Lennox International Inc. 2019 First-Quarter Form 10-Q Summary
Business Context and Reporting Period
Lennox International Inc. designs, manufactures and sells HVACR products and services through three segments: Residential Heating & Cooling, Commercial Heating & Cooling, and Refrigeration. This unaudited Form 10-Q covers the three months ended March 31, 2019, compared with the three months ended March 31, 2018. Results are seasonal and materially affected by weather, economic conditions, construction, replacement demand, commodity prices and tariffs.
Effective January 1, 2019, the company moved its European Commercial HVAC business into the Refrigeration segment and revised historical segment results for comparability. The company also adopted ASC 842 for leases, recognizing $170.1 million of operating lease right-of-use assets and $170.7 million of operating lease liabilities at March 31, 2019.
Financial Results and Key Metrics
| Metric | Q1 2019 | Q1 2018 | Change |
|---|---|---|---|
| Net sales | $790.3 million | $834.8 million | Down 5.3% |
| Gross profit | $201.6 million | $223.2 million | Down 9.7% |
| Gross margin | 25.5% | 26.7% | Down 120 bps |
| Operating income | $94.7 million | $53.0 million | Up 78.7% |
| Operating margin | 12.0% | 6.3% | Up 570 bps |
| Income from continuing operations | $69.4 million | $37.9 million | Up 83.1% |
| Net income | $69.3 million | $37.9 million | Up 82.8% |
| Diluted EPS | $1.73 | $0.90 | Up $0.83 |
| Net cash used in operating activities | $(141.0) million | $(83.5) million | Higher use of $57.5 million |
| Capital expenditures | $37.2 million | $22.7 million | Up $14.5 million |
Sales declined primarily because divested businesses accounted for an estimated 6% reduction and unfavorable foreign exchange accounted for 1%, partly offset by approximately 2% from favorable pricing and mix. Gross margin contracted because of higher commodity prices, freight and distribution costs, and other product costs; these pressures were partly offset by pricing, mix, sourcing and engineering savings.
Operating income benefited significantly from $39.5 million of insurance proceeds for lost profits and a $6.9 million gain from insurance recoveries, net of losses incurred, related to the Marshalltown tornado. Operating results also benefited from the absence of the $10.3 million loss on assets held for sale recorded in the prior-year quarter. Offsetting items included an $8.5 million loss on the sale of the Kysor Warren business.
Segment Performance
| Segment | Q1 2019 Sales | Q1 2018 Sales | Q1 2019 Profit | Q1 2018 Profit |
|---|---|---|---|---|
| Residential Heating & Cooling | $465.6 million | $453.7 million | $86.7 million | $51.3 million |
| Commercial Heating & Cooling | $173.3 million | $179.1 million | $15.1 million | $22.0 million |
| Refrigeration | $151.4 million | $202.0 million | $8.4 million | $8.7 million |
- Residential Heating & Cooling: Sales increased 2.6%, while segment profit increased $35.4 million, primarily due to $40 million of tornado-related lost-profit insurance proceeds, favorable price and mix, and cost reductions. Higher freight, commodity, SG&A and warranty costs were partly offsetting.
- Commercial Heating & Cooling: Sales decreased 3.2% as volume declined 6%, partly offset by pricing and mix. Profit decreased 31.4% due to lower volume, higher product and commodity costs, lower productivity, freight and SG&A expenses.
- Refrigeration: Sales decreased 25.0%, primarily because of the 2018 divestitures of the Australia, New Zealand, Asia and South America businesses and unfavorable foreign exchange. Profit was broadly stable because cost reductions and pricing offset divestiture-related volume losses and cost inflation.
Cash Flow, Debt and Liquidity
- Operating cash flow was negative $141.0 million, reflecting seasonal working-capital needs, increased inventories and receivables, timing of payments and supply disruption related to the Marshalltown tornado.
- Investing activities generated $13.6 million, including $43.6 million of net proceeds from the Kysor Warren sale and $6.9 million of insurance recoveries, offset by $37.2 million of capital expenditures.
- Financing activities provided $108.9 million. The company borrowed $844.5 million from its credit facility and repaid $525.5 million, paid $43.5 million under the asset securitization program, repurchased $100.0 million of common stock, and paid $25.5 million of dividends.
- Cash and cash equivalents declined to $31.7 million from $46.3 million at December 31, 2018. Approximately $16.6 million was held outside the United States.
- Total debt was $1.297 billion, consisting primarily of $697.0 million outstanding under the domestic credit facility, $224.5 million under the asset securitization program, and $350.0 million of senior unsecured notes due 2023.
- The domestic credit facility had $460.5 million available for future borrowings after outstanding borrowings and standby letters of credit. The company stated that it was in compliance with applicable debt covenants. Senior credit ratings were Baa3 with a stable outlook from Moody’s and BBB with a stable outlook from S&P.
- Management expects 2019 capital expenditures of approximately $100 million, excluding insured Marshalltown reconstruction spending, and stated that available cash, operating cash flow and borrowing capacity should fund foreseeable requirements.
Material Changes, Outlook, Risks and Unusual Items
- Marshalltown tornado: The company received $76 million of insurance recoveries in the quarter and incurred approximately $30 million of tornado-related expenses. Management expects cumulative insurance proceeds of approximately $107 million for lost profits and $251 million for reconstruction and other losses and expenses. Future recoveries and costs remain dependent on insurance claims and facility recovery.
- Pension settlement: On April 3, 2019, the company agreed to transfer $100 million of pension assets and related obligations to Pacific Life through a group annuity contract. It expects to recognize a $61 million non-cash pretax pension settlement loss in the second quarter of 2019.
- Divestiture: Kysor Warren was sold on March 29, 2019 for cash proceeds of $49 million, with $8.5 million of loss recognized after net assets, accumulated other comprehensive income reclassification and selling costs.
- Tax outlook: Management expects an annual effective tax rate of 22% to 23%, excluding excess tax benefits from share-based compensation. The first-quarter effective tax rate was 16.4%, compared with 13.9% in the prior-year quarter.
- Commodity and tariff exposure: Steel, copper and aluminum prices, tariffs, freight costs and component costs remain significant margin risks. The company uses pricing actions, sourcing and commodity derivatives to mitigate these exposures.
- Liquidity and covenant risk: Seasonal working-capital requirements, negative first-quarter operating cash flow, substantial leverage, variable-rate debt and the limited remaining availability under the asset securitization program are important liquidity considerations. The asset securitization program expires in November 2019 and management intends to renew it.
- Legal and warranty matters: The company reported asbestos-related litigation expense of $1.4 million in the quarter and total product warranty liabilities of $113.8 million at March 31, 2019. Management does not expect current litigation to have a material adverse effect, but acknowledges that outcomes are uncertain.
Most Important Facts for Investors to Verify
- Whether first-quarter earnings growth is sustainable without the $39.5 million lost-profit insurance benefit and $6.9 million recovery gain.
- The timing, amount and accounting treatment of additional Marshalltown insurance recoveries, reconstruction costs and operating disruption.
- The expected $61 million pretax pension settlement loss in the second quarter and its effect on reported earnings and equity.
- Progress in restoring gross margins amid commodity, freight, tariff and component-cost pressures.
- Debt reduction, availability under the credit facility, renewal of the asset securitization program and continued compliance with leverage and interest-coverage covenants.
- The effect of continued share repurchases and dividends on leverage, liquidity and per-share results.
- Underlying organic sales and profitability by segment after adjusting for divestitures, foreign exchange and unusual items.