10/23/2024

speaker
Margo
Moderator

Welcome to the Linux Third Quarter 2024 Earnings Conference. All lines are currently in a listen-only mode, and there will be a question-answer session at the end of the presentation. You may enter the queue to ask a question by pressing star and 1 on your phone. To exit the queue, press star and 2. As a reminder, this call is being recorded. I would now like to turn the conference over to Chelsea Polchain from Linux Investor Relations Team. Chelsea, please go ahead. Thank you.

speaker
Chelsea Polchain
Investor Relations

Thank you, Margo. Good morning, everyone. Thank you for joining us today as we share a remarkable 2024 third quarter results. Joining me is CEO Alok Miskara and CFO Michael Quinzer. Each will share their prepared remarks before we move to the Q&A session. Turning to slide two, a reminder that during today's call, we will be making certain forward-looking statements which are subject to numerous risks and uncertainties as outlined on this page. We may also refer to certain non-GAAP financial measures that management considers relevant indicators of underlying business performance. Please refer to our SEC filings available on our Investor Relations website for additional details, including a reconciliation of all GAAP to non-GAAP measures. The earnings release, today's presentation, and the webcast archived link for today's call are available on our Investor Relations website at investor.linux.com. Now, please turn to slide three as I turn the call over to our CEO, Alok Miskara.

speaker
Alok Miskara
CEO

Thank you, Chelsea. Good morning, everyone. Lenox delivered another record quarter highlighted by double-digit revenue growth, operating margin exceeding 20%, and strong free cash flow. We also made solid progress on multiple key initiatives as part of our ongoing transformation plan. I am grateful for our talented team and the growth mindset of our customers who enabled these exceptionally strong results. Let us turn to slide three for the highlights of this quarter. Poor revenue grew 15% and our adjusted segment margin expanded 90 basis points to a Q3 record of 20.2%. Resulting in adjusted earnings per share increase of 24% to $6.68. We generated an impressive $452 million in operating cash flow this quarter, which is $139 million, or approximately 44% increase over the same quarter last year. Our industry-leading ROIC also grew to 47%. Both our segments, HCS and BCS, achieved 15% revenue growth in the quarter, and both continue to deliver strong segment profit. Investments in manufacturing capacity and front-end redesign has enabled us to gain share and meet customer demand for our 410A products. In addition, investments in digital processes and distribution technologies led to improved order fill rates within home comfort solutions. The new commercial factory startup remains on track and the building climate solution segment successfully integrated the AES acquisition ahead of schedule. These results reflect the dedication of our 14,000 employees and the continued support of our dealers and customers. Therefore, I'm confident in raising our 2024 EPS guidance range to $20.75 to $21.00. Now, please turn to slide four for more details on our CLO transition. As announced earlier this morning, John Torres, Lenox's chief legal officer, has elected to retire. I want to take a moment to acknowledge John's outstanding 16 years of leadership and his lasting impact on Lenox. He led multiple acquisitions and divestitures to streamline our portfolio and ensure that we operate with the highest ethical standards by strengthening our ethics and compliance office. As a result of our thoughtful succession planning, we are excited for Monica Brown as she takes on the role of Chief Legal Officer effective January 1st, 2025. Monica has been with Lenox for 12 years with a proven track record across our businesses and legal functions. Before joining Lenox, She spent nearly 13 years with a leading outside law firm. Looking ahead, Monica is well positioned to continue John's legacy of success with a focus on advancing our digital capabilities and accelerating future growth. Now, let me hand the call over to Michael to take us through the details of our Q3 financial performance.

speaker
Michael Quinzer
CFO

Thank you, Alok. Good morning, everyone. Please turn to slide five. We are pleased to report our seventh consecutive quarter of double-digit year-over-year adjusted earnings per share growth. This quarter, we increased our adjusted segment margin by 90 basis points and achieved a remarkable 15% revenue growth, resulting in 24% adjusted EPS growth. Now I will share more details on our third quarter financial results. Core revenue was approximately $1.5 billion, up nearly $200 million from last year. contributed mostly to volume gains in both segments. Adjusted segment profit increased by $52 million, or 21%, driven by $86 million in volume, as well as price and mixed benefits. This was partially offset by regulatory transition costs and expenses related to our new commercial factory ramp-up. Ongoing investments also impacted profits as we are committed to strategic initiatives in sales and distribution to support consistent profitable growth. The tax rate was 18.7% and diluted shares outstanding were $35.8 million compared to $35.7 million in the prior year quarter. Let's now turn to slide six and review the third quarter financial performance of the home comfort solution segment. The home comfort solution segment had an exceptional quarter delivering 15% revenue growth, 25% segment profit growth, and an impressive 170 basis point expansion in segment profit margin. Sales volumes increased by 11%, fueled by over 30% growth in our two-step distributor channel, primarily reflecting normal restocking after several quarters of industry-wide destocking. Our one-step contractor channel saw modest volume growth supported by R4 tech availability compared to the broader market, Towards the end of the quarter, we saw early signs of R410A pre-buy demand. Pricing execution has been a key focus for the HCS segment over the past year, driving 4% revenue growth in the quarter. Having successfully met our 2024 price improvement targets, we are now concentrating on pricing for the new R454B products, and these initiatives are progressing well. Finally, our quarterly profit was impacted by anticipated product cost challenges during our transition to our new R454B products and for ongoing investments aimed at enhancing our distribution capabilities and improving the overall customer experience. Moving on to slide seven. The Building Climate Solutions segment also delivered an impressive 15% revenue growth in the third quarter, 6% of which can be attributed to inorganic growth from our AES acquisition. We are very pleased with this acquisition which was completed in the fourth quarter of last year. The integration was finished ahead of schedule, and we have delivered better than expected AES profit margins, driven by additional synergies. From an organic growth perspective, sales volume was up 7% in the quarter, but was constrained by manufacturing challenges and new factory ramp-up inefficiencies that limited production output. Segment profit increased by $9 million, though profit margins declined due to anticipated manufacturing ramp-up costs. Production startup at our new commercial factory in Saltillo, Mexico, remains on track. However, total manufacturing output for commercial HVAC continues to be below demand levels. For emergency replacement, we have started offering products in some pilot markets, and early results are encouraging. Please turn to slide 8, where I will review our cash flow performance and capital deployment strategies. Operating cash flow for the quarter totaled $452 million compared to $313 million in the same period last year. Capital expenditures were $40 million, representing $1 million increase year-over-year. Our cash flow performance has been solid this year, reflecting ongoing efforts to drive revenue growth, expand profit margins, and optimize working capital. Earlier this year, we implemented working capital initiatives with a focus on accounts payable which has been a driver of the $183 million increase in year-to-date operating cash flow. In the coming years, we will unlock additional working capital by leveraging digital tools and efficient processes. Our return on invested capital, ROIC, stands at 47%, an industry-leading figure that remains resilient across business cycles due to high non-discretionary replacement demand. We continue to expand ROIC year over year while also making capital investments that are poised to deliver substantial benefits in the coming years. Finally, we maintain a healthy balance sheet, with net debt to adjusted EBITDA at 0.8 times, down from 1.8 times in the prior year. Our free cash flow deployment strategy remains focused on driving annual dividend growth and executing bolt-on acquisitions. We have reinitiated buybacks in the third quarter and will continue leveraging share repurchases to efficiently return excess cash to shareholders. If you will now turn to slide 9, I will review our revised 2024 financial guidance. After the third quarter results and more visibility into the last quarter of the year, we have raised our full-year revenue guidance. The table on the left summarizes our full-year revenue growth factors. Total company core revenue is now projected to increase by approximately 10%. We now expect mid-single digit improvement in sales volumes, combined price and mix to be up low single digits, and our AES acquisition to contribute low single digit growth. As a result of our strong third quarter profit performance, we are raising our full year earnings per share guidance to $20.75 to $21 from the previously guided range of $19.50 to $20.25. We're also raising our free cash flow guidance to $575 million to $650 million. As you can see, most of our other guide points have not changed except for interest expense, which is now estimated to be approximately $45 million. Overall, year-to-date performance combined with increased clarity on industry demand has given us the confidence to significantly raise our earnings per share guidance. With that, please turn to slide 10, and I'll turn it back over to Alok for an overview of the low GWP refrigerant transition.

speaker
Alok Miskara
CEO

Thanks, Michael. All necessary preparations for design, engineering, and manufacturing of the low GWP products were completed earlier in the year, ensuring a successful launch in the third quarter. As part of this transition, we are also excited to introduce our new Lenox powered by Samsung mini-split and BRF heat pump systems. We have invested heavily in developing new low GWP products and minimizing disruptions during the transition. We anticipate continued manufacturing cost headwinds into the first quarter of next year as we continue to convert production lines in our factories. Our approach to reconfiguring our factories balances production flexibility with cost efficiency. In 2025, we expect a gradual shift in demand for the new low-GWP refrigerant products. The first half of the year, specifically the first quarter, will see continued R410A sales from manufacturers, distributors, and dealers as everyone depletes their regular and pre-bought R410A inventory. We still estimate that for the full year, approximately 65% of the end market demand will transition to low GWP product, which will favorably impact MEX. Looking further ahead, we anticipate existing 410A refrigerant will face price increases as supply tightens and demand moves towards low GWP products. This will increase cost pressure on repairs, leading to higher demand for system replacements. This transition also opens more service opportunities for dealers and contractors given additional safety features and components from the new R454B products. We expect some of the low GWP price and mixed benefits to extend into 2026 as the market fully transitions to the new low GWP product. With that, please turn to slide 11 for our early thinking on the outlook for 2025. we are pleased with the resilience of the North America HVAC industry growth. We remain cautiously optimistic for 2025, given our sustained competitive momentum from our ongoing transformation journey. On the left-hand side of this slide, you will see several factors that will likely impact revenue growth in 2025. Mixed benefits from the low GWP transition with 10 plus percent price increases, will accelerate growth. Lenox has historically executed extremely well during these regulatory transitions, gaining share and confidence from our dealers and distributors. We plan to do the same thing next year. We anticipate higher manufacturing output from our commercial HVAC factories within our BCS segment. In conjunction with the investment we made in our sales team this year, we will be able to recapture some of the previously lost share in the emergency replacement market. Moreover, these improvements will instill greater confidence in our ability to serve national accounts with a full lifecycle value proposition. We are encouraged by the growth opportunities from partnering with Samsung for a ductless heat pump offering strengthening brand recognition, and providing access to a broader customer base. Increased incentives for energy-efficient systems may lead to higher replacement demand as well as higher tier mix. While we are generally optimistic about 2025 revenue growth, it is important to recognize our outlook can be impacted by several end market factors. Uncertain consumer confidence continues to pose challenges alongside a trend towards more value-triered products, which may negatively impact mix. Higher costs for the new products may also create complexities in the ongoing repair versus replace dynamics. From an industry perspective, we expect destocking in the first half of 2025 as distributors sell through R410A pre-buys this year. Additionally, competitors may gain some share as they overcome their current availability challenges. On the right-hand side of the slide, we have highlighted key drivers for margin expansion. We anticipate margin improvements from the low GWP product mix with 30% incrementals supported by our continued focus on price-cost discipline. We also foresee improvements in productivity from higher distribution fill rates as our focus on digital inventory planning and our investment in distribution technologies start to generate results. Greater factory efficiency will also contribute to our margin expansion, particularly in the second half of next year as we begin to lap the ramp-up costs associated with the new commercial factory and low GWP transition. However, these gains may be partially offset by several factors. Our investments in digital capabilities and distribution network improvements are essential for enhancing operational efficiency and improving customer experience. While these investments are crucial for long-term growth, they may create some near-term pressure on margins. Additionally, we anticipate inflationary pressures for both commodities and component costs. We also expect increases in healthcare and employee benefit costs. Ultimately, our focus in 2025 remains on superior execution to drive differentiated growth and expand margins. We will provide further financial guidance when we report our Q4 earnings early next year. Now, please turn to slide 12. As we wrap up today's call, I want to emphasize our confidence in driving sustainable growth guided by five key elements of our strategic transformation plan. Our first focus is on accelerating growth by adding new customers as well as capturing a greater share of wallet from existing customers. Second, we will expand our margins from price-cost productivity and leveraging the strength of our direct-to-dealer network. Third, the Lenox Unified Management System remains key to our success, helping us streamline operations, share best practices, and execute our strategy. Next, our ongoing investments in digital and heat pump technology keep us at the forefront of innovation to deliver cutting-edge solutions for our customers. And finally, our strong culture rooted in core values and reinforced by our pay for performance model drives our success. Our differentiated strategy continues to create sustained competitive advantages and will enable us to achieve our long-term goals. I'm incredibly proud of what we have accomplished so far, and I have no doubt that our best days are still ahead of us. Thank you. We will be happy to take your questions now. Margot, let's go to Q&A.

speaker
Margo
Moderator

Thank you, sir. At this time, if you'd like to ask a question, please press the star 1 on your telephone keypads. You may remove yourself from the queue at any time by pressing star 2. And again, that is star 1 for a question. We'll take our first question from Tommy Moll from Stevens. Please go ahead.

speaker
Tommy Moll
Stevens

Good morning, and thank you for taking my questions.

speaker
Alok Miskara
CEO

Good morning, Tommy.

speaker
Tommy Moll
Stevens

Alok, I want to start on the A2L commentary that you've provided. I hear you talk about the 10% plus pricing tailwind versus the 410A product, and then also about some early success with initiatives in recent weeks or months, I guess. So if we pull all this together, am I correct in saying that Number one, the magnitude of the pricing mix tailwind is unchanged versus prior expectations. And then number two, that your conviction in successfully realizing that is higher now that you've introduced some product into the market, albeit at low volumes.

speaker
Alok Miskara
CEO

I would say both are true, Tommy. The third thing I would add to is the competitive share gain that we get normally during any regulatory transition is the confidence in achieving that in this transition is also higher.

speaker
Unidentified Participant

Thank you.

speaker
Tommy Moll
Stevens

Looking at the 2025 early thinking slide you provided, Alok, I wanted to unpack what you're referencing here in terms of the trend for the value tier and then the repair versus replace. What have you seen to date on those points, and then what do you want to make sure to communicate about how that might evolve into next year? Thank you.

speaker
Alok Miskara
CEO

Yeah, what we have seen so far is not a meaningful shift between repair and replace, but we continue to be cautious about it, especially given that the price of new equipment will rise. So we continue to monitor that, and that's why I want to call it out. On the value tier shift, as we went from sort of 13 SEER to 14 SEER, and as we look at the overall state of the economy, we have seen a shift towards more people buying the minimum SEER. It already used to be, what, 60%, 65% of the industry. So now it might be 65% to 70% of the industry. So that's what we are calling out in the value tier. No surprises, no changes from any of our previous conversations. Just wanted to lay out the positives and the potential watch out for 2025, but really no change in Q3 that we are calling out.

speaker
Tommy Moll
Stevens

Noted. Thank you, Luke. I'll turn it back. Thanks, Tommy.

speaker
Margo
Moderator

Thank you. We'll next go to Ryan Merkle with William Blair. Please go ahead.

speaker
Ryan Merkle
William Blair

Hey, everyone. Thanks for taking the question. My first one is just on the 65% next year that'll be A2L. Can you just talk about some of the assumptions you're making there and then would you say the risk is to the upside there or to the downside? I know that's kind of a hard question.

speaker
Alok Miskara
CEO

It is a hard question, but Ryan, we are here to answer your hard questions. Listen, I think the risk right now is fairly balanced around the number 65. If you remember earlier in the year, we were talking about 50% to 65%, but right now we feel more confident around the 65% number. I think if it's a little lower, it could be because there's more pre-buy in 410As, which we will see in Q4. And if it's higher, it'll be because a lot of the competitors already out of 410A inventory right now. So as we're selling 410A, it could be used this quarter versus being left over for next year. So those are kind of the two dynamics on the 410A that we are selling today. Does that land up becoming pre-buy, which I think is some chances, or it's just because competitors are short on that product. So those would be the pluses and minuses on that trial.

speaker
Ryan Merkle
William Blair

Got it. Okay. And then just on the pre-buy, clearly that helped a quarter. As we think about the first half of 25, can you quantify the magnitude just so we can set our models correctly?

speaker
Alok Miskara
CEO

Sure. So on the pre-buy, I'm not sure how much it helped Q3. I mean, if you think about Q3, what helped us was three different factors. First of all, the end of destocking and beginning of restocking, I mean, that was probably the largest contributor. As you saw, our two-step business was up over 30% or around 30%. So I think that's the biggest factor for what happened in Q3. Second, I would call out is just share gains. I mean, we've been gaining share just because of better execution and there was some impact of competitors running out of inventory. I think share gains were the second factor. Third, which may have happened a little bit towards the tail end of the quarter, is pre-buy. But remember, most of our business goes to dealers. And unless they go start renting out big barns, I mean, they're not going to be able to do a lot of pre-buy. And distributor inventory levels are still pretty close to normal. So I just want to emphasize the point on the pre-buy, on how we expect. What we would expect, as I said, is in Q1 next year, there clearly will be some depletion or destocking of pre-buy. Maybe some carryover in Q2, but that gives us confidence in the 65% number, saying majority of the sales next year will be 454B.

speaker
Unidentified Participant

Got it. Thanks. Thank you.

speaker
Margo
Moderator

And we'll next go to Joe O'Day with Wells Fargo. Go ahead.

speaker
Joe O'Day
Wells Fargo

Hi. Good morning. Thanks for taking my question. I wanted to start on the market share comments that you've made. I think that going back to the 2018 time period and Tornado and a period of time of maybe two or three years of some share headwinds, it seems like over the past couple of years, those have reversed and you've been on a share gain trajectory. But can you just level set in terms of through these periods of time, how much you may have given up, how much you've recaptured, net-net, where do you stand today, and how you're thinking about those share gain opportunities moving forward.

speaker
Alok Miskara
CEO

Sure. I'll start by reaffirming what you said, is that, yes, we have reversed those share losses, and we are back on a positive trajectory. Because we do both one-step and two-step, share is a little difficult as we look at EHRI or any of those data's. But today where we stand because of all the moving pieces, we are confident that we have gained share and we continue to gain share. What we have to do next year is make sure that we can retain most of the captured share because as competitors have inventory, which many of them don't right now on 410A product, then there would be like, you know, a lot of our effort going towards making sure our share gains are more permanent. On the commercial side, where also the share gain comment comes up, we have not been able to recover the share so far. That's part of our plan for 2025 on getting share back on the emergency replacement because we are still constrained by manufacturing capacity, not demand in that segment. So we're going to separate the share comments into commercial and residential.

speaker
Joe O'Day
Wells Fargo

Got it. And then I just wanted to circle back on the 454B pricing commentary, and you've noted that the initiatives are progressing well. Any color that you can provide on what that means in terms of or with respect to the 10% plus price? And I think there's still debate out there on how to think about that price and list versus realize. So any clarification there when you talk about 10% price and if that's a realized number?

speaker
Alok Miskara
CEO

You know, I think as we finish Q4, when we have greater clarity on market movements and acceptance, you know, we can talk about that in early Q1. Right now, you know, the 10% is what we are looking to gain out of a price, but realize we'll apply to only 65% of sales and only the products that are 454B, and we will also be raising price on 410A next year. So the 10% has to be taken in conjunction with 410A pricing today. So there are a lot of moving pieces and we can provide greater clarity. But the overall where we are seeing in the marketplace is the higher cost products that we're introducing, 454B, is being supported by our and competitive moves on 10% price increase into 2025.

speaker
Unidentified Participant

Got it. Thank you.

speaker
Margo
Moderator

Thank you. And next we're going to go to Jeff Hammond with KeyBank. Please go ahead. Hey, good morning, guys.

speaker
Alok Miskara
CEO

Hey, Jeff.

speaker
Jeff Hammond
KeyBank

Hey, just, you know, I appreciate all the color on that 25 moving pieces. If we just kind of looked at the market today, what do you think that res unit and commercial unit kind of market growth looks like as you snap a line today? you know, into 25. I know, you know, there's a number of moving pieces, some noise with the pre-buy, but just kind of underlying unit demand in each of the businesses.

speaker
Alok Miskara
CEO

You know, if you think about res, and we talked about this earlier in the year, that we expected for a dealer, the volume to be flat to down. Then halfway through the year, we upgraded to be flat. And now we're going to say flat to maybe slightly up. is where we are on the red side. And I'm talking about installed units away from stocking, destocking. But think of flat as the conservative flat to slightly up as maybe a little bit more like, you know, aggressive numbers to look at. But it's hard to come to that in a firm number, as you know, with the different moving pieces.

speaker
Michael Quinzer
CFO

Yeah, I think what we need to do is see this Q4 pre-buy play out and see kind of how that impacts the end market demand as well as share gain initiatives that we've talked about, Norm, where we've executed better than others during these transitions. So those are two unknowns that we need to see how they play out over the next quarter.

speaker
Alok Miskara
CEO

So we'll wait for HRI, but I think flat to slightly up would be a good way to look at end market on residential. On commercial, since we remain supply constrained, we just go with the industry figures where I think the market has been growing slightly. It's still not fully recovered from the COVID declined that it happened. Because our markets, remember, we don't have offices. We don't have as much multi-story housing. What we call commercial is typically retail, single-story buildings. So from that perspective, we do see that market continuing to grow low single digits at the end market. And I'm more optimistic about lower interest rates, better market performance going into next year.

speaker
Jeff Hammond
KeyBank

Okay. And then just in commercial, Um, maybe levels, you know, remind us your mix in education and, you know, there's been a lot of funding, ESSER funding around K through 12. And I know that's been a hot market. If you, if you're seeing any signs that as that sunsets, uh, you know, that market might, you know, see a, a, a move back.

speaker
Alok Miskara
CEO

We are not seeing any signs of that market going back. Our exposure in education is probably less than some of our competitors. given historically we have been so focused on retail, but we look at that as a good growth opportunity, but currently we don't see any of that slowing down, as we see also schools issuing bonds and other pieces, because these are very necessary maintenance, and many of these units remain way past their useful life.

speaker
Unidentified Participant

Okay, thanks so much.

speaker
Margo
Moderator

Thank you. Next we'll go to Jeff Sprague with Vertical Research. Please go ahead.

speaker
Jeff Sprague
Vertical Research

Hey, thank you. Good morning, everyone. Hello. I just want to come back to kind of the share game dynamics, and we've got to hop over and see what else Watts goes saying this morning. But, you know, you're kind of playing the share game largely being a function of, you know, some competitors running out of 410A where, you know, they sound like maybe there's actually some bigger problem with somebody. I I'm not expecting you to kind of name names on competitors, but are you actually seeing somebody also struggle with the transition or there's some other kind of systematic problem with someone in the channel other than just kind of running out of 410A?

speaker
Alok Miskara
CEO

Obviously, we don't know what's happening inside the hood with any of those competitors. What we know is our availability right now on 410A products is better than many of the other players, and that's giving us an advantage. We also know that a lot of the investments we made last year in improving our sales team, being a better distributor, making sure we have higher fill rates, and ensuring that we have a decentralized model that gets more aggressive and focused on our typical AOR dealer, all that's paying off as well. So I don't want to break out the share gains into two comments, right? One is totally consistent with everything we have been trying to do. And second, maybe some current advantage because of competition stumbles. It's part of the transition. We made a bet that throughout this year, 410A demand would be higher and the shift to 454B would only happen next year. I believe some of the competitors may have made a different bet and they may have run out of products.

speaker
Jeff Sprague
Vertical Research

And then thinking about the after effects of whatever pre-buy we have into next year, right? I mean, the 35% of the market that's not 454B, almost by definition, right, has to be sitting in distribution by the end of the year, right? You know, if manufacturers are running low on it now. So, I mean, that, you know, I mean, that feels like, you know, really a potentially bigger air pocket early in the year, you know, than, I don't know, maybe people think. Maybe just kind of comment on that, like how you see the state of distribution at the end of the year and how this kind of give back on the pre-buy might play out.

speaker
Alok Miskara
CEO

Yeah, sure. First of all, we will get greater clarity next year because Q4 is still just starting and we've got to work through that. Our 35 number was based on that even manufacturers will have some 410A inventory. Like, you know, we will have 410A inventory at the end of the year that we will be selling. So, like, you know, as we look at our own distribution, and I think other manufacturers will likely also have 410A inventory at the end of the year. So, it's not just inventory at distributors. It's inventory at manufacturers and distributors. Q1 is where we will see the most impact. I think the effect starts waning away in Q2. And that's why the 65-35. But, you know, Jeff, I wish there was an exact science behind this or if we had full visibility and complete transparency. So this is just like, you know, us looking at what we know and coming up with an educated guess. We are going to be wrong. We just don't know whether it's going to be wrong on the upside or the downside.

speaker
Jeff Sprague
Vertical Research

Understood. No, thanks for the color. Appreciate it. Thanks, guys.

speaker
Margo
Moderator

Thank you. Next, we're going to go to Stephen Volkman with Jefferies. Please go ahead.

speaker
Stephen Volkman
Jefferies

Thank you very much. Actually, I'm just going to build right off of that. Alok, wouldn't you rather be wrong by having more R410A so that you are price competitive further into 2025?

speaker
Alok Miskara
CEO

You know, for the whole industry, which is what we care about deeply as well, I would hope that everybody runs out of R410A by the end of the year so we get the better mix and the transition is more seamless for our dealers. For our dealers, dealing with two different product lines and training their crews and all that is just very difficult. So we want to support our dealers and I hope the entire industry runs out, which is quite likely given that some competitors are already running out of 410A. But from our perspective, yes, we would like our manufacturing transition to be clean and for us to move to 454B. At the same time, We don't want to be price disadvantaged in the first quarter when others may have 410A. So that's a daily balance we got to drive, Jeff.

speaker
Stephen Volkman
Jefferies

Okay. And maybe just switching to commercial, any words of wisdom as we think about how the new facility kind of ramps up through 2025 and we sort of try to model that and when the startup costs kind of go away?

speaker
Alok Miskara
CEO

Yeah, the startup costs will go away definitely by Q2. A large part will go away in Q1. Right now where we are is we are on track from the timeline perspective. I would say the startup inefficiency may be a shade higher than what we thought originally. Just because we are putting extra focus on quality and sometimes we are paying more for freight to move products back and forth. And we want to make sure it's a really good quality product and we take care of our customers through the transition. I would say you should expect by mid-next year us to be kind of running up to as we thought the capacity of the factory would be. So think of another three quarters worth of ramp-up associated with inefficiencies fading away in Q1.

speaker
Michael Quinzer
CFO

Michael? Yeah, I'll just add, a lot of these costs we're experiencing right now we believe are temporary. Obviously, we're trying to launch a factory. So in the second half of next year, when that factory is fully operational, these temporary transition costs should evade.

speaker
Stephen Volkman
Jefferies

Great. And then just finally on that, you mentioned earlier that demand is outstripping supply on commercial. When this thing is up mid-year to normal run rates, is that then in better balance?

speaker
Unidentified Participant

We know we'll be in better balance.

speaker
Alok Miskara
CEO

We may still be below capacity because remember, we're only getting 20% of the potential capacity in Saltio up and running. And if demand continues to outstrip supply, we will put up another 20%. I mean, the factory is large enough for us to be able to double our current capacity, but we are doing it 20% at a time. But yes, we'll definitely better balance and better be able to serve our customers. I mean, currently our customer satisfaction in this is very low because we just can't meet the amount of demand and orders we have.

speaker
Stephen Volkman
Jefferies

Helpful. Thank you, guys. Good luck.

speaker
Margo
Moderator

Thank you. Next, we're going to go to Joe Ritchie with Goldman Sachs. Please go ahead.

speaker
Joe Ritchie
Goldman Sachs

Thanks. Good morning, guys. So, Alok, I know that you clearly don't have the crystal ball here, but just to square those comments on your own inventory levels exiting the year, is the way we should think about it that you expect to carry inventory levels of 410A products to at least meet demand for the first quarter, and that's really kind of like the balance that you're that you're trying to make sure you get right?

speaker
Alok Miskara
CEO

Approximately. The reason I say, remember, we are also a distributor, and 70% of our sales act just like a distributor sale. If we turn inventory five times a year, which I know we do around that much, I will have 410A inventory just from phase-in, phase-out perspective that we will sell through in Q1. So I think some of it is just practical constraints of transition, and others, of course, we do want to remain competitive. So while it's not a goal, I think that's just largely how it will play out, because we will continue manufacturing till the time we can.

speaker
Joe Ritchie
Goldman Sachs

Okay, fair enough. And then maybe just sticking on pricing for 410A, given that the products are going to be discontinued going into next year, Does that change the pricing dynamics that you're able to put through in the early part of next year as you typically put your annual pricing increases through? Or how should we kind of think about, you know, that 410A pricing even for the portion of the year that it sells in to the network in early 2025?

speaker
Alok Miskara
CEO

You know, first of all, we want to take care of our customers and be fair. But second, from a demand and supply perspective, if 410A is short in supply, which is what we're experiencing right now, we fully expect to capture the incremental pricing in 2025 for any 410A product sold in 2025. We do annual price increases. Cost of benefits are going up. A lot of the commodities continue to be around inflation and wages. So yeah, we fully expect to have 410A sold in 2025 to be at higher price than 410A sold in 2024. Okay, great to hear.

speaker
Unidentified Participant

Thank you.

speaker
Margo
Moderator

Thank you. Next, we'll go to Julian Mitchell with Barclays. Please go ahead.

speaker
Julian Mitchell
Barclays

Thanks very much, Alok. Maybe first off, there's some sort of interesting bits and pieces on the margins, I suppose, on slide 11. Maybe trying to wrap it together. So I think your operating margin this year is guided up about a point for the year as a whole, just total Lenox. So it's sort of 30-ish percent incremental margin. When we look at the bits and pieces on slide 11, is the main takeaway that it's a similar incremental next year, or is there something I'm missing on some of the moving parts on slide 11?

speaker
Michael Quinzer
CFO

I think overall we expect our margins to expand to both sides next year, predominantly led by the mixed benefits that we'll see. Then offsetting some of that will be some of the investments we're making. We're going to have at least a 30% incremental on the mix, and then we'll get some more volume tailwinds helpful on share, which is also 30% incremental. We'll have to go through all the puts and takes and some of the investments we're making, but 25% to 30% incremental sound in the range, but we've got to go through all the details still.

speaker
Alok Miskara
CEO

Yeah, and Julian, remember our long-term targets for Linux margins that we have published, I mean, we are still not there. So we obviously want to keep making progress towards that over the next year, year and a half to get there. So I don't want to give you exact number because Q4 still has to play out depending on how that goes. But we do expect margin expansion next year for sure.

speaker
Julian Mitchell
Barclays

That's helpful, thank you. And then just my follow-up, revisiting, sadly, the pre-buy stuff again. So I guess it sounds like if we're trying to quantify it, we should not be too concerned, if that's right, for a couple of reasons about the extent of the destock. I think one is, if I look at your residential volume numbers, guide for this year, it's gone up about three points, I think, for the year versus what you said in July. But a lot of that is share gain. So you've got maybe, I don't know, a point of effect from pre-buy this year. And then also if the effect is mostly in Q1 of next year, Q1 is typically a very small seasonal quarter anyway for you, and particularly so for cooling product, which presumably is what the refrigerant change affects rather than hot product. So maybe just clarify for me if I'm misunderstanding anything with those points, please.

speaker
Alok Miskara
CEO

Well, you're not misunderstanding, Julian. This is your classic quote, if I can quote back to you, like, you know, analyzing storm in a teacup, right? I mean, our industry is overanalyzed sometimes. I think companies that execute well, have a strong strategy, do better. But yes, your math is about correct. I mean, 70% of us here are kind of immune to this whole pre-buy discussion, and that's going to work as planned. The other 30%, we believe majority of the effect right now is stocking, destocking, not pre-buy. Having said all of that, Q4 is still out there. You know, I mean, if Q4 has a very heavy Q quarter and a lot of that's driven by pre-buy, then all our answers could change and we will have to talk about that in Q1. But, I mean, so far we are assuming there will be some pre-buy but not a heavy pre-buy that impacts us this year.

speaker
Unidentified Participant

Great. Thank you.

speaker
Margo
Moderator

Thank you. Next, we're going to go to Noah Kay with Oppenheimer. Please go ahead.

speaker
Noah Kay
Oppenheimer

Thanks for taking the questions. Really great quarter for cash generation. And as we look towards 25 and lapping some of the investments you've made in the CapEx side, and I think in the past you talked about getting back to 100% free cash flow generation, 100% free cash flow conversion, how do we think about share repurchases, That picking up here in 4Q levels for 25, it had been a couple of years, but going back, it used to be pretty active on the repo front.

speaker
Alok Miskara
CEO

I'll start by just saying that our new CFO is really helping to drive the free cash. He's bringing a new level of discipline. a new level of accountability, and a new level of focus on working capital management. With that, I will hand it over to Michael to actually answer the question.

speaker
Michael Quinzer
CFO

And I'll just add on that. That's one of the initiatives I started is trying to align the organization on working capital management, especially as we look to get 90% or even close to 100% of free cash in that income. So it's something we're focused on over the next couple of years. But yeah, we are generating a lot of cash. And our deployment strategy is going to be basically consistent where every year we're going to increase our dividend. We're going to look at our dividend yield compared to growth companies in the S&P 500, so we'll do that. And then we're also evaluating bulk on acquisitions that have to have the right fit with the right returns on it. So we're being very disciplined in that, but we're definitely focused there. Then thereafter, it's going to be about share repurchases. We started getting back into share repurchases this quarter. We'll continue to do those, but it will be kind of a tool to efficiently deploy back capital if we don't do acquisitions.

speaker
Noah Kay
Oppenheimer

Okay. And can you talk a little bit about that acquisition pipeline and what your needs might be at this moment?

speaker
Michael Quinzer
CFO

Yeah, I think what we've looked at is different technologies, kind of bolt-on technologies in the commercial space. They just give us a better product offering with our commercial customers. We've looked at distribution opportunities to have a full assortment of products that we can sell through our residential distribution network. Those are two big ones. And then there's just different technologies to make our products smarter, either on the thermostats, IAQ. So it's a host of things that we're looking at, but, again, they've got to have the right fit and the right price.

speaker
Alok Miskara
CEO

And I would add to that, remember, I mean, we are also trying to be more of a distributor versus just a manufacturer, and there's a big opportunity for products that our dealers buy or our key accounts buy that we don't sell today. So if we could look at appropriate products and technologies, as Michael said, and bring them into our network, that would be significantly value-enhancing to our shareholders. So we are very disciplined in capital allocation, and as Michael said, we will look at all those opportunities and balance those appropriately. But it starts with strong cash flow, which I think Michael and the team are doing a great job at.

speaker
Noah Kay
Oppenheimer

Great. I'll have some follow-ups offline. Thanks very much.

speaker
Margo
Moderator

Thank you. Next, we're going to go to Dean Dre with RBC Capital Markets. Please go ahead. Thank you. Good morning, everyone.

speaker
Dean Dre
RBC Capital Markets

Hey, I saw that the plan to build share in emergency replacement is highlighted on the outlook for 25. You talked about this before. Can you just share some color on what it means to refocus on that business? You know, my understanding is you will need to boost inventory in the field because you need 24-hour turnaround and the customers have to know this and it's either you're ready for that order or you miss it entirely. So what kind of working capital burden increase are you looking at to fill emergency replacement and can you size that? Thanks.

speaker
Alok Miskara
CEO

Tim, that's a very good question. Thanks. I agree with you that going back to emergency replacement requires a lot of effort. It starts with us having more manufacturing capacity. Then it goes into making sure we have appropriate inventory within 24 hours, and in some cases, urban market the same day. And then finally, it also comes down to having the right feet on the street and getting all the contractors who may have gone to something else or someone else to come back and look at that forward. And we are doing all of that. Most of that working capital impact will be in 2025 and we'll be happy to come back and look at it. But I can also tell you it won't be as material because today we have excess working capital, but it's on the raw product side as we are starting factories and transitioning factories. I will look to redeploy a lot of that working capital from raw materials more into finished goods and closer to the customer. So it's a pretty heavy move, but from a financial perspective, I would expect a lot of that come from the additional raw inventory we are carrying as part of startup.

speaker
Dean Dre
RBC Capital Markets

That's really helpful. Thanks. And then second question from Michael. On ROIC, Lennox is so far ahead of anyone else in industrials. I think from our coverage, you're probably, you're nearly two times bigger versus the next closest competitor. So just kind of talk us through, as you make decisions, investment decisions, cap-back decisions, are you looking at the ROIC impact? Do you hesitate at all in investments? I know it's a rhetorical question and you're going to insist no, but just the idea that you will at times pressure ROIC. So is this more of an outcome or a target the way you think about it in the company.

speaker
Michael Quinzer
CFO

Yeah, what I'll say is that our industry-related ROIC is mostly driven by our organic discipline approach to investment. So we've not done a lot of inorganic acquisitions. Obviously, when you do those, they will be dilutive. But when we look at acquisitions like we did with AES, it was a good ROIC, well above 20%, but still below the 47% that we're tracking. So we'll continue to look at bolt-on acquisitions that are above our cost of capital. And then from a capital expenditure perspective, we do the same thing. So we're not necessarily targeted on growing above 47%, but we want to stay, you know, 40% and have good ROI projects on these CapEx. And so we're looking at both on the organic capital expenditures and the inorganic acquisitions to have, you know, healthy ROIC above our cost of capital.

speaker
Dean Dre
RBC Capital Markets

That's really helpful. Thank you.

speaker
Margo
Moderator

Yep. Thank you. Next we're going to go to Brett Lindsey with Mizuho. Please go ahead.

speaker
Brett Lindsey
Mizuho

Good morning. Congrats on the quarter. I wanted to come back to the early thinking on 2025 and the 30% incremental comment on low GWP. Is that a volume incremental comment and then price mix should drop through at something above that similar to this year? I'm just hoping you can maybe parse those pieces out.

speaker
Michael Quinzer
CFO

Yeah, what we're expecting is more of a price cost that will come through. We'll have mix-up for the pricing that we just talked about, and then the drop-through on that mix will be at least 30% to maintain our gross margins and reflect the additional costs that we're having to put into the product and investments that we're making. Our volume incrementals are also similar to 30%, so we have both kind of dropping through at 30% the mix next year and our normal volume gains.

speaker
Brett Lindsey
Mizuho

Got it. And then just thinking about new versus replacement in residential, obviously new housing has been a drag. How much was that down so far this year? And then you noted some of the value to your growth for next year. Thinking about a better housing environment and some of the investment, should you maybe pick up some share in new housing next year or grow in line with the market? Any thoughts there?

speaker
Alok Miskara
CEO

Yeah, I think we're starting to see some green shoots in new housing. So we are either bouncing along the bottom or we are coming off from the trough from new housing. So that's positive. And remember, we are kind of six months behind the new housing starts number that you might see. Our share position in there remains very strong. And on the replacement side, again, if you believe even the recent Wall Street Journal article about homeowners starting to do more replacements, repairs and renovations. We think higher demand there will probably result from lower interest rates and consumer confidence. But all that said, there's just a lot of uncertainty. On the value tier, our comment was driven by because of the SEER changes, because of the pricing levels, and because of the higher interest rates that are prevailing versus a few years ago. So we just want to watch out for that going forward. There's a lot more for us to analyze and evaluate before we come to you in 2025 and give you more firm guidance on those things.

speaker
Brett Lindsey
Mizuho

Thanks. Appreciate the insight.

speaker
Margo
Moderator

Thank you. Next, we're going to go to Steve Tusa with J.P. Morgan. Please go ahead.

speaker
Steve Tusa
J.P. Morgan

Hey, good morning. Morning to you. What do you think is driving distributors to stock up in the last couple months of the summer when you know, the demand is effectively like maybe flat up a little bit and you have this transition coming, what's kind of the driver there?

speaker
Alok Miskara
CEO

Yeah, and I think, Steve, depends on which type of distributors. I mean, we can talk about our distributors. We haven't seen our distributors stocking up. We are seeing our distributors going away from destocking. So they're going back to normal inventory level that existed pre-COVID. And we haven't seen them taking extraordinary measures to stock up. Now, I think in Q4, they might do some 410 pre-buy to get some price advantage versus 454B. But I have not seen any, at least from our distributors that we work with, any big push to stock up.

speaker
Michael Quinzer
CFO

And I'll just add on top of the comps, if you go back to Q3 last year, that channel was down 20% due to destocking. So definitely favorable comps year over year as they restock, as Love mentioned.

speaker
Steve Tusa
J.P. Morgan

Got it. And then when it comes to the pricing for next year, so you're saying 10% plus on 70% of your revenue, I think 65% penetration. So that kind of gets you into, you know, firmly in the mid single digit plus range for price for next year, kind of capture for the segment. Is that like the right math that you're talking about?

speaker
Alok Miskara
CEO

Yeah, we'll get you greater clarity in 2025 because I do, we'll have more clarity both on Like, you know, 65, 35, 454B. But I think that's roughly the right math and the way you looked at it right now.

speaker
Joe Ritchie
Goldman Sachs

Okay.

speaker
Alok Miskara
CEO

And then lastly. Most is going to look at mix versus price, right? Because these are brand new products.

speaker
Steve Tusa
J.P. Morgan

Right. So this is mix versus, like, just pure price. But that is the right math right now. It's around, you know, 5%, 6%.

speaker
Michael Quinzer
CFO

And the single digit is a good range. And I'll just add the stick rate we normally see in regulatory transitions is high. because we're making a lot of cost investment. We need to stick it.

speaker
Steve Tusa
J.P. Morgan

Got it. And then just lastly, I guess, with the combination of the pre-buy for the industry, at least, maybe perhaps more. Some of the things you talked about as being uncertain as far as consumer confidence, repair versus replace, all that. Do you expect industry volumes next year at this stage? to be down? Industry volumes. You've talked about your share gains, but is industry volume down next year, do you think?

speaker
Alok Miskara
CEO

Listen, from my perspective, I would say the industry volume, and this is installed on the ground, so away from any distributor stock in or stock out and all that. I would think it's going to be flat to slightly up next year. And a lot of that's just driven by like an ongoing trend, age of units, and the cost of repair versus replace. But, you know, I wish I could predict that more accurately, Steve. Everybody's going to have a different view on this.

speaker
Michael Quinzer
CFO

And interest rates are going to have a heavy influence in that as well.

speaker
Steve Tusa
J.P. Morgan

Right.

speaker
Michael Quinzer
CFO

And then, sorry, one more question. New home construction is picking up, so, right?

speaker
Steve Tusa
J.P. Morgan

Yeah, yeah. Sorry, one more question from, you know, maybe the guy that overanalyzes, as you said, whatever the comment was. The share gains this year with your competitors that have been out of the market, why are those sustainable? Why isn't that a tough comp in the next year? Is this kind of structural share gain you think you've taken because of that?

speaker
Alok Miskara
CEO

Whenever somebody stumbles, some of that becomes permanent. When we stumbled with the tornado, it took us years, six years to get that share back. I look at our past stumbles and Some dealers will switch back, some won't. So, I mean, that's what our comment is. Our goal is to make them as permanent as possible. But that's where execution comes down and see what works. Got it. Okay. Thanks a lot.

speaker
Margo
Moderator

Thank you. Next, we'll go to Nigel Cole with Wolf Research. Please go ahead.

speaker
Nigel Cole
Wolf Research

Thanks. Good morning. We covered a lot of grounds. And let's not overanalyze this situation, but... What is the feedback from your end customers, the contractors, the dealers on A2L? Have they come to terms with the technology, the training requirements, etc.? Do they actually want to have A2L or do they want to take as much 410A as they can? And I'm just wondering, this dynamic of 4Q versus 1Q, if you're going to increase prices effective 2025, is there an incentive for them to stock up in 4Q versus 1Q?

speaker
Alok Miskara
CEO

Yeah, so talking about end contractors, I mean, the good news is we are belly to belly with 10,000 of them. And I can tell you all 10,000 have 10,000 individual views. So depending on whom you ask, you will get that view. In general, I would say most contractors would prefer to continue doing what they're doing. They're chain resistant, but they also realize that they don't have a choice and they have to move to 454B. It only comes down to some of them, especially the high-end one, will want to move sooner versus later because they're selling a high-end product and they're not at the bottom end of the range. Others who are more chuck in a truck and at the bottom end of the range, they will want to keep doing 410A as long as possible. On the passenger side, it's been well accepted. People have gone through training. People understand how to install it. We are spending a lot of time doing training. Other distributors are doing a lot of time doing training. So that'll happen. Is there a risk that some of them will stock up more on 410A at the end of the quarter? Because they do have garages and barns. They may not have warehouses. Yeah, I think there is a risk to that. I mean, that's a risk we deal with every year.

speaker
Nigel Cole
Wolf Research

Yeah, okay. I've got a vision of barns being used to stock up HVAC units. We'll have to do some barn visits.

speaker
Alok Miskara
CEO

I was in a barn in Wisconsin and actually saw that.

speaker
Nigel Cole
Wolf Research

Yeah, side by side with the cheese. Then just thinking then about just conceptually, the repair versus replace dynamic. If we're in a 454b world and you've got a 410a system or a 22 system, you're going to have to replace the whole system if you're going to replace, instead of just a component replacement, etc. So why wouldn't there be more kind of compressed replacements or motor replacements or whatever in a world where we're putting through another 10% price. I'm just trying to figure out here whether we will see kind of more of a repair mix as we transition through this A2L.

speaker
Alok Miskara
CEO

You know, I think fundamentally... It does, absolutely. I still think it comes down to the age of the unit. So if the unit is five-year-old and it's got a compressor broken, the dealer is likely to come and change the compressor. If it's a 12th, 14-year-old unit, where the compressor is broken and the motor is making noises, they're likely to replace the whole system. In the 12 to 15-year-old unit, because the extra cost of 410A, once it spikes and it has not spiked yet, becomes an additional factor that comes into play. So I don't think, just like the R22 to 410A pieces, in the beginning years, it didn't change the repair to replace, but in the future years, it did move it more towards replacement versus repairs. I think the same thing is going to happen. Probably no impact in 2025 for repair versus replace, but in future years it will.

speaker
Nigel Cole
Wolf Research

Great. And then just a quick one. I'm probably the last question here. Have you sized the dollar, Tam, for the emergency replacement market for commercial? What sort of share do you think you can get out of that, Tam?

speaker
Alok Miskara
CEO

We haven't sized or broadcast that yet, but we know what we used to have. And we also know that the industry broadly has a healthy mix between emergency replacement and key account. And we are essentially almost all key accounts. So the industry is 60-40. We are probably 90-10 in that in terms of 90% key account and 10% emergency replacement. So we do know we have a significant opportunity for us to take that forward. You can take that and multiply it by AHRI industry data, but the industry is a lot more weighted towards emergency replacement than we are.

speaker
Unidentified Participant

Maybe next year we will come back and give you some sizing on that. Great. That's great. Thanks.

speaker
Margo
Moderator

Thank you for joining us today. Since there are no further questions, this will conclude Linux 2024 third quarter conference call. You may disconnect your lines at this time.

Disclaimer

This conference call transcript was computer generated and almost certianly contains errors. This transcript is provided for information purposes only.EarningsCall, LLC makes no representation about the accuracy of the aforementioned transcript, and you are cautioned not to place undue reliance on the information provided by the transcript.

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