Lennox International Inc. — Form 10-Q Summary
Business context and reporting period
Lennox International Inc. operates three HVACR segments: Residential Heating & Cooling, Commercial Heating & Cooling, and Refrigeration. This unaudited report covers the three and six months ended June 30, 2018, compared with the corresponding 2017 periods. Results are seasonal and significantly affected by weather, construction, replacement demand, commodity costs, interest rates and economic conditions.
Key financial metrics
| Metric | Three months ended June 30 | Six months ended June 30 |
|---|---|---|
| Net sales | $1,175.4 million; up 6.7% | $2,010.2 million; up 6.0% |
| Gross profit / margin | $361.6 million / 30.8% | $584.7 million / 29.1% |
| Operating income / margin | $195.1 million / 16.6% | $248.1 million / 12.3% |
| Income from continuing operations | $139.2 million | $177.1 million |
| Net income | $137.6 million | $175.5 million |
| Diluted EPS from continuing operations | $3.39 | $4.26 |
| Diluted net EPS | $3.35 | $4.22 |
| Cash flow from operations | Not separately provided for the quarter | $(35.0) million |
| Capital expenditures | Not separately provided for the quarter | $43.4 million |
| Cash and cash equivalents | $39.4 million at June 30, 2018 | |
| Total debt | $1,352.6 million at June 30, 2018 |
Gross margin was broadly stable year over year. Management cited higher commodity prices, freight and distribution costs, other costs and warranty costs as offsets to favorable pricing, material-cost savings, foreign exchange and the absence of a prior-year product-quality charge. SG&A declined to $161.4 million in the quarter and $316.6 million year to date.
At June 30, 2018, total liabilities were $2.280 billion and stockholders’ equity was negative $180.2 million, compared with positive equity of $50.1 million at December 31, 2017. The company’s debt-to-total-capital ratio was 115.4%, compared with 95.2% at year-end 2017.
Material changes versus the prior comparable period
- Second-quarter sales increased 7%, driven by 7% volume growth, 2% favorable pricing and 1% favorable foreign exchange, partly offset by unfavorable mix and divestitures.
- Residential Heating & Cooling sales rose 9.6% and segment profit rose 9.3% in the quarter; Commercial Heating & Cooling sales rose 13.0% and profit rose 17.7%.
- Refrigeration sales declined 12.0%, primarily because of the divestiture of the Asia Pacific business, while segment profit was approximately flat.
- Second-quarter operating income increased 11.2% to $195.1 million. Net income increased from $115.5 million to $137.6 million despite a $31.4 million loss on Brazil assets held for sale.
- The effective tax rate declined to 24.6% in the quarter and 22.5% year to date, versus 30.4% and 27.5%, respectively, primarily due to the lower U.S. federal corporate tax rate under the Tax Cuts and Jobs Act.
- Operating cash use improved from $48.3 million to $35.0 million year to date, but remained negative because of seasonal working-capital investment, including increases in receivables and inventories.
- Debt increased from $1.004 billion at December 31, 2017 to $1.353 billion at June 30, 2018, while share repurchases increased to $350.2 million from $175.0 million in the prior-year period.
Guidance, outlook, risks and unusual items
- Management expects a 2018 annual effective tax rate of 22% to 24%, excluding excess tax benefits recorded through income taxes, and expects approximately $100 million of 2018 capital expenditures.
- Management believes $39.4 million of cash, future operating cash flow and available borrowing capacity are sufficient for foreseeable operating needs, capital expenditures, contractual obligations, repurchases and dividends. The domestic credit facility had $151.1 million available, subject to covenants; the asset securitization program had no remaining availability at June 30, 2018.
- The company completed the sale of its Australia, New Zealand and Asia business and related Milperra property, receiving $111.8 million of net proceeds and recording a $12.0 million loss on the business and a $23.8 million gain on the property.
- The planned sale of the Brazil business remained subject to Brazilian antitrust approval. The company recorded a $31.4 million loss on Brazil assets held for sale and classified $11.6 million of assets and $7.4 million of liabilities as held for sale.
- On July 19, 2018, a tornado damaged the Marshalltown, Iowa manufacturing facility. The extent of operational and financial effects, including potential insurance recoveries, had not been estimated as of the filing.
- Key exposures include seasonal demand and weather, commodity prices, freight and distribution costs, foreign exchange, variable interest rates, customer and supplier conditions, product warranties, litigation, environmental liabilities and debt covenant or cross-default provisions.
- The company reported $110.4 million of product warranty liabilities at June 30, 2018. Management stated that existing litigation is not expected to have a material adverse effect, although outcomes remain uncertain.
- The company adopted ASC 606 using the modified retrospective method; management expected no material ongoing net-income effect. The filing also notes pending implementation of the lease standard, which will recognize operating lease assets and liabilities upon adoption.
Investor verification points
- Assess the effect of the Marshalltown tornado on production, customer fulfillment, insurance recoveries and future results.
- Verify completion timing and proceeds for the Brazil divestiture, including any further impairment or transaction costs.
- Monitor leverage, interest expense, borrowing capacity and compliance with the 3.5:1.0 indebtedness-to-adjusted-EBITDA and 3.0:1.0 cash-flow-to-interest covenants.
- Reconcile negative stockholders’ equity and the sustainability of substantial share repurchases and dividends relative to operating cash generation.
- Evaluate whether pricing and productivity initiatives can offset commodity, freight and distribution inflation.
- Confirm the impact of divested operations on ongoing Refrigeration revenue and profitability, and review the company’s stated tax-rate outlook.