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Morningstar | Lennox Sees Another Year of Growth in 2019; Sets 2021 Financial Targets at Its Investor Day. See Updated Analyst Note from 13 Dec 2018

Narrow-moat Lennox disclosed three important data points at its investor day meeting: 1) an update on the financial impact of its tornado-damaged manufacturing plant in Iowa, 2) 2019 guidance, and 3) three-year revenue growth and margin expansion targets.

Regarding the financial impact of the tornado-damaged facility, Lennox had previously expected $65 million of lost profits and $80 million in additional pretax expenses related to clean-up and repair costs in 2018, and $35 million of lost profits and $15 million in other expenses in 2019. The loss estimate for 2018 has not changed, but management now expects $35 million in other expenses in 2019, up from $15 million previously. However, management noted that Lennox has received $124 million of insurance recoveries in 2018 and another $223 million is expected in 2019. The fact that Lennox has already recovered over 80% of its 2018 expected losses should lay to rest any concern of a contentious insurance recovery process.

Management laid out its financial expectations for 2019, which features 3% to 7% top-line growth, 50 basis points of operating margin expansion (excluding tornado-related charges and recoveries), and about 30% adjusted EPS growth. Management expects mid-single-digit residential sales growth, low-single-digit commercial growth, and flat refrigeration growth.

In terms of longer-term performance, Lennox projects sales to grow at a 6% CAGR to $4.5 billion by 2021, which is in line with our pre-investor day forecast. The company is also targeting a 17.5% operating margin by 2021, which is well above our previous forecast of 15.2% (including equity income). After hearing Lennox's three-year strategic plan, we believe our margin expansion projections were too conservative, and we now assume Lennox can achieve about a 16.5% operating margin (including equity income) by 2021. Our upward-revised margin assumptions caused our fair value estimate to increase about 2% to $175 per share.

We've been impressed with Lennox's margin expansion over the last five years. If Lennox can achieve its 2018 operating margin guidance of 14.7% (excluding tornado-related charges and recoveries), it will have realized over 500 basis points of margin expansion since 2013. Lennox's commitment to annual material cost reductions and selling, general, and administrative expense containment has supported the firm's strong margin performance. The divestment of Lennox's Australian, Asian, and South American refrigeration businesses, which earned just a 3% profit margin on $187 million of sales in 2017, will result in an improved margin profile for Lennox's remaining refrigeration business. Lennox also continues to grow its national account services business, which generates strong margins.

Still, management noted that its 2021 targeted operating margin of 17.5% will require "more work" within its commercial and refrigeration segments. While we're now giving Lennox more credit for its margin expansion plans, we still prefer to take a more conservative stance than management, and we therefore model about a 16.5% operating margin (including equity income) in 2021 versus management's 17.5% goal. At Lennox's current stock price, our DCF model tells us that the market is betting the firm can sustainably generate over 17% operating margins, an all-time high level of profitability that leaves the firm little room for error, in our view. We instead assume about a 15% midcycle operating margin (including equity income) in the final year of our explicit five-year forecast, which leaves the firm more operating cushion in our valuation.