Lennox International Inc. Stock

Hello, everyone, and thanks for attending Deutsche Bank's Industrials Conference. We're back in Chicago. Excited to be here. Thanks to everyone in the room who's sitting in for Lennox fireside chat today. We've got Alok Maskara, who's CEO. And Geoff, please help me with your last name. I should have asked you before we started.

Geoff Dethlefsen.

Thank you. I would have butchered it. And Geoff is VP and GM of Lennox Commercial HVAC.

So Alok, I'm going to start with something kind of high level, and then we'll dig into the nitty-gritty stuff. So you've been CEO for 4 years now, which is really hard to believe, like time flies. What are you most proud of in your time as Lennox CEO? And where do you see the most opportunity for further improvement in your next 4 years?

Sure. Great question. It's always a good time to reflect back when you come to an anniversary and also when your stock price takes an unforeseen decline. I did that recently. Things I'm most proud of, and we'll start with that. Like the first is our growth journey. I looked at it compared to 4 years ago, we have still grown. We've grown like 13% over 4 years despite some divestitures in Europe, some acquisitions. And almost all the growth is driven by building commercial solution for us. We have obviously faced a really tough residential market, but to be able to deliver growth. And that growth is driven by -- we have gained share in 5 of our 6 business units.

One place like in residential, we have gained share in replacement and lost in new construction. It's kind of a mix. That's the one thing we're very proud of is the growth and the momentum that still continues. Second is margin. And I asked AI to do this for me and then a finance team confirm it. Q2 2022 versus Q2 2026, we are up about 500 basis points in margins. So as we talk about margin improvement and our entitlement to get both manufacturers margin and distribution margin, we're making solid progress that beat our Investor Day target for [indiscernible]. We obviously came up with a new set of targets.

So very proud of both the growth journey and the margin journey. What's most proud moment for me is the momentum that's behind all the future improvements that's going to come through. The investments we have made, whether it's emergency replacement and commercial, distribution improvements in residential, relooking at our product portfolio with greater emphasis on heat pumps, parts, the JVs we have done with Samsung and Ariston, we believe all of those momentum is going to carry us forward for the next 4 years. We are early, early innings in almost all of those initiatives to get some meaningful changes. It's super exciting time. I think I'm more excited about the next 4 years because of the potential we have. And given where we are, it's on the trough of the market versus when I started 4 years ago.

Yes, that's a good point. Okay. Got it. That was great answer. So we got to talk about 2Q. It was tough. What surprised you the most? And how much conviction do you have in the new guidance range that you guys have set now? Let's start there.

Yes. Listen, it was tough. We obviously felt terrible about missing our consensus and guidance and lowering guidance is not something any company should take lightly. We did not. But when you lower guidance, you only want to do it once. You never want to do it multiple times. Yes, we put forward a fair guidance. We went with a bigger range than we normally do. At this point, we would have gone with a $0.50 range, but we kept a $1 range because there's still uncertainty in the market. The changes in oil price, the inflation, consumer sentiment, repair versus replace dynamics, there's just a bunch of uncertainty.

So we kept a dollar range to make sure that we don't fall out of the range. We have good conviction in the range. So I think from that perspective. What we learned out of the whole Q2 thing was, a, sometimes we are too transparent. I mean I went back and looked at the feedback around share and then we went back on what other companies said about their residential growth in Q2 last year. So what happens is when you're a sell-through business, you appear to be losing share when restocking is going on, and you gain share when destocking is going on. So last year, almost all our larger competition did not give the equivalent -- for us to look like.

So last year, Q2, if you analyze the number same way, it would have looked like we are gaining share. This year, it does look like we are losing share in addition to the residential new home construction business that we walked away from. So I think we could have done a better job explaining that. We should have seen that coming, and we did not. From a market perspective, as we said in Q2, the overall reason for where we are is the residential recovery in HVAC is delayed.

We said it's going to be the second half when we announced full year guidance in January. And now we are saying it's going to be sometime in 2027. That's kind of the fundamental. Everything else is kind of nitpicking and what we could have done. But from the outside perspective, the largest changes, any big recovery in residential beyond inventory movements and stocking, destocking is likely to be in 2027.

Okay. Okay. Understood. Okay. Can we try to project a little bit more and maybe we can turn our bodies this way. Okay. Okay. So I mean, that was an important point, Alok, that you made around the replacement volumes versus peers. I think there is a lot of perception among investors that you guys have lost share. How do you get comfortable that it is just an inventory issue? Can you see data on sellout that compares more favorably to what peers are seeing?

Yes, we do. Remember, AHRI data are well published, Hardy data, sketchy, not so great. So yes, we analyze market share by ZIP code to [indiscernible], right? And those are getting even more competition. So we can see, compared to the AHRI data, we would have gained share last quarter and we lost this year, but it's essentially the same. I'll give you a bigger answer. So we went back and looked at share data for the past 12 years because we can do that, too, quantitative. Our share at the end of Q2 2026 is about the same as our share 4 years ago when I started going back to the 4-year ago analysis.

This is despite the residential new construction business that we walked away from, which clearly show that we are gaining share in replacement, just not enough to fully offset the residential new home construction loss that we walked away because of lower pricing and margins. So yes, we look at share against competition by ZIP code, by region, by product category, and we can clearly see that trend that our share is good. We have lost a bit in new construction, gained a bit in replacement and net-net, we are doing okay. We have good conviction.

Okay. Very clear. And I guess on the topic of that new construction share loss, which was -- you guys decided to do that, right? You walked away by yourselves. Is it just one contract? Is it a handful of contracts? And is this something that's going to remain a headwind to your volumes for several quarters? Or was it just a 1 quarter thing?

No, it's going to remain a headwind until probably one more quarter. Most of those bids come out in about Q3. There were 2 bids, both large new homebuilders. We walked away at a price that was reasonable given our focus on profitable growth. Our competition went lower than that, which at least in the earnings, you could hear them talk about negative impact on mix as the margins took a big dip on it. So you could see that in both the manufacturing competition and the distribution competition. So you could see that. It's not permanent. There are 2 more bids going on right now. These are large new home builders. The only loyalty is to low price and low cost. So those 2 bids are in the market, and we have another decision to make.

Honestly, we don't like chasing that business. We have a strong value proposition. We provide good value to our contractors. New home construction is a way to fill your factories. And if we choose to do that, we will let you guys know. But from our perspective, it was the right decision. I would rather work on factory efficiency and build our recurring revenue base through our most profitable, most loyal contractors.

Makes sense. Are these like 1-year contracts that come up for renewal every year? Or do they last a long time?

Maximum 2 years. But again, there is no guarantee of anything. The won't take you out an RFP anytime. But right now, there are 2 big RFPs going on. Last year, there were 2 big RFPs -- last year, we were on the defensive side. This year, we are on the offensive side.

Got it. Maybe let's move on to inventory. How would you characterize channel inventory today? Like I know most of what you do is through your own distribution. But I guess if you're seeing anything out there from an inventory perspective with competition? And then in your own factories, how do you feel about inventory? It still looks a bit elevated to me. Is that something that you're planning to work on through the rest of the year?

Yes, it's slightly elevated, and that's because our Q2 sales were a little softer than what we thought. But our inventory reduction is going as per plan, maybe a little better than planned. As you saw when we reduced guidance, we kept our cash flow guidance the same, which is why we are offsetting some of the lower earnings with higher cash from inventory liquidation. So our inventory position, we feel good about. Our fill rates are very well, which is almost more important than our inventory. From a channel inventory perspective, I think clearly, destocking is behind us.

We've started restocking in Q2, which gives you an artificial weird comparison. But we think the channel inventory is a pretty healthy level. I wouldn't say we are overstocked or understocked at this point. So we didn't -- we shouldn't expect a bump from restocking to continue nor should we expect another destocking. I just hope we stop talking about this by next year. So we just talk about sell-through and consumer and how we win share in the good old-fashioned way.

That would be nice. Any comments on how July shaped up or August as we're getting through the hottest part of the summer selling season? It feels like weather has gotten a lot hotter, cooling degree days are up, that good for the business?

It's always -- when you're in the middle of summer, it always seems it's too hot. In the middle of winter, it always seems it's too cold. All I tell you, we were 2 weeks into July when we put in our forecast forward on the consensus. So we sort of took all that into account when we gave our guidance. So no further update.

From our perspective, weather does make a difference. We should acknowledge that. We watch out for other things, mortgage rates, consumer confidence, interest rates, new home construction, existing home sales. And I can tell you, none of those are flashing green. So while weather makes a difference, the repair versus -- we're going to continue shaping the rest of the year.

Okay. That's a nice segue. That was the next question on my list is what you're seeing with respect to repair versus replacement. And I guess like repair doesn't defer replacement forever, right? It's kind of a Band-Aid. Does that mean that if we're seeing a lot of shift to repair today and tell me if still are, that 2, 3 years from now, there should be a surge in replacement demand from all these repaired units.

No, you're absolutely right. So we are seeing more repair versus replacement. In our view, it buys you about 2 years if you change a motor, if you fix a coil, you change a compressor, maybe 3, but this is just deferred replacement because these units are fundamentally at a stage where something else will break. There are 3 or 4 major components in a unit, and they all fail about the 10- to 15-year mark. And so that perspective, to us, that just deferred replacement. And yes, it will come back. That has happened before. At the end of the day, the fundamentals of the residential industry has not changed. There's extraordinary focus in the short term.

And I know that's the upside, downside of being a public company and where we are with the different cycles. But the fundamentals of residential industry remains the same, a very attractive industry, 80% replacement. Replacement cycles are continuing to getting shorter. Energy efficiency does -- replacement in both commercial and some of the other applications. So yes, we remain very bullish on the state of the long-term prospect for residential industrial.

Okay. [indiscernible]?

We do and we model price elasticity. Now 2 things. First of all, a switch from ducted to ductless level is extremely rare. That doesn't happen and some people might use it for their kids [indiscernible] or retrofitting in house that did not have air conditioning. But the cost of doing a ducted to ductless is just extremely rare and not feasible. So put that aside. You could go to more of a site discharge type unit, you could go to more of a type units, those are trading down that we see. You will still see it in the repair versus replace just to think about from that perspective. What we affirm is the following: manufacturer price since COVID has gone up about 40%.

The price to the consumer has gone up more than 100%, right? So if you think of that dynamic, as there is major price elasticity, more and more consumers are getting $2 to $3 crores. After COVID, you got $1 core, somebody showed up and you were thrilled that somebody is coming to repair. Now people are getting $3 crores to $4 crores, and there is price compression between the contractor and the homeowner. The homeowners are getting much smarter about it. They are shopping the door and they're kind of trying to figure out what's a private equity-owned contractor and what's kind of the typical residential home loan. So we do see a lot more price contraction or price in that segment.

And I think that will continue happening for the next few years, and you will see that dynamic happen. But the -- where you see this repair versus replace or downgrades, unlikely you see substitution as [indiscernible]. Those are just short-term fixes or [indiscernible].

Affordability has become a pretty well telegraphed issue here. Does that change at all the way Lennox thinks about approaching price over like a multiyear period versus obviously, a lot of price has been taken because of inflation and refrigerant standard changes and all these things that have materialized since in the post-COVID era?

We do. So I think there are multiple things we are doing right now, right? First of all, we are making more units that are affordable. So in terms of less [indiscernible], simple replacements. So there's a lot more demand for those that we are making those and making them very effectively. So that's one. Second, we are running a lot more consumer promotions. So instead of giving discounts to the contractor, we're running consumer promotions. That could be a $2,000 Costco rebate, preferred partner in many cases or just efficiency rebate back to the homeowner. So we're trying to mitigate that. Third, we are -- and we have launched things like the site discharge units, which are more the box units, more affordable units.

We obviously have a Samsung partnership to go to the mini-split times. The site discharge units are very -- another very affordable option, especially if you're working in California with 0 discharge loss necessarily 0 loss lines and things like that. So yes, we are continuously switching our portfolio to make sure we can provide consumers with an affordable option. And finally, we help with financing. So we have our own financing partners. We will do financing promotions, 0% for 36 months, 0% for 48 months and/or help our dealers work with the financing to do that.

So I think all of us have to be aware of where the economy is, where the consumer is and help out. And we see good traction with them. I think our contractors appreciate that. And at the end of the day, we know a new unit is a better financial decision for the consumer if your current unit is more than 10 years old. That comes with warranty, efficiency, you don't have to worry about down again. We just have to make sure that we get the message and put money where our mouth is by putting the warranty and financing behind it.

Okay. Makes sense. We're all kind of waiting for recovery in demand to happen. What are you looking for? Like what do you think would be the biggest helpful driver to actually cause a recovery? Is it rates? Is it existing home sales? Like...

I think I'll start with consumer confidence. If you go back to the University of Michigan confidence, it goes to a lot of -- it seems like it's bouncing along the bottom. I would hope for a meaningful recovery there. That will help all building products companies, not just us, strong -- all work. So I think that's first of all. Yes, we have to see more existing home sales. So that's a catalyst for people to look at their HVAC system or renovation.

Of course, we'd like to see more new home sales, but that's often cascaded into existing home sales as people interest rates, both mortgage rates and truly borrowing rates for people who are doing home equity loan financing. And those are things we are watching out for. I tell you the oil price or inflation going up doesn't happen. We almost see a fairly direct correlation with consumer confidence and their willingness to change in HVAC system and how stretched they are.

Sure. Okay. Makes sense. Just want to talk about heat pumps a little bit. I think at the last Investor Day, you guys targeted 30% of sales from heat pumps over the long term. How has the customer response to the new heat pump offering been so far? Like maybe because demand isn't great, it's not the best time to ask this question, but any signs of like share wins yet?

Yes. As we talked about, we won -- we are winning share in the replacement market. A lot of that is coming from heat pumps. So heat pumps, let me first touch on the mini splits, which are also heat pumps in a way, right? So the Samsung piece, we launched it at a terrible time. We launched it at right when the market was crashing. So like a tough time to launch, but now it's picked up momentum and it's doing well. What also is helping us is a lot of new products that we have launched. For example, we do heat pumps, indoor unit that worked in Florida because the units were too big. They were designed for Midwest. They won't fit in a cabinet in a condo in Florida. We launched that, whether it's called R2D2, for Star for snacfing, right? So it kind of fits in the closet.

Those have suddenly started making a big difference as our contractors have embraced that and go through all of that. We have also now a whole full series of heat pump with different SEER ranges, so we can offer the entire spectrum. Earlier, we only had the really low end and the really high end. We did have the units in between. So good uptake, good momentum, but you're right, when the market is down, everything feels terrible. So it's hard to kind of show the same underlying momentum where the headline numbers are down.

Yes. Okay. Understood. Good to hear that you're seeing some kind of momentum, though, that's really good in this market. There are the other long-term growth drivers as well, parts attachment, you touched on ductless a little bit and water heaters. Can you just give us an update on how that's going so far?

Very exciting. In hindsight, I would claim the Duro Dyne and Supco acquisition was just brilliant because we bought it right before the repair versus replace and come down. In fact, the seller private equity keeps saying, I don't know how you timed it so well, by the way, because it's not genius. We just wanted to go into parts and we bought it at a good multiple at a good time. That's doing very well for us. We went from more repairs, you need more parts. So we are working through that. That's also helping us build our own internal momentum on how do you do more parts. At the end of the day, our parts attachment rate is right about 15%. It should be 30%. With the acquisition, we added a couple of points to that already. And next year, we'll be launching -- official what we call like a parts distribution strategy because you realize finished goods distribution and parts distribution are very different games.

So next year, right about March, April time frame, we'll be launching a completely revamped part distribution, which will have options for contractors, which will be got new options for our home store, direct ship overnight with our goal is you already buy equipment from us. We make it much, much easier for you to buy parts by giving you the right part at the right price at the right place. And next year, we'll kind of have a big launch on that and truly pick up more momentum. But we remain very confident.

Does that launch for next year give you the ability to get to 30% parts attachment? Or do you have to do more inorganically or organically to get to that 30% attachment?

I think we're done with inorganic on this one, right? We have enough momentum. So that will get us to 30%. In the end, it's -- do we need more sourcing arrangements? Of course, we can do that. But I think we're in good shape with that. And that gives us what we need. And this is not a big CapEx. You won't even see it because of lease facilities, things like that.

So more internally, part of our overall, which is that we're going to be a better distributor. We have addressed the equipment side with the Dallas FTC. I know some of you saw in the Investor Day. we're addressing it through more of a parts distribution center, just getting more specialized and better. So in the end, we are competing with companies like Johnstone Supply. We are not competing with chain and carrier. Johnstone Supply and Grainger and Ferguson and Partstom. So we've got to build capabilities that are very distinct than an OEM manufacturer.

Okay.

[indiscernible] You're talking about -- sorry, good -- that launch went better than expected. That's a rare thing to say, especially when the markets are down, right? So that went very well. We are pleased with the momentum. We think this convergence is real. So the convergence between plumbing and HVAC and putting them all together, so that's been very good. I also want to be clear, we're not going after A.O. Smith and trying to become #1. Our goal is to serve our channel better, but we have no desire or ability to become #1 anytime soon. I get a lot of sh* from my friends at A. O. Smith and other places, and I want to make that clear. We're not going after A.O. Smith. We just want to serve our channel better.

Okay. On record. Just wanting to move on to profitability within HCS. So your -- you said many times, Alok, that you think your margin entitlement is -- you put together the OE margin and the distribution margin since you guys are effectively doing both. What are the key factors that can unlock this over time?

Yes. A year ago, we had outlined the strategic factors remain the same. So number one for us comes down to better distribution efficiency. You remember, 30% to 40% of our freight was being wasted in because we're moving things between our warehouses. So I think we're addressing that early innings, but the Dallas FTC is helping us with that, right? Second is more dynamic pricing. So we have done a lot of key account pricing in more group force. Now we are really investing in dynamic pricing all throughout our network system. It won't be live until mid next year, but that's kind of we are working through. So that's the second piece on unlocking that. Third is just more output from our stores. If you take parts, you take Samsung, you take Arista, put that through our 250 stores. Our stores start gaining more efficiency without having to add more square foot. Because right now, majority of our stores are very inefficient.

So if you think about just distribution logistics, dynamic pricing and getting more through our current stores, all those 3 lead us to the walk on getting back to manufacturers plus distribution. And sticking with our long-term targets. In fact, we remain very confident in our long-term target. What you're seeing now is highly unprecedented changes. We get tariff changes on Friday, and we got to start paying on Monday. We get supply chain shocks about certain companies in China being far from sending products to U.S., and we get 1-day notice to react to that. We see inflation on materials because of secondary impact of tariffs and other things that we hardly get any time to react to. And then, of course, the absorption impact on our factories. So we understand the pressures this year.

We are fighting hard, but it is -- in fact, it might be worse than COVID in terms of the supply chain and the inflation impact, except this time, there's a way to pay for it and make it less bad. But we remain very confident in our long-term trajectory. We just have to fight through the current environment where everything is going up and down every day. I just wish there will be one set of things published on tariffs, one set of trade restrictions, one set of NAFTA or USMCA agreement and just be done with it. So we can run the business as we can. that's probably causing the biggest jokes and changes in our profitability right now.

Understood. Is there anything specific on supply chain that you guys are seeing that's a challenge? Or is it just kind of like whack-a-mole, like things kind of showing up in different places on different days?

It's a bit like whack-a-mole. The latest, which you heard is, I think August 1, the government designated 43 different Chinese companies as companies using forced labor. [indiscernible] those companies supply electronic components. And I think this is impacting everybody, but it's Nidec motors are on hold right now. So automotive, HVAC, I mean everybody. This is a whack-a-mole. I'm sure by next week, I'll be talking about something else. But right now, that's the top of mind for probably half the auto manufacturers and all HVAC is you can't get motors or if you have bought motors, you can't use them because it's changed, and we get literally 0 days...

Is there a supplier in the U.S. that you can use that's qualified?

Yes, there's Regal, from Broad Ocean. It just -- when you get 0 days notice...

Disruptive.

It's highly disruptive. Airfreight things, then you're going to bring in on.

Okay. Okay. Understood. So back to the margin discussion. I think at the Analyst Day, you guys laid out total company long-term segment margin target of 22% to 23%. When you kind of drill down to the contribution to get to that target between the 2 segments, what's the expectation for HCS within that framework?

I think both will be about equal. But both are really good businesses. BCS is a little ahead already. As you know, I mean, BCS' margins has improved substantially. This used to be a low single-digit margin 4 years ago, Nicole. And now we are at a higher margin. HCS, if it wasn't for the 12, 9 months of massive volume challenges and tariff challenges would be in better shape as well. So we're pleased with the underlying. I think both would be about equal when we get it. And we remain very committed and that.

Got it. Maybe just a nearer-term question on HCS. I think you guys got a onetime tariff refund benefit of like $30 million in the second quarter. Do you expect to receive more refunds in the second half? Do you have like more requests to the government for refunds? Or is it done? Pretty much onetime thing.

And we want to clean it up once. Yes. I mean in reality, it's on time. But from a customer perspective, the way we explained it is the new tariffs went into effect beginning of Q2. We delayed our pricing until almost the end of Q2. That's because we were getting this refund. So as customers -- they all call us and say, hey, are you going to pass the refund off to us? I remember the discussion we had. We could have done price increases earlier in Q2 and then you would have got the refund and paid me here versus the awarded the transaction. So in a way, it's onetime, in a way, just continued tariff impact that everybody is facing.

Okay. Understood. And then just another shorter-term question. You guys said on the earnings call that you expect HCS margins to be down again in the second half year-on-year. With volumes starting to improve, particularly in 4Q when the comps are really easy, why is that the case? Like what are the biggest drivers of year-on-year margin pressure in the second half?

Absorption has become a headwind in Q3 because as volumes -- we reduce the volume forecast, we reduced our production as well. So that automatically impacts Q3 numbers for us. So that's the largest driver of that, right? Q4 is just not a big quarter for us. So from an overall perspective of Q4, and we don't produce much in Q4 either as the factories are going through the transition and holidays. The largest single impact is absorption running into Q3, so.

Okay. Okay. Got it. Is it possible that 2027 is a normal year for -- and all we're talking about is actual demand, supply and demand, and that's it?

I sincerely hope so. If I have 4 years in the HVAC industry, we haven't had a normal year, but I'm also on the record saying in 2025 that 2026 might be a normal year. In 2025, we faced the liberation day shock I was calling, we dealt with all of that. Then we knew there will be some destocking, then we have now the war challenge and the consumer confidence. But yes, I would join you in celebrating 2027 as a normal year. I won't count on it yet, but I really hope that's going to be the case. We like winning with new products. We like winning with technology. We like winning by serving our customers better. And I hope we get to do that versus chasing some supply chain switches every day just to minimize tariffs from U.S. to Canada. I mean that itself was a big change in our supply chain that we had to work through.

Okay. Let's all hope. I'm going to move on to questions on BCS, but I wanted to give everyone a chance in case there's anything else to tie up on HCS. Okay. All right. So moving on to the BCS segment. Year-to-date volume growth here has been really impressive, up double digits in both 1Q and 2Q. I guess how much of this would you attribute to the overall light commercial market being stronger than expected? And how much would you attribute to share gain, particularly in emergency replacement?

Geoff, do you want to take that?

Yes. Yes, it's a mix, but mostly share gain. If you look at our BCS business, there's 3 business units within there, refrigeration services and then the light commercial HVAC, which is the business that I run, and that's the business where we get the AHRI data. AHRI data has been up low single digits year-to-date, right? And we're up in the teens, as you just noted, right? So we're taking a lot of share. If you look at where we're taking it, our emergency replacement has really been growing strong. And we've seen outsized gains in our national accounts, our chains business as well. So it's a mix, but mostly share gain.

Okay. Okay. That's great. And I guess like we've been -- you guys have been on this quest to regain share of emergency replacement for some time now. It's nice to see that's like paying dividends. Where do you think we are in that share gain quest maybe in like baseball terms? Like what inning are we in?

Yes. Probably the third inning, I would say. We've got a lot of room to run there. As I think you guys know, we've made a lot of investments in this space, massive new factory, hired a lot of salespeople. We've got 50% more distribution centers with our commercial product in them in the U.S. and Canada, digital investments. So we've made a lot of investments. Now it's time over the next 2, 3 years to get that return on those investments. We said at our Analyst Day another $125 million of sales over the next 2, 3 years. So we see that upside there. We've also got a lot of growth pathways, right? We had to cut off a lot of customers post-COVID when we didn't have capacity. Now we do have capacity to serve them. We've got a distribution business allied within HCS that we can go to. And then we're out winning new business as well, especially with our residential dealers, a lot of them do 10%, 20% commercial business. They're very loyal to Lennox. So third inning, a lot of room to run.

That's good to hear. And you mentioned national accounts as well as a reason for strength. Maybe you could double-click on that a little bit and talk about what you're seeing with national accounts.

Yes, it's a great business for us. I really believe we're differentiated with national accounts with our direct one-step model. But if you look at what we did with our investment in factory down in Mexico, that had the effect of freeing up capacity in our Arkansas factory to better serve national accounts as well. And so we see a lot of room to run there. We're able to go on offense right now because we have capacity there. And I think we've got a great model to do that, and we've seen some nice new wins this year with national accounts that we're really excited about. So we see a lot of room there.

Great. Maybe a shorter-term question here as well. So the full year guidance implies a pretty big deceleration to like mid-single-digit volume growth in the second half. Why? I mean this just seems to me as the most obvious area of the model where there's room for upside versus guidance.

Yes. I'd attribute...

Very interested [indiscernible].

I'd attribute a lot of that to comps, right? If you remember the first half of 2025, we were going through the refrigerant change in commercial. So we're going to be lapping a little bit tougher comp there. And frankly, the industry is still a little bit choppy. If you look at the industry data, May was down. January was down. So 4 of the 6 months to start the year were up, but 2 were down. So I would say we're still maybe not out of the woods completely on the industry growth. So we took a balanced approach when we looked at our second half, kind of weighing some of the macro choppiness in addition to some of the outsized growth pathways that we see as well. So it's a balanced view.

Okay. Understood. And one area that we've had questions on so many times is I think investors have been surprised at how resilient the overall light commercial market has been. If you were to like drill down to the different verticals that you sell to, do you have the visibility into like what's actually driving some of that strength?

Yes. Yes, I can talk about that a little bit. I'll highlight a couple within our national accounts business. Restaurants and retail. We're fortunate to have some great national accounts that are growing at a faster rate than the market. But I would also say that new construction is a relatively low percentage of our national account business. If you look at the pent-up demand, Alok was talking about residential earlier about units last 10 to 15 years. There were a lot of commercial units installed 10 to 15 years ago and those are coming up for replacement. And also over the past 10 to 15 years, units have gotten a lot more efficient and operating cost of running those are quite a bit improved. So there's logic to replace those as well. So I would highlight retail restaurants plus all this pent-up demand give us good confidence that we can grow.

Got it. And I just thought of a question. Sorry to put you on the spot. This wasn't on my list that I sent to you guys. But I guess if you were to look at your BCS sales in terms of versus emergency replacement, what does that split look like today versus essentially very little emergency replacement a few years ago?

Yes. I would say it's still skews -- I don't want to give an exact percentage, but it still skews heavy on the planned replacement as well as the new construction. But we see growth. A lot of growth still remaining with emergency replacement in some of our other areas.

Got it. A question that we often get as well is -- and I don't know if this might be more of an Alok question than a BCS-specific question, but do you have interest in becoming a supplier to data center customers over time? And is there a way you can possibly do that through like product development with the technologies that you have in-house? Or would that require some kind of an acquisition from a technology perspective?

I'll start with the acquisition because we have looked at some of those acquisitions, and we think the multiples are very frothy right now in that space. So we have kind of stayed away from that. Yes, we have the core technology. And in the end, we do refrigeration, HVAC, all of that. We have typically not done data center, but we have put in internal capital. We have developed new products. We don't really have much to talk about right now in terms of kind of sales forecast and numbers. But no, we have interest, and we have the technology, and we are working through -- what we will do is not go to of CDUs that take open compute specs and puts up a factory. That's not our goal.

So you will not see us do that. What you would see us is invest in next-generation technology, which is likely to be non-water-based, purely driven by direct-to-chip, purely driven by 2-phase flow, driven by CO2 type technologies. So I think we're going to invest in the future, not chase the current demand capacity with open compute specs. But it's not something that I would call that as a good option value versus a core part of our future growth.

Okay. Okay. Got it. And then one on BCS profitability. Alok, you mentioned that both segments should contribute to the long-term segment margin goals. But I guess we've seen quite a bit of BCS margin improvement already. You mentioned that. I mean it's been really dramatic. What are the next levers of margin expansion within the business? Is it about just getting leverage on volume growth? Do you see more room to improve operational efficiency?

I'll start by saying, listen, in HCS, you don't see the margin improvement because of the volume constraint. Otherwise, you see it there as well. And that has also grown, just not as compared to BCS and overall number. In BCS, the 2 big margin improvement opportunities remain remember, a new factory is still highly underutilized. We built it right when the market started going down. So I think perspective, there's still a lot more capacity we can add without adding much fixed cost. I think there's a whole series of activities that go in there. Remember, BCS consists of 3 businesses, right? So that's one LCH, which Geoff runs. Second for us is services business. Our services business, which is better than most services business, is still running on [indiscernible] technology. We don't have the appropriate AI-driven route optimization or dispatch systems. We are putting all new technology in that this year. So you're going to start seeing productivity impact of that starting next year.

So I think that's going to become -- it is already just slightly below the BCS average. I think it will start going above the BC average. And the BCS business remains our refrigeration business, which has been gaining share, and it went through significant inefficiencies this year because of the whole regulatory change and then the government pulled it back and then there did no enforcement. When that settles down, there's a lot of productivity opportunity there as well. So again, manufacturing and service are the 2 growth areas of productivity and margin opportunities.

Okay. Understood. I'm going to move on from BCS unless anyone has any tie-ups. Okay. How is NSI going? And I guess, like if you were to look at the baseline level of growth that the business is seeing, has it been better than you guys had expected?

Yes. NSI, which is basically made up of 2 brands, Duro Dyne and Supco, it's going better than what we call our board pro forma. We always have pro forma and we update it every quarter. Both sales and margins are doing better than what we had put in a deal pro forma. When we do the acquisition, I always talk about 65% of them destroy value, and our goal is to be the 35%. Within the 35%, half of them do much, much better, we are in that percentage. So I think it's doing very well. What gives us heft in parts and supplies. We wouldn't have been able to put the new distribution capabilities that we're going to launch next year, it wasn't for these 2. We had like 14 locations, I think. I mean if you take some of the productivity opportunities there, and we have announced a few closures. We are working through all of that. So I think that's going to turn out to be one of our dream acquisitions.

Great to hear. And I guess you've been more acquisitive than past CEOs that we've known at Lennox. You kind of mentioned that you're done with acquisitions on the parts side probably. I feel pretty good about where you're at with that. How is the acquisition pipeline now? And if we're kind of coming to the end of the acquisition journey on the parts side, what's the next thing of interest to you?

Yes. On the parts side, the way I answered the question, just to come back to that said, we don't need more acquisitions to build these capabilities. At the same time, it is highly fragmented. And if we can buy things at 9 multiple that gives us synergies and do that. So we're not ruling that out. But I'm saying I don't need it to get more scale, but it could still have opportunities for us to create value for shareholders. So that part would clarify. But yes, we don't -- we are building our infrastructure based on what we have, not based on what I need to buy. I think that part. But that remains a fragmented space with opportunities. The other pieces we continue to look for is service.

So going back to commercial and BCS, we are highly underpenetrated in service. So if there are opportunities in service in BCS, we continue focusing on that. There are also adjacent categories going back to -- we talked about using energy and home energy management and what we can do in the home energy management space, that gives us a leg up and accelerates the true convergence between the industries that is going on right now. So I think we're looking at that as well.

And in the end, we are also very, very open to doing acquisitions like we did for the recent heat controller, which are 2 of the last remaining brands that are not already owned by one of the big things. So we've got Comfort Air brand that goes to distribution, small distributor. So any time we can find those niche narrow opportunities, we don't use bankers. We proactively approach them. We do the deal ourselves and those opportunities are good. So our pipeline is pretty robust. That Board sometimes gets overwhelmed with the number of opportunities we show them, but we remind them that we only close 4 out of the 20 opportunities we pursue in pay for because whatever we close has to make a lot of sense for the shareholder and has to do better than share buyback. Because in today's world, share buyback is also a very good use of our capital. So acquisition must pass the bar of it better than share buyback.

Okay. I was going to ask if the pendulum is swinging towards buyback after 2Q, it seems like maybe it is.

It will, yes. I mean we strongly believe in a consistent daily share buyback, but then we layer that up with opportunistic buyback when the share price drips significantly below the intrinsic value. So we got lots of financial calculations and we put that together. So yes.

Okay. Well, I think we're out of time. Alok, this was a great discussion. I really appreciate it. Geoff, thank you for coming too, and thanks to everyone in the room.

Welcome to the Lennox 2026 Second Quarter Earnings Call. [Operator Instructions] As a reminder, this call is being recorded.

I will now turn the call over to Chelsey Pulcheon from Lennox Investor Relations. Chelsey, please go ahead.

Thank you, Madison. Good morning, everyone. Thank you for joining us as we share our 2026 second quarter results. Joining me today is CEO, Alok Maskara; and CFO, Michael Quenzer. Each will share their prepared remarks before we move to the Q&A session.

Turning to Slide 2. A reminder that during today's call, we will be making certain forward-looking statements, which are subject to numerous risks and uncertainties as outlined on this page. We may also refer to certain non-GAAP financial measures that management considers relevant indicators of underlying business performance. Please refer to our SEC filings available on our Investor Relations website for additional details, including a reconciliation of GAAP to non-GAAP measures. The earnings release, today's presentation and the webcast archived link for today's call are available on our Investor Relations website at investor.lennox.com.

Now please turn to Slide 3 as I turn the call over to our CEO, Alok Maskara.

Thank you, Chelsey. Good morning, everyone, and thank you for joining us today.

Please turn to Slide 3. The second quarter demonstrated the strength of our direct-to-dealer business model, our dedicated talent and proactive actions taken to manage the current operating environment. I want to thank our employees for improving our customers' experience through enhanced digital and distribution capabilities. I also want to thank our customers and channel partners while navigating a dynamic market environment alongside us.

Lennox delivered a solid second quarter. Revenue increased 3% to $1.5 billion. Total segment profit increased 2% to $355 million and adjusted earnings per share were flat at $7.72. Within Home Comfort Solutions, year-over-year quarterly performance improved sequentially, though the pace of end market recovery remains muted. Elevated market rates, inflationary pressures and historically low consumer confidence are constraining underlying demand. Looking ahead, channel confidence is continuing to grow, and consumer confidence is starting to rebound which supports our positive long-term outlook for the market.

Building Climate Solutions once again performed exceptionally well. We are seeing signs of progress across commercial end markets, momentum in emergency replacement and strong execution in the field to gain share and grow margins. Taking together, the results from the two segments demonstrate the value of our portfolio and the balance it provides across market cycles.

Our long-term demand outlook remains unchanged, even though the residential demand recovery has been slower than anticipated. As a result, we now expect the most meaningful recovery benefits to extend into 2027 rather than occur in the back half of this year.

While we are reducing our earnings outlook, several key elements of our 2026 financial framework, such as revenue and free cash conversion have not changed. Our balance sheet remains healthy, and we remain on track with our inventory reduction plans. The combined strength and the industry's long-term outlook provides us with the confidence to continue investing in the business, advancing strategic initiatives and strengthening our competitive position.

Now please turn to Slide 4. Let me spend a minute on our recently completed acquisition of the Comfort Air, Century and Costar Air brands. This acquisition is an excellent example of our disciplined bolt-on M&A approach. The acquisition expands our reach into small and midsized distributed channel and broadens our product offering allowing us to further accelerate growth. We also sharpened our focus on customer experience by enabling One order, one invoice and one shipment towards distribution and contractor partners for most HVACR, equipment, accessories and parts.

Finally, we see meaningful opportunities to drive margin improvement through product integration, logistics synergies and streamline SG&A through the application of the Lennox unified management system and expect the business to be accretive to our EPS in 2027. The strategic bolt-on acquisition, along with DuroDyne and SubCo acquisition completed in 2025 and the AES acquisition completed in 2023, reinforced our disciplined capital deployment strategy.

Now let's turn to Slide 5 and discuss the current demand environment and how we are positioning the business for growth acceleration. The factors affecting residential demand today including affordability pressures, weather variability, softer consumer sentiment and suppress new construction activity are in our view, temporarily. We believe that much of the shift from replace to repair represents deferred replacements and the underlying demand profile remains unchanged.

Our focus remains on controlling the controllables. We continue to invest in innovative heat pumps, emergency placement capabilities and our direct-to-dealer model to make it easier for customers to work with Leveraging our successful acquisitions, we are expanding our parts, accessories and service offerings, thus creating additional touch points with customers. At the same time, we are leaning into initiatives that strengthen our long-term competitive position including distribution network optimization and partnerships like Samsung and Arista to grow share of wallet. Rather than getting weighed down by short-term market fluctuations, we are executing our strategy and investing in the capabilities that matter most when demand returns.

With that, I will turn it over to Michael to review our financials.

Thank you, Alok. Good morning, everyone. Please turn to Slide 6. The quarter reflected a mixed operating environment across the portfolio. Residential demand is still challenging, while strong commercial execution and contributions from recent acquisitions helped support overall performance. We continue to navigate cost inflation and factory absorption pressures associated with lower residential production models. These headwinds were partially offset by pricing actions and the timing of certain tariff refunds. Cash generation and a disciplined focus on the working capital management support a strong cash flow performance during the quarter.

Against that backdrop, let's turn to Home Comfort Solutions on Slide 7. Residential market conditions remained challenging during the second quarter, although year-over-year demand trends improved compared to the first quarter. Compared to the prior year period, revenue declined 7%, driven primarily by a 12% decline in unit volumes. Favorable mix and pricing contributed 3% growth, while acquisitions added another 2%, partially offsetting the volume decline.

While volumes were down year-over-year again, this represented a meaningful improvement from the 21% decline experienced in the first quarter.

Performance varied across channels. Two-step volumes were relatively flat compared to the prior year, while one-step volumes declined in the mid-teens, driven largely by continued weakness in residential new construction, but revenues were down approximately 30% during the quarter. Segment profit declined $30 million. Lower sales volumes created approximately $50 million of EBIT headwinds during the quarter. Mix and price were favorable and mostly offset cost pressures, including ongoing inflation and approximately $10 million of factory absorption headwinds as we align inventory levels with market demand. Product costs also benefited from approximately $25 million of tariff refunds that we had originally expected later in the year.

Let's move to Slide 8 and discuss our Building Climate Solutions segment. While strong growth in the first quarter, Building Climate Solutions maintained its momentum in the second quarter, supported by improving commercial end markets and continued execution on our growth initiatives. Revenue increased 24%, with organic sales up 12%. Growth was driven by success with national account customers and an increase in emergency replacement activity. Our service business also grew as customers increasingly leverage our combined equipment and service capabilities.

Mix and price contributed 3%, while acquisitions added 9% primarily from DuroDyne. Segment profit also increased, benefiting from higher volumes and favorable mix and price. Product costs reflected inflationary and production cost pressures and were partially offset by approximately $5 million of tariff refunds.

Within other costs, DuroDyne contributed approximately $11 billion (sic) [ million ] of M&A accretion, offset in part by investments in customer-facing digital capabilities and innovation.

Now let's turn to Slide 9 to review cash flow and capital deployment. We generated $172 million of operating cash flow in the second quarter and delivered 92% trailing 12-month free cash flow conversion, reflecting disciplined working capital execution and progress on inventory reduction. While inventory dollars were flat to December due to inflation and tariff-related cost increases, unit inventory levels continue to decline, and we remain on track to achieve our full year inventory reduction implied in our full year free cash flow guidance.

Our balance sheet is strong with net debt to adjusted EBITDA of 1.3x at quarter end. During Q2, we repurchased approximately $130 million of shares in -- After quarter end, we completed the acquisition of the Comfort Air and Century brands using approximately $200 million of debt.

We are also refining our full year capital expenditure outlook to approximately $225 million down from $250 million. The change reflects project timing, but our key investment priorities are unchanged.

With that, let's turn to Slide 10 and discuss our updated financial guidance. As Alok outlined, we are updating our full year adjusted EPS guidance range to $23 to $24. While our overall revenue growth outlook holds at approximately 8%, the composition of that growth has evolved since our prior guidance. At the segment level, we now expect Home Comfort Solutions revenue growth of approximately 1% compared to our prior expectation of 4%. Building Climate Solutions revenue growth is now expected to be approximately 20% compared to our prior expectation of 16%. These changes reflect lower expected residential volumes, stronger commercial demand and approximately 1 point of enterprise revenue growth from the Comfort Air and Century Brands acquisition. This acquisition adds approximately 2 points within ACS.

Reduction in our EPS outlook is primarily driven by lower net volume expectations that stronger commercial demand is more than offset by lower expected residential bonds. We now expect approximately $60 million of productivity versus our prior expectation of $75 million, reflecting ongoing absorption headwinds from lower residential volumes and the delayed timing of some material cost reduction initiatives as resources were shifted to tariff mitigation.

Interest expense is expected to increase to approximately $70 million and M&A amortization to approximately $25 million following the Comfort Air and Century brand acquisition. Importantly, our free cash flow outlook remains unchanged at $750 million to $850 million, reflecting confidence in our inventory reduction plans and working capital execution. Other guidance assumptions including inflation, investments, tax rate and share count have not changed. While residential demand is still below our expectations, the strength of our commercial business and continued cash generation position us well for the balance of the year profit growth.

With that, I'll turn the call back to Alok.

Thanks, Michael. As we close, I want to reemphasize that while current market conditions are dynamic, I believe the long-term growth trajectory of the industry is very attractive. What gives me confidence is the performance of our portfolio, the durability of our cash generation and our ability to continue investing towards growth.

We are committed to innovation and operational excellence, while continuing to allocate capital to expand our capabilities and improve our customer offerings. Most importantly, the dedication of our employees and the values that define our culture continue to drive excellent at Lennox.

Our fundamentals are strong, our strategy is clear, and our best days are still ahead of us. Thank you. We are happy to answer your questions now. Madison, let's go to Q&A.

[Operator Instructions] And we will take our first question from Ryan Merkel with William Blair.

I wanted to start on the resi revenues. The down 12% for the one step is surprising. What are the key issues, Alok? And then any steps you're taking to improve the results?

Sure. Ryan, majority of the decline was due to residential new construction, where we talked earlier about, we walked away from really low margin business. And a large portion of that impact is beet in Q2 due to seasonality. That doesn't mask that the underlying sell-through also remains weak, but is improving both sequentially and as we look at this going forward. So that's really we kind of look at the negative 20%. And we have internally done a lot of analysis and feel confident that, that starts improving because we lapped some of the residential low-margin loss in the second half and the comps get easier even on the overall market dynamics.

Got it. Okay. That's helpful. And then on the guidance cut, it sounds like you had included the refunds some tariffs in the guide. So just confirm that for us. And then it looks like resi, you're going to have weaker margins in the second half. Is that just the fixed cost absorption on the lower volumes? Or is there anything else in there that's pressuring the margins?

That's correct. On the tariff guidance, we had built an inflation assumption of 5%. That includes the net impact of all increases within the 232 tariffs that we saw earlier in the year. And the IEPA refunds that we expected initially in the second half of the year that we've now gotten most of them in the second quarter now.

And there's nothing else based on the second question, Ryan. It is just simply an impact of lower volume and the absorption impact related to that.

And we'll move next to Tommy Moll with Stephens.

Alok, first question for you on the one-step trends for resi. Noted that there's the new construction headwind. Some of that relates to business you've -- low-margin business you've walked away from. I'm more interested on the replacement side there. What's your view on how market share has progressed? Have you seen any evolution or pressure there?

Yes. On replacement, we have seen the small market share gain, while in new construction, we have seen a significant loss as we talked about earlier. And we continue to build our distribution network efficiencies, continue investing in the sales team, but we are pleased with our market share position in the replacement, which has actually picked up over the past 12 months.

Related question for you on pricing, Alok, specific to resi. It seems like there have been some different strategies year-to-date. Some have raised and then lowered depending on differing tariff assumptions. Others have been slower to move. Just characterize for us what the Lennox strategy has been there and what you've seen across the market. There's just been a lot of volatility on that point?

Sure. Putting residential new construction aside because that's a different story. We continue to see higher inflation being offset by pricing action across the wide spectrum. We continue to remain focused and do price competitively. A large portion of the 232 tariff pricing is going to get into effect on 1st July, which is consistent with how some of the other competitors have done. And we feel good about where we are in the replacement side of the business on the residential portion. And obviously, we continue monitoring it. We want to be fair with our channel. Some of the early arrival of tariff reforms also impacted how we thought about pricing and how we're going to take this going forward. So we were able to delay some of the pricing actions because of the early arrival of the tariff refunds.

We'll move next to Noah Kaye with Oppenheimer.

I guess just to make sure that we've got it then on the revised guide, two points. One, so I think you contemplated resi volumes down mid-single digits for the year, does that sort of shift now to down high single digit, down 10%. Is that -- can you give us a finer point on that? And guidance on inflation expectations remaining unchanged with the 232 partial REPREVE. Was there an offset to some of that goodness to keep the inflation guide intact?

Sure. Noah, I'll give you a little bit of insights on that, yes. So within the HCS volume guidance, it now is high single digits. We expect most of the balance of year growth to happen within the direct channel as you have a favorable comp year-over-year. On the direct channel, we expect balance of the year to be down kind of low single digits or so within the direct channel and the balance of the year. .

And then within the inflation, we still expect to be 5%. There's a little bit of benefit that we saw with the adjustment to the 232s, but then we continue to see inflation on commodities, fuel, memory, those mostly offset that benefit.

Okay. And then when we look at the two segments and the demand trends juxtaposed, I mean, really, it is seemingly a tale of 2 markets. is a little unusual to have such bifurcation. But can you talk a little bit about the drivers of the light commercial strength? You mentioned some nice wins. Clearly, national accounts, emergency replacement. But how much of this is sort of underlying versus Lennox share gains?

I think there is significant like share gain that I want to give credit to the team. As we build a new factory, we have focused a lot more on emergency replacement, and that's clearly playing out as we expected, maybe slightly better than we expected. At the same time, the extra capacity is helping us win back the national accounts. But also from an end market perspective, remember, this is the end market that was from data down continuously for like 17, 18 months in a row and now is finally turning around the corner. But I would say, among the improvement, a large portion is share gain and then there's definitely a benefit of the market not declining anymore and showing some signs of life.

And we will move next to Jeff Hammond with KeyBanc Capital Markets.

So just back, it looks like your HCS, you're bringing down 5 points on a core basis. Like is that just all sell-through demand weakness? Or is like this RNC walk away a bigger number? Or is there some other nuance in there? And then just my second one would be just repair, replace. A lot of people are saying like it's normalizing, exiting and this canister issue, and just what are you seeing there?

Sure. So the answer to first is it is all one-step. Two-step, we continue to see good growth, and we are forecasting like the lack of destocking leading to good growth in the second half as well. So but to said One-step the R&C loss is within the 1 step. So I think that's why those two numbers overlap. I would say the large part of the decline in Q2 and one-step was driven by RNC and that's a heavy quarter for RNC you know. And then even a reduction in the second half is primarily to that. Now we do see some underlying demand recovery that's been delayed. But we think from our perspective, the repair versus replace trend has stabilized. We see the channel confidence, which was impacted last year because of has returned fully. And we all know that the consumer confidence is sort of bouncing along based on the end of the pieces. But a short answer to your question, Jeff, is that a large portion of the one-step decline is residential new construction, low-margin business that we walked away from.

Yes. But I guess my question is, is that walkaway number bigger now than you thought? Or you knew that was there and your revisions really all underlying replacement weaker?

It is bigger than what we had originally looked at. That market remains extremely competitive and the margins were there were just not acceptable. So it was a little more than what we had originally thought and talked about.

And we will move next to Jeff Sprague with Vertical Research. .

I just wanted to get some insight into how to think about sort of margins for HCS into the back half. So we got some absorption issues, right, but we're walking away from lower-margin business. I guess you have some time for price to catch up a bit. So can you just give us some insight on how you think margins progress over the balance of the year in HCS, maybe relative to what we posted here in Q2 or relative to last year, certainly would be helpful.

Yes, Jeff, we expect the margin headwind year-over-year in the second half to be better than the first half, even after you adjust for some of the tariff refunds, mostly driven by the volume growth that we expect now up low single digits balance of the year to get to 35% incrementals on that. Also, we had a much heavier first half absorption headwind, and then we're going to pick up a point or two of price in the second half versus the first half, some of the new pricing initiatives that Alok mentioned in -- starting in July come in. So better margin performance in the second half as the volumes start to come back.

And, Jeff, to your earlier point, I want to add that our product mix is positive right now because of walking away from loss-making accounts. That's just masked by the other factors that Michael mentioned because of all the noise around absorption and the pieces. But the underlying mix is positive for us given our decision to not compete on those lower margin, negative margin accounts.

Is it overly optimistic to think that HTS margins are up on a year-over-year basis in the back half?

Well, you're going to get some headwind from the M&A that dilutive. -- price cost is a bit dilutive. That's the volumes accretive. So all of that still might lend to slightly negative.

So I think overall question is, we think it's pretty balanced, Jeff. We don't think it's optimistic, nor do we think it's super conservative. We're trying to put a very balanced picture forward.

Right. But something around sort of flattish to slightly down margins in the back half, I think, is what you're indicating if I read that right?

Yes. That's basically within the guide, that's approximately .

In a range, Jeff.

And what do you actually think industry volumes were in Q2?

The June AHRI data and everything else that we looked at continues to show us continued difference between sell-in and sell-through. That's obviously going to become a much longer conversation, Jeff. But we think the sell-in has obviously improved substantially, and we see that in our numbers. And I think the sell-through, we still have to get more data and see how everybody comes through. And I think that still remains under pressure.

And maybe last one. Do we still have a little bit more work to do on channel inventory as it relates to Lennox? And some related absorption headwinds from that in the back half?

No, I think we are pretty complete on that, Jeff. The tunnel inventory is pretty normalized and there's no more destocking.

And we will move next to Steve Volkmann with Jefferies.

Maybe just to put a sharp point on it, the one-step down 12%, are you willing to sort of say what you think the walkaway business was of that 12%?

No, we're not willing to kind of go into that level of account details of where it was, but we can just tell you the vast majority of that 12% was residential new construction.

Okay. All right. Worth a shot. Look, I think on previous calls, we've talked a little bit about sort of affordability and inflation in the end market. And maybe some demand destruction. And I think your view was that the most likely source of kind of give there was going to be in the installer margins. And I think that was 2 or 3 quarters ago, we had that conversation. So I'm curious if you're starting to see any sort of price normalization to the consumer that might sort of address this affordability issue.

We are, and I think there's obviously the problem is synonymous with the repair versus replays. So consumers -- when the demand destruction for equipment, they still have to repair it. And we do see movement there. I think our contractors are any more promotions. They're getting more aggressive. We are and although the manufacturers are running more consumer-based promotions to take this forward. So yes, I think we are all very aware of that. And both the channel and the manufacturers are doing our part to increase affordability and make sure promotional dollar can apply to consumer purchase.

And we will move next to Chris Snyder with Morgan Stanley.

I wanted to follow up on some of the HCS margin discussion. I guess if we adjust out $25 million from Q2 operating profit, it seems like it takes that 23.7 to like a 21.0. So maybe just like is that right? And then it seems like almost every year, segment margins declined sequentially into both Q3 and Q4. And I guess the question is like, should we be running sequential declines off that 21% number, I couldn't really follow all of the communication before.

Let me start by that saying we wanted to give you the tariff refund number for the sake of transparency, and that's how we are as a company. I don't think it's fair to exclude the tariff refunds as onetime because remember, our overall impact of tariff, pricing, all of that continues in the second half. A lot of our pricing actions are going into effective beginning of Q3. So when we gave you the numbers for sake of transparency, I don't think it's fair to take it out fully because pricing would have offset portions of that if it hadn't come through.

In the margin in Q2, Q3? Yes, there's a Q2 is typically the highest margin. But I think today and this year is not a normal environment. given lots of changes around pricing dynamics, tariff, inflation, Michael mentioned all those pieces. So we feel very comfortable for the full second half guide as we have given, but it's difficult to break it down between Q3 and Q4 at this stage for you guys.

I appreciate that. And I wasn't really commenting on whether or not it's appropriate to leave it in the EPS. I would just kind of more trying to figure out what like the true underlying margin was in Q2 we build into the back half. Like so is it fair to run the declines off the 23.7 or the 21.0, if that question makes sense?

Yes, I would focus more on just our guide points that we expect volume second half to be up low single digits. You get 35% incrementals on that, price cost neutral, more price coming in. I think that's what I would focus on the second half, and that's what we're focused on delivering.

I appreciate that. And then if I could also just follow up on the second half. It seems to me like you guys are calling for HCS revenue in Q3, just -- to be mid- to high single digits above Q2. So is that right? And I guess the question I have is, I think the only year where HCS the revenue increased sequentially into Q3 was Q3 '24, which was, of course, the start of the refrigerant build. So I would just kind of want to make sure I have that sequential top line movement right on HCS.

We don't give quarterly guidance, what I'll say is keep looking back to the second half that we expect Q3 year-over-year better than the Q2 year-over-year, and Q4 year-over-year better than Q3. So we continue to see improve year-over-year as we go through the balance of the year with volumes up low single digits balance of the year, mostly around the indirect channel.

And we'll move next to Nicole DeBlase with Deutsche Bank.

I just have a few nitpicky ones since we've been through a lot in Q&A already. I guess, first, under absorption, I feel like you guys were kind of implying that you had seen most of that headwind in the first half, but that maybe there could be a little bit in the second half. Can you just give us a sense if under absorption is still a headwind in the second half?

Yes. There's a small headwind within the guide now. We reduced some of that cost productivity for that additional absorption, mostly related to now that we have lower sales volumes, we still want to hit our inventory reduction targets within the free cash flow. So a little bit of absorption headwind went into the second half in our new guidance.

Okay. Understood. And then BCS, the incrementals here have obviously been pretty good, high 20s in the first half. Are you guys expecting that high 20s to kind of continue in the second half within your guidance framework?

Overall, we continue to see volume growth there, get 35% incremental. So we're focused on price cost neutral within that side of the business as well.

Yes. We're very pleased with BCS performance. I mean the three businesses within BCS. The services business, the repatriation business and the rooftop business all continue to do very well. And that's a -- as a result of great execution and good supporting market dynamic. So we believe that we are now at the cusp of HCS reaching similar performance as we turn around the corner on market dynamics.

And we will move next to Nigel Coe with Wolfe.

Look, definitely mentioning BCS was fantastic. But I understand the there's a lot of focus here on HCS. I just want to make sure I understand the moving pieces on the guide change for HCS. The plus 1% now includes the acquisition of Heat Controller. So did I hear right that 2 points to HCS. So now we have about 4 points M&A coming in there, so the core is down 3%. Is that right?

That's correct. So within the guide, yes, you picked up 2 points within M&A for the HCS revenue guidance and then you lost 5 for volume. So you went from 4 positive to 1 positive.

Okay. Okay. And there's a bit more M&A. Okay. Great. And then look, just taking a step back, you've had a very transparent strategy of high-grading the customer base, firing lower-margin customers. pushing price. Where are we in that process? Are we more or less complete in that process at this point? Or is there still some ways to go? And maybe, Mike, could you just maybe just clarify, is there any more IP refunds in the second half guide?

Sure. Let me take the first one. I would say we are nearly complete on the lower margin. And some of it was just driven by highly competitive RFP processes where we didn't want to go into negative margins. But at this stage, like some of that volume went to be faster than we thought. And our offsetting growth in the AOR side is coming through just a little slower than we expected. I think that's what you're seeing in Q2. I think the perfect storm. We lost the R&C business a little sooner and the share gain in slower than we expected. But net-net, we feel good about where we are to protect our margins and make smart business choices. So we don't fall victim of taking $100 bills to every unit that is being shipped out to some of these accounts. So we don't want to do that again. We have done that in the past. So we feel good about where we are, and I'll let Michael answer the IEPA question.

So on the refunds, we recognized 100% of our expected refunds that we think we can -- that were entitled to within the quarter. And we've also received a lot of the cash flow already related to the gain on those refunds.

And we will move next to Deane Dray with RBC Capital Markets.

To circle back on the walk away business, but just to be really interested in hearing look, did you change your return requirements this quarter in any way? And I would suspect not, but just maybe some color there in terms of how much of the price competition surprised you?

Yes. No, we didn't change our return requirements, Deane. I think our return requirements have been pretty steady over the past 4 to 5 years. So -- and yes, I was surprised by the price competition in the financial new construction. At the end of the day, our focus is going to remain on our value replacement customers, our valued new construction customers where there's appreciation for the value that we provide versus commodity type business. So I think we feel good about where we are. But we do understand is short-term repercussions for that, and we're going to work through that and appropriately adjust our cost structure and our sales force accordingly.

Good. That's helpful. And then it sounds like there was some good news on the emergency replacement business and the reentry there and have you gained share? Any update would be helpful.

Yes, we have definitely gained share within emergency replacement, our core contractor business in commercial, our residential dealers and working through distribution, all three have gained, and we are pleased with the progress there. The new factory is doing very well. And the freed up capacity in Stargard is also helping us strengthen and gain share in the key account business. So we feel good about that strategy, and the results there are as you can see in the P&L and otherwise, just working out as we expected, maybe slightly better than we expected.

And we will move next to Brett Linzey with Mizuho.

Just a follow-up on the emergency replacement there. So you called it out as a growth driver. It sounds like you're taking some share. I guess from a margin perspective, historically, I know ER was above segment margins. Where are we in that ramp process? Is it accretive to segment margins now? Or do you still need more scale and uptake in that business? Any thoughts on the future profitability there?

Yes. Overall, it's attractive business. The margins are in line with some of our large national account business. We like that business, and we have opportunities to continue to expand those margins as we work on our distribution excellence within that channel. So it's a really good business. And many years of growth opportunities still in front of us.

Yes. And I don't remember it being better than the segment average, but we've always said it's kind of in line with segment averages.

Okay. No, that's helpful. And then on the tariff mitigation, it sounds like you shifted some resources there, which did delay some of the material cost reduction initiatives and led to that productivity cut. When do you think those deferred cost-out initiatives resume? And are they volume dependent, and that's really the driver of that? Or is it just timing and maybe there's an opportunity to recapture some of that $15 million here in the coming months and quarters?

It's mostly timing dependent. I mean there's obviously a small, small element of value, but it's mostly timing dependent as we move resources. I wish I could tell you that we can get all in 2027. And we will -- if there are no more changes to the tariff and the tariff rules. The continuous evolution of tariff rules and tariff changes and Mexico and Canada and -- just that's taken up a lot of my engineering and other resources to mitigate that. But assuming a stable thing, we'll get it all next year.

Since there are no further questions, this will conclude Lennox's 2026 Second Quarter Earnings Call. You may disconnect your line.

All right. Why don't we get started? Thanks for coming, everyone. This is the Lennox presentation. I'm Ryan Merkel. I cover building products at William Blair.

Before we begin, I need to remind you that a complete list of disclosures and conflicts of interest is available on our website. With us today is Alok Maskara. He's the CEO of Lennox.

Lennox manufactures and distributes residential and light commercial HVAC equipment. Products include air conditioners, furnaces, heat pumps and controls. Lennox has a long history of share gains and margin expansion driven by investments in products, distribution and technology.

I'm going to turn it over to Alok. He's going to do about 5 minutes or so, and then we're going to do a fireside chat format.

Great.

Thanks, Ryan. Thank you for having us here. As Ryan said, I'm Alok Maskara. I'm the CEO of Lennox. I've been with Lennox 4 years. I'm going to go through a few slides and then get into the fireside and Q&A mode. As a Lennox publicly traded company, we made it into S&P 500 a couple of years ago. A few things I'm going to highlight on our financials. First is our ROIC. At 36%, our ROIC is one of the highest in the industrial world and definitely highest in the HVAC industry, shows you we are very good stewards of capital, 130-year history of the company. I'm only the eighth CEO. So this is a company that's very well run over an extended period of time.

On commercial side of the business, 38% of our revenue now come from BCS or commercial, and that is now paralleled and got better in profitability compared to our residential business. So it's been a big turnaround story. The other thing I'm going to highlight on this page is 80% of our revenue comes from replacement, 20% comes from new construction, whether that's residential or commercial. What makes us different, although we are a smaller player in the residential industry is, as Ryan said, we own 70% of our own distribution. So we have the largest manufacturing direct dealer base. So when we sell to a contractor under the Lennox brand, they will buy it from our 250 stores that are spread all over the U.S., and we would not go through a distributor. On the commercial side, we focus on light commercial, and we do everything.

We install the equipment, we do preventive maintenance for the equipment. We recycle the equipment. And of course, we manufacture and sell the equipment. So a complete full life cycle solution for our commercial customers, which are typically large national accounts. The other thing that differentiates us is our digital data platforms. Because we have been organic growth, we have really good data lakes. We have really good data. And for example, in our commercial and residential, over half of our business is done directly through our web platform. In residential, nearly half of all our orders come through LennoxPros, which is our own platform. We recently had an Investor Day in March, and we unveiled our 2026 to 2030 transformation plan after a very successful previous Investor Day where we met all the targets that we have laid out.

I will highlight some of the 4 growth initiatives that are focused behind what we unveiled in Investor Day. The 4 things are heat pumps. We are undersized in heat pumps right now, and we want to grow more and have a very credible plan to go and do that. Emergency replacement, which is a huge commercial growth initiative for us is going to deliver a significant amount of revenue and margin expansion as we use our direct-to-contractor channel to win in that. Attachment rate, which is where we have done 2 recent acquisitions, one on service side and one on parts side.

And finally, expanding our total addressable market, which we are doing through joint ventures, joint ventures such as Samsung joint venture and the Ariston joint venture, one in mini splits, one in water heaters. Along with that, we're expanding our margins through expanding our distribution profitability because our distribution still is a breakeven business at best, continue to win the pricing and mix battle and finally, getting back to productivity after 2 to 3 years distraction driven by regulatory changes and other factors. Net-net, we are confident that when we get to 2030, we will get to a revenue base between $6.5 billion to $7.5 billion organically, expand our margins.

Currently, we are at 20.4% to 22% to 23% and continue converting 90-plus percent of our income into cash as we'll be through our recent investment cycles, which were around new factory distribution and into a new innovation center. So delighted to be here, remain confident in our future and would be happy to flip it over to talk about how the 5 things that we always talk about, which is why we are confident in our future is we will deliver growth acceleration. We'll continue expanding our resilient margins. We will continue to show execution consistency. We are known for this. We do it very well, while we invest in advanced technology. And everything we do is because of our talent and our culture. So this remains our framework that we will take forward for the next few years.

Thank you.

Great. Thanks for that, Alok. Why don't we start with a question on the macro. Can you talk about the HVAC demand backdrop? And what are you hearing from contractors in the field?

The contractors in the field, they lost confidence last year because of canister shortage, [ R54B, ] which is new product, required some extra step. They are back being confident. So their confidence is back. So I think that's the positive piece. At the same time, the consumer confidence is not back. So if you think about where we are in the consumer confidence cycle, that's not back. So contractors are back in the field. They are pitching replacement as they normally would have done. And we feel like the destocking is now 100% behind us. Remember, last year, a lot of the impact we saw was due to destocking.

So we feel good about getting into this year and maintain where we think we shake out this year would be not as good as what we had in '23, '24, but not as bad as we back had in the worst year in the HVAC recent history was '25. So we look at we are going back towards normalization.

That's great. And a second question on price inflation. Just talk about what you're seeing in resi and commercial. And then there was a headline yesterday, Alok, with some changes on some tariffs. I don't know if you have any early thoughts on that.

I think the recent tariff changes on Section 232, that puts us back on a better competitive field. Folks who are manufacturing in Mexico, we were disadvantaged. Now remember, we do manufacture a lot in U.S. as well. So we're not solely dependent on Mexico manufacturing. But that now puts us back in a better competitive position. So we welcome that news. That's good for us. Price seems to be sticking just fine. We haven't seen any changes in competitive behavior. It still remains the case where they have 5 manufacturers, 5.5 manufacturers. There's 1,000 distributors and 10,000 contractors, and that industry dynamics continues to favor good pricing discipline going forward.

Mix is mostly all R454B at this stage. The recent regulatory changes or announcements really doesn't impact that too, and we think that's going to continue going forward. So our stance on overall is slightly better after the news 2 days ago, but it doesn't change our outlook and just gets us back into a better competitive playing field.

And then you mentioned the destock is 100% behind you. That was my next question. But maybe just talk about 1 step versus 2 step, where that change happened? And then what is -- now that it's the destock is behind you, what does that mean? Does that mean production can start increasing again in the second half?

Yes. So the destocking, both for us internally, externally in the one step, which is contractors who fill their barns with products and distributors who fill their warehouses with product, we are back to more normal level. I think people had done that in '24, getting ready for the transition with R54B. Some people did that to beat the price increases. But that's now behind us. Hopefully, we don't have to talk about it at all. Internally also, we are now at a better inventory position, which means starting Q3, what we sell versus what we make will be more in a balanced situation. In Q1 and Q2, we have absorption impact because we are manufacturing less than we manufactured last year as we work through inventory normalization.

So starting second half will be in a better spot. And we have baked all this in our forecast. We have publicly talked about the dollar impact of the under-absorption. But it's just good to put that behind us. What we are now focused solely on is consumer confidence and helping our dealers convincing that consumer to say, hey, a new replacement product gives you better warranty, better financing, better energy efficiency, better air quality. It's better for the environment. So let's work towards that sale.

And then zeroing in on the residential market, just talk about what the guidance assumes this year and what's important for investors to know about the residential market this year?

Sure. What the guidance assumes is some of the known dynamics such as dealer confidence coming back is baked in. Some of the known dynamics around destocking getting over in Q2, which at this stage, it is over is baked in. We did not bake in any recovery in new home construction. We did not bake in any major change in consumer confidence. And that's a hard one, right? Nobody knows exactly where we are. We didn't bake in it getting worse. We didn't bake it in getting any better. We did bake in our share decline in new home construction.

As you know, we walked away from lower-margin accounts in new home construction. That's baked in on the residential side. So think of it as we didn't bake in any massive recovery into 2025. If that happens, that will be a surprise and positive. At the same time, the unknown remains little impact of weather and a little unknown impact of consumer confidence. But at this stage, where we are, we feel like we are very appropriately positioned to end the year on a good note. But June is the largest month for us in the year. So it's hard to sit here on the second or third day of June and proclaim anything different.

And then I mentioned it, but you have a long history of share gains. What can you tell the room about what's different about Lennox and why you take market share?

Sure. So I'll tell you, first, we'll acknowledge that our history of share gain continued until 2018 and so and then a tornado hit our Marshalltown factory. Since then until 2023 or so, we actually lost share. So I think we should acknowledge the 5-year period during which we lost share and didn't gain. Since then, when we were back to the share gain mode, the way it works for us is our single largest differentiating factor is our contractor base who buys directly from us versus going through a distributor. That gives them significant advantage. One is that they can reach out to us directly for technical support. They can reach out to us directly for warranty.

They like working directly with the manufacturer, so we get them better training, thing. When we were short on commercial products because of manufacturing difficulty, they sort of lost some ground and now they are getting back in with both residential and commercial products, especially focused on emergency replacement. Our products are really, really good. They are the quietest product. We deliver one of the best warranty support with 10-year warranty on our Elite products. And we really give them the good, better, best through Merit, Elite and Signature Series products. In Signature Series, which is our premium product, they make more money than they make on any product in the HVAC industry.

So end of the day, our contractors, which are the largest single source of the competitive differentiator, they are what causes Lennox to gain share. We are adding more contractors continuously and watching our churn rate and that we do through Net Promoter Score, measuring our fill rate and continuously having a sales team that goes on and adds more contractor.

Now that our portfolio is full with commercial back in availability, with Samsung giving us the mini split to fight against leaders such as Mitsubishi and Ariston bringing the water heater, it's becoming easier for us to flip dealers into the Lennox family. So everything that caused us to win in the past is back with a full portfolio. So we remain very optimistic about the future.

Yes. That's great to hear. Shifting to commercial, talk about the outlook for commercial this year. And why is commercial going to outgrow residential this year?

I think commercial after 14 straight months of decline as an industry grew for the past 2 years. So while residential is in a spot where commercial was last year, we were wondering when the industry is going to turn. We know now it's turning. A few reasons for the turn, right? With current electricity pricing and the new equipment, which actually brings energy efficiency and changes the payback period, key accounts are finally getting to a stage where we talked about deferred demand or average age of rooftops on a big DIY store, they are finally coming through and the industry is turning and these products do bring the payback period down to 3 years versus 4 years historically. So that's been very positive for us.

Second thing on commercial for us specifically is we are gaining share. And that's because of our availability. We have deployed inventory all over U.S. We have now convinced our contractors that they can trust us to get them the product delivery that we could not for the past many years. Both our factories are running very well. And our new commercial heat pump products are getting very good reviews from large national accounts and helping us to flip some of the losses that we have back from 2018 to 2023. Our full life cycle value proposition with the AES acquisition, where we can go to a large account and say, we'll do the whole thing. We will recycle your units, which is a big deal to them. We will give you a preventive maintenance contract through our own employees, not an outsource.

We will install them for you, and we will give you energy saving overall in the package. That's working very well for us. That's resonating with our key accounts. So we are bullish on the industry after 14, 15 months of decline. We are bullish on our prospect. And I think the whole picture together is working very well for us. I think residential will be in a similar shape next year. I know this year is still going to be -- we're already in June and the weather, the consumer confidence, all of that is still TBD. So we could be in '26, but I feel confident by '27, we'll be in a similar situation in residential as well.

And commercial had really strong results in the first quarter. So...

Q1 was the first time where commercial made more money than residential. I actually tell them it's because residential made less than they should have. I think commercial made the right amount. Resi just made less. So that's the way we want to change it.

And sticking with commercial, just to explain for the group because there might be some new people here. You kind of have almost 3 businesses within that. So talk about the go-to-market there.

Sure. So in commercial, we have 3 businesses. One is a standard rooftop equipment business. That's where we compete heavily with other light commercial players such as Trane, AAON, Carrier, Goodman. Second business for us is a service business, often not well known, where we have about 800 Lennox trucks with Lennox employees that go around doing preventive maintenance. That's a growth business that's growing consistently. We are adding more branches and more technicians and we train our own technicians through a build a technician program that's unique to the industry.

Our third business is a refrigeration business where we are the market leaders in refrigeration when it comes to cold storage, refrigeration when it comes to supermarkets, refrigeration when it comes into any 7-Elevens or gas stations that have a walk-in beer freezer. So think of any of those things. That's where our technology is very, very well known. That applies in fast food as well. We make the core cooling element for refrigeration in that. It's known as Heatcraft. Together, that business is a very attractive portfolio. What we don't have in that business is heavy commercial. That's where a lot of the questions come in from, but that's the one we don't have. Otherwise, we're very pleased with our commercial portfolio.

And then switching gears here. You've been at Lennox now since 2022. Talk about when you joined, what were your top priorities and then update us on your progress?

Sure. I was thinking about this. My first conference when I joined as the CEO was this conference. So thank you, Ryan. And I was sitting here and we said, our first priority is $100 million extra EBIT from the commercial business. So we're glad to report that we are way beyond that. We have delivered actually 2 to 3x that much in extra EBIT by turning around the commercial business because we were just not focused, right? So second, we talked about, which we made good progress is our distribution business was not taken as a business. It was taken as we are a manufacturing company and just have distribution attached to it.

We have made significant investment in turning around the distribution, and we still have a lot of room to go. The results are not there yet. So on commercial, we worked on it. The results are here and a lot more growth is yet to come because the factory just started production last year. On residential, on the distribution, we have made changes. We have got the digital infrastructure. We are going to a hub-and-spoke system that went live this year in February, still being rolled out across U.S. A lot of results from that are yet to come. And it's hard to work through that when you're in a down market. People are so focused on the down market. You missed the benefit of some of the upswing on the residential side.

Third priority for us that time we talked about was just succession planning and talent, and that's been working very well. We have changed quite a few things in our culture to make it a lot more focused on customer experience. Customer experience, not as a manufacturer, but customer experience as a distributor because the reason distributors exist is they do a better job running hotshot trucks, better job getting the product data, better job making 99% availability, which manufacturers don't do. So that's the third aspect is still work in progress. At that point, we were filling at about 75%, 78%. Today, we are filling at 90%, 91%. We need to fill at 98%, don't get me wrong. So we still have a long journey to go, but we are working through all of that.

So we feel like the strategy has been working. I would tell you the thing that's not working for us, a, is the residential market; and b, the amount of time it took us to retool our distribution network. I think that was slower than I thought it would be.

And then you mentioned in the Investor Day. For me, the heat pumps, the water heaters, the ductless were some of the big new things you were talking about. Just expand on that a little bit.

Sure. I think we historically grew up as a furnace company, riveted furnaces in Marshalltown, Iowa is our history. I would say we were in denial about the heat pump trend, right? We didn't invest in the heat pump trend. We did not get focused on market share in Florida. When we divested the European business, we said, hey, if we could just all travel to Florida and gain share in Florida, we would do better than having these businesses in Europe. Heat pumps are a critical portion, and now we have embraced it fully. We have completed a full portfolio. So our portfolio in heat pump was not complete.

We didn't have good mini splits. We got that through Samsung. But more importantly, we didn't have the full range of different SEER rating. We didn't qualify for rebates in Massachusetts with our heat pumps. We did not have indoor units that fit in Florida. Now we have the full portfolio of heat pumps that I don't think we internally appreciate and externally folks still don't appreciate that we could not install a heat pump in a cabinet in Florida because typically in a closet in a condo, we just didn't have the product. That product range is going to pay for us significantly over the next multiple years in share gain. And our heat pumps today get only 15% to 18% of our sales. That should be twice as much. And that's going to contribute a lot towards our growth going forward. All the investments are now made and the results are yet to come, including on the Samsung side.

And you mentioned the culture and more focus on customer service, and that came up at the Investor Day as well. So maybe just a couple more examples of what you're doing there and what some of the feedback and data that you've had back on that has been?

Yes. I think that is some part of it being a legacy really good company with very loyal dealer base. We just got complacent. So we first had to accept that we got complacent and then talk about a set of metrics. So we start with what's called a customer charter. Every business has a charter. A lot of the metrics are internal only, but we publish those metrics externally. So if you go to a Lennox dealer conference, we show them, here's the commitment that we are making to you. We want to return all warranty claims within x days. We want to pick up the phone within 30 seconds. We want to acknowledge any defects immediately. We want to make sure our fulfillment rate is at 95% for A items, 90% for B items. We are going to commit to you that we are going to have a salesperson visit you once a week. I'm going down the list, but that charter we publish and then we measure internally and publish that externally. And that's not necessary and required.

And then we use Net Promoter Score in addition to all of that, to measure progress. Each business unit leader sits and discusses the Net Promoter Score with me personally every month. We look at fill rate every week on each of those things. Things that a good distributor would do, a good manufacturer does not because manufacturing, we are still measuring PPM and on-time delivery, but that doesn't matter as a distributor. What matters to distributors is what a contractor fails. So that's a cultural shift. We have had to change quite a bit for that. We had to put in like advanced shipping notification software. We had to change our warehouse management system. We are changing all our telephony system. We have changed our POS system in our 250 stores.

We are changing how we organize our store for parts. There's probably a much, much bigger change than you can imagine. Every business had to get a new customer service leader who really gets measured on how fast you pick up the phone. I mean those kind of things, if you walk into, which I think, some of you are team, into our residential building, there's a 3 big screen that shows you live metrics of are we picking the phone on time or not and green and red. So every employee walking through can see, oh, we are not meeting our metrics. We are red right now. That's a big cultural change that's going on. And I think the results are yet to come on that. I'm super excited about the direction we are going, but it required a lot of changes and still a lot more to come.

Yes. That's great. I want to ask about the convergence of air and water. And just talk about what that means for you. And I know some regulations out in '29 are important to that.

So I think the way we look at it is from a contractor perspective backwards. So we start with a contractor. I said earlier, they are our largest asset, not on our balance sheet. 50% of them sell water heaters today. 10 years ago, 5% of them sold water heaters. So we just have to acknowledge that, right? So if you do the survey every 3 years, you can see the trend. And we do -- by the way, we survey them every year. This is a longer survey that we run. 50% of them sell water heaters. And the reason they do that is multiple. One is in spring and fall, they're looking to fill their portfolio. Second, as many of them have become more professional, either through private equity and other ownership, they're trying to be home services focused versus just HVAC focused.

Third is it helps them from a recurring revenue perspective. It's much easier for them to sell a service contract that includes a water heater maintenance versus just changing the filter. So I'm going to tune your furnace. I'm going to also take a little water heater, flush them if it's needed, pull that all together. Finally, on the technology side, as water heaters become more heat pump water heaters, the traditional plumber is punching out. They don't want to program. They don't know how to program this heat pump. They don't understand the installation difficulty. They are used to cutting pipes and resoldering pipes. They don't get this whole new system that's been put in with a massive control. That's where the HVAC folks are stepping in.

They already have a plumber on staff. They already have an electrician on staff. They've been installing heat pump for a decade now. So they have this thing going on. So that all coming together is why we strongly believe that air heating and water heating is converging and converging rapidly. In 2029, when the new regulation goes into effect, where every water heater above 35 gallon must have a heat pump, that's going to be a step change in that. In future, when you go to a 0 GWP, so natural refrigerant, you're going to have one condenser outside your home. That's going to feed both your water heater and your air cooling system. Now we're not there yet. In Europe, we are getting there faster. But in the U.S., we are going to get there as well. So if anybody doesn't believe the air water convergence, that's ultimate test. You see that in our lab. If you walk AHRI show, every European player has that in their booth because it happened in Europe, and it's going to happen in U.S. It's just a matter of time. So we believe in that.

Our Ariston partnership is a great way to play into that. And our water heater launch has gone better than our expectation.

Great. We just have 2 minutes left. And this last question Alok is just for a bit of fun. So if we're sitting here a year from now and the stock price has worked, it's much higher than it is now, what are the 1 or 2 things that the market is currently underestimating about your business?

This is where -- when you are in a downturn, everybody thinks the downturn is going to last forever. So I think first thing they're underestimating is how long will this -- overestimating how long will this downturn last. Resi HVAC industry has never had more than a 6-quarter decline, and we are approaching -- this will be the fifth quarter, will be 6-quarter decline. So I think that will be the one.

Second thing is like I think we underestimate our commercial business. If you think about -- and I was kidding with one of the analysts, I'm like, what have most people got wrong about Lennox over the past multiple years because the stock has -- when I joined was $200. It sucks when it went down from $690 to $500. So we -- I hate it. But it's up substantially. And the biggest thing we missed is the commercial piece. We get the resi moniker attached to our stock. But commercial is a really good portion of our business, a big strength. So those 2 things will be resi recovery and the commercial strength that we have today.

And then maybe I'll just finish with data centers. It's a small percent of the portfolio today, but at the Investor Day, you mentioned some opportunities. What are those opportunities?

Listen, I mean, first of all, we don't play in hypes. So we're not going to get the data center hype. The way we look at it is the data center cooling technology is going to continue evolving. The current cooling technology is mostly based on chillers that we don't make. So we're not playing. We are sitting out of that, right? That's mostly air. The next generation is liquid. So we start getting some opportunities when it goes to liquid cooling because that's now based on compressors versus air chillers, right? The third-generation technology is most likely going to be a refrigerant direct on 2-phase flow, which everybody is talking about or it could be immersion. I don't think it's immersion, but that's up to time to talk. Once it gets to the refrigerant direct 2-phase technology, we have a credible opportunity to play in there.

Our refrigerant business is a market leader in that space. We are putting in a significant amount of investment to be ready for that, to be able to show our customers and start testing and creating digital twins and having dialogue with multiple people on that, right? So that comes down to, a, us being right about the technology evolution because technology is shifting very fast; and b, being ready for the transition when that happens. But today, we don't have a product.

All right. We're out of time. Thanks, everyone. Thanks, Alok. That was great. Appreciate it.

Thanks.

Well, good morning, everyone, and welcome back to Day 3 of Oppenheimer's 21st Annual Industrial Growth Conference. Noah Kaye, Managing Director in Oppenheimer's Industrial Innovation Research Practice. We're very happy to welcome back to the conference the management team of Lennox: CEO, Alok Maskara and CFO, Michael Quenzer. Gentlemen, welcome to you both. Thank you so much for what promises to be a great discussion today.

Thank you, Noah, for having us. Excited to be here and share our story.

You had a, I think, a very in-depth Investor Day, which we attended a few months ago, and you really laid out a comprehensive view of the business through the end of the decade. You talked about a $500 million revenue growth target from new initiatives by 2030. We estimated that, that represented just over 1/4 of the opportunities you laid out across parts and accessories, emergency replacement, ducted and ductless heat pumps. And you talked, I think, about a point of growth this year from those initiatives on your earnings call. So I guess the question here is really which of these growth initiatives do you anticipate hitting their targets earliest, which might take more time to play out? And where do you think you've left the most room for upside over the medium term?

Sure. I think from our perspective, just as a reminder, one point was total growth impact this year, so roughly about $50 million is what we baked in into the plan across all 4 initiatives. Over the next 3, 4 years, each of them accelerate. So towards the end of the planning period, we feel very comfortable with the $500 million number. So think of it as $50 million this year, over $100 million next year and then it keeps rapidly going up.

We like all 4 of them. I'll tell you the largest opportunity for us is in what I would call the attachment rate, attachment rate for parts, supplies, services, those are the areas where we have made the 2 acquisitions so far, and we continue to feel we are well positioned to win. We have a right to get more attachment rate given our 250 distribution outlets, given how loyal our dealers are. We just haven't made it easy for them to buy those products from us. So that's where we think the largest opportunity for us is going to be.

Other things such as the JV with Samsung and Ariston, they are also both very important to us. And I think that's going to be taking a little longer to play out because our market share is so low and market share takes a long period to shift. In the short term, to answer your question, Noah, emergency replacement is the one that we are seeing the most traction and will likely have the most impact in 2026 itself because we started on that journey 2 years ago with a new factory. We built our sales and distribution position last year, and this is the year we are kind of fully loaded, ready to go forward. So that's going to have the most short-term impact to us is emergency replacement.

That's very helpful. Maybe to put a finer point on the initiative with Samsung and Ariston. You mentioned solid momentum in the first quarter. So I'm curious what solid momentum means for you and your partners in the context of what was a seasonally softer quarter for volumes. How we think about both of those initiatives, at least ramping through the balance of this year?

Sure. First of all, I think in a low quarter, percentages look very good, right? So from that perspective, that's momentum. But that's not what we meant when we said good momentum. What we meant is for us to succeed in the summer season, we need to be prepared by March, April. And we are prepared versus last year, we were not ready for things like Samsung. We didn't get full inventory position until like June, July when we had missed the selling season last year. So that's the momentum we're talking about. Number of dealer sign-ups, number of dealers who have tried and tested the product and are ready to go.

Same on the water heater. We have got warehouses now that have appropriate inventory. We are ready for the summer season. On Samsung, just to go back to it, last year was a very soft year because products was not there, 410A conversion, we were selling through the old inventory. And this year, we've had a good solid start to a good selling season, what we hope stands out in Q2 and Q3. But we're optimistic on both. Our market share in water heater clearly 0. So that's an easy one for us to look at and saying, hey, we're going to build up good market share position going forward. On Ductless, if it's 10% of the market, it's way less than 10% of our sales, right? I mean we are probably 5x underweight in that. So I think over the next 5, 10 years, we'll get that.

Yes. And can you talk a little bit about the preparation of the channel? I mean it's one thing to get inventory into the right hands. It's another thing to kind of arm your dealers and your customers really with the information they need to go out and win the business, win the market share. So can you just talk a little bit about the training initiatives that accompany the rollout?

Sure. So first of all, we continue to invest heavily in training. Right now, we have about 14 different residential training centers. We have a couple of commercial, and we are opening a new commercial one here in Dallas, close to our headquarters as well. So that continues to be an area of investment. And I should mention that a lot of training we do now is online as well. So while the physical centers are very important, the online content is very important, too.

So for the Samsung product and for the Ariston, we have set up a whole separate team that focuses on just getting our dealers trained on it, answering technical questions through that, giving them the tech support and giving them the value proposition training. So for example, the Samsung products, they work very well with the Lennox Home app on your phone. They are integrated together. We have the same kind of value offering in terms of loyalty rebates, loyalty programs, freight programs that come with our unitary product, and they can call the same tech support number and to be able to connect and work with the tech support. So we try and make it very easy for our dealers to work with us. And the consumers, they love the connectivity of the Samsung products. They love the industrial design of that and how quiet that is, which, as you know, is Lennox's value proposition as well. So we try and match that together.

On the water heater, something similar. Besides all the loyalty factors I mentioned, this too works with the Lennox Home Comfort app. And what we try and train our dealers to is when you're down in the utility room, whether it's in the basement or attic and you're there to change the filter and do the service call, take a look at the water heater. Is it 10 years old? Is it about to leak? Give them a value proposition to give them a promotion to say, hey, I can send somebody to change it. And by the way, the new one will be more energy efficient. You might get some heat pump rebate. And it's actually digitally connected. Not that many water heaters are digitally connected. So that's the training we have gone through it. So we are locked and loaded for the selling season.

It's great color. Obviously, there is a potential for more convergence between the heating and cooling and the water heater industries based off of where regulations are going, but also just based off of labor scarcity and a fair amount of overlap, frankly, in terms of functionality in the field. This is something that I used to do with my family business. And so I guess as we see that labor scarcity playing out in the value proposition here, where do you think that the cross-sell can eventually get to on water heaters for your business today? I know it's 0 today, but where do you think you can get to over, say, 5 to 10 years?

I'll tell you some historical data on this, just from the industry, not from us, then I'll answer your question. We do surveys every 3 to 4 years with our dealer base. The most recent survey, which we did by 2025 showed that 50% of our dealers are selling water heaters now, 5-0. I mean it's a big number. If I go back a decade, so let's say, 12 years ago, [indiscernible] the number was like 15% to 20%. So that number has gone up 3x on the number of folks who are actually actively selling water heaters. And that's true when we hold Lennox Live, our own internal dealer conference. The water heater booth was crowded. There was constant traffic there. We had to, in fact, put more people there because we underestimated the demand there.

Now take it forward, I think a decade from now, probably 70%, 80% of our dealers are going to be doing water heaters. It is about labor scarcity. It is also about labor utilization in the non-peak season. So if you look at summer and winter, our dealers are busy. Spring and fall, they're running promotions on water heaters and service calls, which they can do together. It's obviously less labor-intensive to change a water heater versus to install an air conditioning, but they both require a plumbers license and electrical license often. So I think there's a lot of synergies there.

Technology-wise, the heat pump portion of this makes it much more conducive for an HVAC person to install it versus a traditional plumber. The traditional plumber wants to do nothing to do with electronic controls, does not want to program the heat pump, does not want to get trained on it versus HVAC guys have been dealing with heat pump for over a decade.

Finally, the technology convergence, Europe being the extreme example where you have one unit, which is doing hot water boiling and your home heating, there is technology convergence happening. Once we go to natural refrigerant, there's high chances there will be one unit that's going to be both heating your home and heating the hot water for your home. So I think we are early in the convergence journey, but we believe in that. We believe it's coming, and we are delighted that we'll be prepared with our partnership.

It's a great look into what's coming next. I guess going back to your long-term targets, you had an industry volume outlook for resi of 1% to 3% CAGR. And I understand wanting to sort of be prudent here given what happened last year, but it seem conservative to us, again, given that 2025 base. We've seen you already reduce exposure to margin-dilutive corners of the market, such as in residential new construction. I guess the question is, if demand winds up being stronger than that 1% to 3% CAGR you talked about, how does that impact your approach? Do you use that to further refine your exposure to particular end markets? Do you just sort of ride the wave of growth?

Yes. We definitely want to ride the wave of growth. We want to be fully prepared. We want to make sure we have enough production capacity, enough distribution footprint, enough stock in all open market. Listen, I'm glad you found it conservative. That was the intent. What we didn't want to do is defend market growth during Investor Day. We wanted all the focus to be on Lennox differentiated growth initiative. You will make your own market growth assumption anyway, Noah. So why try and come up with a number that you might think is aggressive. So we want to just take that off the table and say, yes, we're going to give you a number that nobody would say you have been too aggressive. And let's talk about the Lennox growth initiative.

Going back to the lower profitability corners of the market, that's a bit of a short-term phenomenon, right? I mean when you make no margin, we don't want to sell into it. But these things go into RFPs every 2 years, sometimes even every year. So I think as those large accounts get experienced working with somebody else and see our differentiated value proposition, I'm optimistic that they will see the value of our value proposition, and they will look at why it is better to work with us even if we are a penny more expensive. So I think that's kind of where we are going to focus on.

We provide better service. We are manufacturer direct. We provide better support. And honestly, we train the dealers and spend a lot of money training those dealers. So from that perspective, I remain convinced that we have a stronger value proposition. And I feel confident that, if not all, many of those customers will realize that and will give us an opportunity again.

And so you would intend to rebid for the next round of RFPs, but with terms that are more attractive to you?

Yes. We'll stick to our margin discipline, but yes, we will.

Very helpful. What about for BCS? You laid out these vectors for secular market outperformance. You talked about the emergency replacement traction, which we're already seeing this year. And then the parts and service attach rate. And 1Q, again, healthy initial proof point. And you're guiding to substantially stronger performance versus peers in light commercial this year. So does that magnitude of outperformance hold if broader industry volumes continue to exceed expectations for the year?

Sure. Michael, do you want to start on that?

Sure. Yes. So we're really pleased with the start of the year within that segment. We had a little bit of an easier comp last year, so some of our performance. But overall, as you mentioned, there's really 2 big growth factors, we're focused on the BCS. First, it's emergency replacement. So it's a bit of a more of a seasonal product, think of the second and third quarter, but we saw some really good record improvement in emergency replacement within the quarter. But the bigger growth factor has really been around national accounts and our ability to get back into that vertical with the health of our factory now in Arkansas to start winning back share. And the stickiness that comes with that revenue in national accounts is that we can build custom equipment for them. We install it through our service offering.

We do preventative maintenance with them. We do monitoring. We do end-of-life recycling and reclamation. So really pleased with that light commercial business and the stickiness of national accounts to go back on offensive. But we're off to a good start. We saw the industry up a little bit in February. So that was another good indicator after being down for 15 months to see the industry starting to come back. But really, similar to what Alok said, it's kind of riding the wave of the industry coming back and continuing our 2 growth vertical vector market share wins on both emergency replacement and national accounts are off to a good start, and we expect that to continue through the second quarter into the third.

You mentioned Stuttgart, the health of the factory. It's been transitioned to primarily configure-to-order facility, right, for the national accounts. And you also have been investing, if I recall correctly, in some testing chambers and R&D, and those are all helpful to product development and conversion. So can you talk a little bit about the uplift you get off of a configure-to-order unit in terms of profitability versus kind of the larger standardized product that you're doing now in Saltillo.

Michael, do you want to continue?

Sure. Yes. So from a margin perspective, the overall margins are actually very similar from an equipment perspective, from a margin percentage on a national account. The average sale price is significantly higher in a configured order, but the margins are very similar to emergency replacement. So we like both businesses. Neither one is really more or less attractive. We think we can continue to expand margins on both. But really, that improvement within the test chambers, what that's going to allow us to do to really speed up our innovation cycle.

There's a lot of focus on big national accounts moving to electrification, hybrid units for both electrified product as well as some gas. So we're moving to a bit of a hybrid heat pump product with the national accounts. So we're excited within that channel to get those new products launched with the national accounts and those test chambers, which are part of our $100 million extra CapEx this year will definitely support us there.

I think, Noah, just to add to that in a way, we felt bad last year. We built a new factory and the market went down, right? But I think that goes down to my history. Every time we build a new factory, we should think of the market going down. What we are very excited is as the market comes back, we are no longer capacity constrained. We have worked through all the kinks of a new factory start-up. And now it's time for us to use our plenty or abundant capacity to go get new share. The team excited. Q1 is just kind of the beginning of that journey. Some of the win back on the national account have exceeded our expectations as Stuttgart became so focused and has got improved lead time. We are down to like our best lead times ever. So we're super excited about the market recovering. So it compounds our growth. It doesn't change our differentiated growth initiatives.

It's a really interesting dynamic to watch going forward. I want to ask you about distribution, which was a major focus at Investor Day, and we had the opportunity to tour your new facility. So after completing the physical build-out, what are the priorities for driving that improvement in fill rate? How do we think about scaling up the distribution centers and the automation investments that you need to kind of have at the end of this cycle?

Sure. I'll start by just reminding ourselves and everybody that at the end of the day, our goal is to make manufacturers margin plus distribution margin, like we need that plus in between. And we have delivered 300, 400 basis point margin growth over the past 4 years, and we think we have still a lot more room to go to get to the final math. It's been a long journey. Glad you had the opportunity to look at our new distribution center, which makes it truly more of a hub and spoke versus the, I would say, random walk through our distribution center that we used to have.

The payback on that investment is very quick. Michael and I were just reviewing that recently, and we are pleased with the playback on that large investment. You won't even notice it in our P&L in a negative way. So I think that's positive. There's a lot more to be done. AI is playing a very critical role in how we take this forward. Now that you've kind of got the physical infrastructure, a lot of this is purely around demand planning, inventory deployment and make it easier for our contractors to order parts and accessories as part of the overall purchase, so we can put a whole kit, including curb adapter from AES.

So the next big 2 or 3 phases is continue to build out our regional network, which is not done yet. So from both residential and commercial, we are still working through the cascading the hub and spoke into different areas, like we just did something new at Sacramento, got more capacity. We're doing something new in Florida. So region by region, I kind of get the right capacity in there. Add on Samsung and Ariston to the distribution network, so they are additive to it. And on commercial, continue opening local stocking points to be able to make that work.

So we still think we are early in the journey, but we're being very disciplined, very thoughtful, and it's working as we intended and the payback has been very good. I wouldn't think of any big capital investment required there because an autonomous truck is pretty straightforward and a better forklift is pretty -- these are not millions in capital like they are smaller within a regular CapEx budget. The big CapEx is what Michael and I called out, which is going to be around our true testing facilities, R&D and innovation, but we've called that out already.

Yes. I guess on the competitive landscape in distribution, it includes large public peers, there's active PE players. Home Depot subsidiary recently entered the market. How do you see competitive dynamics in distribution evolving? What do you need to focus on to grow your share and achieve your target margins?

Sure. In quite a few ways, we welcome the professional distribution approach that's happening with SRS and Home Depot entering that market. We've seen Watsco has put a lot of technology investments in there. So we welcome that because the industry needs more efficiency, needs more larger player. And as the product gets more sophisticated, to get the product information management cascaded through the channel is the right thing for the industry to do. So, a, we welcome that, right? B, it makes it appropriate for us to challenge ourselves to up our game. I mean going back a few years, we were at 75% fill rate. I mean, that's terrible, right? These folks will all fit. So we have to get to 98%, 99%. Now we closed last year at over 90%. So we made huge improvement, and we will continue to do that.

Good news is that everybody making investments. There's no shortage of vendors, whether for automation or demand planning and everybody helps the manufacturers and distributors like us to go through it. So I welcome the opportunity there. You have to realize, though, distributors don't often switch brands. So if you think about it, there's one distributor, Johnstone, very much Daiken favor. Watsco Carrier until they do acquisition, which is kind of noncarrier. Rheem and Ferguson, us and Trane kind of as owning our own. So that remains. So I think in future, what you will see is every manufacturer will need to excel in distribution to continue winning market share. Folks who own their own distribution like us and to a large extent Trane will just have an easier time doing that because there's no friction cost of dealing with a third party in between.

Yes. And you can also, I think, align your offerings in the way in which you are sort of tailoring the product suite to the end customer, right? You can probably also get an advantage around just the information that you're getting back through the system, the visibility. And maybe that's where some of these AI tools play in. Can you talk about that a little bit, kind of how you've improved visibility into kind of the customers' real-time needs, both from a product fit and availability standpoint?

Absolutely. I mean let's start with the most basic thing like thermostats. If you look at thermostats, in the olden days, none of them were connected. They were like mercury diodes on the top, right? Now almost all of them are connected. Among the manufacturers, we sell the most thermostats that are smart thermostats, our own brand through our own stores, and we have launched now lower price point thermostats to get even more mass market. That data is extremely valuable to us for multiple reasons. One is for our own product, we can see warranty issues way before it happens, for example. So I think that's one information for us. And we can talk about run time versus pending demand or replacement versus this. We just get a lot of intelligence out of that.

Second part of that is we make it very valuable to our contractor. They have a dashboard, which the penetration is increasing, that they can see service issues. So before they spend $250 on a truck roll, they know what part to take there and what needs to be fixed. So I think that's something we highly encourage. And finally, for the homeowner, the connected home experience, hopefully, they have a Lennox water heater, Lennox HVAC, Samsung piece. And hopefully, they have Samsung smart things in their home, so their TVs and all everything connects together. We make it easier for them to connect through that. p

AI, which we used to call machine learning earlier, takes a role in each of them. For homeowners, we can do geo-fencing with their phone. So it automatically turns it on and off depending on how your phone is far away or detects audio and adjust things. And we are very proud of our sensors that you can put. So you can have on each side of your bed 2 different sensors that kind of control temperature accordingly. So there's just a lot of cool things we are doing with AI for the homeowner. Same for the dealer, we can do predictive and preventive maintenance, which is huge for them. If they can route optimize their truck and they know that the motor is vibrating and they need to change it within the next 2 months, it's just a lot better for that, right?

And for us, it's a gold mine of information. It just a gold mine of information that we use across. Because we are homegrown and haven't done tons of acquisition, we have like data going back 100 years. And we put on a data lake, we use it all together. And when a dealer goes to -- a contractor goes to Lennox Pros, we can actually tell them what's your purchase behavior. Here's the accessories you should add on. Here's a compatible unit that matches AHRI and make it really easy for them to do business with us. So all throughout the network, AI is becoming like software, right? I mean every software that we use now is AI-enabled.

It's a great example of some of the channel strength that you have. I just want to turn to kind of more general demand questions. Obviously, the 1Q volumes were down in resi as expected. You previously talked about these delivered RNC exits being a 2-point volume headwind to HCS. You talked about just in this discussion, how that might moderate in future years. But does it sort of moderate sequentially as we move into coming quarters? Or is it pretty ratable throughout the year?

The RNC exits are pretty ratable throughout the year because, again, they are kind of annual contracts in that. We do obviously see that impact no more than what we had called out. It might be even less than what we had called out given some of the earlier dynamics we talked about, especially with some of these 232 tariffs that contracts become a little messy to work with. So I think from that perspective, it's no worse than what we had called out.

What we are excited about is just the overall momentum. I mean there's lots happening in the case where we remain convinced that the biggest issue last year was too much inventory in the channel, which is corrected and our contractors lagging confidence in the new product. There is some impact of consumer, but that's like a tertiary impact, not a primary and secondary. So we feel good about where we are. And you saw despite building in the price increase impact of 232 derivative tariff, we kept our volume commitment the same. Now it's a bit of a seasonal business. So it's easy for me to do all this. I mean June is when it really starts making a difference.

Yes. To that, I think the housing starts were up over 10% in March. At this point, are you seeing any signs of sustained improvements into the quarter? And just sort of how much lag you would expect between housing starts and an uptick in your own revenue?

Housing starts typically have a 6-month delay, like 6 months later, they bring the indoor units, 9 to 12 months, they bring the outdoor units. So that we can see in a very predictable fashion. And as you know, they are big builders, small builders, medium builders. So we still have good opportunity to continue growing through that. What we're also seeing is from a consumer perspective, right? So new -- existing home sales are also good opportunities for us because that's when people think about renovation changes, modifications.

In general, the repair versus replacement demand, I think we are going back to the more traditional where consumers make the right economic decisions, and that's replacement for a unit that's 10 to 12 years old. So I wouldn't change anything, but saying continue to have the same confidence we had when we talked about Q1 earnings, much more stabilizing phase versus continuously declining phase than we were last year.

Well, certainly, the dealers are more familiar with the new refrigerant. But we've also seen HELOC and home equity loan rates come down year-to-date. And curious how sort of financing and affordability are maybe translating here to some of the improved repair versus replace dynamics you're seeing?

Clearly plays a role, clearly plays a positive impact. I think, as you know, you can't really finance repairs. But if you couldn't finance replacement either, they were at equal footing. But now you can go back to financing replacement at a reasonable level, replacement goes up, right? So yes, I think that's making a positive impact.

For existing home replacement, how often and how typically is this just financed via one of those types of mechanisms versus outright cash? Do you happen to have that data?

About half these days. It used to be 30%, 40% financed. It's running at about half financed. It's not always through us. Some of the financing is through an HELOC. Some of the financing is through third party. But I would say about half and half of the half, so quarter -- a little more than quarter would be through our partners because we do partner with financing companies and offer financing to our contractors. But we don't directly play a role besides enabling them to connect with appropriate providers.

And just to level set, just remind us what you embedded in the guide, the volume guide assuming on new home construction versus existing home sales?

Yes, generally flat, not a significant improvement year-over-year.

For both existing home sales and [indiscernible] construction.

Correct.

Okay. Very helpful. There were some questions we got after earnings on the sequential inventory build, although honestly, it was pretty modest versus the prior year. Just maybe give us some color on your inventory management and how that might tie to growth initiatives. We know not all inventory is necessarily the same, and it might be for end markets or SKUs that investors might not fully appreciate. So can you talk about that a little bit?

Michael?

Sure. Yes. We're actually in a really good spot with inventory going into the season. After the last 2 quarters, we've taken some significant production reductions out to make sure that we've got our inventory in a really healthy position. We did add some inventory in the first quarter, predominantly around parts and accessories as we try to win some growth within that section, it's about better improved fulfillment. So we're definitely working on making sure we have better fulfillment on parts and accessories.

But even with our traditional equipment, we found that one of our biggest issues and we hear back from our contractors is our fulfillment scores and that we need to make investments in finished goods to win that. Now what we're trying to do is offset that with raw materials and accounts payable and better accounts receivable to help fund that finished goods inventory, but it is a tool to help us help our contractors win in their local markets, and we're making the right investments in the right spots. We launched a new distribution center that eventually over time will give us some more inventory turn improvement. But initially, it's about getting that inventory to help our contractors win.

Trying to reduce raw exposure and inventory plays into what I want to talk about next, which is management of inflation and tariffs. So can you talk a little bit about that effort to reduce raw inventory and how it relates to price cost management for the year?

Sure. Yes. I mean overall, it's a very complex environment, as you can imagine, with the tariffs right now. But what we like is the flexibility we built within our network. We have 5 U.S. factories. We have some in Mexico. So we have a lot of flexibility to try to navigate this complexity. So we'll continue to work the supply chain to reduce some of the headwinds that we see.

But specifically on raw materials, a lot of it is also just working with vendors and cost sharing and figuring out what we can do to optimize our overall cost position in the tariff environment that we're in. So we're in a healthy position on raws, and we think the supply chain is generally in a good shape on almost all components that we're seeing, and we'll just continue to navigate through some of the near-term challenges with 232 tariffs.

And you had raised cost inflation expectations by 2.5 points, largely offset by price. So just how much of the cost increase is tariff-related versus commodity related?

Sure. For this year, it's approximately 80% of that additional cost increase that we did, which is about $100 million. Second half of the year is related to 232. The rest is related to more core input costs that aren't hedged. As you get into next year, we still have opportunity to continue to mitigate and reduce some of that 232 exposure. So some of these longer-term programs that Alok talked about getting engineers on these initiatives to keep reducing that tariff exposure. So we'll continue to reduce that in the next year. And hopefully, we'll see some reduction in the raw material costs, too, as we enter next year as well.

Could you give us a little bit of early color on those strategies around mitigation, maybe where vertical integration unlocks more opportunities versus peers?

Yes, sure. I can jump into help. I think a lot of the New Section 232 derivative tariffs depends on the origin of the metal that is being used, right? So if we make products in Mexico that are made using 100% U.S. steel, they have a much lower tariff rate than they do otherwise. So a lot of our movements are around those aspects. So now we are better of using Mexican steel in U.S. and U.S. steel in Mexico. And so just moving those around, we'll see a lot more goods truck loaded with steel just crossing the border back and forth. So some of that is as simple as that.

Others is just leveraging our dual source. 4 years earlier in Investor Day, we talked about dual sourcing and how that was critical. This year, we didn't talk about it because we've done that. So every time we are dual source, we can now move vendors around and components around to force them to do the same thing. Hey, if you have U.S. -- you have compressors made of U.S. Steel, let's do this. If you have motors made of. So those are the things we are doing on each of those opportunities.

Very helpful. Well, I know we're just about out of time here. As always, I really appreciate the discussion. We are around for the rest of the day if anyone wants to follow up, we look forward to some of the meetings as well.

Alok and Michael, thank you both for the time.

Thank you.

Thank you, Noah, for having us. Take care.

All right.

Good morning, everyone. Welcome to the Lennox 2026 First Quarter Earnings Conference Call. [Operator Instructions] As a reminder, this call is being recorded.

I would now like to turn the call over to Ms. Chelsey Pulcheon from Lennox Investor Relations. Chelsey, please go ahead.

Thank you, Bo. Good morning, everyone, and thank you for joining us as we share our 2026 First Quarter results. Joining me today is CEO, Alok Maskara; and CFO, Michael Quenzer. Each will share their prepared remarks before we move to the Q&A session.

Turning to Slide 2. A reminder that during today's call, we will be making certain forward-looking statements, which are subject to numerous risks and uncertainties as outlined on this page. We may also refer to certain non-GAAP financial measures that management considers relevant indicators of underlying business performance. Please refer to our SEC filings available on our Investor Relations website for additional details including a reconciliation of GAAP to non-GAAP measures.

The earnings release, today's presentation and the webcast archive link for today's call are available on our Investor Relations website at investor.lennox.com. Now please turn to Slide 3 as I turn the call over to our CEO, Alok Maskara.

Thank you, Chelsey. Good morning, everyone. Before turning to our quarterly performance, I want to recognize the exceptional adaptability and dedication of our team as well as the trust and loyalty of our customers. While the macro environment remains uncertain, our core values empower us to respond with discipline, innovation and an unwavering commitment to enhancing the customer experience.

Turning to Slide 3. Revenue was $1.1 billion, up 6% year-over-year as growth initiatives gain traction and channel conditions stabilize. Our segment margin was 14.4% in the quarter, down 130 basis points primarily due to the impact of factory under absorption. Operating cash flow was positive $16 million and adjusted earnings per share for the quarter were $3.35. In Home Comfort Solutions, industry conditions began to stabilize as expected. One-step results continue to be impacted by weak new home construction, while sentiment in the 2-step channel improved as distributors began to restock ahead of the summer season.

In Building Climate Solutions, emergency replacement momentum and disciplined execution contributed to record quarterly performance. We are reaffirming our full year adjusted earnings per share guidance range of $23.50 to $25. With that context, let's turn to Slide 4 to discuss the current economic outlook.

The industry environment continues to gradually improve. Channel destocking has largely concluded as dealers regain confidence and replacement demand strengthens. Consumer sentiment remains cautious, contributing to continued softness in new home construction and remodel activity. At the same time, Lennox-specific growth initiatives are gaining momentum and beginning to offset these pressures. On the cost side, we are experiencing inflationary and tariff-related increases across commodities, components and finished goods. Fuel and transportation costs are also rising. In response, we are sharpening our focus on mitigation activities, including productivity and reductions in material cost. We are also further streamlining our supply chain optimizing manufacturing operation and implementing thoughtful pricing actions.

In Home Comfort Solutions, sales volume year-over-year improved sequentially during the quarter, supported by better performance in the 2-step channel. Repair versus replacement stabilized, providing greater visibility into underlying demand trends. New product introductions, including a successful water heater launch and growing traction with new heat pump products contributed positively. In addition, the on-track integration of Supco parts and supplies strengthens our attachment rate growth better.

In Building Climate Solutions, our superior execution continues with emergency replacement and national accounts, both driving volume growth. Greater engagement across our full life cycle offerings along with the integration of DuroDyne parts and supply is expanding our commercial portfolio. Now let's turn to Slide 5 to highlight recent product introductions.

Innovation continues to be a critical differentiator for Lennox. Our recently launched products further elevate our competitive position to meet the evolving needs of our customers, particularly around efficiency, backwards compatibility and ease of installation. In Commercial, our new Strategos Rooftop with heat pump technology expands replacement options for customers. This product offers greater flexibility in where and how systems can be installed supporting a wide range of electrification as efficiency expectations continue to rise.

In residential, we are broadening our heat pump portfolio to serve all climates and installation requirements. Core climate capabilities allow us to better address demand in northern regions while our new compact air handlers make it easier to deploy high-efficiency systems in retrofit and space-constrained applications. We are also extending our presence within the home through high-efficiency Lennox heat pump water heaters via our Ariston joint venture. This new product integration supports the convergence of HVAC and water heating and strengthens the Lennox home control platform. Together, these innovations expand our addressable market, increase share of wallet and reinforce Lennox's long-term competitive position.

With that, I will turn it over to Michael to review our financials.

Thank you, Alok. Good morning, everyone. Please turn to Slide 6. After two consecutive quarters of year-over-year sales declines, we were pleased in the first quarter to return to year-over-year revenue growth of 6%. Growth from our DuroDyne and Supco acquisitions completed in Q4 2025 contributed 6%, while growth in BCS was offset by continued sales declines in HCS. As expected, residential end markets remained down year-over-year, but the rate of decline improved sequentially versus the fourth quarter of last year. If inventory levels normalize, the segment profit was negatively impacted by approximately $15 million of manufacturing costs under absorption. Against that backdrop, results progressed as expected. Let me turn to the details of our Home Comfort Solutions segment on Slide 7.

In our fourth quarter earnings call, we noted that the first quarter end markets would remain challenging, which should show signs of improvement. Overall, HCS revenue declined 10%, M&A contributed a positive 2%, while organic revenue declined 12%, with one-step down approximately 10% and 2-step down approximately 15%. Organic sales volumes declined 21%, but this represented a meaningful improvement from a 32% decline in the fourth quarter of 2025.

Within the one-step channel, lower new construction activity continue to weigh on results. In the 2-step channel, distributor sentiment improved as customers began to restock ahead of the summer season. Mix and price realization contributed positively to results driven primarily by the full conversion to new R-454B products. Product costs were a $23 million headwind driven by materials inflation and under absorption due to lower production levels. Finally, Acquisitions contributed approximately $2 million of profit and SG&A cost [indiscernible] taken last quarter mostly offset SG&A inflation. Please turn to Slide 8 for an overview of the Building Climate Solutions segment.

BCS delivered another exceptionally strong quarter with organic sales up 26%, M&A growth up 12% and profit margins expanded 300 basis points. Sales volumes increased 17% as national account demand normalized alongside continued growth in emergency replacement and new customer wins across both equipment and service offerings. Price and mix delivered 9% revenue growth, driven by the full transition of light commercial products to the new 454B refrigerant. Similar to HCS, BCS experienced absorption pressure as we optimize inventory levels, but manufacturing cost efficiencies offset this impact. M&A contributed $7 million of profit growth, offsetting SG&A inflation and distribution investments. Please turn to Slide 9 for cash flow and capital deployment.

Free cash flow in Q1 2026 was at $39 million use of cash, an improvement versus a $61 million use of cash in the prior year quarter. Underlying operating performance improved materially. Adjusting for approximately $30 million of higher capital expenditures year-over-year, operating cash flow was $16 million, an improvement of $52 million driven primarily by inventory growth of $60 million this quarter compared to $210 million in the prior year period. Inventory build in the quarter focused on parts and specific SKUs to support customer fulfillment during the upcoming peak season. Given normal seasonality, we expect inventories to moderate from current levels in the second half of the year. We continue to maintain a strong balance sheet with healthy leverage while supporting the $550 million acquisition completed in Q4 2025 and continued share repurchases. We also see a healthy pipeline of bolt-on M&A opportunities and remain disciplined, prioritizing deals that enhance our portfolio and meet our return thresholds. For 2026, we continue to expect approximately $250 million of capital expenditures, focused on innovation and training centers, digital capabilities, distribution network optimization, ERP modernization and targeted AI capabilities. With that, let me move to Slide 10 to review our updated 2026 financial guidance.

Our updated full year 2026 guidance reflects Q1 results and trends, including higher cost inflation and tariffs. The tariff environment continues to evolve with little notice. Earlier this month, new Section 232 tariffs were announced. As Alok noted earlier, we have a proven track record of using multiple levers, including price and productivity to offset tariff-related cost pressure. As a result of our move to FIFO accounting, we do not expect any income statement impact from these new tariff rules until the third quarter. With that context, I will walk through the specific guidance items that have changed since we introduced our initial 2026 outlook in January.

All other guidance items remain unchanged. Revenue is now expected to grow approximately 8% compared to prior guidance of 6% to 7%. The increase is driven by modestly higher mix and price, reflecting the Lennox price actions announced earlier this week, the annual price increase implemented earlier this year and the carryover benefit of the 2025 regulatory mix. Looking at the segment revenue guidance, HCS is now expected to grow 4% compared to the previous guidance of 2% and BCS is now expected to grow approximately 16%. Organic volumes are still expected to decline low single digits, net of approximately 1 point of growth from parts and accessories, commercial emergency replacement, inducted heat pumps and Samsung Ductless products. Cost inflation is now expected to be up approximately 5% from up 2% driven by recent increases in tariffs and input costs for aluminum, steel, copper and fuel. Based on these updated assumptions, adjusted EPS is still expected to be in the $23.50 to $25 range. Free cash flow remains expected to be $750 million to $850 million, driven by inventory normalization and higher profitability. Overall, we feel good about the underlying momentum in the business while recognizing that the external environment remains dynamic and will require continuous focus and execution.

With that, please turn to Slide 11, and I'll hand it back to Alok.

Thanks, Michael. As we close, I want to take the opportunity to share why 4 years in, I'm still genuinely excited about Lennox. We operate in an attractive growth industry with an enduring place in the market. However, what really sets Lennox apart is how we deliver differentiated growth through our execution on enhancing the customer experience, disciplined capital allocation and effective acquisition integration, all of which reinforce our resilient margin profile. What excites me most is that innovation is always at the forefront. Our product and advanced technology portfolios continues to expand, enabling us to capture a greater share of wallet. Of course, not all this would be possible without the strong foundation that is our culture. Guided by core values and guiding behaviors, the Lennox team shows up every day committed to creating long-term value for our customers, employees and shareholders. For all of these reasons and many more, I truly believe that our best days are still ahead.

Thank you. We'll be happy to answer your questions now. So let's go to Q&A.

[Operator Instructions] We'll go first this morning to Noah Kaye with Oppenheimer.

Michael, the [indiscernible] conversion continues to give us talking points. And I want to ask, following up on your comments, just how to think now about the timing difference in cost increases versus price realization. You mentioned the incremental costs, many of them won't really layer in until 3Q. How do we think about pricing? And should we still think about kind of the previous guidance for first half, second half EPS split still applying or is anything shifting given these moving pieces of the outlook?

Yes. First, is write down the guidance. Most of the cost impact and the price impact would fall within the second half. We've announced a price increase earlier this week, it will take some time before we start to see the full impact, maybe you'll start to see a little bit later in the second quarter. But predominantly, both of these should come into the second half of the year. When you look at the revenue split, it'll put a little bit more revenue, obviously, now in the second half than the first half. But overall, profitability should still be about the same as we reflected last year by the quarters.

Okay. And as a follow-up, you called out the $15 million under-absorption impacting this quarter. Any lingering under-absorption headwinds to think about here for 2Q or are we kind of mostly caught up now that restocking is underway and you haven't increased your inventories too much?

I think as you saw within our results in the first quarter, we continue to not grow inventory as much as we did in previous years. So we had some absorption headwinds. We reduced our productions about 30% in the first quarter. So there will be a little bit of absorption that will go into the second quarter. But by the end of the second quarter, the inventory normalization will have occurred.

We'll go next now to Ryan Merkel with William Blair.

I wanted to ask first on HCS, the revenue outlook for 2Q. I think previously you saw it down low single digits year-over-year but it sounds like you're seeing a bit of stabilization. And I'm just curious if April has been a little bit better.

It's pretty hard to call quarter, especially given some of the impact of whether that is still very unknown. So I don't think at this point, we would give you any further clarification compared to what we said in the past and would go with the same assumptions. The change we made in the guidance simply reflects a stronger Q1 overall. And more importantly, the impact of additional price increases that we announced earlier this week that are going to mostly fall in the second half.

Okay. Got it. And then as my follow-up, BCS was really strong. You mentioned good execution. Anything else you'd call out there? And why not raise the guidance a little bit more there?

You should have asked [indiscernible] CFO as I have, Ryan. So listen, on the guidance piece, it's such a seasonal business, weather makes an impact. And I think we have based on everything we know, Q1 is not a quarter to raise guidance anyway. I mean there's just so much more to go given the -- there's just a shorter season. So I wouldn't read too much into Q1.

On BCS, first of all, congratulations to the team. I mean, the execution out there is just super. The new factory is paying strong dividends. We are getting the right amount of productivity that we expected, maybe a little more than we expected. The emergency replacement initiative now that we have inventory position all over the U.S. is paying off meaningfully. And more importantly, the fact that now Stuttgart is more stabilized, is also helping us win back national account and gain additional volume from that. And don't forget our other two businesses, the Service business is benefiting from the full life cycle value proposition, and the refrigeration business also continues to set records both in growth and profitability. So just a good success story and something that we think we are going to start seeing in HCS as well as our markets stabilize and the end markets are not such a big drag on us. So congratulations to the BCS team. Nothing unusual just strong execution on a very, very defined strategy.

We go next now to Julian Mitchell with Barclays.

Maybe just wanted to start on the overall operating margin guide for the company. Is it fair to say that you've sort of got a flattish operating margin dialed in total company for the year? And then within that, you've got HCS down, BCS up and just trying to understand sort of HCS margins, I understand we had a tough time in Q1 for many reasons. How quickly do those margins kind of climb up out of that hole?

Sure. So I'll speak to the overall margin guide. When we talked in January, we expected a slight increase in the enterprise margin expansion now with the increase to revenue and costs, we expect a slight decline in the margin. But you're correct, within BCS, organically, we expect margins to be up there within HCS organically, we expect them to be down. M&A will have a slight drag overall in the enterprise. But we should expect to see as volumes recover in the second half of the year, the incrementals within HCS approved. We just need to go through the first half of the [ Q for HCS ], we'll see that challenge behind us.

Yes. And I think one thing, as we dug into the results in Q1, it became abundantly clear to us that the decline in margin, which we don't love it all is 100% driven by the factory under absorption, we were able to offset inflation with a volume with pricing and efficiency, but it is the under absorption. So as that and absorption kind of continues to become less of an issue as we go into Q2 and second half, we are very confident in the margin going back to normal.

And then my follow-up, I suppose, was around -- so the cost inflation numbers moved from 2.5% to 5%. So is that right that that's roughly kind of $100 million or so extra gross cost headwind? And then I suppose, do you see any competitive implications from that cost base movement? And sort of tied to that, how is the price elasticity of volume playing out in HCS at present, please?

Yes. So I guess on the first piece, your numbers are roughly right, as usual, Julian, so no surprise there. I don't see any competitive dynamic or drawback to us [indiscernible] inflation in oil, commodities, components [ are adapted ] in all of us. The Section 232 derivative tariff impact, that hits deeper differently, but it does hit every manufacturer. Some will bring metal components from overseas, some bring finished products from overseas. So that was -- there may be some slight variation depending on which company, but we don't think it puts us at a competitive disadvantage overall. We remain very sensitive to those competitive dynamics, and we'll continue adjusting those as we go along. Sorry, Michael?

Yes. I'll just add. I mean, if you look at the spot market, since our last guidance, aluminum is up 25%, [ steel 20% to 25% ], Diesel is up 50%. Copper is up 10% to 15%. We have hedging programs that delay some of that. We have fixed contracts. But overall, these input costs are up significantly since our last guidance.

We'll go next now to Chris Snyder of Morgan Stanley.

I also wanted to follow up on the price cost drivers into the back half. I guess there might be some rounding involved, but you guys are still calling for mid-single digit price, but it does sound like more is coming. So just maybe if you could kind of provide a little bit more nuance around that? And then also, why is the incremental on the price action getting better? I think now it's expected to be 90% versus prior 75%?

I'll take the first part of the question. So yes, there is a bit of rounding. I mean mid-single digit is still a broad range. And overall, as you know, we are very transparent with what we do, but it's within the mid-single-digit range. Michael can address the realization point. But essentially, given all the inflation that we just talked about and the additional pricing actions we have taken this week, that just gives us better drop-through because it's just going to stick better going back to each of the inflation piece that Michael just talked about. Michael?

Yes. Specific to the 90%, within that, there's really two guide points. First, we have price that has an incremental of 100% because we have costs on the other side of our guidance. And the mix normally, what happens there is there's an incremental somewhere in the 50-ish percent range that we have within that. So when you blend the two together, you start to get a higher drop-through because there's now more price than mix because the mix is generally behind us now from the carryover the regulatory change last year.

I appreciate that. And then if I could just follow up on the HCS revenue trajectory from here. It seems like on my math to kind of get to that full year guide, the build into Q2 and Q3 off the Q1 level seems steeper than typical on my math. Correct me if you guys disagree with that. And I guess, is that a function of the channels restocking demand is getting better? You guys are taking share, more price? Any color there would be helpful.

So let me start with the second half. I mean the comps get much easier in the second half. I mean that's where we see massive declines last year. Michael did talk earlier about pricing will have more of an impact in the second half. I think in Q2, remember, mix will still benefit us because we hadn't completed the 454B conversion all the way by the time we hit Q2. So I think you put it all together, Q1 last year, the mix was very tough because a lot of people were stocking up in preparation for the transition and buying a lot of 410a inventory. So large part of the answer is just comps, what happened last year. and then the pricing impact. Michael, what would you add to that?

Remember, Q2 had the canister issue last year that was significantly within that quarter with the canister shortage issue.

We'll go next now to Jeff Sprague with Vertical Research.

Just back to the inflation, Yes, Michael, in view of that, let me -- you went through aluminum, steel, copper, et cetera. We've been watching that ourselves, obviously. How would you parse kind of the inflation headwind between the tariff changes and just kind of the general inflation going on? And then obviously, there's an annualized impact on what you laid out here given sort of the half year dynamics. The price that you're putting in place would fully cover you for sort of those carryover headwind impacts into 2027.

So I'll speak to the input costs. We do have hedging programs and fixed contracts for a lot of that, as I mentioned. So we're about on average, 70-ish percent hedged on that, but there is a piece of our overall inflation guide for the remaining 30% and then the balance is mostly tariffs. And then on the annualized impact, we're going to continue to look to find ways to mitigate. As we talked about, this is still not fully mitigated. We still have a lot of levers that take time on the supply chain and the manufacturing processes to be able to continue to mitigate that cost. That's our goal is keep focusing on cost mitigation, just some of these efforts take a little longer.

Yes. And I'm pretty optimistic on our ability, just like we have done before, is to reduce the mitigated impact of tariff. But as Michael says, supply chain moves, manufacturing moves, product SKU moves, buying U.S. Steel in Mexico moves, they just take a lot of time. So we are working through all of that to continue mitigating the impact.

And then just on the channel behavior, right? It's kind of always interesting how we can quickly move from destock to restock. Do you sense in the channel that there was sort of pre-buy in front of inflation or there's been some early heat in some places, maybe a realization that things got a little bit too lean. Just kind of that behave your animal spirits in the channel right now, a little more color on what you're seeing?

No. We have no indication of any prebuy ahead of price increase or inflation. I mean the April tariff announcement took most of us by surprise. So there's just absolutely no opportunity or knowledge within a channel to do any pre-buy around it. We think the restock is pretty normal. I mean, we do like the word re versus de when it comes to stock, so restock is good. And folks are just looking at the upcoming summer season and nobody wants to be sharp. So we think inventory levels are pretty normal. I'm not concerned. But remember, we haven't had normal year in years, and this will be the first time that we won't ever be with a refringent transmission, canister sorted, SEER transition and all of those things. So we think the inventory levels are reaching normal for the channel and for us.

I'll just add, we continue to look at our warranty registration data that suggests that inventory in the channel continues to be normal, especially on the one-step side.

We'll go next now to Amit Mehrotra at UBS.

I guess I just wanted to come back on the Section 232 changes. From my seat, it's a little bit like the blind leading the blind in terms of what the actual impact is. And I'd love to get -- you've got -- done a good job giving us kind of a very high-level view, but there's a lot of moving parts in terms of how much you have in Mexico, how much that's crossing borders, it's actually in the scope of the new Section 232, what the net effect is in terms of the steel content versus the total value, you buy compressors, you move them down to the south and bring it back up north. So just a lot of moving parts. Maybe you can just kind of pull back the curtain a little bit and just explain to us kind of how -- what the scope is and just so we get a little bit of a flavor of what's going on.

Sure. The scope is pretty wide. I'm not a tariff expert, but I can tell you, we have a lot of tariff experts in our company. I think there's a 7 a.m. crisis, war crisis type call every day. I wish I could invite you to that because then you will get answers to all of your questions there, Amit.

I'm happy to join.

The scope is pretty wide. And also, as time progresses, the secondary impacts are coming out to be also quite challenging or new. So the primary impact is often well understood. Once you understand all the different products and the classification codes. But from our perspective, this is not new. This entire thing took us by a little surprised last year when we had [indiscernible] the country. This year, we're getting some reforms. We are paying some more. What we have done is get ourselves and our team used to working through these uncertainties remaining very adaptable, very flexible, moving products, raw material out of media and working with our vendors to share the pain. So I think we are working through all of that. Net-net, when it comes down to is, I think every manufacturer who deals with metal is impacted. So clearly, the only one. And I think overall, we seem to be leading it with appropriate resiliency and appropriate determination. We also have to continue to wait and see, right? Things change dramatically, too. There could be another tweet sometime in the next week or two that could just flip this on its head. So I can't really tell the details on that, Amit, I'm happy to have an offline conversation. But the teams are very qualified, very [indiscernible] and we're working through it.

Okay. I appreciate that, Alok. And then maybe just a follow-up on your comment about replace versus repair sort of stabilizing. And I'm just curious if you're seeing actual evidence of consumers moving back into replacement? Or is it just kind of repair activity that simply is not getting worse? And the context of the question is really, it's natural for inventory to restock at this particular point in the year. I'm just wondering if maybe it's a leading indicator of potential destock unless you're actually seeing real consumer activity moving back towards the replacement paradigm?

Yes. So remember, first of all, one-step channel, we are very close to thousands of dealers, right? and we have 10,000 direct customers, and we have multiple conversations with them every hour, every day. The sentiment, what we get back from them is that it is not getting worse. And if anything, a lot of the deferred replacement that happened last year or so is now coming back up for a replacement so I don't think this is an exact science. But last year, we were hitting a lot more hesitancy even within our contractors to recommend replacement versus repair. They were short on canister. They were not fully trained on 454B and now the contractors are more confident and consumers are back to making the economic decision, which is that let's not repair that [indiscernible] system versus look for replacement, which gives you better efficiency, better warranty, better financing. So definitely not getting worse, definitely [indiscernible] and some green shoots in terms of confidence among dealers and consumers returning back to more economic decisions.

We'll go next now to Tommy Moll with Stephens.

Alok, to continue with that same theme there where you said for the one-step channel, there are at least some green shoots, can you give us any sense of how the volumes have progressed year-to-date, just observing other data points across the industry. Yes. It seems like the year started really slow, but then March and April, things have started to pick up. Some of that may just be a comparison issue, I don't know, but any context you can share would be helpful.

Yes. I think -- so things have improved sequentially month-over-month since the beginning of the year. So yes, both the statement that you made are accurate. Some of it is driven by comparison as last year, people were holding [indiscernible] at this point, and this is now turning out to be more normal. But some of it is also just confidence back in the channel where folks are taking more advantage of our stock-up promotions. We are seeing 2-step getting a lot more eager to make sure they're not left behind in case we have a really hot start to the summer. So yes, sequentially, things have improved.

And then on the BCS side, Alok, specifically emergency replacement, I think you used the word momentum earlier. What additional details can you share there? And what inning are we in? I know you're starting from a pretty low base of revenue. So you have to be strategic about how you attack that market going forward.

I'm still in the second inning or something out of a 9-inning game. Last year, we're not even fully covered in U.S. We are still not fully covered in the U.S., but we're now covered most of the metro areas. Each region gets launched one at a time. What we have positively surprised by and pleased with is the ability of our own Lennox dealers to get back in the game, support us and then some and start using and getting back into the rooftop business with us. So that's been positive. Honestly, I'd tell you what the other good news lurking in there is the fact that we took most of the emergency replacement volume away from Stuttgart makes Stuttgart more of a configured to order factory dedicated to national account. That's been probably better dividend than we had expected in terms of restoring confidence in national accounts with shorter lead times, more custom products, basically going back to basics and there where we used to be very good at and lost our way. So early innings in emergency replacement, but also pleased with the momentum in National Account. The two words we were trying to use, so I'm really pleased you said that is momentum in BCS and stabilization in HCS those are our buzzwords for the quarter as we were practicing.

And I'll just add to that, the bundling of the service offering with the national accounts continues to perform very well.

We'll go next now to Jeff Hammond with KeyBanc Capital Markets.

Just going -- I mean it seems like the lean is more your inflation impact is 232. And you mentioned a couple of times, like you think everyone has the same issues. But I'm just wondering it seems like there's one OEM that does not make product in Mexico. And just what do you think happens if most people move on price, but not everybody moves on price?

Yes. Listen, there are a bunch of game theory scenarios, Jeff, which is hard to get into this, right? But remember, 232 derivative tariffs are not about products made in Mexico. They're about products made anywhere coming from outside as long as the steel content, the [ metal ] content is over x percent depending on weight. That does impact a broader group of folks beyond just what we're making in Mexico. At the same time, remember, the secondary impact of this is a lot of the cost of steel and aluminum, like Michael mentioned, has gone up. So nobody is immune to it. I think like you won't see where everybody lands up on this. We are very confident, and we have done price increases quite thoughtfully to make sure that we are not disadvantageous on share. So we'll work through the dynamics. But at this stage, based on what I'm looking at, I look at us doing the appropriate action and sharing the pain with our vendors and our customers.

Okay. Great. And then just another one on BCS. I mean it sounds like -- I mean the 1Q numbers were pretty eye-popping, and I understand easy comp. And just all the comments you made in the previous question were pretty positive. So -- but it seems like the raise is pretty small. So maybe are there -- were there any aberrations in 1Q? Or is there any reason to temper maybe the enthusiasm on emergency replacement, national account momentum?

No, besides what you already said, like last year, we got beat down because they were bad. So we had easier comps in Q1, the comps get tougher and [ be going up ]. But there's nothing beyond that, that is going to temper the performance going forward. just the comps get tougher as you move along the year.

We go next now to Nicole DeBlase with Deutsche Bank.

Maybe just on the BCS business. You guys obviously have a lot going on with respect to various drivers of market share gain. It's hard to see what's happening with the underlying commercial unitary market. So look, I'd be curious how you'd frame the performance of the overall market? And is it still down overall and Lennox is just outperforming that much? Or have you seen any improvement at the same time?

The overall market remains challenged. The last data that we saw in AHRI the declines have become less. So I mean the second order derivative is kind of turning favorable. But the overall market remains challenging and did decline. So we are clearly outperforming the market in there. But it's not just on unitary equipment, I mean, our services offering, our ability to do a full life cycle. So I think that's all put together doing that. Yet our market remains challenging, but our market share remains very small, Nicole, I mean from our perspective, we continue to have significant opportunity to regain national account and enter emergency replacement in a meaningful way. But at this stage, based on all the data we look at is we are pleased with the fact that we're outperforming the market.

Okay. Got it. And then just a quick follow-up maybe for Michael. I think you mentioned, Michael, that you expect under-absorption to continue but maybe at a lesser rate in the second quarter. Can we just put a finer point on that relative to the $50 million, I think you spoke to in 1Q, what are you expecting for 2Q?

Yes. It's $15 million in Q1. It's not going to be 0, somewhere between that. But there will be a little bit of a headwind in the second quarter. But by the end of the second quarter, that should all be behind us and we should start to see actually some year-over-year absorption benefit as we get to the second half.

Yes. Nicole, and also $15 million makes a big difference. When you make only $160 million, right? I mean Q1 is one of our softest quarter. In Q2, which is a more profitable quarters, it doesn't move the needle at all.

We'll go next now to Stephen Volkmann with Jefferies.

Great. Just a couple sort of bigger picture follow-ups. I think, Michael, you mentioned some spending on ERP and AI targeted. Just any details? Those sound like interesting potential projects.

Yes. So ERP, first, let me take away any fear. We're not doing any massive big ERP changes. We love [indiscernible] as we go into integrating new acquisitions that we have done, we're just moving them to our own platform, and that work is underway. So we are very good at this. We do it diligently, we do it one at a time, so I just want to make sure we take away any risk concerns about that because none and it's limited to the acquisitions we have done recently.

On AI piece, yes, we continue to make investments. We are getting really good results when it comes to 2 or 3 specific areas within AI. As we look at where we are making a difference is, clearly, pricing, we are seeing some good benefits on using AI which increases our win ratio and also increases our overall profitability, which is typically hard to do, but AI enables us to do that.

Second piece, which we are seeing good traction is truly around looking at demand planning, sales inventory, ops planning. I know right now the headline news on inventory is not great, but we are getting better. As that initiative move forward, we are very optimistic on what AI can do there.

Third big bucket is just general productivity with agentic AI and how we have looked at everything from staffing our call centers to our own HR impetus to really looking at robotic process automation. I mean all of those things are helping productivity on the SG&A side. And you saw we did really good on the cost control on SG&A. All of that requires investment, and we are making investments in data lakes. We are making investments in partnerships with LLMs. But we are also very focused on reducing some of that cost by cutting down on useless subscriptions, subscriptions that are no longer needed, sunsetting old IT systems, as we upgrade our tech stack, and we sunset legacy ones. There's just a little bit of bump along the curve, right, because at one point, we are paying for both. But in the long term, I think it's going to be productivity and pricing will outweigh the benefits and outweigh the cost of all the investments we are making. So very pleased with the progress there.

Great. Okay. And then, Alok, I'm interested both Samsung and Ariston kind of your growth programs, I suppose, around distribution. I'm guessing those started before all this tariff noise kind of came to bear. And I'm just curious if you've changed the way you're thinking about those opportunities given the realities of sort of the world today?

So strategically, we remain very committed to both of those ductless and water heater remains core part of our portfolio, and we are gaining momentum in both. I mean we had really solid momentum in Q1 and what did we do, we just launched in March, but in Q1 and March [indiscernible]. The fact that these are joint venture versus buy and supply agreements, that makes us very comfortable sitting where we are because we can have very intelligent discussions about supply chain moves, tariff cost sharing and other future district changes that we can make to mitigate any long-term impact of tariff. So we appreciate the partnership spirit with both those companies, but no change in current dynamics. Almost all ductless today are imported from outside especially when it comes to interior, indoor component and some of the core outdoor components. So no, we are moving with the industry and have no concerns around the structure.

We'll go next to now to Nigel Coe with Wolfe Research.

By the way, Alok, I'm down for the 7:00 a.m. Crisis call. So I'll ask Chelsey to send me the details of that. Could be [indiscernible].

Maybe we start charging you guys, and that could be part of our tariff mitigation effort.

Could be. I'm sure people would pay for that. By the way, I'm not disappointed with the baseball analogy. I thought you're more a cricket guy, Alok, but I'll let you get away with that.

If you will ask me the question, but I don't know how you break down two innings. I would have like to say, like we are 0.2 in the first inning or something...

Yes. The first innings or the first [indiscernible], some of that. That's right. So sorry, I do want to go back to tariffs. Roughly, where are we today in terms of U.S. production of residential like commercial units? And are you planning to redomesticate production? I'm not saying next week or next month, but over time, or does it still make sense to keep your production in [indiscernible] and pay the tariff from a unit cost perspective? And I'm just wondering what sort of non-price mitigations you're [ competing ] right now?

So if you're paying a [ T20 ] cricket game, we are in the third over of the full [indiscernible] so we are early in that [indiscernible]. So first of all, we need things to stabilize before we make any big decisions or changes. I mean, things seem to be moving around quite a bit. Obviously, the USMCA agreement is coming up for renewal, and we'll see where that moves but currently, we are continuing to fine tune, change things, change the source of metal, changed a bunch of like a smaller division but before we make any large decisions, we do want to see some stabilization in policy and more of a consistent approach versus seem like the approach is [indiscernible] so no major changes in the pipeline in terms of massive reshoring. Now remember, we do have 3 residential factories today in the U.S., and we do pretty well going through that. That's in Granada, Orangeburg and Marshalltown, and we have one large one for our residential in Mexico. So we have plenty of flexibility in our network, and we will continue making changes for some big massive transformation, we just need stability in our policies from the government before we look at it. Today, it still makes sense to continue doing what we're doing and just mitigate the impact. One product at a time, one screw at a time and one sheet metal part at a time.

Okay. It doesn't sound like you won't give me the number on the percentages of production and domestic. But in case you do, I just thought I remind you that. Going back to the sell-through, the minus 10% on the single channel sales. You did mention that you were rationalizing your residential new construction exposure last quarter. I'm just wondering if that was an impact during the quarter and whether that process is now complete?

Yes. What we said in the past, it's about 25% of the HCS segment, the residential new construction. We definitely saw the volumes down there more than others is above 30% [indiscernible] in the channel. Not necessarily all just customers move into other competitors. It's a combination of just weak new construction and that, but we definitely saw that channel weigh on the overall one-step volume growth.

Yes. And that share loss which is what we'll show in print is going to negatively impact us all through the year, and that's built into Michael's overall guidance, as we said, 2-step is going to do better than one step. From a profitability perspective, that's going to work in our favor because the margins were like negative [ 20 ] of those businesses that we have lost.

We'll go next now to Joe O'Dea with Wells Fargo.

In terms of the pricing announcements over the course of the past week, can you just give any color on that? We see the HCS guide go from [ 2 to 4 ] but presumably, where your pricing is on a narrower scope of products. And so just looking for any quantification of the recent price increases. And in addition to that perspective on the dollar effect. And so when we think about this, if consumers today are paying $10,000 for a unit, presumably the dollar effect of what you're flowing through is a pretty small number as long as the channel doesn't try to price on top of that?

Yes. So the first one, the price increases for us just went into our customers' announcements on Monday. So I think we need to work through that over the next multiple weeks and you probably know some competitors have announced that the week before. From our perspective, we need to work through that. I would take Michael's guide as the changes in our overall revenue is what we're expecting in price. So there's going to be announcement number. There's going to be a stick rate number out there as normal. But what we are confident is we'll offset the increased cost inflation through those actions is the way ever look at it.

Then on the impact to the homeowner, we still think the equipment is maybe 40% of the total installation costs but we'll have to see how that cost evolves, but we don't see this as a big driver of that input cost. It's most is the contractor labor and margin still.

Yes. I think 40% includes equipment, parts, supplies. And in some cases, it's less than 30% is better, depending on the installed and time. So I don't think it changes the consumer price elasticity in any meaningful way. But we are sensitive to the market demand supply agreement, but remain convinced that equipment pricing is the least of the variable in that equation.

Right. That's what I was getting at. And then just in terms of seasonality in HCS and margins, I think the past couple of years, we've seen margins step up from 16%, 17% in Q1 up to kind of 23% to 25% in Q2. Obviously, absorption headwinds that make it a little bit lower starting point in Q1 of this year. But just looking for weather, you think the past couple of years are a reasonable benchmark for what you think you can achieve as you get that seasonal step up in Q2 of this year.

Yes. I think the main driver is going to be the volume recovery within ACS. Obviously, we had some weird comps last year. But we're building within the guidance that we expect sequential year-over-year improvement Q2 versus Q1, Q3 versus Q2 and Q4 versus Q3. So if you look at the year-over-year declines, sequentially that should continue to improve. That will obviously help our margins. And then when you get on the second half of the year, you'll start to have even better absorption within those margins. That's what we're expecting right now, but we'll watch the summer play out. Q2 is a big quarter for us that we need to get through. And once we see that play out, I think we'll have a really good line of sight for the year.

We'll go next now to Deane Dray with RBC Capital Markets.

I appreciate the update on the new products on Slide 5. Can you just remind us, do you track a new product vitality index or the contribution from the new products? And then just kind of related, I believe you gave an indirect update in Steve's question on ductless, but anything on the Samsung JV would be helpful, too.

Sure. So yes, we track vitality pretty closely. And we track vitality where we do not consider refringent changes as a new product. So excluding that, our vitality remains in the 45% to 50% range. If we didn't exclude that, clearly, 80%, 90% vitality. But excluding the refrigerant change and [indiscernible] changes, we do remain quite pleased with the Vitality number. And I think the exact number is like 48 or something right now, but it's always in the 45 to 50 range. And we see are very pleased with heat pump introductions, indoor air quality introductions, [indiscernible] the control changes. You probably saw a lot more of that during [ Prakash's ] presentation at the Investor Day. So we remain quite pleased on where we're coming down.

On the Samsung joint venture, we talked last year but the meaningful impact is going to be this year because it takes almost a year for us to kind of get it through the channel, get dealer conversion, work through phase out of the inventory, and we are pleased with the current momentum and feel like there's a lot more upside as we take this forward, especially as we look at kind of everybody's impact in the same different tariff.

The feedback from the channel and the consumer has been very good. These are high-quality products with much better controls, much quieter than some of the competitive products. And the contractors like the fact that the same truck that's going to deliver [indiscernible] product also delivers this. The same rebate program can be added. So we are pleased with the direction it's going, and feel this continue to be a lot of upside as we go through the rest of the year.

That's really helpful. And then just a second question. And I'm really not sure the extent whether you can comment, if at all, but regarding the recent litigation against the resi HVAC manufacturers. And if it helps, we had an expert call and published on this where the expert declared the case very weak as it stands today. But just are you able to comment on it?

Well, thanks to you and others who have experts call on their own analysis. I really want to say a lot about this, Deane, and maybe we'll have to wait for some other occasion. Because at this point, I have to read a prepared statement given to me by my lawyers, but I'm glad you asked.

Our response is the matter is pending legal complaint. The lawsuit contains only plaintiff allegation and there has been no funding of wrongdoing. We dispute the accuracy of the allegation and will actively and vigorously defend our position through proper legal channels. Again, there's a lot more, I want to say, but I'm currently constrained because the lawsuit saying only the prepared legal portion of this.

That's great. I'm glad I asked. I'm glad you were able to read that statement and we certainly agree. So we'll leave it there...

You've made my general counsel's day that I read the statement.

We'll go next now to Patrick Baumann with JPMorgan.

A lot has been covered. I maybe just wanted to tie the inventory being normal comment with like the growth that we're seeing on the balance sheet year-over-year. I know some of that's acquisitions. Just wondering if you could give any color on like residential units within that bucket, either looking year-over-year or kind of versus current sales levels relative to history. Any context around where you are on that front?

Yes. Sure, Patrick. So typically, when we go from Q4 to Q1, like just last year, we built about $210 million worth of inventory. This year, we built $60 million. So think of that as $150 million reduction compared to what we normally build because we have to build a lot of inventory as we get into the peak summer selling season. When we ended the year last year, we talked about being $100 million and $150 million more inventory than we needed. So think of it as we are essentially back to a normal seasonal thing. Now I feel like we still have opportunities and Michael referenced through that as we get better in demand planning, better in [indiscernible] to work some of this down. And we'll continue to invest in inventory when appropriate especially when it comes to parts and supplies, which Michael referenced, emergency replacement, which we have been talking about in the past to make sure that our fulfillment rate remains at a very high level. But we are pleased with the progress of our inventory drawdown and feel like we are on track to meet our commitments to get to a stage where we are back to normal inventory.

And then maybe just a cleanup on price mix. Can you give any context on the 9% in the first quarter, how much came from price versus mix? And then for the year, the mid-single digit, it sounds like you added a little bit of price to that. How much is coming from price and mix within the full year guide?

Within the first quarter, the majority of it was mix. Alok mentioned that mix should really taper off here in the second quarter. Then for the balance of the year, it's all price.

Thank you. And ladies and gentlemen, thank you for joining us today. Since there are no further questions, this will conclude Lennox's 2026 First Quarter Earnings Conference Call. You may disconnect your lines at this time, and have a great day.

Good morning, everyone. Welcome to Lennox Investor Day 2026. I want to take a moment to welcome everybody who's here in the room in Richardson, Texas, and also everybody who's joining us online. As you would have probably known, we are proud of what we do, and we really appreciate the time you are taking to learn about Lennox and how we create value for our customers and our shareholders.

As is our usual practice, I want to start with safety. We have an excellent safety record, and we'd like to keep it that way. There is no safety drills planned for the day. So if there's an emergency event and the alarm goes off, please proceed towards the nearest exit as shown on these maps. In case of a severe weather emergency, we will shelter in place away from these windows in the hallways, in the stairwell, all in the restrooms. In case of other evacuation emergencies, we will walk down the stairwell towards the emergency meeting point outside the building entrance. Please follow me or one of your other hosts in a red Polo shirt in case of an emergency.

Before we begin, our legal team and Chelsey have asked me to remind you that during today's event, we will be making certain forward-looking statements, which are subject to numerous risks and uncertainties, as outlined on this page. We may also refer to certain non-GAAP financial measures that management considers relevant indicators of underlying business performance. Please refer to our SEC filings available on our Investor Relations website at investor.lennox.com for additional details, including a reconciliation of GAAP to non-GAAP measures.

I want to start today's main session by highlighting our core values and our guiding behaviors that shape our winning culture. Our core values of integrity, respect and excellence are and have been for the past 131 years, the foundation of our success. Our guiding behaviors that define these core values were updated in 2022 with increased emphasis on accountability and customer experience.

One of the benefits of hosting the Investor Day in the DFW area is that you get to experience our culture and meet our talented leaders who drive our success. I want to thank all the leaders who are presenting our story over these 2 days. In addition, I want to thank everybody who was part of organizing this event, the volunteers who have worked tirelessly for weeks to ensure that the event runs smoothly.

Now I do want to take a moment to introduce our executive leadership team who run this high-performance company. Let me start with Dan Sessa, our Chief Human Resources Officer, who has assembled this talented team over his illustrious 18-year tenure at Lennox. Michael Quenzer, our Chief Financial Officer, has been with the company over 20 years and in the role for 2 years as my finance partner in driving accountability.

Prakash Bedapudi, our Chief Technology Officer, who's led the development of all the world-class products and information technology for the past 17 years. Joe Nassab, the President of our BCS segment who's been with the company for over 15 years and started his current role on the same day that I joined Lennox. Sarah Martin joined Lennox last year as the President of our HCS segment, and brings a fresh perspective on how to accelerate profitable growth at Lennox. Monica Brown, our Chief Legal Officer, has been with the company for over 13 years and been in the role for 14 months with a passion to fully harness the power of intelligence -- artificial intelligence in the legal department.

Mary Ellen Mondi, our VP of Marketing, joined Lennox 3 years ago, and her impact is apparent in the digital enhancement we are making to improve customer experience. Finally, John MacQuarrie joined us with the recent DuroDyne and Supco acquisition, to ensure that we deliver double-digit growth in our aftermarket parts business. At this moment, please join me in thanking all our leaders and event organizers for driving the success of Lennox and this event.

During the main stage session, I will share an overview of the strategy followed by Sarah Martin and Joe Nassab, who will highlight the transformation underway at HCS and BCS segments, respectively. This will be followed by a short break that will allow you to mingle with our leaders, after which Prakash will give you an overview of our advanced technologies that are fueling our transformation. And finally, Michael will wrap it up by summarizing the anticipated fiscal impact of our strategy over the next 5 years. We will welcome all your questions at the end of the session.

Let me start my presentation with a video that recaps the progress we have made since our last Investor Day in 2022.

[Presentation]

I have 4 messages that I want to emphasize during my presentation today. First, as the industry continues evolving, Lennox' competitive differentiation will be even more powerful given our one-step direct-to-dealer model. Second, we remain bullish about the long-term potential of the North American HVAC industry. Third, we have invested in initiatives that will continue driving above industry growth from Lennox while also delivering margin expansion. Finally, we remain committed to continually enhancing the shareholder value through flawless execution and while remaining disciplined with capital deployment.

Our disciplined capital deployment is reflected in a strong ROIC of 39%, which is one of the financial metrics that we are immensely proud of. If you're new to the Lennox story, I should also mention that we have delivered top-tier shareholder return since our IPO 27 years ago, and we were welcomed into S&P 500 in December 2024. Lennox was founded with the differentiated value proposition of serving our contractors directly and even 131 years later, 75% of our revenues come from a one-step channel, which provides us greater intimacy and insights compared to our competitors. Over 80% of our revenue comes from nondiscretionary equipment replacement, which makes us more resilient during economic cycles and less reliant on growth from new construction.

The last point I want to make on this slide is that our BCS segment formed post-European divestiture in 2023 is now a significant contributor to our overall success, delivering approximately 40% of our total EBIT. Having 2 strong segments has made Lennox more resilient and was a critical factor in the company delivering over 20% EBIT in 2025 during the residential channel destocking.

Our recent successes are built on a strong history of innovation dating back to our founding in 1895. Since then, Lennox has continually innovated to better serve our customers' evolving needs. Recent innovations include our expanded heat pump portfolio, our advancement in control technologies, our digital data infrastructure to leverage AI and our JVs and acquisition to expand our market reach. As the industry evolves, our core differentiators will create an even stronger structural advantage for us.

Our greatest asset is our direct-to-dealer relationship where we are shoulder to shoulder with a 10,000 contractors who are served through our own 250 stores outlet and supported by a proprietary digital e-commerce platform. This approach is going to be even more valuable as our channels continue to consolidate and advanced AI technologies make it even more efficient for us to serve our customers. Our single ERP platform, combined with the united data infrastructure, creates the best opportunity for usage of AI tools to generate insights and fuel productivity and growth.

Our recent acquisitions and partnership allow us to expand our addressable market and better serve our customers' evolving needs with a portfolio that includes dockless equipment, water heaters, accessories and expanded commercial service offerings. These acquisitions and partnerships will further increase our competitive differentiation as there is more convergence between traditional HVAC industry and the plumbing industry due to channel consolidation and heat pump technology overlap.

The long-term attractiveness of our industry is due to 6 mega trends that enable above GDP growth for the HVAC industry. Electrification and the associated energy efficiency are accelerating demand for heat pump, which can be 300% more efficient than traditional gas furnaces. The industry's equipment is becoming environmentally friendly as required by regulation and as demanded by the consumers. The refrigerant change from R22 to 410A in 2010 addressed the depletion of ozone layer and the refrigerant change to A12 reduced the global warming potential of HVAC product. We expect this trend to continue as more states start implementing their own regulation.

The introduction of new refrigerants makes it more expensive to repair older equipment versus replacing it with a new unit. As weather patterns become more extreme, they create greater stain on HVAC equipment. For example, when the ambient temperature goes from 80 degrees to 90 degrees, the strain on the cooling system goes up by 30%. This additional strain can shorten the average useful life of the equipment which then requires more frequent replacement.

The focus on healthy living and air quality has increased consumer awareness and demand for additional equipment and accessories that protect indoor air from pollutants, allergens and even harmful bacteria and viruses. This is a long-term tailwind for both residential and commercial HVAC industry. The ongoing migration to southern climates with warmer weather helps with overall equipment penetration, it also shortens the average equipment life as heat pump equipment in harsh southern climate often has equipment life of 10 to 12 years, while the legacy gas furnaces in Northern Climate have equipment life of 20 years.

Finally, the advancement of AI and digitization is giving consumers more information, more control over the HVAC equipment, resulting in greater indoor comfort. This consumer awareness is also driving growth of equipment brand preference, slowly shifting the brand reprint selection from the contractor to the consumer. This shift will benefit equipment manufacturers.

In addition to these mega trends, the North American HVAC industry is also shaped by specific industry trends that also accelerate growth. Consolidation among OEMs continues as today, there are at least 2 fewer North American-focused HVAC manufacturer versus last Investor Day in 2022. This creates stronger brands, more scale efficiencies, improve quality, all of which increase the consumers and the installers trust in the replacement equipment.

Our installed base is aging and there is pent-up demand as many owners deferred replacement during the last few years as the industry was dealing with supply chain shortages, and 2 back-to-back regulatory transitions. There is convergence between the trades given the overlapping heat pump technology. Convergence is also fueled by consolidation among contractors and distributors, each of whom are positioning themselves to be a multi-trade service. The shortage of skilled labor and trade professionals is not getting better despite higher labor rates. This is increasing the relative cost of repair versus replace while also placing a premium on easy-to-install equipment and accessories.

Finally, advancement in digital controls and connectivity has created an opportunity for manufacturers to offer post-install engagement service options for both consumers and contractors. Putting it all together, let us spend a few moments discussing the growth algorithm for the North American HVAC industry, considering both the mega trends and the industry trends. There are many variables that influence the growth algorithm and some of them are listed on the left-hand side of the page. Similarly, there are different type of quantitative models that can be applied to these variables to predict the HVAC industry growth rate. In addition, there are various different types of growth rates, sell-in, sell-out which can often have wide divergence, especially during periods of uncertainty.

In my short 4 years of HVAC industry, I have observed that none of these algorithms are perfect. In fact, they offer 25 different predictions between 10 different experts. Hence today, we are not going to talk about industry unit forecast for 2026 or any other year. But instead, I want to reiterate our view that the HVAC industry units are growing to grow at least 3% CAGR over the next several years. Personally, I feel that the growth rate will be higher than 3%, especially because of the low starting point at the 2025 year-end. I'm not discussing this to convince the skeptics but I'm discussing it to share with you why we are convinced about the attractiveness of the North American HVAC industry and why we are 100% focused on it.

Anyway, let's turn the page and talk about more exciting things like Lennox. When we last held the Investor Day in New York in December 2022, we guided you towards a set of financial and strategic targets for 2026. 18 months after the Investor Day, we increased our 2026 financial targets given that we had a fast start. As we stand here today, even after a challenging 2025, we are pleased to report that we are on track to meet or exceed the long-term targets for both revenue and ROS. We used our strong cash flow to invest heavily in accelerating organic growth. These are high ROI investments, and we are confident that they will position us well for the future.

Our cash conversion for years '23 to '26 will be over 90% at the high end of our cash flow guidance range for this year. I'm grateful for the trust of our shareholders and our partners, and I want to thank our 13,000 employees who have worked hard to deliver these results. This is our accountability in action; promises made, promises kept.

In 2021, Lennox' full year segment margin was 14.4%. That improved in 2022 due to growth, productivity and the divestiture of the European business. Since then, we have further increased our margins by 400 basis points, achieving a record margin of 20.4% in 2025. While we are pleased with the progress on the transformation plan, I want to emphasize that many of the recent investments and initiatives are yet to deliver their full potential. The growth benefits of heat pump investments, emergency replacement initiatives, parts and service acquisition, and our JVs with Samsung and Ariston are going to become meaningful only in the next planning period.

Similarly, the margin upside from enhancing our distribution network, elevating pricing excellence, bolstering supply chain resiliency and investing in cost productivity initiatives is yet to be realized. This makes us excited and confident to unveil our 2026 through 2030 transformation plan. Our new transformation plan also has 3 phases. We are currently in the growth acceleration phase that we started last year. After this, we'll move to the expansion phase for 2 years before entering the elevation phase, the final phase of the 2026 to 2030 transformation plan.

In the growth acceleration phase, our focus would be to further improve our Net Promoter Score by improving fill rates through our distribution network while also generating productivity post-A2L conversion. In the expansion phase, we will grow our share of wallet as our momentum expands from new heat pump products, joint ventures and acquisitions. Our digital investments will make it easier for customers to do business with us. We are also planning for margin expansion as network optimization and factory productivity initiatives start to deliver benefits.

Finally, in the elevation phase, our impact will be elevated as technology and channel convergence starts gaining momentum. And the regulatory changes required for heat pump water heaters and higher efficiency furnaces goes into effect further benefiting our elevation phase of transformation plan. Our revamped distribution network will elevate the impact of our core initiatives, such as emergency replacement and growth in aftermarket part.

Putting it all together, our value creation framework has 4 differentiated growth vectors, 3 drivers of margin resiliency supported by core enablers of technology, talent and LUMS. Let's go to the details of each of these.

The 4 differentiated growth vectors that will drive Lennox's above-industry growth are: one, heat pump; two, emergency replacement; three, attachment rate for parts and services; four, total addressable market expansion. We expect each of these growth vectors to drive at least 50 basis points of differentiated growth for Lennox. For those who went on the tour of our product development and research center yesterday, you witnessed the investments we are making in new heat pump technology. And later in today's presentation, you will hear about this from Sarah, Joe and Prakash. Sarah will also highlight the opportunity for us to expand our total addressable market through joint ventures and then Joe will highlight the investment to grow emergency replacement and service attachments in his presentation.

We have made significant investment in developing these 4 differentiated growth initiatives and are looking forward to the accelerated growth momentum in our planning period. Just like growth, we have 3 well-defined initiatives that will expand our margins over the next few years. The investment in our distribution network to establish a hub-and-spoke network that relies on consumption-based replenishment pull system versus the legacy push system will generate significant cost savings while improving customer service levels. The frequent regulatory changes in our industry will continue improving our mix and the investment in upgrading our pricing processes to enable dynamic pricing will further expand our margins.

Finally, we are investing in automating both our manufacturing and SG&A processes to generate productivity and expand our competitive edge. As a reminder, we have a very resilient manufacturing footprint, single ERP, a world-class data lake that is being utilized to unleash the power of AI on our entire operation. Technology enables our success at Lennox, whether it's a front-end technology to delight our customers, AI technology to accelerate growth and productivity or a sustainable innovation that develops leading energy efficiency product. Later today, Prakash will get into the details of each of these. I don't want to steal his thunder, so I won't spend much time on this slide.

However, I do want to spend a few moments talking about AI and how Lennox is maximizing the potential of AI. We believe we have a unique opportunity to benefit from AI given that we have a single MRP system, common engineering platform and a really rich historical database. To take full advantage of AI, we have created a unified data lake that works with leading AI engines to maximize impact on our business.

We are driving AI impact in 4 different areas. First, we are challenging and enabling our employees to become more efficient using AI. Example of this will be our legal tools such as iManage and [ iCloud ] that make our legal team more productive. Secondly, we are using AI capabilities to rewire our core processes to generate enterprise excellence in key areas such as pricing, software, SIOP and new product development.

Thirdly, we are embedding AI into our own products and solutions, such as control, e-commerce and dealer service dashboard. This is making it easier for customers to do business with us while increasing their loyalty and our share of wallet. Fourth, we are also working diligently to incorporate our products into other people's AI investment. For example, our rooftop products are often used to cool data centers. Our DuroDyne products are critical for installing duct works in data centers and our refrigeration technology can be used for liquid cooling.

While we don't have the chiller technology that is common in today's data center cooling application, we remain optimistic that our development and investments will create new applications for our technology in data center liquid cooling.

Our business operating system, the Lennox Unified Management System, or LUMS for short, is a set of efficient management processes and a digital repository of our best practices. This includes key elements like a balanced score card for gold deployment. LUMS helps us execute better and helps us leverage our scale to punch above our weight class. One example of LUMS is the introduction of company-wide digital tools and processes to make it easier for customers to collaborate with us. We have introduced Net Promoter Score process and the resulting insights have led to investments in upgraded marketing and e-commerce technology stack.

We are standardizing and upgrading our software tools required for contact center, digital asset management, product information management and many more. We know that our greatest asset is our lawyer dealer base, and we know that our data assets used with AI tools, make it easier for our customers to work with us. Another aspect of LUMS is a relentless focus on improving customer experience at Lennox.

As part of LUMS, we are making significant digital investments to deliver exceptional service to our customers. This includes attracting, converting, servicing and retaining our customers. We are managing these initiatives in a unified way across all of Lennox and the early results are very encouraging. We are happy with the improvements in our Net Promoter Score, yet we know that we have many remaining opportunities to delight our customer. This remains our greatest asset that's not on our balance sheet.

Let me wrap up by summarizing why we have great confidence in our future. We participate in an attractive growth industry and have solid initiatives to accelerate differentiated growth. We are expanding our margins and making them more resilient by strengthening our supply chain and expanding our BCS business segment. Lennox Unified Management System drives our execution consistency, and we are very disciplined with the capital allocation decision.

Advanced technological solutions fuel the loyalty of both our unique one-step and two-step customers. Our talent and culture driven by our core values remains our primary differentiators that make our customers want to work with us.

With that, I welcome Sarah Martin to stage to discuss our Home Comfort Solutions segment. Thank you.

Good morning, everyone. My name is Sarah Martin, and I lead our Home Comfort Solutions business, or HCS. It's a little less than a year ago that I joined Lennox, and I spent my first months listening and learning, listening to dealers, to technicians, to our field teams and to our leaders across the organization about what we do well, but critically about where we can improve. Through this process, it became clear very quickly that HCS does have many of the characteristics of a high-quality business, but also has significant untapped potential. We're working on unlocking that potential by refining our investment and focusing on correcting where we've either underserved the market or where we've not yet delivered fully on our commitments.

Our end goal is twofold: firstly, to enhance the power of our direct model to deliver strong growth and margins; and secondly, to amplify the impact of our indirect model with investments in new products and distribution capabilities. And so I'd like to take time today to walk you through some of those enhancements and focus areas which will underscore why I believe the HCS business is well positioned to accelerate growth and expand margins over the next several years.

Before I talk about where we're going, I do want to spend a little bit of time on our segment highlights as well as our view of the current environment and an assessment of how we delivered in HCS on the commitments made at the last Investor Day in 2022. This should demonstrate not only the resilience of the organization, but more importantly, that we've laid a strong foundation for building long-term growth and profitability.

HCS is made up of 3 businesses and that allow us to service the residential end market, whether direct to dealer or one step or indirectly through distribution or 2 steps. These businesses are led by some of the most experienced and passionate leaders in the HVAC industry, including Lanessa Bannister, who has 12 years with Lennox under her belt and over 25 years in HVAC overall; and Bobby DiFulgentiz, who has 20 years of Lennox behind him.

At our core is Lennox Residential, which is a one-step direct-to-dealer business. Being direct gives a competitive advantage through proximity. We're closer to contractors, to technicians and ultimately to the consumer. This gives us a tighter feedback loop, earlier insight into demand patterns and a real-time view of customer sentiment.

Allied and ADP are predominantly 2-step businesses selling to HVAC distributors. This allows HCS to leverage our technology in manufacturing to serve the independent distribution space, and this extends our reach. It allows us to support different customer needs and to remain disciplined about how and where we deploy capital. Whether 1 step or 2 step, the nature of the demand we serve is exactly the same. Approximately 80% of our business is replacement driven, which is nondiscretionary. What that means putting in a different way, when a homeowner system fails, it gets replaced. And that's important because it makes this business fundamentally more resilient regardless of economic cycles and much less dependent on residential new construction activity.

To support this model, we have a significant organizational footprint comprising 5 manufacturing facilities, nearly 30 distribution sites and almost 250 Lennox store locations, plus we have more than 6,000 dedicated employees that make all of these results possible.

As we operate in a replacement-driven world that we are structured in scale to ensure products and services are available and reliable and that expert support is local really, really matters. Dealers, contractors and distributors need to be confident we're supporting them with speed and with certainty.

HCS' strategy is unique in that it combines both a direct and indirect model. It's focused on nondiscretionary replacement demand and it's enabled by technology, real physical distribution reach and a customer experience mindset. These things provide the foundation for everything else that I'll talk about today.

It is well known that the residential environment is experiencing near-term volatility. In fact, it will be disingenuous to suggest otherwise. In the last 2 years, we've experienced 2 regulatory transitions, channel destocking, significant affordability pressures driven by higher inflation and interest rates. These dynamics have introduced short-term volatility influencing both contractor and homeowner behaviors. Despite all of this, what's most important is recognizing what we can control. In other words, we don't set the interest rates, we don't dictate weather, we don't control timing of regulatory transitions. What we do control is how effectively Lennox operates within that environment and how we could outperform the industry even when conditions are challenging.

To do this successfully, we make a key distinction between what's cyclical and what's structural and it's what's structural that's really important. Structurally, the fundamentals of this industry remain the same. Equipment continues to aid, repair costs continue to rise, efficiency and refrigerant regulators continue to add complexity to systems. And of course, we see increasingly extreme weather continuing to shorten equipment life.

If we prioritize positioning HCS to respond to the structural characteristics of the industry, then our focus shifts from chasing short-term volume to controlling the controllables, protecting the economics of the business and improving execution. And this requires continued investment in the capabilities that allow Lennox to grow faster and more profitably than the industry over time.

And simply, this means having the right products in the right place at the right time to support replacement. It means making it as easy as possible for customers to do business with us when it matters most. It means improving fill rates, pricing discipline, enabling the attachment of parts and supplies, all while delivering an exceptional customer experience. And these are all areas where execution and not demand determines the outcome. And this is how HCS is thinking about outpacing the industry, not by assuming a different demand environment, but by executing perfectly within the one that we have.

And finally, before looking ahead, I think it's important to reflect on the commitments that we made coming out of the last Investor Day cycle. The expectations that we set in '22 were very clear. Lennox committed to executing through regulatory change, strengthening how we go to market, improving customer experience, adding capacity where it matters most and unlocking more value from its unique distribution model. These were 5 key commitments that would deliver growth, and we delivered against those commitments.

We work successfully through 2 major regulatory transitions, CO2 and the move to A2L refrigerants while remaining competitive and maintaining our customer trust. At the same time, we strengthened how we go to market in HCS. Revenue operations were built, pricing processes were upgraded and new business development resources were added. These changes improved execution discipline and gave the organization better tools to manage complexity, which has been key to navigating volatile market conditions.

We also focused on improving customer experience through investment in fill rates, adding digital tools and creating structured feedback loops. This makes it easier for dealers to do business with Lennox and over time, this focus has been reflected in sustained improvement in our Net Promoter Scores. In parallel, we expanded capability in heat pumps, coils and air handlers and in multifamily, reinforcing execution discipline and reliability across the business.

And finally, the team made good progress on our distribution excellence journey, restructuring sales and distribution to establish regional P&Ls and updating incentive structures to reflect margin performance, not just revenue. These changes improved accountability at the right levels, sharpen decision-making and directly contributed to improving our fill rates. And while we're encouraged by what we achieved, it's also important to be clear about where we fell short.

We set an expectation to significantly increase heat pumps as a percentage of total sales by '26. There was progress but we did not deliver the growth that we had set out to achieve, and I don't want to gloss over that. What matters most is that we understand why and that we have taken steps to address the gaps, and I'll spend more time on heat pumps later in the presentation.

So in reflection, what stands out for HCS is that we were not perfect, but we believe we've been credible. And Lennox has demonstrated the ability to execute complex commitments and to recognize when adjustments are needed and to invest where the business requires it. And that consistency exactly what we mean by stating promises made, promises kept. It's also the foundation for the growth opportunities that I'll walk through next.

So earlier, Alok talked about the overall strategic framework, and I'll double down a little bit on heat pumps, attachment rates, distribution efficiency and pricing. I'll also talk about some of the core enablers such as technology and LUMS. Our focus is on using that framework as a basis for consistent execution. In the next few slides, I'll demonstrate what this means for HCS.

As I mentioned earlier, Lennox missed its goals for heat pump expansion. The biggest reason for this is that we have portfolio gaps that reduced our ability to service customers. We lacked heat pump and air handler offerings that would appeal to customers in the warmer southern climate, specifically in the Southeast, where cabinet size and form factor really matter. In response, we've expanded the portfolio meaningfully by adding products that meet the form factor requirements, including side discharge units to address tighter lot lines. And at the same time, as technologies improved, we've developed and launched a cold climate heat pump to support the northern regions.

We also revitalized our ductless offering, the Samsung joint venture launched in 2025 really strengthens our position in this category. The JV brings a technologically advanced product portfolio with strong quality, global brand recognition as well as integrated controls. This enables a more seamless customer experience, something many of you will have seen yesterday on the PD&R tour.

Adding strategically to our portfolio gives Lennox a more complete and competitive lineup designed to meet a wider range of applications and customer needs. And this means we have a much greater opportunity for growth acceleration over the next years. Today, heat pumps represent roughly 15% of our total sales. That includes low single-digit penetration in ductless and low double-digit penetration in ducted systems.

At an industry level, heat pumps represent closer to 30% of sales, with approximately 10 coming from ductless and 20% from ducted. And that gap is really important. It reflects areas where we have underperformed historically, but it also highlights the opportunity ahead. With a more complete lineup, we see the potential to gain share across a broader set of applications, and that's why we describe heat pumps as a multiyear entitlement opportunity rather than a single inflection point.

The second growth driver I want to spend time on is attachment, particularly of parts and supplies.

This is where our thinking has changed and evolved in a very meaningful way. Historically, parts and supplies existed alongside the equipment business, but they were not managed with the same level of focus or intent, and that limited our ability to consistently grow attachment even though the underlying demand was absolutely there. And today, we're taking a much more deliberate approach. Parts and supplies are being treated as a distinct growth engine across the enterprise, not only in HCS, but increasingly across the commercial business. This includes OEM parts, aftermarket components and installation supplies, all managed with a focus on availability, category breadth and ease of doing business.

And a key element of this shift has been the addition of dedicated expertise. Through DuroDyne and Supco, we've brought in teams that come from a purpose-built parts and supplies business. And that talent brings deep knowledge, strong supplier relationships and an operating mindset centered on breadth, speed and reliability. This gives us confidence that parts and supplies attachment is now embedded into how the business operates day-to-day.

There's an innate understanding of customer need, inventory strategies, systems and incentives that are more aligned. And our leadership attention is focused on making parts and supplies a more consistent component of the overall customer experience. And to put this in context, our attachment rate today is in the mid-teens. We view best-in-class as operating at levels around 40%. So just like heat pumps, that difference highlights the opportunity that exists within our own customer base if we act with intention, leverage the skill sets that we now have in the wider business. And also as with heat pumps, this is not about a single year or a single initiative. It's about building a steady, repeatable capability that expands our share of wallet over time and strengthens our long-term customer relationships.

As we think about growing share of wallet with the customers we already serve, it's equally important to recognize that the direct model is not the only way that HCS serves the market. Our 2-step channel through our Allied and ADP brands plays an important role in HCS and allows us to expand our addressable market. We participate in this space with the same discipline and consistency that defines our direct business.

Our 2-step model leverages long-term distributor and customer relationships in key territories, and it offers portfolio options that target unique segments that are underserved by the one-step business. At Allied, the multifamily line, including the flagship MagicPak brand, continues to be a good growth engine and the coils and air handlers at ADP give us the strategic advantage of servicing the widest available range of system configurations.

We continue to refine and invest in our 2-step businesses, adding new distributors, launching new products, including an entry-level AC and developing new strategic partnerships that will drive growth over the next years. As we look at the expansion in our addressable market, we've identified strategic partners who are helping us to accelerate our ambitions, broaden our reach and enhance the customer experience overall.

Let's have a look at this video, which illustrates well how we're leveraging partnership to add value to our Lennox customers.

[Presentation]

Our partnerships with Samsung and Ariston strengthens our ability to participate in adjacent markets where complementary technology, product breadth and category expertise accelerates our path forward. These collaborations matter even more as the industry moves towards higher energy efficiency requirements, broader electrification and increasingly technology overlap between HVAC and water heating.

Success in this environment will require integrated platforms, new technologies, shared controls and unified home automation experiences. A great example of this can be found in the convergence of heat pump HVAC systems and heat pump water heaters expected later this decade, including the 29 regulations highlighted during yesterday's PD&R tour. Partnering with Ariston allows us to expand into hybrid solutions that combine our HVAC expertise with their leadership in water heating technology. And through Samsung, we gain advanced ductless capability in a controls architecture that connects naturally to the home ecosystem as well as support for product innovation that fits emerging applications and installation constraints. And finally, these partnerships allow us to move faster, meet more customer needs and position Lennox for a more electrified and integrated future.

Whether we deliver from partnerships or from in-house expertise, our success relies heavily on operating a highly efficient, agile and effective distribution model. Product availability has a significant impact on both customer satisfaction and share. And as mentioned earlier, Lennox has invested heavily in this capability, and we've delivered on our initial commitments, but our strategy continues to refine as customers' needs evolve.

Our distribution organization has come a long way. While the physical footprint is not yet fully optimized, we continue to improve it with intention. We're taking deliberate steps so that each change strengthens the system without disrupting the supply chain or the consistency our dealers depend on. We've redesigned the organization to clarify roles, improved accountability, allowing decisions to be made closer to the customer and aligned our sales and store teams to operate as a single frontline. To ensure we're measuring success and identifying opportunity, we've built standardized dashboards to improve visibility and drive consistency across the entire system. We also upgraded the core digital tools and systems that support our network. This includes new warehouse transportation, point of sale and contact center systems. We've strengthened our focus on parts and supplies, as we've already seen.

So we've made meaningful progress, but we're still early in realizing the full potential of this network. The work underway will transform distribution into a true competitive advantage rooted in consistency, responsiveness and a superior customer experience. We're pushing fill rates higher and elevating the reliability our contractors expect. We're advancing and simplifying our hub and spoke model through the FTC to improve speed, inventory placement and overall flow. We also see clear opportunities in margin entitlement, automation and labor management systems, all areas where disciplined execution can unlock structural improvements over time.

This next distribution phase is all about momentum. It's about taking the progress already made, building on it with purpose and executing with the discipline required to capture the full benefit of the network that we are creating. And later today, some of you will see this firsthand at the FTC tool, where our recent investment in a 1.2 million square foot facility demonstrates how we're redesigning and simplifying our distribution and planning platforms to improve performance over time.

We are certain that pricing discipline is critical in volatile markets and continue to invest in our capabilities remains a priority. We've built a strong pricing foundation, regionalizing our P&L to empower the teams closer to the customer, streamlining the back office and redesigning our sales incentives from revenue to profitable growth. We're now taking steps to invest in systems that provide not only efficiencies but which also create differentiation, provide upscale analytics and offer deeply segmented and dynamic pricing, leveraging the power of AI.

As with distribution and heat pump initiatives, pricing is not about short-term actions. It's about reinforcing the economics of the model with agile systems so we can continue investing with confidence.

LUMS provides the operating discipline and framework that connect strategy to execution, enabling our businesses to deliver on the commitments that each makes in that customer charter. And the customer charter is not just a piece of paper. It's a powerful tool because it sets clear expectations, creates transparency and reinforces accountability, and we share this with our customers as we are transparent about our ambition to improve our service levels and seek feedback and engagement about what they see and what they want to see from Lennox businesses. And it works because performance is visible and our leadership teams are held accountable for execution and attainment. This drives the level of ownership that delivers results and keeps the customer experience front and center of everything that we do.

[Presentation]

Ultimately, ease of doing business is felt day-to-day by dealers and technicians. We continue to enhance our dealer and technician experience and are fully committed to investments in digital tools with around 50% of our sales in residential now through LennoxPROs, building self-service AI training tools, product information and other key resources to support our dealers' needs anywhere and any time. These investments reduce friction and increase customer confidence that Lennox is agile, responsive and serious in our support, which is exactly what you want in a replacement-driven business.

In closing, when I look at Home Comfort Solutions today, I see a business that's structurally resilient, operationally improving and increasingly focused on its highest value opportunities. It's a business that's simultaneously delivered on its commitments while recognizing where we must do more. It's also a business that understands that we are accountable for focusing on what we can control, our customer experience, ease of doing business and building an agile and responsive organization that executes and it's this that delivers sustained long-term outcomes in a replacement-driven market. And this is why we continue to invest in major initiatives like distribution, portfolio, expanding attachment, partnerships, 2-step opportunities as well as critical systems and tools. And executing these initiatives well will deliver the value we need to support our growth and profitability ambitions over the next years. This is so that we can continue to gain share and deliver margins that are appropriate as both the manufacturer and the distributor.

Thank you. I'd now like to introduce Joe Nassab, President and EVP of Building Climate Solutions.

Well, good morning, everybody. My name is Joe, and I lead the group here that we call Building Climate Solutions. I've been with Lennox for 15 years now, and in this assignment since the middle part of 2022. We had the opportunity that year in December to visit during the Investor Day, I remember it well, recognized lots of faces in the crowd, but also very nice to see new faces in the crowd.

So a few years have passed since. I'm encouraged by the solid progress that we've made. And from this update, I hope you take away the following: first, that we put in the investment and the effort to build a very resilient foundation. That was critical to earn back the trust of our customers. We're turning our attention to growth. Second, we're laser-focused on expanding margins, ensuring that our work shows up where it matters the most. And third, we're scaling up with terrific talent and teams. They're deep, they're skilled, they're humble, and they're very, very hungry.

What I'd like to do is begin with a 30,000-foot view of the segment. Building Climate Solutions consists of 2 equipment businesses and a service division. Here, you see our sales mix, financial history and other highlights. Since 2022, we've grown consistently. Sales are up by over $0.5 billion. Return on sales has also grown consistently from 15% to over 23%. We've meaningfully increased manufacturing capacity. Equipment is distributed from 19 fulfillment centers across the country, and we have 140 service branches where our service teams operate from, roughly 4,400 people are part of our team.

So a few words on each of the businesses. Our commercial rooftop unit is all about delivering comfort and air quality. They serve many different markets from national accounts to schools, warehouses, restaurants, convenience stores, grocery stores. Lennox units sit atop thousands of buildings in North America. The business is led by Geoff Dethlefsen, many of you met Geoff yesterday, he is in the back of the room. He's been in his role now for 2 years.

Our Heatcraft division competes in the refrigeration space. They design and they manufacture climate control solutions for the cold chain. Heatcraft systems keep food safe and fresh in grocery stores and convenience stores, cold storage warehouses. Bob Landi is coming up on 25 years with the company. Bob leads our Heatcraft team.

And rounding us out is Lennox Commercial Services. LCS consists of our national account business and AES, the company which we acquired in 2023. The services that we provide encompass now the full life cycle from initial system installation to ongoing preventative maintenance, to plan replacement activity, ending in the recycling of decommissioned equipment. Chris Drury is a 22-year vet. His anniversary is this coming Sunday. He leads our service team.

Here's a very important point. Each of these 3 businesses, they deliver essential solutions. They're essential to the environment. They're essential to the economy and they're essential to the flow and to the movement of commerce.

Alok touched on this a little bit earlier in his discussion, but I think it's worth repeating. We're very bullish on our prospects, and we are for many different reasons. We serve industries which are heavily replacement driven. In any given year between 70% and 80% of total shipments are replacements. The installed base is large and it's very old, old systems, as you know, are less efficient. They're costly to service and they're difficult to maintain. And so at a certain point, a smart economic decision is to replace.

As it relates to weather, there's no debating the trend of extremes extra cold winters, extra hot summers, they tax equipment, that shortens life and it also fuels demand. Advanced indoor air quality is shaping system design in the commercial HVAC space as well. Industry standards are elevating ventilation and outdoor air requirements. And as a result, we see attachment rates for these things increasing. And then we have electrification and efficiency. The world is slowly moving away from fossil fuels. We see this especially with our national account business, many of them have made bold sustainability commitments that require replacing thousands of systems annually well into the next decade. These trends, they play in our favor, and they do so, as Alok said, over the long term.

So as I said, we've come a long, long way since 2022 when we were last together. I told you then that we'd be focusing on a handful of things. I told you that we worked to solidify our foundation, manufacturing and quality in the supply chain. I told you that our teams would execute with discipline, robust operating systems, they make all the difference. And I also said that we delivered consistent growth, both top line and bottom line. Well, since then, we've successfully completed 2 regulatory transitions, fortified the supply chain. We've improved our operation in Stuttgart. We doubled capacity with the new factory in Mexico, improved quality, expanded points of distribution, increased front-end resources, and we enhanced our portfolio with that AES acquisition.

We're encouraged by our progress. We're also encouraged with the improvements on the financial side. Encouraged for sure, but I also tell you we're very far away from being satisfied with where we are. And so I'll spend the balance of our time addressing these 4 areas, beginning with innovation with a little bit of a focus on heat pumps, service efficiency and low GWP refrigerant. Next, we'll touch the emergency replacement market. That's a biggie for us. We're constantly fine-tuning our operations and looking forward, factory productivity will be a major source of margin expansion; and fourth, we're scaling up services because demand is robust, and it's increasing.

Lennox, as you know, has a very proud history of innovation and our direct model provides a distinct competitive advantage. Being the industry's only manufacturer and distributor and servicer enables unique customer access and intimacy. The power of direct demands consistent communication and collaboration and on-site presence. Every single interaction sharpens our understanding and raises our insights. Our product management and engineering teams are focused on developing solutions for building owners and specifying engineers, installing contractors and service technicians. They all matter, all of them and all of them have unique needs from total cost of ownership, to installation ease, to speed of service.

Highlighted here, we have 3 examples, beginning with our ultra-high efficiency heat pump many of you saw yesterday. Technology for this originated out of the DOE cold climate challenge. Now concurrent with that, our team works side-by-side with one of our largest customers. In fact, over 50 separate meetings engineer to engineer to develop heat pump technology specific to them. And as a result, we designed the system backwards compatible with their electrical infrastructure. The electrical side of the equation has been one of the biggest barriers to heat pump adoption. This ultra-high efficiency system will save hundreds of thousands of dollars per store.

Another commercial rooftop example is our Xion platform, also showcased last night. Last year, Xion won the HVAC All-Star Award and was recognized by contractors with the most service friendly design. Xion delivers technician-focused features in the standard efficiency category. This platform is ideally suited to the emergency replacement market.

And on the refrigeration side, Heatcraft was the first OEM to release an A2L offering. They actually designed a dual convertible solution that allows customers to install equipment initially using A1 refrigerant and then upgrade in the field with an A2L conversion kit. This versatile design is both a financial and peace of mind win for contractors, for end users and also wholesalers. Now after the break, Prakash will expand more on this topic of innovation and share many of the other exciting things that are on the horizon.

On to emergency replacement, one of our largest growth opportunities. You touched this often with Alok and Michael. It's a big part of the market. And due to pandemic-related supply challenges, we were forced to pull back, but we've aggressively reentered. Geoff and his team have very clear eyes on what's required to win. It's a combination of 4 elements. We call them here the 4 rights: the right products in the right place at the right time at the right price. It's very simple in theory. The trick, though, as with most things, lies in the consistency and quality of execution. To that end, we've made lots of changes, and we've made plenty of investments.

Started with that new factory in Saltillo effectively doubling our capacity. We have leading platforms in Xion and Raider. Inventory is fully deployed across our network. Today, we have 40% more locations than we did in 2022. And I expect that number will increase meaningfully in the next few years. We've staffed a team with a dedicated group of sellers and to make things easier for customers developed a quick quote tool to maximize transaction, ease and speed. While starting off with a fairly small base, emergency replacement sales grew 50% plus last year. We expect them to grow higher than that this year and continue to grow at an accelerated rate for years to come.

All right. Shifting to operations. Like most every other company, we learned painful lessons during COVID, and it's why we've worked tirelessly to retool our supply chain. We made a major push to dual source our most critical parts and components. That had been a significant issue. It's not any longer. We built a new factory dedicated to high volume, low variation equipment, equipment tailor-made for the emergency replacement market. A few years ago, capacity was a significant issue. It is not any longer. And having the second factory, while it simplifies Stuttgart enables them to focus on premium configure-to-order products systems that are in demand with our national account customers and out of the verticals like education.

It's exciting for me to see our operations folks are now charting the future with strong seasoned leaders with fully staffed factory teams with the complexity of 2 regulatory transitions now in the rearview mirror and a much more robust supply chain. We plan to reduce factory costs every year, every year, and this will drop millions of dollars annually to the bottom line.

Then we come to another growth engine, services. Here are a few interesting statistics. As I said earlier, we have 140 branches around the country. We employ about 1,000 technicians. That number has increased steadily, and I expect that will continue. We have 900,000 rooftops under contract. The average age is 15 years. The systems that we service, heat and cool, over 180,000 commercial buildings. Last year, we recycled 15,000 units and recovered a bunch of refrigerant.

Now due to the size, the age and critical nature of these systems, demand for services is extremely consistent, and it is consistently increasing it's true in good economic times. It's also true during the challenging times. As you know, this is a people business, and it's a technical business. And our growth is regulated by both human and technical capacity. We're increasing both in 2 ways. We hire and train about 200 technicians every year. Most of them come out of trade schools. These young folks apprentice under a lead technician for a year in what we call our Build Detect Program.

We're also keenly focused here on productivity. And with each of our 1,000 technicians, our goal this year is for each of them to perform one extra service call a month, it all adds up, it all adds up. Few years back, services comprise less than 20% of our segment revenue. It's grown to 25% today. As you see, we aim to increase that even further. Our growth will come from cross-selling AES services and solutions from increasing the attachment rate on parts and accessories, including products from DuroDyne. And while we have a strong base with our national account customers, there are many that we're seeking to go even deeper with and there are many others that we're working actively to convert. Growing services will make Lennox better and more predictable and even more valuable.

Now before I wrap up, I wanted to spend a moment on our investments in digital tools and training, which ultimately enabled this business to work at scale. These investments are all about making things easier for customers to work with Lennox. That commercial quick quote tool I talked about is one example. So too are the extensive training programs that we develop and deliver to contractors and technicians and counter reps and wholesalers. We aim to ensure that Lennox customers are the most highly trained and competent and confident in the industry. You got a little taste of that yesterday at the new training center just down the road.

Beyond that, we're implementing new tools in our service division to make it easier to schedule and complete calls. We're very confident that these investments, too, will enhance loyalty and also accelerate growth. So that was a very quick spin around building climate solutions. My hope is that you take away a couple of important points. We have solidified our foundation. We're pleased with our progress, but as I said to you, far away from being satisfied, we've made promises and we've kept the promises.

Bob and Chris and Geoff and our 4,400 associates have put -- points on the board. They have terrific energy and momentum. I feel it and see it every day in every one of these operations. I'm exceptionally confident in this team and excited by what is to come. And so as I wrap, we wanted to share with you another short customer testimonial.

[Presentation]

All right. Well, thank you very, very much. We're going to take a short break. Many of the Lennox leaders will be in the back of the room. As you know, the restrooms are out in the hallway there, and we'll reconvene at 11:10 AM. Thanks again.

[Break]

Welcome back. I trust you had a pleasant break and an opportunity to engage with our team members. As referenced by Alok earlier, my name is Prakash Bedapudi, and I've had the honor of leading global technology function at Lennox for more than 17 years.

To begin with, I want to emphasize 3 key messages that will guide my presentation. First, front-end customer experience. We are investing in smart thermostats and digital platforms that make Lennox easier to do business with and easier to own. The objective is to reduce friction for dealers and homeowners strengthen engagement and create a connected experience that drives satisfaction and loyalty.

Second, artificial intelligence and automation. We are applying AI to enable better diagnostics and faster service, helping technicians resolve issues more quickly, improve the consistency of service and reduce equipment downtime. AI also helps us streamline processes internally, so we can move faster and scale best practices across the company.

Third, sustainable product innovation. We are building on our track record of flawless regulatory transitions and moving aggressively into next-generation products that deliver efficiency, performance and reliability. This is about designing for the future and creating a portfolio that can win across climates, segments and price tiers.

With that framing, let me start with our technology capability and capacity, and then I'll walk you through a few proof points to highlight product innovation, digital experience and AI. So this slide gives you a sense of the scale, depth and breadth of Lennox' global technology capability and why it's a real competitive advantage for us. In recent years, we've broadened our innovation capacity in North America and worldwide to speed up product development, boost product vitality and maintain differentiation.

In Carrollton, Texas, where some of you visited yesterday, we continue to invest in advanced labs and engineering capabilities that support our core residential and commercial platforms. At the same time, our India technology center has scaled significantly, giving us 24/7 development capability and access to top-notch talent. Thanks to these investments, we've seen a significant rise in product vitality shown by a higher share of sales from products launched within the past 3 years. This is an important sign that our R&D efforts are effective and that innovation is having a real impact on our business results.

We have over 0.5 million square feet of lab space, a strong and growing patent portfolio and a global team of more than 1,500 technologies focused on delivering real customer needs, whether that's efficiency, reliability, affordability or ease of installation. The key takeaway here is Lennox has built a scaled, global and highly connected technology organization that enables faster innovation, better execution through regulatory transitions and sustained product leadership.

While our technology capability has expanded significantly, we're not done. Many of you joined us last night at the new Waterview Campus, and that facility represents the next step in our capability build out. The new R&D lab we are adding will let us conduct large commercial test chamber work in-house, boosting development speed and cutting outsourcing costs. We're launching a customer innovation center at our Heatcraft Refrigeration business headquartered in Atlanta, Georgia, dedicated to developing and testing high capacity, low GWP and CO2 refrigeration systems, including liquid cooling for high-density heat rejection applications. In addition to product development, [ each ] facilities support customer and partner engagement by providing practical training, installation, servicing and maintenance of our products.

Looking back at the commitments we made at the last Investor Day, I am proud of how the team delivered on the promises. We have had 2 major regulatory changes in a very short window and our team executed both transitions on time with safe, reliable and high-quality products. At our last Investor Day, I shared that we would scale our new product launches contributing to 50% to 55% of revenue by 2026. We are well on our way to achieving the target this year.

We also committed to advancing our digital solutions to improve customer experience. Over the past 2 years, we've added AI-enabled diagnostics across product and strengthened online tools, our dealers rely on for product access and coding. On the innovation and product leadership, we promised meaningful progress, and we delivered. We launched next-generation high-efficiency cold climate heat pumps, the most compact air handler platform and introduced the L40 smart thermostat, which has already earned recognition for its intuitive design and features. We're doing all of this without sacrificing quality. In fact, the expanded capability and more rigorous validation allowed us to raise our quality standards as we increase our speed.

Finally, our commitment to driving productivity and enhancing our supply chain has yielded positive results. Through engineering and sourcing led cost reductions as well as significant productivity improvements within our manufacturing facilities, we have increased our product cost competitiveness while consistently upholding Lennox' high standards of quality.

This page reinforces an important point. Innovation leadership at Lennox is recognized externally by our customers and validated in the marketplace. During the past decade, our commitment to sustainability, efficiency and customer focus design has been recognized with over 40 dealer design and HVAC All-Star Awards. These distinctions cover both residential and commercial sectors, underscoring the strength and leadership of our product portfolio.

What matters is why we earned recognition. Our solutions provide greater efficiency, improved connectivity, easy-to-use interfaces and dependable performance. Our sustainable product innovation strategy has grown very effective. It is achieving success with dealers appreciated by customers and clearly differentiated within the marketplace. This aligns directly with my initial remarks, sustainable product innovation at Lennox is a demonstrated track record, not merely an aspirational concept.

And that's a perfect lead into my next section because it isn't just about innovation. It's also about flawlessly executing regulatory transitions. So this slide highlights how Lennox has successfully navigated through 2 of the most complex regulatory transitions in our industry, SEER 2 and low GWP, and turn them into a competitive advantage. The SEER 2 transition was executed smoothly with minimal design modifications and very little disruption to our dealers since our solution left the indoor units unchanged, only the outdoor units required design changes.

The low GWP transition was a major multiyear initiative that required coordinated efforts from engineering, product management, marketing, operations and sourcing teams worldwide. We prioritize product safety and ease of installation by integrating refrigerant leak detection into furnace and air handler controls, streamlining installation. Innovations such as Flex Coil supported seamless transition for dealers without workflow disruption.

We have also brought to market our cold climate heat pump technology, which won the DOE Challenge and further establishes our leadership as the electrification megatrend gains momentum. We address supply chain issues, including refrigerant canister shortage by pre-charging units at the factory for longer line settings. This transition did not slow us down. It strengthened our position and build confidence with dealers, customers and regulators alike.

This page explains our commitment to product differentiation after the A2L transition, highlighting how this approach matches customers' top priorities. First, on product differentiation, we are focused on leadership where it matters, higher efficiency, better comfort, ease of installation and serviceability. We are regionalizing core climate heat pump technology, ensuring performance is optimized for the environment where the systems operate, not just designed to a single operating point.

Second, controls and integrated solutions. We are the industry leader in OEM manufactured thermostat attachment, and we are continuing to build integrated system solutions that include indoor air quality, zoning and connectivity.

Third, regulatory compliance. We are developing advanced system architectures that not only meet future low GWP and natural refrigerant regulations but also -- but do so while maintaining leadership in cooling, heating and furnace efficiency.

And finally, cost, reliability and quality. Through value engineering and in-house development of key technologies like variable speed drives, we are lowering the cost while maintaining the reliability and quality our brand is known for. Together, this portfolio ensures we are not just compliant post A2L, we are delivering differentiated solutions that strengthen our competitive version and support long-term growth.

As we advance innovation across these 4 pillars, a key facilitator supporting our efforts is LUMS, Lennox Unified Management System. This operating model standardizes our product development processes, enabling disciplined execution by integrating lean principles, automation, collaboration and continuous improvement to accelerate progress and deliver superior results.

This slide shows how we are using AI to fundamentally accelerate product development, not just to work faster, but to work smarter. By applying AI to optimize design, we've been able to redeploy roughly 10 weeks of development time to more value-added tasks, delivering better performance at a lower cost. That's a meaningful improvement in speed to market while strengthening product economics. Artificial intelligence supports every phase of the [ NPV ] life cycle from initial ideas to product launch and post-launch review. This integration enables faster, better decisions and reduces rework.

As we accelerate how we develop new products, heat pumps are one of the clearest examples of where that speed and focus really matter. Yesterday, you heard the team talk about heat pumps. And today, you heard from both Sarah and Joe reinforce the strategy. This slide highlights how our heat pump system portfolio designed to win across regions, price tiers and applications. On the indoor side, we have streamlined and optimized our air handler lineup to be size and cost competitive, including air handlers to replace traditional furnace applications and multiple mounting options that give contractors flexibility in the field.

On the outdoor side, we are taking a very intentional approach to regional optimization, matching the system design to climate conditions while improving the cold climate performance and overall efficiency. At the same time, we are driving material cost reduction and long-term differentiation by investing in our own power electronics, giving us greater control or performance, cost and supply resilience. This portfolio meets regulations, broadens the markets and adds value to dealers and homeowners, allowing Lennox to gain market share as heat pump adoption grows.

This slide highlights how controls and connectivity are becoming a powerful differentiator for Lennox. We've broadened our thermostat portfolio to cover the full range from entry-level smart thermostats with simple, elegant controlled ultrasmart thermostats with richer functionality while delivering a consistent, unified app experience across the board.

Equally significant, connectivity enhances dealer relationships by facilitating greater utilization of service dashboards, improved diagnostics and seamless integration with broader ecosystems like Samsung SmartThings, Ariston IoT Cloud and emerging standards like Matter. Ultimately, controls and connectivity improve customer experience, strengthen loyalty and bolster Lennox's [ status as ] preferred system.

We are applying AI across 2 complementary value themes: first, growth in customer delight. Using AI to make Lennox easier to do business with, improve the homeowner experience and increase win rates; second, organizational efficiency and productivity. Using AI to eliminate manual processes, improve decision quality and reduce cycle time in core workflows. Let me share how we are using AI to materially improve the customer experience, not as a concept, but at scale and in day-to-day execution.

We are already seeing a strong adoption of our agentic AI tools in the field. More than 9,000 technicians are actively using our AI tool, and the feedback has been exceptional. 95% positive, which is a strong signal that we are improving both ease of use and quickly resolving problems in the field service and tech support. We've logged over 41,500 support sessions across technicians and homeowners and the tool can recognize and interpret more than 250 error codes, helping users to move faster from symptoms to diagnosis to resolution.

We use AI across enterprise including tools for technicians and homeowner support, software coding agents like GitHub copilot, AI-driven selling platforms such as LennoxPROs as well as dynamic pricing and process automation. In summary, AI is helping Lennox win on experience and efficiency at the same time. That's a powerful combination as we scale growth and expand margins.

This slide brings together why we are confident in our ability to win both with AI, with evolving regulatory and customer needs. First, our front-end digital technologies are focused on one simple goal: delivering the best customer experience, making Lennox fast, reliable and easy to do business with. Second, artificial intelligence and automation. These are increasingly integrated into our operations, expediting decision-making process, enhancing productivity and supporting more rapid and high-quality execution.

Third, sustainable product innovation is central to our strategy, creating solutions that address efficiency and regulatory needs while providing value to customers. Finally, we built a strong technology infrastructure that is secure, scalable and ready to support advanced digital capabilities across enterprise. Together, these capabilities position us extremely well to lead through change, outperform competition and deliver sustainable growth.

Thank you for your time and the opportunity to present Lennox technology and innovation efforts. Innovation is most important when it is reflected in our financial results. With that, let me welcome Michael to the stage.

Good morning. It's great to be here with all of you today. As you heard from Alok and our business leaders, our strategy is centered on our customers, strengthened by technology and brought to life through disciplined execution. Now I will walk you through the financial engine that this strategy enables including the results we've delivered, the levers driving sustained performance and our path to our 2030 financial targets.

Let me start with how we've been performing recently. Over the past several years, we have delivered strong results and growth, higher margins and cash flow through operational excellence across the business. Our revenue reached $5.2 billion, up 16%, and margins expanded to just over 20%. This is solid performance, especially given the industry work through 2 regulatory inventory destocking cycles in 2023 and 2025. And with those cycles now behind us, we see additional growth ahead.

A significant achievement has been our margin expansion. We've increased adjusted operating margins by more than 400 basis points through strategic divestitures, pricing excellence and productivity gains. We're also converting profit into cash at a high level, delivering an industry-leading ROIC of approximately 40%. That performance reflects targeted capital expenditures with good ROI, working capital optimization and acquiring businesses at attractive valuations, all while maintaining healthy debt utilization that keeps our leverage near 1.5x. The results you see on this page are driven by what matters most, a strong management team and the Lennox Unified Management System, which keeps us focused in delivering year after year.

Let's take a closer look at our key drivers behind our profit performance. Over the past 3 years, we have increased profit by $325 million. This chart shows how our team delivered that improvement through product mix gains, pricing cost management and sustained cost productivity improvements. The mix benefit comes from upgrading our products to meet the new 2023 DOE and 2025 EPA regulations. On pricing, we've protected our margins by offsetting more than $475 million of inflation with $625 million of price.

We've also remained committed to investing in the business. Since 2022, we have deployed more than $50 million to improve the digital customer experience, launch new products, advance our ERP systems and expand distribution capacity to improve fulfillment rates.

Let's shift now from profit to cash flow. We convert profit to cash at consistently high rates, generating approximately $2.2 billion since 2022. Free cash flow remains solid, even with capital spending running $100 million above depreciation and with about $200 million of temporarily elevated inventory in 2025 that will convert to cash flow in 2026. We also see improved accounts receivable and accounts payable, unlocking more than $100 million of cash flow. We achieved this through better processes and increased IT automation, and we see additional opportunity ahead.

Next, I will show you how we have deployed our cash flow. We take a balanced approach to capital deployment using each option to strengthen the company. Our strategy begins with capital expenditures. We've been investing above depreciation to make up for past underinvestment and to support growth and productivity initiatives. We expect capital expenditures to normalize relative to depreciation after 2026. From there, we deploy capital through consistent dividend growth, opportunistic share repurchases and selective M&A at attractive valuations. All of this is supported by maintaining an investment-grade debt profile that gives us the flexibility to execute through economic cycles.

Let's now dig deeper into each of these deployment methods starting with dividends. Our dividend philosophy is straightforward. We aim to provide a modest and reliable dividend that grows over time and reflects the strength and consistency of our cash generation. Since 2022, we have increased the dividend each year, delivering nearly a 14% CAGR from our IPO. We expect dividends per share to rise with earnings in the years ahead.

Let me now turn to share repurchases and how we have used them over time. Like our dividend performance, we've been consistent with our share repurchases, buying back stock when it trades below intrinsic value. Since 2006, we have repurchased more than 60% of our shares outstanding. We currently have more than $1 billion remaining on our board authorization, and we expect additional authorizations as we deploy the substantial cash flow we will generate in the years ahead.

Next, a look at our portfolio actions. We've been active in shaping the portfolio, beginning with the divestiture of our European operations in 2022, which positioned us to pursue complementary acquisitions and strategic joint ventures. In 2023, we acquired AES at an attractive 6x multiple, strengthening our relationship with large commercial national accounts through a complete offering that includes equipment sales, installation maintenance and end-of-life recycling.

In 2024, we formed a joint venture with Samsung to sell ductless product through a Lennox distribution channel, enhancing both brand quality and product offering. In 2025, we expanded our product portfolio in 2 ways. First, we formed a joint venture with Ariston to sell water heaters. Then we acquired DuroDyne and Supco, which expanded our ability to manufacture and distribute a wider range of commercial and residential parts and accessories. Looking ahead, we will continue this bolt-on approach. We plan to expand our parts and accessories platform, building on the Supco and DuroDyne acquisition. We also see opportunities to expand commercial service presence and accelerate our controls and indoor air quality offerings.

With that, our review of the past several years is complete. Now let me turn to where we are headed and outline our new 5-year financial targets.

As we introduce our new 5-year financial targets, our approach remains consistent with the framework we have used in the past with a focus on revenue growth, margin expansion and strong cash flow conversion. We are targeting revenue of $6.5 billion to $7.5 billion, profit margins expanding from roughly 20% today to between 22% and 23% and cash conversion of more than 90% of net income. These targets reflect the investments already in place and a record of management meeting the commitments we set.

Next, I will walk through the specific revenue and profit drivers behind each of these goals. Our plan to achieve our revenue growth target starts with healthy underlying market growth. As Alok noted, we expect solid demand in both residential and commercial markets over the next several years. We've analyzed the past 20 years of industry shipment data. When we look at a typical equipment replacement cycles, repair patterns and the impact of new construction expanding the installed base, our modeling across multiple simulations indicates market growth above 3%. That gives us confidence that our baseline assumption of 1% to 3% growth is realistic and achievable.

The next growth driver is share expansion. We see meaningful opportunity where our share is below the industry average and in product categories that customers currently source elsewhere. Sarah and Joe highlighted these areas earlier, including heat pumps, parts and accessories, attachment, water heaters and commercial emergency replacement. Across these initiatives, we expect an additional 1% to 2% CAGR. Importantly, the midpoint of these growth initiatives reflects only about 40% of the full opportunity we see today.

With no major regulatory changes on the horizon for the next 5 years, price and mix should normalize to typical levels of 1.5% to 2.5% per year. Our 2025 acquisitions of Supco and DuroDyne will add another 0.5 percentage point to our revenue CAGR. Taken together, healthy end markets and execution on our growth initiatives position us well for sustained sales growth.

Now let us turn to our long-term profit targets. We have already expanded profit margins substantially, and we see more opportunity ahead. First, we expect cost inflation of 1.5% to 3% per year, which will pressure margins. But our pricing actions, better pricing processes and cost productivity initiatives will more than offset inflation and lead to net margin improvement. These cost productivity initiatives include optimizing our distribution network, value engineering cost out of the products, in-sourcing select components, advancing manufacturing automation and using technology to improve SG&A productivity. Together, they are expected to deliver 1% to 1.5% of annual cost productivity.

As we have done consistently, we will reinvest a portion of these cost savings into initiatives that drive future growth and additional productivity. And combined with the 30% incremental margin on higher sales volumes, these actions support profit margins expanding to the 22% to 23% range. That same margin discipline shows up in our free cash flow. Over the next 5 years, we expect to generate more than $4.5 billion in free cash flow. That gives us meaningful capacity for both share repurchases and bolt-on M&A.

Now let me close by bringing it all together with our long-term financial algorithm. As I said at the start, we have a proven record of setting long-term targets and delivering on them. Using the midpoint of our new long-term targets, our financial algorithm compounds consistently. It starts with solid revenue growth from our markets and targeted initiatives. From there, our manufacturing, engineering and distribution teams drive cost productivity that expand operating margins. We then convert a high percentage of net income into cash and deploy that cash to repurchase shares and repay debt. This approach is expected to deliver double-digit returns for our shareholders and makes Lennox an attractive investment opportunity.

I will now hand it back to Alok for a few final closing comments.

Thank you, Michael. Appreciate you summarizing the fiscal impact of our simple long-term strategy. I'm going to wrap up by recapping our long-term strategy. On top of the pyramid, we have 4 growth vectors that will drive our differentiated growth. We've talked about all of them throughout the presentation. Then we have 3 margin drivers below that, that will expand our resilient margins. Supporting growth and margin expansion are our 3 core enablers: advanced technology, execution consistency and talent. Advanced technology establishes product supremacy and enable success by using digital and AI as core competencies. Our execution focus through LUMS, makes it easier for customers to work with Lennox. And finally, our talent and our values are the bedrock of our strength and critical to our success.

We started today's presentations with our values. So I'd like to highlight our talent initiatives before we end our formal session. We have a very strong employee value proposition that allows all of us to be unified in saying, we are Lennox, come, grow and stay with us. To maintain and enhance this value proposition, we have been investing in developing leaders, building bench strength and strengthening our culture. We measure success through employee surveys and our balanced scorecard that shows that 70% of our leadership roles are filled internally. Our culture is the leading reason for our employees staying with us and our customers doing business with us.

To sum it all up, I just want to say that I'm more excited about Lennox' value creation potential today versus when I joined the company 4 years ago. I'm confident that our best days are still ahead of us.

With that, I want to invite all the speakers back on the stage for the Q&A session. As they make their way back to the stage, I do want to take the opportunity to thank our employees and leaders who have worked tirelessly behind the scene to organize this successful event.

To manage the Q&A process, we will start with the questions from the front row and then make our way back slowly. You would have noticed that we have reiterated our 2026 guidance this morning, which means that we have no meaningful update on 2026. Hence, I'm really hoping that your questions will be focused on the long-term strategy that we presented today. If you have a question, raise your hand and either Sam or Alison...

It's Joe O'Dea from Wells Fargo. Can you start on some of the growth opportunities around kind of penetration when it comes to attachment rates and where you're setting targets on those as well as the heat pump kind of time line on targets. So you go from an attachment rate of 18 to 40 or 25 to 40 when we think about HCS, BCS on the service side or where you think about kind of heat pump as a percent of sales? Where do you expect those to be when we next come together for an Investor Day?

Sure. I mean that's a good internal and healthy debate we have been having. But I'll give you some insight. We don't think we get to full opportunity within the next 5 years. I mean some of these are much longer-term penetration opportunities. So what we have built into each of those, and then Michael obviously hedges that appropriately from a financial sense, that we would be between half and 3/4 of the way of those full opportunities. So in each of these opportunities, we had a bar on where we are today, and we had a bar on where we have full opportunities. And we said we'll be between 50% to 75% of that full opportunity in the next 5-year period. And that's what led to our growth algorithm saying each of those initiatives contributes about 50 basis points of growth.

And then just one on investment priorities because you talked about kind of a large opportunity set as the portfolio gets bigger, it expands those opportunities. And so as -- if you kind of narrow that focus within HCS, BCS, kind of -- if you kind of rank order in terms of over the next, call it, 12 to 18 months, 12 to 24 months, just how you're thinking about those investment dollars and sort of the highest priorities within the portfolio?

I think I'll start by saying that a lot of the investment needed for the next few years has already been made. And the -- as Michael says often, the costs are in our P&L, the benefits are not. So I think that should probably give you the bigger overview of the answer. At the same time, on things like distribution, on things like parts and supplies, which are across both the segments, and we share those investments, there's still more to be done.

Prakash highlighted the opportunity for us to invest more in testing, product development, customer experience and training, which is also across both the segments. But I think from each of the segment perspective, the core investments, whether it's manufacturing in BCS, distribution in HCS, those are already in our books. So I wouldn't expect anything significantly incremental to that. And that's why in Michael's walk, you didn't see a drop down for extra investment beyond what we get out of our just regular drop-through on volume.

Tommy Moll from Stephens. I wanted to ask about the parts and supplies attach rate for the resi business. Ultimately, you're asking customers to break a old habit. They've been buying parts and supplies from someone down the street. You got to get them now to do that in your stores. So I'm just curious what additional detail you can provide on how you're going to make that happen. Alok, you mentioned shoulder to shoulder, is that going to be enough to get it done here?

It is. I mean it's frustration of ours that they don't buy it from us. It's a frustration of theirs, our contractors as well because now they need to make 2 stops versus one stop. Yes, they've got used to it because equipment is very good. They like buying from us. We need to make sure of something what Joe said in his segment that applies to parts and supplies as well. We've got to have the right part. We got to have it at the right place, right? We got to have at the right price, and we got to make sure that it is at the right time when they need it, whether it's to deliver to their place, to pick up from the store. I mean the 4 rights that Joe mentioned [ are same ].

We've done lots of surveys, applies to residential and commercial, it is just something we are learning, and Tommy, you know this is, it requires investment. It requires category management. It requires parts distribution centers. It requires small package shipping capability. But we are getting to a stage where we want to deliver one order, one invoice, one shipment. And when we do that, our contractors would rather buy from us because it's maybe annoying to us, it's frustrating to them to have to make 2 stops.

Tim Wojs from Baird. Maybe as you move from kind of a factory driven or a centralized model that something that's maybe more regional or local or decentralized, how do you make sure there aren't any sort of like unintended consequences that may change as you go through that process? And what are some of the, I guess, internal incentives that you changed? And I guess is that all kind of fully implemented at this point?

Yes. We'd like to think that we were always customer-centric model. But you're right. I mean a lot of it was factory-centric is to make products in the factory and then push them into the distribution center. And now what we are doing is we are going to hold the factory inventory at the FTC and pull it. Quite a few things we are doing to make sure it doesn't upset the [ Apple cart ] or doesn't change. First of all, the rollout is going to be slow. And when we go to the FTC this afternoon, we're not going to take all our regional centers and start moving the model immediately, right? We're going to do it one at a time to minimize the risk. So that's kind of the #1 thing, right?

Second is, and you heard Prakash and others talk about it, we are using AI heavily because this is going to be as good as the forecast we can get to and the pool system we can do. So it's significant rewiring of this. For the past few years, some of the investment that Michael highlighted was in a new WMS system. So we do have the new warehouse management system, a new TMS, a new transport management system. So all that's already done. So this is not new for us. We've been preparing for this for about 2 years, and we have already built the digital blocks, taking care of the outdated tools, and have done a lot of process improvement such as sales inventory operation planning to make sure that happens. And the best way to do it is not a big bang approach, but a slow, one at a time to minimize risk and roll out. So far we feel very confident about this working.

Sure. So you've done a nice job of articulating the growth drivers across the 2 segments of the business, they're different, right? I mean there's different opportunities here. There's also different opportunities for margin expansion. Can you give us how in the 2030 outlook, you think about both revenue growth and margin expansion between the 2 segments, understanding that they're starting at a different point?

I'll let Michael answer that.

Yes. So if you look at the total revenue growth to the midpoint of our guidance, it's 6%, and BCS will grow a little bit faster than that, mostly because of the inorganic acquisition side of it. When you look at organically, though, we see about a 5.5% organic growth across the organization, pretty much equal across HCS and BCS. From a margin expansion, it might lean a little bit more toward the HCS, some of those cost productivity and the pricing process improvements will lean a little bit more to that direction. But in general, both should be growing at about the same rate organically for the next 5 years.

Thanks for all the detail. On the kind of resi assumption of the 3-plus units, is that something that you're kind of the shape of that recovery? Is that above that range as you kind of bounce off the bottom in '27 and '28 and then settles in? Or are you thinking this is a bit more of a steady progression of 3% from here through 2030?

We think there's obviously a short-term bounce that we are going to experience. We don't know when, and that's going to commit it. The bigger point, Steve, is no matter what the industry does, we are very confident of the differentiated growth initiatives that we are going to drive. But listen, we are not good at predicting an industry growth rate. So that's at least something we have established over the past 4 years. That none of us are great at predicting the industry growth rate. So I think what we're going to focus on is differentiated growth. Here are the 4 things we are going to do, that's going to be in addition to the industry growth rate. Listen, if it grows above 3%, that's great for all of us, right? If it goes below, we're going to fight harder on the differentiated growth to still make our long-term targets.

Yes, I was going to say I'm not very good at forecasting either. So we're on the same page on that one.

It makes both of us together on that.

Yes. And then just on the capital deployment side, I mean, your share count is pretty low. I know that really doesn't matter from a market cap perspective. But like, is there any pivot to -- like does the appetite for buyback just like run out a little bit? Or -- and maybe a little bit more M&A? Maybe how much buyback are you kind of thinking about on a run rate basis every year?

Yes. Obviously, we're going to generate a lot of free cash. You saw $4.5 billion. So we're going to use that in one or 2 ways. We're going to opportunistically look for M&A, but it has to fit the criteria that we want for the right price, around the core business, around parts and accessories, around service offering. If that happens, we'll definitely want to do that, but it's more bolt-on. But we also believe that consistent share repurchases over time add a lot of value. So we can continue to see that over the next several years as well.

Thanks, UBS. I wanted to ask, could you just mention about the stuff that's in your control versus not in your control in terms of outgrowth. And you do have a forecast for 1 to 2 points of outgrowth. I think it was 1 to 2 points. I don't have the presentation in front of me. But maybe you can attribute that -- I assume that a lot of that's in building and winning back some of the emergency replacement, I think the Mexico facility really helps you do that. Maybe just attribute that outgrowth to specific, either segments or products and how confident you are in delivering on that just given that you have visibility on that, that is in your control?

No, that's a great question. So we operate the company in 6 business units, 3 under HCS, 3 under BCS. Each of them have a very specific set of growth initiatives. In some cases, it's about regular conversion like of dealers and contractors that kind of drives our regular share. We've been doing that for years and that continues, right? So if you think about it, others are more about specific initiatives like emergency replacement. But if we build that all up together, what we are driving towards is 2 points of growth that's differentiated above the market. And on a very simplistic basis, I take the 4 ones like heat pump, emergency replacement, attachment rate and TAM expansion and it's equally spread among all of that. That's come the way I look at it. But Michael can give you a little bit more detail because he's actually -- his Excel often is more detailed than my PowerPoint. I don't know how that happens. So maybe he'll [ give you more ].

It's why we balance each other well. So yes, this $500 million revenue opportunity, I think you saw on the slide, if you break it down about $150 million for parts and accessories, $125 million for emergency replacement, $125 million for water heater and Samsung, and then about $100 million for ducted heat pumps as well. So that kind of breaks down to $500 million. Again, that's to the midpoint of our guide, and it's still less than 50% of what we think is the full opportunity that Joe and Sarah are going to push and execute against.

Great. And just -- that's very helpful. Just one follow-up. Look, you had mentioned this refrigerant opportunity in data centers. Maybe just give us a little -- I assume it's small and a long way out, but maybe you can just provide a little bit more color around what specifically you mean, what opportunity that can be?

Yes. I mean it almost was a point of saying, we don't have any meaningful exposure to data center today. Our products do make it a data center one way or the other. In future, when I think the data center cooling technology evolves, and it becomes more about 2-phased direct-to chip cooling, that's where technology will apply. But at this stage, we have no meaningful revenue and nothing really to declare to talk about that. We are focused on our 4 core growth initiatives. And maybe the next Investor Day, the technology would have moved far enough advance along then we can talk about how our technology could apply in data centers.

Barclays. Maybe a first question just around the water heater push. You mentioned that what is it, $125 million revenue opportunity. You've got well-capitalized strong competitors there already, kind of how much market share should we think about Lennox trying to take over what kind of time period, what kind of counter success there on the market share front? And then secondly, Alok, just following up on the data center point. Help us understand kind of what are your discussions with customers like and maybe flesh out a bit more of the reticence to get bigger in that market sooner?

So on the first one, just to clarify, when Michael gave you the number of $125 million, that was water heaters and ductless from Samsung. So that was a combination of those 2. And I'll be a bit of a phasing because Samsung, we launched last year, which means this year would be kind of meaningful from revenue. Ariston, we're launching this year, so it will be next year before we reach meaningful revenue because there's always a 1-year lag from the launch to getting to meaningful revenue. So it's a combination of those 2.

On water heaters, listen, we're not going to talk about us being the leader or being 20%, 30% share in -- well, that's not our goal. We are doing this to serve our customers better to make sure we can provide them the convenience of one-stop offering. We have 250 locations, typically, within 20 minutes drive from one of our contractors and [indiscernible] that deliver their products every day. We're going to make it easy for them to buy water heaters and these guys are not big buyers of water heaters like a big plumbing contractor. So for our the goal is that, I would say we are looking at small market share. I don't think this is about displacing #1 or #2 or even #3 in that space. It's about getting our share from our dealers by making it easy for them to order both from us.

I was hoping to avoid that, but thanks for the reminder. Julian, I mean, listen, in data center, we are not reluctant to get in the market. We are not anti-data center. We just don't have the product or technology. Most of the data center business today is using chiller technology. For good or bad, the way Lennox is, we just don't have the chiller technology. My comment was all about at some time we're going to go beyond the chiller technology and data center, and some of you are more of an expert on that than I am. At that point, there will be opportunities for Lennox to participate. So we are skipping the current technology of chillers because we just don't have it.

Chris Snyder from Morgan Stanley. So there's a lot of -- in the presentation about the direct selling approach. I guess, is that really just a margin opportunity for the company, like we could look at OEM plus distributor margins? And is that what you are going after? Or I wonder, is there also maybe some opportunity to -- I mean, if you're taking margin from someone else in the channel, are there any ability to like donate that back or give it back to the homeowner, which could maybe help drive some share for you guys through a -- just helping out with the affordability challenges?

There's clearly a margin opportunity. And we've talked about and Sarah mentioned that a couple of times is, we have the entitlement to take margins for manufacturer and distributor. And that's more of an intellectual thing. We got to make sure we wring out the inefficiencies, whether it's in our distribution network, manufacturing network, pricing processes so we can benchmark ourselves against the best-in-class manufacturer, best-in-class distributor and do both. But actually, the bigger reason we emphasize that, it positions us very well for the future. If we were not direct, we could not be selling water heaters, right? If we were not direct, we could not be doing the JV with Samsung. If we are not direct, our parts initiatives would not have the appropriate team and the connection to the dealer. Being shoulder to shoulder, or Joe right to say, belly to belly with the dealers is more about being serving them properly, serving them better. And as the distributor channel consolidates, the dealer channel or the contractor channel consolidates, puts us in a great position to work with them to eliminate unnecessary middlemen, which I would call it unnecessary inefficiencies between us, the manufacturer and them as a channel. So that's where I think the bigger opportunity lies.

I don't think it translates into pricing going to homeowners because one thing that's very well established in this industry is pricing cuts do not lead to share gain. That just doesn't happen in this case. We sell to somebody, who sells to somebody, who sells to homeowner, with labor, with accessory, with warranty, with financing, the whole chain does not work with price cuts from us leading to market share. That just doesn't happen.

I appreciate that. And then, Michael, you kind of talked about when you guys are modeling out growth, looking at the installed base. So I would just be curious on how has the installed base for Lennox grown? Because I would think that at the industry level, the installed bases have slowed over the last 15 years. We've seen the housing stock growth has slowed and I imagine HVAC is hitting or maybe not yet some sort of like theoretical ceiling on where the penetration rates go. So just be interested on how Lennox's installed base has trended?

Yes. We think the installed base continues to grow. Every year you have new construction additions. Every year you have add-on replacement, putting air conditioning in your garage or different units. So that's where a lot of mini split has actually expanded the cooling and the installed base. So we see the installed base has continued to grow. We've also seen the average life of the system shortening for all of the reasons that Alok put on the page. And when you combine that with shipments over the last 20 years and especially more shipments toward the south with heat pumps, we see a relatively normal kind of failure rate going into the future. And assuming replacement rates are also normal, we'll see at least 3% growth from that algorithm.

Jeff Hammond, KeyBanc. Alok, you touched on different pieces of kind of distribution profitability and how you're getting there, but maybe hit it more head on, like I think a couple of years ago or a few years ago, you were saying, hey, distribution is breakeven, we can make it much more profitable. Just give us the big progress steps you've made over the last few years on that end? And what are the big next steps to kind of continue to push on that?

Sure. We 3, 4 years ago did not look at distribution and manufacturing as separate. We even today do not incentivize people necessarily those being separate. But what we have gotten better is benchmarking and creating regional P&Ls. So everybody from a territory manager to a regional director, to a district manager, all have profits as part of the incentive. That's created a lot of visibility and incentives to make that happen. So that part is done, right?

Second piece on distribution that was getting efficiency is our network, which I think Sarah described as a ball of yarn, I call it as a spaghetti on the wall. Going from that to a hub and spoke, there's going to free up significant efficiency opportunities. And that starts happening this year with full impact on next year. So that's the next big step on that it comes out, right?

Third thing on that to come down to is our network and our stores are still under leveraged. So my sales per square foot in a store has an opportunity to be much higher. So I don't need to open more stores to sell more mini splits, more water heater, more parts and accessories. So if you think about those 3 factors and for intellectual reasons, let's just say they are equal. I would say the first one, we are probably 60% there. We have made good progress. We're going to redo the incentive plans, again, to keep going up the profit chain. The other 2, we are just beginning. So I would say we are less than 1/3 of the way towards the final goal of freeing up distribution profitability and getting to more reasonable profitability level and distribution.

Sarah, do you want to add anything to that?

I think you've covered it pretty well. I think you said it. The second one, I think, is the most immediate one in front of us that creating -- going from a push model to a pull model, and that will be over a year or 2, is going to have an impact all the way through our supply chain as well as creating efficiency in the factory. So I wouldn't add anything specifically except that's probably the one that I think is going to add the most value in the first couple of years.

Ryan Merkel with Blair. My first question is on incremental margins. The targets imply like a 29%, 30% incremental margin, which is more or less the 5-year average. My question is, which initiatives provide the most upside to that target in your mind?

I gave you the revenue initiatives. If you think about that, the commercial emergency replacement is one of the highest ones there, really great margins within that. Outside of that, the rest of the margin expansion is really going to be about cost productivity, redefining our distribution network, getting all the cost productivity within that. We've just launched our new products, the new regulatory change within 2025. Normally, after that, we go back and redesign and reengineer, Prakash can add to this. We take a lot of cost out of the product after we go through a regulatory change. And it's going to be about manufacturing productivity. We have not delivered over the past several years much manufacturing productivity at all, and we think there's a lot of opportunity there. So those are going to be the main drivers of margin expansion. The source products will be a little lift to margins, but not as much as the others.

All right. And then my second question is you've talked about improving fill rates to the high 90s. I think that's at the store level, correct me if I'm wrong. But what is baked into the guide for fill rate improvement by 2030? And then can you help us think about quantifying the revenue opportunity if you achieve that?

Yes. I think at the -- we give you ranges on revenue opportunity, which I think was appropriate. On a high end of the revenue opportunities, you should think of us getting to a 96%, 97% fill rate, probably still not at the 98% level. I think we're going to get closer to that. On the low end, you should think of us as being at 92% to 93%, just -- I mean there's a statistical correlation to fill rate and market share. And there's a correlation to NPS and market share. And those are the 2 variables we constantly optimize. And I need to raise bar on both of them, a higher NPS, higher fill rate gets me to higher market share and higher end of the revenue guidance range.

Now on fill rate, the challenge has been quite a few things, right? The centralized planning thing was just not working. So I think the decentralized nature that I mentioned earlier, that's going to help more where there's supply chain experts for every regions that make it happen. AI is going to play a huge role in that. I mean we are spending significant amount of time, effort and resources upgrading so that we can use SAP IBP versus a lot of manual spreadsheets and planning. Just like we are bad at forecasting industry growth rates, turns out we're also bad at forecasting what products are going to be needed in what ZIP code. So this is where, again, AI is going to help us get to what products we can expect to go in which region and getting a more agile thing.

Finally, getting our product classifications to the A,B,C,D level, like big distributors and Ryan, you're familiar with all of them. I want to have a more sophisticated dialogue with you next time we're saying, okay, I'm filling As at 99, Bs at 94, we want to have that level of discussion. And when we have that level of discussion, Ryan, then I will say we are closer to the goal than where we are today.

Great. Thanks. So just a quick one on the margin target, the 2 points roughly of margin expansion. Is it similar across the 2 segments? And the spirit of the question is that BCS is really high level. So...

Yes. The margin improvement will lean a little bit more to the HCS, but both will drive margin expansion.

Okay. Great. And then on the free cash conversion target, 90% plus. It strikes me that a good number of the initiatives, [ growth ] initiatives around parts, around maybe what the JVs requires inventory investments. I'm just wondering, is there going to be a significant inventory investment in the next couple of years? And do you think you can still be within that 90%...

Yes. We feel we've greater than 90% in our current working capital as a percent of sales, we can work within that target. We also have opportunities on accounts receivable and accounts payable to help fund this and even raw materials within the factory. In the end, that's what we want to do is deploy those savings to more finished goods and get them closer to the customer, to Ryan's point, try to win fulfillment because that's what matters for the customer.

And then just a quick one. Sorry, I know this is the third question. So the earlier question about changing customer behavior, getting them to come in for parts or whatever else. Is there any kind of direct marketing initiatives behind this plan?

Yes. I mean from our marketing perspective, realize that majority of it is tailored towards a dealer. So when you could direct marketing for, it's more about educating our dealer. We do a pretty good job with our captive dealer base, like the Lennox dealers through our own internal pieces. And a lot of it is now moving to digital. So over the next few years, we have to be better at lead generation. We are working on that. That's what get loyalty. We have to be much, much better at training our dealers, so especially using digital tools. So we are working through that. We have to be much better at retaining our dealers. So as we look at some of our digital tools, we realize that often we are able to attract that dealer, but we don't do a good job retaining. That's where marketing plays a bigger role, whether it's about doing the value proposition. And if you're in the tool, you would have seen our CRI index. So we will look at customer retention index, customer engagement index and using marketing as an effective tool to go back to the dealers and confirm the value proposition and take any course corrective actions that we need to take. But this would not be -- we would not be going in after a football stadium. We would be not doing TV advertisement. Our primary channel will remain online or direct to dealer.

Any other questions in the room? I think open to the whole room at this stage. If not, thank you very much. We still have a few more minutes to mingle. We will -- and we have box lunches and then Chelsea will let us know when the buses are ready to leave for everybody is going to the FTC. Thanks, everybody. Appreciate it.

Great. Thanks, everyone, for being here. It's my pleasure to have up next Lennox International. We have Michael Quenzer, CFO; Prakash Bedapudi, Chief Technology Officer. So thanks very much, Michael and Prakash, both for being here today.

Maybe we'll just start off with some of the near-term questions, Michael, and then we'll get into the technology side of things. Maybe help us understand kind of how you've seen -- It's been a lot going on in the last few months in terms of consumer confidence that the home data, the weather has been somewhat extreme as well most recently in the last sort of month or so. So kind of how are you seeing everything play out in terms of sell out, I guess, and the trends there?

Yes. I mean obviously, we're early in the year at this point, but we enjoy weather experience. We'd like to see zero degrees in New York and hopefully, followed by 100 degrees in Dallas so those things help systems fail, which is the main driver of the replacement cycle.

So what I'd characterize though January is, okay, and okay is an improvement, though, from bad in the fourth quarter. So it's off to an okay start. If you kind of look at our quarter, though, most of what we rely on the first quarter is our March and our March sell-through and more importantly, the order rates into the 2-step channel in March for April and May. But overall, a decent start, weather definitely helped.

We feel good that inventory in the channel at this point is pretty much behind us. If you think about last year, the 410A obsolescence created an environment that it had to be kind of removed by the end of the year, so we think inventory is low. And now it's about demand in 2026, and we think there is going to be failure demand, and we think the repair activity within that failure will be kind of normal and improving a bit.

Great. And on that point around sort of the inventories, it has been a hard time to get visibility, I think, for all the OEMs into where those stand in the overall market. I know Lennox has started to use that kind of warranty registration data more. So kind of how has that moved the last few months when you're kind of keeping track of that?

Yes. It's a new metric that we've developed where you go back and look at the trailing 3- and 6-month shipments and see what percent of those have not been registered as a warranty. When it gets registered as a warranty, it's basically been installed in that point. We can know that it's not kind of inventory in the channel. And what it does when you go back and look in the second half of 2024.

We definitely saw inventory in the channel on the one-step, which we didn't think kind of existed to the same degree. And you can kind of see that buildup in the one-step inventory. Now when you move forward, you look at this metric, you're actually seeing warranty percentages very high compared to historical averages of the trailing shipments which suggests inventory in the channel is low. In fact, it might be lower than normal. And that, and on the distribution side, there may be some customers kind of leaning on OEMs because of our good availability.

Flip side of that will be when the heat comes on. We're going to be prepared through our inventory availability to service that demand, and we think it's coming back. But overall, we think at this point, inventory is really cleared out and it's a position of growth now.

And when you think about the overall industry, it feels like the last 2, 3 years, every year, there's a sell-in versus sell-out imbalance and that makes things are very challenging for everyone really in the industry. How are you thinking about sell-in versus sell-out in residential this year, whether in terms of the absolute unit millions number and then the kind of year-on-year delta?

Yes, maybe I'll first talk about our guide. So within our guide, we've assumed that we're going to be down about mid-single digits full year in volumes. And if you break it down by channels, it will be a little bit higher in the one-step just because we have some pressures in the residential new construction business. There's some pricing kind of pressures in some of that business, low-margin business that we're losing. So that will be down a little bit more than the two_steps. But the two-steps it's going to have a lot more volatility. It's going to be down from a comp perspective, pretty significant in the first half. And then from a comp perspective, kind of up in the second half. So we think those are how the two channels are going to play out, both be down kind of mid-single digits.

And then longer term, what we're doing is going back and looking at the shipments for the past 20 years, and you can apply statistical failure rates on those shipments and you can run many simulations based off kind of repair activity. And what generally that does support is a healthy repair environment for the next several years, unless there's this massive change in the repair cycle where people continue to add on many, many years for repairs, which we don't think will happen. So we think we're in a position for growth in the next several years when you go back and statistically look at kind of shipments. The average life of these equipment continue to shorten, both because heat pumps are a bigger piece of the population, stress in the system, stressing the system with hotter summer days. So all of that generally is supporting what we think is a growth environment for the next several years. We need to fight through kind of this last leg of the destock comp issue, but thereafter, we should be kind of growing from an industry.

Great. And I suppose one factor that's perhaps new-ish in the industry more recently as a headwind is just around customer affordability constraints. How serious do you see those? And you mentioned earlier, you think repair relative to replace, kind of, is normal or stable this year?

Yes. And I'll put that in the broader context is that we saw kind of repair activity increase last year, really kind of characterized that around three big drivers of why repair activity went up. The first is that we were going through a large regulatory change to the new R-454B product. There's a bit of adoption curve, some complexity around contractors, understanding the product and some shortage of 454B canisters. That created some repair activity in 2025. We think that's behind us. That will now turn into a tailwind. So that's kind of the first point.

Second point is that existing home sales have been -- continue to be depressed. And I think they go back to 1990s, low levels. And you have a lot of homeowners that are stuck in their home, hoping they can maybe squeak out a 2-year repair. So we see that activity coming. Hopefully, existing home sales seem to be maybe bottoming and coming up that will help.

And then last one is about affordability. We do see some homeowners making what we would say is maybe not great economical decisions doing a $4,000 or $5,000 repair in an 18-year-old unit. We think that will continue to neutralize is -- the cost of repairs are going to continue to go up, both the cost of the legacy 410a gas is going to increase. The technician shortage to do these complex repairs are going to go up. Overall contractors make more money on system sales, so they will continue to push the system sale. And also just homeowners will start to recognize the benefits they get of a brand-new system that as utility costs go up with AI and cost of electricity going higher. There's a bit of an ROI on these products to get a new system. So we think all of those will continue to put pressure on the repair environment over the next year or two.

And as you said, there's a repair -- you could characterize a very short-term fix. What does your work in history suggest is the extension that repair activity on average can add to the lifespan of the unit? I realize it's case by case, but...

Yes. I mean if you replace a compressor in a 15-year-old or 17-year-old system, perhaps you get another 1 year, 1.5 years. The reason the compressor failed in the first place is there's something else wrong in the system. There's a leak somewhere, a valve is not working properly not returning lubricant back to the compressor. Those are the things. In many cases or most cases, dealer comes out and replaces what failed. They're not going to go figure out exactly what the root cause. So the underlying root cause is still there. A new compressor will chug along another year, 9 months, 18 months, It'll fail again. So it's not going to extend the life. It's not going to restore another 5, 6 years of life.

So in theory, you might have -- as you said, repair went up last year, stays at a high level, but that happens for a couple of years, and then you'll just get the -- you might tack on a few more years for repair, but if you look at the average life without repair, these are failing faster both because the heat pump adoption, stress in the system. So you have that...

[indiscernible] longer run times, during -- after COVID, we are seeing -- we've got a lot of IoT systems, mainly in IoT-connected thermostats out there. We can see the run times. In general, after COVID, people are staying home longer working from home 3 days, 4 days out of a week or something when they're home, they're running the systems longer. Life of the unit is directly proportional to the run time, the longer you run, the shorter run time. So that's another one, accelerating a replacement.

And one other element, I think, Michael, you mentioned that Prakash interested in your thoughts on this around the heat pumps. Lennox years ago was a bit behind there on technology. I think it's sort of more than caught up today. So maybe help us understand, Prakash, like where does the Lennox -- how satisfied are you with the heat pump quality of what Lennox is putting out and the R&D that's happened there? And how do you see the sort of share of Lennox units that are heat pumps today versus the broader U.S. market?

Great question. First of all, Lennox always had a great heat pump technology. We won the cold climate heat pump challenge for both residential and commercial before anybody else in the industry. So the issue was not having the heat pump technology. The issue was about having all the applications, SKUs required to fit all the applications. For example, in Florida, the air handlers, indoor part of the heat pump is installed in a very tightly constrained space like a closet. So we didn't have an air handler offering that would fit in that. So that automatically rolled us out of that market, for example. So what the technology team at Lennox has done is come up with an -- product portfolio offering, SKUs that fits every application. We just launched the most compact, shortest air handler available in the industry with the highest performance. So that would fit every application required. So that's how we're going to proliferate heat pump and gain the share.

Another thing we're doing is while we have the core climate heat pump technology that works really, really well down to minus 20 degrees. That may not be necessary for Texas or Georgia or Florida. So we are optimizing that technology building blocks to regionally come up with a heat pump that makes the best combination in terms of efficiency and performance for both coal operation and the heating operations. So slightly different recipe fuel. So it's the SKU proliferation and regional optimization of the heat pump technology that's going to enable us to gain significant share in the heat pump market.

And Prakash talked about the ducted but there's also a ductless solution that we've done with the Samsung joint venture. So we have access to a full product portfolio, really strong brand name with Samsung. We launched it last year, still kind of an R410a-year, so we didn't really see the full year. This will be the first year of us really gaining the benefit of that Samsung joint venture as well.

And how -- on that point on the JVs, Samsung is one on VRF and then you've got the Ariston 1 for water heaters. Just remind us kind of the split of, say, technology in those JVs? And who does that investment and then kind of who does the manufacturing? And how does that work with each of those two JVs?

Yes. The core products, mini-split is developed by Samsung. But we work with them very closely in adaptation of that technology to the marketplace, unified apps, for example. So a homeowner who has split system, adds on for their garage or add on sunroom ductless mini-split, we've integrated cloud to cloud between their cloud and our cloud so that one single app on their phone, smartphone can control both systems. They can see the mini-split Lennox powered by Samsung and the Lennox ductless split systems all operate on one app, not only that the dealer can see -- installing dealer can see all the systems on their dealer service dashboard so that they can get prognostic diagnostic error code information. So it's easy for the dealer and easy for homeowner from the experience perspective. That's what we're doing.

Manufacturing is done by them, but distribution is owned by us. We distribute. That's part and parcel of our one invoice, one shipment, one warranty claims process. That's how we're enabling our dealers to win in the marketplace. Same thing with Ariston 1 here. We'll integrate -- go through the same distribution, same app from a user experience perspective, they can set the temperature, they can monitor their equipment.

Michael, anything you'd add?

I think overall, our strategy is to look at our contractors, things that they are currently buying elsewhere that we want to have them buy so 75% of our contractors buy ductless, 100% buy parts and accessories, which we have a limited offering, but we're making track record -- improvements on it then 50% by water heaters. Those are really where a lot of our growth verticals are in those pieces that they're buying product sales were.

Great. And then maybe switching for a second towards the BCS or commercial unitary markets. I think volumes there have been under pressure in the industry. [ K-12 ], we had another HVAC OEM saying that had been soft orders sort of late last year. So how do you see those different verticals in BCS playing out?

Yes, overall, that industry has been challenged a bit. I think it's been down 15 consecutive months from an industry perspective have seen some weakness in the education side that we play in have seen a little bit of weakness in certain retail sides. But I see one of the biggest areas of weakness has been actually in the emergency replacement, which is 40% of that industry.

Well, the benefit to us is that we had to exit out of that piece of the industry as we had supply challenges. We're now back in that piece of the vertical, and we're actually seeing growth. So although the industry is declining, we're actually seeing growth within pieces of the vertical. And even more, our big national accounts have multiyear refreshes that we're working closely with them. They're all wanting to adopt better electrification, which products that Prakash is developing as well as they really enjoy the stickiness of our service offering that we can install. We can maintain that equipment. And at the end, we can kind of reclaim and recycle. So there's a full life cycle offering that we do for big national accounts that are helping us win in that market too.

And that plant in Mexico for BCS, not that new anymore, it's a full production for some time. Kind of how are the economics on that -- the output?

Yes, there are two main drivers of the economics there. First, to grow market share in emergency replacement. You can see within our results, we are driving that. The second was to get cost productivity. We are early in that journey. What we saw was within 2024 and 2025 as we launched that factory, we had some ramp-up headwinds. Those are kind of now behind us. Now as we get into 2026, it's about looking at cost productivity versus 2023 when we started this journey.

But it's also just about improving the customer experience. What we had is really long lead times with some of these big national accounts, we shortened that. We've improved the quality as well. So there's a lot of other qualitative benefits. But overall, extremely impressed with the team that is not an easy thing to stand up a factory like that, and I'd say we delivered it extremely well.

And when we're thinking about pricing trends across the two segments, again, volumes have been under pressure in both. You mentioned, Michael, that some of the very low tier maybe of resi, there's a bit more price competition. How do you see the overall discipline competitively in the two segments?

Yes. I wouldn't say it's on the low tier specifically. It's more on the residential new construction channel where we've seen it, which has an aspect of low tier. But if you look at the replacement side, overall, the industry has generally been disciplined for the past several years. We've had cost inputs coming into our business. Others have as well. And we're going to continue to increase our pricing to maintain our margins. I think others have generally been as well.

We, as an industry, have realized that pricing taking it away, does not win market share. So we're all trying to be out here and be competitive on service level offering, and we're going to announce kind of a mid-single-digit type price increase this year, expect to stick some form of half of -- half of that. And we think that is reasonable in the environment that we're in with the cost inflation, and we'll continue to monitor. But right now, pricing has been resilient.

And you mentioned the sort of cost increase, and I know there's been a lot of investor scrutiny of that 2.5% inflation guidance that you gave a few weeks ago. Maybe help us understand some of the building blocks within that 2.5% figure? And where costs are today, is there any part of this year where you see the biggest squeeze or risk on price cost to margins?

Yes, I think there's been some questions around this specifically because commodity costs are up double digits. So like, well, how can that be up and you're only 2.5%? Well, 2.5% is on our total cost portfolio. So it's the cost of goods sold and our SG&A. So there's big pieces within that cost structure that have little to no increases. We have fixed contracts in things, wages are limited on the increase.

So the biggest drivers of the percentages have been on commodities. And what we've clarified is that if you look at our cost of goods sold, which is $3-ish billion or so, 20% of that is commodities. And within that 20%, half for steel, which we've locked in through kind of fixed forward arrangements and contractual arrangements, about 1/3 of that is aluminum. And what we do is have a hedging strategy for kind of an 18-month period. So we've locked in a good portion of that cost for 2026. And the remaining is copper. And this is where Prakash's team have done a really great job moving away from copper. It would have been a significant headwind to this organization had we not done that.

So overall, we feel good on the 2.5% guide, we'll keep watching it. But right now, it feels reasonable in the environment that we're at.

Is there any period where you'd see a bigger sort of squeeze or risk to the gross margin through this year? Or it's fairly level loaded?

No, I think overall price costs are going to be kind of disciplined, it's going to balance itself. I think the big driver is between the top and the bottom end of our guide are end markets and how the end markets behave and our position to win market share in some of these growth verticals on water heaters and ductless and some emergency replacement in warm climate heat pumps. Those are really going to be the big drivers of our margins. I think price cost is going to be a small piece of it compared to the guide we have out there right now.

And I know there's some excess inventory ending last year at Lennox. So maybe just kind of talk us through the thinking around that and sort of under absorption maybe. I think a lot of investors have pointed out to me, say yesterday, that it seems a pretty big drop off sequentially in the earnings in the first quarter? And sort of trying to understand, is that -- is there really that much under absorption headwind given Q4 you weren't exactly running at full tilt to produce?

Yes. I think what we're trying to do is since we're both an OEM and the distributors, we have to balance the production and demand. So we have two things we need to use our inventory for. And what we've seen historically, I've been with the company 20 years, Prakash has been here two, is that these rebounds can come back fast and putting stress on the factory by significantly reducing it and then trying to bring it back up creates a lot of challenges, a lot of cost in itself.

So what we've been trying to do is very disciplined kind of reduce our inventory levels such that we get to the seasoned selling inventory level we need to be at by April, and we're kind of already there in December. So what we're going to do is reduce some production in the first quarter, keep our inventories flat, but that reduction of production in the first quarter will create an absorption headwind that we'll recognize in the period.

And we've made it visible just because our first quarter is a shoulder season, it's a smaller quarter. So it's a bigger piece of that overall quarter. But we think that absorption always is going to be behind us in the second quarter. And then in the second half, actually, we'll start to see the opposite where we were ramping down factories in the second half of this year. And now we're going to start to ramp up and you actually start to see maybe an absorption benefit in the second half.

Got it. So you'll get a sort of a gross margin improvement and then the cash flow improves as the inventory [indiscernible].

Yes. And then we'll start to burn down -- the excess inventory will burn down in the second half of this year. Correct.

Yes, another challenge ramping down taken the inventory down and trying to ramp up in season is supply chain constraints. Compressors, control boards have certain lead time and you can't really ramp up more than 10%, 15% surge capacity within the season, right? So if the market records quickly, hot summer, you'll be out of compressors and other key components to even if you can add multiple shifts in your factory. So you'll be supply chain constrained. So that's why it's really a good balancing act to have enough component inventory and our finished goods inventory to respond quickly so that we don't lose sales.

It's a small cost to hold this inventory and the obsolescence risk is basically none.

Yes. Got it. But that's really early in the year, the big driver of the earnings rolling sequentially is that absorption.

Exactly. Is that absorption as we navigate through that, correct. Yes.

Got it. And when we're looking at the margin profile in HCS, you said there's a lot of moving pieces. Price cost isn't the biggest one. What's the comfort that those segment margins for the year can be sort of stable?

If anything, I think our demonstrated ability to drive margin execution has been proven. I think we have navigated the cycle well. I think we will continue to navigate it well. We have a lot of cost productivity and initiatives that we haven't fully driven. You can see that in our guide, $75 million of cost productivity across kind of carryover of SG&A that we've already taken, new cost productivity and big distribution investments we're putting in a top of the network distribution facility in Dallas. It's going to drive a lot of freight and other efficiencies and as well as just sourcing and other manufacturing efficiencies that Prakash and team have been driven. So those will help us navigate this. End markets get a little bit better, then we'll even see better performance on margins.

Perfect. And I think one long-standing focus has been since [indiscernible] came in was around sort of can resi capture more of the distribution value and sort of bring that onto your own P&L? Where are we on that front?

Yes. I think overall, it's two things. First, we had a network that's about 20 years old. We needed to make some significant investments both in the physical footprint and the digital deployment of how we navigate through that network, and we're making those investments. And then after that, it's about having more products go through. We talked about Samsung and ductless, we're talking about water heaters. We're talking about parts and accessories.

Parts and accessories is a big opportunity for us. And historically, we've tried this in the past. What we've done differently this time is we've actually put significant effort and investment behind this. We've made an acquisition of Supco and DuroDyne, which gives us a platform and a culture to start to build on. These are specific organizations that know how to do parts and accessories. In the past, it was kind of a product line within our existing business. We've also taken parts and accessories that previously existed in the businesses, kind of brought that with Supco and DuroDyne have a central organization, a new culture, investment around that around a centralized warehouse and deployment.

So we are making investments like we've never made before. And a lot of these are already in our P&L to drive that parts and accessories attachment. So it's about the cost efficiency we're going to get by the optimization of the network, and it's also about the volume leverage that's having more product go through it. All of that will structurally increase our -- both revenue and our margins.

Fantastic. And I know you have an Investor Day coming up soon, but Prakash, maybe give us some insights into some of the biggest kind of technology developments that you're excited about today?

Yes, we're pretty excited about now that we are on our end of the A2L transition, the [ low GWP ] transition. All our technology organization is working on having a full portfolio of heat pump products, like I mentioned, and are handling our indoor component for every application, driving the [ cold temp ] and heat pump technology to the middle of the product line because you need variable speed. Variable speed is a key component of driving heat pump performance. So we have some proprietary variable speed technology we've developed in-house that you are beginning to see at a lower cost point, so that affordability question came up, right? Heat pumps, cold climate heat pumps can be pretty pricey. We're working on bringing that technology building blocks in the middle of the product line. That's one. Controls is another area we're investing more to have a smart thermostat at every level, single-stage entry-level equipment through very complex multistage or variable speed equipment control, all of them on a unified design language, unified app that you can download, you can -- and dealers can carry one brand of one suite of thermostats for all applications. They can monitor them on their service dashboard remotely diagnose, remotely troubleshoot all that stuff. So it's pretty exciting.

On the commercial BCS side, Michael talked about heat pump product. We just launched a brand-new heat pump product that works with existing electrical infrastructure on the national accounts, for example, a big box retailer. If they have to put a new heat pump that has more electric demand called climate heat pump, they'd have to spend $0.5 million to upgrade to store electrical infrastructure without heat pump technology, the way we optimize it, it works with the existing electrical infrastructure, no additional switchgear, transformers, wiring. So that's pretty big relief for them. So we're able to work with them within the constraints. So now that we've done with one big national account customer, other national account customers are noticing that they're also doing field trials of that technology, that equipment on their roofs. So pretty excited about lot more options we can give them on that heat pump platform. So we're pretty excited -- portfolio.

We look forward to seeing more of that in a couple of weeks. So with that, I'll pivot to audience response survey questions.

The first one is really about do you currently own shares in Lennox? Generally, no. Not At the moment.

The second question though is around kind of general bias or attitude to Lennox at the moment? Slightly positive.

Thirdly is around earnings growth profile, Lennox versus the multi-industry average is the peer set here. So below peers slightly.

Next question is around use of excess cash. So mostly share buyback.

Next question is on valuation. What multiple should Lennox trade at on 2026 PE? So around 20x.

And lastly, what's the biggest kind of anchor on the valuation of Lennox right now? So organic growth. Which, historically, not a problem for you guys. We'll see.

Well, great. Thanks so much, Mike and Prakash.

Appreciate it. Thank you.

Great to see you. Thank you.

Welcome to the Lennox fourth quarter earnings conference call. [Operator Instructions] As a reminder, this call is being recorded.

I would now like to turn the call over to Chelsey Pulcheon from Lennox Investor Relations. Chelsey, please go ahead.

Thank you, Madison. Good morning, everyone, and thank you for joining us as we share our 2025 fourth quarter and full year results. Joining me today is CEO, Alok Maskara; and CFO, Michael Quenzer. Each will share their prepared remarks before we move to the Q&A session.

Turning to Slide 2. A reminder that during today's call, we will be making certain forward-looking statements, which are subject to numerous risks and uncertainties as outlined on this page. We may also refer to certain non-GAAP financial measures that management considers relevant indicators of underlying business performance. Please refer to our SEC filings available on our Investor Relations website for additional details, including a reconciliation of GAAP to non-GAAP measures. Please note that the results being presented today reflects the FIFO accounting method adopted by the company as of Q4 2025. The rationale and the financial impact of the change are summarized on Slides 15 through 18 in the appendix. The earnings release, today's presentation and the webcast archive link for today's call are available on our Investor Relations website at investor.lennox.com.

Now please turn to Slide 3 as I turn the call over to our CEO, Alok Maskara.

Thank you, Chelsey. Good morning, everyone. I'm pleased with how our team executed throughout 2025, especially given the level of disruption the industry face. It was a year marked by regulatory changes, softer demand and broad market headwinds, yet the team remained resilient and delivered solid results. Most notably, we achieved full year margins above 20% for the first time in our history. This meaningful milestone reflects the structural improvements we have made in our production and operational efficiency. I'm grateful for the continued support of our dealers, distributors and contractors whose partnership played an important role in helping us navigate such a difficult year. Their loyalty, along with them with our team's commitment to excellence continues to create value for our shareholders.

Let's turn to Slide 3 for an overview of our fourth quarter and full year financials. Revenue was down 11% in the quarter due to weak residential and commercial end markets. The impact was further amplified by deeper channel destocking and soft residential new construction activity. Our segment margin was 17.7% in the quarter, driven by volume declines and expected absorption headwinds. Operating cash flow was $406 million, adjusted earnings per share for the quarter was $4.45.

Full year revenue was down 3%, driven by volume headwinds from destocking and softer end markets. However, the team still delivered a record 20.4% segment margin despite tariff impact and other inflationary pressures. Operating cash flow was $758 million down from last year due to temporarily inflated inventory levels. Overall, 2025 was a complex and challenging year, and I'm proud of the team delivering $23.16 in adjusted earnings per share. This is 2% higher versus last year's comparable $22.70.

Now let's turn to Slide 4 for an overview of end market conditions. 2025 was an eventful year for the North America HVC industry and Lennox. We safely and timely converted our product portfolio to meet the low GWP requirement. However, the industry volume for residential products declined significantly, primarily impacted by channel destocking. The situation was further complicated with low dealer and consumer confidence and the lack of housing recovery.

On the commercial side, we fully ramped our emergency replacement growth initiative in several metro regions, while the light commercial HVC industry declined for 17th consecutive month by December 2025. We are cautiously optimistic that the industry backdrop is going to shift favorably in 2026 as one-step channel destocking is nearly complete, and 2-step channel destocking is anticipated to be complete in the second quarter of this year.

In addition, unique challenges from 2025, such as the canister shortages have been addressed and we expect housing to improve given lower market interest rates. Our internal growth initiatives such as parts and services growth, commercial emergency replacement coverage and Ducales product penetration are also expected to accelerate our

Now let us turn to Slide 5 to review our investments that support our strategy of delivering differentiated performance. Our confidence in the outlook is reinforced by the strategic investment made over the past several years. Since 2022, we have deployed an incremental $300 million to broaden our capabilities, streamline our operations and strengthen our competitive position. These investments are now embedded in how we run the business and are reflected in our financial statements. At the same time, the benefits they unlock are only building to materialize and will continue to build as we move forward.

We focus first on elevating front-end excellence to create a more efficient and responsive operating model. As part of this effort, we have expanded and reorganize sales team to ensure alignment around pricing and improved coordination across the organization. This approach gives our teams clearer priorities and strengthens the connection between how we engage with customers and how we generate profitable growth. We also expanded our portfolio through joint ventures that increase our share of wallet and allow us to offer more comprehensive solutions to customers. In addition, our AI-enabled tools and upgraded e-commerce platform are making it easier to do business with Lennox by improving our dealers' quote, order and receive support.

Operationally, we have made meaningful progress. Our expanded distribution facilities enable a hub-and-spoke network designed to improve speed, reliability and fill rate. We enhanced this with new IT systems for warehouse and transport management that reinforce network productivity and MC. On the manufacturing side, we doubled the square footage dedicated to our commercial operations, completed a major product redesign to meet regulatory requirements and continue to advance our heat portfolio for long-term electrification trends. Looking ahead, we will continue to invest strategically to support future growth.

In 2026, we will add new customer training and engagement centers and build our digital tech stack to enhance customer experience. We will also invest in automation across our existing labs, very new test chambers to in-source certification and expand our engineering capabilities through new R&D centers. We anticipate these investments will carry attractive returns, expedite innovation and improve customer support.

In summary, Lennox is positioned to respond with agility as demand recovers while continuing to accelerate growth and improve margins well into the future.

With that, I will turn it over to Michael to review our 2025 financial results and 2026 guidance.

Thank you, Alok. Good morning, everyone. Please turn to Slide 6. As Chelsey mentioned, we updated our 2024 and September year-to-date results to reflect the change from LIFO to FIFO inventory accounting. The appendix includes quarterly adjustments for both 2024 and 2025. Overall, adoption FIFO increased our 2024 full year EPS by approximately $0.12 and raised EPS for the first 3 quarters of 2025 by approximately $0.55. Full year 2025 EPS impact was approximately $1.

We've also included a page in the appendix outlined the rationale for this change, which is driven by 3 key benefits: First, FIFO simplifies our accounting processes by eliminating the truck detailed held inventory layers; second, it aligns cost increases more closely with the timing of price realization; third, FIFO is the predominant method used by industry peers and better reflects the physical flow of goods.

Moving to our quarterly results. Overall performance can be attributed to ongoing destocking, softer-than-expected residential end markets, along with better cost productivity in response to inflation. We continue to execute well on price cost and expense management. This helped EBIT decline to 16% despite a [ 23% ] [indiscernible]

[Technical Difficulty]

Resulting in a [ $90 ] million SG&A reduction partially offset the higher product costs.

Please turn to Slide 8 for an overview of the Building Climate Solutions segment. BCS delivered another strong quarter with organic sales growth in down markets and continued margin expansion. Revenue grew 8% as -- mix and pricing actions offset lower organic sales volumes. The completed acquisition contributed approximately 7% revenue growth. Light commercial industry shipments remain below normal levels, with strong execution in emergency replacement in national accounts loaded organic volume declines to mid-single digits. Like HCS, product cost headwinds reflected absorption pressure and the timing of inflation expense recognition under pipe.

With that, let's move to Slide 9 to review the full year performance for Lennox. Overall, 2025 was a challenging year from an end market standpoint with channel destocking, R-454B canister shortages slowing new system adoption and tariff driven inflation. Despite these headwinds, we executed well. We expanded profit margins to a record 20.4% and delivered more than $75 million in cost productivity while continuing to invest in long-term growth.

Please turn to Slide 10 for cash flow and capital deployment. Free cash flow for 2025 was $640 million, above our prior guidance of $550 million. The team is focused on strong collections and disciplined payments helped partially offset temporary elevated inventory levels. FIFO inventory levels decreased by $300 million compared to December 2024, partially to support key growth initiatives in commercial emergency replacement, Samsung ductless products and improved equipment fulfillment. We also have about $200 million more inventory than is seasonally typical which will remain slightly elevated in the first quarter, but it's aligned to meet second quarter peak demand. This inventory management strategy will create some additional absorption headwinds in the first quarter but minimizes the disruption on our factory employees and suppliers.

During 2025, we repurchased $482 million of shares and deployed $545 million on bolt-on acquisitions and joint venture investments, all supported by a strong balance sheet that continues to enable repurchases, disciplined M&A and healthy leverage profile. Alongside these actions, we also invested $120 million in capital expenditures during 2025 to advance key strategic priorities. Looking ahead to 2026, we plan to invest $250 million in capital expenditures, targeting strong turn opportunities across innovation and training centers, digital technology, distribution network optimization, ERP modernization and AI tools.

Please turn to Slide 7 as our review of our 2026 guidance. We are initiating our full year 2026 guidance, which reflects stabilized end markets, normalized channel inventories and contributions from recent acquisitions and joint venture investments. For revenue, we expect total company growth of 6% to 7%. Organic volumes are expected to be down low single digits, net of approximately 1 point of growth from initiatives across parts and accessories, commercial emergency replacement as well as Samsung ductless inducted heat pump products. Sales volumes in the first half, especially the first quarter expected to be down more than the full year decline followed by growth in the second half. Combined price and mix are expected to contribute mid-single-digit growth driven by our 2026 price increase and carryover benefit from 2025 regulatory mix. M&A is expected to contribute mid-single-digit revenue growth, reflecting the full year benefit of recent acquisitions and joint ventures.

At the segment level, we expect approximately 2% growth in reflecting down but improving end markets and a low single-digit contribution from M&A. For BCS, we expect approximately 15% growth supported by industry shipments returning to growth, strong emergency replacement in national account performance and a high single-digit contribution from M&A.

On costs, inflation is expected to be up approximately 2.5%, reflecting tariff carryover and moderating price cost pressure. We plan to invest approximately $35 million in additional operating expenses to enhance our customer experience. ERP upgrades for recent acquisitions and continued expansion of our training and innovation centers. M&A-related amortization is expected to increase by approximately $15 million. Productivity and cost actions are expected to deliver approximately $75 million in savings driven by material and factory initiatives, distribution network efficiencies and SG&A productivity. Interest expense is expected to be approximately $65 million, reflecting the impact of our M&A activity and share repurchases. We expect a tax rate of roughly 20%.

Based on these assumptions, we expect adjusted EPS of $23.50 to $25. Free cash flow is expected to be between $750 million and $850 million driven by inventory normalization and higher profitability. Overall, we are cautiously optimistic for 2026 as we expect to return to revenue growth and build on our momentum to deliver our fourth consecutive year of EBIT margin expansion.

With that, please turn to Slide 12, and I'll hand it back to Alok.

Thanks, Michael. I want to highlight the progress we have made on our self-help transformation plan, which is now entering its final phase. From 2022 through '24, the team focused on stabilization and consistent execution. During that period, we reinforced pricing discipline, restored commercial margins and build the organizational and operational foundation for sustainable growth. In 2025, our priority shifted to diversifying the portfolio and strengthening our market position. The Samsung joint ventures, along with Durdan and Saco acquisition broadened our product offering and will increase our share of wallet. The new commercial manufacturing capacity, improved product availability, especially for the emergency replacement market. By addressing constraints at our existing Stuttgart factory, we also created opportunity to grow our commercial national account business.

Beginning in 2026, we will move into the expansion phase of our self-help transformation plan. This stage focuses on scaling our footprint, broadening our product portfolio and extending our reach across residential and commercial end markets. It includes adding training centers, customer experience centers and new distribution capabilities. From an innovation perspective, we will invest in testing and certification labs, digital and AI solutions and a healthy pipeline of new products. We remain on track to deliver on our most recent long-term commitments, and we will share updated long-term target at the 2026 Lennox Investor Day on March 4, where we will also provide deeper visibility into our strategic growth initiatives.

Now let's turn to Slide 13 for why I believe Lennox along the industry. Lennox remains a highly attractive long-term investment. Our markets benefit from strong replacement fundamentals, and we operate with a direct-to-dealer model that differentiates our customer experience. Our margin profile is resilient driven by disciplined pricing, operational excellence and a portfolio aligned to the evolving needs of contractors and consumers. These trends are reinforced by a high-performing culture centered on advanced technology and execution, which positions us well as we embark on the next phase of our strategy. I'm confident in our strategic direction and remain committed to delivering sustained value for our customers, employees and shareholders. I believe that we are building meaningful momentum and that our best days are still ahead.

Thank you. We will be happy to answer your questions now. Madison, let's go to Q&A. .

[Operator Instructions] Our first question comes from Ryan Merkel with William Blair.

I wanted to start with HCS revenue in the fourth quarter, down 21%, was a little worse than I was thinking. And clearly, it was hard to call. So two questions. First, how did HCS trend through the quarter? My feeling is November and December or maybe a little worse in October? And then secondly, where was the surprise? Was it more the one step or the two steps?

Sure. Great to speak with you. Thanks for your question. Yes, November and December were worse than where October was trending. So I think that's a fair assumption. I think surprise for us was more on the residential new construction side, which I think performed worse than we expected. But I think the one-step channel and 2-step channel behave similarly, both undergoing destocking. So while the 2-step impact was more that was expected. But I think we both went through destocking in Q4, that was more than we expected.

Got it. Okay. That's helpful. And then Slide 4 is really helpful. Thanks for that. A few tailwinds into '26. But Alok, can you square those tailwinds with the guide for HCS up to? Because it implies volumes are down maybe 3% plus. I don't know if there's M&A in there, but just square that up for us, how you're thinking about that?

Sure. I'll take that. So within the HCS guide, we have about a mid-single-digit decline in volume for the full year, down more in the first half as we're going to see continued destocking into the first quarter, specifically on the 2-step channel, a little bit on the one step. But as we get into late Q2 into Q3 and into Q4, that's when we start to see growth, that will kind of normalize us and be a positive inflection in the second half of the year by year. But the first quarter will dry down on the full year.

We'll move on to Amit Mehrotra with UBS.

I wanted to ask about inventory levels, and obviously, they're up a lot year-over-year in dollar terms. I'm just trying to understand when you expect those to normalize? And maybe you can talk about it from the perspective of both one step and two steps.

Yes. I mentioned that in the script there, we have about $200 million more than seasonally normal at this point. We have another $100 million in there for just investments to get better experience with our customers. Within that $200 million, you'll see some continue to go down a little bit in the first quarter, but we also need to make sure that we have the right level we hit the summer season in the second quarter. And right now, those inventory levels in December approximately align with what we'll need in the summer season. So a little bit of work to do in the first quarter to ramp factories down to get some absorption. But overall, we think we're going to be in a really good spot in the second quarter without having to do a ton of disruption on our factory by ramping it down significantly and then ramping it back up, we found that this is the best approach to mitigate some of these destocking industry issues that we're fighting through.

And Amit, if I could just add, first of all, let to the Lennox coverage universe, great to have you on the call. Amit, your question was answered by Michael on our inventory levels. On a channel perspective, Michael also mentioned, we think one staff is completing the destocking and largely done in Q1 and 2 steps destocking will be done by Q2. So that kind of inventory outside our

Yes, makes sense. And then just a follow-up. I know price mix has guided up to mid-single digits this year. I'd be curious if you could just give a little bit of a sense of how much of that is kind of the carryover effect? And how much of that is prospective increases? Obviously, you make regular price increases this year. Just trying to understand the bifurcation between those two would be helpful.

Yes, a little bit of a carryover in the first half, specifically on the mix benefit of point-ish, maybe close to 2 points in the first half of the carryover mix, and then the rest is new price initiatives that we're going to start to launch into this quarter and into Q2.

We'll now move on to Joe Ritchie with Goldman Sachs.

Can we just maybe just talk a little bit about seasonality and cadence of EPS and how to think about the first quarter, just given all of the moving parts, just any guidance that you can give us around 1Q would be helpful.

Sure. Obviously, it's been quite cold recently, Joe. So that may impact a few things. But in general, remember on the HCS side, we're going to be facing pretty tough comps. There's a lot of stocking up going on as some of the 454 items have just been launched, but people are still buying [ 410 ] On the BCS side, we had it a quarter with our own production move and some of the key account challenges. But net-net, we would expect Q1 to be down. We would expect first half to be down in the second half to be up overall. But yes, we don't expect a great first quarter right now.

Okay. That's helpful. And then just going back to your assumptions for resi volumes this year, I think you said that you had it down mid-single digits for the full year, down more in the first half. I guess as you're kind of thinking through like the swing factors as you progress through the year, like maybe just talk through some of your key assumptions on the mid-single-digit number as you progress through '26?

Sure. I mean I think, obviously, we got more than 11 months to go. But from where we are, we're going to be closely watching consumer confidence, which remains uncertain. Interest rates and housing, both existing home sales and new home sales is something we will be closely watching. We're obviously will be closing watching our dealer confidence as well, which was shaken last year by the transition and the lack of comes shortage which I think is improving. So they can actually outline on Page 4, those are the key things we'll be watching for. From our prospective, Q4 and Q3 were significantly impacted by destocking, and we remain fairly confident that that's going to be behind us in the second half. So that's probably shaping our overall view on the largest factor on 2025 performance lost destocking. And the fact that that's going to be behind us, that's going to help us get to a better number this year.

And Joe, I'll just add to that, we'll watch the seasonal demand. I mean if it turns into a hot summer early, there's a lot of replenishment of inventory that happens that could happen very quickly, and we're in a really good position for that. So I think that's one thing we'll start to watch this the season play out as we get into March and April as well.

We'll now move on to Tommy Moll with Stephens.

Look on pricing last quarter, this is specifically to resi, if I recall correctly. Last quarter, there was a conversation about maybe a mid-single -- lift increase and you dial something in the low sole digits range. Is that still a reasonable bogey to use for this year?

Yes. I think for a new pricing, that's still a reasonable bogey and then Michael mentioned there's a carryover effect, right? So while it can be too precise, I mean I look at our mid-single digit as a combination of new pricing, which we have announced already across the entire business portfolio and then carryover. Remember, last year, we talked about the mix was going to be roughly 40% 410A, 60% 454B. So that 40% 410A is gone, and it's all going to be R-454B. I think the price mix lift from last year used to the overall number of mid-single digits that we have put in our guide.

Great. And then in on ready here for volumes and even more specific on the one step. It sounds like destocking is nearly entirely in the rearview mirror here. So in the outlook you've provided for resi volumes, would one step be implied up for the full year? Or are you still assuming even without destocking headwinds that there maybe see some additional headwinds?

I would say, listen, I mean, 70% of our business is one step. So I think the way we would look at it one step is going to be flattish to maybe slightly up, two steps going to be down. So I think that's as much precision as we have in our forecast at this stage. But yes, one step will do better than two steps, especially given that two steps would be going through destocking at the second quarter. Now at the same time, if something changes and Michael said it bean early start and a hot start to summer. They don't do step might come back and start holding more normal level of inventory, current assumption is exactly what you said.

We'll now move on to Jeff Hammond with KeyBanc Capital Markets.

Maybe just starting with BCS, the 15% growth, if you could unpack similarly, like you did for the res business price volume M&A in there? And then just maybe -- I think you were saying that you thought that would maybe start to turn and what you're seeing just relying on the commercial unitary business?

I'll give some guide points within that. So we expect within the 15% high single-digit growth from the acquisition most of that M&A kind of lean towards that segment with the Duradyne business. From a volume perspective, we expect up mid-single digits with recovery in end markets and share gains. And then price mix combined are going to be kind of more in the low single digits on that side of the business.

Yes. And I think from what we are seeing in the market is gone through 17 straight months of decline as for the AHRI data by December. So I think just comps get better, and we are seeing good uptake in quotations and good uptick in the backlog as well. So while it's not boom years, I think it's going to become less of a better year as we go into 2026.

Okay. And then just on the repair replace dynamic, how are you building that into your -- as you talk to more of your contractors? Is the view that the consumers tighten this persists or it was mostly a canister issue and it kind of goes away?

Sure. I mean, first of all, we look at that dynamic more as deferred replacement because anything that you repair will come back for replacement typically in 12 to 24 months. So I think that's the way we would look at it. When we speak to our contractors, we find that the dealer confidence on the new product, the dealer confidence on upselling to a replacement, the dealer confidence because of canister shortage was a large part of the impact. Clearly, there's consumer sentiment there as well. The fact that the dealer sentiment has turned to more positive going into the year makes us a little bit more favorably inclined throughout that trend this year. But so far, what we have assumed is it's not going to get any worse. We haven't assumed that's going to get better either. So we think it will remain at the 2025 level, which you know had heightened repair versus replace.

We'll now move on to Noah Kaye with Oppenheimer.

I think, Michael, you mentioned a couple of times the absorption factor for 1Q. Can you expand on that? And would that lead decrement on volumes in 1Q to be kind of worse than the typical 30-ish percent decline?

I think we have some cost actions that we're trying to mitigate within that you saw we did some really good SG&A cost productivity in the fourth quarter. Some of that's going to repeat into the first quarter. A lot of material cost reduction programs are on tariff mitigation and other things are going to soften it. But Q1 is kind of a light quarter from a volume perspective. So if you think about $10 million to $15 million of absorption that can have a pretty big impact within the decremental. But we think as you get through Q1 that absorption goes away and we get back into cost productivity across factory materials and our distribution network. But a little headwind as we get inventory to the right spot for Q2.

Okay. That's helpful. And then I believe I heard you say the CapEx number would be $250 million for the year?

Correct. Yes. It's normally about $150 million of just normal recurring CapEx and then we have $150 million of strategic innovations that we're doing and a good proven track record of ROIs and organic investments. So I think we have a good pipeline of these projects that have really strong ROIs for the next several years, and we're going to keep a bus now and got the customer experience, and that's where we're focused on both digital and our physical distribution network.

Yes. I think the second part of the question was just to ask whether we should view those growth organic investments in CapEx as something more permanent? Or should we think about kind of future reversion more towards the typical maintenance CapEx range?

No, I would not think of those I think our maintenance/regular CapEx remains in the $125 million range, $125 million to $150 million. Three years earlier, we had called out and we have said it any other big investments, we'll call it out. So now we're just calling out that we're going to be spending additional $100 million or so. And those are really good projects. Many of the projects are deferred because all our engineering and the resources were tied with So -- but no, I would say after that, we go back to our usual maintenance-type CapEx.

We'll now move on to Chris Snyder with Morgan Stanley.

I wanted to follow up on company inventory and the associated absorption headwinds that come from that. It seems to me that inventory was kind of flattish quarter-on-quarter into Q4 when normally it would step down maybe to like the mid-single-digit level. So I guess, has there not been any destocking yet? And maybe that's the first part of the question. And the second part is, why do the absorption headwinds end after Q1? It seems like this $200 million excess inventory will be sold into peak summer demand. But I would think that, that means under production up in those summer months. And I would expect that -- I would have thought that the absorption headwind comes to on a lag as it flows off the balance sheet into the P&L.

Sure. Chris, on the inventory piece, yes, we did ramp down production. But as you saw, our sales came in much lower than expected in Q4. So that's why the inventory didn't go down meaningfully. It did go down slightly, so now we have to ramp production even more and which we did towards the end of the quarter. On the second question on absorption, Q1 will have the largest impact because at the time we start ramping up for selling product into Q2. So the manufacturing for sales into -- to plan the happening in Q1, just given the lead time from when the product is manufactured to when it's stored, hence we caught it out. There will be some impact of absorption in Q2, but most of it will be in Q1.

I appreciate that. And then maybe just following up on the cost inflation. The 2.5% came in below what I was expecting just kind of based on some of the tariff wrap and then the metal inflation and other cost inflation we're seeing in the market. So can you maybe just kind of help us unpack that number? How much is tariff wrap? How much is new cost inflation? And I think it seems like there's maybe some offsets there in mitigation that's perhaps keeping that number a little bit lower than we would have thought?

That's a correct interpretation of the gut. So right now, what we apply is the 2.5% to our total cost, that would be manufacturing costs, distribution costs and SG&A costs. Not all are going up the same. We are seeing a little bit more inflation on the commodity side, but we also have hedging programs that delay some of that cost increase, and we've significantly moved away from copper and we have more of an aluminum product. So that's softening, at least from the metals perspective, why it's not as in within the guide.

Tariffs, there will be kind of some wraparound impact of tariffs. It's about $125 million full year 2025. We'll have a little bit of carryover in the first half of that, assuming the tariff structure stays the same, which is what we've built within the guide. But overall, we assume that inflation and then we're going to drive productivity and investment actions against that inflation number.

Yes. If I could just add to that -- we have significant cost reduction that went in fact in 2025. We have 1,000 less employees than we had before we went into the cost reductions free. And we are not going to bring all of that cost back. So some of the benefit that you see is from our perspective, the productivity aspect of it, both on materials, manufacturing and SG&A is something that we have baked in going forward.

We'll now move on to Julian Mitchell with Barclays.

Maybe just wanted to start with overall operating margins. I don't think that's been fleshed out too much yet. But just wondered, is it fair to say the full year guide is embedding operating margins down slightly maybe year-on-year. And then you've got between the segments. Anything you'd flesh out perhaps BCS up for the year? And anything you could help us around kind of first half versus second half year-on-year on the margin front, please?

Yes. So overall, the guide implies EBIT ROS expansion of about 20 basis points to mention that in our script. We're looking at the fourth consecutive year in a row of margin expansion. Within BCS, it's going to be up more. Within HCS, it's going to be flat to slightly down at the -- are down. So the volume leverage within BCS, you'll start to really see that within their margin expansion. .

Within the seasonality, like talk a little bit about that. But when you look at 2025, the seasonality first half to second half from a revenue perspective was about 50-50. As we think about next year or 2026, it will be 3 or 4 points less than 50% in the first half, 3% or 4% higher in the second half. Normal incrementals on the volume that we talked about a 35% of the decremental and incremental plus the cost inflation and productivity initiatives. So overall, a little bit more headwind in the first half, but the margin expansion will definitely start to show in the second half.

That's helpful. And just wondered kind of any perspectives on the market in HCS. Maybe last year, the market was, I don't know, 7.3 million -- 7.4 million units and the sell-out just under 8 million. Just wondered your thoughts around how we're thinking about those very big moving parts for '26? And what degree of repair normalization you're expecting this year in the industry?

Yes. Julien, we're getting trouble every time we try and predict the number of units in the market. And I know you guys have pretty sophisticated models just like we do. I think from our perspective, the ocean has been that your sell-in number was heavily impacted by destocking and the end of destocking would lead to automatic improvements. Our assumption is that the repair versus replace activity is stabilized going forward. So we're not expecting it to turn back, but we are expecting it to stabilize at least going forward. So net-net, I mean, on a sell-in basis, you will see higher numbers than where we ended the year, as you said, 7.3 million, 7.4 million. And on a sell-out basis, I mean those numbers are really not that reliable. So we focused less on that. What we have seen in our own one-step channel is that the confidence of dealer has come back and people are now looking at 2026 as a fresh start with our R-454B, that's probably the best news out there, Julian. Given all the other potential headwinds, including consumer confidence and numbers that don't seem to be improving including yesterday's number where consumer confidence was very, very low.

We'll now move on to Jeff Sprague with Vertical Research.

Look, maybe just coming back to the -- a piece of that last point. Just on repair versus replace stabilizing. That is sort of a thesis at this point? Or do you think there's actual evidence of that? And I guess maybe a lie to that point is within the mix, any evidence that people are trying to mix lower? Obviously, you got the mix carryover on the refrigerant coming through. And I guess it's getting harder the mix lower as all the Sear levels have continued to move up. But -- is there any evidence of just more distress on what kind of units they're buying and whether it's a replacement or repair?

Yes. So the first one, it's supported by our own research and data. Now we don't have data on all the dealers, but we do see quite a few of the dealers that have direct conversation with them. Is it statistically relevant? I mean that goes down to a DC road that I won't go to back. It's more than just a hypothesis. It's definitely something that we have rented out on stabilizing.

On the second quarter mix, I mean, remember, 70% of the sales are now to the lowest year as the minimum has gone up. Are they trained downs that are happening? Yes. Are they going to be meaningful impact to us? Unlikely given that 70% of it is already revenue to your numbers. Now it comes down to single-stage variable speed at some stage that we are continuously, looking to refine and put forward. But you will see overall that from our perspective, the mix will improve because 454B versus 410A, that's a county would effect coming forward.

And Jeff, I'll just add on the repair side. We expect the input costs there going to be up significantly more than systems starting this year and into the next few years, our 410A gas is going to be up. The cost of the technician complexity is going to be -- continue to go up. So we expect that equation within the repair brisk replaced to lean more toward a system replacement in the next year to 2 as well.

Yes. No, understood. And then maybe just on capital deployment. Obviously, you become a bit more active on the M&A side here. Is there an active pipeline? Should we anticipate more in 2026? What are your thoughts there?

Yes. We maintain a pipeline. We obviously have to digest what we bought and make sure the integration goes well. But if you have a bolt-on acquisition as per our consistent strategy remains a focus, I would say, over the next couple of years, you should expect more -- can be definite about anything in this year but the size of what we bought is something we like. I think people look at similar size, we'd be slightly smaller acquisitions in the pipeline. And I know our focus will remain on things that we can sure, 2 plus 2 is going to be greater than 4. So things that we can apply our stores network, things that they can apply our national account team, and that's where we're very happy with the DuroDyne and Supco acquisition because a net add to us and a significant room for improvement on the margin side as well.

We'll now move on to Nicole DeBlase with Deutsche Bank.

Just circle back on the question about quarterly cadence. I think, Michael, you answered that with respect to revenue. When we think about that one-half to two-half, is that kind of reflected in EPS as well? Or is it maybe a bit more pronounced because of the under absorption in the first quarter?

Definitely into the first quarter, you'll start to see that, but there's also going to be some more cost productivity as we get into the second quarter to mitigate some of that absorption. So first quarter is going to be tougher. But I think from a revenue perspective, that's the main thing that drives the margins at 35% decrementals and then offset with some productivity and/or absorption. That's the main driver of our

Okay. Okay. Understood. And then just coming back on price as well. When you guys kind of look out over the competitive landscape, we've heard some noise around maybe some price competitiveness particularly in the new construction channel recently. I guess, what are you guys seeing out there in the market? Do you think that your competitors are kind of aiming for a similar level of price increase for 2026 as you are?

Yes. Based on everything we have seen so far, yes, we see our competitors aiming at similar price increases. So not surprised. Yes, we have seen some of the low-end R&C business get more competitive and we talked about that earlier. We have chosen some of those not to go down that path, and instead focus on our core dealer network and the right kind of customer experience there. But nothing is surprising and nor is it any major deviation from the past. If I believe on one sales person in one small territory, they will tell me that they're facing significant price competition, that's probably true for all our competitive scenario. But if you look at broad-based across U.S. for basis, industry remains very disciplined, industry remains very focused, and we compete on technology, we compete on availability and service and that's how we compete.

We'll now move next to Joe O'Dea with Wells Fargo.

Can you elaborate a little bit on the price mix trends in HCS over the past few quarters? I think we saw that step down a small amount from Q2 to Q3. Q4 was a few hundred bps below the Q2 level on similar comps. And so just in terms of what you're seeing on the price side or the mix side that's been contributing to that?

Yes, Joe, it did step down a little bit in the fourth quarter versus third quarter. It's mostly related to just the bigger decline in condenser sales where we saw the bigger mix lift. Also, we had a bigger proportion of furnace and parts and accessories and things that didn't have that same big mix lift up in the fourth quarter. Same proportion of the third quarter. That's the main driver. Besides that, price/mix continues to stitstick within each product channel.

Makes sense. And then can you just talk about like what you're doing with your dealers to help kind of position them for posturing toward more selling of replace over repair, understanding that last year and kind of the introduction of a new refrigerant had its challenges along with canisters. But just entry-level economics and what the message is as well as any color on what is the entry-level cost today versus what it was 5 years ago? Because I think that's something that seems like face value. It's a -- there's a little bit of shock value with it, but how the economics are compelling on sort of the replace versus repair side and what you're messaging or helping on the marketing side with dealers?

Sure. I'll start by saying our contractors and dealers are naturally inclined to focus on replacement versus repair because it's higher margin to a; and b, are of the clear understanding that repairing is just differing replacement and they try and communicate that to their own consumers and make sure that they make the smart choices. Remember, repairs are hard to finance than replacements. We help them with financing. We help our dealers with training. We help them with the sales collateral and material. And run appropriate promotions with them, especially when it comes to financing and rebates to incentivize replacement versus repair. We clearly didn't do a lot of that last year given the transition, and I think we are back to that board now that the dealers have good confidence on it.

On your price perspective, compared to sort of pre-COVID level up to now, the price from manufacturer to the contractor or the channel has definitely gone up, but the price from the channel to the consumer has gone up even more. Some of it reflects the higher labor cost as the skill labor shortage persists and grows across U.S. Some of it also reflects the fact that consumers were not getting as many cores, and we see now consumers are getting many more cores and that's coming more back to normal. So I see any price pressure is going to play out between the consumer and the channel versus the channel and the manufacturer. And then finally, as we look at this going forward, what I started by saying is true is any repair is simply deferred replacement. So a lot of things that were patched up and then repaired last year may come back again for replacement this year, if not definitely next year. So we feel very good about the long-term trend despite some short-term disconnect that we all saw last year.

Joe, I'll just add to that, we expect or if you believe the expectation that electricity costs are going to continue to increase. There's potential monthly savings in utility build that homeowners can get with the new system. The minimum system efficiently has increased significantly over the last few years, and there's a lot of cost savings that a homeowner can get the new system now as well.

We'll now move on to Steve Tusa with JPMorgan.

Detail as usual. Just on these other items from Slide 10 from the last quarter where you had growth in the value tier. I know Jeff touched on the repair versus replace, but the rationalization of low-margin RNC accounts. Any change in those? I don't see them on the tailwinds, headwinds slide. Any change in those dynamics?

No, no change in the dynamics, and we talked about the already impact in Q4 already. So I think that continues to move towards trade down, we touched on the Q&A but nothing changed. What we highlighted on Slide 4 of this time was on a comparison to what we think things are going to improve or be different in 2026. But those 2 factors remain the same, Steve.

Okay. And then just lastly on its accounting change. How would that have kind of impacted the shape of the year? And I guess you guys hedge as well on copper and maybe a little more aluminum, like what kind of would we -- what would we have seen? And maybe when does that kind of recouple to wherever these commodities are moving?

You mean the 2026 year or 2025 year?

Yes, '26. I mean you gave us the differences in '25. So just how would the shape of '26? I mean it all normalizes in the end, right, but like how would the shape of '26 maybe been a bit different?

Yes. I think it leans to that absorption Covent make in the first quarter where some of that's going to come into the first quarter of '26. You're going to see some variations in the fourth quarter of 2026 go to 2027, just that's the natural timing of FIFO vs LIFO, but net kind of neutral impact for the change of the FIFO in 2026.

We'll now move on to Brett Linzey with Mizuho.

Just wanted to follow up on the repair replace one more time here. Did you actually see positive parts growth in the fourth quarter? And then are there any regional or efficiency level observations where the trade down might be more pronounced?

The answer to the second question is no, we don't see any specific regional differences that could dry repair versus replace trade downs. On the first part, I mean parts have been really growing more than the equipment pretty much most of 2025. Now you see that in the AHRI data, we also see it in our own data. So yes, I mean, we do have actual data to support the fact that parts grow more. And we heard that from other conference calls and our distributors as well.

Got it. And then just a follow-up on NSI and the parts strategy. Maybe an update on how NSI is now tracking organically in the organization. And then as you continue to build out that parts pull-through strategy better throughput, how do we think about incrementals in the context of better branch flow and volumes going forward?

Sure. So yes, I think NSI acquisition overall -- we remain very pleased with it. We only have sort of 2 months of data from last year. But I think the sales performance as we expected, it is just like other parts businesses growing. I mean they obviously have some destocking impact. Going forward, I think this year is obviously going to be focused on integration, and we have expenses and all that associated with that. And Michael referred to that as part of some of our ERP conversion cost in there. But we would expect go through on -- to be at or better than our overall margin levels going forward. And by 2027, I think it will definitely be on the better side compared to our usual incrementals.

And I'll just add to that. We're really excited about the platform that, that brings. It brings culture and experience to our partners that we didn't have. We had about $500 million of legacy parts and accessories within our existing business. And joining that with that existing parts and accessory business is going to help us really get that attachment rate into the 20% to 25% of our sales currently. It's only about 15% in the HCS segment. So really excited about the opportunities that we have around that acquisition, helping our existing parts and accessories business as well.

We'll now move on to Nigel Coe with Wolfe Research.

Lot of ground. But I did want to go back to the two step as one step for both the quarter and FY '26. Obviously, we've got the AI data through to November. It looks like 4Q was trending down, I don't know, 40%, 45%. Is that what you saw in your two steps which would imply one step down with [indiscernible] in units. And then in '26, look, you mentioned one step up low singles. Just want to make sure you're inferring that two steps down probably mid to high single digits?

Yes. So I think let me start with the Q4 number, right. Obviously, December is still to come. But yes, we saw similar behavior on the two step, and that gives you the right calculation to interpret what happened on the one step for us in Q4. And I'll let Michael answer the question.

Talking to the full year revenues. We break the volume down -- the volume down mid-single digits, slightly less down in indirect as that business will come back a little stronger. And then on the direction, we've got a little bit of headwind in there from RNC as well just being weaker on that side of the channel.

Okay. But you still think you'll grow low singles with the RNC headwind, is that fair or?

Correct. That's with mix and price, correct.

Okay. Okay. Well, that's with mix and price. Okay. Got it. Okay. Understood. And then just a quick one on the $75 million of productivity in '26. That's a big swing in the bridge. I think you've got some compensation benefits in '25, which I'm assuming would impact that number as well. So maybe just unpack of $25 million in a bit more detail. And maybe just if you could just clarify, I think this is Michael. The material productivity is in the 2.5% inflation number. And so that this seminar would not include that.

Correct. Yes. So we start with basically a cost inflation of 2.5%. And then from there, we draw activity against it. So we have $75 million of productivity against that overall inflation. It's really across several things that's within the factory. We're going to finally start to leverage a lot of the productivity within the BCS factory that's going to be fully up and running in the -- throughout the year. We're going to see distribution investments we've made on the efficiencies on our network. You saw in the fourth quarter, we recognized a lot of SG&A cost actions. Alok talked about the headcount reductions that will carry into 2026 as well as technology and AI investments around systems that will help drive some of that cost And then finally, it's about tariffs. We've seen a lot of tariff costs within 2025, and we know a path to mitigate some of that. So the new cost pool that we can drive productivity against. But we feel real focus on the productivity number and hope to exceed it.

And we will move to our last question from Deane Dray with RBC Capital Markets.

Just a couple of quick ones for Michael. It looks like you all did a really good job at containing your decrementals quarter, that benchmark to try to keep it in a down market to decremental 25% looks really well done. I just was curious, are you managing to that number? Or is this more of an outcome? Because it looks like you took out a lot of SG&A at the right time to hit that decremental. But just let to hear kind of behind the scenes, how are you managing that?

Yes, definitely. We managed two main things within the first. It's the price cost equation to make sure we're positive on that. So that helps in the decremental. And two, as we saw end markets deteriorate in the second half of 2025, both BCS -- within HCS took some cost actions, and you start to see those in there to help mitigate the decrementals that we know is temporary. And we believe that we've restructured the organization in a way that when the volumes come back into Q2 that we'll be able to drive strong incrementals at the 35% with the cost structure and placement.

And I think, Dean, we have every year a strategic planning process. And during that, we have ABC cost items that we would pull if markets go down. Last year was the year we had to put all ABC and maybe items as well, given how steep the volume decline was. So it's not that we're managing to a number. We just have a strategy and a set of processes that we leverage to make sure that costs flow in line with our growth or revenue.

That's really good to hear. And just a quick 1 on free cash flow, which was a real strong point in the quarter despite carrying more...

The whole thing was designed telling I hope being notice of this.

Okay. Well, I noticed. And just the idea you carried more inventory, so that would have worked against you, but it looks like you really came through on the receivables side. Just were there any one-timers in there? Did you pull any those receivables forward? Just some color there would be helpful because it was a really standout quarter free cash flow?

I would give Michael full credit for it. I think he's done a really good job centralizing our teams, consolidating accounting, moving things to shared services and driving some really good processes, especially around collection and timely things. So I think you have a lot of process improvement. And you would see there's a good trend of us managing APAR more disciplined fashion than we have done in the past. So I wouldn't say there's any onetimers there.

Thank you for joining us today. Since there are no further questions, this will conclude Lennox's 2025 Fourth Quarter Conference Call. You may disconnect your lines at this time.

All right. Great. We're excited for our next session. We're here with Alok Maskara, the CEO of Lennox. Alok, thanks so much for being here today.

Thanks, Joe.

I'm sure we have a lot to talk about. But Alok, I think you have -- you want to start with some prepared comments, and then we'll dig in.

Sounds good. Thanks, Joe, for having us over. Good morning, everyone. I have a few slides. I'm going to cover that in less than 10 minutes, so we have plenty of time for Q&A.

Again, if I haven't met you before, I'm Alok Maskara. I'm the CEO of Lennox. I've been with Lennox for about 3.5 years. And I'll tell you this before I start is, I see more potential for Lennox going forward than what I saw 3.5 years ago. And let's just talk about why.

For those who are not familiar with Lennox, let me just quickly ground you on where Lennox is. We have 2 business segments, BCS and HCS, Think of them as building climate as commercial, home comfort as residential. That has shifted significantly over the past few years. BCS used to be single-digit ROS. Now it's higher ROS than HCS. And we have boosted the portfolio through acquisitions, partnerships. And one thing we're very proud of in this chart is our ROIC. Our ROIC, which is probably the highest in the industry, just speaks to the disciplined capital allocation philosophy that the company has followed for many years, and I can promise you, we'll continue following in the future as well.

The other thing I'll point out on this slide is from an adjusted profit margin perspective, the same slide, if you had looked at it about 3, 4 years ago, the number was around 15% versus 20%. So we have delivered good profit growth along with better-than-industry growth on the revenue side.

Our growth algorithm going forward is while there's lots of noise and questions around the industry, our differentiated factors are going to be 4 growth initiatives, and those are around heat pumps being #1. We are undersized and underpenetrated in heat pumps compared to the industry. Just to give you some numbers, our heat pump sales are less than 20%. Industry heat pump sales are close to 1/3 of the total. So we have incremental opportunity.

The reason we had not penetrated fully is we just didn't have enough products to cover the entire range. And we have launched some products. We are launching some more, and we think this is going to be -- continue to be a differentiated growth performer for us.

Emergency replacement, number two. This is one where we just didn't have capacity. We are putting up a new factory in commercial. We put in a new sales team. Early signs in 2025 are very good, and we see this as a long-term growth contributor, a differentiated growth contributor for Lennox.

Third for us is the 2 acquisitions we have done, only 2, relatively small bolt-on, one on the parts space, one on the service space. And both of those will continue increasing our attachment rate. Again, our attachment rate right now is in the teens, and it should be 30%, 35%. So a huge growth opportunity.

And finally, we have been expanding our total addressable market through JVs: Samsung JV, which we launched products this year and will have a meaningful growth impact next year; and then the Ariston JV on water heater that we are going to launch next year and will have a meaningful growth impact in 2027. Each of these, if they contribute 50 basis points of differentiated growth each, that's what our growth algorithm looks like, and that's what we like to target.

I already touched on parts and accessories, but if you just focus on the recent acquisition, we are very excited about this acquisition. We bought this business at what we believe is a fair and attractive price. We think the potential of this business to continue being accretive to our margin, accretive to our growth rate and accretive on an EPS perspective remains very strong. There is no reason this business margin would not expand even further as we integrate the business, substantially reduce the number of locations and look at truly leveraging the sourcing benefits of being part of a much bigger corporation. Super excited about this acquisition.

And if I were to wrap up the prepared comments by just saying, we believe we have a framework that's about growth acceleration because our end markets remain attractive irrespective of where 2025 is headed given the regulatory transition. Our margins remain resilient. And you saw in the Q3 results, even in a declining market, we were able to eke out margin growth. And we believe the opportunity to grow margin remains so that we can earn manufacturer's margin and distributor margins. Our execution is strong, has been strong and will remain strong as we work through all differentiated different factors.

And finally, we have a direct-to-dealer network, whereas technology grows, as more digital penetration happens, as controls become a bigger part, as AI drives greater penetration, we are naturally advantaged compared to others.

And finally, what sets us apart compared to anybody else is our talent and our culture. 130 years old, I'm only the eighth CEO in this history of this company. We'll be around for a long period of time. And the culture that we have about putting our dealer first continuously improving our customer experience is what separates us apart. So thank you for allowing a few moments for prepared remarks.

Yes, that's helpful, Alok. thank you for going through that. So let's get all the resi questions out of the way. And then we'll talk about some of those things as well. So like this year, clearly a transition year, hard to call the market. What are maybe kind of some of the things that you think about the past year that you could have foreseen? And then also as you're thinking about the market for next year, like what's your base case?

Sure. I'll tell you from an investor perspective, I wish we had not increased guidance after Q2 results because at the end, we land up where we had started the year. We beat Q2 and we raised guidance and that kind of hurt us. But we actually had fairly good insights going into the year, and I wish we had not done that.

But let's talk about operations side, which matters more. The whole canister shortage issue, we should have done a better job with it. I mean we are direct to dealer. We should have had better forecasting. We should have seen through that because that is the single biggest reason on why there was more repair versus replacement across the industry. Our dealers just didn't have enough confidence, and we should have trained our dealers better so that, that wouldn't have happened.

The third thing is I think we overplayed the 454 versus R-32. It's just a technical engineering thing. That caused investors some heartburn, that caused our contractors some heartburn. We should have just talked about they are both really good refrigerant and moved on. What we did very well as an industry and as a company is made a safe transition, did better than the R-22. So it all comes down to is I look at this as any other crisis, which is a good way for us to look at lessons learned and do it better in the future.

Can you expand on that last comment? Just when you say overplay it, what does that mean exactly?

Our industry over analyzes everything. And I think part of it is they're both good refrigerants. One company chose one, others chose the other one based on just their own supply chain and how it looked at it. They both meet the regulatory requirements. Each of us will talk about why it's a better solution. And I don't think that just helps the contractor who gets confused with all the different marketing pitches. I just -- now, our salespeople will continue pitching why 454 is better than R-32. I just don't think it helps the industry having that differentiation.

Got it. Okay. That's helpful. And then I guess as you're kind of thinking about next year, right, what's baked into your guide for the fourth quarter is about, call it, mid-20s type volume declines in 4Q. How has that trended relative to your expectations? And then how do you feel about like inventory levels heading into next year?

Yes. Sure. I think from a sell-through perspective, it's been as we had been expected. Sell-in is hard to call out at this point in the quarter because with year-end rebates and all of those things, it could make an impact. A lot of our distributors are not going to earn the year-end rebate that they do. So the 2-step might be a little softer than what we would have expected. But that's often artificial because everybody has growth rebates and things like that, that are baked into it. Net-net, not meaningful enough to make any difference on as we think of '26.

A softer Q4 probably will work towards a better 2026. But at this stage, it's all about stock up, stock down, stocking, destocking versus the underlying demand, which I would say I'm pleased with. I mean the underlying demand, some doomsday scenario think like it's just catering and it's not. So that's the part that gives us a lot of confidence.

So let's talk about that, right? So this year, if you take like the AHRI shipments, you're going to probably net out somewhere around that 7.5 million unit level. As you think about like 2026 and then just where units have gone over the last 20 years -- I mean, I have a hypothesis, but like in 2026, like is the base case that we kind of stay at these levels and then get back to normal? Or like how are you kind of -- how are you thinking about it?

Sure. I'll tell you, so AHRI -- and you already know this, AHRI units are about sell-in versus sell-through, right? So we know sell-through is higher than sell-in. So everybody would agree. Now whether that number is 8 million or 8.5 million, it just depends on how we analyze, but we know it's higher. Let's just say for today's purposes, we think it's 8 million or a little higher. That part will remain the same next year. If anything, that will grow because this year, the 454 transition caused some dealer to lose confidence, and I think that changes, right?

Along with then, you make assumptions on new home construction, existing home sales. And that's what we focus on because 70% of our sales are in that number. So I see the 7.5 million to be growing next year. And just the lack of destocking makes that positive, right? So that's the way where we stand.

Now with -- if you talk to 5 companies, you'll get 5 different views. Everybody's views are shaped by their own experience. Because we are more focused on selling to contractors, we probably have a more positive outlook on it. But I see next year numbers to be growing compared to the 7.5 million number this year.

Okay. Can you talk about that whole dynamic on the conference call that you're like, well, inventory levels are not going to normalize really until the second quarter. And some of that -- the big reason for that is the dynamic that we're kind of shifting into the shoulder season, right? So how much did this like hot versus cold or cold versus hot dynamic really impact that statement? And then ultimately, when we get to the second quarter of next year, how do we think about like the margin impact, things like excess inventory at the OEM level?

Sure. I think the difference between ending at end of this year versus ending in Q2 is probably 1 month because of the hot versus cold as you talked about, right? But just to go back to what we said is that on the sell-through or a one-step channel, destocking ends at the end of this year. On 2-step, it will end at Q2. We still stick with that.

And by the way, the way we got to it is not based on opinions, but based on data where we looked at our own sales date versus warranty registration date when we know the units got installed, analyze it 10 years worth of data on that and then use AI models to kind of predict it. So all I'm saying like this is not Alok's view made up on thin air, but it's really driven by registration data, sell-through data and [indiscernible].

Now I wouldn't overanalyze our statement versus somebody else's statement because they're both probably true based on what they look at it. Remember, our 2-step channel are typically smaller independent contractors. Others may not have that kind of a split. They might be focused on different type of 2-step distributors. So I think we all probably say the thing that we've analyzed and understood very well. But to answer your question is, it isn't hot and cold driven, shoulder season driven. And still the difference between end of this year and Q2 is probably 1 month of sales, not 4 months of sales.

Got it. That's helpful. So then the last question I asked you was around margins and like the margin impact for 2Q. So because you did run your factories in the third quarter, there's a view that this is going to have like a margin impact in the second quarter of next year. Like how would you respond to that?

Yes. So I'll tell you, this year, we built more than we sold. Next year, we'll sell more than we build. There's an absorption impact. Good news about our industry is majority of our costs are variable. We're not a heavy fixed cost industry. I'll just give you an exact number.

Under absorption will have a $10 million impact per quarter, so Q4 and Q1. And by Q2, we would have caught up. So there will be no impact on Q2. Now keep in mind -- so this was baked into our Q4 guidance, so no new surprise. On Q1, remember, we stubbed our toes pretty badly in '22...

LIFO?

Exactly. And the BCS where we had the impact of Saltillo start-up and all that. I think it starts washing out. So it's not a big number. But yes, it's a number, and we are cognizant of that. We still feel we are doing exactly the right thing by level loading production versus trying to jerk and start up and stop production just to meet some artificial year-end numbers. So...

Yes. And I guess I should have clarified this earlier, but like the buildup in inventories in the third quarter was predominantly in the residential channel. Correct?

That's right.

Okay. So the $10 million impact basically is a wash with the LIFO impact that you had a year ago in the fiscal.

And we had inefficiencies for our R-454B conversion as well, which we called out because that's the time we were converting lines still one at a time. So...

Yes. Not to get the nitty-gritty of the first quarter, but I'm sure many people are listening. The -- there's also the benefit that you have from the inefficiencies that you had in BCS, which was, I think, like a $7 million impact in the first quarter of last year and that's...

That's right.

Okay. So that should be...

And keep in mind, we'll have carryover on price mix that will benefit Q1 the most.

Got it. So I know we've started going down the path on some early thinking on 2026. Some of the breadcrumbs are out there. Any other thoughts that you want to give across the portfolio on early 2026?

Yes. I'll just tell you, listen, there's lots of uncertainty this year. There's obviously carryover uncertainty going on next year. Our goal would be to deliver 2026 where our revenue is higher than 2025, number of units sold higher than 2025 and our margin ROS higher than 2025. Now we got to give all of this into a package thing. We'll do it when we announce Q4. But our planning assumption are those 3 that I just shared. So we'll try and break it down more in January when we announce full year results.

And are those comments on higher ROS for both segments? It's easy to see the case for BCS. It's maybe a little bit tougher to see the case for HCS?

Right now, it's for both segments. And if you go back and look at our Q3 results, despite significant volume challenges, we did okay on margin. Remember, starting next year, we are redoing our distribution network and footprint, and we'll have some benefits on how we manage our logistics and transportation costs that goes live in Q1. So I do think some of that's baked into this statement as well.

How do we think about the price mix into next year? Because you're definitely going to get some carryover benefit from the transition to 454B and you saw pricing step up or price mix step up as the year progressed. So what's kind of like the initial expectation for pricing? And then will you continue list pricing next year, even given the fact that like you saw a pretty substantial increase in pricing across the business this year?

Yes, I'll start with the last one. Yes, we fully intend to have a price increase. The cost of metal has gone up compared to what -- where we were just a few months ago. Our health care costs continue to go up. We do see secondary impact of tariff impacting many of our cost. So I do fully expect our price -- list price increase to happen across both segments. We have seen some competition already announced on the commercial side. I expect others will do the same. But we are facing genuine inflation. I mean inflation has not gone away. And I think that would be reflected in the price.

The other piece of that is, yes, there's a price/mix carryover. There's kind of multiple chunks to it, right? I mean one is the 454B versus 410A, then the tariff-related pricing, and we do fully expect that carryover benefits to continue in 2026. Just by definition, you will see more of that in the first half and second half, you start lapping yourself. So...

Yes. That makes sense. And it's fair to say -- I don't want to put words in your mouth, but you should be able to price above inflation for next year?

The industry has always done that. So that would be our goal.

Great. I'm going to open it up to the audience in a second. But let's just talk about repair/replace. So you had -- you had already made some comments around the canister issue really influencing what happened this year from a repair/replace perspective. How has that continued throughout the quarter? Any other comments you want to make on the dynamic there?

Sure. First of all, I'd say over the long-term trend, whether it's 10 years or 20 years, replacements are more than repair. And I think that trend. This year, that didn't happen. So let's talk about that.

The biggest factor was contractor confidence in the conversion. I mean they didn't have canister. We're not really sure about 454B. They just repair 410A for now. So I think that was one. Consumer confidence also played a big role. And the consumer confidence was around: I may not be in the home for many years; I'm not sure about my job, maybe I'll have to move; yes, let's just repair it even if it's uneconomic decision. So those both factors played a role.

The contractor confidence, we are pretty certain will go away and has already gone away. People are now -- 100% of the units are -- close to 100% are 454B and the canister shortage is behind us and the training has gotten better. The consumer confidence we're going to watch out for. We'll be looking for, obviously, published index, existing home sales and other factors to see where we are. So I do see what happened this year. This is not where we have scientific data, I can tell you monthly trend, right? A lot of this is anecdotal. A lot of it's in our parts and supplies sales. So I can't have like month-by-month trend.

But I'm pretty confident that this is a blip on a long journey and the long journey is about more replacement versus repair. And that's because the labor required to repair is much more skilled, much more scarce and much more expensive.

What's your take on the fact that systems have just gotten way too expensive over the last few years. And I've even had some people tell me that ducted homes are going to move to like air conditioning systems that are either hanging-in windows or mini split units. Like what's your take on this whole dynamic?

Yes. Well, the window shakers, as we call them, the window units or the mini splits, they have also gone up in price. So if I think about it, they haven't remained [ same price ]. But if you come back and look at, yes, the units have gone up in price. So let's acknowledge that. A large part of what the consumer is saying is not the price from the OEM to the distributor or distributor to contractor. What they're seeing is the contractor to the consumer. And we are seeing quite a few dynamics there.

Let's just call a few of them out, right? Post-COVID, average quote per job was like 1.2, which means if you gave a quote, you had 80% chance of winning that quote. That number historically was close to 2 to 3 quotes and the win rate was 30%, 40%. We are seeing a trend back to normalization there, which usually also means that the dealer channel has to give up margin. No different than car dealers and others that had similar. During scarcity, their margins are the one that increased the most.

So I do see the consumer pricing coming down. I think a lot of that's going to come from competition at the different levels, not from OEM, whose margins have actually not expanded substantially over the period from COVID to now. It's more the inflation side. At the same time, we are arming our contractors to talk about the benefit of replacement versus repair, promotional things such as warranty, especially around higher-end unit. So we are arming our contractors to do better.

Now the fear of ducted home going to ductless, it's unreasonable. I just don't think that can happen practically. Will you see more hybrid systems? Yes. And I think a lot of that's driven by site discharge units, homes in California and other pieces. But net-net, that works better for the industry. You can't get mini-split installed in $1,000 either. So mini splits -- and we are very big on that now with learning through with Samsung. Those are pretty expensive as well.

I agree with your comment on ducted versus ductless for what it's worth. I'll open it up to the audience. Any questions from the audience?

All right. I'll keep going. Since we're talking about HCS, and let's say, in an environment, I know that you've said this already that your expectation is that margins will grow. If we're in a flat to modestly declining environment, are those expectations that you still will get margin expansion in HCS?

Yes. And I think the reason it's qualified, yes, it's kind of flat to decline depends on how much decline, right? I mean at some point, we might run out of it. But if we're talking about 1 or 2 points decline, yes. I mean I think our potential to make manufacturers margin plus distributor margin has not changed. And we are in a fairly long-term trajectory to continue improving that. So we have made good improvements over the past 3, 4 years, and I think that trend continues.

It's not just due to pricing. A lot of it is due to productivity, material cost reductions, which we couldn't focus enough on during because of A2L conversion, that's back in play. And our manufacturing productivity has also lagged behind as we converted these lines. So I do think extra focus on productivity is what we are putting together, including on SG&A. So the answer is yes.

Okay. Great. Let's talk about some of the things you started us off with. And specifically, I want to talk about the Duro Dyne-Supco acquisition. So interesting to lay out the parts opportunity. Just maybe kind of help us level set how big your parts business is today, where it could potentially go, the strategic rationale of the deal and how to think about like the potential accretion from it?

If you think of overall across Lennox, parts are a little over 10%. So just think of its teens in revenue, right? If you were to look at a good distributor, they're probably 30% to 40% parts. So we have a significant gap between where we are versus that.

A lot of that in this comes down to is having the right part at the right place, the fastest shipment. A contractor is not going to wait for us to find parts for 2 days. They need it when they need it. So going back to some of the improvements we are making on our distribution network, that applies to parts as well. We just didn't have enough scale or the expertise or the mindset that comes from Duro Dyne-Supco acquisition, where they are fanatic about saving the contractor 5 minutes on install time by having a different type of a screw, a different type of a hangar, a different type of a connector.

Equipment manufacturers like us don't think like that. That's not how our salespeople are trained to. So that's the one we're excited about using Duro Dyne-Supco and their DNA to manage our overall parts business while investing in distribution, while investing in that. That business, again, margin accretive when we bought it, should be close to a 30% margin business when we are done.

Overall, as we grow from this teens to over multiple years to our entitlement, which at minimum is 30%. I think that's a great journey for us to continue focusing on. Our 250 stores used to be called Parts Plus for a reason. Now is the time we can actually deliver on that promise of it being Parts Plus to sell more parts through that. But that involves a lot of changes and investments that we've already made, including planograms at store, training our salespeople, having a dedicated parts and supplies sales team because given a choice, our salesperson will sell a $1,000 condenser versus a $20 capacitor.

So how do we have the right kind of training mechanism and people who are incentivized to sell that $20 capacitor and sell 50 of those. I mean that's what we have to work through. So lots of hard work ahead, but I'm excited about the potential.

Great. And you made a comment saying that this was a lot of investments that you already made. Are there additional investments that you need to make with this acquisition to fulfill the dream of increasing from 10% to something much higher going forward?

Not from an SG&A perspective that we'll see. Yes, we'll have to invest a little bit more in like inventory dollars. But given that I'm carrying so much more finished goods inventory, you won't notice it. I mean it's within that range of that. So yes, we'll do some of those. But remember, at the same time, this is a business where we also have 8 to 10 points of margin expansion opportunity. So any investment we make will be much, much smaller compared to the margin improvement opportunity we have here.

So you mentioned that kind of like their DNA is to be fanatical about helping the contractor. What do they have from an asset base today that actually helps you bridge the gap between 10% and 30%?

So from an asset-based perspective, first of all, they have really good brand loyalty. Duro Dyne, very, very well known on the commercial side, whether you are hanging ducts in here. Since we made the acquisition -- by the way, we already look at ducks and how they hang it and what kind of different connectors we put together. And Supco from just pure brand recognition. Imagine those products now in every Lennox store displayed well, sold well, our salespeople trained well and the sales reps and the salespeople who truly know how to sell parts, along with good fulfillment capabilities.

We can only enhance all of that while bringing the sourcing savings because we actually buy more motors than they buy just because you're a big OEM, we buy more capacitors than they buy, we buy more switches. So it's a winning combination. Now the only thing is it's a smaller acquisition, which helps us go through the integration properly and leaves room for more. we have more in the pipeline for us to expand in that category.

Can you talk about one of the other initiatives, the emergency replacement business? I know you've ramped up Saltillo at a time when like, look, the light commercial markets haven't been great this year, right? So how do we kind of think about the contribution going forward now that you're -- I think you're fully ramped up, the share gain opportunities? And like what kind of volume environment do you need in light Commercial to really kind of see the traction that you want to see?

Sure. So first of all, let's take a step back, and you've known this longer than I've been here, Joe. If you think about our Commercial Rooftop business, we lost share pretty steadily from like 2018 time frame until 2023. '24, we evened out. '25 for the first time, we will have a really meaningful positive share gain. '24, we eked out share gain and a large part of it is driven by emergency replacement, but also driven of some key account win back because we now have capacity. We delivered growth despite the industry being down in Q3, and we'll do the same thing for full year.

So we'll obviously continue that trend, realizing that we were not live on this initiative until middle of the year. So we are still ramping up on that. We're doing it by region by region, Chicago, then Minneapolis, then Denver, then Atlanta because we want to do it appropriately. We can't disappoint our contractor. So I remain bullish. And we've talked about emergency replacement. Let's say it's about 40% of the market. It was only single digits for our sales. So we have a long way to catch up for that. And I think this tailwind continues for us for many years.

The good news for us is the same contractor who does residential often also does commercial. And we let them down for past year, and they are really excited about now having a full portfolio. And that also strengthens our residential business and makes our market share more sticky. So lots of benefits here.

That's super helpful. And great to see the traction in the recent quarters. One of the questions that we get as well because of the disruption that A2L caused this past year is you've had one competitor who didn't have the canister issues who's gained some share. And so the question we get is like, well, is that competitor going to be potentially disruptive to the industry going forward with additional share gains? And how do you respond to that?

Yes. First of all, let's -- last year, we called out temporary share gain for us and everybody else, right? And this year, we would acknowledge that the temporary share gain is no longer there for within practical reason. That's because in our industry, shares don't just shift much. Remember, this is an industry where every player gained share every year, which means nobody gains share every year, right? I mean it just like a flattish share market and the channel loyalty is very strong.

A Lennox dealer who's a multigenerational Lennox dealer, is not going to switch. I mean, it just doesn't happen. So from that perspective, I'm not concerned. That competition brings a lot of good things to the table. One of it is they're very price disciplined. One of the things is they're very focused on using technology as a differentiation. And we like that about the industry. That's true for pretty much any competition that you talk about in our industry is let's use technology as a differentiation. Let's use our controls, our warranty as a differentiation. Let's not get into a price war. So we like that.

So I'm actually curious, you bring up your -- the stability of the Lennox dealers. There had to be some frustration this year, I would guess, with your dealer network, just given the demand environment, the canister. So you're saying that you didn't see a lot of like your dealer network going outside of like the Lennox offering to other brands this past year. Is that a fair statement?

I think that's really a fair statement because the canister shortage was not a Lennox issue. The canister shortage was -- everybody who dealt with 454B had the canister shortage, right? So I don't think that impacted anybody more or less than us.

You all just felt it the same?

We all felt it the same. And that's why the only person who probably gained share was the one who did not have it. But they suffered something else last year. So it kind of normalized it out. I think the frustration with our dealers was probably more around training their workforce, having them the confidence. And every time we talked about the industry not doing well, they get worried, too. So as an industry, we just owe it to our contractor base to train them more, educate them more, give them the confidence that, "Hey, industry goes through ups and swing, but it's a solid industry." And I think that's what we're all doing right now.

Got it. So my last question is really just around free cash flow because you've had some odd inventory dynamics this year. You had to take down your free cash flow guidance for the year. As you think about 2026, it would seem that working capital should be a tailwind, but how are you thinking about the benefit that you could potentially see in free cash next year?

Yes. I mean, listen, the excess inventory that we have, we will clearly convert that into cash next year. We'll give you full detailed guidance on that. But yes, I mean, we fully expect to convert that extra inventory into that. We will invest some inventory in parts that I mentioned earlier, like there will be some offsetting pieces in that, there'll be some offsetting on emergency replacement as we ramp up, there's going to be some. But net-net, yes, your statement is accurate.

And we'll balance all of this out and give you guys a walk in January. And we remain confident in our capital deployment strategy overall. And this year, the reason we're going to end up with higher inventory, it's just better for our shareholders to have a steady production over the next 6 months, which to do a big restructuring and then try and ramp up again next year. So that's the way we are looking at it.

Makes sense. Look, any other closing comments you'd like to make?

No, I'll just come back and say the 2 or 3 things that haven't changed despite 2025 is, believe it or not, this refrigerant transition went better for the industry than the last one, which is R-22 to 410A. All of us kind of saw it coming. It was a little maybe worse than we expected. As Lennox, when we held our Investor Day, we refused to talk about 2025 guidance because we said it's going to be a messy year. It turns out it's more messy than that.

But for us, the second portion is we remain confident in the industry remaining a very attractive industry. I think the fears about a price war are overblown. I think the fears about repair versus replacement being a long-term trends are overblown. I think it's a nondiscretionary spend remains the case. The fact that the average life of units has continued to come down, that remains positive. The fact that Lennox has a direct-to-dealer model that's only going to get stronger as there's more digital penetration, as there's more AI-driven thermostats, as consumers are getting more brand aware, all of it puts us in a very solid space, both as an industry as a company. And I wish all our competitors, everybody trade at a high multiple, but it is a very attractive industry. So thank you.

Alok, thanks for being with us here today.

Thank you, Joe. Appreciate it.

Welcome to the Lennox Third Quarter Earnings Conference Call. [Operator Instructions] As a reminder, this call is being recorded.

I would now like to turn the conference over to Chelsey Pulcheon from Lennox Investor Relations. Chelsey, please go ahead.

Thank you, Katie. Good morning, everyone. Thank you for joining us as we share our 2025 3rd quarter results. Joining me today is CEO, Alok Maskara; and CFO, Michael Quenzer. Each will share their prepared remarks before we move to the Q&A session.

Turning to Slide 2, a reminder that during today's call, we will be making certain forward-looking statements, which are subject to numerous risks and uncertainties as outlined on this page. We may also refer to certain non-GAAP financial measures that management considers relevant indicators of underlying business performance. Please refer to our SEC filings available on our Investor Relations website for additional details, including a reconciliation of GAAP to non-GAAP measures.

The earnings release, today's presentation and the webcast archived link for today's call are available on our Investor Relations website at investor.lennox.com.

Now please turn to Slide 3 as I turn the call over to our CEO, Alok Maskara.

Thank you, Chelsey. Good morning, everyone. I'm proud to report that Lennox maintained resilient margins and high customer service levels amidst a very challenging external environment. Our talented team worked tirelessly with our loyal customers and channel partners to deliver these results, and I'm very grateful for their hard work. Our results were also fueled by our recent investments, which will accelerate our growth and expand our margins as the industry turns the corner into a brighter 2026.

Let us turn to Slide 3 for an overview of our third quarter financials. Revenue this quarter declined 5% as growth initiatives and share gains were unable to fully offset the impact of soft residential and commercial end markets. Ongoing channel inventory rebalancing and weak dealer conference following the regulatory transition created more complexity for the quarter. Our segment margin was 21.7%, a record for the third quarter. Operating cash flow was $301 million, which was lower than last year as a sharp industry decline has temporarily elevated our finished goods inventory levels. Adjusted earnings per share was a third quarter record of $6.98, a 4% year-over-year increase. HCS segment profit margin expanded by 30 basis points as the team executed meaningful cost actions to offset industry headwinds.

HCS' revenues declined 12% as the residential industry faced a weak summer selling season and as both contractors and distributors rebalance inventory post regulatory transition. BCS segment results were impressive as profit margins expanded 330 basis points and revenue grew 10%, even though the end markets remained weak. The team was able to offset end market conditions with rigorous execution of growth initiatives such as share gains in emergency replacement, business development and refrigeration and full life cycle value proposition in commercial services. Given current end market conditions, we are adjusting our full year outlook to reflect an anticipated sales decline of 1%. We now expect adjusted earnings per share in the range of $22.75.

Now let's move to Slide 4 to discuss how our recent acquisition will increase the attachment rate for our parts and accessories. Differentiated growth at Lennox is driven by 4 growth vectors: heat pump penetration, emergency replacement share gains, higher attachment rates for parts and services and total addressable market expansion through joint ventures, such as Samsung and Ariston. Our bolt-on acquisition of AES Industries in 2023 helped accelerate the attachment of commercial services and was a tremendous success based on financial and strategic metrics. As a result, our commercial services business has more than doubled over the past 3 years. Similarly, the recent acquisition of Duro Dyne and Supco will help accelerate attachment of parts and accessories across both HCS and BCS segments.

The acquired business has annual revenues of approximately $225 million and a solid growth trajectory with strong margins. This acquisition meets our disciplined criteria and will be accretive in 2026. The acquired business provides Lennox with additional products brands and distribution scale to accelerate the growth of our parts and accessories portfolio. We see a significant opportunity to increase the attachment rates, 1 of our 4 key growth vectors, the integration of Duro Dyne and Supco will also lead to meaningful cost synergies that make this transaction even more attractive to Lennox stakeholders. Our integration team has already identified sourcing opportunities, and we are confident about creating additional value as we align the business with Lennox standard infrastructure and implement our unified management system.

Now let me hand the call over to Michael, who will take us through the details of our Q3 financial results.

Thank you, Alok. Good morning, everyone. Please turn to Slide 5. As Alok outlined, in the third quarter, we continued to navigate a dynamic operating environment characterized by uneven demand due to the new refrigerant transition and broader macroeconomic uncertainty. These pressures resulted in a 5% decline in revenue. However, our team acted decisively and maintained operational discipline, delivering 2% growth in segment profit and achieving margin expansion. This profit improvement was primarily driven by favorable product mix and pricing, supported by the successful launch of our new R454B products. We also saw benefits from improved cost management, including reductions in selling and administration expenses. These gains were partially offset by lower sales volumes and increased product costs, largely due to ongoing inflationary pressures. .

Let's now turn to Slide 6 to review the performance of our Home Comfort Solutions segment. Home Comfort Solutions experienced a softer demand in the third quarter, with revenue declining by 12% and primarily due to a 23% decline in unit sales volumes. While we anticipated a decline in sales volume, the extent was greater than expected due to several contributing factors, contractors and distributors actively reduced inventory levels, macroeconomic softness weighed on both new and existing home sales, moderate weather dampened demand and there was a clear shift towards systems repair rather than full replacements. Despite these challenges, mix and pricing remain favorable, supported by ongoing transition to the new R454B products. On the cost front, inflationary pressures on materials and components continue to weigh on product costs.

These headwinds were partially offset by successful tariff mitigation strategies and sustained improvements in operational efficiency driven by targeted cost actions. We also benefited from SG&A cost reductions, though these were partially offset by ongoing investments in our distribution network.

Moving on to Slide 7. Building Climate Solutions gained momentum in the quarter, delivering a strong 10% revenue growth, driven by a 10% benefit from favorable product mix and pricing while volumes were flat. Light commercial HVAC, which represents approximately 50% of BCS revenue, continued to see year-over-year declines in industry shipments. Despite these market headwinds, we maintained volume levels through share gains in emergency replacement products and solid growth across our refrigeration and service offerings. On the cost side, material inflation remained elevated but was partially offset by gains in factory productivity as our new facility continues to enhance operational efficiencies.

Turning to Slide 8. Let's review cash flow and capital deployment. From a free cash flow standpoint, we are revising our full year 2025 guidance to approximately $550 million. This adjustment reflects elevated inventory levels driven by lower-than-expected sales volumes. We expect inventory levels to normalize in 2026, while continuing to support strategic investments in commercial emergency replacement and the launch of our new Samsung [indiscernible] product line. The $550 million of free cash flow includes approximately $150 million in capital expenditures primarily focused on expanding our distribution network, enhancing the customer digital experience and establishing multiple innovation and training centers designed to help our customers succeed in their local markets.

On capital deployment, we have repurchased approximately $350 million in shares year-to-date, and with $1 billion remaining under our current authorization, we will continue to opportunistically repurchase shares. We also continue to evaluate strategic bolt-on acquisition opportunities that enhance our distribution capabilities and expand our product portfolio. As we pursue these initiatives, we remain committed to preserving a healthy debt leverage across all capital allocation decisions.

If you'll now turn to Slide 9, I'll review our full year 2025 guidance. In response to evolving market conditions, we are updating our full year guidance to reflect deeper inventory destocking trends and continued macroeconomic weakness, particularly in home sales and consumer confidence. Starting with revenue. We now expect full year revenue to decline by 1% compared to our previous guidance of 3% growth. This revision is primarily driven by lower total sales volumes in Home Conference Solutions which are now expected to decline in the mid-teens range compared to our previous guidance of high single-digit decrease. With the successful closing of our Duro Dyne and Supco acquisition, we expect an approximate 1% contribution to full year revenue growth with a minimal impact on EBIT due to purchase price amortization of approximately $10 million.

On mix and price, we continue to expect a combined benefit of 9%, consistent with our prior estimate. Turning to cost estimates. We now expect cost inflation to increase total costs by approximately 5% and down from our prior estimate of 6%. This improvement is driven by successful tariff mitigation efforts and additional cost actions. Looking at other key metrics. We now expect interest expense to be approximately $40 million, reflecting our recent $550 million acquisition and lower free cash flow due to elevated inventory. Our tax rate is projected to be around 19.3%. On earnings per share, we are updating our EPS guidance to a range of $22.75 to $23.25 and down from the previous range of $23.25 to $24.25. And finally, as mentioned earlier, we now expect full year free cash flow to be approximately $550 million revised from our prior guidance of $650 million to $800 million.

In summary, while 2025 remains challenging with industry softness and double-digit declines in sales volumes, our continued focus on operating discipline positioned us to grow earnings per share, and we remain optimistic about a return to market growth in 2026.

With that, please turn to Slide 10, and I'll turn it back over to Alok.

Thanks, Michael. As we reflect on this quarter, I want to acknowledge the challenges we have faced as a company and an industry. The environment has been tough with destocking higher interest rates and shifting consumer patterns, all of which have weighed on our results. However, I am confident that these headwinds are temporary. Our team has navigated this period with discipline and resilience and the actions we have taken have positioned us for a strong rebound next year.

Looking ahead to 2026, we expect channel inventory to normalize and with the prospect of lower interest rates, both new and existing home sales should begin to recover. We are also moving past the disruption of this year's refrigerant transition. While dealers were understandably cautious due to industry-wide canister shortages and supply chain friction, we expect dealers to regain confidence as the transition-related component shortages are finally in the rear view. We are positioned to gain share through several avenues, including a renewed focus on new product introductions and contributions from joint ventures including ductless products and water heaters. Of course, we are mindful of some headwinds.

As economic pressures persist, we anticipate higher demand for value-tiered products along with elevated repair activity in lieu of system replacements. As federal energy efficiency incentive sunset, they may create some additional uncertainty. However, we do not expect them to materially impact overall demand, especially as some states and utility incentive for energy efficiency are expected to continue. On the margin side, we expect mix improvement from carryover of our 454B refrigerant products, particularly in the first half of the year. In addition, we also anticipate customary annual pricing actions to offset inflation. Beyond pricing, we are driving disciplined cost productivity efforts to sustain margin resiliency. Optimization of our distribution network will lead to lower logistics costs, higher fill rates and better customer experience.

Targeted SG&A cost actions will streamline our processes and enhance efficiency across the organization. With our new commercial factory in Salto, now fully operational, and delivering measurable improvements, we expect additional manufacturing productivity in 2026. At the same time, we are making strategic investments that strengthened our foundation for future growth, including digital front-end tools that simplify how our businesses work with our dealers. Expansion of our distribution network enhances our capabilities and reach and the addition of new innovation and training centers accelerate product development and dealer loyalty. We continue to closely monitor inflation, tariffs and rising input costs across commodities, components, health care and benefits. However, our disciplined cost management effective pricing and focus on operational excellence gives me confidence in our ability to navigate these pressures while sustaining margin resiliency.

Now let's turn to Slide 11 and for why I believe Lennox outperforms the industry. As highlighted last quarter, our strategic focus has not wavered. Even with recent challenges, we continue to execute ahead of schedule on the commitments outlined in our transformation plan. Looking forward, we expect growth to accelerate supported by consistent replacement demand and initiatives across digital enablement, dockless solutions, commercial capacity and the parts and services ecosystem.

Cost productivity has become increasingly important to maintain resilient margins, and we are achieving this without compromising growth investments. We continue to make targeted investments to elevate customer experience and product availability. Simultaneously, we are scaling our digital capabilities across both product offerings and customer touch points, leveraging proprietary data and broadening our portfolio of intelligent controls. This progress is made possible by a highly talented team and a culture rooted in accountability and results. I remain confident in our strategic direction, and I'm committed to delivering sustained value for our customers, employees and shareholders. I firmly believe our best days are ahead. Thank you. We'll be happy to take your questions now. Katie, let's go to Q&A.

[Operator Instructions] Our first question will come from Ryan Merkel with William Blair.

My first question is just [indiscernible]. Can you put the residential volume declines in perspective a little bit more comment on what was the performance of 1 step first 2 step. And then if you excluded the destock, any sense for what sell-through volumes would be for resi in the quarter?

Ryan, what I can do is I'll give you some clarity. On the total sales within Q3, we saw total sales and sell-through down about 10%. And about 20% down on sell-in. So that's total sales, which would include the price/mix benefit. Alok, did you want to talk about that?

Yes. And I think, Ryan, one thing that's been very clear to us during this quarter, is when we look at our sales to our contractors or whom we call dealers, they also were holding inventory. And in some cases, it was more than we thought. So as we've gone around and spoken to hundreds of our contractors and dealers, we have realized they have done some destocking as well. So it's not purely as the numbers are coming through. So I think there was destocking happening on both sides. But if your question is taken differently and said, what do we believe the consumer demand for this looks like?

We do think it's weak impacted by interest rates impacted by housing stock that's not turning over as it used to be, and in some cases, impacted by the type of a summer we had for the past 10 summers, with the hottest summer on record for the 10 years. So I think that also impacted our relative sales.

And Ryan, I'll just add on the parts and supplies. We did see some growth on parts and supplies in our business, which suggests that there is a bit of a trend toward more of a repair of risk replaced.

Right. Okay. And then my follow-up would be on fourth quarter margins. Third quarter was much better than expected, but sequentially, the margins are coming down a little more than I would have expected on sort of similar volume declines in 4Q versus 3Q. So what are some of the key assumptions there that you can [indiscernible]?

Sure. I think, Ryan, the biggest one is we are pulling back on manufacturing to rightsize our inventory level and that's the absorption benefit that we had in Q3 would be less as we look forward to Q4. That's probably the single largest factor, Ryan.

Our next question will come from Damian Karas with UBS.

So just a follow-up question, thinking about this channel inventory destocking. What's your sense on when those -- when the inventory levels will be more normalized? Is that going to happen kind of soon out than later? Or is this going to kind of be a trend that we see through the first half of next year? And getting the sense that the destocking is not just kind of a 2 step, I think you mentioned also on the one-step side. Is the reality that like maybe some of the contractors out there just been carrying more inventory than you guys have suspected?

Yes. I think we talked about in the past, many of our contractors rented bonds and put inventory in the barns during coat situation. Now that the supply chains have improved and our own lead times are down to 1 or 2 days, they no longer feel the need to maintain that extra bond full of inventory. So these are not months of inventory that our contractors were carrying, but they were carrying a few weeks of inventory, and that destocking did take us a little bit by surprise. But I think in a way, it's testament to the improved industry lead times and just the lack of confidence they had after a weak summer selling season. .

Okay. That's helpful. And then I wanted to ask you about the BCS segment. Obviously, that's -- you're seeing some nice trends there and relative strength. When the dust settles on 2025, where do you think you'll be in terms of the emergency replacement market share and what do you view as achievable thinking about 2026?

Yes. We're really pleased with the progress in emergency or placement. It started with the factory, getting the inventory availability, getting all deployed. So we saw significant growth nearly 100% growth on a very small base of emergency replacement in the quarter. To put it in perspective, if you look at the total BCS segment, about 5% of the revenue is emergency replacement. We see a lot more growth potential there because we didn't fully catch the full season with emergency replacements. So we're ready for next year. We've got the inventory deployed and we see multiyear growth within that channel.

Our next question will come from Nigel Coe with Wolfe Research.

Really, really good job on the margin preservation. Really impressive [indiscernible]. And Mike as well, of course. Just on the -- going back to the inventory. Obviously, your inventory levels are quite high, pretty flat Q-over-Q, which is very unusual. I'm just -- just want to make sure that the bulk of that would be within your captive distribution network, which seems to suggest that maybe inventory levels across the industry are still a pretty high level. So I just want to maybe just kind of double-click on that inventory number. Is it a buildup of emergency replacement inventory? Just some kind of effect it does look like we got a fair way to go here on the destock.

Yes. I think from our inventory level, it's true. It's mostly in the direct-to-contractor level. And I think we were cautious and optimistic going into the quarter. Hence, we have got more inventory than we would have liked to be. I didn't fully answer the question that was asked in the last question as well. It's hard to predict when the destocking would be over. But if I had to guess right now, say the destocking would probably be over by Q2 of next year. So not the entire first half, but I think this is going to continue for a while, and we are preparing accordingly. And I think that's the same forecast we have for our inventory is that we'll be back to normal levels by Q2 next year.

Okay. That's helpful. And then just quickly on the repair versus replace dynamics. Maybe just your perspective on why now? Is it consumer confidence? Is it more around the 8 dynamics? Is it the price [indiscernible] 3? Any comments there would be helpful.

Clearly, by the way, this is a difficult thing to come back and give you a data-based answer. I think it is all 3, but the primary reason, in our view, was the 2-well conversion, our contractors and dealers, who are the one who convinced homeowner that replacement is a better economic decision in the long term, we're just hesitant to sell new products because of canister shortages and everything else that was going on. So they were not as effective as they normally are. There is obviously some impact of consumer confidence, which, as you know, is now in multi months low. So it will be all 3, but I think the primary was just the confidence of our own dealers. .

And I'll just add one more on the existing home sales. Some of these homeowners have very low interest rates. They're wanting to move into new homes, but they don't want to put a whole new system investment and if the next 2 years interest rates come down and they can move to a new home as well.

Our next question will come from Joe O'Dea with Wells Fargo.