Lennox International Inc (LII) 2003 Q4 法說會逐字稿

Ladies and gentlemen, thank you for standing by.

Welcome to the Lennox International fourth-quarter and full-year 2003 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, Vice President of Investor Relations.

Good morning and thank you for joining us.

This morning, our CEO, Bob Schjerven, will review Lennox International's financial performance for 2003 and highlight some of the key accomplishments we had for the year.

Bob will also comment on our company's outlook for 2004.

Rick Smith, or CFO, will take you through our financial performance for the fourth quarter, including detail by business segment, as well as address key income statement and balance sheet items and initiatives.

We will wrap up today's call as we usually do with a Q&A session.

We're broadcasting today's conference call on the Internet and a direct link to the Web cast is provided on our corporate Web at www.lennox -- (technical difficulty).

This call will be archived on our Web site and will be available for replay.

Before I begin this morning, I'd like to mind 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, including our outlook for the Company's earnings, are subject to risks and uncertainties.

A list of these risks and uncertainties is included in our publicly available filings with the SEC and could cause our actual results to differ materially from those that we express to you this morning.

I will now turn the call over to Bob Schjerven.

Good morning. 2003 was a very successful year for Lennox International.

As we sharpened our focus on our three core businesses, we achieved a substantial improvement in our profitability.

We generated strong cash flow and finished the year with a stronger balance sheet.

The improvement in our numbers for 2003 is impressive.

Let me begin this morning by summarizing our performance for the year.

Lennox International's total corporate sales grew 7 percent to $3.1 billion when adjusted for heat-transfer revenues included in the prior year's sales, essentially all of which are now part of our joint venture with Outokumpu and no longer reported by LII.

Foreign currency fluctuations contributed 3 percent to our topline growth.

International sales -- those outside of the U.S. and Canada -- generated 13 percent of our total revenues.

Our operating income grew 19 percent to $150 million with our operating margin expanding 70 basis points to 4.9 percent of sales.

Our net income, before the cumulative effect of an accounting change in 2002, increased 31 percent to $77 million, and diluted earnings per share rose from $1 to $1.28 on the same basis, exceeding the most recent guidance.

We generated very strong free cash flow of $113 million in 2003, allowing us to continue reducing our debt.

In the past three years, we have cut our total debt by $328 million and the renewed strength in our balance sheet gives us increased flexibility to pursue improvement opportunities.

While we are pleased with our 2003 results, it is important to spend a little time on the story behind the numbers.

I guess actually two stories, so to speak -- a terrific performance in a manufacturing businesses more than offsetting disappointing numbers in our Service business.

Our two manufacturing businesses -- that is the Heating and Cooling segment and the Refrigeration segment -- earned a very solid combined segment operating income margin of 10 percent for 2003.

We continue to lead the industry in new product innovation.

In fact, in 2003, more than one-third of the revenue in these businesses came from products that have been introduced in the past three years.

Innovation has been a core value at Lennox International for more than 100 years, and we remain committed to developing new products and services to meet the needs our customers.

We grew the topline and we gained market share in our Heating and Cooling business by developing new customers and strengthening our existing relationships.

Our National Accounts Group increased Commercial Heating and Cooling equipment sales by partnering with 38 new accounts during the year, including accounts such as Universal Cinema Services, Talbots, and Limited Brand.

New products supported sales growth of our Lennox brand of residential equipment, and we expanded distribution of our increasingly popular Duquesne line with key air-conditioning markets.

We are seeing the benefits from the factory rationalization initiatives undertaken as part of our "clearing the decks" initiative, which have reduced excess manufacturing capacity and related overhead expense.

We are focused on productively employing our assets.

For example, using lean manufacturing principles to build our newest generation of furnaces in our Marshalltown, Iowa factory, we now build every model of these furnaces every day, allowing us to better satisfy customer demand with lower inventory.

As a result, manufacturing leadtimes have been reduced from three weeks to five days, while quality has been significantly enhanced.

We are also effectively leveraging our existing resources through the agreement we have to manufacture the new Whirlpool-branded product line, which was rolled out to the market earlier in 2003.

Focusing on performance, we integrated and coordinated many key operations across our business segments, helping us to realize substantial cost savings.

We moved aggressively to reduce waste and cut costs by extending Six Sigma into the design process.

We continue to combine our procurement activities across operations to drive down costs.

Our manufacturing businesses are indeed running well.

With our strong brands, a reputation for quality products, a well-capitalized asset base and our established multichannel distribution networks, we are confident in continued improvement.

On the other hand, Service Experts, our direct-to-consumer service business, remains an unacceptable contributor.

Our performance in the fourth quarter obviously fell short of our expectations.

Much of the shortfall came from our operations in Canada.

We have made a change in both the leadership and structure of our Canadian region and are moving ahead on the deployment of the STARS Information Technology system in those Canadian dealerships.

STARS facilitate the consolidation of back-office accounting function, as well as tracking the metrics coming out of our Best Practices implementation, to ensure that they are moving in the correct direction.

(indiscernible) weak results throughout 2003 and no improvement evident in the fourth quarter, we are taking a more aggressive posture on turning Service Experts around.

The key issue is not our vision for this business but rather that we continue to fall short on execution.

We believe in our original vision for Service Experts, that this one is the right one -- that is namely to build a profitable, Direct-to-Consumer business that's focused on service and replacement opportunities in metropolitan areas in the U.S. and Canada.

The original strategy focuses on repair, replacement and service. (indiscernible) focused on these business segments in both the residential and light commercial markets were the targets of our initial strategy and have proven to be consistently more profitable.

Already, we are seeing Scott Boxer and his team take steps to strengthen such centers and to migrate the bulk of Service Experts' resources to initiatives that support a refocusing on the original strategy.

At the risk of repeating myself, we continue to establish consistent, efficient processes that provide the tools proactively, allowing profitable management down at the center level.

Accordingly, the rollout of project Titan (ph), a project that is focused on the sharing of Best Practices across all residential service replacement dealer service centers, continues to be a top priority.

In many ways, this means that we are ringing the same lean process orientation that has proven successful in our manufacturing businesses to the operation of our service centers.

Completion of the rollout of project Titan (ph) is anticipated for the third quarter of this year.

These initiatives are not enough.

We need to change the profile of this organization to one that is closer to the original vision, one that has more focus on profitable service and replacement opportunity, a network consisting of service centers that are better able to realize the synergies in marketing programs, accounting and other operational inefficiencies.

We have intensified the pace of change at Service Experts and have started significant actions to bring us closer to realizing our original visions.

Scott's team has taken action to close four centers that do not fit this profile -- centers predominantly focused on longer-duration commercial, new construction contracts.

These centers incurred a combined operating loss of $4 million in 2003.

Our actions to move Service Experts to improved profitability will continue through this year 2004.

We will aggressively strengthen our regional accounting centers and ensure that centers are right-sized to take advantage of economies of scale, both benefits of the strategy we have spoken about.

We will update our progress no later than our first-quarter report in April, and at that time, we will quantify the impact of any actions we take.

Let me assure you, we are committed to taking whatever actions are necessary to realize the full potential of Service Experts.

Overall, 2003 was clearly a productive year for Lennox International.

Our earnings exceeded expectations; we improved the focus of the company, and our businesses are well positioned for profitable growth, going forward.

Looking ahead, we are optimistic about 2004.

We expect our full-year earnings per share will be in the range of $1.38 to $1.48 per share, an 8 percent to 16 percent improvement over our 2003 results.

We also expect continued strength in our cash flow generation with cash flow from operations less capital expenditures approaching our net income.

Now, I'd like to turn the call over to Rick Smith, our Chief Financial Officer, to take a closer look at the fourth-quarter of 2003.

Thanks, Bob.

Lennox International reported a very solid performance in the fourth quarter.

Our total revenue increased 11 percent to 779 million.

In constant currencies, though, sales were up 6 percent.

Our quarterly operating income was $30 million, up from 13 million last year's fourth quarter, with our operating margin more than doubling to 3.9 percent.

Net income was 16 million, compared with 5 million in the year-ago period.

Diluted earnings per share for Q4 were 27 cents, compared with 8 cents for the same quarter last year.

Foreign exchange benefited that EPS figure in the quarter by about 4 cents.

Taking a more detailed look at the performance of each of our businesses, fourth-quarter revenue in our Heating and Cooling segments rose 14 percent to $455 million.

In constant currencies, sales were up 11 percent.

Segment operating income increased 71 percent to 57 million, and operating margins rose to 12.6 percent from 8.4 in the fourth quarter last year.

The residential piece of our Heating and Cooling business we believe outperformed the market and achieved a revenue increase of 14 percent to $323 million.

That was driven by stronger growth at our Lennox and Armstrong units, as well as in our hearth products business.

Sales adjusted for FX were up 11 percent in residential Heating and Cooling.

The operating income for this segment in the quarter increased to 44 million from 28 million last year, with operating margins expanding to 13.5 percent from 9.7 last year.

Whether it might have helped a bit, as higher volumes and significantly improved performance in our Hearth Products business contributed to this increase.

The improvement trend continued in our Commercial Heating and Cooling segments as well with revenue advancing 15 percent, and that's 10 adjusted for foreign exchange, to $132 million.

Segment operating income for Q4 more than doubled to 14 million from $6 million last year, and operating margins improved to 10.4 percent from 5.2 percent the previous year.

Domestically, we achieved very strong sales growth both with national accounts, as well as in our commercial sales districts, that focus on contractor customers.

Higher revenues, together with strong factory performance, drove the significant improvement in profitability.

While demand in Europe remains soft, our sales there were up modestly and our profitability improved there as we realized the benefit of factory consolidation activities earlier in the year.

Turning to Service Experts, sales were up 4 percent but down 1 percent when adjusted for currency fluctuations to $244 million.

Service Experts had an operating loss in the quarter of $10 million, compared with an opening loss of 2 million for the prior year.

As Bob said, this result clearly falls short of our earlier expectations; we had thought that Service Experts would be modestly probable in the fourth quarter.

Although Service Experts generally maintained topline sales, across the system, the price-driven margin erosion we saw in the third quarter continued and labor inefficiencies further reduced profitability.

Quite frankly, we didn't increase our headcount and hours to the degree we should have following the peak of cooling season.

Also, expanding on Bob's earlier comments, we had unfavorable impact on earnings due to inventory valuations, percentage of completion contract adjustments, bad debt expense and severance in our Canadian operations.

We are working to improve the timeliness and visibility of Service Experts' results, particularly in Canada, and have completed the implementation of the accounting tools that represent the best practices in center-level financial management that we use in the U.S. centers.

In our Refrigeration segment, revenues rose 14 percent nominally; they were down 1 percent in constant currencies.

We achieved a sales growth in Europe and North America, and that was offset by a decline in the Asia-Pacific region.

Segment operating income was $7 million, down from 9 million last year.

Operating margins were 7.2 percent, compared with 9.5 percent in the prior year's fourth quarter.

End-market demand in Refrigeration remained sluggish and price concessions necessary to maintain sales volume in our domestic business pressured margins.

Now, turning to a few key items below the operating income line and on the balance sheet, our total interest expense in the quarter was $7 million, essentially flat with the previous year, with lower debt levels offset by modestly higher average rates, as we increased the proportion of our fixed-rate debt.

Our effective tax rate was 38 percent for the full year, 2003.

Our corporate -- (technical difficulty) -- essentially flat in the quarter but I want to assure you, we continue to invest in initiatives ranging from procurement to lean enterprise thinking, which will benefit our three core businesses in the future.

Our total debt at December 31st was $362 million, 17 million lower than it was at the same time the previous year.

Year-over-year, the debt-to-capital ratio dropped to 37.8 percent from 46.1 percent, and working capital -- an important metric relative to sales -- working capital was down 70 basis points to 18.9 percent by year-end.

At the end of the fourth quarter, we had a zero balance in our off-balance sheet asset securitization program, compared with a balance of 99 million the same time last year.

Changes, as I think most of you are aware, in the asset-securitization balance -- which are classified as nonoperating transactions -- are not treated in our free cash flow calculations as a generation or use, and so the 17 million of debt reduction, taken together with the 99 million of securitization balance, tied pretty closely with our free cash flow.

Finally, Capital Expenditures were $19 million in Q4 and $31 million for the full year 2003.

That compares with 3 million and 23 million for the fourth quarter and full year of 2002, respectively.

Now, at this point, Bob and I would be pleased to address any questions that you may have.

(OPERATOR INSTRUCTIONS).

Michael Regan with Credit Suisse First Boston.

Bob or Rick, could you just dive into North American Residential a little bit more?

It was obviously phenomenal performance, both from a topline perspective and profitability or margin perspective, and really quite unusual that margins were up sequentially from the fourth quarter over the third quarter.

Rick, you alluded to perhaps whether (inaudible) may have helped a little bit.

Can you just break it down a little bit between the core Lennox Heating business, Armstrong, and the Hearth business?

First of all, generally speaking (inaudible) the fourth quarter, it is true that we saw a nice uptick in terms of business, some of which was weather-related.

We also have seen, significantly, something that we are very pleased with, and that is good performance in the new product area, particularly the Dave Lennox (ph) Signature Series products that we've had, both in terms of higher premium, of course, as well as higher overall revenue.

That has been a solid performer and that growth, as a percent of total sales, continues quarter-over-quarter, all of which were very nice circumstances.

Similarly, we saw improvements pretty much instep with that across the board on the two-step side?

This, of course, would be our Duquesne product, as well as what we have at Armstrong.

Hearth also showed increased market-share and profitability as well.

I think, as a general comment, on the cost side of the ledger, in all of those operations, we are performing very well, continuing to exact even more benefits from the focus that we've had for the past couple of years around the lean enterprise approach that we've taken throughout the Company with a special focus on manufacturing.

I know I alluded to, for example, the real beneficial performance that we get from that -- looking at the new generation furnace lines that we have in our Marshalltown, Iowa plant.

We expect that kind of performance to continue.

Certainly, (indiscernible) you mentioned residential but balanced out nicely with performance that we saw on the Commercial side (inaudible) just exactly the same manner as we have improvement across the manufacturing operations in Residential.

Our (indiscernible), Arkansas manufacturing plant in Commercial is absolutely world-class and doing just a fine job -- high flexibility, very short leadtimes and costs continuing to decline.

So, I wouldn't point to any one particular feature on the landscape that generated the phenomenal performance.

I guess, probably in the vernacular, you might say that, on the Heating and Cooling side, we are beginning to hit on all eight cylinders.

Bob, again, maybe to ask it a different way, year-over-year, in the March quarter, the North American Residential margins were up 1.8 percent, the June quarter up 1.9 percent, the September quarter up 1.6 percent -- great performance, fairly consistent.

We thought you guys did a great job.

Suddenly, we jumped almost 4 full percentage points change in the December quarter, year-over-year.

So again, to ask it a different way, what changed in the fourth quarter year-over-year to accelerate the margin performance relative to the first three quarters of the year?

Two things are working together, and that is the volume that we had is significant, both (indiscernible) year as well as on a quarter-over-quarter basis.

Aside from the obvious observation about what that does in terms of better overhead absorption, the fact is that's working in concert with the aforementioned improvements that we've got throughout the manufacturing process that are driving down product costs.

So, it's a combination of both of those things.

Again, we're pleased with the volume that we're seeing in the fourth quarter and expect that to be a pretty solid indication of the acceptance of the value that the new products are bringing, as well as -- particularly on the Commercial side -- the relationships that we continue to grow and expanded upon with our National Account customers.

Rick, can you split out volume by region and let's say look at volume for North American Residential in the Southeast versus the Midwest, or the Southwest versus the Northeast?

Because again, I mean, to understand how much was weather-driven -- obviously, we've had a very cold start to the winter in the Midwest and the Northeast.

I'm just wondering, if we look at the volumes by those two regions versus where it's been more normal, down in the Southeast and the Southwest, if you've seen dramatic differences in the volumes.

I apologize; we don't have that regional color yet.

That comes in with a lag in our closed process.

That's the sort of material we develop for the MD&A and the 10-k and we will put it together as soon as we can.

Great.

I was just hoping to try and understand some of the dynamics there.

Next, obviously, I can't have a conference call without asking about Service Experts.

You know, if we talk about the strategy, going forward, we close down these four service centers that contributed $4 million of the $7 million loss in 2003.

So if we ex those out, we had a $3 million loss without those.

What are the kinds of things that are going to cause that $3 million loss to swing to some level of profitability in 2004?

A couple of things -- first of all, as we moved -- particularly through the Canadian operations -- in preparation for putting in a very rigorous accounting system, we generated a number of adjustments that we recognized in the fourth quarter, which is certainly a onetime operation.

But how much of the fourth-quarter loss was sort of onetime accounting transactions and things like that, Rick?

A good piece of that.

It's a chunk of it.

Is it 5 million?

Seven million?

I really don't have it that precisely.

How much of the accounting adjustments were related to the four service centers that are being shut that accounted for the $4 million of the loss for the whole year?

In other words, I'm trying to understand what the base profitability of Service Experts would have been for the year ex the four service centers that you're setting and ex the onetime catch-up kinds of adjustments.

The 4 million we referenced on the centers that are in the process of being wound down -- that is a separate bucket from the adjustments.

I think you might look at the rest of it as two equal pieces, just fundamental execution throughout the system, and then the adjustments largely out of Canada.

There's something I'd like to say about that, Michael.

That is I certainly don't want to -- the comments about the onetime expenses overshadow the fact that, across the entire operation, our operating performance was totally unacceptable.

There's as a number of issues that go into that that, of course, we are addressing, things such as predominantly recognizing the need for a variable workforce that responds to differences in demand, both seasonal and otherwise -- a different region is extremely important.

The controls and the tools that we are providing the center -- general managers -- enable them to more accurately look ahead and to hopefully do a better job of that.

For a variety of reasons, that was not done well and we take full credit for that mess.

Again, I'm not trying to deflect the comment around performance by talking about the onetime thing.

The execution issue still continues to loom large and the things that we are addressing need to be fixed.

It has for awhile, Bob, and so I guess the genesis of my question is just simply, going forward, what's going to be different?

The performance of those centers is going to be different because the utilization of the tools and discipline down at the center level will do a better job of both controlling SG&A as well as (indiscernible) (inaudible).

I think to be fair, I mean, we started to roll out those tools 18 months ago. '03 was supposed to be the year -- especially I would have thought in the fourth quarter - when we kind of got pretty good traction at using those tools.

Yet, it hasn't shown up in the numbers.

So is my perspective on it incorrect, or -- (multiple speakers)?

I'd say your perspective is the same as ours, that we have not gotten the traction because those tools have not been effectively utilized at the center level.

Again, the Titan (ph) project really is not going to see complete roll-out until about the third quarter of this year.

Again, I don't want to make excuses because that's not the case.

Kit Case with Southwest Securities.

A few questions here.

First of all, in your '04 guidance, could you kind of go through some of your assumptions of growth and profitability, maybe by division?

Kit, as you know, we don't really talk about giving guidance by segment but I think, as you know, we're looking at the Residential market being essentially flat with some downtick in housing starts on the new construction side being essentially offset by a better tone around the replacement business.

In Commercial, again, you know we are very much, in North America, a rooftop company.

That market seems to be coming back nicely.

From what we hear anecdotally, relative to our competition, maybe the applied market in North America -- which we are not a big factor in -- is a little bit behind that.

Then thinking further about Commercial, HVAC, the European business again is showing signals -- flashing signals -- that it might come up a bit, but we really don't expect a significant improvement in overall market demand there in '04.

The Service Experts -- obviously, we are working on what you might call to improve our store-for-store performance; all of those things that Bob talked about are built into our guidance.

So, those cover the major segments of the Company.

Do you think -- (indiscernible) guidance, are you assuming Service Experts will contribute to profitability just on a general basis?

I think, as you can tell from Bob's comments, '03's performance is unacceptable.

That should give you a pretty good feel for where our expectations are for '04.

Refrigeration -- you know, very sensitive to the economy.

What expectations specifically do you have to that group?

The refrigeration businesses, of course, is our most global business.

Again, we're seeing some better tone in North America in Refrigeration right now, but again, that seems to be a bit behind, let's say, the HVAC business, even though they are both obviously driven by commercial, new construction and replacement cycles.

I think our Asia-Pacific business ought to pick up.

You heard, from our comments, that that was not as strong in the fourth quarter of '03 as we had hoped.

So net/net, just in terms of topline, I think of a low single digit number for Refrigeration holding foreign currency constant.

Obviously, we saw huge movements in FX in '03 and then the task for us in the refrigeration business is to drive that flow-through the same kinds of things you saw coming out of a volume (sc)in our -- for example, in our Residential HVAC business.

What's embedded in the guidance, I guess, on the currency side?

You're assuming it stays flat or do you think the dollar might strengthen -- (Multiple Speakers)?

We're not very good at forecasting currencies.

Embedded in the guidance is an assumption that the December 31 levels will prevail throughout the year just underway.

So I think, as we start to report out the quarters, we will certainly comment if that turns out to be a number that drives actual results differently.

What was the currency impact on EPS for the year?

We had, as I indicated, about a 4 cent number in the quarter, and it's probably twice that in the year.

Again, the dollar decline really accelerated in the fourth quarter.

The next question -- what percent, I guess, of the Heating and Cooling manufacturing revenue growth was really through new customers versus organic growth, so to speak, from existing customers?

I really don't have that metric yet.

Of course, in our two-step business, it will be pretty hard to quantify anyway because you want to know where the final demand is on that front.

I just don't have that;

I'm sorry.

Is it safe to say that, generally speaking, that strength from your existing customers and then the new customers boosted the growth or -- just generally speaking?

I think I might say a couple of things.

Again, with the kind of customer base we've got for the Lennox Brand, many thousands of independent dealers, you're always going to see some movement in that customer mix.

But conversely, on the two-step, our significant new distribution/customer relationship would be Whirlpool.

We've got some color on that, but we like to think that the revenue growth in the HVAC Residential piece is really what we would call organic.

Should Whirlpool continue to kind of boost growth in '04, or has that leveled out, do you think?

There's still some what I will call pipeline fill so that a year-over-year basis in '04, you'll see that effect but it's really tapering off where we are right now.

Has that been above expectations or right at expectations?

I can only speak to the Lennox International expectations.

I'm sure the distribution and the Whirlpool folks could speak to it but it's certainly in line with our expectations.

We are pleased with how that's working out.

The last question -- if the stock keeps moving up, what are your plans with this convertible if it is converted back into equity?

How would you use the equity?

I think it would be a nice problem to have because the stock would have to move a couple of bucks for that to happen.

Since that will be a non-cash transaction -- obviously, though a big change in the composition of the right side of the balance sheet -- we would have to think about it at the time and here's hoping!

But could we assume that you would boost that debt back up with some acquisitions, or -- it seems like, right now, with the Refrigeration business being fairly weak, there might be some attractive pricing out there.

We really don't have any specific plans like that.

Certainly, the conversion of the convertible would strengthen the balance sheet and give us more flexibility, but it would be, as I said, non-cash in nature, so we would simply have to make that decision at the time.

All right, thanks.

Justin Mower (ph) with Lord Abbott.

Good morning, guys.

Just a few questions for you -- Bob, can you talk maybe a little bit -- take a step back in Service Experts and talk kind of -- philosophically I guess is the best way to describe it?

Obviously, it's much more, if not solely -- or at some point, it will be solely focused on the Residential market as opposed to ASP or York, who are much more commercially focused.

What do you think it is about the business that you guys own that makes it so tough, relative to the Commercial side, that has the ability of generating double-digit operating margins?

Is it solely an execution issue that you guys think you can fight to that over time, or you think there is just something endemic about the Residential business, whether it's scheduling or whatever that just makes it tougher?

That's a pretty insightful question, so (indiscernible) a little philosophical on that, if I could.

First of all, when you look at and compare the four segments, which would be two rough divisions, new construction versus service replacement and then, within that, the division between Commercial and Residential (sic).

You mentioned York and others, for example, as a comparison.

The thing to recall is that those folks, when they talk commercial, there's a large percentage of that, a large built-up (indiscernible) systems and that's a completely different kind of a business, for example, particularly in terms of the new construction side, than we see in (inaudible) commercial.

Having said that, I will tell you that the commercial service replacement business within Service Experts is doing very well, and that is well-managed.

There is a business model that we have in there allows us to do (sic) a real good job of that.

Those are different kinds of customers, obviously, but they are much more highly dispersed, much more seasonally driven (indiscernible) service replacement business on the Residential side.

It's in that particular environment that the execution, particularly around manpower deployment and right-sizing of SG&A (indiscernible) to what you're seeing in your particular business within that local geography are really crucial.

To that business acumen that's required at the center level to do that, the tools are aimed and, quite frankly, that's the area where execution is the most difficult; that certainly has created a pretty substantial headwind for us.

With respect to the new construction side of those businesses, there is certainly a difference between Commercial new construction and Residential.

Probably the easiest way to consider that difference is to think of the gestation period, or the length of time that a new construction on the Commercial side (indiscernible) issue around (indiscernible) for project management, project evaluation, of course, are fairly high and narrow skills.

The relationship with local, large architects, engineer firms, design and build firms are really important as well.

So that is a substantially different business model than you have in either Residential new construction or in the Service Replacement businesses.

Also, because of the length of time, it leaves you out there longer with your Accounts Receivable and also subject to a number of these fluctuations that we see in percentage completion accounting, which has been a nettlesome issue for us on the profitability accounting side, if you will, for Commercial new construction as well.

So, there are a host of reasons that make those four businesses different, but when you look at the original vision and strategy -- and it's clear to see that, particularly on the residential replacement and service, there is a large gap across this $40 billion market for a cohesive brand, a company that provides even service with predictable quality and results for the consumer.

Of course, that goes to the heart of the original vision that we had for the business.

Can you be in one, though, without the other?

What I mean by that is, whether it's commercial or residential, can you be in what you'd love to be in, which is just the replacement service side of it?

Because I would think that your customers, particularly in the Commercial side, would demand, in certain regard, that you also are bidding for jobs or being active on the new side to say, hey, if you guys are selling in the product and installing it, then that's where you pick up the better-margin business, which is the recurring stream.

So, are you able to kind of elbow your way in or elbow the new construction guy out by doing that, or is it kind of a necessary evil to be in the upfront market where you may have to take a hit in order to get the better business in the back-end?

No, it's not, but let me depict that (indiscernible) we've seen for you.

A commercial new construction job that is, let's say, an extremely large multi-unit proposition that extends over three to six months gestation time, build time, is clearly different from a smaller strip mall activity and a number of small (indiscernible) business, things like (indiscernible) and so forth that are done very quickly, (inaudible).

It's quite common, not just in our company but across a good many HVAC contractors, to have a residential service replacement business that also does a certain percentage of their business in commercial new construction, only smaller, much quicker turnaround type commercial applications.

So, we would expect to always see a certain percentage of the business, as you say, nested in those businesses, which might be predominantly residential service and replacement, or could well be (inaudible) commercial service and replacement, still doing smaller commercial jobs, a certain percentage of the business -- which I think gives them that hook that they need for the follow-on business in the market -- and able to do that without bidding on extremely large projects that, again, take, I think, completely different skills sets and leave the center of the Company exposed much longer on AR and so forth.

Okay.

Back to more practical kind of here-and-now issues for Rich.

When you look and talk about that business -- you're going to reassess it in April -- does that imply whether it's additional charges required or asset impairment charges, that type of thing that you guys will provide some more detail to?

What we're going to do is report out on a whole action plan.

As I said, Scott Boxer and his team are immersed in this and doing a lot of great things.

We want to let them complete this work and then tell the outside world at the end of the quarter.

The exact nature of what that update will contain I really don't have.

I don't want to try to second-guess them this early in the process.

Just a couple of other things, Rich, housekeeping type stuff -- when you talk about the free cash flow generation in '04 approximating net income, you're saying when you take net income plus any working capital changes minus CapEx, that number should approximate net income.

Is that right?

I think that's exactly what we're saying.

Now, we are trying to start with a GAAP number -- the cash from operations -- which includes depreciation and amortization but I think it gets to the same point exactly where you were.

You probably noticed that our capital expenditures -- the pace did tick up a little bit in the fourth quarter.

We continue to invest in new products and cost-reduction programs, but that arithmetic you just went through is what we're going to do.

Bob's not going to let any of us lose our focus on working capital productivity.

It, of course, gets a bit tougher as you continue to drive that number down, but we're not going to let up on the front.

Then the net earnings -- that will be the single largest factor in our free cash flow.

The way we see '04 right now -- and that's built into that guidance we said earlier.

What does that CapEx assume there?

Essentially, we expect to be up by a healthy margin over 2003.

It will probably be in the approximate range where depreciation is.

The way we look at it, we've probably got 25 million or so of CapEx each year that is need-to-do just to keep the operations humming and maybe a like amount in what I will call expect expansion, margin expansion, not necessarily unit expansion, but also a significant investment in new products, particularly in our HVAC business.

Then just relative to raw material costs -- a lot of talk, obviously, about steel and other metals prices.

What are you guys seeing in that regard?

Do you have contracts?

What do you think about price increases to your customers?

Is that a possibility this year?

Well, it easier for me to talk about the cost side and what we're doing in terms of what we're going to do on the pricing side, (indiscernible) customers; that's really a business-specific decision.

That news would come out of each of our businesses in terms of what our value proposition is for those customers.

But certainly on the cost side, we are seeing very firm markets for our big raw materials, copper probably at the top of that list, but aluminum and steel have got ahead of steam as well.

We would generally undertake hedging transactions.

We think that is still the case.

We think that's a prudent thing to do for at least a portion of our needs.

We don't have perfect insight into what the competition is doing, but we think, from a competitive standpoint, we're going to be well-situated on the cost side and we're going to watch that, though, very closely here as we hope the global economy moves along in step with the North American.

Then just lastly -- I'm sorry I'm taking up all the time.

Relative to your inventories and distributor inventories, yours look like they are in good shape entering the year and I get the sense that distributor inventories are probably at the same, despite a reasonable the year last year.

Do you guys feel pretty good about the spring build season in hopefully, what will be a reasonable sell-in the first part of the year until the weather hits?

Bob, do you want to take that one?

No.

I just wanted to tell you that all of the indications that we have so far would give us confidence that that is really going to be the case.

In terms of inventory levels, we know that, as of the latest information for December, distributor inventories for unitary equipment (indiscernible) Association were down about some 7 percent from the prior inventory.

Again, we feel that we have got our inventory well in control and we feel confident that we will be able to nicely support the beginning of the spring season that we see coming up.

I should also mention that we had a national sales meeting on the HVAC side just completed.

Talking with all of the people that out there on the front lines (inaudible).

Similarly, I would say quietly optimistic about what (inaudible) they are seeing from their customers, which of course is the end demand.

Steve Houston (ph) with JPMorgan.

Very solid quarter.

I just wanted to get into the Residential margins again, getting back to the initial question on the Q&A.

You know, should we think about -- you mentioned mix was a factor, you know, premium, new products.

Should we think about this fourth quarter -- I mean, you guys have never done double-digit margin in the fourth quarter as far as -- you know, back as far as I have to I think the late '90s -- and you know, close to (indiscernible) is a pretty darn good result.

Should we think about next year as kind of, you know, year-over-year, by quarters, you know, continued (indiscernible) type of margin improvements?

I mean, should we expect a similar margin in the fourth quarter of next year?

Is there something fundamental about the mix here that's going to allow you to sustain this type of margin?

I would say, in terms of the mix, aside from the commentary on a noticeable but not an overwhelming shift to premium products principally driven by the new product development that we have had out there -- you know, aside from that comment, I wouldn't feel that the mix was totally abnormal.

The increase in penetration that we are seeing -- and anybody can probably speculate on precisely what's driving that -- helped us with the level of volume in the fourth quarter.

Of course, there was a noticeable effect on margin because typically the fourth quarter is sort of a flattish type thing.

I'm not quite sure what I would tell you.

We don't really forecast quarter-by-quarter by business segment to the public on the outside, but we've been bullied, I think, by what we've seen this fourth quarter and we would expect that, on a forward basis, we probably will see stronger results in the fourth quarter than what had traditionally been the case for years past prior to 2003.

I mean, hopefully, that will help bracket that for you a little bit, but that's -- beyond that point, my crystal ball gets a little fuzzy.

Okay.

As far as Service Experts is concerned, you mentioned that you rolled out, you know, an accounting-related program.

I may have misunderstood you.

Did you say that that is complete, or is that in the process?

You know, how confident are you -- you know, usually, when any system gets rolled out, there are bumps in the road.

I just want to make sure that I understood that correctly, that you have already rolled that out in Canada and that is complete.

Really, a couple of things and I might have gone through them a bit quickly.

Let me back track, if I could.

Just throughout the system, we are doing more and more what I will call regional administrative centers.

That process will continue.

We have not had that kind of an approach in Canada but will early in 2004.

Separately from that, we talked about the STARS system.

I guess, to some way of thinking, it's an accounting system, but it's really more of a management system.

It gives us a lot of the metrics that help us keep a finger on the pulse of the business, how we are doing.

It provides the data that are actionable.

Now, that's going to be a bit more measured in its rollout; it takes a lot of training.

I'm trying to recall, but I think we said, in the earlier comments, by third quarter of '04.

Of course, that's for the rollout and the actual usage of that tool -- you'd like to see some benefits quarter-by-quarter and throughout 2004 but again, with a weighting towards the back end of the year.

Okay.

Sorry -- '04 -- are there any other -- you know, we mentioned the raw materials costs potentially.

Are there any other headwinds that are non-operating in nature?

You know, pension, medical, insurance, anything like that that, you know, you guys have factored into your forecast?

Certainly, the things you've mentioned and -- you are making it probably a little bit easier than I deserve on some of these overhead-type items like insurance and pension.

We would continue to see pressure, we think, in a lot of the self-insurance areas, such as those that are driven by medical, whether it's employee medical or the medical part of Workers' Compensation.

Other insurance markets seem to be moderating, leveling off a bit -- again, at levels that are a bit pricier than they were a couple years ago for sure, but those appear to be manageable in the overall scheme of things.

So, I can't really point to any other factors that are out there on the horizon in terms of major headwinds.

Bob, did you want to add anything to that?

No, I think you (inaudible).

Great, thanks guys.

(OPERATOR INSTRUCTIONS).

A follow-up from Michael Regan.

Rick, on cash flow for '04 equals -- or hope to the equal to net income, if depreciation and amortization are going to be --?

Michael, could you get a little closer to your phone? (inaudible).

Sorry.

Would you mind repeating?

Rick, just back to free cash flow, what kind of contribution are you expecting from working capital to get to the sort of free cash flow equal to net income in 2004?

Again, I don't want to get in trouble with the boss here, because he's got some more ambitious guidelines in terms of what we're hoping to see come out of the businesses, Michael, but built into our guidance would be a relatively modest contribution from working capital in terms of free cash flow, certainly more modest than has been the case in the last couple of years.

Right, so any other things moving within free cash flow that you expect in 04?

In other words, if you've got net income and CapEx is roughly equal to depreciation and CapEx is even flat, you could do that as long as nothing else is sort of moving within the cash flow statement?

I think you nailed it.

I mean, in terms of our building blocks, depreciation and amortization generally in line with the CapEx output and working capital may be a modest positive.

We've got, as I say, most of the dollars -- which we think goes to the quality of our cash flow coming out of the net income side as we see it right now.

Okay, thank you.

Justin Mower.

Sorry, guys, more questions.

Rick, just on the debt issue, as you mentioned, you did a good job of getting out of the securitization.

What do you see that flexing up to in the spring?

Could it go back to 100 million type of level, or do you think that (indiscernible) with the amount of cash you guys are generating?

Let's call it a normal cooling season.

That build-up could well be 100 million.

I think that's actually been darn close to what we've experienced.

I'm not talking year-over-year as much as I am from him from December 31 to that -- it's kind of a mid second-quarter peak -- may come off a little bit from 100 by the end of the second quarter, so folks on outside really never see that kind of adulthood but that's what we're set up to handle in terms of our credit facilities.

We've left the securitization program in place.

I mean, we like it.

If we're using it, that means we're selling product.

What about any maturities on the 200 million of debt that you have (inaudible) the next couple of years?

I'm just wondering, kind of big picture, what plans are for cash now that you've kind of used the securitization for the working capital swings but you're still generating a ton of cash.

Well, again, we do have -- although not the bulk of it in '04 but in the next, let's say, 18 months or so, we've probably got about 100 million of debt maturities.

I think I may have overstated that.

It's probably closer to 90.

If we get out a little bit in front of that, that's not all bad.

So I think the base case, until the businesses come along with better ideas, is to just assume that we will hold that as we generate it until we can reduce some additional debt.

Does that answer the question?

Yes, that's good.

Then just lastly on kind of the industry issue of replacement versus new constructions generally two-thirds, one-third type of mix -- is that fair?

Generally, it varies a little bit I think (inaudible) Residential versus Commercial, but a good typical number to look at is like 60/40.

Just wondering, with the last couple of years of huge starts, has that changed from what you guys can tell?

I know the distribution ends up going to the same place.

Perhaps a little bit.

So, you're not concerned -- I mean, to your earlier point about start slowing down -- that you still think there's plenty of business to be had out there?

Yes and I think it's important to note that, on the Residential side, we typically run about 70 percent on the replacement service side, 30 percent on the new construction.

Another thing too is -- and I think we've seen some of this past year -- it has been our theory that, over the 2.5, 3 years of sort of the economic malaise that we've been thorough, that based on what we and other people are saying in the industry and our interactions with the consumer, we felt there was a fair amount of pent-up demand, where people were deferring (inaudible) long-term decision and replacing a system with one that provides more comfort and serving more efficient use of energy, simply because of the uncertainty in the economy.

We feel that now that the economy has begun to be a bit more positive in the minds and perspective of the consumer that to whatever degree that pent-up demand is out there, that some of that is being released as well.

Of course, that also bode well for the Service and Replacement side.

Let's hope the investors understand that one -- (Multiple Speakers) -- market starts to slow down a little bit.

Thanks.

We have no further questions.

I will turn it over to Mr. Bob Schjerven for any closing comments.

Thank you.

In summary, I'd like to say that we feel that Lennox International has had a very successful year in 2003.

Again, we earned our earnings per share of $1.28, exceeding expectations.

Our manufacturing businesses are performing quite well and (indiscernible) employees (indiscernible) continued improvement in the year ahead.

We are taking decisive action to turn around the performance of Service Experts.

In 2004, we expect earnings per share to be in the range of $1.38 to $1.48, up some 8 to 16 percent over the results in 2003.

I'd like to thank you all for taking the time to be with us today.

Good-bye.

Ladies and gentlemen, that does conclude your conference for today.

Thank you for your participation, and you may now disconnect.