Erie Indemnity Q1 2023 Earnings Call Transcript

Quartr
Provided by Quartr
April 27, 2023

There are 18 speakers on the call.

Operator

Welcome to the Lennox First Quarter 2023 Earnings Conference Call. All lines are currently in a listen only mode As a reminder, this call is being recorded. I would now like to turn the conference over to Chelsea Polshan From Lennox Investor Relations team, Chelsea, please go ahead.

Speaker 1

Thank you, Britney. Good morning, everyone, and thank you for joining us for Lennox's 1st Quarter Earnings Results. I'm here today with CEO, Alok Musgara CFO, Joe Reitmeier and VP of Finance, Michael Kwenzer. Alok will discuss highlights for the quarter, and Joe will take you through the company's quarterly financial performance and our view on 2023 fiscal guidance. After that, we will have a Q and A session with Alok, Joe and Michael.

Speaker 1

Turning to slide 2, 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. Please refer to our SEC filings available on our website for additional details. All comparisons mentioned today are against the prior year period unless otherwise noted. Speakers may also refer to certain non GAAP adjusted financial measures that management may consider to be relevant indicators of underlying business performance and trends. A reconciliation of all GAAP to non GAAP measures is included in today's earnings press release, SEC filings and in the appendix of this presentation.

Speaker 1

The earnings release, today's presentation slide and the webcast archive link for today's call are available on our website at www.lennoninternational.com. Now let me turn the call over to our CEO, Alok Musgara.

Speaker 2

Thank you, Chelsea. Good morning, and welcome, everyone. Allow me to start by sharing my appreciation for all of our employees whose hard work has enabled us to deliver exceptional performance this quarter, including record quarterly earnings per share. We take great pride in our team's effort To gain share, expand margin and seamlessly transition our product portfolio to meet the new minimum energy efficiency regulations. This successful quarter reflects our company's product leadership, strong direct customer relationships And advanced digital platforms.

Speaker 2

These factors will continue to fuel our share gain and margin expansion I want to also take this opportunity to thank our dealers and customers For their loyalty to Lennox as we improve our service levels while delivering the best HVACR products and solutions in North America. Now please turn to Slide 3, where I want to highlight 4 key messages. 1st, Lenox is proud to report another quarter with record financial results. 1st quarter 2023 core revenues grew 3%. Our margin expanded 2 10 basis points resulting in our adjusted EPS increasing 15% to $2.83 Our free cash usage this quarter was $114,000,000 which is typical given the seasonality of our business.

Speaker 2

2nd, we are pleased with the pace of margin recovery in our commercial business segment. Our profits more than doubled compared to last year as manufacturing operations stabilized and the benefit of price and mix outpaced inflationary cost increases. 3rd, we continue to help our dealers and customers Succeed during the transition to the new minimum efficiency regulations that went into effect on January 1, 2023. Our superior design and successful track record of executing during regulatory changes in conjunction With improved service inventory levels has put us in a strong position to gain share. 4th, Given the strong quarterly results, we remain comfortable with our previously issued full year financial guidance.

Speaker 2

We continue to closely monitor end market sentiments, track movements in commodity pricing and execute countermeasures, Including additional price increases. We are also optimizing our inventory levels given improved lead times and current sales outlook. Now please turn to Slide 4 for our view on the current end market conditions. In the residential end market, we are experiencing destocking in our 2 step distribution channel just as we had expected. We anticipate the destocking to continue through the beginning of second half of this year.

Speaker 2

Volume in our direct to dealer channel was flat in Q1. However, we are expecting softness later in the year, driven by fewer new housing starts in 2022. We are closely monitoring consumer confidence for any changes that may impact the replacement versus repair decisions, But we are also encouraged by the recent improvement in the new housing starts. There is no change in our full year outlook For mid single digit decline in residential unit volumes. In commercial, our backlog is strong And our lead times have improved as the factory situation has stabilized.

Speaker 2

The industry lead time for commercial equipment Remains extended due to the shortage of common components. We still believe that commercial sales will grow by high single digits this year. On the price versus inflation balance, we are price cost positive, but we are monitoring recent inflation in commodities Such as steel and copper. To offset the higher material cost, we have implemented a targeted residential price increase That will become effective on June 18 this year. Overall, we are well positioned to gain share With our success in seamlessly transitioning to the new minimum efficiency standards and given our improved service inventory levels.

Speaker 2

In addition, we are strengthening our go to market organization by adding more field resources and offsetting those investments By driving back office SG and A productivity. Now please turn to Slide 5. To accelerate our profitable growth and to expand margins, we are investing in pricing excellence at Lennox. Over the past few years, we have managed to offset inflation with price, but there remains a significant opportunity For us to refine our pricing strategy to derive greater benefits from both price and mix. We are strengthening our pricing infrastructure by increasing price analytics, engaging outside experts And further developing our internal talent.

Speaker 2

Recently, we have revised our company wide contract signing authority To ensure appropriate scrutiny over key account pricing and have redirected new business development on higher margin channels and applications. We also plan to expand our rebate auditing process and take all the necessary steps to increase price netting. Another priority of ours is to work with our larger key accounts to optimize our cost to serve So that we can establish win win partnerships. In summary, we know that pricing excellence is an important step towards Lennox Regaining our competitive margin advantage and thus we are increasing our focus to meet or exceed our long term margin goals. Later in the presentation, I will provide an update on our long term goals.

Speaker 2

But for now, I'm going to hand the call over to Joe Reitmeier, will go through our Q1 financial performance.

Speaker 3

Thank you, Luke. Good morning, everyone. Please turn to Slide 6. Looking at the quarter for Lennox overall, the company posted strong revenue and profit growth. Core revenue, which Our European operations was a record $990,000,000 up 3% compared to prior year.

Speaker 3

Both our residential and commercial segments experienced sales volume declines, but price execution and favorable product mix more than offset the volume headwinds. Total adjusted segment profit increased $24,000,000 or 20% versus prior year. Price and mix exceeded product cost inflation by $63,000,000 with partial offsets of $17,000,000 from lower volume And $22,000,000 for inflationary effects and investments in distribution and SG and A expenses. Total adjusted margin was 14.4%, up 210 basis points with most of the margin expansion driven by performance in our commercial segment. In the Q1, corporate expenses increased $6,000,000 to $19,000,000 due to the timing of incentive compensation expenses.

Speaker 3

Moving on to net income and cash flow performance starting on Slide 7. The 1st quarter not only achieved record levels of revenue in Segment profit, but also marked record earnings per share with GAAP earnings per share rising 20% to $2.75 And adjusted EPS growing by 15% to $2.83 Our first quarter adjusted net income included a 21.4% tax rate And diluted shares outstanding were 35,600,000 compared to 36,400,000 in the prior year quarter. The company used $79,000,000 of cash in operations compared to a use of $98,000,000 in the prior year. Working capital optimization is a priority and we remain on track to achieve our 2023 cash flow target. Capital expenditures were approximately $35,000,000 for the quarter, an increase of $10,000,000 compared to prior year.

Speaker 3

Capital investments will be higher this year as we fund growth and increase capacity, including a new factory for our commercial business. We used $114,000,000 of free cash flow compared to a use of $123,000,000 in the prior year quarter. In the quarter, the company paid approximately $38,000,000 in dividends. Total debt was $1,670,000,000

Speaker 4

at the end

Speaker 3

of the quarter And our debt to EBITDA ratio was 2.1. Cash, cash equivalents and short term investments were $48,000,000 at the end of the quarter. Moving to the business segments, starting on Slide 8, where our residential segment delivered record 4th quarter revenue. Residential revenue was flat to prior year as sales volume declines of 8% were offset with 4% favorable price, 5% favorable mix and 1% unfavorable foreign exchange. Total sales, which go direct to dealer, Represent about 70% of our segment revenue and were up mid single digits.

Speaker 3

The remaining 30% of our revenue goes through distributors Where total revenues were down low teens, the result of expected industry destocking, residential segment profit rose 3% $111,000,000 a first quarter record. Segment margin expanded 50 basis points to 16.3% As continued pricing gains more than offset product cost inflation of our new minimum efficiency standard products drove favorable mix. Partially offsetting these gains were $12,000,000 of lower volumes and $16,000,000 from inflationary headwinds on distribution and selling and administrative expenses where we've made investments to fuel growth. Turning to Slide 9 in our commercial business. As announced in our last earnings call, beginning in the Q1 of 2023, The commercial segment results will include our North American Refrigeration operations.

Speaker 3

Our European operations will be reported in our Corporate and Other segment Until we complete the divestiture of the European businesses. Revenue was $309,000,000 in the quarter, up 10%. Combined price and mix were up 16% and volume was down 6%. Commercial segment profit was up 110% And segment margin expanded 770 basis points to 16.2%. We are pleased with the profit recovery in our commercial segment where price and favorable mix were the main contributors to profit growth early in the year.

Speaker 3

In the Q1, we successfully transitioned our HVAC products to the new minimum efficiency standard, But industry wide supply chain challenges constrain production output and can continue to limit sales volumes. Demand from customers remains robust with a solid order backlog. While supply chain challenges persist, Lead times to our commercial customers are shortening and are competitive with the industry. Turning to Slide 10, let's review our 2023 full year guidance. Our outlook provided on our last conference call remains unchanged.

Speaker 3

As a reminder, I will reiterate a few guidance points. We expect core revenue to be flat to up 4% for the year and earnings per share of Between a range of $14.25 per share to $15.25 per share. Free cash flow is targeted within a range of $250,000,000 to $350,000,000 We are planning capital expenditures of $250,000,000 that includes investment in a second commercial factory Investments related to refrigerant transition to take effect in 2025. Price benefit, including price associated with the 2020 transition is now expected to be $175,000,000 and we now expect net material costs to be a $45,000,000 headwind in 2023. The material cost headwind is driven by component cost inflation of $100,000,000 Net of $30,000,000 in savings from cost reduction initiatives along with $25,000,000 from commodity cost benefits.

Speaker 3

Corporate expenses are still targeted at $80,000,000 We will manage SG and A tightly by continuing to manage necessary investments in the businesses to support growth initiatives and drive productivity. And finally, we still expect the weighted average diluted share count for the full year to be between 35,000,000 to 36,000,000 shares, which incorporates our plans to repurchase $100,000,000 to $200,000,000 of stock this year. With that, let's turn to Slide 11 and I'll turn it back to Alok.

Speaker 2

Thanks, Joe. Please turn to Page 11 for an update on the key initiatives reviewed during last year's Investor Day to deliver on our long term targets. As a recap, our 2026 target is to deliver an ROS of 18% to 20% with revenues over $5,000,000,000 We believe that our laser like focus on North America HVACR market, our direct to dealer business model And our superior technology portfolio will ensure long term success. We are executing 6 self help strategic imperatives outlined on the right hand side of this page to meet or exceed our 2026 goals. 1st, growth acceleration to drive share gain will be achieved by optimizing our go to market effectiveness, By improving our brand customer experience and by increasing growth capacity.

Speaker 2

2nd, we will increase resilient margins Through commercial recovery, productivity and pricing excellence, which was highlighted earlier in the call today. 3rd, to maintain execution consistency, we have introduced a balanced scorecard operating system. We are transitioning to a dual source supply chain and we are implementing lean digital processes like sales and inventory planning. 4th, we are reconfirming our commitment to 90% to 100% cash conversion and a healthy balance sheet, While building a bolt on M and A pipeline focused on North American HVACR. 5th, We will enhance our technology leadership through the frequent regulatory transitions by winning in core climate heat pump And investing in digital AIML adoption across all our business functions.

Speaker 2

6th and finally, We are reinforcing our high performance talent and culture by rolling out guiding behaviors to support our core values. In addition, we are undertaking succession planning and ensuring that our compensation scheme remains aligned with value creation. Once again, I would like to thank our employees who are working hard to successfully implement this self help transformation plan. To close our prepared remarks, I would like to summarize on Page 12 the reasons why I believe LII is an attractive investment opportunity. Lennox is a narrowly focused North American leader in the attractive industry of energy efficient, environmentally friendly HVACR solutions.

Speaker 2

We operate in high growth end markets with strong replacement demand that provides us with resiliency Even during periods of economic uncertainty, the company has a unique direct to dealer network, Which creates a sustainable competitive advantage. And we have a history of robust execution with disciplined capital allocation. As I complete my 1st year at Lennox, I'm even more excited about Lennox's future And continue to believe that our best days are ahead of us. Thank you. Joe, Michael and I will be happy to take your questions now.

Speaker 2

Britney, let's go to Q and A.

Operator

We'll take our first question from Joe O'Dea with Wells Fargo. Your line is now open.

Speaker 5

Hi, good morning everyone.

Speaker 3

Good morning Joe.

Speaker 6

Just to start on the commercial margins, certainly some encouraging progress there. Anything that you can talk about that you would consider sort of Non repeat in the quarter versus just some of the progress that you were expecting maybe coming through a little bit faster. Kind of We've that into how you're thinking about sort of the go forward from here as supply chain continuing to improve and those margins continuing to improve sequentially?

Speaker 2

Yes. So Joe, on the commercial, we are pleased with the progress. We had talked about earlier that we think there's a reset coming in the Q1 of this year, Given that many of our key accounts had to be repriced with the SEER change and the new product addition And you saw that loudly reflected in our P and L. So that's consistent with what we expected. We had also talked about Almost a little over under a year ago, dollars 100,000,000 in EBIT improvement.

Speaker 2

And over the past Few quarters, we have already delivered $60,000,000 of that $100,000,000 So yes, we are a little ahead of where we expected and that's a good thing. We remain on that journey. I think we are going to get to that $100,000,000 faster than what we had originally talked about, just given we are more than halfway through with that. And with supply chains improving, demand remaining strong, we still expect high single digit growth this year and we still expect margins to hold. No, there was nothing unusual in Q1.

Speaker 2

We would expect the performance trajectory to continue going forward.

Speaker 6

Great. Thank you. And then on the resi side, can you talk a little bit about your sort of expectations For the year on the sort of direct to dealer versus to distributor kind of outline And you gave some color on the Q1, but curious sort of how you think about that, if you're able to talk at all about Your framework for the Q2 thinking about that and then just generally for the full year, how we should think about those varying trends?

Speaker 2

Sure. So I think let me start with the end consumer, right, because that's how we look at it. I mean, the end consumer demand seems to be holding pretty well. From our perspective, as you know, this was not a great season from a heating perspective. It was unseasonably warm in quite a few parts of the country.

Speaker 2

Despite that, we talk about that in our direct to dealer business, we had flat units Coming through and on our 2 step model, we had declines. And that was largely destocking driven. So from our perspective, the end consumer demand remains healthy. There's obviously slowdown in growth, but we don't see any declines coming up Because the replacement business is holding pretty steady. For the rest of the year, Joe, I will expect a decline in direct Mostly because of residential new construction that slowed last year and that's going to impact our demand now.

Speaker 2

On 2 step, I think the declines get better. So I think in Q2, we'll see less destocking that we saw in Q1 and Q3 will probably see little to no destocking as that gets behind us. We are only in April. May, June are bigger months for us than in April. But overall, we remain confident in the full year outlook of Mid single digit unit decline was 0% to 4% revenue growth for us as we look at all these factors combined together.

Speaker 5

I appreciate it. Thanks.

Speaker 2

Thanks, Joe.

Operator

We will take our next question from Nicole DeBlase with Deutsche Bank.

Speaker 7

Maybe just going back to the commercial margins, obviously, really this quarter. And with respect to Joe's question, I mean, I think you usually see a step up in margin seasonally in commercial from 1Q to 2Q and then a smaller step up in the Q3. Would you say that it's possible that we could see a seasonal increase? It's just Kind of hard to gauge since 1Q was so strong. Thank you.

Speaker 2

Yes. I mean commercial, listen, overall, For the long term, we expect that business to be a 20% ROS business. And Q1 was good, but we are only at a 16%. I think there's still room for improvement for us. I don't want to accurately try and predict Q3, Q4 or Q2.

Speaker 2

I mean, we don't have that level of precision. But I would see no reason why our typical seasonality trend won't hold this quarter. Because remember this quarter, we also had some inefficiencies Related to the CO transition as we completed those. So stay tuned. I mean, I think we're starting at a good spot and We expect to end in a few years at closer to 20%.

Speaker 7

Thanks. That's really clear. And then second question just on price cost, obviously a benefit to margins in the quarter. How does that phase through the year, especially given the new price action you talked about today? Thanks.

Speaker 2

Yes. So the new price actions that we talked about are on the residential side. On commercial, we had a reset going into Taking note this year, so I think the price cost benefit that you saw, we will see the levels remain the same, but obviously we start going through more difficult comps Because we had done significant price increases. So the year over year comps get difficult, but I think the levels on a As is basis remains. Where we have to do more pricing effort is on the residential side and that's where we are putting a lot of our emphasis and focus And that's where the new price increase that we talked about goes into effect on June 18.

Speaker 2

Thanks. I'll pass it on.

Operator

We will take our next question from Tommy Moll with Stephens Inc. Your line is now open.

Speaker 8

Good morning and thanks for taking my questions. We appreciated the insight you provided on the pricing excellence Strategy and I wanted to drill down on a couple of the items in there specifically around the optimizing local versus central decision making. Can you bring us in on what that involves and to what extent was that related to the mid year price increase that you just announced on resi to us today or was there some other factor driving that decision? Thanks.

Speaker 2

I think as we went through The tornado many years ago as we went through COVID and significant inflation, we went into more of a command and control more because we had to. Those were crises that we're managing. Historically, we have really good territory managers. We have really good branch leaders. We have really good folks.

Speaker 2

We have good field intelligence. And we need to act accordingly just like a distributor does, because although we are a manufacturer, like our 250 Outlets act more as distributor. So as we are looking at it, we want to give more input, more say to local pricing decisions versus looking at things doing more centrally. And so obviously, you want to set our strategy centrally, but our local field force have a lot more Market intelligence and look at every region behaving a little differently. So that was the comment was, we are going to optimize it And that's a pretty typical thing for us to do.

Speaker 2

Pricing in South Florida may be very different than pricing in North Dakota. And We need to make sure that we appropriately account for those differences.

Speaker 8

As a follow-up, I wanted to look at the residential Profit contribution versus the commercial side, which was quite robust this quarter. But if we think about the full year trajectory there, Your guidance does imply some growth in profitability year over year. Given the residential volume Headwinds that you've articulated, should we assume that all or substantially all of the profit growth this year should come on the commercial side or is that not the right way

Speaker 2

No, I think it will be a balance between residential and commercial. Listen, commercial had a good start. I think residential has lots of room for improvement With the price, with the mixing, with the inventory level coming down, so I'm optimistic on residential and we are driving that hard. Commercials did have easy comps too compared to where we started in Q1 last year, right. Obviously, we look at that.

Speaker 2

But no, I think the overall Profit increase for this year would be balanced between those 2 as residential, the benefit of SEER change Also it's going to happen a little slower than commercial because commercial we didn't have as much finished good inventory sitting around. And in residential we sold Quite a bit of the lower SERE products in Q1 as we are finishing that inventory. So I think putting it all together, we are Equally optimistic about residential improving for the rest of the year.

Speaker 8

Appreciate it, Luke. I'll turn it back.

Operator

We will take our next question from Jeff Hammond with KeyBanc. Your line is open.

Speaker 9

Hey, good morning guys. Just want to come back on price. I guess first, what's informing another price Chris, kind of around this June 18. And then just as you talk to contractors and get feedback, any start you're starting to see are you starting to see any pushback From contractors or fatigue from the consumer on kind of these multiple increases?

Speaker 2

Yes. I know, maybe some costs keep going up. I mean, as you saw, steel has been up significantly, copper started to go back up. And what we also did is, Vikram, just like you would expect good companies to, we did a pricing benchmark on where we stand. So I think the price increase in June is a targeted price increase.

Speaker 2

We targeted areas where we think we have greater opportunities. And that's because for the past couple of years, We were sort of doing brute force price increases versus what I would call sophisticated price increases. So a lot of that is Working with our own analytics and our teams to go through that and fully offset the inflation and make sure we remain competitive in the market And capture the adequate balance. So it's a lot of details and analytics behind it, Jeff, but we remain confident Got the right thing to do and supports the industry pricing level. On the second part of your question, no, I mean, remember the equipment Price is only a small portion or less than half of what the consumer pays or sees in there.

Speaker 2

And we have seen no Pull back because the repair versus replacement dynamics, in fact, still favors replacement, Given that repairs are more expensive, R-twenty two units are very hard to repair, the cost of R-twenty has gone up. And cost of spare parts and labor has gone up more than the cost of equipment. So we haven't seen any changes and I think that's consistent with the industry. Well, obviously, we remain closely aligned with 10,000 dealers and we keep getting their feedback and we'll adjust if anything changes.

Speaker 9

Okay, great. And then just as we look at it, it seems like you still have a lot of confidence in the resiliency res, seems like commercial is ahead. What kind of precluded you from kind of moving the guide at this point?

Speaker 3

Yes, Jeff. I think once again 1st and 4th quarters are seasonally our lightest. We've got a lot of the year still in front of us Just didn't really want to once again, we approach it with conservative cautious optimism, I think, is the right way to characterize it. We remain confident in our gauging the underlying markets, but just wanted to get into the peak season before we made a call on the full year.

Speaker 10

Okay. Thanks guys.

Speaker 2

Thanks Jeff.

Operator

We'll take our next question Julia Mitchell with Barclays. Your line is now open.

Speaker 4

Hi, good morning.

Speaker 2

Hi, Julian.

Speaker 4

Good morning. Maybe I'll leave commercial margins in peace for the time being. Maybe just on the commercial kind of Top line, fully understand the excitement around the good margin performance. But on the top line, maybe remind us of some of those main sort of End market exposures for the commercial piece in terms of kind of end market verticals, obviously, a lot of concerns from people out there on things like Office and retail and so forth in recent months. So have you seen any kind of shift in customer behaviors?

Speaker 4

Any color you could provide on sort of bookings or orders at all on the commercial side? And again, any sort of flavor Could you give on how the end markets break out for the business?

Speaker 5

Hey, Julien, this is Michael. Yes, on the commercial side, the backlog still is healthy. We're Seeing good demand across most of our verticals. New construction is kind of 15%, 20% of that business. We're not seeing any credit issues yet, but backlog is definitely still healthy going and reaching into Q3.

Speaker 5

So we're really not seeing a pullback on the demand yet. Backlogs are extended a little bit because of some of the lead times in the factory, but from a demand perspective, it still looks healthy.

Speaker 4

Thanks very much. And Michael, any color you could give on sort of vertical splits, I don't know, education versus more Commercial applications, anything like that?

Speaker 5

Yes. We're seeing some good demand on the education side. That's predominantly a summer season though, when the schools We're out of season and we can get in and do the replacement work. So schools are more of a Q2, kind of Q3 dynamic more than Q1. Right now, it's still just executing our backlog that we've had for quite a while and we're seeing a good demand across most of the channels.

Speaker 3

Yes. And I'll add a few more things, Julien. Where we put a concerted effort was preserving our national account customers. Once again, that Strategy, I think, is paying off for us as once again the order rates and backlog remain strong there. And then as we continue to reengage in the emergency replacement segment of the market, That should provide us additional upside more in the second half than first half.

Speaker 3

But regardless of how the underlying vertical is performing, we still think given where our business is positioned today, We still have tremendous runway, particularly in the second half of the year.

Speaker 4

That's helpful. Thank you. And then just my quick follow-up Going back to sort of residential volumes, so understand Maybe Q1 is a bit noisy with the SIA transition just sort of happening and so forth. And you had that and maybe weather constraints. So you've got the down 8 volumes in resi in the quarter just behind you.

Speaker 4

As we think about how that plays out through the year and what you've seen in April, albeit it's a very small month for the quarter. But do we assume sort of second quarter is down about Same amount, sort of volumes down high single digit in the second quarter. And then by the Q4, you're probably growing volumes again, is that the way to think about the year for resi volume?

Speaker 2

I mean, it's hard to say in April. I mean, April doesn't really give a trend. I mean, if you think about the key drivers of the volume decline in Q1, Almost all of it was destocking, right. So I mean, if I take that destocking part and I would say Q2 will see some more destocking. I don't know if it'd be as extensive as Q1, probably not because Q1 was the most pullback as people completed CEO transitions and Knew that they were comfortable stock and that's what we expected.

Speaker 2

I think Q2, they'll be a little less destocking, Q3 will be minimal to 0 and then Q4, we should be done with destocking. I think that's the way to think about it. End user demand seems to be holding just fine. I mean, there's no growth that we saw, rapid growth that we saw during COVID and other places, but that demand seems to be holding just fine. And R and C, residential new construction, we can predict very well The housing starts is what drive it.

Speaker 2

So I think the volume declines moderates, it won't be 8% in Q2, Q3. But in Q4, to your specific portion, I'm not sure if it returned to growth because that will depend on the residential new construction, which is looking better. We started the year thinking it will be down 20%. Right now, it's look like it's closer to 10% from housing start perspective. We do need to watch and monitor that, Jotin.

Speaker 4

That's helpful. Thanks a lot.

Speaker 2

Thanks.

Operator

We'll take our next question from Jeff Sprague with Vertical Research Partners. Your line is open.

Speaker 11

Thank you. Good morning, everyone. Hey, I want to come back to kind of the maybe it's on Slide 5, kind of the pricing slide. Hello, can you dig a little deeper into maybe the opportunities? I guess I'll call them non price actions, right?

Speaker 11

Rebates, leakage, things like that. Is this an area where the firm once lost it or this is a new area of focus and maybe you could give some color insight on Like how significant driving some of these netting actions might be?

Speaker 2

Yes, I guess having done pricing back in my consulting days, I strongly believe that all three levers are important, setting, getting and netting. So I think it's important. In some of these cases, yes, we had strong discipline. And during COVID and other cases, we as we pulled back on Non critical activities, like some of these just had to give as we had to focus on other things such as Recovery on COVID, looking at supporting the volume constraint. So I think we have that muscle.

Speaker 2

We got to kind of make sure we retrain it. We'll make sure we find it and deploy it. A lot of this is also around, we have structural advantages When it comes to serving some of the large accounts, whether it's, we call it national accounts or key accounts, And it's going to be for us to work jointly with our customers to find the lowest cost way to serve them And create win win situations there. Because we are direct, right? We can optimize a lot of freight distribution And make it win win for us and these large growing often like sponsor owned PE dealer network.

Speaker 2

So we think that's a big opportunity Where it's less about what the list price is, but it's more about what's margin on both sides and we have an opportunity to optimize that. So we used to do it very well. We lost some ground just because we had to focus on other areas. We are bringing that back And we are excited about the structural advantage we have in going after larger accounts where the cost to serve would be lower on both sides.

Speaker 11

And then just on inventories, you spoke to the channel destocking and the like. I just wonder if you could address your Own inventories, I guess we're up 30% year over year and 20% sequentially. It's Not crazy given the inflation that's out there, but maybe just address where your inventories are visavis where you think they should be, Any particular absorption or other issues embedded in the guide as you work through that or anything else to be aware of there?

Speaker 5

No, I think what you saw was our inventories definitely grew in Q1, but that's normal with our seasonal nature of our business. We always grow inventory in the Q1 And then we'll burn that off in Q2 and Q3. Built into the guidance that burn off of the inventory, we're going to look to potentially do a little bit more. We think there may be some upside to exceed the free cash guide, but it's normal to build inventory as we did in Q1.

Speaker 2

If I can just jump on that, I mean if you go back again a few years ago, when we were turning inventory at 5 to 6 times a year and we still have room for improvement there. I mean right now we are turning it at 3 to 4 times. I think over the 3 day year planning period, you can expect us to go back to turning inventory at The historical levels driven by finished goods optimization that Michael mentioned, but also raw material. As supply chains became extended, We bulked up on raw material and we don't want to do anything crazy here, but over the next 2 to 3 years in a very disciplined manner, working with our suppliers and our customers, We are going to drive our inventory turns to be better.

Speaker 11

Great. Thanks a lot. Appreciate it.

Operator

We'll take our next question from Josh Pokrzywinski from Morgan Stanley. Your line is open.

Speaker 12

Hi, good morning guys.

Speaker 3

Hey, Josh. Hey, Josh.

Speaker 10

Look, I want

Speaker 12

to follow-up on, I guess adjacent to price, but really about share gain. If you think about where you see the biggest opportunity today, is it more on kind of the larger dealers, Bigger national accounts like homebuilders, is it in the smaller guys? Maybe talk about where this kind of newer field autonomy is really Designed to try to meet the market between different customer types.

Speaker 2

Sure. I mean, Josh, I think the simple answer is all of them. I mean, we have an opportunity with smaller dealers because we underserved them post the tornado. I mean, we were known for our Dave Lenard Signature Series products. We had really good partnerships.

Speaker 2

And because we didn't have enough inventory or service levels, many of them were forced to look somewhere else. So we need to win them back. And I think that's where a lot of the local autonomy, the improved service levels and all of that goes into, right? 2nd part of that is just geographic based on legacy and driven. I mean our market share in South Florida is much lower market share in Marshalltown, Iowa and that's been for years.

Speaker 2

I mean that's where a lot of the efforts we have done including Increasing our reach, investing in our distribution footprint, getting more heat pump coverage, all of that helps. I think second factor is geographic. 3rd, to come back to the national dealers or the larger dealers, that's where we have a structural advantage and it's a different more sophisticated approach of working With them on trying to make sure that we create a win win partnership. So Josh, we have opportunities in all three areas. And don't forget at the same time our indirect business, which is also doing very well.

Speaker 2

So when I talked about our direct, on the indirect size where we are targeting through Allied, Our independent distribution network and giving them a stronger better value proposition that works well. I think all 4 are important, right? Smaller dealers that we lost unfortunately during and after the tornado, Truly looking at regional expansion, going into key accounts and getting to make sure we have a win win value proposition, And finally, continuing to expand our 2 step model as well, because we believe we have a unique value proposition. So those are kind of our 4 Levers for market share gain.

Speaker 12

Understood. And then just shifting over to the product side and the 2025 Transition coming up. I know you're reiterating guidance today, but it does look like you have a little bit of padding to start the year, It's a good performance in commercial. Anything that you're able to pull forward on R and D, CapEx, anything else on Getting set for 25?

Speaker 3

Yes. It's a situation where I think we're doing all that we can. Once again, our priorities are Elevating our service levels with our customers, making sure we've got the right mix of product to meet end market demand and then continuing to pull forward and we've done that to extent, Josh, you'll notice that our capital expenditures are $250,000,000 $50,000,000 of that is associated with Staying ahead of the 2025 transition. So we're making those investments, pulling ahead those activities that we can to deliver value to our customers. And once again, much like we did with the minimum efficiency transition this year, seamlessly attack what's ahead of us in 2025.

Speaker 10

Got it. Thanks for the color. Best of luck, guys.

Speaker 13

Thanks.

Operator

We'll take our next question from Noah Kaye with Oppenheimer. Your line is now open.

Speaker 2

Good morning. Good to

Speaker 10

be with you. Thanks. I guess To start with, interested in the commentary around the SEER benefit to mix, look, I think you said actually it was a fairly Small amount of SEER product sold to the resi channel in 1Q. Is it possible to quantify the SEER benefit to mix In the quarter, how you would think about that into the seasonal uptick and what's embedded for Sears specifically In the full year guide.

Speaker 2

Sure. Michael will answer that question, but let me just clarify. Maybe I didn't what I was saying is that not All our sales in Q1 were the new SEER products. About 1 third of our sales in Q1 were still the older SEER

Speaker 5

Right. Yes. In residential, we did see favorable mix. It's predominantly for the Sears transition. As we've talked about previously, it Daxmoor, volume and price, it dropped through at about a 30% drop through that we saw in residential.

Speaker 5

We should start to see that for the rest of the year at a similar 30% drop through on The benefit for the mix shift and a little bit higher margins on the drop through on the commercial as we're able to get some additional pricing on top of that, But should be about a 30% drop through that we see in residential.

Speaker 10

Okay, great. And then what did you see from the e commerce channel this quarter? I think To the question around share gains overall, just how did that channel factor in?

Speaker 2

Yes, we don't break out e commerce sales by quarter. But needless to say, as we talked in the Investor Day, it's a very important channel for us. We look at Over a third of our sales, as we mentioned in the Investor Day, go through e commerce. We find that all of those are very sticky customers And that continues to grow. So I think the numbers we disclosed in December still hold our better, but we don't break that out quarterly, nor do we think it's relevant to break it out quarterly.

Speaker 2

It's important part of our growth strategy. And what we are even more excited about is to be able to leverage those data And the relationship and using artificial intelligence and machine learning to make critical decisions, everything from inventory planning to pricing, Also looking at making it easier for our dealers from predictive maintenance perspective and others. It's a huge investment for us, very important for us, but the quarterly breakdown of that is not something we think is relevant.

Speaker 10

Yes. Appreciate the color. Thank you.

Operator

We will take our next question from Ryan Merkel with William Blair. Your line is open.

Speaker 13

Hey, everyone. Just a couple of cleanups for me. Just going back to commercial, Alok, can you put a finer point on why you're so far ahead On the margin recovery because I think before you thought it was a 3 year sort of linear progression and now it looks like you might be there at the end of this year.

Speaker 2

Well, first of all, I'd say it really pays to have a conservative CFO. So I think that will be the first start point on that, Ryan. Listen, it definitely helps. And when we said 3 years, we really looked at that being like our external Internally, obviously, we were driving it to a faster pace. I think the SEER transition worked well for us.

Speaker 2

I mean, as we looked at The factory converting over, the labor stabilizing, getting the new products, which I give full credit to the team As we were also able to rationalize our SKU, so we have like 40% less SKU in the factories working through And simplify. So a lot of just the core discipline was restored. We make a step forward with SKU rationalization. We were able to work with our key because these new SKUs are not covered by some of the legacy contracts. So all of the so I think we If there was a like an optimistic scenario and a conservative scenario, we were probably guiding you guys to the midpoint of that.

Speaker 2

And right now, we are fighting on cylinders to hit closer to the optimistic, but it's within the range of what we thought, Ryan.

Speaker 13

That's helpful. Thanks for that. And then just on resi, any differences in the quarter by geography? We obviously had some weather out west. Just curious there.

Speaker 2

Not substantial. I mean, there is weather related, right, because the Winter was mild in certain cases. Northeast did not do well, but I think that's an industry wide factor, not the southern states did well. I think it could also be because some of our competitors stumbled during this year transition and we had inventory. So I think some of the southern states we saw Particular strength, but nothing that I could call out or give you an database answer on Ryan.

Speaker 13

Got it. Thank you.

Operator

And we will take our next question from Nigel Coe with Wolfe Research. Your line is open.

Speaker 14

Thanks. Good morning, guys.

Speaker 2

Hi, Nigel. I see

Speaker 14

we covered a lot of ground already. Hi, guys. Just on that last point, so obviously we saw a pretty significant share shift during the Q4 with the transition. It sounds like that continued perhaps not as a stream, but that continue in the Q1. Is that fair, Alok?

Speaker 2

Yes, that's fair. And I think these things typically Given the abrupt nature of the regulations, but the difference between North and South, I think we all have got I mean, all industry players have got sophisticated on Starting to make them in Q4 and continue selling them through end of kind of Q2 to make sure the inventory doesn't become So I think we have done all done a good job with that.

Speaker 3

And I think our direct to dealer strategy benefits us Due to the destocking in the 2 step channels. So once again, I think we were probably unjustly criticized for losing share As the 2 step channels stocked up, once again as it destocks, we'll see some of that benefit in the form of additional share.

Speaker 14

Yes, that's very fair. Going back to commercial margins, I know that this has been well vetted. But if you think about the Arkansas facility, Where is labor and material productivity trending today relative to normal? And I'll leave you to define normal, but where are you sort of This target on that curve?

Speaker 2

I'm glad you're going to leave us to define normal. I'm going to leave it to somebody else. So it's hard to define normal. But here's the thing, right? I mean, wages are not going back.

Speaker 2

So let's put it that perspective. But our factories are still fairly inefficient. Lot of the inefficiencies that crept Including expedited freight, including overtime, including line rates running below normal, those still persist. And Q1 was actually a little bit worse on that because we had to go through SEER change. So imagine retooling all your lines And getting to new products, which were completely new design for us, remember our 3 new models that we introduced at the beginning of the year.

Speaker 2

I think there's still room for productivity improvements for us going forward. Our priority is still output there, right? I mean, I The more we can produce, the more we can sell. We're still limited by output. But getting the output up, getting manufacturing productivity And working on the 2nd factory, remember all of this is still based on the existing factory.

Speaker 2

Once we have 2 factories And can truly look at one being focused on made to stock, going after emergency replacement, Making standard products at very high velocity, very high efficiency and the other being on made to order for key accounts specific. I mean that's sort of our Vision that hasn't changed. We just got to the one factory improvement sooner. Okay. Thanks a lot.

Speaker 2

I'll leave it there.

Operator

We will take our next question from Joe Ritchie with Goldman Sachs. Your line is open.

Speaker 13

Hey guys, good morning. Hey, can you touch on just your visibility into the independent So it looks like your Allied business was probably down. I'm guessing volumes are down like high teens this quarter. Just what kind of visibility do you actually have to destocking being pretty much behind you in 2Q?

Speaker 2

Sure. So when we say 2 step, we mean ADP and Allied. So combined together and you're right, I mean the volume was down in the range you mentioned. We have very good relationship with this channel and we have good visibility. That's the reason we are kind of hinting at we would expect these talking to continue in Q2 2.

Speaker 2

And then beginning of Q3 or beginning of second half, we think that will be behind us. It's hard to quantify because every distributor is different, right? Mean, nobody has the same exact operating rhythm as somebody else in a different state. But The amount of excess inventory that the distributors are holding is should be complete with destocking by beginning of Q3.

Speaker 13

Got it. That's super helpful. And I guess maybe just a follow on on commercial. I know we've talked about it and Congrats on being way ahead of plan on getting that $100,000,000 back. It's probably unfair for me to even Ask this question, but how are you thinking about what where the margin improvement is going to come Post achieving the $100,000,000 which seems like it's going to come a lot faster than you originally anticipated.

Speaker 2

Yes, I mean, I'll point out to a few different things, right? First of all, remember the $100,000,000 we had said does not include the 2nd factory benefit. I think we are still holding to that. So the second factory, we've started construction, things are moving along well. We expect To be under roof by the end of the year, we would expect production sometime next year.

Speaker 2

So that will give us significant benefit As we have 2 factories very focused operating, like you know to serve our customers really well. So that's going to be one part. 2nd on that is I think there's significant opportunity for us to continue looking at our service growth. Service is very attractive business for us and we were Not fully focused on that given all the disruptions happening here. So getting service and increasing our service focus, Which is good margin, it's repeatable, it's predictable and gives us great insight for equipment sales.

Speaker 2

I think the service would Really help us well. And finally, going back to the manufacturing inefficiencies, I don't want to rule that out. I mean, we are in the early stages of working through manufacturing inefficiencies And getting all of those out of the system. So long term, we are committed to 20 plus percent ROS across both the segments. And we are excited about all the steps.

Speaker 2

And those are sort of the Things I mentioned in the last page when I talked about the 6 key self help initiatives we are working on, They kind of equally apply to both residential and commercial.

Speaker 13

Makes sense. Great. Thanks, guys.

Operator

We'll take our next question from Brett Lanzi with Mizuho. Your line is open.

Speaker 15

Hi, good morning all. Hi, Brian. Just wanted to come back to commercial briefly. So you noted the backlog remains Strong and order rates are solid. What degree of visibility on those orders converting do you have for this year?

Speaker 15

And is there anything specific of mix, Whether it's national account versus other verticals that we should be aware of over the next 2, 3 quarters?

Speaker 2

I think the second question first. So on the mix side, no. I mean, we don't have large projects that funnel through the pipeline or anything, right? I mean, these are All projects and these are looking at products that we price accordingly. So no, the margin in our backlog is no different than the margin we're expecting in Q1, if that's your question, We have good visibility into that margin and it's all good.

Speaker 2

Nothing to worry about there. On the overall demand visibility, It's everything from some key accounts who want to plan 2025 volume right now post the low GWP To people on emergency replacement who wants product tomorrow, but our backlog is healthy. I mean, the industry lead times remain stretched. I mean, today somebody places an order, whether it's us or our competition, chances of getting a product this year It's low. I mean, you would likely get into Q4 next year.

Speaker 2

So I think there's some flexibility here and there, but that's kind of the demand visibility we have. It's pretty solid going forward both from actual revenue sales and also margin perspective.

Speaker 15

Okay, great. And just to follow-up on the news this week with one of your peers making a portfolio move into European heat pumps. Could maybe just speak to your appetite to compete internationally, be it organically, be it inorganically? And then maybe just How much investment do you think is required to maybe reinvigorate that part of your portfolio?

Speaker 2

As you know, we made a decision last year to Make a portfolio move which includes divestment of our European operation. We like being laser like focused on North America HVACR business. It's a very large industry. We have low share. I think our focus is going to help us win.

Speaker 2

So no, I think we are currently 100% committed to remaining in North America HVACR player, we still have lots of bolt on opportunities here, whether it's about service or expanding our Line cards so stores can be more efficient and looking at other opportunities. So I think for us, Never say never, but currently we like our laser focus and I think that will help us win share. That will help us through the transition. Everybody at Lennox gets up every morning and is focused on winning in North America HVCR. And all our 11,000 employees focused in that direction.

Speaker 2

We are confident that's a winning formula for us. And if you guys want to diversify for other international, you can always buy shares in other international companies.

Speaker 11

All right. Thanks. Thanks a lot. Best of luck.

Speaker 2

Thanks.

Operator

We'll take our next question from Steve Tusa with JPMorgan. Your line is open.

Speaker 16

I don't quite I'm not sure I heard this before, there have been a lot of calls this morning. But could you guys comment at all on How April was looking relative in resi to what you guys posted for the Q1?

Speaker 2

We didn't comment specifically on April, but I'll tell you it's consistent with what we expected. And April is a hard month given that Most of the summer sales starts in kind of May June, but there's nothing in April that would have caused us to change our full year outlook.

Speaker 16

Okay. And then I think you mentioned there were some production inefficiencies in the Q4 on new products coming up to speed. It was my understanding that you guys didn't really do like a major clean sheet kind of Redesign for this SEER go around. I thought you were maybe taking a legacy product and you were you got the outdoor unit kind of advantage there. Can you maybe just explain How your product strategy kind of progressed through that?

Speaker 2

Sure. So let's start with the 2 segments separately, right. So on the commercial, We did redesign our product and that's what we were referring to earlier. So we launched 3 new models and replaced most of our legacy that included significant SKU rationalization, more modular design and more modern. So commercial more modular design and more modern.

Speaker 2

So commercial, we did redesign our product line. On residential, We had to redesign our outdoor units just because that was air conditioning and heat pump, but that's what regulation does. We did not re launch an indoor unit because our indoor units are still very new. They were launched just a year or so ago They're already very high efficiency and they're compatible. So we believe that gives us competitive advantage in the marketplace is that our new Higher SEER air conditioning and heat pump units are backwards compatible with our existing furnaces and air handlers indoor.

Speaker 2

So that's the piece I think of the product strategy we had mentioned earlier.

Speaker 16

Got it. Okay. And then one last one on this price increase. How much in total is the price increase? And then can you just remind us of how that works with your distribution channel?

Speaker 16

I mean, are you selling does that price increase Go independent versus your captive, like is there a difference between what the contractor is seeing and what your Independent distributors

Speaker 2

seeing? Yes. We call it a targeted price increase, Steve. And I think a lot of those discussions are the customers are starting now. So I would rather not go into tons of details in that one, but the answer is, we believe that this is a right step for us And all we are doing is making sure we can offset inflation.

Speaker 2

You'll notice in our full year guide, we now Talk about $175,000,000 in pricing benefits. Earlier, we had given a range with a high end at $175,000,000 and we took our commodity inflation up by offsetting $10,000,000 So that's kind of where we are on the numbers.

Speaker 16

Got it. So it's embedded in that 175 now that your realization whatever you expect to get in June?

Speaker 2

Yes, we just removed the range and stuck with the high number.

Speaker 16

Yes. Okay, great. Thank you.

Speaker 2

Thanks, Dean.

Operator

And we will take our next question from Jaret Patel with Jefferies. Your line is open.

Speaker 17

Thanks. I just wanted to cover the Allied piece, just one more kind of a blush here. 1, I was just kind of looking at what the opportunity kind of seems like for you guys over time. I know in the past we've talked about the idea of Share gains of $300,000,000 or so to get to that 2026 target. How much of that is Allied?

Speaker 17

What do you kind of see the growth? Is there acceleration In that, is there opportunity to partner with additional distribution channels to kind of expand that product, just trying to get a little bit more sense for what you see as that particular piece of the business growing versus the core Lennox brand?

Speaker 2

So first of all, we're very proud of Allied. I mean, they have done great over the past many years. I The business has grown up 4x. I mean the margins have expanded beautifully. And I think Jonas Saab and the team have done a fabulous job taking that.

Speaker 2

At the same time, we don't think we're anywhere close to being done. We have significant room for improvement. I can easily see that business doubling again Over the next 5 years, as we continue to add distributors, have a very focused product portfolio that wins a lot of awards And we truly focus on best serving these independent distributors. So excited about Allied. We think there's a lot of growth potential ahead.

Speaker 2

At the same time, I don't want to break down $300,000,000 in opportunity between Business A and B. Ideally, both of them will get it, right? I mean, Ideally, we did both get the $3,000,000 targets and we deliver more to the shareholders. The super excited about Allied, I think we have shared gain opportunities on direct And in indirect, we will keep driving both of them.

Speaker 17

Appreciate that. Would there be a mix shift if that were to grow a little bit faster or slower on the margin side, I just mean?

Speaker 2

No. And we don't break out margins. I just we remain committed to 20% margin on residential overall. It's hard to kind of break down margin artificially because remember we share the same infrastructure for manufacturing, product development and all of that. So that just becomes allocation game, right?

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Earnings Conference Call
Erie Indemnity Q1 2023
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