Lennox International Inc Q3 FY2022 Earnings Call

Ladies and gentlemen, thank you for standing by. Welcome to the Lennox International's Third Quarter Earnings Conference Call. At the request of your host, all lines are currently in a listen-only mode. There will be a question-and-answer session at the end of the presentation. As a reminder, this call is being recorded. I would now like to turn the conference over to Steve Harrison, Vice President of Investor Relations. Please go ahead.

Good morning. Thank you for joining us. I’m here today with CEO, Alok Maskara; and CFO, Joe Reitmeier. Alok will discuss highlights for the quarter and Joe will take you through the company’s quarterly financial performance and guidance for 2022. After that, Alok will discuss our current view on 2023 before Q&A. To give everyone time to ask questions during the Q&A, please limit yourself to two questions or follow-ups and re-queue for any additional questions. The earnings release with GAAP to non-GAAP reconciliations, today’s presentation slides, and the webcast link for today’s conference call are available on our website at www.lennoxinternational.com. The webcast also will be archived on the site for replay. All comparisons mentioned today are against the prior year period, unless otherwise noted. Turning to Slide 2, I would like to remind everyone that in the course of this call, we will be making certain forward-looking statements which are subject to numerous risks and uncertainties. For information concerning these risks and uncertainties, see Lennox International's publicly available filings with the SEC. Before I turn the call over to Alok, let me remind everyone of our upcoming annual investor day on Wednesday, December 14, when we will discuss specific guidance for 2023 and our three-year outlook as well as provide an update on our strategy. Now, let me turn the call over to CEO, Alok Maskara.

Good morning and welcome everyone. I want to start by thanking all our employees who are working exceptionally hard, given the ongoing supply chain disruptions to better serve our customers. As a result of their efforts, Lennox was able to deliver another record quarter while improving our customer service level. On Slide 3, I want to start by highlighting four key messages. First, our record third quarter financial results included double-digit revenue growth in all three of our business segments. Overall company revenues were up 17% to a third quarter record of $1.24 billion. Adjusted earnings grew 21% to a third quarter record of $4.10. Second, we are prepared for the upcoming minimum efficiency regulation to be effective on January 1, 2023. As part of the preparation, we are replenishing inventory levels, which will also help us increase supply chain resiliency. Given our inventory build cash from operations was $171 million in the quarter, down $51 million from a year ago. Third, the recovery in our commercial business segment is progressing well, and the daily output from a factory in Stuttgart is steadily increasing. Third quarter commercial segment profit was up 72% sequentially and up 31% year-over-year. Today, we are also announcing investment in a second commercial factory to be built in Mexico. The total capital required for the new commercial factory is expected to be in the range of $125 million to $150 million over the next two years. The new commercial factory will provide us the much-needed additional manufacturing capacity while enabling margin expansion. Fourth, given persistent supply chain inefficiencies and the adverse mix impact driven by shortage of components for high-end residential products, we are revising our full year EPS guidance range to the lower end of the prior range. Now, please turn to Slide 4 to discuss our preparedness for the minimum efficiency regulatory changes. In our residential and commercial end markets in the U.S. and Canada, the new required minimum cooling efficiency level for air conditioners, heat pumps, and rooftop units is increasing on January 1, 2023. For air conditioners in the south and southwest regions, the change is based on date of installation, while for air conditioners in the north regions, and for all heat pumps and rooftop products, the change is based on date of manufacture. For the new 2023 compliant units, we expect a double-digit benefit of price and mix to more than offset the higher costs of the units. For residential products, our competitive design includes single-stage compression, more efficient aluminum coils and an optimized external footprint. This design approach achieves higher efficiency standards without having to change indoor units, making our solution better for dealers and end users. Lennox historically has done very well competitively during these minimum efficiency transitions, and we believe we are well positioned to do so again. Now please turn to Slide 5 for an update on a commercial profit recovery efforts. At our existing Arkansas manufacturing facility, we have met our targets for hiring and retaining talent, resulting in staffing levels reaching normalcy, which is up 30% since April. Since achieving normal staffing levels, we are systematically increasing our daily output, which is now up 15% since April. Higher output is improving service for our customers who have been mostly understanding of our challenges given industry-wide supply shortages. We are grateful for our customers' loyalty and patience and want to assure them that we are doing our utmost to increase capacity and reduce lead times. We are deploying additional talent and working closely with our suppliers to satisfy current demand levels and remain committed to delivering additional manufacturing output and productivity from the existing factory. However, in the fourth quarter, we are expecting sequentially lower manufacturing efficiency and output as we transition our product lines to build our newly launched Enlight and Xion products that meet or exceed the new minimum efficiency standards. Similar to residential, price positioning of the higher efficiency commercial products will enable us to more than offset the associated higher cost. Looking ahead, we have decided to invest in a second commercial factory in Saltillo, Mexico, near our existing residential operations. The new factory will increase our capacity to support our customers' forecasted demand, and it will also position us to regain lost share, especially in the emergency replacement market. We expect an 80% lower hourly labor cost at this new facility, although some of those savings will be offset by higher freight costs. Overall, as commercial production continues to recover, we expect a $100 million segment profit improvement within the next three years. With that, I will hand the call over to Joe on Slide 6 to discuss full quarter financials and guidance for the full year.

Thank you, Alok, and good morning, everyone. Looking at the quarter for Lennox International overall, the company posted record third quarter revenue and profit. Revenue was $1.24 billion, up 17% as reported, and up 18% at constant currency primarily driven by volume growth and price. GAAP operating income was a third quarter record $186 million, up 14%, and in the chart, you see the total segment profit rose 15% to a third quarter record $189 million. Total segment margin was 15.2%, down 30 basis points primarily due to supply chain inefficiencies and lower mix driven by manufacturing constraints on higher-end products. GAAP EPS was up 17% to a third quarter record $3.99 and adjusted EPS rose 21% to a third quarter record $4.10. Now moving to the business segments starting on Slide 7, you see a record third quarter for residential in revenue and profit. Residential revenue grew 17% to $835 million. Volume was up 7%, price was up 10% in the quarter. Residential replacement and new construction sales were both up high teens with new construction growing faster. Residential segment profit rose 7% to $154 million. Segment margin contracted 190 basis points to 18.4% due to lower mix as we were unable to increase output of hiring units due to the component shortages. Regarding Lennox Stores, we opened four new locations in the third quarter to bring our total store count to 239. We expect to end the year with approximately 245 stores. Now turning to Slide 8 in commercial business, revenue was $253 million in the quarter up 20% led by strong growth in the national account business. Commercial price was up 9% and mix was up 11%. Commercial segment profit was up 31% and segment margin expanded 100 basis points to 11.7%. Commercial demand and backlog remain strong and our Arkansas factory recovery continues to progress well. We have recruited and hired the number of employees we need for the factory. The daily output is increasing and we continue to make progress on improving processes and productivity. Now turning to Slide 9 in our refrigeration business. Revenue was $157 million for the third quarter up 14% as reported, and up 21% at constant currency. Price was up 16%, volume was up 5%, foreign exchange had a negative 7% impact. Revenue growth was led by North America, up more than 20%. Europe revenue was up 2% as reported and up 20% at constant currency. Overall for the refrigeration segment, profit rose 54% to $22 million and segment margin expanded 370 basis points to 14.3%. Refrigeration demand and backlogs remain strong. Turning to Slide 10, let's review our 2022 full year guidance. We now expect revenue growth for the full year of 12% to 15% compared to the prior range of 10% to 15%. For the industry, we continue to assume low single-digit shipment growth in North American residential markets and mid-single-digit shipment growth in North American commercial unitary and refrigeration markets. We are updating our guidance for GAAP and adjusted EPS for the full year to a range of $13.80 to $14.20, compared to the prior range of $13.80 to $14.50. Now looking at the puts and takes that are changing. Price is now expected to be a $425 million benefit for the year, a yield of 10%, which is up $25 million from our prior guidance of $400 million. Residential mix is now expected to be a $45 million headwind for the full year compared to our prior guidance of a $25 million headwind. The mix headwind is attributed to the shortage of higher-end products as supply chain constraints continue to limit production of our Dave Lennox Signature Series. Commodity cost inflation is now expected to be $120 million, down $10 million from our prior guidance of $130 million. However, we are still seeing inflationary pressures on components and other materials and now expect $120 million headwind compared to prior guidance of a $100 million headwind. Supply-related factory disruptions are now expected to be a $25 million headwind compared to prior guidance of $15 million headwind. Interest and pension expense guidance is now $40 million, up from our prior guidance of $35 million. And as we invest more in inventory for supply chain resiliency, buying ahead of continued component price increases and the minimum efficient regulatory transition, free cash flow is now expected to be approximately $300 million for the year compared to prior guidance of $400 million. And stock repurchase guidance is now $300 million for the year, which has been completed, compared to our prior guidance of $400 million. The effective tax rate will be approximately 19% for the full year. Now for the guidance points that are not changing. Freight costs are still expected to be a $20 million headwind. We still expect corporate expenses to be $95 million. And we are still planning for $125 million of capital spending. And we still expect a weighted average diluted share count of approximately 36 million shares for the full year. And with that, let's turn to Slide 11. And I'll turn it back over to Alok to talk to you about our thoughts on 2023 at this time.

Thank you, Joe. While we will be giving specific guidance on 2023 at our Investor Day in mid-December, I wanted to spend a few minutes today on the different headwinds and tailwinds that are guiding our 2023 outlook. On the headwind side, we are prepared for a decline in residential unit shipments due to the downturn and single-family new housing starts, as well as possible impact on replacement units from the rising interest rate environment and broader economic slowdown. On the cost headwind side, we expect the first half of 2023 to continue seeing component inflation, and we also expect some of the current supply chain disruptions to persist in the first half of 2023. For the 2023 tailwinds, we expect to see a price and mix benefit from minimum efficiency regulatory increase in both residential and commercial. We also see significant carryover and annual price increase benefits. Our 2023 margins will also be favorably impacted by commercial manufacturing recovery and easing commodity costs. In addition, our material cost reduction pipeline will provide meaningful savings as we expect that most of the supply chain inefficiencies will be behind us by the middle of the year. Our commercial and refrigeration businesses have strong demand and backlog into 2023. And all our businesses have shared gain opportunities ahead of us. Bottom-line, even if residential units are down due to new construction and macroeconomic softness, we still expect revenue, margin, and EPS growth for LII in 2023. Please turn to Slide 12. For some final thoughts before Q&A. I would like to close our prepared remarks by summarizing why I joined Lennox and why I believe LII is an attractive investment opportunity. Lennox is a narrowly focused leader in energy-efficient, environmentally friendly, climate-controlled solutions. Our innovative products continually reduce global warming potential. We operate in high growth end markets with strong replacement demand that provides us resiliency even during economic uncertainties. The company has a unique direct-to-dealer network, providing a strong sustainable competitive advantage. And we have a history of robust execution with disciplined capital deployment. In summary, I believe LII is a compelling investment opportunity as we look at 2023 and beyond, and that our best days are ahead. Thank you. Joe and I will be happy to take your questions now. Operator, let's go to Q&A.

We will take our first question from Gautam Khanna. Please go ahead.

Yes. Hey, thank you guys. A couple of questions. First, I was wondering on the commercial side, as we think about supply chain and get to the root cause of what's happening there. Is there any evidence of, well, a, is it getting better? And likewise on the high-end residential product? And b, are you seeing anything where maybe you guys aren't getting as strong an allocation from certain suppliers relative to some of your competitors? Is there any evidence of that? And then lastly, if you could just talk about the CapEx required to build the new commercial facility and the timeline? Thanks.

Sure. Gautam, good morning. So on the supply chain side, both for residential and commercial, yes, it is getting better. But I've said this a few times and then something hits like COVID hit once and the Ukraine crisis hit as well. But so far everything that we are seeing things are getting better, maybe not fast enough, but they are. Second, we have no concerns or have no evidence to show that the allocation issue is impacting our supply chain performance. We have long, lengthy relationships with our core suppliers. And we believe that, through a lot of the challenges we are facing, are exactly the same as other industry players. So we are not concerned about any of the allocations. On the capital spend, we highlighted for the new factory, it's about $125 million to $150 million. We would for now planning purposes, assume that to be like evenly split between the two years. But we can give you more guidance on that when we are together for the Investor Day on December 14.

Our next question will come from Jeff Hammond with KeyBanc. Please go ahead.

Hey, good morning, guys. Just back on the residential supply chain, like you kind of commented that it's getting better, but it feels like it's getting worse. And I'm just wondering, if there's anything with how you use your supply chain, and a little bit more sourcing from Asia is creating a little bit of a lag or just want to understand, because it just seems like across the board, people are saying things are getting better. And this seems kind of seemed worse.

I think I would separate the supply chain situation with the Q3 residential margins. Because if you look purely at the margins year-over-year, you could reach a conclusion that it's getting worse. But frankly, a few decisions we made in Q3 to expedite materials and spot buy to make sure that we could serve our customers well. And I wouldn't look at our Q3 margins as an indicator, especially the year-over-year change in Q3 margin as an indicator of supply chain. Our inventory levels are getting healthier, our lead times are improving, there are pockets of challenges remaining, especially on the high-end products, which are more dependent on microelectronics and semiconductors. But overall, things are getting better. And I think our guide implies that our Q4 margins on a year-over-year basis will be down less, significantly less than what we saw in Q3. So I look at Q3 as a one-time impact of multiple different factors. So I would come back and reiterate, Jeff, that, no, our supply chains are getting better. Unless another shoe drops that we aren't aware of, we would expect most of the supply chain inefficiencies to be behind us no later than mid-next year.

Okay, that's helpful. We are beginning to hear about the pricing changes related to the regulatory change. Can you share your observations on that? As we consider the challenges and advantages heading into next year, it appears that the advantages are significantly more substantial than the ongoing challenges. Could you provide us with a clearer perspective on this? Thank you.

Sure. So the pricing for the new minimum efficiency products, I mean, when we talked about a double-digit benefit. And clearly, we're going to do our best to make sure that we get the appropriate price benefits. Currently, we remain very confident that will more than recover the additional costs associated with that. Clearly there are nuances which I won't get into in the call on which product series and what. But we remain confident that it's going to be a double-digit increase. And that's consistent with the higher costs and what we're hearing, like acceptable levels from our customers and channel partners. On the second side, yes, I mean, that's a good takeaway. I thought if I put three bullets on the headwind and eight bullets on the tailwind, I would naturally drive everybody to that conclusion that there are more tailwinds than headwinds. The biggest unknown there, Jeff, which we have talked about in the past, is how well is the replacement demand going to hold? We think it's going to hold well. We think the replacement versus repair equation is going to tilt more towards replacement given the various dynamics, including higher labor costs for repair and including the Inflation Reduction Act and other pieces that naturally drive people towards replacement. But yes, we'll give you more details in December. But I think that's a fair way to interpret what we said.

Okay. Great color, Alok. Thank you.

We will take our next question from Nicole DeBlase from Deutsche Bank. Please go ahead.

Maybe we could start with pricing questions. So maybe putting a finer point on like attempting to loosely quantify the pricing tailwind in 2023. Alok, can you talk about like when you combine the impact of the double-digit improvement due to SEER standard change? And then, think about just the price carryover from the actions that you guys took throughout 2022 that lead into 2023 as that is annualized, is there a sense of how much of a pricing benefit that can be in percentage terms for next year?

From a percentage terms, we could probably give you a lot more color in December, as we finished launching all the higher SEER product change. But I mean, we do expect that number to be meaningful in the first half of the year, we obviously will have a significant carryover benefit on pricing that comes through, and for the full year, there will be annual price increases, and there will be the mix and price benefits from regulatory changes. But at this point, Nicole, I would say I think it's best for us to wait until December before we can give you like a range of price number. But what we are indicating is that it will be more than any volume decline that we are expecting at this stage on the financial side.

I will also add to that. Nicole, we expect to be more price-cost positive than we were here in 2022.

Okay. Got it. That's really helpful. And then maybe just anything you guys are seeing with respect to channel inventory dynamics, obviously, there's a lot of questions about this from investors. And I think that it's especially tough to understand the level of inventory in the channel right now, with what's going on with this SEER standard change. So how do you guys feel about where inventory is in your own distribution as well as allied things?

Sure. So in our own distribution, which is where the majority of our sales come from, I think the inventory level is getting healthier, but we're still short on some of the higher-end products. And, if we could, we would actually maintain more inventory to ensure that we have all the products that our customers need as they go into the SEER change, which does make it messy. On the independent distribution, which the majority of the industry uses, we think inventory levels are getting healthier. In those areas, I do worry about an air pocket, sometime in the near future, driven by lead time improvements, and driven by sort of like the post minimum efficiency change, people may try and resize the inventory. But I think that's not something we are experiencing now. And that air pocket probably is going to be early next year as most people are being cautious and will want to keep sufficient inventory for the SEER change.

And just to make one more point, the air pocket is more attributable to those that go through to step distribution versus our direct-to-dealer model.

We think that impacts us very little.

Thank you, guys. I'll pass it on.

We will take our next question from Julian Mitchell from Barclays. Please go ahead.

Thanks. Good morning. I just wanted to start off with a sort of a question about the fourth quarter. So just wanting to understand is the sort of assumption at the midpoint that you've got, mid-high teens, sales growth in Q4, not too different total or across the segments than what you saw in Q3. And then, it's kind of a flattish margin year-on-year in the fourth quarter. So a little bit better year-on-year and that's because of resi. Is that the right way to think about it and kind of still single-digit growth in resi volumes in Q4?

Yes. When I sort of step away and look at things year-over-year, particularly in the fourth quarter, I think what we're going to see is more of an impact on the commercial business and fourth quarter margins. We had better margins last year in the fourth quarter. And because of the challenges we have in that business, that's going to be the biggest drag in the fourth quarter on margins. The challenges in the residential business, we intentionally made some investments to procure inventory to make sure we can serve our customers. And that simply came at a higher cost, which we don't expect to repeat in the fourth quarter of the same degree. And then, our refrigeration business continues to do very well. Net-net, we expect margins for the fourth quarter, even though we typically don't give guidance. I'll give you a little bit insight here, flattish to up slightly in the fourth quarter.

Thanks very much, Joe. And then maybe my follow up would be around kind of cash flow and cash uses. So I think yes, this year you're running at about 60% free cash flow conversion from adjusted net and understood it's because of the supply chain constraints. And then, you have the sort of the CapEx for the new plan for the next couple of years. So are we thinking it's, cash flow conversion, headline-wise probably doesn't get back to 100% for two or three years? Just wanted to check that's the right way to think about it. And also any context as to the reduction in the buyback guide. Thank you.

Yes, I'll start with the reduction in the buyback. What we did in over the last few months is continue to evaluate what we need production-wise to meet end market demand and continue to look for opportunities to create slack in our supply chain, and also fend off component price increases that will stick come January 1. So we made additional investments in inventory in lieu of share repurchases to make sure that we had adequate supply to support our customers going into a critically important time in 2023. So that's the trade-off there. And we'll continue to do things with the share repurchases to target our desired leverage points of between one and two. We've talked historically about targeting between 1.5 and 2. I think we want to be closer to the midpoint as we embark on 2023. And with respect to free cash flow conversion going forward, the way that I would do it, Julian, is start with the assumption that we're going to deliver free cash flow that approximates net income, and then take the incremental spend of the new manufacturing facility for commercial and adjust cash flow accordingly for that, and that should give you a pretty good proxy for what the next two years cash flow looks like.

That's very helpful. Thank you.

We'll take our next question from Jeff Sprague with Vertical Research Partners. Please go ahead.

Look, maybe first on the new commercial plant, can you give us some sense of the increase in productive capacity that comes with this plant in terms of whether it's square footage or potential revenue outputs, something that kind of frame the size of this increase relative to the current base?

Yes. I think, listen, we are working through all the details. And what we did is work backwards from our customers' forecast and looked at how much capacity we would need five years from now, 10 years from now and worked backwards through that. So the plant may start out with lower capacity, but it will be very much matched to the customer's demand. The other thing, remember, in Stuttgart, we are running much lower than nameplate capacity, given the local challenges and the labor availability. So at this stage, I don't want to give a number. But if it's sufficient to say this plant will give us capacity, at least for the next five to 10 years to keep serving our customers with the forecast they need. Our customers and us, both remain pretty optimistic about commercial replacement demand, especially as they know the new regulations come in and the ESG benefits that the customers receive. But given a lot of sensitivities around construction timelines and the impact on our existing facilities, I would rather not give exact details. But rest assured, we have a fairly detailed plan that we will execute on within the next two years to make sure we can ramp and start production by the end of 2024 at the new facility.

Understood. And then, just thinking about the SEER change again and kind of the mix impacts. As you exit 22, what percent of the business was at minimum SEER levels across the country in 2022 and, therefore, subject to the mandatory step up?

We've always talked about, is more than 50%. I mean, the industry number typically hovers about 60%, 65%, and we are in a similar range. That number is probably a little higher in '22 just because the higher-end products use more microelectronics, and they remain in somewhat short supply but I would use a number of around 60, which is the industry average, and that'll apply to us as well.

Great. And then, maybe just one last one, just the comment about higher-end componentry and the like, is that causing any friction on the new SEER unit so you're talking more 18, 20 SEER kind of up in there where you're having kind of components supply issues?

20, 24, 28, remember we make the highest SEER units and are very well known for that on those that typically go as part of our signature series products. That's where we are seeing shortages, which, unfortunately, forces a dealer not to be able to upsell. I mean, our dealers are really good at upselling and getting customers more energy-efficient products. And we have just been constrained on that. But we do see that easing as well as we get into 2023.

Great. Thanks for the call.

We'll take our next question from Ryan Merkel with William Blair. Please go ahead.

First off, you mentioned being prepared for the SEER change. How does your equipment lineup look competitively with the other brands?

Ryan, as a CEO, I always believe we are the best in this, right? So listen, a lot of the changes are still being unveiled. We believe that our design with a keep the box size the same. So the footprint remains optimized. We believe as we have put single-stage technology that gives us a competitive advantage. We believe our aluminum heat exchangers are better. But I think the most important difference is that for our products, a dealer does not have to change the indoor unit. And just by changing the outdoor unit, they can meet the higher efficiency standard. For many of our competitors, they got to change the indoor unit and the outdoor unit. So listen, I'm biased, but I think we've got a great solution. I think our dealers and end users are going to be well positioned. And we are looking forward to getting some share through the transition.

Got it. Thanks for that. And then nice job on commercial. I'm curious what inning are we in for increasing production? And then, did you say that in mid-23, you'd be at full production for commercial?

While if you follow cricket that we are in the first inning, if you follow baseball, we are probably in the second or third inning on that one. Listen, we are in early innings, labor was a big challenge, we got that. But we're still no way close to meeting our customers' full demand or the natural lead time. At minimum, our production should go up another 15%, 20% in the near future. And improving our manufacturing processes is a big deal. I mean, this is not acceptable level of productivity. And finally, now our suppliers have to ramp up with us and these are often smaller suppliers that we have let down in the past few years. So we are working through that. But early innings, probably the second or third inning on a baseball terminology.

Very helpful. Thank you.

We will take our next question from Tommy Moll with Stephens Inc. Please go ahead.

The 2023 early peak was helpful. I wanted to follow up on one of the comments that you made around resi replacement for next year. Specifically, where you talked about the potential for some volume pressure there in the context of an economic slowdown. How much of that, in your mind is just a repair versus replace dynamic? Or are you also hinting at some discretion with respect to the timing of when a homeowner decides to spend, like, for example, in the context of an existing home sale?

No, I think pretty much all of it is a balance between repair and replacement. We continue to believe that this is a non-discretionary spend. Now, would there be a small percentage that people will choose to live with a broken air conditioner, that always there but I think that's negligible. When we think it's purely a repair versus replacement, we're still working through the analysis. We have looked at other recessions and economic uncertain environments in the past. And we think this time around, if there is a softness, the repair versus replacement will still turn more favorably towards replacement. So I think we continue to believe it's all non-discretionary, and answer that nobody knows. And we just have scenarios around it, is how much of repairs versus replacement trade-off is going to change in a time of economic uncertainty. And we'll do our best to dive it more towards replacement.

Yes. Okay. I think that's helpful.

I believe there are additional factors influencing the situation that lean more towards replacement instead of repair. One factor is the ongoing issue with R22 refrigerant, as there are still many R22 units in use, making it challenging, if not costly, to source this refrigerant for repairs. Another factor is the changes in minimum efficiency standards, which I think will provide some advantages. Additionally, government incentives for heat pumps and electrification also suggest that replacement may be more cost-effective compared to the rising costs associated with repairs. Therefore, I think these factors are now more aligned than they have been in the past during tough economic times.

And as one of your analysts with an R22 system, I'm keenly aware of these dynamics, so personally know all the contexts there. We'll circle back after the call there, for sure. Joe, I did want to ask about interest expense for next year, I know some of your debt is floating rate, is there any way that you could frame based on the information you have now or maybe the rate curve, what the headwind in terms of interest expense might look like next year?

I'm going to wait until December to clarify that for you, if you don't mind. We still have a lot of work to do on our plan, etc., and all of that. So there's lots of moving pieces, various scenarios that we're whittling down at this time. So I don't think it'll be significantly different than wanting to stay will be higher, but it won't be significantly higher than that where it is today.

Okay. We'll talk again in December, and thanks for everything. I'll turn it back.

We will take our next question from Joe O'Dea with Wells Fargo. Please go ahead.

I wanted to begin by discussing costs. If I understood correctly, it seems that part of the inventory investment was possibly in anticipation of rising component costs, so could you clarify that? Additionally, when considering the composition of cost of goods sold, how do you view the balance between raw materials and sourced component exposure? It seems likely that raw material prices may decrease, but what are your expectations regarding the pricing of sourced components? Do you anticipate prices will decline, remain stable, or possibly increase in the future?

Sure. Let me begin with the inventory aspect. As we move ahead, we will likely adjust our mix a bit, increasing our finished goods and decreasing our raw materials. Currently, we have a higher level of raw materials due to our own supply chain lead times. I believe this will change over time, and overall, we are approaching fairly normal inventory levels. The majority of the buildup we have is reverting back to standard levels of finished goods, and I expect this trend to continue. In my factories, we continually emphasize the need for less raw material and more finished goods in our warehouses to better serve our customers. However, we don't typically break this down historically, and we won’t do so right now. Regarding component costs, we anticipate inflation to persist for a few more months, especially as it tends to lag behind commodity prices. Our supply team has negotiated excellent contracts in some cases, which means there may be no price increases next year, potentially linked to this year's commodity pricing. This situation often results in a six to twelve-month lag. Therefore, we expect component costs to remain inflationary. However, considering the combination of components, commodities, and our initiatives for material cost reduction, we anticipate a positive impact next year, contrasting with the net negative effect this year. We will provide more detailed information on this in December.

That's all really helpful. And then, I wanted to circle back on minimum efficiency pricing and just so that we kind of do the right math in terms of how much of the portfolio that applies to and so and you talked about like what percentage of the air conditioning and heat pumps would be at the minimum efficiency level but if we think about total residential, I don't know that the right math is to just say 60% is going up 10% to 15% maybe just kind of help us step through that a little bit?

Yes. A little more complicated than that given the way the transition is particularly on residential, where you can still sell 13 SEER in the North. It just had to be manufactured by December 31st of this year. So I think that's something that will scale that number back a bit. I'm not going to give you the math because I'm not certain of it. So I'm not going to lay it on the table. But I just want to play those dynamics back to you because once again, it is a very difficult thing to get our hands around roughly 50% of the revenue, 60% of the units are at minimum efficiency. So you start there and then, like I said, you need to consider the timing of the transition and the way that it's laid out in the North versus South particularly on the residential side to come up with a tighter number around that. We may give you more color around that in December, but I'm not prepared to do that at this time.

Got it. Thanks very much.

We will take our next question from Josh Pokrzywinski from Morgan Stanley. Please go ahead.

Yes. Alok, on the commercial startup here with CO, and then you mentioned you kind of hit a few milestones and stuck, what should we think about as sort of the increments along the way to restoring that $100 million of profitability you talked about because I think on one hand, the reasons that you guys decided for what drove the reduction sound like they've been remedied. So I'm sort of wondering like, what's the next thing to watch and are there any sort of buckets of profit restorations that you would think about as correlating with that?

Yes, right before the call, I met Joe Nassab, our President and COO of Commercial, and he said, we got to strike a balance. So I'm going to use his words on making sure we are demonstrating and celebrating progress but acknowledging that we have lots and lots of hard work still ahead of us. The improvements on $100 million is still going to be spread over the next two to three years. A lot of that’s going to come with higher output because our output is still way below nameplate capacity at Stuttgart, a lot of that’s going to come from just manufacturing efficiency. I mean, just our number shows that we have increased staffing by 30%, but output only by 15%. So we should be able to make 15% more products without adding any labor, just simple math on that. And then, there's a lot more benefit that comes from improving our manufacturing processes. I mean, you don't get to the state we got in April with robust manufacturing processes. So we need to establish those processes. And then, finally, as we take the step forward towards SEER change, the price mix benefit that we talked about in residential also applies to commercial, where some of our national account contracts had artificially constrained us on our pricing levels. Put it all together, I mean we are confident of the $100 million, we think it's going to be in three years or less, I hope to deliver it in two but we commit to delivering it in at least three.

Got it. That's helpful. And then, I apologize if you’ve covered this earlier, I cut out a couple of times during the prepared remarks. But on IRA and some of the heat pump points to watch, I think you guys probably lean a little bit more towards furnace than some of your peers out there. I would imagine that comes at the expense of heat pump. On the other hand though, heat pumps I think in terms of the incremental technology benefit might help you a little bit more in the North than what they would have historically. I guess, how do you think about both product and channel positioning to maybe kind of execute on that opportunity here?

Sure. So you're correct that our heat pump exposure is less than some of our peers, mostly because we serve or have a higher share in the North versus the South. I look at it as a huge opportunity for us to increase heat pump penetration. We had strong growth this quarter, just like previous few quarters in heat pumps. Our new cold climate heat pump technology gives us an edge over our competition as heat pump penetration goes from South to North. And I believe the Inflation Reduction Act is going to make a meaningful difference for us to increase heat pump penetration and often use the Inflation Reduction Act to go with a dual fuel system where you have a heat pump and a furnace in areas where a heat pump may not work in the coldest few months but work very well for the remaining nine to ten months. So there are a lot more opportunities ahead for us, and I'd love to talk and show more of some of these points during the Investor Day. But pretty exciting opportunity for us and the rest of the industry I think it gives us more favorable benefits given our low penetration and our cold climate heat pump technology.

Do you think you'll be able to quantify IRA or will we limit the opportunity discussion until Investor Day?

Potentially going to still remain very hard; part of it is, it needs to flow down to states and each of the states come up with their own local regulation. We know it's positive. I don't know if any of us, our sort of peers can give you actual quantification. We can probably point to themes and I'm looking at Joe and he's kind of nodding it, yes, I think it's going to be hard to quantify the exact impact, just because it hasn't flown down to states and utilities and how it's actually going to be implemented.

Got it. Understood, appreciate it.

We will take our next question from Steve Tusa with JPMorgan. Please go ahead.

So first of all, what was the independent channel, how did that perform for you in the quarter? I know it was up pretty big last quarter in resi.

We serve mostly through the direct on the Lennox and then with Allied and Heatcraft we do go to the independent channel. I would say the growth was similar across the board. We historically don't break it out but right now the growth was similar across the board.

I think it was breaking out in your 10-Q, or is that, no, you're not going to disclose that anymore?

Yes, we do break it out in the 10-Q, what Alok was talking about is in our formal presentation and prepared remarks, that's what he's referring to.

Got it. Okay.

They're not meaningful enough for us to point it out here.

Great. And then just one follow-up question. So I guess what everybody in the industry is now saying is that there's basically zero elasticity in the residential HVAC market. I mean, prices are up 30% to 35%, relative to a couple of years ago, you're going to get another kind of artificial price increase with basically zero return for the consumer in spending that much money and everybody is generally replacing today versus repairing. So you're just saying this market is kind of like, fundamentally bulletproof from elasticity perspective, is that kind of what I'm hearing on residential?

No, I don't think we said that the market is pricing elastic. I think what we have to do as industry players, is make sure that we serve our customers best with the right solution. The repair was a replacement dynamics. I'm not saying there'll be no shift. In fact, earlier in the call, we did talk about that there may be a potential shift and what we are doing is preparing for that. I don't think any market ever 100% price in elastic. But the current dynamics do favor more replacement versus repair given some of the factors we talked about. I don't think those SEER change pricing is artificial. I mean, I think that's real. There are real costs associated with it; there's real benefits associated with it; it's driven by regulation that impacts the whole industry but there are many unknowns. Our job as leaders is to be prepared for those unknowns and react in the best interest of our shareholders as those different factors play on, Steve.

Yes. I guess what I was just saying was that the consumer doesn't really care about regulation or any of that. So for them, that's just another 10% price increase that they’re not and they’re not worried about your increasing cost and there's really not a payback associated with it. So just one more question for you. What in kind of the new efficiency systems, what is the average cost of install to replace one of these things now, in your view in the channel? It's kind of your average, as you look across your fleet. If I'm a consumer and I'm replacing, what is that average now, cost?

So first of all, let me thanks for bringing up the cost of install, because to a consumer, the cost of equipment is often less than the cost of install. But that obviously depends on whether you are in Topeka, Kansas, or whether you're in New York City. I mean, that obviously varies substantially based on the cost of labor. But the cost of equipment on average is less than half of the total cost to the consumer, given the cost of installing and supplies and labor and other pieces that are put out on to that. We don't have a number, because it does vary so much to give you in terms of what's the average cost of install and the industry data that you can, I'm sure well aware of. But in our view that has gone up substantially as well over the past few years. And last thing I would say there is a benefit to the consumer with higher SEER changes as lower electricity costs. Most consumers may not see that on their daily bills or may not be fully aware of it, but there is a benefit to the consumer in terms of lower energy consumption that is meaningful when energy prices are at a record high sometimes.

Great. That’s the sort of color. I really appreciate it.

We will take our next question from Nigel Coe with Wolfe Research. Please go ahead.

So look, I think that you raised the point about the alternative pricing as a driver of replace versus repair. I think this is a really important debate because it's something that we hear a lot of debate about in the field. There are drop-in refrigerants like R-407, R-438, et cetera, that can replace an R-22 at much lower prices and have performance very similar. Are we not seeing that happening? I mean, you haven't got to pay R-22 prices at this point. So I'm just wondering what the view is on that?

Specifically regarding the R-22 unit, it's important to consider the cost of refrigerant along with factors like the equipment's age and the remaining life of the compressors and motors. You're correct that it's not just about that. We see a significant installed base that is due for replacement soon, and the higher refrigerant costs provide our dealers with an opportunity to discuss replacing it with a more efficient unit that uses environmentally friendly refrigerant, offers warranty, and may qualify for rebates from the Inflation Reduction Act. It's essential to view this as a comprehensive package. There is indeed a substantial debate regarding repair versus replacement, and while there are various models, our aim is to encourage replacement that benefits consumers while also being ready for any outcomes. If consumers opt for repairs, we want to ensure we can supply the necessary parts, and if there's a shift in this dynamic, we will update you on the changes we observe.

Right. And then just a quick one on the IRA, we beat this one to death. But you alluded a lot, this is, don't hold your breath, this is a government thing, the COGS turn slowly, are we thinking here this as more of a 2024? I mean certainly, if you look at the disbursements and the budgets, CDO productions is much more 24 than 23. But when do you think your contractors and dealers can go out and actually start selling customers on these benefits?

I believe it will begin in some states next year, particularly those that are faster to implement it, and you might see it along the coast sooner. Some of it will roll out in 2024. This is beneficial for our dealers as they can begin discussing it now. If you look at our press releases and those from our competitors, it's already being utilized, and there are existing rebates available from utilities and states that are not linked to the IRA. This gives our dealers a chance to talk to consumers about potentially available rebates. However, the actual effects of the IRA are expected to start in 2023 and continue into 2024, though it’s difficult to quantify without complete details on the rollout.

Great. Well, thanks a lot. Appreciate that.

We will take our next question from Joe Ritchie with Goldman Sachs. Please go ahead.

So I might have missed this earlier but can you parse out the commercial growth this quarter? How much pricing came through this quarter versus volumes? And then, also, if there's any commentary on commercial orders, that'd be helpful.

Yes. I think we mentioned in the script that the pricing for commercial was 9%, the total growth was 20%, so you think of it 11% from core unit volume and 9% from pricing. We don't typically break out order information. But I mean the orders remain healthy and currently are at or above our sales rate. So our backlog continues to build and in addition to the backlog or a book, there's also anticipated demand as many of the key customers are working with us on planned replacements here as they need to meet their ESG criteria. And at least here there's a very sophisticated decision about repair versus replacement because through our national account service, we have huge insights into potential breakdowns than replacements coming up. So it's all positive in terms of, I think pricing is picking up, volumes holding strong and we have good insights into orders on the book and future orders beyond what's in the book.

Got it, that's helpful. And then it was nice to see a lot of the margin expansion this quarter, both sequentially and I mean year-over-year basis in commercial. I know that there's some seasonality in the business of 4Q and 1Q tend to be seasonally lower quarters. I'm just curious, as you're kind of thinking through the margin progression from here, are these margins that can hold or do you expect the margins kind of take a step back at least from an absolute level sequentially because of the seasonality in the business?

So a couple of things, right? Overall, for Lennox, our margins are going to go up in the future. So I think the current margin levels are lower than what I expect a year from now, two years from now, or three years from now and we'll talk more about that on the Investor Day. Q4, specifically you're right, margins are seasonally low and quite a few of our manufacturing lines are going to go through a transition as we shift to minimum efficiency products, especially on the commercial side. Hence, we hinted that in Q4, the commercial margins may take a step back, but that’s planned changeover where our factories lines need to be just reworked and shut down to support the new products. But overall on margins, listen we were a little disappointed with the resi margins this quarter, but we understand some of the one-time factors and the mix impact. We are cautiously guarded for Q4 but we are optimistic about margins in the future. Like as we look at 2023 and beyond.

Thank you for that. I have a quick question regarding the new commercial facility you plan to bring online, which you mentioned should be fully operational by 2024. Currently, the orders in the commercial end markets are strong. However, it’s uncertain how the landscape will look in 2024. My question is about the added capacity in that facility. What flexibility will you have to adapt to potential changes in market conditions? Specifically, if we find ourselves in a different situation concerning non-residential construction or commercial HVAC in 2024, how will you adjust your capacity to avoid significantly high decremental margins if the market fluctuates?

I know that that was part of the concern and the equation we went through. There may be a short-term softness two years from now which none of us would know. First of all, I think the new facility gives us a lot of flexibility. I mentioned in my script that the hourly labor costs at the new facility would be 80% lower than our hourly labor cost at our current facility. Also, the new facility is close to our residential facility, which gives us flexibility in moving labor around if we need to between an optimizing it collectively, as Lennox International. So yes, I think we will have significant flexibility to react as we have done in the past, in terms of ensuring that margin degradation is minimal as we go through any volume decline based on external factors. Having two facilities will give us a lot more flexibility than if we only had one when things went south economically.

I want to remind everyone that our costs are approximately 85% variable concerning product costs. This means we do not operate in a capital-intensive industry, so a decline in volume would not lead to severe margin losses.

Okay. Thank you.

We have reached our allotted time for Q&A. That was our last question. That concludes today's presentation. Thank you for your participation and you may now disconnect.