Morningstar | Lennox's Residential Business Drives 1Q Sales and Earnings Beat; Kysor Warren Sold for $49 Million
Narrow-moat-rated Lennox International's residential heating and cooling segment was the bright spot of its first-quarter earnings release. Residential sales increased 3% year over year, and the segment's adjusted operating margin expanded 730 basis points to 18.6%. Lennox's other two segments, commercial heating and cooling and refrigeration, had a more challenging quarter, and both businesses reported a decline in sales and operating margin relative to the quarter a year ago. Still, the residential segment's results were enough to push Lennox's adjusted sales (excluding refrigeration divestitures) and adjusted EPS past consensus estimates (sales beat by 1% and EPS beat by $0.25). We've increased our fair value estimate about 3% to $180 mainly due to the time value of money since our last update.The residential segment's financial results continue to be affected by the July 19, 2018 tornado that damaged its Marshalltown manufacturing plant. Management estimates that $35 million of segment sales and $18 million of profits were lost during the first quarter. However, $40 million of insurance proceeds more than offset lost profits and contributed to the segment's strong operating margin expansion. After adjusting for these items, we calculate that residential sales would have grown over 10%, with 160 basis points of operating margin expansion to 12.9%
Lennox completed the sale of its Kysor Warren refrigeration business on March 29, for $49 million, or 0.3 times 2018 sales. Lennox bought the business in 2011 for over $143 million, or 0.75 times Kysor Warren's 2010 sales of approximately $190 million. Lennox incurred a $50 million pre-tax impairment charge to write down the value of Kysor Warren's assets in 2015, and we estimate the business lost $3 million before taxes in 2018. While the sale of this disappointing acquisition will improve Lennox's profit margins, it doesn't change the fact it was a value destructive use of shareholder capital.
Commercial heating and cooling sales (adjusted for the reclassification of Lennox's European heating, ventilation, and air conditioning business to its refrigeration segment) decreased about 3% year over year and the segment's operating margin contracted 360 basis points to 8.7%. Management attributed the sales decline to a mid-teens decline in new construction and flat replacement business sales.
Refrigeration sales (adjusted for divestitures and the European HVAC reclassification) decreased about 2% and the segment's operating margin contracted 180 basis points to 8%. Excluding the unfavorable effect of foreign currency translation, refrigeration sales were up 2% year over year. However, this increase was entirely because of the European HVAC business, which is now included in the refrigeration segment. Management said European HVAC revenue was up over 20%, while European refrigeration sales were down slightly and North American refrigeration sales were down in mid-single digits.
Despite a tough start to the year for both commercial heating and cooling and refrigeration, management expects both segments to post full-year revenue growth and margin expansion.
Except for GAAP EPS and share repurchase spending, management's full-year guidance remains unchanged. Management still expects 3% to 7% adjusted top-line growth and adjusted EPS ranging between $12.00 and $12.60. GAAP EPS guidance was lowered to $12.65 to $13.25 (from $14.30 to $14.90 previously) because of the updated tornado impact expectations and a $61 million non-cash, pre-tax pension settlement charge that will be recorded during the second-quarter. Lennox transferred $100 million of pension assets to Pacific Life Insurance Company and annuitized $106 million of its pensions obligation. The company will write off $61 million of accumulated actuarial losses in connection with this arrangement with Pacific Life. In terms of capital allocation, management now expects to spend $350 to $400 million to repurchase shares in 2019, up from previous guidance of $350 million. The increased share repurchase guidance is likely to be the result of management having an extra $49 million following the sale of Kysor Warren.
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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