Morningstar | Lennox Closes Out 2018 with Solid 4Q Results; Sale of Kysor Warren Refrigeration Business Is Pending
Narrow-moat-rated Lennox International reported solid fourth-quarter results despite still contending with the after effects of a July 19 tornado that damaged a residential heating and cooling manufacturing plant. While reported revenue declined over 5% year over year to $844 million, which missed Wall Street's expectations by about $12 million, this decline was due to the divestiture of Lennox's Australian, Asian, and South American refrigeration businesses earlier in the year, and the tornado-related manufacturing disruption. However, adjusting for the divestiture and management's estimation of lost volume due to the damaged plant, Lennox's fourth-quarter revenue grew over 8% year over year. The firm's adjusted operating margin improved 70 basis points to 13%, which was driven by strong margin gains from Lennox's residential segment and lower corporate expenses. A 4% increase in adjusted pretax earnings, a 630-basis point lower adjusted tax rate, and a 5% lower share count caused adjusted EPS to grow 18% year over year to $1.93, which met the consensus estimate.The big news, however, is that Lennox is selling its Kysor Warren refrigeration business, which the firm acquired in 2011 for over $143 million, or about 0.75 times Kysor Warren's 2010 sales of approximately $190 million. In our view, this acquisition has been highly disappointing. Lennox incurred a $50 million pretax impairment charge to write down the value of Kysor Warren's assets in 2015, and based on the company's pro forma disclosures, Kysor Warren generated under $150 million of sales and lost $3 million before taxes in 2018. Management said that they expect the sale to close during the first quarter but didn't disclose the buyer or estimated proceeds. We don't see this sale as a needle mover in terms of valuation, but optically it will improve refrigeration segment margins. We don't expect to materially change our $175 per share fair value estimate as we roll our valuation model forward.
Lennox also announced that it's reclassifying its European heating, ventilation, and air conditioning business from its commercial heating and cooling segment to its refrigeration segment. Based on our math, the European HVAC business generated just a $2 million pretax profit on $143 million of sales in 2018, so the reclassification of this business out of the commercial segment will optically improve commercial heating and cooling operating margins. Indeed, the commercial segment's pro forma 2018 adjusted operating margin, which excludes the European HVAC business, was 17.5% versus 15.3% reported. Given the changes to Lennox's business, management recast its 2021 commercial operating margin target to 19% to 21% from 17% to 19% previously. The firm's operating margin targets for the residential heating and cooling (19% to 21%) and refrigeration (15% to 17%) have not changed.
In terms of fourth-quarter segment performance, residential sales were down 3% year over year to $461 million due to lost sales from the tornado-related manufacturing disruption. Management estimates that adjusting for the lost volume, residential sales would've been up nearly 11%. Residential segment operating margin expanded 170 basis points year over year to 17.7%. Commercial segment sales grew 8% to $270 million, but the segment's adjusted operating margin contracted 240 basis points year over year to 15%. Excluding the Australian, Asian, and South American refrigeration divestitures, refrigeration sales were flat versus the prior-year quarter at $113 million, and the segment's operating margin declined 310 basis points to 9.2%.
Our Aug. 21 and Dec. 12 analyst notes discussed the financial impact of the tornado in detail. Management noted during the earnings call that the company is on track to "meet or exceed" its tornado recovery plan. As a reminder, Lennox's losses are covered by its property and business interruption insurance policies. Recovery at the damaged manufacturing plant is progressing well; management noted that it reached full production capability for its cooling products and expects to reach full production of heating products during the first quarter.
Lennox International provides climate control solutions. The company designs, manufactures and markets products for the heating, ventilation, air conditioning and refrigeration markets. The company's segments are: Residential Heating and Cooling, which manufactures and markets furnaces, air conditioners, heat pumps, packaged heating and cooling systems, equipment and accessories, comfort control products, and replacement parts and supplies; Commercial Heating and Cooling, which manufactures and sells unitary heating and cooling equipment; and Refrigeration, which manufactures and markets equipment for the global commercial refrigeration markets under the Heatcraft Worldwide Refrigeration name.
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