Lennox International, Inc.

Ladies and gentlemen, thank you for standing by, and welcome to the Lenox International First Quarter 2020 Earnings Call. At the request of your host, all lines are in a listen-only mode. There will be a question and answer session at the end of the presentation. To put yourself in queue, press 1, then 0. As a reminder, this conference is being recorded. I would now like to turn the conference over to Steve Harrison, Vice President of Investor Relations. Please go ahead.

Good morning. Thank you for joining us for this review of Linux International's financial performance for the first quarter of 2020. I'm here today with Chairman and CEO Todd Bluedorn and CFO Joe Reitmeyer. Todd will review key points for the quarter and the outlook, and Joe will take you through the company's financial performance and expectations. To give everyone time to ask questions during the Q&A, please limit yourself to a couple of questions or follow-ups and read Q for any additional questions. In the earnings release we issued this morning, we have included the necessary reconciliation with the non-GAAP financial measures that will be discussed, two GAAP measures. All comparisons mentioned today are against the prior year period. You can find a direct link to the webcast of today's conference call on our website at www.linuxinternational.com. The webcast will be archived on the site and available for replay. We'd like to remind everyone that in the course of this call, to give you a better understanding of our operations, we will be making certain forward-looking statements. These statements are subject to numerous risk and uncertainties that could cause actual results to differ materially from such statements. For information concerning these risk and uncertainties, see Linux International's publicly available filings with the SEC. The company disclaims any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise. Now let me turn the call over to Chairman and CEO, Todd Bluedorn.

Thanks, Keith. Good morning, everyone, and thanks for joining us. Let me start with a quick overview on the first quarter, then discuss our current outlook for 2020 and the actions we are taking in this unprecedented time. For the first quarter, company revenue was $724 million, down 8% on a GAAP basis, and down 4% on an adjusted basis that excludes the impact from the vestiges last year. GAAP operating income was $36 million, down from $95 million in the prior year quarter that included approximately $47 million of insurance benefit related to the 2018 tornado. GAAP EPS from continuing operations was $0.32 compared to $1.73 in the prior year quarter that included $0.87 of insurance benefit. On an adjusted basis, total segment profit was $38 million compared to $99 million in the prior year quarter that included $40 million of insurance benefit. Total adjusted segment margin for the first quarter was 5.2% compared to 13.1% in the prior year quarter as reported and 7.8% excluding the insurance benefit. Adjusted EPS from continuing operations was $0.56 compared to $1.68 in the prior year quarter that includes $0.75 of insurance benefit. Looking at the business segment performance for the first quarter, there are a couple overarching comments to make. First, weather continued to have a significant adverse impact. Heating degree days were down from last year and every month and down 15% overall for the quarter. Second, we saw an increasing impact on our business in March from the COVID-19 pandemic, first in Europe and then in North America. On the demand side, We saw contractors stocking up less residential equipment ahead of the spring and summer seasons due to the rising economic uncertainty, and national account customers and both our commercial and refrigeration businesses have pushed orders out. Operationally, HVAC has been designated an essential business in North America, Europe, and in Mexico. We have managed to supply chain well across regions that we source from, including Asia. And combined with our buffer stock, we have not seen an impact on our manufacturing capability in this regard. In late March, we did make the decision to close some of our factories for a couple weeks and broadly protected the Lenox team from COVID-19 cases at those locations. These factories are all back up and running, and of course, protection for the team members are in place. In our residential segment in the first quarter, revenue was down 5%. Revenue from replacement business was down high single digits, impacted by the warm weather. New construction revenue was up high single digits as the warm weather generally enabled homebuilders to get an early start in the year. Residential segment profit was $33 million, down from $87 million in the prior year quarter on a reported basis that included the $40 million of insurance benefit that I mentioned earlier. Segment margin was 7.4% in the quarter compared to 18.6% as reported, or 10% excluding insurance benefit in the prior year quarter. In commercial, revenue was up 3% in the first quarter, and segment profit rose 24%. Segment margin expanded 180 basis points to 10.5%. Commercial equipment revenue was up low single digits in the quarter. New construction revenue was up high teens, and replacement revenue was down high single digits. Breaking out the business another way, revenue from regional and local business was up low single digits. And national account equipment revenue was also up low single digits in the quarter. On the service side, Lenox national account service revenue was up low double digits. In the refrigeration segment for the first quarter, adjusted to exclude the impact from the best issues in the prior year, revenue was down 11% of constant currency. Segment margin declined 730 basis points, to 0.7%, and segment profit was down 93%. The segment has approximately 55% of its revenue from North America and 45% from Europe, which has seen soft markets for some time and then was impacted earlier from the pandemic than North America, including a shutdown at both of our French factories. North America revenue is down mid-single digits, and Europe revenue is down high teens. Looking ahead for the company overall, market conditions are highly uncertain and there are significant challenges we are addressing. But Lenox has a focused and seasoned team with experience managing through economic downturns and difficult times. For me personally, I manage Carrier's HVAC business in Southeast Asia in the wake of the Asian financial crisis in the late 90s. Those of you who don't remember it, I encourage you to go Google it. I manage Carrier's North America HVAC businesses through the impact from 9-11. and then a CEO at Lenox through the residential new construction collapse and the global financial crisis of a little over a decade ago. Based on how HVAC markets performed in those prior downturns, our current view is that the North America residential and commercial unitary HVAC and refrigeration markets will be negatively impacted about 20% this year by the pandemic. We have reset our financial expectations for the year based on that level of market impact. I now expect revenue to be down 11% to 17% from last year versus our previous guidance for growth of 4% to 8%. We expect adjusted EPS from continuing operations in the range of $7.50 to $8.50 for the year. We have already taken cost reduction actions to realize approximately $115 million in SD&A savings for the balance of the year. The decremental drop through on the guidance reduction on our revenue is 25%, which reflects our aggressive cost actions. We expect cash generation to remain strong for this year as working capital requirements shrink and capital expenditure plans have been reduced from 153 million to 120 million this year. We tend to think of maintenance CapEx levels of being around 10 to 15% of that. We are targeting 340 million in free cash flow for 2020. Lenox is rated investment grade by both S&P and Moody's, and we expect to remain well within our debt covenants. Our bank revolver and asset securitization line do not have to go through renewal again until the latter half of 2021, and our senior notes do not mature until November 2023. The company's quarterly dividend plans are unchanged. Most recently, $0.70 per share or more than $115 million in total for this year. We repurchased $100 million of stock in the first quarter of our $400 million plan going into this year. But we have placed repurchases plans for the second quarter on hold, and we will review plans for the third and fourth quarter as the year progresses. As I turn it over to Joe to discuss financial results, I will just say that while we execute on what is required in these current economic conditions, we remain mindful of the future and are confident we will once again strengthen our position in the market as we emerge in the recovery. Now I'll turn it over to Joe.

Thank you, Todd, and good morning, everyone. I'll provide some additional comments and financial details on the business segments for the quarter, starting with residential heating and cooling. In the first quarter, revenue from residential heating and cooling was $442 million, down 5%. Volume was down 6%, and price and mix combined was up 1%. Foreign exchange was neutral to revenue. Residential profit was $33 million, down 62% as reported, or down 30% adjusted for the insurance benefit in the prior year quarter. Segment margin was 7.4%, down 1,120 basis points as reported, or down 260 basis points adjusted for the insurance benefit in the prior year quarter. Segment profit was negatively impacted by the year-over-year difference in the insurance benefit, unfavorable weather, COVID-19 pandemic that led to lower volume and factory shutdown costs, higher other product costs, and unfavorable mix. Partial offsets included favorable price, lower material costs, lower tariffs, favorable warranty costs, lower freight costs, lower SG&A expenses, and favorable foreign exchange. Turning to our commercial heating and cooling business, commercial revenue was up 3% to $178 million. Volume was down 2%, price and mix combined was up 5%, and foreign exchange was neutral to revenue. Commercial segment profit rose 24% to $19 million. Segment margin expanded 180 basis points to 10.5%. Segment profit was favorably impacted by favorable mix, lower material costs, and lower SG&A expenses. Partial offsets included the COVID-19 pandemic that led to lower volume and unfavorable warranty costs. In refrigeration, on an adjusted basis, first quarter revenue was down 103 million, down 12%, or excuse me, first quarter revenue was 103 million, which was down 12%. Volume was down 12%, price and mix combined was up 1%, and foreign exchange had a negative 1% impact on revenue. Refrigeration segment profit was $1 million in the first quarter, down 93%. and segment margin was 0.7%, down 730 basis points. Segment profit was impacted by the COVID-19 pandemic that led to lower volume and factory shutdown costs, higher other product costs, and unfavorable mix. Partial offsets included favorable price and lower SG&A expenses. Regarding special items in the core, the company had net after-tax charges totaling $9.2 million. This included $8.3 million in total for other tax items net, and excess tax benefits from share-based compensation, $1.3 million for loss from natural disaster, net of insurance recoveries, and a net benefit of $0.4 million for various other items. Corporate expenses were $14 million in the first quarter, and overall SG&A on an adjusted basis was $131 million, or 18.1% of adjusted revenue, down from 18.7% in the prior year quarter. In the first quarter, the company used $99 million of cash from operations compared to a usage of $141 million in the prior year quarter. Capital expenditures were $25 million compared to $37 million in the prior year quarter that also included $7 million of proceeds from divestitures and insurance. Free cash flow was a use of approximately $123 million in the quarter compared to a use of $171 million in the prior year quarter. Due to the seasonal nature of our business, the company tends to have a use of cash early in the year and generates cash later in the year. The company paid $30 million in dividends and repurchased $100 million of stock in the quarter. Total debt was $1.44 billion at the end of the first quarter, and we ended the quarter with a debt-to-even dollar ratio of 2.3. Cash equivalents and short-term investments were $43 million at the end of March. Now, before I turn it over to Q&A, I will review our current market estimates for 2020. For the industry overall, we now expect North American residential HVAC shipments to be down mid-teens compared to prior expectations to be up mid-single digits, a 20-point negative impact from the COVID-19 pandemic. We expect both commercial unitary shipments and refrigeration shipments in North America to be down 25% compared to our prior expectation for flat markets. Under these market assumptions, we expect our revenue to be down 11% to 17% from the prior year compared to our prior expectations of 4% to 8% growth. We expect GAAP DPS from continuing operations to be in a range of $7.07 to $8.07 for the year, including a pre-tax charge of approximately $10 million expected in the second quarter for restructuring actions. We expect adjusted DPS from continuing operations to be in the range of $7.50 to $8.50 for the year. Previous EPS guidance for both of these was a range of $11.30 to $11.90. Looking at the various puts and takes in our financial assumptions for 2020, we now expect a benefit of $25 million in net price for the year compared to our previous guidance of $30 million. We now expect a $20 million benefit from sourcing and engineering-led cost reductions compared to prior guidance of $25 million. Residential factory productivity is expected to flip from a $10 million benefit to a $10 million headwind given the significantly lower volume. Residential mix is now expected to be flat compared to prior guidance of a $5 million benefit. Tariffs are now expected to be neutral compared to prior guidance for a $5 million headwind, and commodities are still expected to be a $20 million benefit, and freight is still expected to be a $10 million benefit. A few other points to mention in our current financial outlook. Corporate expenses are targeted at $75 million compared to $90 million previously. Net interest expense and other expense is now expected to be approximately $40 million compared to previous guidance of approximately $50 million. We still expect an effective tax rate in the range of 21% to 22% on an adjusted basis for the full year. We continue to expect weighted average diluted share count for the full year to be between 38 to 39 million shares. And as Todd mentioned, our purchase of $100 million of stock in the first quarter of our $400 million plan going into this year. but we have placed the repurchase plans for the second quarter on hold, and we will review plans in third and fourth quarters as the year progresses. The company's quarterly dividend plans are unchanged, most recently $0.77 per share, or more than $115 million for the total year. We are targeting capital expenditures of $120 million this year, down from $153 million previously. Free cash flow is expected to be $340 million this year. compared to previous guidance of $410 million. And as Todd talked about, we have taken SG&A cost reduction actions to realize $115 million of savings over the remaining three quarters of this year. We are well prepared to manage through these market conditions and make adjustments as needed along the way. And with that, let's go to Q&A.

Thank you. Ladies and gentlemen, if you wish to ask a question, please press 1 and 0 on your touchtone phone. Our first question comes from the line of Ryan Merco with William Blair. Please go ahead.

Hey, thanks. So first off, Todd, can you break down the Resi mid-teen decline to interior replacement and new construction?

We haven't broken out that guide. We usually don't give the annual guide. But I think sort of the phenomenon that you saw in the first quarter will play out for a little bit longer, which is the starts that have started will continue. And so I wouldn't be surprised to see in the near term new construction up as add-on or replacement continues to go down. But I certainly think during the second half of the year, the new construction will start to pull back significantly.

Okay, and then maybe talk about the sales cadence through March and into April. Are you seeing resis down 10% plus at this point?

Yeah, we are. I mean, what we've seen is through the end of March, it's sort of hung in there, and then during the first two weeks of April, it's been down mid to high teens. And that's quite frankly what I would expect. I mean, what we're seeing is we really have two broad buckets of add-on and replacement this time of year. Demand business, which is dealer sees a job, buys the equipment, installs it. The demand business actually is hanging in there relatively well. I mean, it's down low single digits. But where we're seeing a real slowdown is dealers stocking up for the summer selling season. They're just not doing that given all the uncertainty. Now, and I will get a little bit more into this later, is you know, we're an essential business, and so we're going to continue to produce. People need our products, and it's going to continue to flow. So we'll see what happens.

Okay. All right, and just lastly, on the $150 million of cost saves, how much of that is temporary versus permanent, and then what's the quarterly cadence for our model?

I would look at it, I would think about the $150 million cost savings this way. About 20% of the savings comes from salary and headcount reductions. About 40% comes from discretionary spending, like cuts like travel, marketing, incentive trips, et cetera. And about 40% comes from pay actions. Zero executive incentives and a salary reduction for our salary employees. 50% for me, 12% for other executives, and 6% for other salary employees. And when you think about those snapping back, if I was modeling 2021, I would certainly assume that the salary reduction snapped back in 2021 because if you do longer than eight or nine months, it's really not temporary. And then the other two categories, we'd just wait and see what was going on with the market conditions.

Okay. Greg? Thanks.

Thank you. Our next question comes from Julian Mitchell with Barclays. Please go ahead.

Hi, good morning. Morning. Just my first question around decremental margins. Those were pretty steep in Q1. I think you're expecting a narrowing of those as you work through the year, even though the sales trends deteriorate, presumably in Q2 and Q3. So maybe just help us understand the logic behind that. And also, what impact did the under absorption that you'd cited back at the Q4 call that we should expect in Q1, how bad did that end up being given you had an additional volume shortfall?

Well, I think there's sort of a lot to unpack there. The decremental margins in the first quarter were primarily driven by the bad mix that we had in residential, and we talked about that publicly in at Steve Toose's conference about midway through March. And what we said there was that the warm weather had impacted our furnace sales and our parts and supply sales, and those are our two most profitable business lines, and that had a real impact to the business. When I think about the balance of the year, the reason we're able to get 25% incremental is we've taken $115 million cost out of the business. Our normal contribution margin is order of magnitude 38, 40%. And if we took no cost actions, then the decrementals come in around 40. But we took out $115 million of costs, and so we're now going to see decrementals in the order of magnitude of 25%. And then, you know, the other point I would make, I haven't been asked the question, but I'll ramble while I'm talking. I mean, 20% is an uncertain number. you know, we have to ask for an obvious statement for the day. And as I mentioned on the call, I've been through a couple of these when I was a carrier in North America running commercial business after 9-11 and then here at the financial crisis. And sort of 20% sort of feels right given what happened during those downturns. But it's sort of a ballpark number. And we were able to get 25% decrementals on a 20% drop in the market. But if the market goes down more than 20, the cost levers are harder to find. And so if you're building your own model, our decrementals after we're down more than 20% revenue are going to be more like 30, 35%. But for that first drop of 20%, $115 million of cost takeouts will allow us to deliver a 25% decrementals.

That's very helpful. Thank you. And maybe just my follow-up question. You've talked a fair amount about residential trends. Maybe just clarifying in the commercial side of the business, what are you seeing in terms of, I guess, the aftermarket parts of commercial and any major bifurcation you'd call out in your guide for commercial unitary between OE and aftermarket just for 2021? as a whole.

The guide that we gave is down 25% for North America Unitary. We haven't bifurcated it. Although I would, without putting numbers on it, tell you that my experience, what will happen, quite frankly, what is happening is that it's like residential. New construction continues until all the projects that have started wind down. And that hasn't happened yet, but it will. The planned replacement continues to flow for a little bit until all the decision makers decide what they need to do to pull back to get their companies lined up correctly. So planned replacements, some of it's slowing down over the last two weeks. And then the third piece of the business is at once demand emergency replacement. And that continues to flow, even in the tough times, because people need to buy HVAC. And so my experience when I ran Carrier during 9-11 is the marble rolls off the table on commercial quickly. And I better state it, when it happens, it happens quickly. And the marble hasn't rolled off yet. I mean, we're down. Backlog order rates are down maybe 10%, not 25% yet. But our guess is it will be.

Great. Thank you. Thanks.

Thank you. Our next question comes from the line of Jeff Hammond with KeyBank Capital Markets. Please go ahead.

Hey, good morning, guys. Hey, Jeff. So can we just talk about just obviously a lot of moving pieces here, just what you're seeing from a share-shift dynamic and being able to get that back, and just what plans have changed, if any, for kind of Parts Plus build-out?

The Parts Plus build-out is we've put the 20 stores that we're going to add in 2020 on pause for right now. So right now, the plan is not to add. We're not in the process of adding any new stores. We'll get partway through the year, just like in the share buyback and re-evaluate that. What we've been very focused on is we made these SG&A cuts. Again, my experience from prior downturns is it's easy to cut costs. It's easy to gain share. It's hard to do both at the same time. We've been very focused about what are the investments we want to protect. We've protected all our new product development programs. We've protected all our key digitization programs. While we aren't adding new stores, we're not decimating our distribution network. We're keeping it intact. It's protection of the key growth initiatives that we have. We're still keeping those intact. We've asked for shared sacrifice of employees as we've taken a salary reduction rather than cut some of those key programs.

Okay. And then just on the, you know, it sounds like the biggest impact on Q1 was kind of seasonal build. What kind of feedback are you getting from, you know, contractors in terms of like the selling season and, you know, people change, you know, them being able to kind of get out just that, I'm just wondering if, you know, if you go into the season with less inventory and then maybe things are a little more normal, do you get, you know, some spring loading here or catch up?

Sure answer is yes to that final piece, which is we got lots of inventory and we're not, you know, we're going to manage inventory appropriately to hit our free cash flow target. But we're prepared for the spring back. And so, you know, we hope we're wrong on the 20%. I hope it's a lot less than that. And if it is, man, we're going to be chugging, and we'll be selling product, and our dealers will be ready to go. They just don't want to carry the inventory right now, so we're carrying it for them. When we talk to the dealer contractors, depending on what part of the country you're in, and you could figure that out on your own, where there's less concern about all this, they're still relatively optimistic. But, again, my experience on prior crises was – If you rely on your dealer or contractor to tell you the market's going to turn, then you've waited too long. That there's sort of the quick and the dead in all this, and you either sort of figure out that the market's turning, you get your costs in line, and you have inventory in case you're wrong, and then you bounce back with it. If you don't do that, what happens is you chase the market down with cost cuts, and you end up cutting costs right when the market's getting ready to turn. And it's better to cut them now, get it behind you, move on. That's what we've done. The optimistic answer to your question is if we're wrong on the market and the market starts to come back, we'll rock and roll, and so will our dealers.

Okay. And then if I could just squeeze one last in. You know, the refrigeration margins, you know, got hit pretty hard, and I think you mentioned a couple things. But just maybe speak to, you know, that business, you know, what really happened. I mean, there are a couple things from a margin perspective.

Yeah, there were a couple things in the quarter that really drove the margins down, and obviously they were disappointing margins. One is we had our two French factories shut down because of COVID virus, and that was about $2 million of EBIT negative impact. We had year-over-year difference in refrigerant sales. Remember last year we sort of had this windfall of a couple million in the first quarter. That didn't repeat. And then the volume being down 10%. The volume went down 10%. and we hadn't taken all the cost actions yet, and so we had some painful decrementals. As we go through the balance of the year, hopefully the factory shutdowns are behind us, but who knows? The refrigerant noise is behind us, and we've taken the cost actions to adjust our costs for the lower volume.

Okay. Thanks, Todd.

Thanks, Joe.

Thank you. Our next question comes from the line of Steve Tusa with JP Morgan. Please go ahead.

Hey, guys. Good morning. Hey, Steve. Thanks for all the details as usual. You know, a lot of companies are obviously not even giving guidance, and so, you know, the color is always very helpful, and you guys are always on top of this stuff. So I appreciate that.

I'll just sort of give an advertisement then for my colleagues. We've always been transparent, but every training and leadership instinct I've ever been taught or learned is, in a crisis, you want to even be more transparent. So I think sort of pulling guidance and hiding is isn't the way to go now. Again, we're putting large caveats around our guidance. I mean, 20%, God knows whether we're right or not, but we're trying to give you a view of our decrementals at 20%, our decrementals if it's worse than 20%, and the costs that we've taken out and sort of how those costs will behave when the market recovers. And so that's what we're trying to communicate.

Right. I mean, I was giving more credit to Joe and Steve anyway, but you get a little bit of credit as well.

I'm glad to see this crisis hasn't softened you in any way.

You've got to get the rubber stamp. So anyway, how much of your business is housing now? I feel like a couple of years ago you guys were a little bit overweight on the housing front. How much of your business is builders and housing?

15%.

15% to 20%, 1.5% to 2.0%. Okay, got it. And then just on the guidance. So if I kind of do the bridge of the midpoint, negative kind of 14% of revenue and then 25% decrementals, it's kind of more around the $7 of EPS range, not $8. Is that right? Am I missing something there, or maybe there's a few kind of below-the-line items that we haven't kind of squared away on that front? I can also take that offline if I'm off.

Interest rates are down, and so we have better interest costs. That may be a piece of it. I don't know if that explains the whole dollar, but that's it. But take it offline. I mean, we work in detail ourselves, so we can work with you. Yeah, we can walk through it, Steve.

Okay, and then how are you balancing this? I mean, it seems like you have embedded some share gains in your numbers, or are you no longer embedding that? And how are you kind of balancing these cost cuts with that drive to kind of recapture some of the tornado share?

We still have some share gain in there, but again, as we talked about at the end of December when we were together, a lot of that share gain is already baked into the cake. In other words, those were dealers we were converting in third and fourth quarter. And as we turned our new business development process loose, and so now we'll just need those dealers to buy. So I think we already have some new share baked into the cake. And then again, as I mentioned earlier, we continue to sort of protect our key investments to go gain share. And our sales guys, while they're not physically calling on many of our customers, they're calling on our customers and we're still out there pushing and driving to get a share of wallet of our customers. So again, there's not heroic share gain in that number, but there's some share gain in that number.

Okay. And then just one last quick one. Usually commercial kind of has a week one queue and then steps up to almost double that in the second quarter and then bounces around a little bit, perhaps kind of fades to the rest of the year. Um, given you kind of, you know, you didn't really see a drop off there yet, but your experience, you're going to kind of experience one here in the next couple of quarters. Are we, should we just kind of assume like a, you know, flat to up type of number from the first quarter for, for the rest of the year? Like I'm just trying to kind of, um, better understand the seasonal dynamics or the lack thereof.

So let me get this right. Most of my peers are pulling guidance and you want me to give a segment revenue forecast by quarter.

No, I guess just do you anticipate that seasonal step up, I guess, is the simple question. It would seem like you do in your guide, but that's the simple question.

I think the answer is our commercial team is on a roll, and they were on a roll before the virus hit. And so the virus is going to impact them in a meaningful way. The market's going to go down 25%. but they're gaining share and they're winning in the marketplace, and I think all that's going to be consistent even with the market that's down 25%.

Okay, got it. Thanks a lot, guys. I really appreciate the details again. Thanks.

Thank you. Our next question comes from the line of Nicole de Blasé with Deutsche Bank. Please go ahead.

Yeah, thanks. Good morning, guys. So maybe carrying on from Steve's question a little bit – With respect to the 20% revenue impact that you've embedded for the full year, is all of that coming in the second quarter? And I guess, was there any in one queue? And are you embedding, like, a pretty quick snapback in the second quarter, just trying to get a sense of, like, where that impact is lying?

No, I mean, I'm not going to necessarily give quarterly guidance. But what we baked in was for the balance, for full year, our guide's down 20%. And so... For balance of year, it's down even more than that. I think if you do the weighted average of what happened in the first quarter, it's down 21%, 22%, 23% for the balance of year. And that's the guide that we're giving. Now, I think it may be worse in second quarter than it is in third and fourth quarter, but I'm not sure. But the way we've loaded it into our internal models is equally split across the quarters. It's down the same each quarter because, again, I don't want to give too much precision assumption around the 20%. I mean, it's not like we did this bottoms-up role by quarter, by business unit, by AOR, by new construction, and came up with this detailed number. It's 20%. And we ran it across the business. We did it by quarter, and we set our costs that way. And we're going to just have to see how this plays out. There's too many variables to really know for certain how it's going to play out.

Okay, totally fair. Got it. Thanks, Todd. And then just for my follow-up, then maybe drawing on what you've seen in your career in past downturns, is there a risk that in the resi business we see a big shift away from replacement and towards repair, band-aid of systems over the next several quarters as this plays out?

Yes. I think if we end up in a world, which it looks like we're going to, with 25%, 30% unemployment, people are going to try and band-aid their units. So, yes, I think we'll see a spike up in parts and repair parts and a decline in units. Now, I think that assumption sort of baked in, broadly speaking, to our number. But, yeah, that's what happened. Now, how's this for trying to find a silver lining? Just like we saw after the financial crisis, that demand doesn't go away. It just gets pushed out. And I'm looking forward to, I don't know if it's a year from now or a year and a half from now, We'll have a new model out about all the pent-up demand that was created in the throes of all this, and all that demand will come back to us. And just like in 10, 11, and 12, we'll have rising markets that are up double digits because all this pent-up demand will be unleashed. So we're not Carnival Cruises. We're not Caesar's Palace. It's not when this demand goes away it never comes back or you lose it forever. This demand gets pushed out, and so we're pushing it out, but it will come back.

Thanks, Todd. I'll pass it on.

Thanks.

Thank you. Our next question comes from the line of Tim Wojcicki with Baird. Please go ahead.

Hey, guys. Good morning.

Hey, Tim.

I guess among some of your third-party distributors and just some of your larger stocking dealers, how do you feel about just kind of their financial profile and kind of access to credit, I guess, more broadly?

You know, that's a great question. We keep a close eye on that. They're in good shape. broadly speaking. I'm not aware of any of our large dealer or distributor customers who are having any issue. They're savvy business people. We aggressively reached out to the dealer network and had webinars and training around the small business loans that were available or grants. And hopefully there's more of that money coming. And we've worked with our partners to make sure they have access to that if that's something that they want to do. But again, it's a little bit of the survival of the fittest. Most of our customers survived the financial crisis and the housing downturn and the bubble of residential market. And so they're savvy and they know what they need to do.

Okay. Okay. And then just on mix, have you seen, I guess on the demand oriented business, have you seen any changes in mix, you know, over the last probably four to six weeks and then Are you embedding some deterioration as you kind of go through the summer?

You know, again, it's early, you know, because we're only a couple weeks into this. But what our expectation would be, you'd have some mix down in resi, and that's built into the numbers.

Okay. Okay. Well, thanks for all the color, and good luck to this. Thanks.

Thank you. Our next question comes from Lydie. Nigel Cole with Wolf Research. Please go ahead.

Thanks. Good morning. And I do want to say, you know, well done on the guidance because I don't think there's going to be too many people giving us perspective. So it's really well appreciated. Thanks a lot. So on the components of the guide, you took down the price by $5 million. Is that purely just on the lower volumes you get less price benefits or is there some element of pricing pressure across I guess the question is, are you seeing any deterioration in price?

No, you got it. It's broadly speaking, the reduction in volume.

Okay, great. And then you mentioned shutting down factories at the end of March in both U.S. and Europe. We've seen this across the board. To what degree did that impact your productivity, actually having those factories shut for a week or so in the quarter? And then on a go-forward basis, you know, testing employees and maintaining distances within the factory, to what extent does that limit or maybe raise costs in terms of wrap-up production and raising kind of go-forward costs?

You know, we've managed it well so far. We've cleaning the factories, lots of hand gel, even things like putting plastic barriers between some of the assembly stations. We're in the process of ramping up PPE gloves, taking people's temperatures, those sort of things. And so like most of industrial America, we're working our way through this. We had a shutdown in our two French factories. We had a shutdown in our Marshalltown factory. because we had some cases and also quite a few quarantines. But both those factories are up and running. As I speak today, I didn't check first thing this morning, but as I speak today, all our factories are running. Different levels of absenteeism in our factories as people stay away from work. And, again, this isn't a political statement. It's just an observation that our factories in places like Iowa, Arkansas, Georgia – And they're not in New York City. They're not in California. And so some of our workers have a different perspective on the virus than I do, maybe. And so they're coming to work. But even beyond that, we're taking care of them, make sure it works. And then the second order equation, obviously, in our factories has to do with the supply chain. And our team has done a great job of managing that, first in Asia, and that's now way in the rearview mirror. Increasingly, it's about Mexico and U.S. making sure that our supply base runs, and it has. And then the final piece is you get a little bit more wiggle room on this when the markets are declining. So the markets are declining. Even if we have some issues around production, we're able to absorb it in a natural way because even if we had 100% production capability, we would have to bring down our factories in any case to help manage the inventory levels. So even if we have some places where we have to take it down, we take it down in an orderly way.

That's great, Carlo. And then a quick one on the Mexican supply chain. I hear that one or two factories were shut down by the Mexican government. Is that now back up and running?

Our factory was never shut down. So we actually went through – I've got to be careful I don't advertise it to too much of the government where they want to prove me wrong – But we had the federal Mexican government come in and inspect us on an afternoon, and we got a stamp of approval both as an essential industry and also about all the processes that we were using to protect our people. And so we were down in Mexico. We took it down just for production reasons, but we haven't taken it down because the government thought we should.

Okay, guys, good luck. Thanks. Thanks.

Thank you. Our next question comes from the line of John Walsh with Credit Suisse. Please go ahead.

Hi. Good morning. Hey, John. Hey. So I guess I think it was in response to an earlier question when you were talking about how the decremental throttle at different volume declines. You've obviously run that scenario analysis. So, you know, what are you watching – to see if volumes could actually be, you know, down worse than you're kind of expecting? Is it the employment numbers? Is it consumer confidence? Something else maybe? You know, what are the indicators you're watching for that?

Yeah, I mean, this is, as you know, an imprecise science, and I think we're watching macro trends, but I mean, we're sort of off the board with macro trends, and so we're trying to spend time with our customers. We're looking at order rates. We're just seeing what happens. The one number that I have taken most comfort in to date has been the demand business in our residential. And as I said earlier, that was down a little bit month to date, but still reasonably solid, all things considered. And that gives me comfort that When people's air conditioning breaks, they need to get it fixed, they need to get it dressed, they're at home, and it's still flowing. And the other thing that we keep track of is that we're happy that we're in a central business. And so our dealers are working across the country, and they're up and running, and they're going out taking care of their homeowner customers. And so as long as all that's in place, then that's a good sign that we look at. But, you know, the way I think about this is... We measured twice, and then we cut once. So we measured 20% down. We cut. And now we, quite frankly, just got to let it play out a little bit. I'm not sure we're going to know a whole lot more next week than we know today or even three weeks or a month. I think we're going to have to get through the summer selling season or into the summer selling season to see how things are behaving, and then we'll readjust our thinking then.

Thank you. And then maybe just a follow on a high level picture here. Obviously, one of the nice secular tailwinds in HVAC is around energy efficiency regulations, refrigerant changes. It might be too early, but are you hearing conversations that some of the bodies that govern this might be wanting to throttle back or push back when we get some of these changes or Is that not something you would expect to see depending on the duration of this downturn?

The honest answer is I don't know. We haven't heard anything yet. I mean, there's two ways to look at it. One would be some may think that's a stimulus to the economy, not to force industries to add costs. Another view may be the scientists may actually be right on some of these things and protecting the environment may make sense. So I think it could cut both ways. Great. Thank you.

Thanks. Thank you. Our next question comes from Deepa Raghavan with Wells Fargo Securities. Please go ahead.

Hey, good morning, all. Hey, can you talk to how your revenue mix is right now on the residential front versus geographies that have been hearted with the lockdowns? I mean, New York, California, Pennsylvania, and some parts of the Midwest, obviously. But are you underrepresented or overrepresented in some of these places? Can you talk to that broadly, please?

No, I'm not worried about being underrepresented anywhere or overrepresented somewhere else. I think, you know, again, it's a small sample size, but sort of over the last three or four weeks, there's parts of the country, the southeast, that continues to do well. So our revenue in resi over the last three weeks in the southeast is actually up. Our revenue in Canada is down and down pretty significantly, and I think that reflects the Canadians took the lockdown pretty serious, and things aren't flowing as well there. But I don't think we're under – we're not under – we have lower shares, certainly, and higher shares, depending on where you look in the country. but there's no step function difference. So we're ready to play no matter where the markets are strong.

Okay, so you've not necessarily been additionally hit in places where the lockdown has been stronger?

No, I misunderstood the question. Yeah, I mean, in the parts of the country where people are abiding most closely, so in the Northeast, we're down much more than we are in the Southeast. And so in Florida, we're actually up year over year, uh, in April and, and, and, and, uh, the Northeast we're down and down pretty significantly year over year. So yes, I think you can think about it that way.

Okay. Got it. Uh, my followup is on, um, you know, some color versus last cycle. You, you obviously divested some businesses since the last recession, heart, et cetera. Can you talk through some data on how the repair and replacement dynamic played out, not including those businesses, and how maybe you're thinking through, you know, how unemployment rate or any of these other metrics that you probably analyzed at your end that actually will determine when people actually get back into replacement mode. You know, I mean, obviously, going to recession, people choose to repair. you have mid-teens unemployment rate, but that probably starts to peter out. But is there like a threshold metric, like an unemployment rate or something?

No, I mean, there's not a math formula. When I think about what happened during the financial crisis, it was multitude of things. And some of them are true now, some of them aren't, and there's a whole new set of things now. So one thing we saw during the financial crisis is it was a housing-led problem. And so that was in our sweet spot. And existing home values went down in many parts of the country 30%, 40%, 50%. And that had a chilling effect on people wanting to spend $5,000 to put an air conditioner in. And then you laid on top of that the housing – crisis turned into a financial crisis, which led to unemployment and lack of consumer confidence. Now, where we sit today so far in this is it's going to be higher unemployment. Consumer confidence, we'll see how that plays out, but my guess is it's going to follow unemployment. But we haven't had the crash in the housing market so far. And then the other question is, what's the recovery look like and how quickly do people come back? And so I just think there's variables out there. I think there's clearly going to be some repair versus replace in the near term. How long it lasts, I'm not certain.

Got it. Thank you so much.

Thanks.

Thank you. Our next question comes from the line of Walter Liptech with Seaport Global. Please go ahead.

Hi, thanks. Good morning. And I'll say thanks, too, for the guidance. And, you know, I wonder if you could talk a little bit more, you know, kind of on a follow on to the last question about this re-recession analysis, which I think looks like the right way to look at this. But, you know, each one of those recessions was a little bit different. And, you know, I wonder why, you know, considering what you just said in the last question, why you took the conservative route with the guidance versus expecting more of a snapback in the second half?

My experience, especially from 9-11, running the carrier commercial business, is it was death to chase the market down. I think you've got to get out ahead of it and get your cost sized right. And the costs that we took, a lot of them were pay cuts and incentive cuts and things that we can – sort of unleash again if we had to, if the market takes back. But the worst thing to do, I think, or one of the worst things to do is to, you know, one call we say the market's going to be down five, then it's down 10, then it's down 15, then it's down 20. Because then that means we're running our business that way. And if you're chasing the cost down, it's just so disruptive to the organization. It's better to get it out of the way, measure twice, cut once. And if you're wrong... have enough inventory to prove everybody that you can manage the upside also. And I think that's what we've done. I just find that a better way to run a business.

Okay. Okay. Fair enough. The, the bad, the bad debts this quarter didn't look that bad yet. And I wonder if you can talk about how bad debts should trend given your outlook and how they did in the last recession.

Yeah, they held up well last time. We didn't have much of a debt problem. And again, we're not, We're exposed to tens of thousands of small customers, and we have a pretty good group who's constantly monitoring that. And even on the national account side, we sell to pretty high-caliber brands and customers. And so that wasn't a concern last time. I don't expect it will be a major concern this time, although we're focused on it and watching it. Okay, great. Thank you. Thank you.

Thank you. Our next question comes from the line of Robert McCarthy with Stevens. Please go ahead.

Good morning. Thank you for all the support. Two questions, and I know we're getting kind of to the top of the hour, so I'll keep it quick. One, on the commercial side, it looks like you took a very appropriate assumption for that 25% decline. And again, thank you for all the detail on the guidance. So this is a bit of an unfair question, but it probably takes into account the initial disruption. But we just hosted a call with a former CFO of a large retail-based restaurant company for quick service dining in a lot of malls. And from that standpoint, given what we're seeing with casual dining and then the expected cut in units and then also the independents, You know, we could be in kind of a nuclear winter for commercial real estate for quite some time. How do we think about that in the context beyond the guide of how you're going to manage your business? Because could it be maybe not as bad as the 25%, but could we be looking at two to three years of just kind of a really tough slog here on the commercial real estate side? And let us know how you think about it.

Well, I'd say a couple things. I mean, in our commercial business, we're two-thirds, close to 70% replacement. And so we're buffered from commercial new construction in many ways, and that's because we're a replacement market, and replacement units are going to have to flow. And then I think there's pockets of demand. I mean, Amazon's a customer. Costco's a customer. Walmart's a customer. Those are all big customers of ours. And so... Yeah, new construction, you know, you pick your worst case, and it could be bad, but we're a replacement, and we have some large customers, and some are doing well, and some aren't doing well. And again, as I said earlier, look, I don't have a crystal ball, and I can convince myself it's going to snap back. I can convince myself that I should put my head under water. but, you know, we picked a middle path and it's sized the business accordingly, and if we're wrong either direction, we'll adjust.

And then just anything else you can add in addition to what you've talked about in terms of just cash collection and should we be nervous about, you know, cash conversion this year, just given, you know, kind of the sui generis nature of this downturn, or do you think that's going to be something... something that's fairly manageable.

I think it would be fairly manageable. I mean, we'll see how it plays out. But, I mean, we've, you know, we're going to shrink our working capital. We have a line of sight with our customers, and we're collecting receivables. They're not aging fast yet. And we'll shrink the inventory. And so we'll generate cash there, and then we pull back our working capital. And if you look what happened during the financial crisis, and, again, it was different. And I know you lived through it, Rob. I'm not sure everyone on the call did intimately, but you didn't have the fear of dying, but you certainly had the fear that the world was on fire. And even during the financial crisis, we generated more cash during the financial crisis than we did before because we were able to take working capital off quicker than our earnings go down, and that's what we'll see this year.

And the last thing is, it sounds like from a financing perspective, the fixed income and financing markets remain very robust. Wouldn't you confirm that from your seat?

Yeah, I don't know if I – I'm not sure I'm in a position to say very robust. I'd say we have no concerns. We have no concerns, no issues. We're in great shape. Thanks for your time.

Thanks. Thank you. Our next question comes from Damian Karatz with UBS. Please go ahead. Hi.

Good morning, everyone. Hey, Damian. Appreciate all the color on your preparedness to navigate through this downturn, as well as on how you're getting to the 20% forecast. Just have a quick follow-up question on resi mix. You know, you talked about in the past during the global financial crisis how you kind of really saw a bifurcation, if you will, in the resi market with a much higher proportion of the population flocking to minimum efficiency. Have you started seeing that dynamic play out yet? It sounds like in your guidance you're expecting to some extent that to happen. And could you just kind of remind us of how this sort of price and margin variance is as you move from the minimum efficiency up through your premium products?

It scales rough. On the price side, it scales roughly – in line with this year. So a 26-year order of magnitude is twice as expensive as a 13-year. And then the margin percentages, they don't scale quite that way, but a margin percentage at the high end, you know, we have a greater margin percentage on the high end than we do on the entry level, although much closer than it was seven, eight years ago as we've taken costs out of the entry-level product. Yeah, as I said earlier, we expect certainly some mix-down, and it's early, but two or three weeks into April, we're seeing some of that. And again, as you mentioned, or you correctly remembered, what we saw during the financial crisis was a barbell distribution. People who had money continued to have money, and people who were in trouble weren't or didn't, and so bought entry-level. But You know, all these things are different. We certainly expect some mix down. We built that into our guide.

Okay, that makes sense. And with the current lockdown situation, just wondering if you've seen any change in trends with your online platform. You know, is there potential here to maybe see, you know, an acceleration in the ramp there or just kind of too soon to tell with the softening demand environment?

You know, our online platform is for our dealers, contractors, and our sales guys are talking to them all the time. So if they want to give us an order over the phone, we'll take it there. So I don't think there's this huge ramp up online. It's not like instead of going to the grocery store, I'm using Ships instead to buy it, then it's all going online. Our relationship with the dealers hasn't changed that much. We're not going into their office every day, but we're talking to them every day. And a lot of the orders, quite frankly, that don't come online, the dealers just tell us and we place the orders ourselves.

Makes sense. Appreciate the call, guys. Good luck.

Thanks. Thank you.

Thank you. Our next question comes from the line of Tom Khanna with Cowan. Please go ahead.

Thanks, guys, and appreciate the granularity as well. I'll be brief. A lot of questions asked and answered. But first, Todd, I was hoping you could give us some historical perspective on how pricing behaves in these downturns and why the industry will be more rational this time.

Even in the financial crisis, we got price. We got prices. I'm doing it from memory, but I think the worst year in pricing, we got 15, 20 million in price on a smaller business than we have today. And we're able to pass it on because there's still sort of pressures that you have on the business. They're not commodities anymore, but it's the additional cost that we have to help protect us from COVID. It's the absenteeism that we have to manage through. So it's sort of the inflationary pressures or the cost increases that we're having in that direction, and we pass the price on. And we've already, in many ways, passed the price on. It's in the price books. We've had the conversations with our customers. And so we're going to pass it on, and my expectation is our competitors will do the same thing.

And as a follow-up, you know, we've asked about consolidation forever. Do you think the current environment makes it more or less likely to happen?

I mean, I think I'll just give you a textbook answer. I think it would be if someone gets into a liquidity issue, it certainly helps. And it would have to go on. The equity values at the current levels would have to stay there. Hopefully they don't, but would have to stay there for some period of time before people reset expectations. But it's hard to imagine that very many deals get done in the near term anywhere in any industry because people just don't believe that they're worth, you know, 30% less than what they were a month ago or two months ago.

Right. And I'm sorry, a last one, if I could sneak one in. Just to play macroeconomist, what year would you expect to get back to 2019 levels? I mean, just based on historical context, is this a three-year workout, a five-year workout? How bad is it from where you're sitting?

The last answer, I don't know. And the reason I don't know is I think you have to answer the medical, in my opinion, you have to answer the medical question first. And I just don't know. And so, look, if we have therapeutics in two months, I'd say it's Katie bar the door. You know, if it's three years and we're still searching for a vaccine and the barns burned down. So you have somewhere between those two, and I just don't know.

Appreciate the candor. Thank you.

Thanks. Thank you. And our last question comes from the line of Joe Ritchie with Goldman Sachs. Please go ahead.

Thanks. Good morning, guys, and appreciate all the detail. Yep. So I'll keep it quick. I'm not sure I heard your answer to Julian's question earlier on the cost outs. Are they linear? And then secondly, you know, if this does turn out to be worse than a down 20 market, you know, Todd, what other kind of levers do you have at your disposal to try to offset some maybe more dire weakness?

I'm not sure I answered that question earlier, so I'll answer for you. I mean, broadly speaking, the cost takeouts are linear, although – All things being said, as you can imagine, some of these things kick in a little later in the year. But we've already announced internally the restructuring. They're already effective. The salary reductions take effect May 1. So all that's happening. And then in terms of what other costs we have, I mean, it's still the same three buckets. you'd have to attack heads, you'd have to attack discretionary spending, and you'd have to attack pay. But as I said earlier, we were able to get to a 25% decremental with a contribution margin of close to 40. And so the next tranche down, I would expect the decremental to be closer to 30, 35%. And so that means while there's some cost there, there are you run out of diminishing opportunities.

That makes sense. Thanks very much, guys.

Thanks. Appreciate it. Okay, everyone. Appreciate the time. Appreciate the interest. To wrap up, these are unprecedented times, but Lennox has a focused and seasoned team with experience managing through difficult challenges. We will execute on what needs to be done near term while mindful of the future and are confident we will again strengthen our market position as we emerge in recovery. Thanks, everyone, for joining us today. Have a good day.

Thank you, ladies and gentlemen. That does conclude our conference for today. Thank you for your participation and for using AT&T Event Conferencing Service. You may now disconnect.