Lennox International trades at a discount to private market value based on the Goodman Global (8.8x EBITDA and 15.1x EPS) and Trane (11.2x EBITDA and 19.0x EPS) transactions. Its balance sheet is nearly debt-free and the new CEO has brought better cost and capital allocation discipline. Recently, a large share buyback and increase in the dividend payout was initiated. Based on current trading prices, the stock sells for 7.1x and 12.5x 2008 EBITDA and EPS guidance.

 

On December 12^th, Lennox held an Analyst Day. Management discussed 2008 guidance and showed revenue and operating earnings targets for 2008-2010. The company’s goals consist of annual revenue growth of 5-7% and a 10% operating income margin (versus 7.4% in 2007). These numbers imply operating earnings growth of 18%, excluding the benefit of share buybacks flowing to the bottom line.

 

On July 25^th, Lennox announced a new $500 MM share repurchase plan. Based on the stock’s closing price on that day ($37.00), the share repurchase would represent over 20% of the outstanding shares. At the end of November, 32% of the program was completed. The target completion date is Q3 2008. Even after the buyback, leverage should only be in the 1.0x area.

Lennox is a global provider of climate control solutions, specifically heating, ventilation, air conditioning and refrigeration. Brand names include Lennox, Armstrong Air, Ducane, Bohn, Larkin, Advanced Distributor Products and Service Expects. The company’s residential and commercial heating and cooling market share is 16% and 5%, respectively. Geographic split: US (77%), Canada (9%) and International (14% - 2/3 Europe / 1/3 Asia-Pacific).

 

Residential Heating & Cooling (43% sales / 49% segment profit):

The company manufactures furnaces, air conditioners, heat pumps, packaged heating and cooling systems, replacement parts and related products for both the replacement (75%) and the new construction (25%) markets in the US and Canada. Similar to Carrier, Lennox maintains a broad line of products ranging from ultra premium to value brands. Additionally, Lennox sells hearth products (80% new construction), such as prefabricated gas, wood burning and electric fireplaces, free standing pellet and gas stoves, fireplace inserts, gas logs and accessories.  

 

*Note >20% of residential sales are premium 14 SEER and above products compared to 15-16% for the industry.

 

Commercial Heating & Cooling (23% sales / 27% segment profit):

The North American (70% sales) business sells unitary heating and cooling equipment (rooftop units and split system/air handler combinations) for light commercial applications. Product offerings are found in low-rise office buildings, restaurants, retail centers, movie theaters, churches and schools. 

 

The European (30% sales) business sells both unitary and larger applied systems. These products consist of small package units, rooftop units, chillers, air handlers and fan coils that serve medium-rise commercial buildings, shopping malls, other retail and entertainment buildings, industrial applications, etc.

 

*The commercial business split is 55% new construction and 45% replacement.

*Serves 11 of the top 25 national retailers (70% of retail space).

 

Service Experts (18% sales / 6% segment profit):

These dealer service centers (120 company-owned) provide installation, preventive maintenance, emergency repair and replacement of heating and cooling systems in metropolitan areas. This segment serves residential (80%) and light commercial customers (20%), primarily in the service and replacement market. The company’s market share in this business is 1.5%.

 

Refrigeration (15% sales / 18% segment profit):

The refrigeration segment is a truly global business (Americas - 45%, Europe - 20% and Asia-Pacific - 35%). The North American division produces condensing units, unit coolers, air-cooled condensers, fluid coolers, compressor racks and small chillers. These cold storage applications preserve food and other perishables for supermarkets, convenience stores, restaurants, refrigerated warehousing and distribution centers.

 

The international segment produces similar products with manufacturing locations in Europe, Australia, New Zealand, Brazil, China and Mexico (50% JV). The company also owns a 21.75% interest in a manufacturer in Thailand that produces compressors.

   

Distribution:

The key to this business is distribution. According to the major HVAC players, distribution is the key barrier to entry limiting foreign competition. Lennox’s products are sold through independent and company-owned dealer centers, other installing contractors, wholesalers, manufacturers’ representatives, OEMs and national accounts. For its high-end products, Lennox uses a one-step model selling directly to dealers who install the product. The two-step model involves selling product to distributors who then sell directly to consumers. In the residential business, approximately 75% of product is sold through the company’s owned distribution versus 25% via independent distribution.

 

Since Todd Bluedorn became CEO in mid-March, the company has done an excellent job removing excess costs and improving margins. His leadership provides a greater margin of safety. Here’s some information on his background.

 

-Graduated with distinction from the USMA, West Point in 1985 with a BS in Electrical Engineering

-Served in the Army from 1985 to 1990 as combat engineer officer and US Army Ranger

-Earned an MBA with distinction from Harvard University in 1992

-Engagement manager for McKinsey

-Started at United Technologies in 1995 and served in several roles

 -President, Americas for Otis Elevator

 -President, North America - Commercial Heating, Ventilation, and Air Conditioning for Carrier Corporation

Revolver ($650 MM)            $48.5  

Short Term Debt                   $3.8

Promissory Notes                  $107.2

Other Foreign Debt               $1.0    

Total Debt                             $160.5                   

Cash                                     ($118.6)

 

Equity Market Cap (FD)      $2,431.7

Enterprise Value                   $2,473.6

*Debt is typically the lowest in 3Q based on working capital cycles.

*Entered into new $650 MM Revolving Credit Agreement on October 12, 2007.

                                2005                        2006                        2007E                      2008E

Revenue                  $3,366                     $3,671                     $3,730                     $3,800

EBITDA                 $246                        $292                        $311                        $350

EBIT                       $208                        $248                        $263                        $300

EPS                         $1.76                       $2.18                       $2.47                       $2.92

 

*Includes the benefit of commodity hedging, although this is minimal in 2007/2008.

*Capex has been higher than depreciation and amortization in recent years, but this should normalize in future years.

 

“Core” 2008 EPS is projected to be $2.85-$3.00 versus 2007 “Core” EPS of $2.45-$2.48. The buyback accounts for ~$0.30 and we should still see the benefits of prior cost cutting initiatives.

 

As expected, the residential business has been impacted by weak housing starts and lower consumer spending.  In 2007, total industry residential new construction (30%) and replacement demand (70%) decreased >20% and high-single-digits. The company expects continued declines in 2008 with residential new construction down mid-teens and replacement demand flat to down low-single-digits. The last time the replacement market fell three years in a row was 1972-1974. Mix should help offset some volume declines due to additional sales of higher SEER products.

 

The commercial business is a different story as both sales and margins increased in 2007. Total backlog remains strong. The company added 26 new accounts and grew market share. However, the retail segment is slowing down and orders have been pushed out into 2H08. Net, net the company expects 2008 unitary commercial to be similar to 2007, but market share gains and margin expansion should lead to year-over-year improvement.

 

The refrigeration business is seeing robust growth in Asia with good performance in Europe, as well. Lennox expects refrigeration to be up low-single-digits in the US and Europe in 2008. On the service side, the company is concerned that out-of-work residential contractors could hurt volumes and margins, but remains focused on increasing its 1.5% market share.

 

Goals:

As mentioned above, the company targets 2008-2010 annual sales growth of 5-7% and an EBIT margin of 10%. To achieve these targets, the company listed several growth and margin drivers on recent calls:

 

-Consumer and business focus on environmental sustainability and energy efficiency

  -Higher SEER purchases

  -Various legislation driving replacement cycles and the sales of more efficient units

-Recent investments and management focus on improving market share in the Sunbelt region

-Refrigeration expansion into China (focus on cold chain storage)

  -The company has recently added a factory, sales force and distribution arm in China

  -See WSJ article from August 30, 2007 (“China Hurdle: Lack of Refrigeration)

-Clean air systems

-Cost savings

  -Mexican plant ($20 MM savings)

  -Facility consolidation

  -Additional low-cost sourcing (currently only 15% of components are sourced outside the North America)

  -Corporate expense streamlining (eliminated corporate jet = $2 MM)

Goodman Global and Trane were recently purchased for 8.8x ‘08 EBITDA and 15.1x 2008 EPS and 11.2x ’08 EBITDA and 19.0x ’08 EPS, respectively. Goodman Global is a better comparable. Its business is more exposed to residential construction, but without the upside from premium units and refrigeration growth. Trane is a better company with a larger installed base and a stronger market position, but the multiple is still a good data point.

 

Pro forma for the aforementioned transactions, Lennox is the only remaining pure play HVACR player. The company makes an attractive takeout for a foreign player trying to crack the North American market or a US player wanting to add to its residential/commercial business and enter the global refrigeration arena. If Lennox remains independent, you’re buying a company with a good business and management trading at 7.1x ’08 EBITDA, 8.2x ’08 EBIT and 12.5x ’08 EPS. The strong balance sheet, large share buyback and recent transaction multiples should provide a good margin of safety.