then secondarily, if you could talk about whether you are going to be free cash flow positive at 03 at this point if you could tell and if you could give us a range if that is at all possible?

Yeah, Bob I will take that. This is Rick Smith. The -- at the end of September, actually, we were undrawn on our U.S. revolver, which is sized at 270 million dollars -- million dollars. So a lot of capacity there on the bank front. The bank debt we did have was in our non North American operations, Europe and Australia. On the question of free cash flow for next year, we haven't really yet put all the balance sheet plans in place. I think Bob is going to have some comments in terms of the outlook, but certainly our focus, we have learned a lot in the last couple of years with the focus on free cash flow, and it is inconceivable for me to imagine a year in 2003 where we would not have positive free cash flow. We are going to put a little more flesh around that when we update our guidance over the course of the Q4.

Thank you very much.

Jay, this is Robert Schjerven. There is one thing I would add to that. Because we have discussed, in the questions and have come up occasionally, around the issue of our expectations for capital expenditures. And just a couple of numbers that I think are worth knowing in addition to the fact that we anticipate spending approximately $30 million in CAP-X this year, very early projections show us at being approximately 50% higher than that next year and that is still well below the $55 million a year depreciation for what we have in place. And speaking about that, which we have in place, I think a fundamental fact which we need to emphasize, because it is important, and that is in our manufacturing businesses, we have continued to move forward with lean initiatives, that is how we continued to free up excess capacity and permitted the rationalization we talked about. We are well situated with capital investment throughout the organization to Dale, we have got our physical plant facility and equipment well in place, so the focus you see when we spend capital moneys have been to drive additional cost reduction, supporting lean, for example, and also importantly, in the area of new product introduction. We introduced a number of very interesting and very important new products in the residential front the first quarter of this past year, and the industry is going to be pleasantly surprised when they see how that pace is accelerated as we go into next year. So we are not Cap Ex poor and we are not starving any part of the organization. Quite to the contrary.

Thank you very much.

Very good.

We do have a question from Michael Reagan with CS First Boston. Please go ahead.

Thanks. On your balance sheet, there was what seemed to be a pretty big ramp-up in receivables in the Q1 -- I am sorry, in the Q2, and then they dropped pretty substantially here in the Q3. Can you talk about that at all?

Sure, Michael. A lot of that is seasonal. That is a normal pattern we would see going from Q2 to Q3, we do get the additional effect of any changes in securitization show up in that regard. You also have of course the effect in the Q3 of the divestiture of -- or the deconsolidation I should say of the heat transfer business, which did have some receivables on its books. So that -- again, the effects of that we did not include in our free cash flow calculation, but between normal seasonal collections and receivables after a pretty good cooling season, in May, June, July, and the deconsolidation of the heat transfer business, that is really what drove that this year.

Thank you.

There are no further questions. Please continue.

Okay. I want to thank everybody for taking the time to be with us today. And you know, while we are never satisfied, the fact is we are pleased that Lennox International Inc.'s financial performance improvement continued in the Q3. The actions that we have taken to focus on those three core businesses continues to position us well to build shareholder value as we go forward. I can tell you that this management team is energized. We sincerely believe we have the programs and the processes already in place to deliver on the guidance of 90 cents to a dollar for 2002 earnings as well generate free cash flow nicely in excess of $75 million. Have a good day.

Ladies and gentlemen, that does conclude our conference for today. Thank you for your participation and for using AT&T executive teleconference service. You may now disconnect.