Welcome to the Lennox International Fourth Quarter 2022 Earnings Conference Call. All lines are currently in listen-only mode, and 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 Alok Maskara, CEO. Alok, please go ahead.

Thank you, Ashley. Good morning, and welcome. I hope everyone is having a good start to 2023. It was nice to meet many of you face-to-face during the Investor Day on December 14th. Thanks for attending and sharing your feedback. Turning to Slide 2, a reminder that during today's call, we will be making certain forward-looking statements that are subject to numerous risks and uncertainties, as outlined on this page. Please refer to our SEC filings available on our website for additional details. Before we begin, I want to express my gratitude and appreciation to all of our employees who enabled us to deliver record financial results in 2022. Last year, our dedicated employees improved our customer experience while facing significant supply chain disruptions. This enabled us to reestablish our cadence of gaining residential market share. I want to take this opportunity to also thank our dealers and customers for their loyalty to Lennox. We will continue to improve our service levels while maintaining the best HVACR products and solutions in North America so that we can continue gaining share in the future. Now please turn to Slide 3 where I want to highlight four key messages. First, we are proud to report solid fourth quarter results that capped off another record year for Lennox. Q4 revenues of $1.1 billion and full year revenues of $4.7 billion were both up 13% year-over-year. Strong price execution and continued volume growth enabled us to set new records for both quarterly and full year revenues. Q4 adjusted earnings per share of $2.63 and full year EPS of $14.07 both grew 12%, establishing a new record of full year EPS. Second, we successfully transitioned our product portfolio to meet the new minimum regional efficiency regulation that went into effect on January 1, 2023. We believe that our superior design and solid execution have put us in a strong position to win share during and after the transition. Third, we ended the year with fully replenished finished goods inventory levels to support our customers through the SEER transition. In addition, we are also carrying a higher level of raw material safety stock to mitigate the impact of ongoing supply chain disruptions. Given this, our 2022 free cash flow was $203 million, which was below our expectations. We are undertaking countermeasures to improve our cash flow forecasting and remain committed to converting 90% to 100% of our net income into free cash over the long term. Fourth, our 2023 full year outlook remains unchanged, and we still expect revenue growth of 0% to 4% and an EPS range of $14.25 to $15.25. Now please turn to Slide 4 to discuss business updates as a follow-up to our dialogue during the Investor Day. In terms of end market update, as we approach February, our order rates remain consistent with our prior expectations. While we are noticing signs of a slowdown, we remain confident in our dealer network's ability to continue driving both replacement and new construction sales, especially as equipment lead times normalize. We do anticipate some channel destocking in our two-step distribution businesses like Allied Air, ADP, and Heatcraft. We are maintaining solid communication with our distribution partners to effectively manage channel inventory levels. In addition to successful execution during the SEER transition, we are pleased to report that we remain on track to transition our portfolio to comply with the upcoming 2025 low GWP regulation. In terms of order updates on our innovation roadmap, we recently launched our next generation thermostat controller, the Lennox S40, which has built-in indoor air quality monitoring capabilities and improved connectivity to further improve the experience of our customers and our dealers. We also continue to make progress on accelerating our heat pump growth, and we're proud recipients of the good design award for our Dave Lennox signature series collection heat pump. Switching gears. As part of our commercial recovery effort, the construction of our new commercial factory in Saltillo has started and will be complete by the end of 2024. Lastly, on this page, the formal process for divesting our European assets has started and our internal segment consolidation is complete. We expect to close the European divestiture sometime this year. With that, let me hand the call over to Joe, who will provide you a more detailed view of our financial performance.

Thank you, Alok. Good morning, everyone. Please turn to Slide 5. Looking at the quarter for Lennox overall, the company posted strong revenue and profit growth. Revenue was a record $1.1 billion, up 13% as reported and up 14% at constant currency, with the growth driven by volume and price. Total segment profit increased $30 million or 30% versus the prior year as pricing gains more than offset cost inflation, and all three segments contributed to profit growth. Total segment margin was 12.1%, up 150 basis points as price gains outpaced cost inflation and Commercial margins improved due to higher factory output. GAAP EPS of $2.65 was up 17% and adjusted EPS rose 12% to $2.63. Regarding special items, the company had an $800,000 adjustment for the fourth quarter and $6.6 million for the full year. Corporate expenses were $34 million in the fourth quarter and $91 million for the full year. Overall, SG&A was $155 million in the fourth quarter or 14.2% of revenue, down from 15.7% in the prior year quarter. And for the full year, SG&A was $627 million or 13.3% of revenue, down from 14.3% in the prior year. Our full year 2022 income tax rate was 19.3%, which was up from the 17.2% last year, the result of higher tax benefits from share-based compensation and the finalization of our prior year tax obligations with taxing authorities. For 2022, the company generated cash from operations of $302 million compared to $516 million in the prior year. The reduction in cash flow was primarily due to inventory cost inflation and investments to both minimize supply chain disruptions and prepare for the minimum efficiency regulatory change that took effect on January 1, 2023. Capital expenditures were approximately $101 million for the full year compared to $107 million in the prior year. Free cash flow was $203 million for the year compared to $410 million in the prior year. In 2022, the company paid approximately $142 million in dividends and repurchased $300 million of the company's stock. Total debt was $1.5 billion at the end of the fourth quarter and we ended the year with a debt to EBITDA ratio of 2.1. Cash, cash equivalents, and short-term investments were $61 million at the end of the year. Moving to the business segments, starting on Slide 6. Our Residential segment delivered record fourth quarter revenue and profit. Residential revenue grew 13% to $703 million. Volume was up 5%, price and mix were up 9% and foreign exchange had a negative 1% impact. Residential segment profit rose 8% to $119 million. Segment margin contracted 90 basis points to 16.9%, primarily due to incremental costs associated with supply chain disruptions and the factory changeover for the new 2023 minimum efficiency standard products. For the full year, Residential segment revenue was a record $3.2 billion, up 15%. Volume was up 4%, price was up 11% and product mix was flat for the full year. For the full year, Residential profit was a record $597 million, up 10%. Segment margin was 18.7%, down 80 basis points, primarily the result of supply chain challenges, which drove manufacturing inefficiencies and unfavorable product mix with reduced production output for higher-end products. Now turning to Slide 7 and our Commercial business. Revenue was $241 million in the quarter, which was up 19%. Commercial price and mix were up 17%. Volume was up 3%, and foreign exchange had an unfavorable 1% impact. Commercial segment profit was up 79%, and segment margin expanded 390 basis points to 11.6%. Commercial demand and backlog remain solid, and our Arkansas factory recovery is progressing well. Staffing in the plant is at our desired levels with productivity progressing and production output increasing. For the full year, Commercial revenue was $901 million, up 4%. Price and mix were up 13% and volume was down 9%. For the full year, segment profit was $81 million, down 27%. Segment margin was 9%, down 380 basis points. Looking at our Refrigeration business on Slide 8. Revenue was $150 million for the fourth quarter, up 5% as reported and up 10% at constant currency. Price and mix were up 21%, volume down 11% and foreign exchange had a negative 5% impact. Revenue growth was led by our North American business with price and mix, which was up more than 20%. Europe revenue was up 9% as reported and up 22% at constant currency. Overall, the Refrigeration segment profit rose 42% to $19 million and segment margin expanded 330 basis points to 12.5%. Refrigeration demand, order rates, and backlog remain strong. For the full year, Refrigeration revenue was $619 million, up 12%. Volume was up 3%, price and mix was up 14% and foreign exchange had an unfavorable 5% impact. Segment profit was $79 million, which was up 60% and segment profit was 12.7%, up 380 basis points. Turning to Slide 9 for a free cash flow update. Free cash flow was $203 million and was impacted by inventory replenishment to get our distribution network back to effective levels to serve our customers, along with inventory investment to buffer the supply chain to support demand for the new minimum efficiency standards that became effective January 1st. As we look to 2023 and free cash flow, we expect cash from operations to increase as we work to optimize inventory levels while we prepare for the next regulatory change to take effect in 2025 for the new low GWP refrigerants and minimize supply chain disruptions. Our capital expenditures in 2023 will be approximately $250 million and include investments for a second commercial factory and investments necessary to prepare us for the 2025 refrigerant change. Free cash flow in 2023 is planned within a range of $250 million to $350 million, including increased capital spending to support regulatory change and growth initiatives, including factory capacity. Free cash flow in 2023 is planned within a range of $250 million to $350 million, including increased capital spending to support regulatory and growth initiatives, including factory capacity. Now turning to Slide 10. Let's review our 2023 full year guidance. Our outlook collectively for the end markets we serve remains unchanged. We expect revenue to be flat to up 4% for the year. There is no change to our EPS guidance of $14.25 to $15.25 that we shared with you during our Analyst Day. Free cash flow is targeted within the range of $250 million to $350 million, as I mentioned. And we are planning capital expenditures of $250 million that includes the necessary investments in a second factory, as I mentioned, and investments related to the refrigerant transition that take effect in 2025. Price benefit, including price associated with the 2023 SEER transition is now expected to be within a range of $150 million to $175 million. Now turning to the cost side of the equation. We expect net material cost to be a $35 million headwind in 2023. That material cost headwind is driven by component cost inflation of $100 million, net of $30 million in savings from sourcing and engineering initiatives, along with a $35 million commodity cost benefit. Corporate expenses are still targeted at $80 million. We will manage SG&A tightly while continuing to make the necessary investments in the businesses to support growth initiatives and to drive productivity. And finally, we expect the weighted average diluted share count for the full year to be between 35 million to 36 million shares, which incorporates our plans to repurchase $100 million to $200 million of the company's stock this year. With that, let's turn to Slide 11, and I'll hand it back over to Alok.

Thanks, Joe. Summarizing our financial results and providing an update on the assumptions behind our 2023 fiscal guidance. Please turn to Slide 11 for the key success factors for Lennox this year that are summarized on this page. While we have little control over the industry unit shipments in 2023 that are still expected to decline year-over-year. Given that, we are focusing our efforts on the three controllable factors to grow our revenues and expand our margins. First, to offset inflation, we are maintaining and expanding our pricing initiatives. We have already implemented price increases for 2023 and are confident in our ability to offset cost inflation with pricing. Second, on the heels of a strong Q4 performance, we continue to maintain focus on commercial profit recovery. As Joe mentioned earlier, staffing levels are stable and the Stuttgart plant has switched over to the 2023 SEER standards while simplifying our product portfolio. Our new commercial product lineup provides greater value to our customers and we intend to share part of that value through pricing and contract negotiations. Third, Lennox is now well-positioned to start gaining share again. As you may recall, our service levels suffered after the Marshalltown tornado in 2018, and we were unable to fully restore the service levels during the COVID years. Now, the Marshalltown reconstruction is complete, our finished goods inventory levels have been replenished, Saltillo continues to add capacity, and our commercial lead times are approaching competitive levels. The improved service levels, along with recently introduced new products, put us in a strong position to relaunch our share gain programs. Even during a period of economic uncertainty, our confidence in executing on the three controllable key success factors makes us cautiously optimistic for 2023. Again, I want to thank our employees who are working hard to sustain and improve our customer service levels. Now please turn to Slide 12 for some final thoughts before Q&A. I would like to close our prepared remarks by summarizing why I believe LII is an attractive investment opportunity. Lennox is a narrowly focused leader in energy-efficient, environmentally friendly climate-controlled solutions. We operate in high growth end markets with strong replacement demand that provides us with resiliency even during periods of economic uncertainty. The company has a unique direct-to-dealer network, which creates a sustainable competitive advantage. And finally, we have a history of robust execution with disciplined capital allocation. Thank you for listening. Joe and I will be happy to take your questions. Ashley, let's go to Q&A.

We'll take our first question from Julian Mitchell with Barclays. We'll move on to Gautam Khanna with Cowen.

It's Gautam here. I was curious if you could explain your opening remarks about experiencing some pressure on volumes. Could you discuss the differences between the Allied and Lennox brands in terms of destocking, if applicable? Also, do you think this might be an early indication for Q1 based on what you're seeing in the residential market?

So I guess, first of all, as you know, majority of our sales are direct to dealers. And we highlighted Allied, ADP, and Heatcraft as the three business units that do go through two-step distribution model. Each of them are in a different stage of the distribution inventory cycle. For something like Heatcraft, we saw some destocking already occur, and we might be back to more normal levels. For Allied and ADP, as we talk to our channel partners, we believe there's some destocking that's going to occur this year, which frankly, puts our Lennox brand in a strong position. That all is baked into our guidance as we look at 0% to 4% revenue growth. While we don't give quarterly guidance, Gautam, as you know, so far, I mean, as we said, the Q1 order rates are consistent with our expectations. And I don't see anything falling off a cliff or so, but we do see a gradual slowdown that we have talked about in the past.

And then if you could just comment on the recovery on the high-end product, Lennox products. Sort of where are we in that journey, and do you expect to be a full participant in the summer selling season with that product line that was impacted last year?

Yes, Gautam, now since the Marshalltown tornado, this would be the year, 2023, we have all the inventory levels needed to launch our programs, to recapture our position on the high end, especially as we look at some of the new products like the Dave Lennox Signature series heat pumps and the new higher efficiency furnaces. So we feel good going into the year to be able to capture our fair share of the market and higher than growth in 2022 on the higher end products.

We'll take our next question from Nigel Coe with Wolfe Research.

So I was a little bit late joining the call. So I just wondered, could you give any color in terms of the order activity in Q1? I'm guessing not, but if it did, it'd be helpful to hear that. But just my broader question is, how has the SEER transition from a market perspective and obviously, asset, how has that gone versus expectations and has it caused any sort of air pocket post the year end?

We didn't provide specific numbers for Q1, but we did mention that the order rates in January aligned with our expectations. Everything went as anticipated. Regarding the SEER change, I believe it was managed well across the industry. The industry has adapted to these changes. We feel confident in our design, as we discussed in the last call, and we don’t need to modify some of the indoor units, only the outdoor unit. Overall, we performed well and will wait for industry numbers to evaluate our market share. Generally, the industry has adjusted smoothly, and most major players experienced a seamless SEER transition. Some smaller players may have faced challenges, but overall, I think the transition went as well or even better than expected for the industry.

And then my follow-on is on inventories. You built inventory into Q4 versus Q3, quite unusual from a seasonal perspective. But I'm curious, was that planned or were there some issues that caused that build?

I believe the inventory increase was intentional. We aimed to achieve two objectives. First, we wanted to ensure we had enough high-end products in stock, even though those won't sell until the summer due to the challenges we faced. Second, with the SEER change, we wanted to maintain sufficient inventory of the new SEER product as we entered the new year. I think that aspect was well-planned. Where we fell short was in more accurate forecasting and our positioning with some raw materials. As our supply chains stabilize, we should be able to convert more of that inventory into cash. So at this point, we have completed the inventory build.

And we'll go next to Joe Ritchie with Goldman Sachs.

Alok, can we just maybe just talk about the Commercial business for a second? It sounded like pretty positive comments on the hiring front. I guess just where does production stand relative to normal levels? And then maybe just talk about how you're seeing that business from a share gain perspective. It sounds like you're starting to recover some gains or recovering some share that you may have lost previously.

So first of all, we are pleased with the recovery in Commercial and remain committed to $100 million EBIT improvement in Commercial over the planning period. We had a strong Q4, as you saw from numbers slightly better than expected, and that was kind of the prime driver of why we came to the higher end of our guidance. The recovery was driven by very stable levels of staffing. I mean, at this stage, we're hiring as much as we are losing and that's kind of back to normal levels. I think the team has done a good job making sure that the output has come back up compared to the lows of the year, but we are still not back to normal. I would say we are probably still about 20% below normal on factory output where we could get there just with this factory even before the next factory comes online. So we remain pleased with the efforts in Q4. Q1, that's going to go through SEER transition. And obviously, that's something we are very excited about given the change in product lineup. So net-net, excited about the new Commercial segment. We will continue delivering and focusing. And even as we take a step into '24, '25, the new factory will give us more productivity, more capacity. And the last question you have is, yes, we did lose share in Commercial despite all the things I said earlier. Most of that was earlier in the year. Towards the end of the year, we started recovering shares and we did a little better. And we think that trend will continue because the industry lead times remain extended and ours are now getting to very competitive levels within the industry.

And just to elaborate a little bit on what Alok mentioned, where we lost share was in the emergency replacement segment of the market. And as productivity and output improves, it'll enable us to replenish our distribution channels with that stockable product and then you should really see the share gain gain traction. Once again, we're able to reengage in the emergency replacement side of the market.

I have a follow-up question. Residential volumes remain positive, although you anticipate a decline for the year, and I understand you don’t provide quarterly guidance. Based on current inventory levels, do you expect things to turn negative at the beginning of the year, or is that likely to occur later? Any insights on seasonality as we move through 2023 would be appreciated.

First of all, there’s significant uncertainty remains and at some stage, your guess is going to be as good as ours. January met expectations. Because the majority of our business is dealer direct, the impact of channel destocking would be minimal. But for the industry, I do saw it happening more in the first half versus the second half. So I think the industry will see some decline in sales to distributors that distributors pull back orders to get the inventory rightsized. I think the seasonality, as we typically expect in the summer seasonality, still remains. So I would say, yes, there's going to be some channel destocking impact in the industry in the first half. It's going to impact us less. But beyond that, it's going to be watching all the numbers that you would watch, consumer confidence, interest rates, new home starts and see where we come up. Because the new home starts that fell in the second half of 2022 will have an impact in 2023 at those come up for completion, because our new home business did well in Q4 that's lower margin, as you know. But going into '23, we expect that to slow down for sure.

We'll take our next question from Steve Tusa with JPMorgan.

What was the growth rate difference between Allied and Lennox brands in the fourth quarter?

I don't have it in front of me, and I think it was pretty consistent…

I'll be honest with you, Steve, I don't think it was radically different than what we saw in the direct-to-dealer business because we had a really solid and we had a record year in our Allied business, they did a tremendous job. They gained more than 100 basis points of share, along with our Lennox business. So it was a pretty good quarter for both businesses.

As you look ahead to the first half and consider the impact of destocking, what kind of distribution do you anticipate for January? Additionally, how do you expect this destocking cycle to influence the first half?

Yes, in the Allied business, we would expect a slower start because, as Joe said, they had a good year. I mean in Q4, they grew very well, Lennox grew well as well. Allied grew faster than Lennox in Q4. And as we take this forward, I would expect 20% of our business, which is on through two-step distribution to have a slower start to the year versus the rest of our business, which is dealer direct.

Can you provide some insight on that? Is it a 10% difference or 20%? There are many variables to consider, so it would be helpful to know roughly what kind of split you would anticipate between sell-through and sell-in, if you want to frame it that way.

I think that's a fair question and we are wondering the same questions in that. I mean, 30 days in, we haven't noticed a huge difference between the two. So like time will tell. Some of it also comes down to how distributors are thinking of the year and what kind of signals and tea leaves they are reading about demand this year. But sometimes when these air pockets come in, in the two-step model, they last a few weeks. We haven't started experiencing that yet. We're just prepared to experience that. Unfortunately, we don't have any numbers. And your guess is going to be as good as mine, Steve. What were the actual inefficiencies from this year's changeover? What exactly were they? We faced several challenges this year. First, in our factories, we had to switch between different production lines, which led to work stoppages at various times on a rotating basis. This obviously resulted in labor inefficiencies and underutilization. Second, we needed to use air freight and purchase some components at higher prices to ensure we met our deadlines. Lastly, within our distribution network, we incurred extra costs as we managed the transition between old and new standards and adjusted freight logistics. These three areas included air freight and component costs, factory efficiency, and additional distribution expenses.

And we'll take our next question from Julian Mitchell with Barclays.

I wanted to check on the Commercial business, not so much the sort of internal self-help initiatives. We can see that clear green light on Slide 11 for that, but more just on the sort of the market as you see it. Classically, there was a lag, but a relationship from Residential trends to light Commercial unitary, just wondered how you see that dynamic playing out this time, if you have seen any more kind of choppiness in project activity or so forth amidst higher interest rates and weaker housing starts activity.

Julian, you are correct. Historically, there has been a delay in the correlation. If that occurs this time, I believe it will be prolonged due to the industry's long lead times and ongoing pent-up demand from the number of replacements that were opted for repair in recent years. When a unit failed, they could have replaced it but chose to repair it instead. In our conversations with larger customers, we do not see any changes in their replacement or spending plans. However, that could change. So far, we have not observed any issues. Many customers are still discussing their plans for significant upgrades to their facilities and HVAC systems in 2025, using low GWP refrigerants to align with their carbon footprint objectives and improve their ESG values. In the short term, we haven't noticed anything alarming. The lead times remain between 24 to 52 weeks. As we approach 2025, we expect many key accounts to begin increasing orders and planning for replacements. We are closely monitoring the situation, using the same data you would, from ABI and other indexes. Currently, it appears to be more about lead time and supply limitations rather than a lack of demand.

And then just looking at Slide 10, you laid out some of those moving pieces below the top line around the net material cost inflation. So I noticed, I think the components headwind that you expect went up a bit from what you'd said in December, any more color around that? And when you're looking at that net material cost inflation of sort of minus $35 million, what are the latest thoughts on how that headwind is weighted sort of first half versus second half? Are you getting a good tailwind in the back half or it's closer to flat?

We get some tailwind in the back half. I mean, it's right now heavily weighted but at the same time, we haven't locked in the commodities for the second half yet. So some variability still exists in that. The component piece is higher and we wanted to be upfront. It’s higher than what we thought. But some of the items such as compressors, variable speed motor, given the supply constraints that everybody is facing, I think vendors have decided to charge higher, and we clearly had to play a part in that. So yes, the component costs are higher and that just puts more onus to get pricing. That's why you see pricing, we increase our range and talk about $150 million to $175 million versus just a flat number of $150 million. So different moving pieces. We'll remain committed to offsetting material costs with pricing and keep doing our best to bring components down. And if commodities ease in the second half, the number could get better.

We'll go next to Jeff Hammond with KeyBanc.

I want to explore the momentum in gaining market share a bit further. Firstly, regarding the Commercial sector, you mentioned you're re-entering the emergency replacement market. I'm curious about how feasible it is to regain market share and build trust with dealers and distributors. On the Residential side, you indicated that you're positioned for share gain for the first time in a while. Could you provide more details on whether this is due to having everything organized effectively, including your plants, or do you believe it stems from having superior products and better availability?

Yes, I think on the emergency replacement side, Jeff, I think it's very difficult to distinguish. Where you compete there is on availability and price and we've got the distribution network, we've got the people who sell it. In 2022, we were just short of product. So it's a matter of once again, I'm just replenishing those distribution channels such that we have the product available, and we feel we're back in the game on emergency replacement, and we expect that to happen over the course of 2023.

To address the Residential segment, we faced challenges in 2018 regarding product mix and inventory. However, we are optimistic about the new leadership in that area and our fully stocked warehouses. We have also focused on enhancing our sales strategies, which are yielding positive results. Historically, during regulatory transitions, we tend to gain market share because we believe our products are superior, and our current design will deliver additional advantages. This gives us confidence in the Residential segment.

And just to elaborate a little bit on what Alok mentioned, we just kicked off a process literally this week, the teasers went out. So we're waiting for, once again, the NDAs to flow in and engagement to take place with potential suitors. We should have more news for you on the first quarter call, but we're out of the gate with the process. And we're excited about what lies in front of us with the portfolio of businesses that we have in 2023.

There are no further questions, and this concludes Lennox fourth quarter and full year 2022 earnings call. The earnings release with GAAP to non-GAAP reconciliations, today's presentation slides and the webcast link for today's call are available on our website at www.lennoxinternational.com. This webcast also will be archived on the site for replay. Thank you for joining us today.