Lennox International Inc (LII) 2006 Q1 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to the Lennox International first-quarter 2006 earnings conference.

At the request of your host, all lines are in a listen-only mode.

There will be a question-and-answer session a 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.

Please go ahead Sir.

Good morning and thank you for joining us for this review of Lennox International's financial performance in the first quarter of 2006.

We're broadcasting today's' call on the Internet and we've placed a link to the webcast on our corporate web site at www.lennoxinternational.com, and 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 the first quarter and Sue Carter, our Chief Financial Officer, will review operating performance by business segment as well as address some key income statement and balance sheet items.

We will wrap up the call with our Q&A session.

In the earnings release we issued this morning, which you'll fid posted on our web site, we've included several tables providing financial details and reconciliations to the GAAP measures which Bob and Sue will discuss. before we begin, I'd like to remind everyone that in the course of this call to give you 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 is included in our public available filings with the SEC and includes the impact of higher raw material prices, our ability to implement price increases for our products and services, the impact of unfavorable weather, a decline in new construction, activity on the demand for our products and services and the potential impact on operations related to the implementation of the new NACA efficiency standards.

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

With that, I would now like to turn the call over to Bob Schjerven.

Good morning.

Lennox International had strong financial results in the first quarter, giving us a good, solid start for 2006.

Our revenue increased 14%, or 15% adjusted for FX, to $800 million, and our operating income grew 30% to $35 million.

Our diluted earnings per share were $0.28 compared with $0.19 in the prior year's first quarter.

Adjusting for unrealized gains open futures contracts for copper and aluminum that resulted when these contracts were marked so dramatically the higher market price and [for] restructuring charges, income from continuing operations was $19 million, or $0.26 per diluted share, compared with $8 million, or $0.12 per diluted share in the first quarter 2005.

Sue will be taking you through the detail of these adjustments.

Despite an unseasonably warm winter, residential Heating and Cooling did have an exceptional quarter.

Our HVAC management team did just a terrific job in managing the transition to 13 SEER.

We were ready with a comprehensive and competitive range of new products, all the way from entry-level up through full featured when the new NACA regulation took effect on the 23rd of January.

Our new cooling product lineup has been very well-received by our customers and we've benefited from the strong demand as distributors and dealers prepared for the upcoming cooling season with purchases of 13-plus SEER equipment.

In the first quarter, 86% of our conditioner and heat pump sales were for 13 SEER or higher efficiency equipment.

The record warm weather, particularly in January, did hamper Service Experts progress this winter, which was reported to be the warmest on record in Canada and the fifth warmest in the U.S., depressed replacement and demand service of heating equipment.

We experienced pricing pressure as we endeavored to maintain our topline and keep our service techs productively employed, and we incurred significantly higher fuel cost.

We continued to invest in this business, investments that position service experts for continued improvement and the accomplishments in the first quarter were significant.

We continued to upgrade our service center management with the initiation of a fourth class of our general manager fast-track training program.

We bolstered the infrastructure at our regional accounting centers and we put in place a centralized call center to handle afterwards inbound calls for all centers.

In addition, we initiated a customer satisfaction program to measure service center performance against our Service Experts' standards of excellence and the initial results of almost 9000 completed surveys reflecting our ability to execute against those standards of excellence are very encouraging indeed.

Demand for commercial heating, cooling and refrigeration equipment continues to improve in the Americans and our business units in these markets are operating very well.

We recently announced a capacity expansion at our Stuttgart, Arkansas factory that will allow us to meet our anticipated production needs for the foreseeable future.

In Europe, demand is firming, but pricing pressure does remain.

Looking ahead to the rest of 2006, we are reaffirming our expectation of a full-year diluted earnings per share in the range $2 to $2.10, which represents a 9% to 15% improvement over our adjusted 2005 performance of $1.83.

We continue to expect LII's revenue growth to be in the mid-single digits in each of our segments.

And as we discussed when we announce the consolidation of our [two-step] residential Heating and Cooling operations, our full-year guidance assumes we will be able to offset restructuring charges through gains and other positive non-operating items throughout the year.

The recent sharp escalations installations in commodity prices does represent the greatest risk to our guidance.

We have recently announced another round of price increases on all of our Heating and Cooling brands and our management team is very focused on realizing the price increases, cost reductions and productivity improvements necessary to offset higher input costs.

Let me now turn the call over to Sue Carter.

Sue?

Thank you.

Bob, good morning.

Before addressing our business segment performance, let me provide additional commentary on a few line items in our consolidated company results.

In Q1, we reported a pretax gain of $18 million related to commodities futures contracts.

This amount includes $9 million in gains on futures contracts for copper and aluminum that's settled in the first quarter.

These contracts were mark-to-market prices.

This gain was offset in the segment profit of our equipment businesses where cost of goods sold reflects market prices for the related commodities.

The remaining $9 million represents net unrealized gains on future contracts that remain opened.

These too were mark-to-market.

This $9 million gain on open contracts offsets higher commodity prices that we expect will be reflected in cost of goods sold when the contract is settled at some future time.

The full $18 million of future contracts related gains is included in our full-year 2006 earnings guidance.

We have been working with an outside consultant to assist us with the design of our policies, procedures and controls associated with commodity hedging activities and we have not initiated additional hedging contracts during the time that this process has been underway and we expect that this work will be completed during the second quarter.

In addition in the first quarter, we incurred pretax restructuring charges of $6 million relating primarily to the previously announced consolidation of operations for our two-step residential Heating and Cooling business in South Carolina, including the closure of our facility in Bellevue, Ohio.

This project is progressing as planned.

Our balance sheet, which was already in very good shape, keeps getting stronger.

Our total debt at March 31 was $123 million, down from $309 million at the same time a year ago.

Our debt to total capital ratio was 13%, down dramatically from 39% a year ago.

Cash used in operations was $50 million and the Company invested $15 million in capital expenditures, resulting in a free cash outflow of $65 million for the quarter.

This was in line with our expectations.

Due to the seasonal nature of our business, it's typical for us to consume cash in the first half of the year and generate cash in the back half.

We continue to expect our capital expenditures for the year to be approximately $70 million, driven by 13 SEER equipment carryover from 2005, the cost for warehousing in South Carolina as part of the consolidation program, the expansion to accommodate continued growth in our domestic commercial Heating and Cooling business and IT investments.

In the first quarter, we used $7 million to buy back 214,000 shares of Lennox International stock.

Our cumulative repurchase since the program was announced last year has been 661,000 shares for a total cost of $20 million.

Management across our organization remains focused on working capital.

Our operational working capital ratio as a percent of trailing 12 months sales was 16.2%, a substantial improvement over the 18.9% level a year ago.

Corporate and other expenses increased $5 million in this quarter due in part to the absence of income from our heat transfer joint venture earned in the prior year's quarter, the impact on equity-based compensation resulting from LII's performance, higher insurance costs and an increase in professional fees related to audit and compliance activity.

Benefiting primarily from a lower debt balance and interest earned, our total interest expense of $1 million in Q1 was down $5 million from the prior year.

Now taking a look at our business segment performance in the first quarter, revenue in the residential piece of our Heating and Cooling business increased 22% to $416 million.

Adjusted for foreign exchange, sales were up 21%.

Segment profit increased 30% to $37 million with operating margins expanding 50 basis points to 8.8%.

While productivity at our factories was affected by 13 SEER transaction, the ramp up to meet heavy demand and production schedule changes prompted by component availability and demand uncertainty, the impact was more than offset by higher sales volumes.

Also in comparing the year-over-year improvement in segment profit, keep in mind that we incurred approximately $2 million in higher warranty and product liability costs in last year's first quarter primarily due to revaluing warranty reserves based on higher material input costs.

The warm winter resulted in proportionately less replacement sales for heating equipment and related repair parts which negatively impacted mix, but we clearly benefited from a mix shift within cooling equipment to higher efficiency equipment. 86% of our Lennox brand cooling equipment sales in Q1 were 13 SEER or higher and our blended average selling price for air conditioners and heat pumps increased by 20%.

Our Commercial Heating and Cooling sales advanced 5% in Q1, or 7% adjusted for foreign exchange, to $133 million paid.

For foreign exchange, sales were up 11% in North America and flat in Europe.

Segment profit increased significantly from $4 million last year to $6 million this year with operating margins improving by 90 basis points to 4.4%.

The profit improvement was driven by our domestic business and in our residential business, component availability issues resulted in production schedule revisions on higher volume and improved pricing more than offset the impact on productivity.

Our performance in Europe was stable year-over-year, albeit at unacceptable levels, and we remain focused on improving profitability in this region.

We are beginning to see improvement in demand and enter the second quarter with a significantly stronger order backlog versus year ago levels.

Sales for Service Experts were up 4%, or 3% when adjusted for currency fluctuations to $141 million.

Service Experts had a segment loss of $6 million in the quarter, unchanged from the prior year.

While we had a beneficial shift in revenue in the quarter from new construction to service and replacement, unfavorable weather depressed demand.

The resulting price competition, along with more maintenance and less demand service, prevented margin improvement.

We also had to contend with approximately $600,000 in higher fuel costs in the quarter.

Lower bad debt and warranty expenses were offset by higher personnel costs, including additional district marketing specialist and added infrastructure at our (indiscernible) accounting centers, as well as employee development cost.

Despite the weather-related slow start this year, particularly in January, performance continued to improve as the quarter progresses.

In our Refrigeration segment, revenue rose 12%, or up 15% in constant currencies.

Segment profit increased 29% to $11 million.

Operating margins improved to 8.6% from 7.5% in the prior year's first quarter driven by higher volumes and good cost control of fixed expenses.

Sales and operating profits improved in the Americas, Europe and Asia Pacific regions.

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

(Operator Instructions).

Curt Woodworth, J.P. Morgan.

A couple of questions.

First on the raw material issue with copper up, what is your visibility on this near-term, specifically around the second quarter?

Do you feel like the price hikes you have in place should be enough to offset some of the increased costs you are seeing?

First of all, we have price increases both past and then price increases future.

And about the first of May I think it is, you will see another shift upward in pricing out there.

As far as work, the [red metal] is [going to go] in terms of its price [going].

We're all sort of sitting here watching it with a little bit of amazement.

But just as we have been doing over the past 18 or so months, we watch those markets very close and take all the appropriate action that's necessary, including responsible price increases where warranted.

What is the price hike for May 1 going to be?

Up to 4% on the Lennox brand of residential and commercial equipment.

And when was the last price hike put through?

It was in the -- well, on the Lennox brand, it was in the latter part of last year, and earlier this year we initiated price increases on some of our other brands of Heating and Cooling equipment.

Okay.

On the unit volumes in residential HVAC this quarter, given that you said you had 20% ASP or mix benefits, so is it right that your unit volumes were only up 1%?

When you take a look at mix and price, given that on the cooling side we're dealing with an entirely new range of products, there is some blending of what is mix and what is price.

We are seeing that our unit volumes across the board for residential are up in the mid- to high-single digits.

To get a better understanding for it, it's probably important to look closer at the data.

If you look at for instance compressor bearing units, which would include air conditioners, heat pumps and residential package units, we are up about 6% there, gas furnaces are up mid-single digits, about 5%.

And then we are up much stronger on coils and air handlers, well in excess of 20% for those two.

Okay, the revenue growth was 22%, and I thought Sue said the mix and price benefit was a 20% benefit.

I'm not sure we did say that.

Did I hear that wrong?

Okay.

Our price curve was, again, difficult to say, but would be in the mid-single digits, probably 3 or 4% would be price, high-single digits would be unit shipments, and then the balance would be in the neighborhood of 10% would be mix related.

Okay, so 10% on mix, okay.

Yes, approximately.

What we said, Curt, was that our blended average selling price for air conditioners and heat pumps increased 20%.

We did say that.

You have to keep in mind, that that's for air conditioners and heat pumps only; the residential segment includes many other things.

Okay.

On the Commercial segment, you mentioned that the order backlog was much stronger year-over-year.

Can you tell us what the backlog growth was?

The piece that we were referring to was actually our European operations, and so if we look at the order backlog and sort of the year to date orders, we would say that they were up about 20% on a year-over-year basis, but that is Europe.

How does the backlog look in the U.S.?

(indiscernible)

The backlog looks substantial, I guess is the way to put it.

It's pretty much on par with what we've seen over the past several quarters.

The commercial side of the operations are doing quite well.

Okay.

And lastly on Service Experts -- on the margin outlook for the remainder of the year, you mentioned higher fuel costs, some personnel and added infrastructure this quarter.

Is there anything that would alter your thinking in terms of the structural opportunity there, and where you think you are going to get maybe relative to where you were starting the year?

I don't quite understand your use of the word structural opportunity.

Well, fuel seems like it's going to be sustained at a high level.

You're going to continue to make maybe more personnel costs.

So the question is, is the cost structure maybe different from where you thought entering the year, or maybe how analyst communities should think about modeling it for the remainder of the year?

I think first of all, the month of January in particular was really a difficult month I think for everybody in the industry where you would normally have a fair amount of furnace, work done, maintenance work, repair calls, for example.

Because of the unseasonably warm weather, it really was not a very good month from the standpoint of throughput.

That said, when you look at the fuel cost side of the business, naturally everybody on the contracting side of the business, that is a concern.

And we're reflecting that appropriately with respect to what we do in pricing and so forth.

I think that's also -- it's good to note that what we have seen in that business since the month of January has been a good, steady improvement in terms of topline and things looking like they ought to look in terms of a plan without any kind of real structural disconnect I guess as you would call it, kind of what we need to do to go ahead and [call it].

So we feel good about that thing going forward, but we do readily admit that January was a difficult month if you were in that particular business because the phone did not ring hear as much as it would normally.

Okay, great.

Thank you very much.

Jeff Hammond, KeyBanc Capital Markets.

I wanted to follow up on the I guess commodity cost issue.

Can you give us a sense of what percentage of your purchase requirements in '06 are currently hedged for copper and aluminum?

Jeff, it's Sue.

For the remainder of the year as we look out, we have about 70% of our copper hedged for the remainder of 2006 and a little over 80% of our aluminum hedged.

Okay, great.

And then, can you give us a sense of what price-wise versus your -- I mean, did price cover your incremental commodity headwind this quarter?

And I guess given your hedging experience, where you think commodities come out and your price expectations, what do you expect going forward?

I think as we look at 2005, it was probably a little easier to talk about the fact that price did cover the headwind on commodity cost.

I think that is a little bit less clear in the first quarter for us.

I would believe that it's probably close, but again, as you look at the hedging activity, because we are not eligible for hedge exempting if you will, there are some gains that occur from mark-to-market in Q1.

So that is a tough issue, but I would think it was close.

Just to add to Sue's comments, Jeff, you asked about looking out for the rest of the year.

Bob mentioned, we do have another round of price increases on our (indiscernible) coming in May.

I believe you have seen that the industry, major players, have raised prices and our guidance has been reaffirmed.

So all that rolled together, our expectations are that we are going to continue to manage escalations in raw material prices.

Okay, great.

And then of the 9 million settled contracts, I think in the last press release, you called out by segment where each of those sales fell so we could see kind of on an operating basis or the way you used to report it, what the profitability would have been.

Can you provide that?

I can help you with that a little.

And as we look back to 2005, just by way of explanation, Jeff, we had the $16.7 million that we re-classed out of cost of goods sold down to other gains and losses, which was the realized gains.

And we provided very specifically on that because it was a re-class entry as we did the restatement.

For 2006, because we're not eligible for hedge accounting, that does not get booked that way.

Having said that, though, let me help you a little bit with where that belongs.

About a little north of 80%, somewhere between 83 and 85% of the $9 million of realized gain belongs Worldwide Heating and Cooling, and then the Refrigeration is the other piece of that.

So 17-ish type percent.

Okay, perfect.

You mentioned the 86% of the Lennox brand being 13 SEER.

Can you give us a sense of the non-Lennox brand experience on that same --?

Yes.

Jeff, that's correct.

And actually, the 86% is a blended number and the Lennox brand was a touch under that and the other brands were a touch over that.

And then, can you give us a sense of where you think -- what your comfort level is with your inventories?

Looked like a little more than normal seasonal buildup.

And then, your look into the channel, I guess particularly with your non-company-owned distribution channel.

And maybe just give us a sense of how much 10 SEER you see left in the channel, or 10 and 12 SEER?

(technical difficulty) what else has been said in the industry, Jeff.

I hope you understand that I have to preface this with the fact that this is my opinion after looking at a lot of information.

That caveat out there in the open.

What I honestly believe that we've seen, first of all, there is some difference of opinion I think or speculation on how much product might be out there that is abnormal, talking about the overall system.

I'll get to our inventory in a moment.

We think that it's likely that there is some number for air conditioners and heat pumps that's several hundred thousand units more than what you would normally have seen.

We have seen a disconnect and we've done quite a bit of research on this between the amount of product that has crossed the boundary to the consumer versus the amount product that has come a couple of links in the chain upstream and gone into the distributor level.

Again, all of these numbers have been moved all around, and I will stand by that.

The other thing that we have seen is that, and I think this is understandable when you step back and look at what has happened with this whole NACA change, is that the more -- a greater than average percentage of the product has gone into residential and new construction.

Certainly when you consider the relative strength on new construction, of course that picture is muddy both on what is happening at the macro level, as well as the fact that we had pretty good starts because of the warm weather that we had in areas that otherwise might not have had started until like January or February.

That aside, there was product, an abnormally large amount of product that went into the residential new construction sector.

If you look at our inventories, first of all, our working capital ratios are down lower than they have ever been before, so there is no inventory issue per se.

But, there is a little change in terms of where inventory is at the moment.

We are holding and shipping some of the last product for residential new construction customers at their request so we have a little bit more of that than we normally would have.

That's probably another month type issue and my guess is it's probably pretty well gone.

And then also there's another smaller (indiscernible) of additional inventory over what we would had a year ago in the area of our commercial business because of an initiative we have to change the distribution strategy a bit on the commercial side, making for what we call a two-minute market -- more product readily available, more products in the Company, which is working well for us.

So those two things are out there.

But again, in terms of overall inventory, if the question might be, is there a lot of 10 SEER in the product that we're concerned about.

The answer to that would be an emphatic no.

Great.

Then just a final question.

As you look at your revenue guidance, I think you stuck with the mid-single-digit growth.

Looks like this quarter, you were well above that.

I understand kind of the year-on-year comparisons, but as I look at price increases to come, the mix shift that you're seeing from 13 SEER, it would appear to me that that revenue target would look somewhat conservative at this point.

I guess second question is -- I think you originally really all of the segments you were looking for about mid-single-digit growth.

Has there been any change within the segments where you think maybe growth is a little bit above or below that?

I don't think we would change our guess in terms of the kind of growth we're going to see by segment because, again, going back to my comment of a moment ago, we do believe that there are some issues that are potentially lined up against people that are in the residential side of the business.

The combination of I what I do really believe is a slight surplus of product in the overall pipeline.

Second thing of course is the fact that as part of the year-over-year comparison, we've pretty good headwind in the industry because of the hot weather that we had before.

You look at the issues with respect to the -- or the uncertainty around raw material cost as we go throughout the year and in terms of the industry's ability to go ahead and continually recover those through pricing action, and it just looks to us that there's enough things that are out there that are floating around a bit that -- as is our cost on (indiscernible), we need to stay on pretty solid ground.

And we certainly as we move through the year, if we do see that some of these things resolve themselves favorably or whatever, we'll be the first to go ahead and tell folks about that.

Jeff, I will just add one additional piece of color on the segment revenue guidance, and that's mid-single-digits of course is a range.

Bob mentioned that we had a slow start to the year on Service Expert that was weather-related, and so Service Experts potentially might be at the lower end of that range that we gave and the equipment businesses might be mid point, a touch higher.

Okay that is helpful.

Thank you.

(Operator Instructions).

David Mills, JDM Capital Markets.

Good morning.

I'm a customer as well as an investor, and last summer the air-conditioning services in my area where you stopped taking new customers because you were out of capacity, and I'm wondering whether this is a problem elsewhere in the country and if anything is being done about it?

First of all, I would have to understand more of the specifics.

Let me just give you a general answer, what happened in terms of flow throughout the industry.

There was definitely in last year as we moved through the third, fourth quarter and to a certain extent continuing this year, issues for everyone with the attainment of several key components.

Compressors would be one.

The other would be [TVXs], or expansive valves that are used predominantly in the high-efficiency product.

Had a major supplier of that, that decided at an inconvenient moment to move all of their operations to Mexico, and of course that created real havoc in the source of supply for everyone.

So I think that as a general industry comment, everybody struggled with trying to produce the product that was required.

We certainly feel like these situations are very much under control of this point in time.

And really when you think about it, this is been an unprecedented change for this industry.

I've been industry for 40 years and I just cannot recall anything like that.

And there's always speculation, and as I indicated, I think there is a fair amount of speculative build that was done overall throughout the industry.

There was just heavy, heavy requirement placed on key components suppliers who for the most part, not every in case, but for the most part, are really reliable and this was the kind of an increase that I think that just took everybody a little bit flat-footed.

Thanks.

We have no further questions, so Mr. Schjerven, I will turn it back to you for closing remarks.

Well Lennox International had strong financial results in the first quarter and we do feel like it gave us a good launch for the year.

We are reaffirming our earnings-per-share guidance of $2 to $2.10 for the full year of 2006.

We are definitely focused on realizing the price increases, cost reductions and productivity improvements that are necessary to offset material cost inflation in the manufacturing businesses.

Despite a slow start at Service Experts, this unit remains on the right track for continued improvement.

Thank you for taking the time to be with us today.

Thank you, 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.