Lennox International Inc. — Form 10-Q Summary
Business context and reporting period
The filing covers the three and nine months ended September 30, 2017. Lennox operates in three HVACR segments: Residential Heating & Cooling, Commercial Heating & Cooling, and Refrigeration. Results are seasonal and influenced by weather, construction, replacement demand, economic conditions, commodity prices, and foreign exchange rates.
Key financial metrics
| Metric | Q3 2017 | Q3 2016 | 9M 2017 | 9M 2016 |
|---|---|---|---|---|
| Net sales | $1,052.3 million | $1,010.0 million | $2,947.9 million | $2,744.4 million |
| Gross profit | $313.7 million | $310.3 million | $865.5 million | $808.9 million |
| Gross margin | 29.8% | 30.7% | 29.4% | 29.5% |
| Operating income | $154.6 million | $156.9 million | $390.8 million | $361.3 million |
| Operating margin | 14.7% | 15.5% | 13.3% | 13.2% |
| Net income | $103.5 million | $101.7 million | $262.5 million | $237.3 million |
| Diluted EPS | $2.44 | $2.33 | $6.12 | $5.38 |
| Net cash from operating activities | Not provided for quarter | Not provided for quarter | $129.0 million | $126.9 million |
Q3 diluted EPS from continuing operations was $2.45 versus $2.33 in the prior-year quarter. The nine-month effective tax rate was 28%, including $9.6 million of discrete tax benefits from excess tax benefits related to share-based compensation. Management expects a 2017 annual effective tax rate of 31%–32%, excluding those benefits.
Segment performance
- Residential Heating & Cooling: Q3 sales increased 3.1% to $590.5 million and segment profit increased 1.8% to $114.7 million. Nine-month sales increased 9.1% and profit increased 11.5%.
- Commercial Heating & Cooling: Q3 sales increased 7.2% to $269.4 million and segment profit increased 2.2% to $50.0 million. Growth was primarily volume-driven.
- Refrigeration: Q3 sales increased 3.5% to $192.4 million, while segment profit declined 12.7% to $20.0 million due primarily to lower factory productivity, higher SG&A, unfavorable price and mix, and higher commodity costs.
Material changes versus the prior comparable period
- Q3 sales rose 4.2%, driven by 3% higher volume and 1% favorable foreign exchange. Nine-month sales rose 7.4%, entirely attributed in the filing to higher sales volume.
- Q3 gross margin declined 90 basis points to 29.8%. Higher commodity prices, product costs, freight and distribution costs, and warranty costs were partly offset by material cost savings, favorable price and mix, and foreign exchange.
- Q3 operating income declined 1.5% despite higher sales, reflecting margin pressure, increased losses and other expenses, and higher restructuring charges.
- Q3 net income increased 1.8%, aided by lower income taxes and a $1.5 million discrete tax benefit.
- SG&A increased to $158.7 million in Q3 but declined to 15.1% of sales from 15.5%; the increase reflected wage inflation, healthcare costs, and investments in information technology and research and development.
- Shares outstanding declined, with diluted weighted-average shares falling to 42.4 million from 43.7 million in Q3, primarily reflecting repurchases.
Cash flow, liquidity, and debt
- Cash and cash equivalents were $60.7 million at September 30, 2017, including $37.1 million held in foreign locations.
- Nine-month operating cash flow was $129.0 million. Capital expenditures were $60.5 million, and management expects approximately $100 million of capital expenditures for 2017.
- Total debt increased to $1,124.1 million from $868.2 million at December 31, 2016. Short-term debt was $326.0 million, including $325.0 million under the asset securitization program; long-term debt was $775.7 million.
- The $900 million domestic credit facility had $438.0 million of borrowings, $3.0 million of standby letters of credit, and $429.0 million available for future borrowings. The facility matures in August 2021.
- The company repaid $200.0 million of senior unsecured notes that matured in May 2017 and had $350.0 million of 3.00% senior unsecured notes due in 2023.
- Debt-to-total-capital increased to 97.2% from 95.8% at year-end 2016. Management stated that all debt covenants were satisfied and that available liquidity was sufficient for foreseeable operating, capital, contractual, dividend, and repurchase needs.
- The company paid $58.4 million of dividends and repurchased $250.0 million of common stock during the first nine months. A further $75 million accelerated share repurchase transaction initiated in July was expected to settle in Q4.
Guidance, outlook, risks, and unusual items
- Management expects the annual effective tax rate to be 31%–32%, excluding excess tax benefits.
- Demand is exposed to weather, construction activity, consumer and business spending, financing availability, economic conditions, commodity prices, foreign exchange, and factory productivity.
- A vendor-supplied component defect affected a Residential Heating & Cooling product line. The company recorded $5.7 million of estimated repair costs in the first nine months, including $0.5 million in Q3, and initiated a dealer field-repair program.
- Q3 losses and other expenses included $1.5 million of special legal contingency charges, $1.5 million of asbestos-related litigation expense, and $0.5 million of environmental liabilities. Nine-month asbestos-related litigation expense was $3.9 million.
- The company is cooperating with SEC and DOJ inquiries concerning an alleged approximately $475 payment to a Russian customs broker or official and related questions involving operations in Poland and Ukraine. Management does not anticipate a material adverse effect, but the investigation remains a contingency.
- Restructuring charges were $1.9 million in Q3 and $2.1 million year to date; total charges expected for ongoing 2017 activities were $18.4 million.
- Commodity and foreign exchange hedges mature through 2019. The company was not currently hedged against interest-rate risk, leaving variable-rate debt exposed to rising rates.
- The company adopted ASU 2016-09 in 2017. Revenue recognition guidance effective January 1, 2018 was not expected to materially affect revenue timing or amounts but will require expanded disclosures. Lease accounting adoption is expected to place operating lease assets and liabilities on the balance sheet.
Investor verification checklist
- Verify the sustainability of margin performance amid higher commodity, freight, warranty, and product-quality costs.
- Assess leverage, refinancing needs, asset securitization usage, covenant headroom, and exposure to variable interest rates.
- Monitor the SEC/DOJ investigation, asbestos and other litigation, environmental liabilities, and associated insurance recoveries.
- Evaluate whether Residential and Commercial growth can offset weaker Refrigeration profitability and seasonal working-capital requirements.
- Reconcile reported EPS growth with the discrete tax benefits and substantial share repurchases.
- Confirm final settlement of the July accelerated share repurchase and the remaining $396 million authorization under the company’s repurchase plans.