Despite Residential Market Slowdown, Lennox Is On Pace to Deliver a Strong 2023 Performance

Sector Director

Brian Bernard

Lennox has capitalized on its efforts to gain market share and cut costs against a backdrop of improving end-market demand. Its margin expansion story has been remarkable, with adjusted operating margins rising from about 8% during the last sales peak in 2007 to about 15% in 2019 before the pandemic (excluding an insurance recovery benefit and adjusting for divestitures of lower-margin refrigeration businesses). We think its expanding distribution network and product portfolio have helped Lennox gain market share, while low-cost manufacturing and product sourcing and more cost-efficient product designs helped reduce its cost base.

Lennox-branded products are distributed through a company-owned distribution network, which we believe is advantageous because Lennox has more control over sales strategy, marketing, and dealer support. Its store strategy has expanded its distribution network and improved product availability and fulfillment rates. In terms of new products, Lennox entered the variable refrigerant flow market and introduced an emergency replacement product line to go head-to-head with Carrier. Overall, we believe a growing store footprint and product portfolio will help the firm better penetrate dealers and gain market share. 

Strong residential HVAC demand was a bright spot in pandemic-stricken 2020-22. However, we have a cautious near-term outlook. While stricter energy efficiency standards should be a tailwind, we believe the replacement cycle has matured. We see a more favorable demand backdrop for the commercial HVAC business, which we think can support at least mid-single-digit growth over the next few years especially once Lennox's new manufacturing plant is up and running. We see heightened focus on air quality and energy efficiency as a longer-term secular opportunity for the commercial business.

In November 2022, Lennox first announced its intention to divest its European commercial HVAC and refrigeration businesses. In September 2023, Lennox announced it had agreed to sell these businesses to Syntagma Capital during fourth-quarter 2023.

Business Strategy & Outlook

Lennox is a leading player in the North American heating and cooling market along with Carrier, Trane Technologies, York (Johnson Controls), and Goodman (Daikin). We estimate the top seven players, including Lennox, control nearly two thirds of the North American HVAC market. The companies compete mainly on product quality and performance, price, product availability, and service. Although Lennox does offer entry-level HVAC products, its product mix skews more toward premium offerings. Despite tough competition, Lennox has consistently capitalized on its brand equity and company-owned distribution network to drive excess returns. Indeed, since Lennox’s initial public offering in 1999, we estimate the firm has generated an average return on invested capital of over 20% and outearned its weighted average cost of capital every year except for fiscal 2000 and 2001. The company’s ROIC has materially improved since 2011 because of the sale of its underperforming businesses, increased volume supported by strengthening end-market demand and market share gains, and successful cost-reduction initiatives. We expect the firm will maintain its competitive advantages in residential and commercial heating and cooling over at least the next 10 years. As such, we award Lennox a narrow economic moat, supported by intangible assets.

The Lennox brand is well recognized and associated with premium, high-performance products in both residential and commercial HVAC end markets. Although the company’s premium products have a higher price tag than lower-rated products, they also provide greater energy efficiency that results in significant cost savings over the life of the product. Lennox’s ability to extract a price premium for higher-end HVAC products results in favorable margins compared with competitors offering lower-tier products.

The firm utilizes a company-owned distribution network to sell its Lennox-branded products to dealers/contractors and end consumers. This model differentiates the firm from competitors that tend to rely on fragmented independent distribution networks. Lennox has approximately 20 HVAC distribution facilities and approximately 230 stores throughout North America. Lennox's stores act as mini distribution centers; about 80% of the average store is utilized as warehouse space, while the remaining 20% is used for front-end wholesale transactions. These stores are quite profitable; we estimate the average store that has been in existence for at least 18 months generates operating margins that are above the company average. We believe the company-owned distribution networks allow the firm to better control its sales strategy and marketing efforts, while also directly providing training and support to the contractors that install and service Lennox’s products. Furthermore, the company’s store footprint has greatly improved product availability and reduced working capital requirements for HVAC contractors. Lennox now boasts a 98% fulfillment rate on same-day or next-day delivery from a 35% rate before it invested in regional distribution centers and its store strategy. Given the ease of obtaining Lennox products, contractors can pick up products on the installation day, which eliminates their need to hold inventory. Overall, we believe Lennox’s company-owned distribution model supports its brand reputation and drives improved product availability and service, which has helped the company gain market share in the last few years. 

While we believe Lennox’s distribution model has aided in the firm’s growth and improved profitability, it is difficult to quantify the direct financial impact. We believe that the tangible advantages of direct distribution (higher realized sales price due to the elimination of margin-grabbing middlemen) are about offset by incremental operating costs needed to run the distribution model. As such, we do not view Lennox’s distribution model as a meaningful cost advantage. Rather, we view the company’s distribution capabilities as an important factor that supports the value proposition of its brand.

We estimate roughly 25% of commercial heating and cooling sales are generated from Lennox’s National Account Services business, which provides installation, service, and preventative maintenance for large commercial customers, such as Lowe's (which has an exclusive contract with Lennox). NAS customers leverage Lennox’s scale and expertise to help maintain efficiently functioning HVAC systems across multiple facilities. We believe NAS is a relatively sticky business because competing local and regional contractors probably have inadequate scale to service businesses with national scale. We think the use of smaller contractors to service a large facility footprint would require meaningful search costs and likely result in inconsistent service quality. We believe NAS benefits from customer switching costs, but at about 5% of consolidated sales, this business isn't large enough to award customer switching costs as a moat source for consolidated Lennox, in our view.

In our view, Lennox's primary environmental, social, and governance risks include environmental and social impact of the firm's products and services and product governance. However, we don't believe these risks could result in material value destruction.

Lennox's failure to keep pace with global green building standards and product demand trends could result in reputational risk and lost market share, but we see a low probability of this risk materializing. As one of the leading manufacturers of energy-efficient light commercial and residential HVAC products, the firm has long been focused on maintainability, and based on its recent product strategy and growth investments, we believe this focus will continue. Lennox has a history of manufacturing safe, high-quality products, which has supported the company's intangible asset moat source. As such, we don't see product governance risk as a particularly material threat for the firm.

Narrow

Economic Moat

Lennox International

Lennox International, Inc. engages in the design, manufacture, and marketing of products for heating, ventilation, air conditioning, and refrigeration. It operates through the following business segments: Residential Heating & Cooling, Commercial Heating & Cooling, and Refrigeration. The Residential Heating & Cooling segment manufactures and markets furnaces, air conditioners, heat pumps, packaged heating and cooling systems, equipment, and accessories. The Commercial Heating & Cooling segment sells unitary heating and cooling equipment used in light commercial applications. The Refrigeration segment includes retail equipment for the commercial refrigeration market including condensing unit, unit coolers, fluid, coolers, air cooled condensers, supermarket display cases, and systems. The company was founded by Dave Lennox in 1895 and is headquartered in Richardson, TX.

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Does Lennox International (LII) have what it takes to be a top stock pick for momentum investors? Let's find out.

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