Lennox International Inc. — Form 10-Q Summary
Reporting period: Three and six months ended June 30, 2010; filed July 27, 2010. Lennox operates four HVACR segments: Residential Heating & Cooling, Commercial Heating & Cooling, Service Experts, and Refrigeration. Results are seasonal and sensitive to weather, construction, consumer spending, interest rates, commodity prices, and economic conditions.
Financial performance and position
| Metric | Q2 2010 | Q2 2009 | Six months 2010 | Six months 2009 |
|---|---|---|---|---|
| Net sales | $872.1 million | $784.0 million | $1,516.2 million | $1,364.5 million |
| Gross profit | $264.7 million | $227.5 million | $439.1 million | $365.2 million |
| Gross margin | 30.4% | 29.0% | 29.0% | 26.8% |
| Operating income from continuing operations | $79.3 million | $59.6 million | $79.8 million | $33.4 million |
| Operating margin | 9.1% | 7.6% | 5.2% | 2.4% |
| Net income | $48.3 million | $31.7 million | $46.7 million | $13.6 million |
| Diluted EPS | $0.86 | $0.56 | $0.82 | $0.24 |
Six-month operating cash flow was negative $26.0 million versus positive $82.7 million in the prior-year period. Cash usage reflected increases of $115.4 million in receivables and $107.8 million in inventories, partly offset by higher earnings and an $81.7 million increase in accounts payable. Investing cash use was $47.3 million, including $19.7 million of capital expenditures, $7.4 million for acquisitions, and $23.8 million placed into restricted cash. Financing provided $10.8 million, including $199.8 million of senior-note proceeds, offset by debt payments, share repurchases, and dividends.
At June 30, 2010, cash and cash equivalents were $61.9 million, with an additional $23.8 million of restricted cash. Total debt was $356.2 million, comprising $6.1 million of short-term debt, $0.5 million of current maturities, and $349.6 million of long-term debt. Debt-to-capital increased to 41% from 28% at December 31, 2009. The company had $132.0 million drawn under its $650 million revolving facility, $72.0 million committed to standby letters of credit, and $446.0 million available after covenant limitations. The facility matures in October 2012, and the company reported compliance with its covenants.
Material changes versus the prior comparable period
- Second-quarter sales increased 11.2%, driven primarily by approximately 10% higher volumes across all segments; price and mix were approximately 1% unfavorable, while foreign exchange contributed approximately 1%.
- Six-month sales increased 11.1%, with volume growth of almost 9% and a favorable foreign-exchange effect of approximately 3%.
- Gross margin expanded 140 basis points in the quarter and 220 basis points year to date, mainly from material savings and manufacturing efficiencies.
- All four operating segments reported higher second-quarter sales and profit. Residential Heating & Cooling sales rose 9.0% and profit 33.6%; Commercial Heating & Cooling sales rose 8.1% and profit 44.0%; Service Experts sales rose 13.9% and profit 45.5%; Refrigeration sales rose 14.5% and profit 59.4%.
- SG&A increased $16.2 million in the quarter and $30.3 million year to date, primarily from incentive compensation, new-product launches, advertising, and variable selling costs, although SG&A as a percentage of sales declined modestly.
- The company issued $200.0 million of 4.90% senior unsecured notes due May 15, 2017, using proceeds partly to repay revolver borrowings and for general corporate purposes.
- Six-month share repurchases were approximately $94.5 million according to management’s discussion; the cash-flow statement reports $99.5 million of common-stock repurchases.
- Discontinued operations declined to a $0.4 million quarterly loss and a $0.7 million six-month loss, compared with losses of $4.2 million and $4.6 million, respectively, in 2009.
Guidance, outlook, risks, and unusual items
- Management remained cautious about near-term economic conditions but stated that residential new-construction recovery, sourcing savings, restructuring savings, and operating leverage should support results.
- Commodity costs and incentive compensation were expected to pressure earnings. The company uses pricing, productivity measures, and commodity derivatives to mitigate raw-material volatility.
- Management expected approximately $15 million of incremental restructuring expense savings in 2010. Approximately $4.8 million of additional restructuring charges and $14.8 million of future cash outlays were expected for projects in process, generally over the next two years.
- A $5.6 million charge was recorded in the second quarter for a class-action lawsuit involving certain hearth products. The company denies liability and cannot predict the ultimate outcome or potential additional losses.
- An accrued product-quality liability of $18.9 million remained for a heating and cooling product line manufactured in 2006 and 2007; no additional 2010 provision was recorded, but future charges remain possible.
- The annual warranty review reduced warranty liabilities by approximately $6.1 million, principally because of lower-than-expected failure rates and revised cost estimates. Total warranty liabilities were $75.9 million at June 30, 2010.
- Restricted cash of $23.8 million was placed in a trust for workers’ compensation claims and reduced the captive insurer’s letter-of-credit requirement by approximately $25 million.
- Market risks include commodity prices, variable interest rates, and foreign exchange. Management estimated that a 10% change in exchange rates would affect net income by approximately $2.2 million; a 100-basis-point benchmark-rate change was estimated to affect interest expense by approximately $1.2 million.
- The company stated that operating cash flow, available revolver capacity, and other funding sources should be sufficient for operations and planned share repurchases. However, first-half operating cash flow was negative because of seasonal working-capital investment.
Investor verification items
- Reconcile the reported share-repurchase amounts of $94.5 million in management’s discussion and $99.5 million in the cash-flow statement.
- Monitor receivables and inventory conversion, since working-capital growth drove negative operating cash flow in the first half.
- Assess leverage, covenant headroom, revolver availability, and the maturity profile following the $200 million note issuance.
- Evaluate potential additional costs from the hearth-products class action and the 2006–2007 product-quality issue.
- Verify whether projected restructuring savings and remaining restructuring cash outlays are realized as expected.
- Track commodity, foreign-exchange, and interest-rate exposure, including the effectiveness and valuation of related derivatives.
- Consider the seasonal nature of HVACR demand and the company’s caution regarding broader economic conditions when extrapolating interim results.