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Lennox International: Market May Be Fully Valuing The Company At This Time

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Lennox International (NYSE:LII) is a pure-play company focused on the heating, ventilation, air conditioning, and refrigeration [HVACR] market. It has good long-term growth prospects, profitability, and financial returns. The market may be fully valuing the company at this time. The stock will reflect any further market volatility and downturn. So, it may be best to wait before buying Lennox.

Revenue Turbulence May Soon Come to an End

In Q2 FY 2022, Lennox saw its revenue increase by 10% to a record $1.37 billion compared to the same quarter in 2021. In Q1 2022, Lennox’s revenue rose by 9% to $1.01 billion. Over the past few years, Lennox has experienced an uneven growth rate [Exhibit 1]. The company was dealt a blow when a tornado struck and destroyed its factory in Iowa in July 2018, and the COVID pandemic knocked some wind off its sails. The company decided to rebuild the factory and retain jobs. But Lennox is beginning to turn around and has shown good growth in the past few quarters.

Exhibit 1: Quarterly Growth Change in Revenue, Gross Profit, and Operating Profit

Quarterly Growth Change in Revenue, Gross Profit, and Operating Profit (Seeking Alpha, Author Compilation)

This recent increase in revenue growth may be the start of good things for Lennox. However, investors should expect turbulence in revenue growth in the short term due to a sharp fall in new home construction and an increased risk of a recession. Although home builders will be eager to complete the homes they started in the last few quarters. Lennox may also benefit from the recently passed Inflation Reduction Act by the U.S. Congress. The law sets aside $21 billion over ten years for energy-saving improvements to people’s homes.

Lennox May Have to Look to Asia to Continue Growing

The company generates 95% of its revenue from North America and 5% from Europe [Exhibit 2], and 75% of its sales come from the replacement market. Europe is amid an energy crisis with the soaring gas prices increasing inflation to multi-decade highs and increasing the chances of a recession. The outlook for Europe may be much bleaker than that of the U.S., where the consumer is still going strong. The good and bad news from a geographic perspective is that Lennox has no presence in the fast-growing economies of Asia. The good news is that it presents an opportunity for Lennox to build a company from the ground up and gain strong revenue growth for years to come. The bad news is that Lennox has no brand recognition in Asia, and it will take years to build a brand and a network of sellers in that region. Lennox will have to spend heavily to gain a foothold in Asia. In contrast, Carrier Global (CARR) had $1.3 billion in revenues [13% of total revenues] from Asia for the six months ending June 30, 2022.

Exhibit 2: Lennox’s Revenue Distribution

Lennox’s Revenue Distribution (Lennox International Investor Presentation)

Profit Margins, Dividends, and Share Buybacks

The company has steadily increased its margins over the past decade. The company has averaged a 28.8% gross margin since 2016 [Exhibit 3]. It is an increase of 100 basis points compared to its average since 2012. It had a 12.8% operating margin since 2016, an increase of 150 basis points above its average over the past decade. For 2021, the gross margin stood at 28.34%, above the average of 27.84% since 2012.

The company has paid total dividends of $791 million from 2012 until 2021. The dividend yield stands at a paltry 1.73%, slightly higher than the 1.57% dividend yield of the S&P 500 Index (VOO). The risk-free U.S. 10-Year Treasury Note yields 150 basis points more than Lennox with a 3.269% yield. But the company has grown dividends at a double-digit CAGR over the past decade [Exhibit 4].

Exhibit 3: Lennox International Gross Margin, Operating Margin, and Net Income Margin [2012-2021]

Lennox International Gross Margin, Operating Margin, and Net Income Margin [2012-2021] (Seeking Alpha)

Exhibit 4: Lennox’s Dividend Per Share and Dividend Growth Rate [2012 -2021]

Lennox’s Dividend Per Share and Dividend Growth Rate [2012 -2021] (SEC.GOV, Author Compilation)

Monthly Price Returns of Lennox Have Strong Positive Correlation with the S&P 500 Index

Since June 2019, Lennox International has averaged a monthly price return of 0.07% compared to 1.08% for the Vanguard S&P 500 Index ETF. The third quartile return for Lennox International was 4.24% compared to 4.19% for the Vanguard S&P 500 Index ETF. There is a strong positive correlation of 0.69 between the returns of Lennox International and the S&P 500.

But, a linear regression of the monthly returns with the Vanguard S&P 500 ETF as the independent variable and Lennox as the dependent variable yields an adjusted R-squared of 0.466, meaning that the returns of the S&P 500 index explain just 46% of Lennox’s monthly returns.

According to Yahoo Finance, Lennox International has a Beta of 0.95 based on five-year monthly returns. The linear regression model of the monthly returns between June 2019 and August 2022 yielded a Beta of 0.99. In essence, Lennox’s stock moves in line with the markets. Lennox will not help an investor diminish the adverse effects of a broad market downturn, unlike Campbell Soup (CPB), which has a very low Beta and can protect a portfolio from a market downturn. Lennox has lost 27%, while the S&P 500 has lost 14% in the past year.

Conclusion

Lennox International has good growth prospects, profitability, and financial returns. But, the company may be fully valued at this time. It trades at a forward PE of 17x and a forward EV to an EBITDA multiple of 14x. The company’s five-year average forward PE was 23x and a forward EV to EBITDA multiple of 16.9x. Seeking Alpha’s factor grades gives Lennox a D on valuation.

Exhibit: Seeking Alpha Factor Grades for Lennox

Seeking Alpha Factor Grades for Lennox International (Seeking Alpha)

The prospect of further interest rate hikes by the Federal Reserve may cause more market volatility. Since Lennox’s beta is close to one, Lennox’s stock may reflect the market’s volatility. Lennox International is a quality company with good, steady growth prospects in the coming years. The company may have no alternative but to expand into the fast-growing markets of Asia. But, it will take time and money to succeed in Asia. Given the state of the U.S economy and the potential of a recession, and the company’s reliance on U.S. sales, it may be best to wait before buying this stock.