Lennox Earnings: Commercial Business Recovery Surprises to the Upside; Full-Year Guidance Raised

Last quarter, Lennox’s LII commercial business, which had been in turnaround mode, reported 10% revenue growth and adjusted operating margin nearly doubled to 16.2%. This business fared even better during the second quarter, with revenue climbing 24% year over year to $408 million and adjusted operating margin reaching a very robust 25.3%. Commercial revenue growth was mostly driven by favorable price and mix, which together contributed 22 percentage points of revenue growth. Volume increased 4%, while unfavorable foreign-currency exchange was a 2-percentage-point headwind. We don’t think that a 25% operating margin is maintainable, but we now see stronger commercial profit margin during the second half of 2023. We also now have stronger conviction that the commercial business will achieve management’s targeted margin range of 18%-20% over the next few years. Our more optimistic outlook for the commercial business caused our fair value estimate to increase 3% to $275 per share.

The residential segment, which accounted for nearly 70% of “core” revenue (that is, excluding European operations, which will be divested), faced headwinds from inventory destocking and a cooler start to the summer. After a surge of demand for residential HVAC units during the pandemic, demand is now normalizing. Management sees end-market unit volume down by a high-single-digit percentage, in line with our own expectations. That said, pricing should remain resilient and mostly offset volume declines. Residential segment adjusted operating margin was solid at 21.6%, but that was 50 basis points lower than the year-ago period.

Management now expects core revenue to grow 2%-4% in 2023, up from previous guidance of 0%-4%. Adjusted EPS and free cash flow guidance are both higher as well. Management’s EPS target is $15.50-$16.00 (versus $14.25-$15.25 previously), and the midpoint of its free cash flow target is 8% higher to $325 million.