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Morningstar | Lennox's 3Q Results Hampered by Tornado-Damaged Manufacturing Facility; Maintain $172 FVE

Narrow-moat Lennox International's third-quarter revenue and adjusted EPS both fell short of Wall Street's estimates. However, we think most of Lennox's top and bottom line miss can be attributed to lost production from its tornado-damaged Marshalltown, Iowa residential heating and cooling manufacturing plant. Previously, Lennox had estimated the damaged facility would result in $100 million and $55 million of lost revenue and profits during the second half of 2018, respectively. The company now expects a $115 million sales and $65 million profit deficit, respectively. The company still expects to incur about $80 million in additional pretax expenses related to clean-up and repair costs in 2018. Management fully expects to recover all lost profits and property-loss expenses from insurance proceeds in 2019. Given that Lennox's losses are covered by insurance policies, and we don't expect the damaged manufacturing facility to affect the firm's longer-term prospects, we're maintaining our $172 per share fair value estimate.

Lennox's adjusted third-quarter revenue grew about 2% year over year to $1.02 billion, 3% below the consensus estimate. While Lennox's adjusted EPS increased almost 8% to $2.72, it missed the consensus estimate by $0.20. The increase in adjusted EPS was mainly driven by a lower effective tax rate and share count compared with third-quarter 2017; adjusted pretax income declined 6% year over year.

Despite the tornado-related lost revenue and profits, Lennox's residential segment grew revenue almost 1% and residential adjusted operating margin only declined 40 basis points to a still solid 19%. The commercial segment increased revenue over 2% year over year, but commercial adjusted operating margin contracted 170 basis points to 16.9% as price increases and productivity initiatives were not enough to offset higher input costs. Refrigeration segment adjusted sales grew nearly 4% with operating margin expanding 190 basis points to 15.4%.

The refrigeration segment's adjusted revenue excludes the Australian, Asian, and South American refrigeration businesses, which were divested in 2018. These businesses generated a paltry $6.4 million profit on $187 million of sales in 2017, so divesting these businesses has had a positive impact on refrigeration margins.

Lennox was able to manage a favorable price-cost spread during the third quarter despite higher input costs including tariff headwinds. We expect Lennox will be able to maintain a positive price-cost spread over the remainder of 2018. Indeed, the firm expects to realize an $80 million price benefit, which should more than offset a $45 million increase in commodity costs, a $25 million uptick in freight costs, and $5 million of tariff-related costs. Lennox also expects to realized cost savings of $30 million related to sourcing and productivity initiatives in 2018.

Unfortunately, the damaged Marshalltown facility is not expected reach normal production capacity until the first-quarter of 2019, at the earliest. Specifically, management noted that they expect air-conditioning production to be back at full capacity in the early fourth quarter of 2018 and furnace production to return to normal production in the first quarter of 2019. Management projects that lost volumes in 2019 will result in $85 million and $35 million of lost residential segment revenue and profits, respectively. Management also expects to incur $15 million of additional tornado-related pretax costs next year. Like the losses realized so far in 2018, management fully expects lost profits and added costs in 2019 will be recovered with insurance proceeds.