Lennox International Inc (LII) 2006 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by.

Welcome to the Lennox International Second Quarter 2006 Earnings Conference Call.

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

Later there will be a question and answer session at the end of the presentation.

As a reminder, this call is being recorded.

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

Please go ahead.

Thank you, Beverly.

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

A link to the live webcast of this call can be found on our corporate website at www.lennoninternational.com.

We will archive this call on our website and it will be available for replay.

In a moment, Bob Schjerven our Chief Executive Officer will comment on our Company's progress and performance in Q2, and Sue Carter our Chief Financial Officer will review key income statement and balance sheet items, as well as address business segment operating performance.

We'll wrap the calls we usually do with the Q&A session.

In the earnings release we issued this morning which you will find posted on our website, we have included several tables providing financial detail and reconciliation to the GAAP measures, for the metrics 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 a better understanding of our operation, 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 publicly 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 NAECA efficiency standards.

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

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

Good morning.

Q2 was a record for Lennox International with the highest sales, the highest net income, and the highest earnings per share we have ever achieved in the second quarter.

Favorable cooling season weather supported our residential businesses, and demand in our commercial equipment end markets continues to improve both here and also abroad.

Our transition to 13 SEER was exceptional.

Our new lines of 13 and higher SEER cooling equipment have been well received and we were well-positioned to meet our customers demands.

The higher price points on these products favorably impacted our mix.

Price increases, and the futures contracts we had in place, allowed us to cover rising commodities costs in the quarter.

While we are seeing the softening in the residential new construction market, we continue to make in loads into that segment with the addition of new accounts.

Of greater significance, is that our larger and more profitable replacement business is offsetting the downturn, and we are confident in our ability to do so will continue.

We continue to invest in our core businesses to position us for continued growth.

We broke ground on a new distribution and administrative facilities in South Carolina in the second quarter, to accommodate the consolidation of our Allied Air operations, and in Arkansas we began a much needed expansion at our commercial heating and cooling factory.

Our North American commercial heating and cooling sales have increased by 60% in the past three years, and this expansion provides the capacity to support our expected continued growth.

Service Experts had a solid quarter, achieving a 3% increase in segment profit on 6% increase in sales, again benefiting from a good start to the cooling season.

Our customer satisfaction program that measures service center performance and gives our Service Experts standards of excellence, is reinforcing nicely the progress that we're making.

Our biggest immediate challenge in this business, is to capture rapidly inflating costs in everything from equipment, to parts and supplies, to fuel, into our pricing structures in a timely manner.

Recapping our second quarter results, our consolidated revenue increased 15% to a record $1 billion.

The first time we have hit this milestone in a quarter.

Our operating income from continuing operations grew 29% to $90 million, and our net income was 64 million or $0.85 per diluted share.

It was our most profitable quarter ever.

This performance compares very favorably with the $41 million in net income, or $0.59 earnings per share in the prior year's second quarter.

Adjusting for realized gains on open futures contracts, restructuring charges and the benefit from tax planning items, our income from continuing operations was $54 million or $0.72 per diluted share, compared with $39 million or $0.56 per diluted share in the second quarter of 2005.

Sue Carter will provide you with additional detail on each of these adjustments.

We have had a very solid first half of 2006, and we are reaffirming our guidance [of] full year diluted earnings per share in the range of $2.00 to $2.10.

This range assumes gains, and other positive non-operating items during the year, offset restructuring charges for the consolidation of residential heating and cooling ops into South Carolina.

Also, based on our performance in the first half, we now expect revenue growth of approximately 10% in each of our equipment businesses, compared with the expectation of mid single digits earlier.

Our expectation for top line growth at Service Experts remains mid-single digits.

Continued escalation in commodities prices represent a significant risk to our guidance.

Notably, steel prices have recently increased to levels approximately 20% higher than our expectations earlier in the year.

To deal with these higher prices, and as our futures contracts on copper and aluminum roll off, we have already announced additional prices increases on all of our heating and cooling brands, with the effective dates in the July to August timeframe.

We expect to benefit from this round of price increases, will however lag the escalation in costs with the full benefit not being realized until the end of the fourth quarter.

Sue Carter will now give you a closer look at our second quarter numbers.

Sue?

Thank you, Bob.

Good morning.

Let me provide you with some additional commentary on a few line items in our consolidated company results, before I review our business segment performance.

Our results reflects market prices for commodities and costs of goods sold and futures contracts related gains on recorded in the gains, losses and other expenses line items.

In the second quarter we reported a pretax gain of $27 million related to commodities futures contracts.

This amount includes $23 million in pretax gains on futures contracts for copper and aluminum that settled in the second quarter.

Material related to these contracts was also received in the quarter.

This amount represents the gains since the inception of the contract.

Again, this gain was offset in the segment profit of our equipment businesses where the costs of good sold reflects market prices for the related commodities.

The remaining $4 million of pretax gains represents net unrealized gains on open futures contracts that were mark to market offset by the gain on settled contracts that had been recorded in higher periods.

At June 30th, approximately 60% of our projected back half copper requirements were hedged as were about 65% of our projected aluminum needs.

As you know, futures contracts for steel are not available.

LLI elected not to initiate new hedge contracts in the second quarter in the current commodity price environment.

In the second quarter we incurred pretax restructuring charges of $2 million, relating to the consolidation of our Armstrong and Ducane operations of residential equipment into South Carolina, including the closure of our facility in Bellevue, Ohio.

This project is progressing as planned.

We also recorded $9 million in a one-time net tax benefit from revaluation of a deferred tax asset allowance.

As we've indicated in our guidance this year, we expect positive items like this to offset previously announced restructuring charges in 2006.

Our total debt at June 30th, was $136 million, down from $275 million at the same time a year ago.

Our debt to total capital ratio was 14%, down dramatically from the 35% we recorded a year ago.

Our balance sheet remains very strong.

Cash from operations was $14 million and the company invested $17 million in capital expenditures resulting in a free cash outflow of $3 million for the quarter.

This was in line with our expectations.

As you're probably aware due to the seasonal nature of our business it is 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 costs for warehousing in South Carolina as part of the consolidation program, the expansion of our domestic commercial heating and cooling factory and IT investments.

In the second quarter we aggressively pursued our stock buyback program, using $46 million to repurchase 1.5 million shares of LII stock.

The remaining authorization on a stock repurchase program is 7.9 million shares.

Our inventory at the end of the second quarter was up $91 million year-over-year.

This increase was driven in part by planned buffer inventory to accommodate our consolidation projects, higher levels of commercial heating and cooling inventory at regional distribution centers could better position us for growth in the replacement market, as well as higher average unit costs due to the 13 SEER transition.

Despite this increase in inventory, our operational working capital ratio as a percent of trailing 12-month sales, was at an all time low at 16.1% and substantially below the 18.5% level a year ago.

Corporate and other expenses were $2 million lower in the quarter due in part to one-time benefit form a new lease arrangement on our corporate headquarters facility and lower legal fees.

And finally, benefiting from a lower debt balance and interest earned, our total interest expense of $2 million in the second quarter was down $3 million from the prior year.

As our review on business segment performance in the second quarter, keep in mind that cost of goods sold reflects market prices for commodities, and that the benefit from the futures contracts we had in place, is recorded as a gain below the segment profit line.

Of this gain, which totaled $23 million approximately 61% is attributable to settled contracts in our residential heating and cooling segment, 23% traces the commercial heating and cooling, and the remaining 16% is from futures contracts that settle in the quarter in our refrigeration segment.

Revenue in our residential heating and cooling business increased 24% to $539 million.

Adjusted for foreign exchange, sales were up 23%.

Segment profit of $52.4 million went down from $55.7 million last year.

Higher volume and expenses and improved pricing were offset by higher input costs, as well as a $6 million revision of the warranty reserve calculation to reflect a 15-year warranty on certain heating products produced in the 1994 to 1999 time period.

Our business in the second quarter reflected a post-13 SEER transition environment with 13 and higher SEER efficiency products, accounting for 98% of cooling equipment sales.

Component shortages continued in the second quarter and more manageable and need to continuously adjust those schedules to maintain customer service levels negatively factory efficiency.

With all of the focus on 13 SEER in the past few quarters, I would also like to acknowledge that our hearth product unit is operating very well gaining share in the factory built fireplace market.

This business which accounts for roughly 10% of our residential heating and cooling segment revenue has been improving steadily and in the second quarter achieved over 10% contribution margins to segment profit.

Our commercial heating and cooling sales increased 6% in the second quarter or 5% adjusted for foreign exchange to $181 million driven by growth in North America.

We have added 19 new national accounts so far this year and have also increased sales in the replacement market to our regional distribution centers.

Segment profit was $14.1 million, down from 14.7 million last year with higher commodity costs and higher freight costs offsetting volume and price improvements.

Despite a decline in sales in Europe profitability in this region improved driven by product mix benefits.

We did enter the second quarter with a strong order backlog in Europe but many of these orders are for delivering in the back half of the year giving us some optimism for this business as we look out to the remainder the year.

Service Expert sales were up 6% or 4% when adjusted for currency fluctuations to $178 million.

Service Experts had a segment profit of $9.5 million, up 3% from the prior year.

Higher volumes and vendor rebate offset more margins and higher advertising and promotion charges.

We also had to contend with approximately $500,000 -- $500 million in higher fuel costs in the quarter.

We had a beneficial mix shift with 79% of revenue in the quarter coming from service and replacement markets with the remaining 21% from new construction, but as Bob mentioned earlier in the call, the frequency and the magnitude of vendor price increases are making it challenging to completely pass these price increases on in a timely manner, and for those of you listening that was $500,000 in fuel costs.

And in a number of cases in Service Experts where we've had general manager turnover we have elected to consolidate the U.S.

Service Centers.

As a result, our service center count now stands at 122 down from 130 at the start of the year.

In our refrigeration segment revenue rose 11%.

Foreign exchange did not meaningfully impact sales growth.

Our domestic business performed well in the quarter, with strong sales increases to supermarket, OEM, and cold storage customers.

Segment profit rose from $9.5 million last year to $10.6 million driven by higher volumes in our domestic and Europe markets.

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

Thank you, ladies and gentlemen.

[OPERATOR INSTRUCTIONS]

Our first question comes from Curt Woodworth from JP Morgan.

Please go ahead.

Yes.

Hi, good morning.

Good morning, Curt.

Can you provide some more details around the performance of the residential [HVAC] business this quarter?

What was the mix impact for the top line?

What was the volume growth?

Well if you look at the heating and cooling side of the business in residential 1% was volume but 4% was price and we deem maybe about 19% was mix.

Great.

And then if you were to include the [61%] of the settlements on the hedging gains, and back out the warranty costs what do you view as kind of a clean or go forward operating margin for this quarter for the residential segment?

That's a good question.

I tell you one thing.

The reconciliation around the very good time of rapidly escalating commodities was really sort of a messy thing.

I think the last time we talked we talked about the amount of gains that we had in the -- sort of shoot a percentage for each one of the businesses.

As I recall it was like 80% for the HVAC side of the business.

So would the right math just to take 61% of the 23 million realize gain, and add that to property income for the segment?

Yes.

Is that right, okay.

If you did that math, you'd be somewhere in the 11.5 to 12% range, Curt.

We don't do the math that way, but if you did that's what you'd come up with.

And in terms of the new 13 SEER product line the margins on that relative to maybe your average mix last year, are you seeing much higher margins on that mix?

Can you talk about that?

Well we are seeing higher margins, but I don't know if we're going to be real specific.

See the total is up like 28%, something like that.

Yes.

The average price point Curt, for the cooling equipment that was impacted by 13 SEER was up 28%.

The percentage margins were holding or up modestly on most of the lines so far this year.

Okay.

And last question if I may.

Bob, you talked about the fact that the commodity costs are going to go up more than you can offset on price next quarter.

Can you get us into the magnitude of that impact?

Not really, but if you look at what's happened steel is going up some 20% [in] round numbers is moving in the second half compared to the first half.

That's significant, and then that number is something just under $20 million for the half.

And then of course, you look at cooper and aluminum, again as we get more towards the back half of the year we have more of the benefit of the economic hedges that were in place begin to level off.

And I think the last time, the last quarter we had maybe like about 75% from that.

The last three quarters are positive now.

We're at about 58% something like that.

So you can sort of see from that the degree [to which] as things roll off as we continue through the year.

Okay, thank you.

Thank you.

Thank you.

[OPERATOR INSTRUCTIONS]

We'll go to the line of Jeff Hammond from KeyBanc Capital Markets.

Please go ahead.

Hi, good morning.

Good morning, Jeff.

Just wanted to understand the guidance a little bit better.

I mean it looks like you kept your earnings guidance and you've ramped your top line growth by about five points in three of the four businesses.

I mean what's going the other way with the stronger top line to kind of keep you at the same range of earnings guidance?

That's a very fair question.

I think when looked at what we said.

Again, when you look at the total revenue guidance for the year, we have to also put in the balance the fact that in the first half sales were up about 15% -- that's increase; mention the fact that the steel prices are going to be up from 20% -- or are up from 20%.

You look at cooper and aluminum, the fact that some of the [color] that we've had is result of economic [inaudible] -- a piece of that has continued to roll off in the second half, and certainly fuel prices and the costs of freight continue to be a headwind for us.

And then also, when we gave the last guidance we weren't expecting to incur about $6 million in the additional warranty expense from reserve, which by itself equated to about $0.05 impact on earnings per share.

So in the interest of being real, and being conservative and I think everybody in the industry has talked a little bit to the outlook for the second half [and] we have some question marks associated with it -- with pieces of it anyway.

We feel that our guidance is solid, and it's the prudent thing for us to do.

And I think, initially you were thinking for the market residential units would be down kind of mid-single digits for the year.

How are you thinking about that number, as you look at the first half, and visibility into the second half?

That's a good question, and certainly other people that -- I mean if you're looking at this as well as weighed in.

And so far the range seems to be somewhere between about 8 and 15% in units.

I guess we wouldn't take issue with that.

We'd probably take the downturn at just maybe a tad stronger in that, than what we might have said, let's say at the end of the first quarter and the middle of the first quarter, something like that.

So I guess, we're pretty much going with the pack.

Certainly the combined effect of higher ticket prices for consumers as well as what's happening in the housing market are two issues.

I think that still an issue out there is the amount of product that may still be in various parts of the distribution pipeline from the manufacturer to the end consumer, although we certainly think that a lot of that is washing out.

So a combination of all those things, and I think I'd probably stand in line with my peers and tell you it's somewhere in that neighborhood of 8% up to 15%.

Can you give us a sense of where inventories are both -- on a unit basis what you're seeing and then at the -- obviously you hold more of it in your company-owned distribution, but at the non-company-owned piece and maybe where that was relative to where you thought it'd be at the midpoint this year?

Well, everybody speculates in this and I think we talked to this the last couple of quarters because it's certainly relevant.

When you look at what we see in the two-step market going to distributors versus what we see in one-step, we certainly see the end demand at the consumer side being reasonably flat, reasonably solid.

But we do see evidence of the fact that, at least with some distributors, that their inventory levels are a little bit higher than what probably we'd normally see and so they're being a little bit cautious in reordering.

So you compare that to previous quarter, and I guess I would stand by my previous comment and I think that some of that has rolled up, but there's certainly still some of that [inaudible].

As far as our company is concerned, about the only inventory that you would have seen in the residential side that we've got that's of note, would be the additional inventory that we put in place to manage through the consolidation and moving of operations that we had talked about on the Allied Enterprise side.

Okay.

And then on the component shortage issue, is there any way to quantify how big of an impact that was on profitability in the quarter?

And then also, could you comment on is that issue still a major problem, is it getting better, is it fully resolved?

The problem is not fully resolved.

There may be -- there has been perhaps some improvement on the pump side, but the problem is still very much with us as an industry.

We've not done a calculation, to be frank about it, with respect to what it's cost us in terms of shipments of profitability.

And again, that's sort of in a speculative side, that's sort of in the would-have, could-have category and we don't do much of that because it's not very profitable actually.

But certainly it's been noticeable and we've incurred not only product that we and I'm sure others couldn't ship, but also it requires people to manage their factories in a different way with changes that are unexpected and so forth.

And that of course incurs a little additional operating variance at the factory level.

Okay.

And then finally moving to Service Experts, can you just give us a sense of where profitability is coming in year to date, where you thought it -- versus where you thought it would be?

And then to the inflationary issues, I mean what's the confidence level that you can indeed pass those through in a timely manner?

Well, let's see.

First of all, if you look at over this year, Service Experts did, like other people at the contractor level, saw the warm winter weather which occurred in the first quarter that got everybody at the contractor level, not just ourselves, but others off to somewhat of a slow start for the year.

We certainly are satisfied that Service Experts in a range for the internal plan that we've got and they're doing very nicely with the increased volume that we're seeing that the hot weather has brought.

That said, the last comment that you made about the ability to capture pricing, that certainly has been an issue because you've got a couple of things.

First of all, you've got the highly distributed operation that has pricing databases, if you will, that folks are using to do their pricing with, a lot of which is flat rate type pricing.

And it takes some effort to go ahead and in a timely manner move all of the changes and increases when they start coming at a fairly fast pace down into that environment.

The second thing is I think we appreciate the fact that we've talked about this marketplace being populated by, pick a number between 30 and 40,000-plus people, the degree of sophistication in systems and personnel and so forth throughout that whole marketplace is such that sometimes awareness around margin preservation and so fourth is perhaps not as sharp as it should be.

So at different times and places you wind up with [inaudible] competitive situations as [cross move] and the prices perhaps don't move as rapidly as they ought to be moving.

So that's a long way around of saying we're getting there but it's not getting there as fast as I know our folks in Service Experts would like to do.

Okay, thanks.

I'll get back --

Again, that's a pace issue, that's not a -- the prices will get where the prices need to be obviously, but it is a pace issue.

Thanks.

I'll get back in queue.

Fine, thanks.

Thank you.

We'll go to the line of Michael Coleman with Sterne Agee.

Please go ahead.

Thank you and congratulations on your $1 billion quarter mark.

Thank you, Mike.

Did I hear you right, Sue, that you chose to not to initiate new contracts in the current environment?

That is correct.

Okay, so if copper comes down you stand to benefit, and if it's flat then you would have paid that anyway essentially?

Yes, essentially.

Okay, that's good.

The commercial in terms of the new accounts, can you talk about any of the names of those accounts or to maybe give an idea of the potential size?

Yes, we probably could, but we probably aren't going to.

Okay.

I'll just tell you they are certainly of size and importance, as the folks that we already are serving in that business.

And again, I'd emphasize the fact that we have had a very solid national accounts program for quite a few years and that's the reason that we enjoy probably about 35% market share amongst the national accounts domestically.

Michael, it's a broad list and it's names you would recognize very, very easily.

It includes retail, it includes food service, it includes big box and a marquee list of customers.

In general I know each of those contracts and so forth are negotiated individually, but do they have escalation clauses in them if perhaps -- if copper or what -- or how is that done?

Is it a fixed price for a period of time?

How are those contracts negotiated?

It's a good question.

Each one of course is individual and I think the provision that you'd see in contracts today vary a bit with respect to acknowledging what's going on with material prices.

If you go back in history, they did not have escalation clauses and generally were for about a year in length.

But all of us would agree we're clearly in different times and that calls for different kinds of agreements.

Okay.

Great, thank you.

Thank you.

Thanks, Michael.

Thank you.

We do have a follow-up from Jeff Hammond with Keybanc Capital Markets.

Please go ahead.

Hi.

Just a couple more follow-ups.

Any resolution to your hedging policy?

I thought at this point you were trying to work back to being able to use hedge accounting.

Any update there?

Sure, Jeff.

We have developed our models for going forward with hedge accounting, so that really isn't an issue.

And you can also, if you step back away from trying to marry the actual metals cost with the hedge, you can always hedge.

And you can do economic hedges, which would be reported the same way that we are right now.

So I think that -- I think that's something that you could do it if you wanted to and we just chose not to in the second quarter.

Okay.

Any -- are you -- there are a lot of concerns about new housing.

Are you seeing any impact from those concerns starting to leak through in your business and how would you characterize pricing in the new construction side relative to replacement?

A good question.

I guess one of the things that we see the offset to any anticipated softness has been additional accounts that we've added on that side.

So in terms of having a profound effect, there's nothing that has bubbled up to our level in terms of a warning flag at this point.

Not to say that there won't be some continued.

I'm sure that if you look at the business with existing customers on an individual customer basis, we probably would see in their forecasts a reflection of the kind of things that we're all seeing printed nationally with respect to the housing market.

As far as pricing is concerned, I honestly haven't heard of any kind of flags come up with respect to that.

So I guess the presumption would be that those contracts are going along as they have been.

Of course, a number of those have been [in force].

I guess I'm speaking to as far as new -- signing up new contracts.

I mean are people staying rational given that the expectation that the housing does come in?

To this point I would say yes.

Okay.

And then your refrigeration has had a couple quarters here of acceleration at top line, some nice margin improvement.

I know you made a management change a little while back.

Could you just help me with what's driving that business?

Is it market share gains, are you seeing some renewed investment in certain pockets of the market and that does not seem like a market that is seeing a whole lot of new investment, but obviously you're coming in with good results.

I just want to understand that better.

Well, it's a combination of a couple of things.

Certainly in food storage side we've seen good activity and certainly people like Wal-Mart on the supermarket side continue to prosper and do nicely.

But I will tell you that we continue to be really proud of what we've done on the refrigeration side with respect to -- two things in particular come to mind immediately and one is the continued focus on the customer relationships.

That's a business unit that has historically done very, very well with that and continues to drive new and better ways to stay really close to their customers to be sure that what they've -- they get what they want.

Certainly the improvements in lean manufacturing that we've seen in that unit have really set the pace, I think, for everyone in the industry and that affords flexibility and other benefits to the customer as well.

The other thing is that they continue the advancement on the technology side with the constant introduction of new products as they go along and certainly some of that has been responsible this year.

So it's a combination of doing a lot of things right, a group of really well practiced and very professional mangers that run this part of the business, and so it doesn't come as a surprise.

And I think you can count on them in the future to continue to be at the front, both in terms of market share as well as leading the industry in technology.

So we've been very pleased with what we've seen.

And I guess final question, obviously you're more active on your share repurchase this quarter.

Can you just talk about how you're thinking about that maybe differently or the same given how the stock's moved over the past few months?

Well, certainly we wouldn't go out and project what we're going to do on that since we are doing an open market purchase program.

But it's our expectation that we'll continue to do that.

And you're right, our activity level was up in the second quarter and that's all we can really say about that.

Okay.

Thanks, guys.

Good.

Thanks, Jeff.

Thank you, Jeff.

And with that I'll turn it back over to Mr. Bob Schjerven for any closing comments.

Well, Lennox International has performed well in the first half of 2006 with record sales and profit in the second quarter.

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

We are focused on realizing the price increases, cost reductions and productivity improvements that are necessary to offset the headwind we're seeing from rising input costs.

I want to thank you for taking the time to be with us this morning.

Bye-bye.

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

Thank you for your participation as well as for using AT&T's executive teleconference service.

You may now disconnect.