Lennox Going Into 2023 With An Iffy Mix Of Headwinds And Tailwinds

Writing about Lennox International (NYSE:LII) over a year ago, I wrote that I was more bullish on the short-term opportunities for the company than the Street, but found the valuation unappealing, and particularly so given some longer-term challenges. Since then, the company has indeed executed well on its residential HVAC opportunities, as well as refrigeration, but the shares are down about 20%, lagging the broader industrial group and most of its HVAC peers (Carrier (CARR) has done a little worse, Daikin (OTCPK:DKILY), Johnson Controls (JCI), and Trane (TT) have done better).

I do agree that the company is going into 2023 with price/cost tailwinds at its back, not to mention healthy ongoing trends in refrigeration, but I also still believe that the company’s lack of leverage to commercial HVAC (particularly outside the U.S.) is a meaningful headwind. Valuation is more reasonable now than before, but not what I’d call compelling yet.

 

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Lennox Going Into 2023 With An Iffy Mix Of Headwinds And Tailwinds

Lennox Pushing A Stronger-For-Longer Case In Residential HVAC

 

Investor enthusiasm for HVAC-R hasn’t really waned all that much, but Lennox (LII) isn’t participating like it was before. While Lennox is still outperforming the broader industrial space on a year-to-date basis, the shares have lagged both the industrial group and other HVAC-R players like Carrier (CARR), Daikin (OTCPK:DKILY), and Trane (TT) over the last three months and since my last update on the company.

There’s a bit of an interesting debate around the stock now, with sell-side analysts largely dismissing management’s arguments in favor of a “stronger for longer” residential HVAC cycle, just a few weeks after writing reports that included praising the CEO for his history of candid and balanced commentary (in the context of the announced CEO transition next year). Although I personally think the CEO’s commentary is more “bull-case” than “base-case”, I am in the odd position of being more bullish on the underlying fundamentals of the business but less bullish on the relative valuation.

In any case, I still find Lennox to be an expensive stock here. At best I can make an argument for a fair value in the $340’s, largely driven by the company’s above-average ROTA, and I think the long-term annualized returns from here are likely to be fairly pedestrian.

 

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Lennox Pushing A Stronger-For-Longer Case In Residential HVAC

Lennox Leveraging Incredibly Strong Residential HVAC Demand

 

The HVAC space has stayed pretty hot in 2021 despite robust valuations, as the major players in the U.S. market, excluding Daikin (OTCPK:DKILY) have continued to outperform the broader industrial sector. Although the companies have been relatively careful with guidance and the sell-side continues to fret about a potential slowdown in the residential space, investors seem quite willing to pay rich multiples for growth rates that are admittedly, for now, well above what other sectors are offering.

Since my last update on the company in the fall of 2020, Lennox Intl (LII) shares have underperformed the broader industrial sector and most of its HVAC peers (except Daikin), though they’re still up about 15%. That could make some sense in the context of Lennox’s greater reliance on U.S. residential demand and less leverage to commercial HVAC in general and OUS HVAC in particular.

I still have trouble reconciling the multiples in the HVAC space today, and Lennox is no exception. Although I have pretty bullish growth expectations (relative, at least, to the sell-side), I can’t see a path to better than mid-single-digit long-term annualized returns from here, and that’s not attractive enough for me.

 

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Lennox Leveraging Incredibly Strong Residential HVAC Demand

Lennox's Strong Performance Smacks Into High Expectations

If these early reports and reactions are any indication, it's going to be an interesting earnings season. Sandvik (OTCPK:SDVKY) reports pretty lackluster results in its SMS division and the market responds with "don't worry, you'll get 'em next time!" and Lennox (LII) has a very strong quarter and the market responds with "yeah … I dunno."

Now, to be fair, not only are the addressed markets very different but so too are also the valuations, with HVAC companies like Lennox trading at quite high multiples going into the quarter. Still, I think the market is likely overestimating the risk to continued residential HVAC growth in 2021 (and beyond) while still being a bit too casual about the risk of weaker commercial new-builds (offset, though, by opportunities in energy efficiency and air quality retrofits).

I thought Lennox was pricey after second quarter results, and with the shares having largely tracked the industrial sector since then (dipping below with the post-earnings sell-off), I don't feel any different. I appreciate the strengths and appeal of the HVAC market, but not at these multiples and I'd still prefer Daikin (OTCPK:DKILY) in the HVAC space.

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Lennox's Strong Performance Smacks Into High Expectations

Lennox Riding High On HVAC Enthusiasm

Multi-industrials have had a good run of late on growing optimism around the post-pandemic recovery, or at least increasing confidence that the more bearish scenarios are unlikely to occur, but HVAC companies have done even better, with the worst performer over the past three months (Trane (TT)) still beating the broader industrial peer group, while Johnson Controls (JCI), Lennox (LII), and Carrier (CARR) have all done even better, with Carrier seeing a remarkable run.

While I've liked the HVAC segment on a relative basis, I definitely underestimated the enthusiasm that the market was going to have for these stocks when I last wrote about Lennox. Still, even with what I consider to be pretty bullish expectations - my 2020/2021 are on the high end of Street estimates, and my 2022/2023 are a little higher still on a relative basis - the valuation just really doesn't work unless you're willing to just assume that wherever the S&P 500 is is "fair" and build a premium on top of that.

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Lennox Riding High On HVAC Enthusiasm

Lennox Looks Richly Valued On Strong Sentiment For HVAC

While HVAC has proven to be a relatively popular end-market among investors, that hasn’t spared companies like Lennox (LII) or Trane (TT) in this recent downturn, as the HVAC market is proving that it too is not immune to pandemic-related declines. Lennox is one of the few companies so far to offer guidance for 2020 (most companies are pulling/suspending guidance), and this management team is estimating a 20% hit from COVID-19 to 2020 revenue.

While Lennox hasn’t been notably stronger than industrials in general this year, I nevertheless find today’s price/valuation too high. I appreciate that HVAC is a popular market with attractive long-term characteristics, but I think that’s true more of commercial HVAC than the U.S. residential market where Lennox is particularly strong. Although I can see Lennox as a potential M&A target, the valuation seems to already reflect that, and this is not one of my favored names.

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Lennox Looks Richly Valued On Strong Sentiment For HVAC

Emerson Playing A Hot Hand

Emerson Electric (EMR) is a significant player in two of the strongest verticals within industrials today – process automation and HVAC. What makes Emerson’s better performance so far this year (up about 3% versus a sector that’s down about 2%) a little more interesting is that the company’s performance in the HVAC business hasn’t been all that impressive so far. Assuming that the Climate segment picks up later in 2018, Emerson should be looking at one of the better revenue growth and margin leverage outlooks within its peer group.

I can’t really say that Emerson is undervalued. Even with a more forgiving/aggressive EV/EBITDA methodology that rewards Emerson for its healthy margins, the shares look more or less fairly valued. That said, investors often pay for performance and pay up for growth and I’d be leery of assuming that just because Emerson looks a little pricey today it can’t continue to outperform if the results from the Automation business remain this strong and Climate picks up.

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Emerson Playing A Hot Hand

Healthy Markets And Price Leverage Bode Well For Ingersoll-Rand

Ingersoll-Rand (IR) has had a so-so run of late. Although the company has been reporting some good core revenue and order growth numbers and a general upward trend in margins, the shares have lagged peers/comps like Lennox (LII), Gardner Denver (GDI), and only just matched the industrials sector as whole (and Atlas Copco (OTCPK:ATLKY) had also been outperforming Ingersoll-Rand until a recent dip tied to its semiconductor-exposed vacuum business).

I find that performance interesting given that the company continues to benefit from healthy cycles in the non-residential and residential building markets, has little meaningful exposure to sectors of concern like autos or electronics, and still has leverage to price/cost improvement and growing aftermarket/service sales. Although Ingersoll-Rand isn't cheap enough to call it a clear bargain (those are few and far between in the industrial sector), I wouldn't ignore the significant boost to guidance and the potential for IR to be one of the relatively few beat-and-raise stories in the second half.

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Healthy Markets And Price Leverage Bode Well For Ingersoll-Rand

The Tide Is Turning For Ingersoll-Rand

A year and a half ago, I thought that Ingersoll-Rand (NYSE:IR) looked undervalued, and the shares are up more than 70% since then. Now, to be fair, I thought Atlas Copco (OTCPK:ATLKY) was the better pick at that time, and Atlas's almost 80% rise since then isn't that much ahead of Ingersoll-Rand, so I think this had more to do with being generally right that the market was too worried about the long-term future of these industrial businesses.

In any case, Ingersoll-Rand's management has made progress in both improving the business and shifting the sentiment. I frankly think there's been more progress on the former than the latter, and so there could still be some upside as investors take a more "normalized" view of the company and its prospects (rather than always seemingly expecting something to go wrong). The May 10 Investor Day likely isn't going to be revolutionary for sentiment, but a clear discussion of the company's innovation and productivity initiatives as well as its plans for capital deployment could further strengthen that improving trend in sentiment.

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The Tide Is Turning For Ingersoll-Rand

With Watsco, It's About Quality Versus Value

If somebody offered you a brand new Ferrari for $1,000, you'd probably be extremely suspicious of the offer and/or the car. Quality products don't typically come at a bargain price, and that's something investors largely have to make their peace with in the industrial distribution/MRO sector, as quality names like Grainger (NYSE:GWW), Fastenal (NASDAQ:FAST), and WESCO (NYSE:WCC) often look pricey. So it is with leading HVAC distributor Watsco (NYSE:WSO), and especially now that stocks in this sector have shot up 15% to 30% in just the last month.

If you're happy with a lower total return, or you believe that Watsco can grow free cash flow in excess of a 10% compounded annual rate over the next decade, maybe there's some appeal here. I don't find either of those clauses acceptable, though, and so I will watch this distributor from the sidelines as it continues to benefit from a healthy residential HVAC market and invests in IT and supply/logistical improvements that should pay rewards in the coming years.

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With Watsco, It's About Quality Versus Value

Dover Still Searching For Traction

I want to give Dover (NYSE:DOV) management a break and the benefit of the doubt. It's easy to lose count of the number of times it has guided to lower expectations and it's easy to criticize DOV for having a poor handle on its business. On the other hand, "I don't know" are some of the hardest words to say in the English language and I scarcely believe that many on Wall Street would applaud management for admitting to low visibility on the business outlook, let alone criticize it any less than it will for being wrong.

Still, business is not healthy here. Perhaps the company is navigating through the worst of it and the next couple of quarters will see results, bookings, and guidance firm up. Likewise, it's worth noting that in a field full of expensive industrial stocks, 3% to 4% growth over the long term is enough to support Dover's share price today. While I'm not bullish on the company, I think I'm going to start paying more attention with an eye toward whether investor fatigue is creating an opportunity (or whether this collection of businesses really is that bad).

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Dover Still Searching For Traction

Seeking Alpha: Ingersoll-Rand Better Valued, But Not Better

It has been a while since I've liked Ingersoll-Rand (NYSE:IR), as I believe the shares have been buoyed by quite a bit of faith around the Street in the company's restructuring efforts. This skepticism has kept me on the sidelines, and with the shares down around 20% from the time of my last article, I can't say as though I've missed out on much.

The startling weakness in global equity markets since the start of the year and in industrial stocks, really, since the middle of 2015 has created some bargains provided that 2016 isn't the start of another deep or prolonged recession. I still have a lot of quality-based issues with Ingersoll-Rand - the company is a strong player in HVAC, but I don't believe the company is doing much to shrink the gap with Atlas Copco (OTCPK:ATLKY) in industrial and there's still a lot of work to be done on margins. At this price, though, I don't think so much benefit of the doubt is baked into the price and patient investors could see some upside from here.

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Ingersoll-Rand Better Valued, But Not Better

Seeking Alpha: Dover On The Defensive

I closed my last article on Dover (NYSE:DOV) with the admonition that "how much worse can it get?" are maybe the most dangerous words in investing (although "it's different this time" is a top contender). Dover hasn't been a disaster since then; the shares are down about 8% and on par with Emerson (NYSE:EMR), but investors are right to wonder why management has apparently misestimated the scope of the energy decline. What's more, it would seem that opportunities like "close the case" in refrigeration aren't quite what they were cracked up to be.

I don't think that Dover is a bad or broken company, but I do think it is at least fair to ask whether this is a particularly well-run conglomerate. Valuation isn't demanding at this level, but energy could be weaker for longer, and there are some areas of concern in multiple industrial markets. Patient investors will probably do alright with Dover, but General Electric (NYSE:GE), Eaton (NYSE:ETN), and Honeywell (NYSE:HON) all seem undervalued to varying degrees and are at least worth a look before committing to Dover.

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Dover On The Defensive

Investopedia: Ingersoll-Rand Improving, But Are Investors Already Too Optimistic?

I will say right from the beginning that I haven't been a fan of Ingersoll-Rand (NYSE:IR) for some time now. While the involvement of activist investors and a commitment to launch debt-funded share buybacks has helped the stock significantly since October of 2011, the next leg of improvement is going to have to come from better execution. This is where I'm not sure the company can deliver, and where I fear investors have given too much of a benefit of the doubt to management. That said, investors who have more faith in management could look to improving construction markets as a driver for the next move in the stock.

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Seeking Alpha: Ingersoll-Rand And The Power Of Change

When I last wrote on Ingersoll-Rand (IR) in February, I thought that this industrial conglomerate was the sort of perennial underachiever that could do well if and when management started delivering better results and the market really bought into the idea of reliable improvement. Although it's still early, it looks like Nelson Peltz's involvement with the company has improved sentiment, and it does look like management has credible plans for healing what has been a long record of underperformance.

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Ingersoll-Rand And The Power Of Change

Investopedia: Is Ingersoll-Rand's Bar Finally Low Enough?

For all the talk of restructurings, initiatives and goals, the reality is that companies generally stay more or less in their historical slots - good companies continue to be good companies and laggards continue to lag. That makes it difficult to have a lot of faith in the idea that Ingersoll-Rand (NYSE:IR) is underpriced and primed to be a solid stock over the long term. Although IR does have some solid businesses, there is just simply no record or habit of outperformance here and investors bet on that at their peril.

Ample Skepticism  
Ingersoll-Rand certainly lives in a tough neighborhood these days, as not only have industrials been weak in general, but those with above-average exposure to areas like construction have had an even tougher go of it. That said, Ingersoll-Rand has still suffered more than most; it's 2011 performance certainly trails the likes of United Technologies (NYSE:UTX), Johnson Controls (NYSE:JCI), Honeywell (NYSE:HON) or Dover (NYSE:DOV).

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Investopedia: Johnson Controls Seeing Multiple Recoveries

Passenger vehicles and non-residential building are two sectors that have seen some pretty ugly conditions in recent memory, and that certainly showed up in a 25% revenue decline for Johnson Controls (NYSE:JCI) in 2009. Economic conditions have turned around, though, and the company has seen a strong rebound in its results. Now with signs of life in the building efficiency segment, could even better results be on the way for shareholders? 

A Mixed Fiscal Second Quarter 

Like so many other companies this quarter, Johnson Controls gave investors a mix of good news and some disappointment in its fiscal second quarter results. Revenue jumped 22% and was comfortably above even the high end of the range, as all units posted solid progress. The auto business led with over 25% growth, but even the building efficiency segment saw better than 18% improvement from last year. (For more, see Johnson Controls Sitting Well.)

Margins were more problematic, though. Gross margin ticked down 20 basis points, due largely to commodity inflation and product mix. Segment income did improve by over 30% and all segments did show year-on-year improvements in their operating margins. Unfortunately, analysts had expected even better improvement, particularly in the building segment. So while patient shareholders may not be too bothered or disappointed with 30% segment income growth, the short-term trading tenor may be negative. 

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