Lennox International Inc. — Form 10-Q Summary
Business context and reporting period
Lennox International Inc. operates in three HVACR segments: Residential Heating & Cooling, Commercial Heating & Cooling, and Refrigeration. The filing covers the three months ended March 31, 2017, compared with the three months ended March 31, 2016. The 2017 first quarter included five additional days, or approximately 6% more selling time, which management expects to be offset by fewer days in the fourth quarter.
Key financial metrics
| Metric | Q1 2017 | Q1 2016 | Change |
|---|---|---|---|
| Net sales | $793.4 million | $715.2 million | +10.9% |
| Gross profit | $210.9 million | $183.6 million | +14.9% |
| Gross margin | 26.6% | 25.7% | +90 bps |
| Operating income | $60.8 million | $43.7 million | +39.1% |
| Operating margin | 7.7% | 6.1% | +160 bps |
| Net income | $43.5 million | $24.9 million | +74.7% |
| Diluted EPS | $1.00 | $0.56 | +$0.44 |
| Cash flow from operations | $(107.6) million | $(101.6) million | More seasonal use of cash |
| Capital expenditures | $24.9 million | $23.8 million | +$1.1 million |
Sales growth was driven primarily by a 10% increase in volume and 1% from price and mix. Gross margin benefited from lower material costs, favorable mix and pricing, and foreign exchange, partly offset by freight, distribution, product-cost and warranty pressures. SG&A increased to $152.4 million from $140.4 million, but declined to 19.2% of sales from 19.6%.
Segment performance
- Residential Heating & Cooling: Sales increased 11.3% to $419.8 million; segment profit increased 11.0% to $42.5 million. Volume growth came from replacement and new-construction business.
- Commercial Heating & Cooling: Sales increased 14.8% to $195.5 million; segment profit increased 34.5% to $19.1 million, primarily from higher volume in national accounts and districts.
- Refrigeration: Sales increased 6.3% to $178.1 million; segment profit increased 56.7% to $14.1 million, helped by favorable mix, material costs, foreign exchange and volume.
Liquidity, debt and capital allocation
Cash and cash equivalents were $48.8 million at March 31, 2017, including $33.3 million held in foreign locations. Operating cash flow was negative because of seasonal working-capital requirements, including a $101.2 million increase in inventories and a $40.9 million increase in receivables.
Total debt increased to $1.103 billion from $868.2 million at December 31, 2016. Debt included $200.0 million under the asset securitization program, $341.5 million outstanding under the domestic credit facility, $550.0 million of senior unsecured notes, and capital lease obligations. The domestic credit facility had $524.1 million available for future borrowings after outstanding borrowings and standby letters of credit. The $200.0 million senior notes due May 15, 2017 were classified as current.
The company reported compliance with its debt covenants and stated that cash, expected operating cash flow and available borrowings were sufficient for foreseeable operating, capital, contractual, dividend and repurchase needs. The 2017 capital expenditure expectation was $100 million. The company paid $18.5 million of dividends and initiated a $75 million accelerated share repurchase transaction during the quarter; final settlement was expected in the second quarter.
Material changes and unusual items
- Adoption of ASU 2016-09 generated a $7.4 million discrete tax benefit in Q1 2017. The reported effective tax rate was 19%, while management expects an annual rate of approximately 32% excluding such excess tax benefits.
- Net income and EPS benefited materially from the discrete tax benefit and from the additional five selling days in the quarter.
- Losses and other expenses declined to $3.1 million from $4.3 million. Q1 2017 included $1.7 million of asbestos-related litigation expense, $0.9 million of special legal contingency charges and $0.5 million of environmental liabilities.
- Restructuring charges were $0.1 million in Q1 2017, compared with a $0.2 million restructuring gain in Q1 2016. Total expected charges for ongoing restructuring activities were $16.1 million.
- The company’s debt-to-total-capital ratio increased to 100.1% from 95.8% at December 31, 2016, reflecting negative consolidated stockholders’ equity of $1.0 million.
Outlook, risks and contingencies
Management did not provide explicit full-year sales or earnings guidance in the filing. It expects approximately $100 million of capital expenditures in 2017 and an annual effective tax rate of approximately 32%, excluding excess tax benefits. Demand remains seasonal and sensitive to weather, economic conditions, interest rates, financing availability, construction, consumer spending and replacement activity.
Commodity prices for steel, copper and aluminum, foreign currency movements and variable interest rates remain key exposures. The company uses commodity and foreign-exchange derivatives but was not hedged against interest-rate risk at March 31, 2017. Derivative gains and losses expected to be reclassified from accumulated other comprehensive loss could affect future earnings.
The company estimated total product warranty liabilities of $102.6 million. A supplier-quality matter had a probable liability range of $0.9 million to $9.1 million; $0.9 million was accrued, and the supplier was reimbursing most related costs. The company also disclosed asbestos-related claims and an ongoing SEC and DOJ investigation concerning an alleged approximately $475 payment involving Russian customs. Management did not expect a material adverse effect from the investigation but noted that it was ongoing.
Management stated that litigation and claims were not expected to have a material adverse effect, while acknowledging that outcomes could adversely affect a particular period. The filing reported no material changes to the risk factors in the 2016 Form 10-K.
Investor verification points
- Verify the refinancing or repayment of the $200.0 million senior notes due May 15, 2017 and the resulting effect on liquidity and interest expense.
- Assess whether sales and earnings growth remains strong after normalizing for the five additional selling days in Q1.
- Monitor inventory and receivables growth, seasonal operating cash usage and reliance on the asset securitization program.
- Reconcile reported EPS and tax-rate trends excluding the $7.4 million discrete tax benefit.
- Track commodity costs, foreign exchange, freight and distribution costs, and the effectiveness of related hedges.
- Follow developments in the SEC/DOJ customs investigation, asbestos litigation, supplier-quality exposure and warranty liabilities.
- Confirm completion and final share delivery under the $75 million accelerated share repurchase transaction.