LENNOX INTERNATIONAL INC quarterly report, Q3 FY2016

Lennox International Inc. — Form 10-Q Summary

Business context and reporting period

Lennox International operates in three HVACR segments: Residential Heating & Cooling, Commercial Heating & Cooling, and Refrigeration. The filing covers the unaudited three and nine months ended September 30, 2016, with comparison to the corresponding 2015 periods. Results are seasonal and materially affected by weather, construction, replacement demand, economic conditions, commodity prices, and foreign currency movements.

Financial performance and key metrics

Metric	Q3 2016	Q3 2015	9M 2016	9M 2015
Net sales	$1,010.0 million	$955.0 million	$2,744.4 million	$2,633.3 million
Gross profit	$310.3 million	$273.4 million	$808.9 million	$719.8 million
Gross margin	30.7%	28.6%	29.5%	27.3%
Operating income	$156.9 million	$127.0 million	$361.3 million	$284.9 million
Net income	$101.7 million	$80.3 million	$237.3 million	$175.3 million
Diluted EPS	$2.33	$1.76	$5.38	$3.85
Operating cash flow	Not separately provided	Not separately provided	$106.9 million	$106.9 million

Q3 operating margin was 15.5%, compared with 13.3% in the prior-year quarter. The nine-month operating margin was 13.2%, compared with 10.8%. The effective tax rate was 32.2% in Q3 and 30.4% for the first nine months, compared with 34.2% and 34.3%, respectively, in the comparable 2015 periods.

Q3 sales increased 5.8%, primarily from 5% higher volume and 1% from price and mix.
Q3 gross margin improved 210 basis points, principally from lower material costs; productivity also benefited results.
Q3 SG&A increased to $156.5 million from $143.8 million, reflecting higher incentive compensation, wage inflation, and increased information technology and research and development investment.
Q3 segment sales and profit: Residential Heating & Cooling sales of $572.7 million and profit of $112.7 million; Commercial Heating & Cooling sales of $251.4 million and profit of $48.9 million; Refrigeration sales of $185.9 million and profit of $22.9 million.
Cash flow from operations was unchanged year over year despite higher net income, primarily because of higher taxes paid and a discretionary $50 million U.S. pension contribution.
Capital expenditures were $59.4 million in the first nine months, versus $47.0 million in 2015. Cash dividends paid were $50.5 million, and share repurchases totaled $300.0 million, excluding $26.3 million repurchased for employee tax withholding.

Balance sheet, debt, and liquidity

Cash and cash equivalents were $47.8 million at September 30, 2016, including $27.4 million held outside the United States.
Total debt was $1,055.9 million, compared with $741.1 million at December 31, 2015. Debt-to-total-capital increased to 97.8% from 87.9%.
Debt included $325.0 million under the asset securitization program, $515.0 million outstanding under the domestic credit facility before debt issuance costs, $200.0 million of senior unsecured notes due May 2017, and $16.0 million of capital lease obligations.
The amended domestic credit facility totals $900.0 million, matures in August 2021, and had $380.6 million available for future borrowings after outstanding borrowings and standby letters of credit. The company reported compliance with its debt covenants.
The asset securitization program was amended in July 2016, increasing capacity to a range of $200.0 million to $325.0 million; $325.0 million was utilized at quarter-end, leaving no remaining availability under the stated eligible amount.
Management believes cash, operating cash generation, and available borrowing capacity are sufficient for foreseeable operating, capital expenditure, contractual, dividend, and repurchase needs.

Material changes versus the prior comparable period

Profitability improved substantially, driven primarily by lower material costs, higher volume, and productivity, while SG&A and incentive compensation increased.
Residential Heating & Cooling was the primary growth contributor, with Q3 sales up 10.6% and segment profit up 25.1%.
Commercial Heating & Cooling sales increased 1.9% and profit increased 9.2% in Q3.
Refrigeration Q3 sales declined 2.3%, but profit increased 12.8% due mainly to lower material costs and lower depreciation following a 2015 impairment.
Foreign currency reduced nine-month sales by approximately 1% and adversely affected certain segment results.
The company completed a $200 million accelerated share repurchase in Q3 and initiated a second $100 million accelerated share repurchase in August, expected to settle in Q4. Shares outstanding and weighted-average shares declined year over year.
The company replaced its prior $950 million credit facility with a $900 million facility in August 2016 and increased receivables securitization capacity.
Stockholders’ equity declined to $24.2 million from $101.6 million at year-end, largely reflecting share repurchases and treasury stock activity.

Guidance, outlook, risks, contingencies, and unusual items

Management expected a 2016 annual effective tax rate of approximately 31% and approximately 32% in subsequent years, supported by international tax reorganization and foreign tax credit benefits.
Expected 2016 capital expenditures were approximately $95 million, with targeted dividend payments of $65 million to $75 million.
The company expected a pre-tax pension settlement charge of approximately $30 million in Q4 2016 related to lump-sum distributions; the related pension obligation was expected to decline by approximately $50 million.
Restructuring charges were $1.2 million for the first nine months, with total expected charges of $15.8 million for ongoing activities.
Total product warranty liability was $100.2 million at September 30, 2016. A supplier quality matter carried an estimated probable liability ranging from $1.9 million to $9.1 million; $1.9 million was accrued, with the supplier reimbursing most related costs.
Asbestos-related litigation expense was $2.3 million for the first nine months, compared with $1.0 million in 2015. Management did not expect existing litigation to have a material aggregate effect, while acknowledging litigation outcomes remain uncertain.
In October 2016, the company self-reported to the SEC and DOJ an alleged approximately $475 payment to a Russian customs broker or official. An investigation with external counsel and forensic accountants was ongoing; management did not anticipate a material adverse effect.
Key risks include weather and seasonality, HVACR demand, commodity prices, foreign exchange, interest rates, customer and supplier matters, pension obligations, substantial leverage, debt maturities, covenant and cross-default provisions, litigation, warranty costs, and execution of restructuring and repurchase programs.
The company had not selected a transition method or determined the financial reporting impact of the future lease accounting standard. It planned to adopt the new revenue recognition standard using the modified retrospective approach, but the ongoing effect remained under evaluation.

Most important facts for investors to verify

Whether material-cost savings and productivity improvements remain sustainable as commodity prices, pricing, and product mix change.
The refinancing or repayment plan for the $200.0 million senior unsecured notes due May 2017 and the effect of high leverage on liquidity and ratings.
Completion and final share delivery under the $100.0 million second accelerated share repurchase and the resulting share count.
The actual Q4 pension settlement charge and cash impact.
Developments and potential financial, legal, or compliance consequences from the Russian customs investigation.
Changes in warranty, supplier-quality, asbestos, environmental, and other litigation exposures.
Actual 2016 tax rate, capital expenditures, dividends, and operating cash flow compared with management’s stated expectations.