Lennox International Inc (LII) 2005 Q1 法說會逐字稿

Ladies and gentlemen, thank you for standing by.

Welcome to the Lennox International first quarter 2005 earnings conference call.

At the request of your host, all lines are in a listen only mode. [Operator Insturctions].

I would now like to turn the conference over to Bill Moltner, Vice President of Investor Relations.

Please go ahead.

Thank you Kathy.

Good morning and thank you for joining us for this review of Lennox International financial performance in the first quarter of 2005.

We are broadcasting today's call live on the Internet, and we welcome our webcast listeners.

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.

In a moment, Bob Schjerven, our Chief Executive Officer will comment on our Company's progress and performance in Q1, and Sue Carter, our Chief Financial Officer, will review operating performance by business segment as well as the draft the income statement and balance sheet items.

We'll wrap up the call with Q&A.

In the earnings release we issued yesterday, which you will find posted on our web site, we've included several tables providing financial details and reconciliations of the financial metrics that Bob and Sue will discuss to generally accepted accounting principle measures.

I'd like to remind everyone that in the course of this call, to give you a better understanding of our operations, we will be making certain forward-looking statements.

These forward-looking statements are subject to risks and uncertainties.

A list of these risks and uncertainties including the impact of higher raw material prices, our ability to implement price increases for our products and services, and the impact of unfavorable weather on the demand for our products and services, is included in our publicly available filings with the SEC.

These risks and uncertainties could cause our actual results to differ materially from those that we express to you today.

I will now turn the call over to Bob Schjerven.

Good morning.

In the first quarter of this year, which is typically the seasonally weakest, Lennox International's financial results are tracking to our internal expectations.

Our commercial heating and cooling segment continues to perform very well, with double-digit top line growth, and segment profits that grew threefold.

We also achieved improved profitability in our two-step residential heating and cooling business, and in our Hearth Products Unit.

Higher commodity prices continue to present a challenge.

Escalations in steel, copper, aluminum, and related components, are creating a headwind of about $21 million for the manufacturing businesses in the first quarter.

We are realizing meaningful improvements in the price increases we have implemented, however, mix issues negatively impacted margins in the quarter, particularly true in our residential businesses, where we saw a relative increase in the proportion of our sales that come from both lower margin new construction business, as well as from the more price competitive regions of the country.

Service Experts did show year over year improvement, and despite incurring an anticipated loss in the quarter is on track to be a modest profit contributor in 2005.

In the first quarter this year, Lennox International's total revenue increased five percent to $700 million.

Our top line benefited from strength in both the Euro and the Canadian dollar.

In constant currencies, our sales were up four percent.

Income from continuing operations was $7 1/2 million or $0.12 per share, compared to a loss from continuing operations of $177.7 million last year.

Adjusting for the $185 million after-tax goodwill impairment charge that was taken in the first quarter of last year, income from continuing operations in the prior year's quarter was 7.4 million or $0.13 per share.

We incurred $1.1 million in after-tax discontinued operation charges in the first quarter of this year, and those are related to last year's divestiture of some 48 Service Experts centers resulting in a reported GAPP net income of 6.4 million, or $0.10 per share.

Sue Carter will review our cash flow performance just a little bit later, but let me just say that we had a very strong free cash flow generation in the first quarter, after last year's disappointing fourth quarter.

We generated $19 million in free cash flow, which allowed us to continue to reduce our short-term borrowings.

At March 31st, the debt on our balance sheet was 56 million below year ago levels, and our off-balance sheet asset securitization balance was $60 million lower, an effective reduction of $116 million in economic debt of our company on a year over year basis.

Over the past four years we've made very good progress paying off our debt, and we are comfortable with the reduced leverage that we now have on the balance sheet.

Looking ahead, we like the flexibility that our cash flow provides us, and we are evaluating the best opportunities to deploy that cash to build shareholder value.

Looking ahead, we remain optimistic about this year, 2005.

We are reaffirming our guidance for full year earnings per share in the range of $1.50 to $1.60, and we project the year over year improvement to accelerate in the back half of the year as the gap between commodity cost impact and price realization disappears.

This EPS range represents an eight to 15 percent improvement over our 2004 performance.

We expect that LII's revenue growth will be in the mid single digits.

Price improvement continues to remain our highest priority.

Our management team is focused on achieving the price increases necessary to offset higher input costs.

Furthermore, as we move through this year, and closer to the January 2006 implementation of the new 13 SEER minimum efficiency standard, it will be very important to establish prices that reflect not only the higher manufacturing and distribution costs, but also the value in the new range of products that we're going to be selling to meet that regulation.

Now, before Sue takes you through our segment results, let me take a moment to just recap some of our notable first quarter accomplishments.

We continue to strengthen our reputation as an innovation leader.

Our entire line of cooling products is being redesigned.

We are using the new NAECA regulations as an opportunity to not only comply with the new 13 SEER Energy efficiency requirement, but also to standardize product platforms across our brands and to integrate other improvements in to those products.

We will be ready when the new efficiency standards take effect in January of next year.

A great example of these efforts and the latest addition to our Dave Lennox signature collection of premium home comfort products, is the XC21, the first residential air-conditioner to be rated at over 20 SEER.

Not only is this the most energy-efficient air-conditioner you can buy, but the system has a host of other features, including environmentally friendly R410A refrigerant, and also our Silent Comfort Technology, which makes it approximately 13 times quieter than a standard air-conditioner.

We announced that Outokumpu Copper Products of Finland has exercised its option to purchase LII's remaining 45 percent interest in our heat transferred joint venture for approximately $39 million.

You may recall that nearly three years ago LII and Outokumpu announced a joint venture, with Outokumpu initially purchasing a 55 percent interest in LII's heat transferred business segment for $55 million.

Selling our remaining interest allows us to further focus our energy and resources on how three core equipment and service businesses.

This transaction is not expected to have a significant financial impact on our 2005 performance, excluding an anticipated gain on sale that will be quantified when the transaction is completed.

Our current expectation is that that will be late in the second quarter of this year.

For the third straight year the Environmental Protection Agency has selected Lennox industries as an Energy Star manufacturer of the year for Lennox's outstanding contribution in developing, manufacturing, and promoting energy-efficient products.

Lennox is the only HVAC manufacturer ever to be chosen for the annual EPA award.

This award acknowledges our leadership position and promoting the importance of using energy more efficiently through our product offerings, consumer education, technical education, and training.

And finally, we continue to strengthen the leadership at Service Experts through our General Manager Development Program.

This is a people business, and we continue to invest in the people who can make a difference in Service Experts performance.

We have completed the training of our second class of general managers and the graduates have assumed leadership positions at dealer service centers.

Let me now turn the call over to Sue Carter, our Chief Financial Officer, to take you through our business segments operating results.

Sue?

Thank you, Bob.

Good morning.

Taking a closer look at our business segment performance, first quarter revenue in the residential piece of our heating and cooling business increased six percent to $343 million, driven primarily by the growth of the Lennox brand of heating, cooling, and hearth products.

Sales adjusted for foreign exchange were up five percent.

Residential heating and cooling segment profit for the quarter was $29.6 million, down from $32.6 million last year, with operating margins declining from 10.1 percent in last year's first quarter, to 8.6 percent this year.

You may recall that last year we saw relatively little impact from higher commodity prices in Q1 due to our hedge position, making this quarter's comparison a difficult one.

We were able to offset the large majority of the material cost increases we incurred in the first quarter of this year, but has Bob has mentioned, mix issues, primarily in our Lennox brand contributed to the margin erosion.

Mild temperatures in the Midwest and Northeast resulted in a sales SKU to more price competitive Southern markets and mix between new construction and replacement shifted away from the more profitable replacement business.

Although we had very solid factory performance in the quarter, we incurred approximately $2 million in higher warranty and product liability costs, primarily due to revaluing warranty reserves, based on higher material input costs.

Price improvement remains a priority in the segment, and our Lennox brand recently announced another round of price increases that go into effect in the second quarter.

On a positive note, Centex recently announced Lennox as the exclusive supplier of heating and cooling systems to the new homes that it will build for the next three years.

Our commercial heating and cooling segment continues to outperform the market.

Revenue in Q1 advanced 16 percent or 14 percent adjusted for foreign exchange, to $126 million, driven by a strong increase in our sales to our domestic national accounts.

We are beginning to see domestic demand improved, but market conditions have been more difficult in Europe, where growth is limited to Central and Eastern European countries.

We are achieving price improvement in the U.S. and Canada, although there is some lag as national accounts contracts are renegotiated.

Segment profit increased sharply from $1.4 million last year, to $4.7 million this year, with operating margins improving by 240 basis points to 3.7 percent, driven by higher volume and better pricing.

Sales force Service Experts' continuing operations were down two percent or down three percent when adjusted for currency fluctuations, to $136 million.

Service Experts had an operating loss in the quarter of $6.3 million, an improvement over the $7.7 million operating loss of the prior year.

We are making progress on reducing fixed costs, but as in our residential equipment business, margins were impacted by unfavorable mix, as new construction markets were more buoyant been replacements.

We are realizing price increases on the heating and cooling equipment we sell, but price improvement on related parts and supply has been insufficient.

In our refrigeration segment, revenue rose two percent, but was flat in constant currencies.

Segment profit declined from $10.6 million last year to $8.9 million this year, due to weaker performance in our international businesses.

Operating margins declined 8.0 percent, from 9.7 percent in the prior year's first quarter.

Demand in Europe remains weak, and many jobs were delayed due to whether related construction delays.

We had solid performance in the Americas, with price increases holding and again marginally offsetting commodity cost increases.

We had good growth in OEM sales at service the supermarket and walk-in refrigeration segment.

Our total debt at March 31st was $309 million.

As Bob mentioned, this was $56 million lower than it was at the same time a year ago.

We had a balance of $5 million in our off-balance sheet asset securitization program, down from $65 million a year ago.

Our debt to total capital ratio was a solid 39.3 percent, down significantly from 48.2 percent at the end of the first quarter of 2004.

We also feel it is important to remind you that almost one-half of our total debt is in the form of convertible notes, the dilution of which is included in our EPS guidance.

Our balance sheet is in very good shape.

While we typically consume cash in the first half of the year and generate cash in the back half, due to the seasonal nature of our business, we were cash flow positive in Q1.

In the first quarter, our cash provided by operating activities of continuing operations was $38 million.

During the quarter we invested $14 million in capital expenditures and we increased our asset securitization balance by $5 million, resulting in free cash flow of $19 million for the quarter.

This strong cash flow performance is due in part to the correction overinflated working capital that we had on our books when we closed 2004.

Management across our organization is clearly focused on working capital in 2005.

Our operational working capital ratio as a percent of trailing 12 months sales was 18.9 percent.

We continue to expect our capital expenditures for the year to be approximately $80 million, driven largely by increased spending to comply with the new NAECA 13 SEER standard.

Benefiting from a lower debt balance, our total interest expense of $5 million in the first quarter was down to million dollars from the prior year.

Our effective tax rate on continuing operations was 37 percent, a rate that we expect to maintain for the full year.

And finally, with the recent delay in the mandatory adoption of stock option expensing, we're evaluating the approach that we will ultimately use.

We did not expense stock options in the first quarter, however, our variable accounting treatment of long-term equity based incentives did not yield a materially different result in Q1 than if we had.

And due in part to LII's higher stock price, the resulting impact on equity based compensation included in our corporate and other expenses in the quarter was a primary reason we saw a $3 million increase in that line item.

That includes our prepared remarks and at this point we would be pleased to address any questions that you may have.

Ladies and gentlemen, One moment please [Operator Instructions].

Our first question comes from Curt Woodworth, with J.P. Morgan.

Please go ahead.

Yes, hi, good morning.

Good morning.

Some questions on the price dynamics in the industry.

Can you break out what you're price realizations were among commercial, residential, and refrigeration this quarter, and talk about what the price recovery was and your expectations going forward?

And also, the second quarter price increases, can you quantify what those were please?

Good morning Curt, it's Bill Moltner.

On price realization in the first quarter, in our manufacturing business we saw about three percent price realization.

It was a little bit higher than the residential heating and cooling fan that average, and a little bit lower in both the commercial heating and cooling and the refrigeration businesses.

And I'm sorry I missed the second half of your question.

Yes, your price increases in the second quarter, how large are those?

Well, we announced price increases on our Lennox brand range of five to eight percent on the residential equipment.

OK, and have there been any other price increases for refrigeration or commercial products?

On our Two-step residential brands, we announced April price increases.

OK, and then a question on cap ex.

Cap ex is going up pretty dramatically this year.

Can you talk at all about how much of that cap ex is one time in nature, in terms of kind of retooling your operations to get ready for 13 SEER, you know, essentially trying to get a sense for what the run rate in cap ex would be looking at to 06.

What we've said, Curt, is that while our guidance for the year is the $80 million that you've talked about, that the increase over 2004, which was about $40 million, was primarily related to the changeover to the 13 SEER type of product, and also to some IT spending that we had.

So our expectation is that as we look out into the years after 2005, that we would go back down to about equal to our depreciation or somewhere more in in the 40 to $50 million arrange.

OK, great.

And lastly on your comments regarding capital, capital deployment, could you talk a little about some of the uses that you're evaluating now for your cash flows?

Well, I think they fall into your typical kinds of areas.

First of all, we have to you know look at the remainder of the year and what our cash flow generation is.

And as you know, we haven't given guidance on that, and what the timing of those flows are, and then of course we work with the entire management team and our Board of Directors to determine what the best uses for those are.

I think they are, you know, your fairly standard type of uses, and none of those are things that we actually comment on until we actually have a specific announcement to make.

Yes, OK, thanks.

Thank you.

Our next question comes from Jeff Hammond with KeyBank Capital Markets.

Please go ahead.

Hi good morning.

Good morning Jeff.

Good morning.

I wanted to dig in a little bit on the residential margins and maybe could you give us a sense -- it looks like there are two separate mix issues.

Can you may be give us a sense of how you're thinking about those going forward, do you have any sense, you know, into April, if those are persisting or backing off?

This is Bob Schjerven.

First, you are right, there are two different threads, I guess, to this particular story.

And the first is we've seen a bit of an exchange to the residential new construction site, which of course has somewhat lower margins, and we saw that driven I think to a large extent by the weather patterns that we saw, and that people were not inclined to go forward as robustly as they might otherwise do in the replacement activity, particularly through the upper Midwest and parts of the Northeast.

And you know, it's that kind of a mix, which on both of those counts would certainly be a temporary type of a condition and we expect to have good strength in both replacement and residential new construction and more ratios between the two as we go forward.

Okay and then the warranty issue is that - would you characterize that as one-time to kind of true up or does that persist?

No Jeff.

I would characterize that as one-time and if you break it down into a smaller component level it's essentially just taking the higher commodity increases that we experienced as we rolled our standards in 2005 and putting them into the warranty model.

So it's nothing deeper than that.

Okay and then if we think about the relationship of raw material increases and price increases I guess we've seen steel costs come down, copper costs move higher.

I guess with those move and then at the same token you're putting through a follow-on increase at least on the residential side.

I mean how should we look at those moving pieces going forward in terms of you being able to cover your raw material (inaudible) or I guess asked another way.

Do you see your raw material head one being any less given the move steel has had or your price realization conversely any better given the follow-on?

This is Bob again Jeff.

The strong direction inside the company is the focus that everyone has is certainly the compete recovery of all of the increase in costs moving forward and certainly you've got the same phenomenon in a time of rising costs like this where we had a little bit of a lead lag effect and that's why you see not just ourselves but other people in the industry continuing to re-access and put forward additional necessary price increases to be sure that we cover not only our costs but our margin on a go forward basis but certainly we have this lead lag effect like everybody has and my prediction would be that you could expect that to diminish as we go through this year.

That's our plan.

That's our intent.

Are you seeing any release on raw materials costs relative to your original expectation?

I guess I have not got to do - you'd have to get to a very detailed level even down for example in terms of steel looking at the different classes of material because each one of those have a different story but certainly as we say we expect those commodities to jigger about and we continue to go forward and you're quite inaccurate in that the upper crust area continues to be most noticeable amongst the non-ferrous materials.

Okay and then I guess final question moving to service experts.

It looks like the improvement was mainly on reducing fixed costs and I just wanted Rob if you could speak to - you know at what point do you see in the results improvement from some of the productivity initiatives underway or general manager changes or speaking specifically to project Titan.

When would you expect benefits from those productivity initiatives to start showing through?

Very short question.

Our expectation is that we will see those to continue to feather in the next quarter and the quarters after that.

However, I have to be pretty clear with everybody and that is that these programs are fairly sweeping and this is a people business so it's probably a function of how quickly people assimilate and begin to use effectively the program so it's not a matter of a couple of quarters it's a matter of not only something in excess of six quarters to see those things fully deployed and fully operational.

Jeff it's Sue.

I would also add to that when you look at service experts and the improvement on a year over year basis and you call out the fixed costs some of the things that we've talked about with the process improvements and all of that are going to fall into that fixed cost area.

So we are seeing some of those improvements come through and that is part of why that is happening and what we're seeing.

Okay perfect.

Thanks guys.

Thank you Jeff.

If there are any additional questions please press star then one at this time.

Next we go to the line of Michael Pullman from Southwest Securities.

Please go ahead.

Morning.

Good morning Michael.

Morning.

The Suntec announcement does that change kind of the outlook for the mix of new versus replacement on a 40/60 kind of going forward?

If it does I think it would be really sort of minimal because we're looking at additional expansion in other areas on the replacement side as well.

So perhaps you'd be able to - with a real fine caliper finding at the end of the year but I don't think it's going to be a market affect that you should be concerned about as you work with your model.

Okay.

In the 13th year I was wondering if you could maybe update if you changed your expectation for what you think may happen in the back half of '05 with respect to a pre-buy?

I don't take that.

I haven't come out with any expectations.

I'm not saying you have.

I'm just saying what would your expectation be?

I guess I can only give you the same answer that I gave before which was speculation and that is we think first of all that it is probably not going to be a necessarily a good business decision by distributor to try to stock on a lot - and that been a concern and I frankly don't see anybody in the industry encouraging anyone to do that and also on top of that is the fact that over the past half a dozen years or so virtually everyone in the industry as we've improved our manufacturing cycles and our flexibility in terms of model mix and so forth distributors have found it less necessary to put into stock more - as much product as they did in years past and so I think that a long with that there probably is a level of generally rising business acumen amongst folks that are in that link of the distribution chain which indicates that it is not necessarily a good idea to do let them.

If you asking me for a personal expectation I think that that phenomenon although there may be a little bit of it is probably going to be deminus.

Your guidance does not reflect any sort of meaningful pre-buy?

That would not be our plan.

In the refrigeration business I saw that the Heath Craft began to export from China to India in January and I was just wondering if you could talk about that and the opportunity for that?

I'll be very frank with you.

I'm not quite sure you achieved - you came across that piece of information because primarily what we're doing in China is to serve the domestic market.

What would be in terms of the refrigeration potential kind of longer term operating margin for that business do you have any kind of target on a longer term basis what that operating margin might be?

Well first of all when you look at the performance of that business in the U.S. domestic and I think that that pretty well shows what upper level of performance from a manufacturing business like that serving that kind of commercial market can probably achieve is under a (inaudible) and so although I certainly haven't got a timeframe if you look at what our business is doing in individual parts of the world on the longer term basis and on multi year basis they certainly are working to achieve that.

I would say that overall on an all in basis today we're looking at a business that's probably with all of the pieces properly weighted and blended in something in the neighborhood of about 10% EBIT margin business.

And you announced a couple of extreme announcements in the quarter.

The Burlington and the sale of JV.

Are there opportunities with either JV or subsidiaries for additional streamlining?

Frankly no there's nothing on the radar screen at this time.

Those two things I think pretty well give us some pretty good fighting trim.

Okay thank you.

Sure thank you.

Good questions.

We have a follow-up question from Curt Woodworth with JP Morgan.

Please go ahead.

Hi.

Could you tell me what your current mix of ten and eleven CR products is and what your mix of 13 CR products are right now?

Curt, it's (inaudible).

Right now we're not giving specific guidance on or disclosing specifically what that breakout is but suffice it to say that we have a significantly larger percentage of our share or our sales in the 13 CR versus the industry and when you look at lower than CR there's really two segments there.

There's the 10 CR and then 12 CRPs and we have significantly less than the 10 CRPs than the industry does as a whole.

Okay.

I mean would it be fair to say that 10 CR would be at least 50% of your mix?

We're significantly less than the industry and I think you're seeing that the industry is about two-thirds of the total shipments are 10 CR products and were significantly less than that.

Okay.

Would I be really off base by thinking about 50% level?

Or is that too high?

We're significantly less than the two-thirds of the industry.

That's really the extent that we're going to disclose on it.

And then can you talk a little bit about - I don't know if you're willing to apply on this but your ability to hold margin as you ramp up in the 13 CR you know do you foresee any negative margin impact kind of in that-

We've actually talked about two different things going on this year.

One is the price increases that we're seeing in the industry to cover the escalated costs of raw material and then also looking at the impact of 13 CR and what that's going to look like when it goes out.

First of all let me be again very emphatic in this.

I think it's important that this message is not missed and that is irrespective of whether we're talking about response on current product pricing to material costs or what we do in 13 CRs we think that this corporation has a resolve and an aware with all to be absolutely confident when we say that we are going to cover costs and margins for both of those situations.

The other thing that I think that's really important to understand is that as we redesign the products on the cooling side of the business we're doing a number of things as is demonstrated by the advent of the FC21 that we announced here just a couple of weeks ago to provide really high features in the differentiated products across the line as go into 2006 and we fully expect to get full value for all those additional features and benefits that will accrue to the consumer.

Okay and lastly.

Were you including options expense in your guidance for this year.

Yes.

We were estimating what we thought that that would do for us in 2005.

And what was that impact?

We actually did not disclose the total amount of the impact.

We just stated that it was included in our guidance.

What was the impact for '04?

We don't have that in front of us Curt.

Let me get back to you on that.

Okay.

Thank you.

We have a follow-up question from Jeff Hammond with KeyBanc Capital Markets.

Please go ahead.

Hi.

Just a couple of finer point questions.

Can you give us the share count in the quarter?

I didn't see that in the release.

We'll get that for you in a moment.

And then maybe while you're looking for that.

You'd mentioned that 401 price increases in residential we've seen I think this week a competitor come with follow-on price increases in the commercial side.

I think someone else is out there with a follow-on.

I mean should we expect any type of follow-on in your commercial business?

You know there's a phenomenon in the commercial business Jeff.

It's really got a couple of different parts.

Certainly from the standard across the accounting replacement type product if I can classify them that way in the unitary side the price increases that we're seeing somewhat in the same kind of measure and pace that we've got on the residential side.

However a fair amount of our business as you may recall is new construction and goes through national accounts and of course in those particular cases you've got a contractual obligations and things that come due and are renewed at different times of the year.

So there's sort of a permanent statico (ph) effect with that part of the business look for our company that's very large because as I mentioned before our presence in the national accounts is very strong.

And Jeff to your share count question. 64.4 million was the diluted share count.

I'm sorry.

64.4 million.

Okay and that looks like a bump from the end of last year.

What would the difference have been?

I guess two million higher?

Yes it would include stock that has been exercised.

Stock options that have been exercised.

Okay thank you.

I would now like to turn the conference over to Bob Schjerven.

Please go ahead.

Yes.

Just before we turn it back to Bob, Jeff one more point of clarification.

It stock options exercised but also the diluted count you know when look at the share price as well which weighs into the calculation.

Okay.

Let me summarize by saying that although this first quarter is seasonally our softest quarter Lennox International had significant accomplishments that will continue to strengthen this business as we go forward.

We are on track to achieve our earnings per share guidance of $1.50 to $1.60 per share in 2005.

We're focused on realizing the price improvement that are necessary to offset material costs in place and in our manufacturing businesses.

Service experts is on the right track.

Our initiatives to improve this business are taking hold and we expect it to be modestly profitable this year.

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

Good day.

Ladies and gentlemen that does conclude our conference for today.

Thank you for your participation and for using AT&T Executive teleconference.

You may now disconnect.