It goes without saying that the western world is pursuing a move away from fossil fuels to more environmentally friendly energy sources. According to the World Economic Forum, buildings consume 40% of global energy and produce one third of greenhouse gas emissions. In the United States, the figures are in line with the global ones. Heat pumps can reduce carbon dioxide emissions from heating up to 80% and are seen as one of the solutions to drive down emissions from buildings.
Here, Lennox International Inc. (NYSE:LII) comes into play. It’s one of the companies producing heat pumps and energy efficient building products that is set to benefit from the megatrend. On the surface, the company looks interesting among its peers when looking at the financial performance and valuation. Unfortunately, the company has engaged in boosting its EPS unsustainably. Facing a possible slowdown in the housing market, the stock is only a buy below $200.
Lennox produces heat pumps, air conditioners, furnaces, heating and cooling systems and indoor air quality products. The products are necessities that have a long but regular replacement cycle. 75% of the sales are estimated to be replacement sales. The products are primarily sold either through the wholesale channel or directly. Lennox is relying more on the latter, and it also has its own (and expanding) network of 235 stores. 66% of the revenue and 77% of the profit is coming out of the residential segment.
Despite its name, Lennox International is actually not international but generates 95% of its sales in North America. Lennox competitors include Carrier (CARR), Trane (TT), AAON (AAON), Johnson Controls (JCI), Swedish Nibe, and recently listed Italian Ariston. All operate in the United States.
Why look at the producers of heat pumps?
According to the IEA, the global installed base of heat pumps should increase from 180 million units to 600 million units by 2030 to be in line with the Net Zero Emissions by 2050 Scenario. Meeting this goal would require rapid acceleration of heat pump demand and installations from the current pace of sales.
According to AHRI, in the United States the deliveries of air-source heat pumps increased by 15% in 2021, 10% in 2020, and 6% in 2019. During the year 2021, approximately four million units were shipped. In addition to air-source heat pumps, there’s water-source heat pumps. According to Global Market Insight, the market size is approximately 300 thousand units and is forecasted to grow at 9% CAGR.
In Europe, the heat pump sales reached an all-time-high figure, growing 34% and reaching an installed base of 17 million units and 14% share of heating market.
The demand for energy efficient solutions is often subsidized by governments. Also, the United States encourages to improve residential energy efficiency with tax credits. Increasing gas prices in relation to electricity prices could also help to stimulate the demand for heat pumps.
Historical valuation seems attractive
The peer comparison and recent financials present Lennox as a healthy company. The margins are on a healthy level. The company has been growing nicely the past couple of years. Last year revenue was up 15% and net income grew 30%. The earnings per share have grown 15% annually for the past 5 years whereas net income has grown at a rate of 10%.
The recent Q2 results came in strong, reaching a record quarterly revenue and earnings per share. Both revenues and EPS growing 10% year-on-year, but company’s volumes were flat. For the current year the company is projecting sales of $4.6 billion and EPS between $13.80-14.50, up from $4.2 billion and $12.60 respectively. The residential segment performed the best and the commercial segment saw a decline of 13% in revenue and 62% in profits.
The estimated numbers seem optimistic due to the fact that there seems to be first cracks of the market slowing down seen with the deliveries of furnaces and water heaters. The deliveries of air conditioners and heat pumps were still growing in May. At the same time, there’s still plenty of headwinds from production material inflation and freight costs. In the latest Q2 presentation, the Lennox states that a potential decline in residential new construction would be a headwind for the company.
After a 30% share price decline year to date, the stock seems to be trading below its typical valuation range. For example, the P/E ratio is a lot lower and dividend yield is much higher than typically seen in the past. The market seems to be pricing in a slowdown of the business, but the stock could see a nice bounce when posting strong quarterly results.
Lennox could be a buy below $200
When considering an investment in Lennox, we need to take into account the cyclicality of the industry. In 2009 the earnings per share came down from $2.17 to $0.92, a whopping decline of 58%. The earnings quickly recovered but stagnated for the next three years.
Let’s assume that the feared decline in the housing market is a bit milder this time and see if a possible decline is already priced in, and what is the intrinsic value of the stock in different scenarios.
In the worst-case scenario, we assume that the EPS first declines 50% and then returns back to $8. The company would not be able to grow the EPS at the same rate as in the past. In this scenario, the intrinsic value would be $130.
In the base scenario, the EPS would decline the same 50% and then bounce back to $9, where it was in 2018. The earnings would return to the path of growth in line with the historical net income growth. In this scenario, the intrinsic value would be $197.
In a more positive scenario, the EPS would decline 40% and then bounce back to $10, where it was in 2019-2020. The earnings would return to the growth pace we have seen in the past years. In this scenario, the intrinsic value would be $275.
The average P/E multiple for Lennox has been 25 for the past five years, reflecting that different terminal multiples are applied to different scenarios based on the assumed growth rates. The discount rate is set at 10% in all scenarios.
In summary, the current stock price is reflecting either EPS contraction, growth slowdown and/or lower applied multiples. The current stock price implies 2% annual growth from the estimated EPS with 10% discount rate and terminal multiple of 20.
If we give different probabilities for the scenarios above, 35% for the worst case, 40% for the base case, and 25% for the best case, we arrive at an intrinsic value of $193. The reason for such pessimistic probabilities, despite the supporting megatrends, is the financial engineering that the company has been performing over the past years.
How long can financial engineering continue?
The largest concern about Lennox is its financial engineering. The company has reduced the amount of shares outstanding by 30% during the past decade. Due to the inadequate cash flow from operations, Lennox has had to rely on debt in order to fund the buybacks. The repurchases have helped to boost the EPS, but how long can it go?
Lennox increased its long-term debt during the first quarter by over $300 million to $1600 million. According to the latest 10-K, $600 million of the debt will mature in 2023 and another $300 million in 2025. So far, Lennox has had access to debt at a favorable rates. The weighted average borrowing rate in the end of Q1 was 1.68% and at the end of 2021 it was 1.38%. Interest expenses have been around $25 million for the past three years. At the moment, servicing the debt doesn’t represent a challenge. Based on 2021 numbers, the debt to EBITDA stands at 1.8.
However, the company has been overspending on buybacks, dividends and other capital expenditures more than it earns. Issuing debt and reduction of working capital have been required to fund buybacks, dividends and capital expenditures. Even though Lennox’s margins have been healthy, the lack of revenue growth puts a pressure on how long the company can continue the outsized buybacks.
The capital allocation of Lennox has focused on repurchases of common stock. The share repurchases have averaged $380 million over the last five years. Lennox has been growing its dividend for 18 consecutive years. The 5-year dividend growth rate is 16% and the payout ratio currently stands at 30%. Last dividend increase was 15%. The dividend payments have averaged $105 million in the past five years. Capital expenditure has remained steady over the last five years averaging close to $100 million per year.
During the last five years cash from operations has averaged $470 million per year versus $685 million of capital spent. On average share repurchases and dividends have amounted 142% of the free cash flow over the past five years. The company has guided for $400 million stock repurchases for the ongoing year.
If Lennox needs to give up on buybacks it would most likely jeopardize the EPS growth. As we can see in the two graphs above, in the time of trouble, year 2020, the company had to reduce the buybacks and pay down debt. The share repurchases have been a key driver for the EPS growth. Therefore, there’s a higher probability given for the worst-case scenario in the intrinsic value calculation.
Lennox is in a business that has a major favorable megatrend behind it. In spite of this, the revenue growth has been relatively modest. Lurking slowdown in construction will most likely force a halt on the buybacks. Therefore, the financial engineering to grow its EPS probably doesn’t have a long runway ahead of it.
In these circumstances, it is difficult to see that Lennox could keep up with the EPS growth seen in the past. In the short term, the stock could see a nice bounce upwards if the company would meet its projections for the year. Considering the strong tailwinds for the energy efficient building products and a modest but growing dividend, Lennox could still be a buy below $200.