Lennox International Inc. — FY2018 Form 10-K Summary
Reporting period: Fiscal year ended December 31, 2018. The filing is an annual report, not a standalone fourth-quarter filing; quarterly information is provided for reference. Lennox is a global HVACR manufacturer and service provider operating through Residential Heating & Cooling, Commercial Heating & Cooling, and Refrigeration segments.
Business Context
- 2018 net sales were generated primarily in the United States and Canada; sales outside the United States represented 15.7% of total sales.
- 2018 segment sales were $2,225.0 million for Residential Heating & Cooling, $1,043.5 million for Commercial Heating & Cooling, and $615.4 million for Refrigeration.
- The company sold its Australia, Asia, and South America businesses during 2018, primarily affecting the Refrigeration segment.
- Demand and profitability are seasonal and strongly affected by summer and winter weather, construction activity, interest rates, commodity prices, and customer financing conditions.
Financial Performance and Key Metrics
| Metric | 2018 | 2017 | Change |
|---|---|---|---|
| Net sales | $3,883.9 million | $3,839.6 million | +1.2% |
| Gross profit | $1,111.2 million | $1,125.2 million | Down $14.0 million |
| Gross margin | 28.6% | 29.3% | Down 70 bps |
| Operating income | $509.5 million | $494.5 million | +3.0% |
| Operating margin | 13.1% | 12.9% | Up 20 bps |
| Net income | $359.0 million | $305.7 million | +17.4% |
| Income from continuing operations | $360.3 million | $307.1 million | +17.3% |
| Diluted EPS from continuing operations | $8.77 | $7.17 | +22.3% |
| Cash flow from operations | $495.5 million | $325.1 million | +$170.4 million |
| Capital expenditures | $95.2 million | $98.3 million | Down $3.1 million |
Segment Results
| Segment | 2018 Sales | 2018 Profit | Year-over-year sales change |
|---|---|---|---|
| Residential Heating & Cooling | $2,225.0 million | $399.4 million | +4.0% |
| Commercial Heating & Cooling | $1,043.5 million | $159.5 million | +7.2% |
| Refrigeration | $615.4 million | $66.1 million | -15.2% |
Residential segment margin increased to 18.0% from 17.5%. Commercial segment margin declined to 15.3% from 16.2%. Refrigeration margin improved to 10.7% from 10.0%, despite lower sales following the divestitures.
Cash Flow, Debt, and Liquidity
- Operating cash flow increased to $495.5 million, primarily due to higher net income and improved working capital.
- Investing activities provided $30.5 million, including $114.7 million of net proceeds from business and related-property sales, partially offset by $95.2 million of capital expenditures.
- Financing activities used $537.8 million, including $450.2 million of share repurchases and $93.9 million of cash dividends.
- Cash and cash equivalents were $46.3 million at year-end, including approximately $29 million held outside the United States.
- Total debt was $1,041.3 million, consisting primarily of $268.0 million under the asset securitization program, $408.0 million under the domestic credit facility, $350.0 million of senior unsecured notes, and capital lease obligations.
- The company reported $429.5 million of available future borrowings under its domestic credit facility after outstanding borrowings and letters of credit. In January 2019, maximum revolving commitments increased by $350 million to $1.0 billion.
- The company stated that it was in compliance with its debt covenants at December 31, 2018. Required ratios included consolidated indebtedness to adjusted EBITDA of no more than 3.5:1.0 and cash flow to interest expense of at least 3.0:1.0.
- Debt-to-total-capital increased to 116.8% from 95.2%, primarily because stockholders’ equity declined to a deficit.
Material Changes Versus 2017
- Sales increased modestly, led by volume and pricing in Residential and Commercial Heating & Cooling.
- Gross margin contracted because of higher commodity costs, freight and distribution costs, and tornado-related factory inefficiencies. Favorable pricing, mix, sourcing, and engineering savings partially offset these pressures.
- SG&A declined by $30.0 million, or 90 basis points as a percentage of sales, primarily due to the divestiture of international businesses.
- The effective tax rate declined to 23% from 34%; 2017 included a $31.8 million deferred-tax revaluation charge associated with U.S. tax legislation.
- Refrigeration sales declined 15.2%, primarily because of the Australia, Asia, and South America divestitures.
- Share repurchases increased to $450.2 million from $250.0 million. The company had $446.0 million remaining under its repurchase authorizations at year-end.
- Quarterly dividends increased 25% in May 2018, from $0.51 to $0.64 per share. Full-year dividends declared increased to $2.43 per share from $1.96.
Guidance, Outlook, Risks, and Unusual Items
- Management expected a 2019 effective tax rate of approximately 22% to 23%, excluding excess tax benefits.
- 2019 capital expenditures were expected to be approximately $215 million, including $115 million for reconstruction of the Marshalltown, Iowa facility; management expected insurance proceeds to fund the reconstruction.
- Management expected to return another $350 million to shareholders through share repurchases in 2019.
- The July 2018 Marshalltown tornado caused $86.0 million of expenses and losses. The company received $124.3 million of insurance recoveries in 2018, including $27.4 million for lost profits, and expected additional 2019 proceeds of approximately $232 million for lost profits, reconstruction, and other losses.
- 2018 included a $27.0 million net loss on the sale of businesses and related property, comprising losses on the Australia and Asia and South America businesses partially offset by a gain on the Milperra property sale.
- Management identified risks from weather and seasonality, construction and economic cycles, competition, commodity and component costs, supply interruptions, tariffs and regulation, foreign currency, cybersecurity, litigation, product warranties, environmental obligations, pension funding, and reliance on key facilities and suppliers.
- Product warranty liabilities were $111.6 million at year-end. Estimated future asbestos-related litigation exposure was $19.3 million to $34.6 million before probable insurance recoveries; $19.3 million was accrued.
- The asset securitization program, with $268.0 million outstanding, was scheduled to expire in November 2019 and management intended to renew it.
- For 2019, management planned to move European Commercial HVAC reporting from Commercial Heating & Cooling to Refrigeration and planned to divest the Kysor Warren business.
- The company adopted ASC 606 in 2018 using the modified retrospective method; management expected no material ongoing net-income impact. The company expected to recognize approximately $130 million to $160 million of right-of-use assets and operating lease liabilities upon adoption of ASC 842 in 2019.
Important Facts to Verify
- Whether Marshalltown reconstruction, insurance proceeds, and production transfers proceed on the timing and amounts projected by management.
- The renewal and available capacity of the asset securitization program before its November 2019 expiration.
- Debt covenant headroom, refinancing requirements, and the effect of increased interest rates on variable-rate borrowings.
- Whether commodity, freight, labor, and supply-chain pressures continue to compress gross margins.
- The sustainability of earnings growth after removing tornado-related insurance proceeds, divestiture gains and losses, and tax-related benefits.
- The effect of the planned Kysor Warren divestiture and the European segment realignment on reported sales, margins, and comparability.
- Future cash requirements for product warranties, asbestos and other litigation, environmental remediation, pensions, leases, and reconstruction commitments.
- Execution of the $215 million 2019 capital expenditure plan and the planned $350 million of share repurchases while stockholders’ equity remains negative.