Lennox International Inc. — 2017 Form 10-K Summary
Reporting period: Fiscal year ended December 31, 2017. The filing includes fourth-quarter information but is an annual Form 10-K, not a standalone quarterly filing. Lennox designs, manufactures and services HVACR products through Residential Heating & Cooling, Commercial Heating & Cooling, and Refrigeration segments.
Financial performance and position
| Metric | 2017 | 2016 | Change |
|---|---|---|---|
| Net sales | $3,839.6 million | $3,641.6 million | +5.4% |
| Gross profit | $1,125.2 million | $1,076.5 million | +4.5% |
| Gross margin | 29.3% | 29.6% | -30 bps |
| Operating income | $494.5 million | $429.4 million | +15.2% |
| Operating margin | 12.9% | 11.8% | +110 bps |
| Net income | $305.7 million | $277.8 million | +10.0% |
| Diluted EPS from continuing operations | $7.17 | $6.34 | +13.1% |
| Operating cash flow | $325.1 million | $373.9 million | -13.1% |
| Capital expenditures | $98.3 million | $84.3 million | +16.6% |
Segment results
- Residential Heating & Cooling: Sales of $2,140.4 million, up 7.0%; segment profit of $373.9 million, up 7.2%.
- Commercial Heating & Cooling: Sales of $973.8 million, up 6.1%; segment profit of $157.3 million, up 5.4%.
- Refrigeration: Sales of $725.4 million, up 0.3%; segment profit of $72.6 million, up 5.4%.
Liquidity, debt and shareholder returns
- Cash and cash equivalents were $68.2 million at year-end, including $39 million held outside the United States.
- Total debt was $1,004.0 million, compared with $868.2 million in 2016. Debt consisted primarily of asset securitization borrowings, domestic credit-facility borrowings, capital leases and $350 million of senior unsecured notes due 2023.
- The domestic credit facility had $500.1 million of available future borrowings, subject to covenants and other limitations. Management reported compliance with debt covenants.
- Debt-to-total-capital was 95.2%, compared with 95.8% in 2016. Senior credit ratings were Baa3 and BBB, both with stable outlooks.
- Dividends paid were $79.7 million, and the quarterly dividend was increased 19% to $0.51 per share. The annual dividend declared was $1.96 per share.
- Lennox repurchased $250 million of stock, or approximately 1.5 million shares, during 2017. Share repurchase authorization remaining at year-end was $396 million; management expected to return another $350 million through repurchases in 2018.
Material changes versus 2016
- Sales growth was driven mainly by volume and market growth in Residential and Commercial Heating & Cooling, with additional support from foreign exchange and price/mix.
- Operating income benefited from higher sales, sourcing and engineering-led cost reductions, lower pension settlement costs and lower corporate expenses.
- Gross margin declined because of higher commodity costs, factory inefficiencies and distribution investments. These pressures were partly offset by pricing, favorable mix and cost reductions.
- Operating cash flow declined by $48.8 million, primarily because of increased working capital, including higher inventories and receivables.
- Interest expense increased to $30.6 million from $27.0 million due primarily to higher average borrowings.
- The 2017 effective tax rate was approximately 34%, compared with 31% in 2016. The Tax Cuts and Jobs Act caused a $31.8 million charge to revalue deferred tax assets and liabilities, partly offset by $23.6 million of excess tax benefits from share-based compensation. Management expected future effective tax rates of approximately 22% to 24%, excluding excess tax benefits.
- Unlike 2016, when Lennox recorded a $31.4 million pension settlement charge, no comparable pension settlement occurred in 2017.
Outlook, commentary, risks and unusual items
- Management’s strategy emphasizes premium market positioning, organic growth, acquisitions, product innovation, manufacturing and sourcing efficiency, distribution expansion, geographic expansion and expense reduction.
- Demand is seasonal and weather-sensitive, with sales and segment profit generally higher in the second and third quarters. Working-capital needs are generally higher in the first and second quarters.
- Management stated that cash, operating cash flow and available borrowing capacity were sufficient for operations, planned capital expenditures, contractual obligations, dividends and planned repurchases. No U.S. defined-benefit pension contribution was required in 2018.
- A vendor-supplied component defect affected a Residential product line. Lennox recorded $5.7 million of estimated repair costs in 2017 and implemented a dealer field-repair program. Total warranty liabilities were $109.9 million at year-end.
- Asbestos-related litigation exposure was estimated at $28.5 million to $46.5 million before probable insurance recoveries; accrued amounts totaled $28.5 million. The company also recorded $3.5 million of 2017 asbestos-related expense.
- Lennox self-reported potential customs-related irregularities involving Russian, Polish and Ukrainian operations to the SEC and Department of Justice and continued to cooperate with the investigation. Management did not anticipate a material adverse effect, but the ultimate outcome remains uncertain.
- Other 2017 unusual or non-operating items included $3.7 million of special legal contingency charges, $2.2 million of environmental liabilities, $3.2 million of restructuring charges and $1.1 million of acquisition expenses.
- Principal risks include HVACR competition, construction and macroeconomic cycles, adverse weather, commodity and component costs, supply interruptions, foreign exchange, regulatory and refrigerant changes, product warranties and liability claims, unionized labor, litigation, pension funding, cybersecurity and debt-market access.
- Management reported effective disclosure controls and internal control over financial reporting. KPMG issued an unqualified opinion on the financial statements and internal controls.
Investor verification checklist
- Verify that volume growth, pricing and cost reductions continue to offset commodity inflation, factory inefficiencies and distribution investments.
- Monitor working-capital requirements and operating cash conversion, particularly during seasonal build periods.
- Reconcile total debt, asset securitization availability, credit-facility capacity and compliance with leverage and interest-coverage covenants.
- Track the Residential component-repair program, warranty accrual adequacy and any additional product-quality costs.
- Review developments in the SEC/DOJ inquiry, asbestos claims, environmental matters and other legal contingencies.
- Assess the sustainability of planned dividends and share repurchases given high debt-to-total-capital and limited reported stockholders’ equity of $50.1 million.
- Confirm the final tax effects of the Tax Cuts and Jobs Act, including deferred-tax remeasurement, foreign tax credits and potential GILTI impacts.
- Evaluate the effect of upcoming accounting standards, particularly revenue recognition and lease accounting, on disclosures, balance-sheet presentation and comparability.