Earnings Call Transcript - LII Q4 2024

Operator, Operator

Welcome to the Lennox Fourth Quarter and Full Year 2024 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. Operator provided instructions about the Q&A. 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.

Chelsey Pulcheon, Investor Relations

Thank you, Angela. Good morning, everyone. Thank you for joining us today as we share our 2024 fourth quarter and full year results. Joining me is CEO, Alok Maskara; and CFO, Michael Quenzer. Each 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.

Alok Maskara, CEO

Thank you, Chelsey. Good morning, everyone. I want to start by expressing my gratitude to our 14,000 employees, our 10,000-plus dealers and all of our customers for their loyalty and innovation that enabled us to deliver an exceptionally strong finish to 2024. One of the highlights for 2024 is that for the first time ever, Lennox delivered over $5 billion in revenue, and over $1 billion in adjusted segment profit. Another achievement in 2024 is that both our segments delivered double-digit revenue growth. In addition to delivering record results, we also made thoughtful investments such as starting a new commercial factory to create growth capacity. Let us turn to Slide 3 for the fourth quarter and full year 2024 overview. Adjusted earnings per share was a record $5.60 for the quarter and $22.58 for the full year. Core revenue grew 22% in the quarter and 13% for the full year. Our adjusted segment margin expanded 250 basis points in Q4, and 150 basis points for the full year to 19.4%. The team also delivered a record $332 million in operating cash flow in the quarter and $946 million in the full year. Michael will provide more details later in the presentation, but I want to highlight how proud we are of the work the team did this year to deliver significant year-over-year improvement in our cash conversion. Now please turn to Slide 4, as I review some of the drivers of our 2024 success. In 2024, we successfully completed the initial phase of our self-help transformation plan. The team's effort in 2023, including pricing initiatives, portfolio simplification and strategic acquisitions not only restored margins, but also established a strong foundation for an exceptional 2024. Our strategic initiatives enabled us to successfully navigate the construction of a new commercial factory and overcome challenges associated with the refrigerant transition, showcasing our resilience and outstanding execution. In 2024, we continued making strategic investments while delivering impactful results, positioning us to continue our momentum into 2025 and beyond. We successfully navigated the manufacturing transition from R-410A refrigerant, effectively meeting customer needs, and investments in sales and distribution channels elevated the customer experience. Our ongoing focus on pricing excellence programs partially offset the investments for improving customer experience. Our new commercial factory is now online and will be key to enhancing output and productivity. The AES integration remains ahead of schedule, exceeding the original value proposition. We maintained our strategic M&A pipeline and our disciplined M&A approach. The best deals for Lennox in 2024 were the deals that we decided not to pursue, thus safeguarding long-term shareholder value. Finally, by driving accountability through the Lennox unified management system, we ensured consistent performance. Before I hand the call to Michael, I want to extend my heartfelt gratitude to Gary Bedard, President of our HCS segment since 2023, who has announced his decision to retire from Lennox. Gary's 26-year tenure at Lennox will leave a legacy that will continue to shape our future. We have initiated a search process to identify our next HCS President. I'll now hand it over to Michael, who will walk you through how we successfully invested in the business, while also delivering strong results.

Michael Quenzer, CFO

Thank you, Alok. Good morning, everyone. Please turn to Slide 5. We are pleased to report our eighth consecutive quarter of double-digit year-over-year adjusted earnings per share growth. This quarter, we increased our adjusted segment margin by 250 basis points and achieved an impressive 22% revenue growth, resulting in 54% adjusted EPS growth. Our success was driven by volume growth in both segments as we continue to effectively manage the transition to low GWP refrigerants. As expected, customers pre-purchased R-410A equipment, which is estimated to have positively impacted revenue by $125 million and increased earnings per share by $1. Now let's proceed to Slide 6 to review the fourth quarter financial performance of our Home Comfort Solutions segment. The Home Comfort Solutions segment had an exceptional quarter, delivering 25% revenue growth, 67% segment profit growth and an impressive 550 basis point expansion in segment profit margin. Sales volume increased by 21%, driven by over 50% growth in our two-step distributor channel, primarily reflecting the industry-wide R-410A equipment pre-buy. Our one-step contractor channel also saw volume increase low double-digits. This was supported by better R-410A product availability compared to the broader market as well as some prebuy. After adjusting for the prebuy, segment sales volume still grew by mid-single digits. Pricing initiatives continue to progress well. Although the impact to the quarter was limited, we have implemented price increases on our new R-454B products, and these initiatives are progressing as expected. Moving on to Slide 7. The Building Climate Solutions segment delivered a very strong fourth quarter with revenue growing 17%. Of this growth, 3% was driven by inorganic contributions from our APS acquisition. From an organic perspective, sales volume increased 14% during the quarter. This reflects early revenue benefits from our new Saltillo, Mexico manufacturing facility as well as some R-410A equipment prebuy activity. Segment profit increased by $8 million. However, profit margin declined due to $20 million in higher product costs related to new factory ramp-up activities and inefficiencies at our existing manufacturing facility. Production output continues to grow and is well-positioned to support our 2025 emergency replacement growth initiative. Turning to Slide 8. Lennox delivered an impressive performance for 2024. We successfully navigated the low GWP refrigerant transition, achieving notable volume gains. Our disciplined pricing strategy drove consistent quarterly price yields contributing to margin expansion of 150 basis points. While strategic investments for future growth tempered this margin improvement, these investments are expected to deliver significant benefits in the coming years, including sustained revenue growth and further margin expansion. Turning to Slide 9. Let's review our cash flow and capital deployment. While revenue and earnings growth were impressive, our cash flow performance stood out even more. As highlighted in the Q3 earnings call, enhanced working capital efficiency has been a key focus. We've made significant progress, particularly in accounts payable initiatives, resulting in a free cash flow conversion rate of 97%. This strong cash flow conversion comes despite capital expenditures exceeding depreciation by approximately $65 million. Capital expenditure investments in high ROI projects remain a core component of our cash deployment strategy. Over the past two years, capital expenditures have consistently outpaced depreciation. This trend is expected to continue in 2025 with estimated capital expenditures of $150 million. We maintain a robust balance sheet with net debt to adjusted EBITDA at 0.6 times, down from 1.3 times in the prior year quarter. Our free cash flow deployment strategy continues to prioritize inorganic growth opportunities that deliver ROIC exceeding WACC within three years of acquisition. Additionally, we will continue leveraging share repurchases to efficiently return excess cash to shareholders. If you will now turn to Slide 10, I will review our 2025 full year guidance. Anticipating another year of profitable growth, let's begin with the table on the left, which summarizes our full year revenue growth drivers. Total company core revenue is projected to increase by approximately 2%. However, the 2024 prebuy will result in year-over-year revenue headwinds in both Q1 and Q4. We also expect a low-single digit increase in sales volume, driven by growth in our BCS segment. Additionally, mix growth from the introduction of the new low GWP products will contribute an estimated 4% to revenue growth. The phaseout of legacy 410A products is expected to conclude by the second quarter. Turning to the right side of the slide. We've outlined key cost assumptions for 2025. Inflation is anticipated to increase costs by approximately 3%. At the same time, we plan to make strategic investments in areas such as information system advancements, distribution growth initiatives, and projects designed to improve customer service. These investments will also include enhanced sales and marketing efforts with total investments estimated at approximately $25 million for the year. In terms of cost productivity, we expect to generate savings of $50 million as the ramp-up costs of our new BCS factory subside and material cost efficiencies are realized. In summary, even with the headwinds from the 2024 prebuy, we anticipate revenue and profit growth with profit margins relatively flat. We expect adjusted earnings per share to fall within the range of $22 to $23.50, and free cash flow is projected to fall within the range of $650 million to $800 million. With that, please turn to Slide 11, and I'll turn it back over to Alok for an overview of our 2025 priorities.

Alok Maskara, CEO

Thanks, Michael. Let us revisit our self-help transformation plan which has been a cornerstone of our success since 2022. We transition from the recover and invest phase to the growth acceleration phase at the end of 2024. As we move through 2025 and into 2026, we will maintain a disciplined approach to investing in the business while prioritizing growth. This year will lay the groundwork for the next phase of expansion supported by the momentum from share gains and new product introductions. Investments in digital customer experience are making it easier for customers to engage with us, strengthening loyalty and satisfaction across all touch points. Our expanded heat pump offering supported by the Samsung joint venture not only broadens our product portfolio, but also positions us to capitalize on growing demand for energy efficient solutions. Additionally, our focus on improving attachment rates for parts and accessories ensures that we provide a more comprehensive customer experience while driving incremental growth. An additional growth driver is our commercial emergency replacement program enabling us to better serve a significant segment of the market that we have been unable to fully supply in recent years. Second, we are committed to resilient profit margins. Benefits expected from the low GWP product transition, increased productivity from BCS volume improvements and material cost reductions, strengthen our ability to deliver consistent and reliable financial performance. Lastly, we will continue to utilize our Lennox unified management system to deliver superior execution with clear priorities. Defined M&A strategies, a robust distribution network and ongoing investment in customer satisfaction, underscore our commitment to operational excellence. As we look ahead, the investments made over the past two years set the foundation for growth in 2025 with a strong trajectory into 2026 and beyond as we move towards the expansion phase. With our collective commitment and strategic focus, I am confident that we are not merely executing a plan, we are creating a path for ongoing success. We remain confident in our long-term vision and given progress so far. We believe we will be within the 2026 revenue target range of $5.4 billion to $6 billion and at the high end of our ROS target range of 19% to 21%. The prebuy dynamics in 2024 will create impact in 2025, which is expected to normalize by the end of this year. Hence, we anticipate a stronger 2026 as our strategic investment expense continues to drive momentum. Now let us turn to Slide 12. Let me wrap up by summarizing the five reasons that make Lennox an attractive opportunity for all our stakeholders. First, we are 100% focused on North America growth end markets of HVACR and are accelerating growth through share gains. Second, we are expanding our resilient profit margins through pricing, productivity and mix optimization. Third, we deliver superior execution through the Lennox unified management system. Fourth, we are an advanced technology industry leader with high efficiency products and services supported by a digital customer ecosystem. Fifth, we win because our exceptional talent and culture is defined by our core values and guiding behaviors. Our pay-for-performance philosophy ensures that our internal goals are closely aligned with those of our shareholders. As I look forward, I remain confident that our best days are ahead. Thank you. We will be happy to answer your questions now. Angela, let's go to Q&A.

Operator, Operator

Operator provided instructions about the Q&A. We'll go first to Ryan Merkel with William Blair. Your line is open. Please go ahead.

Ryan Merkel, Analyst - William Blair

Hey, thanks. Good morning and congrats on the nice quarter. I wanted to start with the prebuy. It looks like it was a little bigger than maybe you were expecting. Can you just comment on what you saw and why that was? And then what does it mean for Q1? I think it's really the question I have.

Alok Maskara, CEO

Hey, Ryan. Good morning. I don't think I heard the second part of the question properly. But the first part on the prebuy, we are calling out $125 million in prebuy. As you can imagine, it's an estimate; you don't have 100% visibility into the number. And we know there was some cloudiness because we had temporary share gains that happened in Q4 as some of our competitors were out of product. So it's a little higher than we expected, but I would say it's within the range of where our expectations are.

Michael Quenzer, CFO

And then, Ryan, on the second part of your question, the impact to Q1 is really the $125 million being pulled forward into Q4 from Q1. So we'll see a headwind there. And then also, you'll see that in Q4 in 2025 as the year-over-year comps won't have that as well.

Ryan Merkel, Analyst - William Blair

Got it. Okay. So $125 million revenue in Q1 sort of the math. Then, the second question — the flat volume outlook for the HCS segment: I mean, I think it makes sense to be conservative, but just talk about some of the assumptions behind that.

Alok Maskara, CEO

Sure. There's a lot of uncertainty in the market. You saw existing home sales are at a fairly low level and mortgage rates continue to be high. So based on what we saw in 2024, we continue to model a flattish industry volume. It may be a little conservative, but given the uncertainty in the market, that seems like the right assumption to make at this point.

Ryan Merkel, Analyst - William Blair

Yeah, that's fair. Okay. Thank you.

Alok Maskara, CEO

Thanks, Ryan.

Operator, Operator

We'll go next to Joe Ritchie with Goldman Sachs. Please go ahead.

Joe Ritchie, Analyst - Goldman Sachs

Hey, good morning, guys. Great year. So look, historically, you guys have tended to guide very conservatively. As I look at the components of this bridge in Slide number 10, it seems like what you're baking in for incremental margins, if I just take into account price, mix and inflation, is very low. I'm calculating something like low double-digits. So just help me understand, number one, where you think there might be some potential cushion in the guide and how to think about that equation between price, mix and inflation?

Michael Quenzer, CFO

Hey, Joe. I think there's some opportunity potentially that Alok just mentioned on the volume. If interest rates go down, maybe the HCS volume could give us a little bit more; that would come through at 30% incrementals. But if you look at the overall guide, it does imply overall margins are approximately flat at 19.4%. The inflation assumption of 3% might come in a little less, but right now it feels prudent to keep inflation up there. And then, as a group, we are trying to drive as much productivity as possible, so from a cost productivity perspective, we're going to focus to drive a little bit higher if we can as well.

Alok Maskara, CEO

And I think the bigger issue here is the amount of uncertainty that's present. If you look at noise around tariffs, noise around migrant labor and labor shortages for our dealers, and if you just look at mortgage and interest rates, there's a lot of uncertainty. So we went with a fairly wide range. I wouldn't call it very conservative, but it's consistent with what we have done in the past.

Joe Ritchie, Analyst - Goldman Sachs

Okay. That's helpful. And then as I think through Q1 specifically, in answering Ryan's question: the right way to think about things sequentially in HCS is you've got, call it, $125 million that goes away Q4 to Q1, and then there's typically a mid-single digit sequential step down. So is the right interpretation maybe that there's organic growth in HCS in the first quarter? Am I thinking about it correctly?

Alok Maskara, CEO

Well, first of all, the Q1 number is an estimate. Maybe only in January; some of it could extend to Q2, depending on how dealers convert because we're now already selling the 454B equipment, and it just draws a line in the sand somewhere. But on your sequential question, maybe Michael can give you some clarity.

Michael Quenzer, CFO

I think that's generally close, but not all $125 million was in the HCS segment; some of it was in the BCS segment. But as Alok said, we did have a little bit of R-410A inventory going into the quarter, so some of this might move into Q2, but predominantly will be in Q1.

Joe Ritchie, Analyst - Goldman Sachs

Okay. Great. Very helpful. Thanks, guys.

Operator, Operator

We'll go next to Julian Mitchell with Barclays. Please go ahead.

Julian Mitchell, Analyst - Barclays

Hi. Good morning. Maybe just wanted to switch tack for a second to the BCS segment and sort of the guidance there. I think people have been concerned about the revenue outlook because you don't have AI exposure in BCS. And there are some question marks around ESRA funding unwinding into 2026. So maybe help us understand what you're seeing in the BCS segment top line wise across different verticals. The mid-single digit underlying volume growth assumption clearly speaks to a much healthier market than many investors have been thinking.

Alok Maskara, CEO

Sure. From our perspective, the markets that we serve remain healthy. We are not terribly concerned about data center exposure; our exposure there was low to zero to start with. Our exposure remains in retail, food service, warehouses, big box, and DIY-type stores. We see the replacement volume, which is primarily our sales, actually picking up now since we have made the conversion to 454, and some of these companies have been waiting to go to the new refrigerant before they purchase. Second, underlying our confidence is that we have a new factory. We were primarily supply constrained, not demand constrained, and that was still the case in Q4. So we expect to get more fair share of the market, including emergency replacement that we talked about. Regarding school funding and ESRA, we've heard concerns, but we see most of the programs continuing to move forward and some schools issuing bonds and other things. Keep in mind, this is a non-discretionary spend; if air conditioning breaks, you can't run these schools. So given the non-discretionary nature of these replacements, we don't see much impact and that gives us sufficient confidence in our guidance.

Julian Mitchell, Analyst - Barclays

Thanks very much. And then just my second one: I don't really want to mention the P word, but if we're thinking about Q1 specifically, classically Q1 in recent years has been 16% to 17% of the year's earnings. I understand there's extra pressure due to the refrigerant change. If we had to put a finer point on it, is the right interpretation maybe that it's a couple of points less of the full year's earnings in Q1 than one would normally expect, and then we get catch-up in the rest of the year, particularly Q2 with a big mix tailwind?

Michael Quenzer, CFO

Julian, I'd look more at the first half because of the dynamic shifting from Q1 to Q2 with the sell-through of the 410A. From a revenue perspective, we think the first half will be about 45% of the year and the second half 55%. This is different than a normal 50-50 split. In the second half of the year you'll really start to see the mix benefit of the 454B product as well as more gains from the new commercial factory.

Julian Mitchell, Analyst - Barclays

That's great. Thank you.

Alok Maskara, CEO

Yeah. Thanks, Julian.

Operator, Operator

We'll go next to Noah Kaye with Oppenheimer. Your line is open. Please go ahead.

Noah Kaye, Analyst - Oppenheimer

Thanks very much. Alok, we've had a couple of years now of regulatory transitions where the company has executed well and claimed opportunity around pricing and share gains. You mentioned potential tariffs and labor and other considerations brought about by the administration change. How would you think about opportunities related to that? For example, if there are tariffs on USMCA partners, perhaps that could be a pricing opportunity, and with your investments there could be share gain opportunities. The essential question: how are you thinking about contingency planning and responding to potential changes?

Alok Maskara, CEO

Sure. Things remain dynamic. If tariffs increase on China and not on Mexico or Canada, we would be a net beneficiary as we have reduced supply chain reliance on China. The Samsung JV also means items like our mini splits are now coming from Korea, not China, which would be a benefit if tariffs on China arose. If tariffs came from Mexico, roughly 40% of industry capacity is in Mexico, so we would all have to offset with productivity and price. There could be a timing delay if tariffs are announced and we have to react. On the labor piece, there is no impact to our factories; our factories have a different labor profile than the field installers. Replacements require less skilled labor than repairs, so the trend toward replacements likely continues. For contingency planning, we stay close to customers and dealers, monitor tariffs, and work on supply chain redundancies. We have a heavier dual-source focus than two to three years ago, giving us flexibility. On the consumer side, the biggest impact will be consumer confidence, interest rates and mortgage rates. We will work with dealers on financing programs and educating consumers and keep engaging with new homebuilders, which are more guaranteed volume for us.

Noah Kaye, Analyst - Oppenheimer

No, it was comprehensive. I realized I asked some multipart questions. I'll take myself offline and follow up. Thank you very much.

Alok Maskara, CEO

Thanks, Noah.

Operator, Operator

We'll go next to Tommy Moll with Stephens. Please go ahead.

Tommy Moll, Analyst - Stephens

Good morning and thank you for taking my question.

Alok Maskara, CEO

Good morning, Tommy.

Tommy Moll, Analyst - Stephens

I want to start on the topic of your 454B pricing. Are we still thinking 10% or maybe 10% plus? There's at least one OEM in the market that's less disciplined than that. If we look at the mix guide for Home Comfort in the mid-singles range, maybe you could bridge us from whatever the 454 contribution is to how you get to that mid-singles.

Michael Quenzer, CFO

Tom, our plan is still an average 10% price increase on 454B product and that equates to about 70% of the revenue in the HCS segment. We will continue to sell through some 410A equipment in the first half of this year, so it will take time to fully transition to 454B. We think about 65% of the full year will be sales of the 454B product. When you do that math, it dilutes down to that mid-single digit mix benefit for Home Comfort Solutions.

Alok Maskara, CEO

On the competitive question, Tommy, we have heard that too, but we also saw 2024 pricing dynamics where some OEMs released 454 in 2024 and set pricing. We are optimistic that as we move forward, OEMs will adjust price in 2025, which typically happens in the first quarter anyway.

Tommy Moll, Analyst - Stephens

Thank you. And as a follow-up, I wanted to unpack the home volume outlook. You talked about the prebuy as a mid-single digit headwind and the separate flat volume callout. I want to make sure I'm interpreting correctly that for the volumes you report you just add those two together, so it would be a mid-single headwind. Clarify how we should think about that.

Michael Quenzer, CFO

That's exactly right. That's how to look at it.

Tommy Moll, Analyst - Stephens

Okay. And then if we take that mid-single headwind for the segment level, can you give any sense of the sell-in versus sell-through assumptions you're making there?

Michael Quenzer, CFO

You can see in the fourth quarter results we were more impacted in the two-step channel for the sell-in to distributors, but we did see a little bit of a prebuy on the sell-through as well.

Tommy Moll, Analyst - Stephens

Okay. Thank you. I'll turn it back.

Operator, Operator

We'll go next to Christopher Snyder with Morgan Stanley. Please go ahead.

Christopher Snyder, Analyst - Morgan Stanley

Thank you. You talked to $125 million prebuy in Q4. But if I look at it next year, it's about a 2% headwind on a $5 billion-plus revenue base. Does that imply there was a similar amount of prebuy impacting Q3 numbers as well or am I missing something?

Alok Maskara, CEO

Chris, great question. If you take that $125 million, first we'll get the destocking impact of that, which may impact Q1 and Q2, and then in Q4 2025 we'll face difficult comps. So it impacts you twice: first the destocking and second the comp impact.

Michael Quenzer, CFO

And then in Q1 2026, you'll get that benefit back.

Christopher Snyder, Analyst - Morgan Stanley

Okay. Thank you. I appreciate that. So the assumption is there wasn't a material prebuy impact in Q3? And maybe just how did you go about estimating the $125 million since it's hard to triangulate?

Alok Maskara, CEO

We admit it is not easy nor precisely accurate; we think we're directionally correct, not precisely accurate on the $125 million. We did not encourage prebuys, but there was last call on 410A so some distributors pre-ordered. We delayed switching all our lines to 454B as some competitors did; that led to better availability for Lennox products and gave us temporary share gain in addition to prebuy. Our goal is to keep as much of that share gain as possible, but realistically we baked in that we are unlikely to keep all temporary share gain, which is one reason we're muted in the volume outlook for 2025.

Christopher Snyder, Analyst - Morgan Stanley

Thank you. I appreciate that.

Operator, Operator

We'll go next to Brett Linzey with Mizuho. Please go ahead.

Brett Linzey, Analyst - Mizuho

Hey. Good morning, everyone.

Alok Maskara, CEO

Good morning, Brett.

Brett Linzey, Analyst - Mizuho

First question is on the new commercial Mexico facility. You said it's online. Are you able to quantify what you're embedding in 2025 in terms of the volume contribution and better throughput there?

Michael Quenzer, CFO

If you look at the volume guide in BCS, we're up about mid-single digits. There's a few points in there for share gain, which would be predominantly related to the new factory supply improvement.

Brett Linzey, Analyst - Mizuho

Is that more back-end loaded or progressing evenly through the year?

Michael Quenzer, CFO

A little more back-end loaded. The season for emergency replacement is predominantly Q2 to Q3, so it starts ramping in late Q2 into Q3.

Brett Linzey, Analyst - Mizuho

And a follow-up on inefficiencies in the existing facility: was that in Stuttgart late in the year? Any update on the status of those improvements into January?

Alok Maskara, CEO

The existing facility inefficiencies were related to startup as we sent many components from Stuttgart during ramp-up to Saltillo and did trial runs. It was late in the year and was higher than we expected. Those inefficiencies should be recovered in 2025 as we move through the ramp-up phase. Stuttgart was the bigger impact. The factory in Stuttgart is doing much better now. Having the new factory in Saltillo means we will reduce the number of SKUs manufactured in Stuttgart as emergency replacement SKUs move to Saltillo, so we are optimistic about recovering.

Brett Linzey, Analyst - Mizuho

All right. Appreciate the insight.

Operator, Operator

We'll go next to Joseph O'Dea with Wells Fargo. Please go ahead.

Joseph O'Dea, Analyst - Wells Fargo

Hi. Good morning.

Alok Maskara, CEO

Good morning.

Joseph O'Dea, Analyst - Wells Fargo

Michael, you mentioned inflation being a bit conservative. Can you unpack that? The 3% inflation is presumably across all costs—labor, materials, freight—bundled. Anything in particular where you're seeing more inflationary headwinds?

Michael Quenzer, CFO

Yes. On average across all of our costs—about $4 billion of costs—we're seeing higher inflation in SG&A around health care and some wages that are more than the 3%, and a bit lower on commodities. It kind of blends to 3%. We'll continue to watch it; there could be some conservatism, but inflation continues to exist, especially on SG&A.

Alok Maskara, CEO

Keep in mind some tariff uncertainty impacts that as well. If there are tariffs on things like steel, we want to acknowledge that and be prepared.

Joseph O'Dea, Analyst - Wells Fargo

So the 1% in the revenue bridge for price compared to inflation of 3%—you're not assuming all cost increases can be passed through to the market, correct?

Michael Quenzer, CFO

Correct. We had some of that through mix as well, and we're looking to drive more productivity.

Joseph O'Dea, Analyst - Wells Fargo

And regarding the 10% 454B price: at what point do you expect visibility on realization, given seasonality?

Alok Maskara, CEO

I think mid to late Q2 we'll get a good sense because some OEMs have not announced 2025 pricing yet. Early signs are positive. The impact is what we called out: 70% of HCS revenue is 454B, so you see the numbers we presented. As we go to the second half, a greater portion will be captured, and there is no reason to be concerned so far.

Joseph O'Dea, Analyst - Wells Fargo

Got it. Thank you.

Operator, Operator

We'll go next to Jeff Hammond with KeyBanc. Please go ahead.

Jeff Hammond, Analyst - KeyBanc

Hey. Good morning, everyone. Just a few cleanups. On the Mexican production, you said industry capacity is 40%. Can you level set on what your mix is and whether you're below that industry average?

Alok Maskara, CEO

We looked at different OEMs and come up with that number; it's directionally correct. We make many of the low-to-mid products in Mexico. We believe about $1 billion of the industry would be impacted by tariffs, so 20% of our output could be impacted. We make premium residential products in the U.S. and have three residential factories in the U.S. Commercial production was primarily in the U.S. Historically, many competitors manufacture in Mexico as well. I would say we're slightly below the industry average on Mexico exposure, but it varies by OEM.

Jeff Hammond, Analyst - KeyBanc

Okay. And on the distribution margin focus, level set on progress over the past year and big opportunities this year—do you think you can start to move those margins up or is it longer term?

Alok Maskara, CEO

It's a long journey, but some results you see today are based on that initiative. In HCS we had a record ROS, which is consistent with getting more distributor margin. Some incentive changes and reorganizations happened at the end of Q2 2024 and results are coming through. Manufacturers plus distributor margin is higher than our 2026 targets; progress so far gives us confidence we'll be on the high end of our 2026 targets.

Jeff Hammond, Analyst - KeyBanc

What is your parts and accessories mix today and what do you think entitlement is?

Alok Maskara, CEO

It hasn't changed much over the past year. We remain around 20% in parts and accessories. I believe entitlement is roughly twice that, but we've been working on it for years and expect to show results over the next months and years.

Jeff Hammond, Analyst - KeyBanc

Great. Thanks, Alok.

Operator, Operator

We'll go next to Nicole DeBlase with Deutsche Bank. Please go ahead.

Nicole DeBlase, Analyst - Deutsche Bank

Thanks. Good morning. How are you thinking about new construction versus replacement demand within HCS for 2025?

Michael Quenzer, CFO

New construction is about 20% of the HCS segment. We think it's going to be flattish, but the big driver would be if interest rates decline. If they go down, there's pent-up demand for new home construction that could occur, but labor challenges remain on that side.

Nicole DeBlase, Analyst - Deutsche Bank

Understood. And thinking through margin dynamics by segment, directionally: HCS could be more challenged year-on-year given the 2024 prebuy, and BCS should be up. Is it fair to assume BCS sees more margin expansion in the second half as ramp-up costs roll off?

Michael Quenzer, CFO

That's correct. Overall margin guide is about flat, up in BCS and down in HCS. The larger portion of the $50 million of productivity will be BCS, which will occur through the year, with more of the gains in the second half as the factory productivity ramps.

Nicole DeBlase, Analyst - Deutsche Bank

Thanks, Michael. I'll pass it on.

Operator, Operator

We'll go next to Deane Dray with RBC Capital Markets. Please go ahead.

Deane Dray, Analyst - RBC Capital Markets

Thank you. Good morning, everyone. I'll echo previous comments; you provided good calibration on prebuy. Alok, you referenced competitors who had stockouts because they switched earlier. How much of a surprise was that, how tactical were you positioned in Q4, and could you give a sense of how the individual months played out—was it a windfall in December or level loaded?

Alok Maskara, CEO

We were not surprised that a competitor would have a misstep in a regulatory transition, but we were surprised which competitor had the misstep. We were fully loaded and had high fill rates, which allowed us to capture additional share. The challenge is to make that share gain more permanent. In Q4 it was fairly even across all three months; anything we could manufacture we sold. Some temporary share gain started in Q3, so share gain was a Q3 story that bled into Q4. We were selective about customers to focus on higher-quality, longer-term relationships.

Deane Dray, Analyst - RBC Capital Markets

That's a high-quality problem to have. Second, Alok, you said some of your best deals in 2024 were those you did not do. Was that about price or other strategic reasons? Any color would be helpful.

Alok Maskara, CEO

Yes. We passed on data center opportunities, international expansion opportunities, and some domestic consolidation deals. It came down to a disciplined framework and ROIC targets. We can often gain share with better execution versus buying it through M&A. Credit to the finance team for discipline; we are proud of those calls.

Deane Dray, Analyst - RBC Capital Markets

Thanks. I appreciate it.

Operator, Operator

We'll go next to Nigel Coe with Wolfe Research. Please go ahead.

Nigel Coe, Analyst - Wolfe Research

Thanks. Good morning. Alok, can you dig into the BCS volume guidance for the year, up mid-single digits: any way to quantify how much is baked in for the Saltillo ramp-up? Is it industry flattish and the mid-single is all share gain?

Alok Maskara, CEO

We think there's a little market growth and about 1 to 2 points of that guidance is share gain specifically around emergency replacement tied to the new factory.

Nigel Coe, Analyst - Wolfe Research

Back to 410A: any industry estimate of excess units shipped in 2024—would it be 1 million units or any way to size that? Also, your inventory levels in Q4 were a bit higher Q-over-Q; is that a way to think about 410A inventory held at year-end?

Alok Maskara, CEO

Industry estimates vary. Our estimate range is roughly $300 million to $600 million of revenue, not 1 million units—about 0.5 million units as a range. As for our internal inventory, a couple of things: commercial inventory is being positioned for emergency replacement, so we are building inventory locally; you'll likely see that trend continue into Q1 because Q2 is our peak season. That commercial inventory build is driving variation in models.

Nigel Coe, Analyst - Wolfe Research

Okay. That's helpful. Thanks, Alok.

Operator, Operator

We'll go next to Damian Karas with UBS. Please go ahead.

Damian Karas, Analyst - UBS

Hey. Good morning, everyone. I wanted to ask about the free cash flow guidance. Cash flow came in better than expected in 2024, but the guidance range for 2025 is wide. Could you spell out the moving pieces?

Michael Quenzer, CFO

If you look at conversion, the midpoint of our free cash flow guide to the midpoint of net income is about 85% conversion, a little below our traditional ~90% due to reinvestment in inventory in both BCS and HCS and capex exceeding depreciation. We expect to be back into the 90% range by 2026 and beyond. The high end of the range would reflect better performance on receivables and accounts payable initiatives that I'm leading.

Damian Karas, Analyst - UBS

Got it. Thanks. Alok, on potential policy implications—pause on IRA funding—any cause for concern about heat pump penetration and your 2026 targets?

Alok Maskara, CEO

The IRA's pause is not having a material impact for us in 2024 and likely not in 2025. The tax incentives for energy efficiency remain, and most programs are moving forward at the state level. So no material change to our expectations.

Damian Karas, Analyst - UBS

Okay. Great. Thanks a lot.

Operator, Operator

We'll go next to Stephen Tusa with JPMorgan. Please go ahead.