Business Context and Reporting Period
Lennox International Inc. is a heating, ventilation, air conditioning and refrigeration company operating through Residential Heating & Cooling, Commercial Heating & Cooling, and Refrigeration segments. This unaudited Form 10-Q covers the three and six months ended June 30, 2019, compared with the corresponding 2018 periods.
Demand is seasonal and materially affected by weather, economic conditions, new construction, replacement activity, commodity prices, tariffs, foreign exchange rates and customer financing availability. The company realigned its European Commercial HVAC business into Refrigeration beginning January 1, 2019 and revised historical segment results for comparability.
Financial Performance and Key Metrics
| Metric | Three Months Ended June 30 | Six Months Ended June 30 |
|---|---|---|
| Net sales | $1,099.1 million, down 6.5% | $1,889.4 million, down 6.0% |
| Gross profit | $332.1 million; 30.2% margin | $533.6 million; 28.2% margin |
| Operating income | $213.8 million; 19.5% margin | $308.5 million; 16.3% margin |
| Income from continuing operations | $111.0 million | $180.4 million |
| Net income | $110.7 million | $180.0 million |
| Diluted EPS from continuing operations | $2.81 | $4.53 |
| Net cash used in operating activities | Not separately provided for the quarter | $(111.0) million |
| Capital expenditures | Not separately provided for the quarter | $53.5 million |
Second-quarter gross margin declined from 30.8% to 30.2%; six-month gross margin declined from 29.1% to 28.2%. Management attributed pressure primarily to higher commodity, freight and distribution, tariff and other product costs, partly offset by pricing and mix, sourcing and engineering savings, warranty costs and the effect of divested lower-margin businesses.
Second-quarter net income declined to $110.7 million from $137.6 million, while operating income increased to $213.8 million from $195.1 million. The operating income increase was substantially influenced by $26.0 million of insurance proceeds for lost profits and $5.9 million of net gains from insurance recoveries related to the Marshalltown tornado.
Segment Results
| Segment | Q2 2019 Sales | Q2 2019 Profit | Six-Month 2019 Sales | Six-Month 2019 Profit |
|---|---|---|---|---|
| Residential Heating & Cooling | $689.1 million, down 3.8% | $153.4 million, essentially flat | $1,154.6 million, down 1.3% | $240.1 million, up 17.2% |
| Commercial Heating & Cooling | $261.3 million, up 3.6% | $53.9 million, up 6.1% | $434.7 million, up 0.8% | $68.9 million, down 5.4% |
| Refrigeration | $148.7 million, down 28.3% | $19.1 million, down 18.4% | $300.1 million, down 26.7% | $27.5 million, down 14.3% |
Residential results were affected by unfavorable North American weather but benefited from pricing, cost reductions and Marshalltown insurance proceeds. Commercial benefited from favorable price and mix despite lower volume. Refrigeration sales were reduced primarily by the divestitures of the Australia, New Zealand, Asia, Brazil and Kysor Warren businesses, with additional foreign exchange pressure.
Cash Flow, Debt and Liquidity
Cash and cash equivalents were $36.4 million at June 30, 2019, compared with $46.3 million at December 31, 2018. Receivables increased to $718.8 million and inventories to $630.2 million, contributing to negative operating cash flow of $111.0 million, compared with $(35.0) million in the prior-year period. Management attributed the cash use primarily to seasonal working-capital requirements and the timing of working-capital payments.
Total debt was $1,466.8 million at June 30, 2019, versus $1,041.3 million at year-end 2018. Long-term debt was $1,155.8 million, including $785.0 million outstanding under the domestic credit facility and $350.0 million of senior unsecured notes. The company had $357.5 million available for future borrowings under the domestic credit facility after outstanding borrowings and standby letters of credit. The asset securitization program had $290.0 million of beneficial interests transferred and no remaining availability as of June 30, 2019.
The company stated that cash, expected operating cash generation and available borrowings should be sufficient for operations, capital expenditures, contractual obligations, dividends and planned repurchases. It reported compliance with applicable debt and lease covenants and maintained investment-grade ratings of Baa3 from Moody’s and BBB from S&P, each with a stable outlook.
Material Changes Versus the Prior Comparable Period
- Sales declined primarily because of divestitures, lower volume and unfavorable foreign exchange, partly offset by favorable price and mix.
- Operating income increased despite lower sales, largely because of Marshalltown insurance proceeds and the absence of certain 2018 asset-sale and asset-held-for-sale losses.
- Net income and diluted EPS declined because 2019 included a $60.6 million pension settlement charge and higher interest expense.
- Interest expense increased to $13.1 million in the second quarter and $23.9 million for the six months, reflecting higher average net borrowings and, year to date, higher interest rates.
- Share repurchases were $250.0 million in the first six months of 2019, compared with $350.2 million in the prior-year period; dividends paid were $50.8 million versus $42.4 million.
- The company adopted ASC 842 leases in 2019, recognizing $166.2 million of operating lease right-of-use assets and $167.2 million of operating lease liabilities at June 30, 2019.
- The Kysor Warren divestiture was completed March 29, 2019 and generated an $8.8 million loss for the six-month period.
Guidance, Outlook, Risks and Unusual Items
- Management expected a 2019 annual effective tax rate of 22% to 23%, excluding excess tax benefits recorded as a reduction of income taxes.
- Expected 2019 capital expenditures were approximately $100 million, excluding insured Marshalltown reconstruction spending.
- Management expected to return approximately $400 million to shareholders through 2019 share repurchases. In July 2019, the company repurchased 0.5 million shares for $150.0 million.
- Management expected 2019 Marshalltown insurance proceeds of $94 million for lost profits and $154 million for reconstruction and other losses and expenses. Cumulative expected proceeds were $121 million and $251 million, respectively.
- Key operating risks include weather-driven seasonality, commodity and component costs, Chinese import tariffs, freight costs, foreign exchange, divestiture effects, customer demand and financing conditions.
- The company has product warranty liabilities of $113.9 million, asbestos-related and other litigation exposure, environmental liabilities and a headquarters lease with potential purchase, sale or deficiency obligations at expiration. Management did not expect these matters to have a material adverse effect, but noted that outcomes remain uncertain.
- The pension settlement transferred $100.0 million of pension assets and $105.6 million of related obligations to a group annuity contract and generated a $60.6 million charge.
Investor Verification Checklist
- Verify the sustainability of operating income and segment margins excluding Marshalltown insurance recoveries and other unusual items.
- Assess whether working-capital investment and negative operating cash flow improve as the seasonal cycle progresses.
- Reconcile the increase in debt with share repurchases, capital spending, insurance receipts and future liquidity needs.
- Monitor renewal of the asset securitization program, which was scheduled to expire in November 2019.
- Evaluate the effect of divestitures and the European segment realignment on future revenue and margin comparisons.
- Track Marshalltown reconstruction progress and the timing and sufficiency of remaining insurance recoveries.
- Review exposure to commodity prices, tariffs, freight costs, weather, foreign exchange, warranties, litigation and environmental remediation.