LENNOX INTERNATIONAL INC quarterly report, Q3 FY2018

Lennox International Inc. — Form 10-Q Summary

Business Context and Reporting Period

Lennox International Inc. operates in three HVACR segments: Residential Heating & Cooling, Commercial Heating & Cooling, and Refrigeration. This unaudited report covers the three and nine months ended September 30, 2018, compared with the corresponding 2017 periods. Demand is seasonal and materially influenced by weather, construction, replacement activity, economic conditions, commodity prices, and tariffs.

Key Financial Metrics

Metric	Q3 2018	Q3 2017	9M 2018	9M 2017
Net sales	$1,030.2 million	$1,052.3 million	$3,040.4 million	$2,947.9 million
Gross profit	$301.9 million	$313.7 million	$886.6 million	$865.5 million
Gross margin	29.3%	29.8%	29.2%	29.4%
Operating income	$145.2 million	$154.6 million	$393.3 million	$390.8 million
Net income	$108.0 million	$103.5 million	$283.4 million	$262.5 million
Diluted EPS	$2.65	$2.44	$6.86	$6.12
Cash flow from operations	Not separately provided	Not separately provided	$231.3 million	$129.0 million

Q3 operating margin was approximately 14.1%, compared with 14.7% in the prior-year quarter. Nine-month operating margin was approximately 12.9%, compared with 13.3%. The Q3 effective tax rate was 19.3%, versus 29.2%; the nine-month rate was 21.3%, versus 28.2%, primarily reflecting the lower U.S. federal corporate tax rate under the Tax Cuts and Jobs Act. Management expects a full-year effective tax rate of 22% to 24%, excluding excess tax benefits.

Segment Performance

Residential Heating & Cooling: Q3 sales increased 1% to $594.7 million, while segment profit declined 1.5% to $113.0 million. Nine-month sales increased 6% to $1,764.4 million and profit increased 6.8% to $317.9 million.
Commercial Heating & Cooling: Q3 sales increased 2.4% to $275.8 million, while profit declined 6.6% to $46.7 million. Nine-month sales increased 6.9% to $773.5 million and profit increased 4.5% to $118.9 million.
Refrigeration: Q3 sales declined 17.0% to $159.7 million, primarily because of divestitures, while profit increased 15.0% to $23.0 million. Nine-month sales declined 10.4% to $502.5 million and profit was essentially flat at $55.8 million.

Material Changes Versus Prior Comparable Period

Q3 sales declined 2.1%, principally due to the divestiture of the Australia, New Zealand, Asia, and Brazil businesses; favorable pricing partially offset the decline.
Q3 gross margin decreased 50 basis points. Management attributed the pressure primarily to higher commodity costs and freight and distribution costs, partly offset by favorable price and mix and lower material costs.
Q3 operating income decreased 6.1%, while net income increased $4.5 million because of the lower tax rate and other items.
Nine-month sales increased 3.1% and operating income increased 0.6%. SG&A declined to $466.1 million from $479.6 million, primarily reflecting divestitures.
Interest expense increased to $28.5 million for the first nine months from $23.3 million, reflecting higher average net borrowings and interest rates.
The company completed divestitures of its Australia, New Zealand, and Asia businesses and its Brazil business. It recognized a combined net loss of $49.6 million on the business sales, partly offset by a $23.8 million gain on the sale of the Milperra property; the net consolidated loss on sale of businesses and related property was $25.8 million.
The company adopted ASC 606 using the modified retrospective method. The reported impact on 2018 net income was immaterial.

Cash Flow, Debt, Liquidity, and Capital Allocation

Operating cash flow was $231.3 million for the first nine months, up from $129.0 million. Investing activities provided $59.3 million, including $115.9 million of proceeds from business and property sales, while capital expenditures were $60.9 million.
Financing activities used $316.6 million, including $350.2 million of common-stock repurchases and $68.2 million of dividends paid. Cash declined to $46.1 million from $68.2 million at December 31, 2017.
Total debt was $1,125.9 million at September 30, 2018, compared with $1,004.0 million at year-end 2017. Debt included $377.3 million under the asset securitization program, $390.5 million outstanding under the domestic credit facility, and $350.0 million of senior unsecured notes.
The domestic credit facility matures in August 2021. Available future borrowings were $447.0 million, subject to covenants, and the company reported compliance with its debt covenants.
The asset securitization program had $2.7 million of remaining availability at September 30, 2018, based on eligible receivables and program limits.
Management stated that cash, operating cash generation, and available borrowing capacity should be sufficient for operations, capital expenditures, contractual obligations, repurchases, and dividends in the foreseeable future. Expected 2018 capital expenditures were approximately $100 million, excluding Marshalltown repairs covered by insurance.
Debt-to-total-capital increased to 108.4% from 95.2% at December 31, 2017. Senior credit ratings were Baa3 with a stable outlook from Moody’s and BBB with a stable outlook from S&P.

Guidance, Outlook, Risks, and Unusual Items

Marshalltown tornado: A July 19, 2018 tornado severely damaged the company’s Iowa manufacturing facility. The company incurred $49.4 million of related costs and had received $45.0 million of insurance recoveries, with a $4.1 million insurance receivable recorded. The reported net income statement impact through September 30 was $0.3 million.
Management estimated approximately $100 million of lost 2018 revenue and $55 million of lost 2018 segment profit, plus approximately $85 million of lost 2019 revenue and $35 million of lost 2019 segment profit. It estimated approximately $80 million of 2018 pre-tax tornado-related charges and an additional $15 million in 2019, with expected insurance recoveries largely or more than offsetting these amounts.
Commodity and component cost inflation, tariffs, freight and distribution costs, foreign exchange, and weather-related demand remain important risks. The company uses pricing actions, cost reductions, and commodity and currency derivatives to mitigate exposures; it was not hedged against interest-rate risk at September 30.
Product warranty liabilities totaled $110.2 million. The company also recorded asbestos-related litigation expense of $3.3 million for the first nine months, net of probable insurance recoveries. Management did not expect current litigation to have a material adverse effect, while noting that outcomes remain uncertain.
Restructuring charges were $1.9 million for the first nine months, with total expected charges of approximately $20.9 million for ongoing activities.
The company expects adoption of ASC 842 leases in 2019 to add approximately $150 million to $200 million of right-of-use assets and operating lease liabilities to the balance sheet.
Management reported no material changes to previously disclosed risk factors and concluded that disclosure controls and procedures were effective as of September 30, 2018.

Most Important Facts for Investors to Verify

Whether Marshalltown production recovery and insurance proceeds meet management’s estimates for 2018 and 2019 revenue, profit, and pre-tax charges.
Whether pricing actions continue to offset commodity, tariff, freight, and distribution inflation without weakening demand.
The sustainability of cash generation and liquidity given total debt of $1.1 billion, limited asset-securitization availability, substantial share repurchases, and negative consolidated stockholders’ equity of $86.8 million.
The effect of divestitures on ongoing revenue growth, Refrigeration segment scale, and future earnings comparability.
Compliance with domestic credit facility, asset securitization, and cross-default covenants as debt and interest costs rise.
The final accounting and balance-sheet impact of ASC 842 lease adoption and any remaining uncertainty regarding GILTI and other Tax Cuts and Jobs Act provisions.