Welcome to the Lennox Fourth Quarter and Full Year 2023 Earnings Conference Call. All lines are currently in a 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 Chelsey Pulcheon from the Lennox Investor Relations team. Chelsey, please go ahead.

Thank you, Shelby. Good morning, everyone. Thank you for joining us this morning as we share yet another quarter of outstanding performance. With me today is CEO, Alok Maskara, our new CFO, Michael Quenzer, and our outgoing CFO, Joe Reitmeier. Alok, Michael, and Joe will share their prepared remarks before we move to the Q&A session. Turning to Slide 2, a reminder that during today's call, we will be making certain forward-looking statements, which are subject to numerous risks and uncertainties as outlined on this page. We may also refer to certain non-GAAP financial measures that management considers relevant indicators of underlying business performance. Please refer to our SEC filings available on our Investor Relations website for additional details, including a reconciliation of all GAAP to non-GAAP measures. The earnings release, today's presentation, and the webcast archive link for today's call are available on our Investor Relations website at investor.lennox.com. Now please turn to Slide 3 as I turn the call over to our CEO, Alok Maskara.

Thank you, Chelsey. Good morning, and welcome. I'm proud to represent our 13,000 employees as we delivered another full year of record results. We are pleased with our 2023 growth, margin expansion, and more importantly, cash generation. Our strong results were noteworthy, given the unprecedented destocking faced by residential HVAC manufacturers last year. I'm deeply grateful for our employees and our customers whose hard work, loyalty, and dedication drove the results that we will be discussing today. I would like to begin by highlighting 4 key messages on Slide 3. First, we delivered $3.63 in adjusted EPS for Q4, an increase of 41% year-over-year. Adjusted EPS for the full year was $17.96, a 27% increase year-over-year. Our 2023 full-year results were also notable for 6% core revenue growth and 300 basis point expansion in adjusted segment margin. In addition, our operating cash flow more than doubled compared to the prior year. Second, we continue to invest wisely in manufacturing capacity, distribution optimization, technology transitions, and growth initiatives while maintaining our industry-leading ROIC of 44%. Third, while end market uncertainties linger, our transformation momentum sets a strong foundation and gives us confidence in our 2024 EPS guidance range of $18.50 to $20. Fourth, given the robust progress on the self-help transformation plan, we are pleased to increase our previously announced 2026 financial goals. Now please turn to Slide 4 for more details on our 2023 self-help accomplishments. In 2023, Lennox experienced significant success during the first phase of our self-help transformation plan. Our strategic initiatives allowed us to effectively navigate the destocking challenges, which demonstrated our resilience and exceptional execution. This phase laid a solid foundation for future growth and positioned us to capitalize on further growth opportunities. We accelerated growth by strengthening our distribution muscle to better serve our existing customers, attract new customers, and increase our share of wallet from HVAC dealers. We are investing in our sales and stores teams to create greater alignment, accountability, and autonomy for improving the customer experience. To ensure resiliency, we implemented pricing excellence initiatives to recover margins from previously depressed levels as many long-term key account contracts, which were signed before the recent inflationary period, came up for renewal. We also achieved higher factory output, enhanced productivity, and optimized our product mix. Together, these measures contributed to overall margin expansion and strengthened our margin resiliency. Finally, to ensure consistent execution, we implemented a balanced core card-based operating system, which we refer to as the Lennox unified management system. This system was instrumental in driving accountability and ensuring alignment with our strategic goals to accelerate revenue growth and expand margins. We also simplified our portfolio with the sale of the European businesses and improved our total life cycle value proposition with the recent AES acquisition. On the next slide, I will share more about how we fine-tuned our internal engine to ensure success of the transformation plan and accelerate growth throughout the journey.

Thank you, Joe. Good morning to everyone. Please turn to Slide 6. As Alok mentioned earlier, 2023 has been a record year with Q4 being no exception. Core revenue, which excludes our revenue operations, was $1.1 billion, up 7% as price and mix drove the year-over-year improvement. Adjusted segment profit increased by $44 million to $69 million, which were partially offset by inflation and investment in SG&A and distribution. Total adjusted segment margin was 15.9%, up 320 basis points versus the prior year. For the fourth quarter, corporate expenses were $30 million, a decrease of $3 million. Our fourth quarter tax rate was 20%, and diluted shares outstanding were $35.8 million compared to $35.6 million in the same quarter last year. The fourth quarter achieved record levels of revenue, segment profit, and adjusted earnings per share, which grew by 41% to $3.63. Let's shift our focus to Slide 7 and review the financial results of our Home Comfort Solutions segment, formerly referred to as the residential segment. The left graph shows revenue grew 1% to a record $709 million in the fourth quarter. The segment benefited from a favorable mix of higher efficiency products and effective pricing execution. This was partially offset by volume declines. Although unit sales volumes for the segment declined by 5%, our direct-to-contractor sales volumes remained stable, signaling a resilient consumer demand landscape. Unit sales volumes through independent distribution channels declined by more than 20%, driven by continued industry destocking. Home Comfort Solutions profit decreased approximately 4% to $115 million, and segment margin also experienced a decline of 70 basis points to 16.2%. The decrease was attributed to a $9 million decrease in sales volumes and a $25 million impact from inflation and investments in distribution and selling.

Thank you, Alok, and greetings to everyone joining us this morning as we announce Lennox's record-setting performance and outlook. I've had the pleasure and privilege of serving as Lennox's Chief Financial Officer during a period of transformation and record-setting achievements. Portfolio changes enabled a more intense focus on our key North American end markets, and the team introduced new and innovative solutions. We delivered on initiatives that drove significant increases in profitability, and that coupled with efficient capital allocation resulted in industry-leading returns on invested capital. We fortified the balance sheet, and most significantly, we generated exponential increases in returns for our shareholders. Now before I hand it off to Michael, I'd like to reflect briefly on 2023. It was another year of exceptional performance while strengthening the foundation for the future by investing in our people, sustaining industry-leading innovation, and enhancing our capabilities to better serve our customers. Now while I'm extremely proud of my time with such a great organization that has accomplished so much, I take even greater pride knowing that I'm leaving an extremely talented and seasoned team that is very well positioned both strategically and financially for long-term success. I'd like to wrap up my comments with a sincere thank you to all Lennox employees, our valued customers, the investment community, and other stakeholders for your partnerships over the years.

Thank you, Joe. Good morning to everyone. Please turn to Slide 6. As Alok mentioned earlier, 2023 has been a record year with no exceptions in Q4. Core revenue, which excludes our revenue operations, was $1.1 billion, up 7% as price and mix drove the year-over-year improvement. Adjusted segment profit increased $44 million at $69 million, while price and mix benefits were partially offset by inflation and investment in SG&A and distribution. Total adjusted segment margin was 15.9%, up 320 basis points versus the prior year. For the fourth quarter, corporate expenses were $30 million, a decrease of $3 million. Our fourth quarter tax rate was 20% and diluted shares outstanding were $35.8 million compared to $35.6 million in the prior year quarter.

As we look forward to the coming year, it is important to recognize that while our transformation momentum has yielded positive results, we are still facing challenges in the end market. Within our Home Comfort Solutions segment, the health of the consumer will remain a significant driver of demand and greatly influence the repair versus replace dynamic. We are mindful of consumer sentiment, especially in an election year, and we will continue to track macro data for early indicators. It is important to point out that we have not yet noticed any meaningful shift from replace to repair. EPA rulings have also introduced an element of uncertainty regarding industry inventory levels. Ahead of the R454B transition, we do not anticipate a large pre-buy due to inventory fatigue in the channel and the increased cost of carrying inventories. However, we do expect distributors to normalize inventory levels this year as the channel returns to its usual ordering patterns.

And we'll take our first question from Jeff Hammond with KeyBanc Capital Markets.

Joe, look forward to seeing you in Cleveland, look me up. Just on margins, I'm trying to think about the puts and takes. You've got some profit incrementals on the left of Slide 11, and then you talk about a number of headwinds. I'm just wondering if you could put a finer point on just overall incrementals embedded in the guide and maybe how to think more five-point. Much of this refrigerant inflation, manufacturing efficiencies are going to cost similar to how you did for the factory ramp-up costs?

Yes. So on the left-hand side, you can see our contribution margins. And on the right-hand side is the increase related to rate for costs as well as investments. So you have to join those two together to see the full impact. But we do expect some margin improvement for the enterprise next year when you look at the combined. Our component costs are a big piece of our cost of goods sold are nearly 45%, and then refrigerants will also go up significantly. So most of that pricing should be there to maintain our current gross margins and then we'll get a bit of leverage on the volume and a little bit of leverage on the acquisition as well. But overall, we do expect margins to be up, just not 300 basis points like we saw in 2023.

Sure. I'll take that, Jeff. Regarding our internal working capital improvements, I believe there is always room for enhancement, but we are approaching a certain level, particularly with the upcoming A2L transition. I anticipate that these levels will be relatively stable. We may need to increase our working capital in the latter half of 2024, which is already factored into our guidance to facilitate a smooth transition. Concerning the independent channel, the destocking in Q4 exceeded our expectations. We also expect some destocking to continue in Q1, especially with product line releases, though it's uncertain if weather will play a role. Overall, we expect some destocking to carry over into Q1, but we remain confident that by the second half of Q2, the destocking in the independent channel will be mostly resolved, particularly as distributors prepare for the A2L transition and the EPA ruling permits some sell-through in 2024.

Congratulations, Joe. Enjoy your retirement. I'm not sure if this is a tough question, but regarding Jeff's earlier question about incrementals, you mentioned that price mix has a 90% incremental margin. I'm curious how that factors into the mid-single-digit component of inflation. Essentially, if you anticipate a mid-single-digit contribution from price mix with the incremental, does that lead to an EPS tailwind of about $3 to $4? Is that your perspective on it?

Yes. I mean what we have to do is look, it's predominantly price, price drops through to 100%. There's a little bit of mix that we'll get from the carryover benefit from the minimus year transition. So that will kind of drop through at 30%. When you blend the two together, you kind of get to the 90, but then that then covers some of the cost inflations we have on the right-hand side where we think our components are going to be up significantly, both from the normal inflation, mid-single digits, as well as the refrigerant. So that kind of sets a lot of that, which maintains your gross margins. And then thereafter, we start to make investments in distribution and SG&A. And we still see overall operating margins improving think of it maybe to be a little less than 50 basis points within the guide.

And I would like to add that we need to consider the inefficiencies at the factory, both for the start-up in Saltillo and for the A2L conversion, which involves a significant transformation. Every production line must be redone, and we will have phases of factory shutdowns. We have accounted for all of these inefficiencies in our guidance.

And we'll take our next question from Tommy Moll with Stephens Inc.

I wanted to start on price mix and your outlook for the year, mid-single-digit contribution. Can you give us any sense of the phasing there? I presume it's going to contribute a little bit more to growth in the back half versus the second half? And then if you think about what's the art of the possible here over the next 2 years, Alok, I think in the past, you've said 15%, 15% plus is a good bogey to use for where we'll land by the end of 2025. But I wonder if you could just refresh us there? And are you any more or less confident on that outlook?

Yes. So I'll first answer on the price, we see that mostly starting to build in through Q2, Q3, and Q4. As we announced in Q1, it will take a little bit of time to get that new price increase. But in Q1 is where you'll see the carryover benefit on the mix side from the minimum SEER product, we'll get the full year benefit of that.

I think, Tommy, on the overall, we stick to the 10% to 15% total pricing impact by 2025. A large part of that is going to happen in 2025 as like in our 54 products start getting launched towards the tail end or second half of this year. So we will see a lot more of that benefit next year than they will see this year which is unfortunate because we'll see some of the manufacturing inefficiencies this year as we transition our line from 410 to 454B, a lot more of the benefit coming to as tail half of this year or like early next year is when we start seeing those benefits. But our view and outlook has not changed on that, and I was glad to see that others in the industry are also now catching up to that dynamic because there's extra cost of sensors, there's extra cost of controls, there's extra cost that we're going to do as we look at the heating capacity, compressors. There's just a lot of extra cost that we must offset.

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

Thanks, Joe, for all the help. My first question is regarding the earnings cadence throughout the year. Is it tricky to determine if pre-COVID seasonality still applies, or have changes occurred, particularly with the Mexican plant and the refrigerant change? Are we assuming a 50-50 split between first half and second half earnings, considering that Q1 is usually low and you might be starting the year with weak home comfort volume?

Yes, I think I'd look at the revenue seasonality in kind of 50-50. Q2 and Q3 should be pretty similar kind of 30% of the year each then you have kind of 20-ish in Q1 and Q4 on the revenue guide. That's similar to what we saw in 2023.

Sure. I think overall, we expect that to get even by 2025. I mean, in the independent channels of the distribution channel, we fully expect because of comps and because of inventory get to appropriate level, increase in sales versus last year. We're not sure of the timing on when that stops, given all the comps and everything else. But we do think inventory levels and order patterns normalize and we will see a bounce back in our sales to the channel, irrespective of what happens from the channel to the dealer. On the dealer side, we were pleased with the resiliency that we saw, although volumes were down, they were better than most of us expected. And that resiliency gives us comfort going into 2024, and we expect and have baked in sort of flat to down numbers on that going into 2024. Just because of all the chatter around repair, replace, interest rate, election year, which so far has not turned out to be true, but we want to kind of make sure we put all of that and let you guys decide. Like here are assumptions that you can decide how you look at it. We focused on what we control, and we know we are going to win share through the transition, and we are recovering our service levels nicely.

Here's a potentially easy one. What drove the rebranding of the segments? Any functional difference to be aware of?

No, no functional differences to be aware of. We simplified it from 3 to 2. We had some internal confusion going on between business unit name and segment name, so we embarked on a new branding, which I guess the positive message. Overall, at Lennox, we have not focused on building a brand with dealers and consumers, and there were just different confusion going on. We simplified our websites. We have huge investments in improving our customers' experience, introducing new technology, and updating even our email addresses and our Lennox.com. It was part of a big rebranding exercise. It was just about time to differentiate the residential segment from the business unit, but I wouldn't read anything more into it besides just simplifying our internal nomenclature and better reflecting what we do, right? Because what was called commercial also had a tiny bit of refrigeration in there. So I do think the new names better reflect what we do and are more consistent with our new branding guidelines. Sure. Let's start with me at the highest level on the executive staff. So last year was the first year where our short-term incentives had a growth component or a revenue component to it. So 20% of our short-term incentive now comes from growth. And that just changed the mindset. Just to give you an example, but let's take it down to a few levels on where it really matters. So if you think about sales incentives and compensation, it used to be the other way around because only on revenue are not enough on profits and margins. So as we talked about accountability, autonomy, and in deploying all of that in the sales force, we are now measuring our sales team more on profits, more like a distributor would measure them versus purely on revenue. And that's a long journey because you can't change these things overnight, especially if they have been seeped into the culture for many, many years. But we are pleased with the early results and fully prepared for the long-term journey as we add technology and finance scorecards and metrics-driven behavior versus the storytelling behavior, so I'm pleased to get there.

Thank you, Joe, for everything. Have a great retirement. It's well deserved. So my question is for Alok and Michael. It sounds like the implied 1Q guide is above where consensus is today, and consensus is towards the high end of your full year guidance for the year. So I'm just trying to understand kind of like the conservatism that might be baked into the low versus the high end. So any color you want to provide there would be helpful.

Sure, I'll start, and then Michael will jump in. Because we really did not consider consensus was giving guidance, and we don't give guidance by quarter. But here's what we did, right? We laid out the volume assumptions on Page 11, so you can look through that. And that kind of brackets our low end and the high end, all on the volume assumptions. As we look at it, Q1 is going to be a little weird because we get more mix benefits, as Michael said earlier, because last year, we still had old SEER and new SEER products. Some of the price increases go into effect in February for us, as you saw along with the other competition. So you get only half a quarter benefit on that. And seasonality will be similar to what we have seen unless there are any unusual weather patterns. So honestly, we didn't spend tons of time looking at quarter-over-quarter. We were just thinking of the longer term where we are focused and drive that. Michael, what would you add to that?

Yes. I would just add, we obviously don't give quarterly guidance. But generally, when you look at the seasonality that you plot as we just talked about, maybe a little bit more destocking as Alok talked about through the distributor business in Q1 and then starting to revert back up thereafter. And then a little better production out of the commercial factory, maybe little better volumes in Q1 from commercial as well.

And we'll take our next question from Damian Karas with UBS.

I wanted to ask you about your commercial outlook for this year. You spoke to a lot of the pent-up demand and the older installed base. You're guiding the building climate volumes to up low singles. Could you maybe just kind of parse that out, how you're thinking about planned replacement versus emergency and new construction?

Sure. It's a bit of a mixed situation with several factors at play, but let's focus on the positives. Our order rate continues to be strong, and while backlog is not a major concern right now, it remains solid in the short term. Our sales team is quite enthusiastic and we haven't noticed any effects from various reports, such as the KBI index, although some projects are getting delayed. We are a bit cautious moving forward. When speaking with our key accounts, there's a lot of excitement about the R454B product, but there is some concern that they might decide to wait for the 454B rather than choosing the current product. We have considered various competing factors and are happy with our current order rate, backlog, and production output. We're particularly excited about our Saltillo factory, which will increase our output as we continue to face a supply constraint. We also want to acknowledge some of the uncertainty regarding the construction pace and any potential disruptions related to the transition to the 454B product.

And we'll take our next question from Joe O'Dea with Wells Fargo.

Can you discuss what percentage of the commercial mix was emergency replacement in 2023 and how you plan to increase that in 2024? I believe it may be around 30%, but I think we are still moving towards a more normalized situation.

Yes. So listen, we were close to 0. I think we hit double digit in '23 in terms of trying to get to emergency replacement. Barely, I would say, high single digits, double digits in 2023, and that includes both our direct and going through our distribution partners. And we still think there's a lot of room ahead. We probably won't move that needle until Saltillo comes in production in the second half of this year. So expect us to hover in high single digits, low double digits until Saltillo comes online.

I wanted to ask about the IRA and how well defined it is in the states in terms of the tax rebate.

IRA has become such a topic for the past 12 months with very little to show for you kind of stopped banking on it, and one aspect of IRA, which was through the SEER tax credits that's kind of flowing through in some cases, some states are renewing it on their own. I don't think any of us saw the big impact we were expecting from IRA, but we're starting to see drips and dribbles. If the government really gets their act together and figure out this whole income qualification criteria to get the IRA piece, which there's no practical way to do it for a dealer right now, then I do think there's upside left, but we're not counting on it right now, especially given the election year, I don't know if the government will put this as a priority to figure it out with the state governments and dealers on how to make that work. But the rest of it is kind of slowly dripping in.

Got you. And then given the confusion, I guess, the phase-in of the new refrigerant residential systems in '25, what are your updated expectations for pricing over the next 2 years, average pricing in the past, we've talked about something like 15% off of the '23 levels. Do you think that's still valid or do you think it's lower now?

Yes, that's valid.

And we'll take our next question from Steve Tusa with JP Morgan.

Yes, I missed you at HR. I'd say attendance of investors was also at a record which may be inversely correlated to multiples someday, but we'll see.

I saw you from far in a different company booth, but you're holding a good audience, I didn't interrupt.

Regarding the price capture dynamics, you mentioned implementing some midyear price increases this year, and your capture rate in the fourth quarter was approximately 2%. Can you discuss the strategies you employed at midyear, your net realization, and how that process unfolded?

Sure. I'll start. So I think the overall, as we talked about price increases, we talked about doing residential new construction price increase in the middle of 2023. That did go ahead as expected and as we looked at the overall drop-through that is about what we expected, maybe a share worse than we expected, to be honest. And I think that just came down to the mix between residential new construction and the seasonality baked in there. Not a whole lot of R&C gets shipped toward the in Q4 timeframe. So from that perspective, that went as we expected. We have key account price increases going into effect this year, mostly early this year, and we know we announced a price increase, broader, and that goes into effect in February. So all the pricing actions that we talked about is gone as we had expected. We remain comfortable on where we are. And it's been good to see that the whole industry moving in that direction as well.

Thank you for joining us today. Since there are no further questions, this will conclude Lennox's fourth quarter conference call. You may disconnect your lines at this time.