LENNOX INTERNATIONAL INC LII S
September 20, 2022 - 12:14am EST by
kismet
2022 2023
Price: 245.00 EPS 14.35 15.18
Shares Out. (in M): 36 P/E 17.1 16.1
Market Cap (in $M): 8,747 P/FCF 24 19.2
Net Debt (in $M): 1,631 EBIT 703 777
TEV (in $M): 10,377 TEV/EBIT 14.8 13.4
Borrow Cost: Available 0-15% cost

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Description

Residential HVAC replacement volumes and pricing are at levels last seen during the prior housing peak in 2005. System affordability is coming into question after 30-40% cost increases to the consumer in <2 years. The macro and housing outlook is awful and HVAC unit sales are highly correlated to existing and new home sales. Coupled with a pull-forward of demand over the last 2-3 years and a collapse in industry residential HVAC volumes over the coming 6-24 months appears inevitable. Lennox (LII) is the most exposed to the residential HVAC market and should suffer the most from these dynamics. The sell-side is still too bullish despite the storm clouds brewing. As negative earnings revisions start after the first surprise volume data point, the stocks will follow those earnings revisions downward. The recent 30%+ rebound from the June lows provides a second bite at the apple on the short side. Despite being down 30% from all-time highs, I see further downside from here of up to 40% with EPS hitting $9.25-9.50 (versus $15.18 2023E consensus today) in a bear case scenario (which is more bullish than the prior housing cycle decline).

Brief Company Background:

Lennox is one of the leading manufacturers of HVAC and refrigeration equipment in North America. The market is dominated by 5-6 players that comprise ~80%+ of total volume. Lennox operates under three business units:

 

Residential HVAC (70% revenue, 80% EBIT): 90%+ US/10% Canada. Company owned distribution (~250 stores) is 75-80% of sales (Lennox brand) with 20-25% through third party distributors (Allied brand). Replacement demand is 80% and new construction (newco) is 20%. 

 

Commercial HVAC (20% revenue, 10% EBIT): Light commercial (retail, restaurants, schools, office buildings). 90%+ US, 10% Canada. Two separate businesses: Equipment (85%) with 50% of that from national accounts and Services (15%) which operates under the NAS (National Account Services) business with >100 centers to large national accounts.

 

Refrigeration: (10% revenue, 10% EBIT): Chiller, coolers, and European light commercial HVAC. 60% US/40%  Europe, 75% refrigeration, 25% HVAC. Food and industrial end markets.

 

Why Short LII vs TT, CARR, JCI:

  • LII has the highest percentage of total revenue and profit from North American residential HVAC (see above 70% revenue, 80% EBIT) of the public players and I expect the residential HVAC end market to see the largest decline in volumes (see below) from the recent peak.
  • CARR (largest NA resi share) only has ~20-25% of total revenue tied to resi HVAC, Daikin (Goodman) has the next largest share but has significant amount of non-HVAC and international revenue, TT has similar resi revenue mix as CARR (20-25%), Rheem is private, and JCI has an immaterial portion of total revenue to resi HVAC (more commercial and alot of international other revenue).
  • LII has the smallest market cap of the group with the highest leverage (2.4x) so should theoretically have the most beta and see the most downside in an industry decline.

Volumes at Peak and Going Lower (Potentially Much Lower):

Residential HVAC replacement volume comprises 80-85% of total industry units in any given year and generally trends in-line with the growth in the installed base (~100m units). However, like any industry with secular growth, there are cyclical waves in that secular growth and the industry is not immune to downturns. I believe the residential HVAC cycle is in the midst of a blow-off peak in a 10+ year bull cycle and set to go into a 12-24 month downturn before the cycle is reset. Note that this is a cycle short, not a secular short. Lennox and the HVAC OEM’s are considered above average industrial businesses in a secular growing end-market with industry pricing discipline and normally recession proof characteristics given the large and growing installed base and consistent replacement and repair demand from that installed base.

 

Since 2H20, the industry has been growing unit shipments well above the growth in the installed base and is currently 25% above trend, the highest since 2005 when the prior housing cycle peaked. The current replacement rate is near 9% implying an average life of just ~11 years for the installed base. Most OEMs and analysts estimate the average life to be 15-16 years. That is inline with the long-term average replacement rate of ~6.5%. Just to get back to normal trend implies a -20% decline in replacement units as consumers opt to repair over replace.

 

 

Reasons for the recent above trend replacement growth:

  • WFH/COVID - Working from home caused HVAC systems to be overworked and stressed relative to the past when workers were in the office stressing commercial systems. That stress caused an increase in potential resi replacement units.
  • Consumer Liquidity - Free money from the government and higher savings rates from not traveling or enjoying oneself outside of the home gave consumers the liquidity to opt for a replacement unit rather than repair a unit. 
  • Wealth Effect Higher Home Prices - The increase in home prices (and stock market) resulted in consumers willing to spend more on their home. Coupled with low interest rates and cheap consumer financing, consumers opted to replace versus repair more often than in the past.
  • Existing Home Sales - Replacement rates tend to correlate highly with existing home sales. With migration and millennials moving into homes, existing home sales increased. When people move into a home they tend to upgrade older HVAC systems. More movement in the housing stock means more potential replacement.
  • Higher Prices - The spike in inflation, specifically central AC unit prices (+25-30% from the OEM in 12+ months, +30-40% including contractor price increases), caused a pull forward in demand with consumers afraid prices would continue to rise. They were more likely to opt for replacement today at a lower price than repair today and pay a higher replacement price in 1-3 years.
  • Prior Cycle Housing Cohort - The prior housing cycle peaked in 2005 and those homes’ HVAC systems were nearing the end of their life in 2020. The above conditions likely drove that large cohort of homes to replace their systems, accelerating what would have already been a peak in replacement demand.

I believe all of the above conditions have or about to come to an abrupt end and volumes are going to collapse in the next 12-24 months with 2022 being this cycle peak. Workers are being forced back to the office, personal savings rates are back to or below normal trends, consumer debt is rising, housing is crashing before our eyes with home prices declining (negative wealth effect), home sales are stalling and inventories are at multi-year highs, housing affordability is at the lowest level since the 2005/6 prior peak, interest rates are rising and consumer financing is becoming more expensive, HVAC system costs are 30-40% higher and the replace versus repair math no longer makes economic sense, price inelasticity for an essential service is being tested, and most of the 2005 cohort of systems have likely been replaced already. 

 

Total unit shipments per year is a function of replacements (and system additions), plus new construction, plus inventory changes. Over the next 6-24 months I expect replacement rates and implied life of the installed base to start to trend back to a more normalized level. In my base case I assume the implied life of the installed base goes to 14 years in 2024, implying a 7.1% replacement rate (from 11+ years and ~9%). 

 

Almost all new homes these days are built with central AC so NewCo unit shipments are highly correlated to housing completions. Completions trail housing starts and are a better proxy for HVAC unit shipments because HVAC systems are placed in service towards the end of a home being built. So far in 2022, housing starts are already close to 20% lower than the peak and I expect completions will start to follow. I assume a high-teens decline in NewCo units through 2024 back to 2019 levels given housing unaffordability.

 

It is widely expected that 2022 shipments will benefit from pre-buying of lower priced, lower efficiency units that currently dominate the market (35-40%+ of total unit sales). Those units are being phased out at the beginning of 2023 due to new SEER regulatory changes that will drive the cost of a low-efficiency unit higher by 7-10%+. Pre-buy of 5-10% happened in 2005 and 2014 and while the pre-buy is expected to be at the lower end due to geographic differences in the regulations, that pull-forward of distributor sell-in will cause a spike in 2022 shipments and a commensurate cliff in 2023/24E.

 

Putting it all together I see a ~15% base case decline in 2023/24 industry unit volume. While that may seem egregious based on recent history from a 10+ year bull cycle, it is important to put that into context of the last housing cycle peak. From peak to trough, units declined ~40% from 8.3m in 2005 to 4.9m in 2009/10. Lennox shipments declined -12%/-12%/-15% YoY in 2017/18/19.

While I dont expect a housing decline on par with 2005-09 given banks and consumers are in better shape and more people locked in low fixed rate mortgages, I do believe it is entirely within reason that we see a very deep housing decline and recession. In that scenario, a bear case decline of -25% is within the realm of possibility and would only require the implied life of the installed base to return to 15.5 years, its historical average, nothing heroic.

 

 

 

Despite all the macro signs pointing to a significant decline in resi HVAC volume, the street is not nearly bearish enough. Consensus estimates currently call for a brief decline in 2023 of ~5%, followed by a return to unit growth in 2024. It seems very unlikely that will be the case given the level of pull-forward in demand and the declining macro outlook in the housing market. I would be shocked if the downturn and turnaround happens that quickly given the excess in the HVAC and housing markets.

 

The Inflation Reduction Act (IRA) is one of the bull cases often cited for why LII will not see a significant drop in volumes (and a big reason for the recent share price rally). The IRA will give consumers up to $14k in rebates and credits for energy efficiency projects around the home. Specifically related to HVAC, there is up to $8k available for a new high efficiency system. However, those credits will generally only apply to high-efficiency ductless heat pump systems which cost ~2x the lowest efficiency central AC systems (~$24 vs 12k). The people willing to buy a system at that price are generally not price conscious and likely would have replaced rather than repaired anyways. The consumers that are about to be cash strapped from inflation, lower savings, and higher interest rates, likely won't opt for those systems. At $428m/yr and $8k max credit, that equates to just 54k units, or 0.5% of total units shipped in a year. Not nearly enough to blunt the impact of the cycle. 

 

Pricing Could Surprise to the Downside:

The HVAC equipment industry is known for its ability to consistently capture price every year given its oligopolistic structure. There has not been a meaningful price decline in 10+ years and it seems most investors believe that prices can only go up. That may be about to change and could catch investors completely offsides.

 

The industry may see a perfect storm of demand declining at the same time that supply chains are improving and prices are peaking (+30-40% in 12-18 months), resulting in a classic inventory glut that will force OEM’s to fight for market share with price. A decrease in commodity and component costs will be the fuel on the fire for those price declines as it will give the manufacturers the margin cover to go fight for share.

 

While inflation is rampant everywhere, the HVAC industry has done a good job at increasing prices and keeping margins. LII’s resi pricing should be up 20%+ cumulatively by the end of 2022 versus 2021 and its 2Q22 resi operating margins are down just 50bps from 2021 and +140bps from 2Q20. In 3Q18, LII’s Marshalltown, OH residential manufacturing plant was hit by a tornado, taking a significant amount of volume out of the market. That has likely played an industry specific factor in the recent price increases. Lennox has also publicly noted that they plan to recapture that market share, meaning a higher likelihood of a price war when industry volumes are not robust.

 

It should be noted that LII may fare better than the rest of the industry when it comes to pricing in a downturn given its captive distribution system (80% of resi sales) which should give it better insight into sell-through end demand (versus competitors with more distribution sales), but it won’t be enough to offset the war for market share in a rapidly declining volume environment.

 

Carryover pricing from 2021/2022 price increases should continue to keep YoY prices moving higher over the next few quarters until volumes collapse. The coming SEER regulations should drive +3-4% positive mix impact (35-40% of the market will shift to 7-10% higher priced units) but given the street is expecting 3.7% and 1.75% price increases in 2023/24, the risk for disappointment and downward revision remains high even with that positive mix impact. There are already some indications of inventory building with public company inventory to sales metrics nearing prior peak levels.

 

Reading the Tea Leaves from the New and Old CEO:

Lennox announced in July 2021 that its long-time CEO Todd Bluedorn would be stepping down after 15 years at the helm (started in April 2007). This announcement nearly top-ticked the stock price and does not seem to be by accident. Bluedorn had done a remarkable job as CEO, growing revenues, improving margins, and creating significant shareholder value (share price +8x despite starting in 2007, 18% TSR CAGR vs SPX 10.3%, industrials +11.9%). At the time of the succession announcement, he was under 60 years old and likely had a few more years in him if he believed the cycle had legs to it. He wanted to go out at the top and likely saw where the cycle was heading.

 

Alok Maskara (former CEO of LXFR and previously with Pentair) was appointed CEO effective May 2022. At the time and soon thereafter, shares of LII were at their lowest level since Covid, and lowest prior to that since 2018. It is surprising that he didn't buy any shares at that time to hit his ownership target - unless he thought there was more downside to come. In fact, at a recent conference, when asked why he joined the company, he all but admitted the industry was at peak and that the next 2-3 years were going to be challenging.

 

“And yes, the industry had gone through a boom, that significant. But this wasn't the only one, right? I also follow other industries, which is either could be water heaters, could be pool pumps and all of that. They are industries that have gone through that. So it was looked like I have -- clearly, you're getting into the peak. But I looked at it, I'm going to do this job for 10 to 12 years, right? This is not a 2- to 3-year job that I was looking at.

 

Actions and words by the former and current CEO speak volumes about the volume outlook for the industry, in my view, and it will be an uphill battle for a CEO in a new industry to combat the largest downcycle in 10-15 years. 

 

Valuation:

One could make the case LII is not overvalued based on current estimates (16x 23E EPS, inline with S&P and industrials index, 4x discount to TT and inline with CARR/JCI, below ~20x historical valuation and 30x peak), but the street is not pricing in the potential impact of a significant volume and/or pricing decline and the associated margin degradation from each. The market multiple has de-rated to a more appropriate level, but the earnings revisions will be the next shoe to drop. In my scenario analysis below, I assume that at some point in 2023/24, there will start to be negative earnings revisions as volumes start to decline. These are not point in time estimates but scenarios as to where the market may price a continued earnings degradation on a NTM basis over the next two years.

 

Base Case ($13.50 EPS, -11% vs 23E consensus): 

Residential volumes decline -15% (see volume discussion above) and price/mix holds +2% due to carryover pricing and SEER changes. Decremental margins are assumed to be 20% versus the 30% incrementals the company is targeting as I build in some efficiency and cost cuts (margins roughly flat with 2022). 

 

Commercial is widely expected to see relative strength compared to residential as commercial usage ramps up with people going back to work and LII improves margins from the all time lows in 2022. There is a belief that commercial strength will help to blunt the impact of a soft resi market, but with LII’s mix, that is highly unlikely.  I put base case commercial volumes flat under the assumption that if residential declines materially we are likely in a recession and commercial will decline, similar to the last housing cycle, but will be offset by the easy company specific comps from 2022. Margins should improve (assume +350bps) relative to the margin issues of 2022 depending on the success of the operational turnaround (had a wave of retirements, lack of labor, and higher labor costs to attract new less efficient workers).

 

Refrigeration assumes -5% volumes, -2% price, and -5% FX because I think Europe is going into a recession worse than the US in 2008/09 and 40% of revenue comes from Europe (which will be cutting energy usage, driving lower commercial replacement rates).

 

Bear Case ($9.25-9.50 EPS, -40% vs 23E consensus): 

In the bear case I see residential volumes -25% (vs prior cycle peak to trough of -40%), with -3% pricing, and 25% decremental margins as volumes collapse, bringing margins to just 2016-18 levels. Commercial volumes should also go lower (assume -5%, but could be worse) with pricing -2% and margins still improving +200bps from 2022. Clearly there could be more downside in commercial but this is meant to show the downside EPS revision if just residential falls off a cliff. Refrigeration I assume incremental downside from the base case assuming a prolonged European recession and a downturn in US refrigeration. 

 

Bull Case ($17.00, +13% vs consensus):

While unlikely given the macro situation and industry specific peak demand dynamics, there is a non-zero chance of a soft landing where the Fed stops hiking rates before breaking the economy, the consumer keeps spending, inflation moderates and/or declines leaving incremental purchasing power for the consumer, etc. In the bull case I still only think volumes are flat while pricing sees modest growth due to industry pricing discipline and mix shift from SEER regulation changes.  

 

Assigning a 40% probability to the base case, 40% to the bear case, and 20% to the bull case, the risk-adjusted FMV would be ~$200, or -18% from today. However, I expect the negative earnings revision cycle to drive the stock lower on a NTM valuation basis by 25-40% before the market starts to price in the bottom of the cycle with a higher multiple. There is 24% downside to just the June 2022 lows and EPS revisions have yet to start (2023E EPS has remained roughly unchanged for the last year at ~$15.18). If the bear case starts to materialize and a multi-year down cycle begins to become more likely, the market will put a lower multiple on lower earnings and higher leverage (and lower repurchases) and the stock could very well see $140ish (15x $9.25 of EPS). Unlike prior cycles when volumes decline and OEMs can sell down inventory, this time around they will likely need to rebuild some inventory, causing FCF to be less than EPS despite LII’s 100% conversion target. The pending decision on a new commercial plant may also drive FCF lower as the cycle turns.

 

At the point when downward earnings revision stop I will look to buy this stock for what should be a compounding secular grower with normally recession-proof demand characteristics (large installed base, replacement vs newco drives most demand, climate change and energy efficiency themes, etc).

 

 

 

Risks:

  • Volumes are more resilient due to a resilient consumer that still has equity in their home and excess savings. Or the Inflation Reduction Act effectively blunts the impact of the HVAC cycle.
  • Commercial volume is resilient and the operational turnaround yields the 19-21% margins targeted at the recent investor day.
  • Pricing is stickier than expected and margins are higher during a more modest volume decline due to the mix shift impact of the SEER regulatory changes and/or realized cost efficiencies.
  • LII gets bought. JCI was rumored to be interested in 2015/16. JCI does not have a residential presence so a deal would make industrial logic and JCI is ~4x as large as LII so could easily finance it (so is CARR and TT but unlikely that would pass regulatory review).
I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

A public HVAC OEM reports a YoY volume decline and/or industry data shows volumes starting to decline, leading to what should be a series of negative earnings revisions.

Pricing/margins start to erode.

Continued decline in housing prices.

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