Lennox International (NYSE:Iii) has performed very well in recent years as the company’s growth has been excellent in 2021 and 2022. As Lennox’s margins have grown significantly in the long term as well as in 2023, the share price has followed with a large return despite a very modest rate of revenue growth. Although Lennox’s financial performance has been strong, I don’t see the stock’s risk-reward as favorable – the stock appears to be priced into even very good future performance.
Company & Shares
Lennox manufactures and sells heating, ventilation, air conditioning and refrigeration products for residential and commercial use. Of the residential and commercial segments, the residential segment represents the majority of Lennox’s operations with 68.8% of income in Q3. The company operates primarily in North America, but also operates on an international basis with presence in Europe. Presence will be part of the story for Lennox, however – the company is planning to divest its European operations to create more of a focus on North America.
Shares of Lennox have performed exceptionally well – over the past ten years, the stock has increased at a CAGR of 17.0%. Additionally, Lennox pays a small dividend with a stream yield of 1.11%.
Lennox has had a good organic performance in the company’s long-term history. From 2002 to 2022, the company’s revenue has grown at a compound annual growth rate of 2.8% with very minimal acquisitions:
After weak revenues in 2019 and 2020, growth appears to have accelerated – in 2021 and 2022, the achieved revenue growth was 15.4% and 12.5% respectively.
The main driver of long-term earnings growth has been Lennox’s steadily increasing margins – the margin has steadily increased from a 2002 EBIT margin of 3.8% to a 2022 figure of 13.8%:
Margin appears to be a result of operating leverage – although EBIT margin has increased significantly, Lennox’s gross margin has remained largely unchanged at between 25% and 30% with some years varying from range. In the period from 2002 to 2022, Lennox has made impressive progress in controlling SG&A driving higher margins – although Lennox’s revenue has grown significantly since 2002, the company’s SG&A expenses have declined in dollar terms from the year.
So far in 2023, Lennox has reported very good financials. The company’s EBIT margin has increased to a current trailing figure of 16.0%, up significantly from the level achieved in 2022. After sluggish single-digit growth in the first half of 2023, Lennox’s revenue grew by 9.8% in the third quarter. In the future, growth should also come as Lennox is acquiring AES for about $90 million according to Lennox’s Third Quarter Investor Presentation. AES generates about $100 million in installation services revenue, and Lennox sees significant synergies in cross-selling. Additionally, Lennox is building a new manufacturing facility, which should also slightly accelerate the company’s future growth.
Lennox’s forward P/E multiple currently stands at 21.0, very close to the company’s ten-year average of the same rounded figure:
In my opinion, the P/E multiple looks to have good upside. To further contextualize the valuation and estimate an approximate fair value for the stock, I constructed a discounted cash flow model in my usual fashion. In the model, I estimate that Lennox’s moderate growth will continue in the future. For 2024 and 2025, I estimate a 6% revenue growth rate as the company’s new plant ramps up production over the years. After 2025, I believe growth should decline to a more historic level – I estimate 4.5% growth for 2026, with growth further decelerating to a permanent growth rate of 2.5%.
Lennox’s margin expansion has historically been excellent. I believe the company should be able to achieve further expansion as the new factory opens fueling growth, and as the company spins off its European operations – I estimate the EBIT margin to increase from a 2022 figure of 13.8% to 18.0%, due in 2031 Since Lennox’s gross margins have historically been between 25% and 30%, I don’t see a margin above 20% as likely. I believe that Lennox’s cash flow conversion should be quite good going forward as the equity capital associated with new plant construction is reduced.
In total, the valuations mentioned together with a cost of capital of 9.35% create the following DCF model with a fair value estimate of $282.41, a value about 28% below the stock price at the time of writing. The stock appears to be appreciating a higher amount of earnings growth than I’m comfortable estimating:
The cost of capital used is derived from a capital asset pricing model:
In the third quarter, Lennox had $11.2 million in interest expense. With the company’s current amount of interest-bearing debt, Lennox’s interest rate comes in at a low 3.11%. Lennox uses debt quite moderately and I estimate a long-term debt-to-equity ratio of 15% for the company.
On the cost of capital side, I use the 10-year United States bond yield of 4.62% as the risk-free rate. The equity risk premium of 5.91% is by Professor Aswath Damodaran most recent assessment for the United States, made in July. Yahoo Finance rates Lennox’s beta at one figure of 0.96. Finally, I add a small liquidity premium of 0.3% to the cost of capital, bringing the figure to 10.59% and the WACC to 9.35%.
Although Lennox is currently performing very well, I don’t believe the current price represents a very good entry point. The company should be able to achieve growth and margin expansion with the AES acquisition, sale of European operations and new factory opening in 2024. However, when factoring in margin expansion and a good amount of growth in my DCF model, the stock the price seems too high. Since the stock appears to have a significant downside at valuations that I see as reasonable, I have a sell rating on the stock at the moment.