Thinking About Money

It must be 100 outside, and the national Academy of Sciences today said the Earth is the hottest it’s been in 2,000 years. Makes me glad I have air conditioning. And started me thinking – I wonder what public companies make air conditioners?

Having recently seen “An Inconvenient Truth“, and being quite convinced that we are moving into a period of more extreme climate changes, investing in climate control companies is positively a no-brainer for the mid to long term (given the fact that ten of the hottest years in history were in the past 14 years, investing based on this trend is not at all unreasonable).

My first thought was Carrier, but they are just a small part of United Technologies. But then I ran into Lennox International, a company focused entirely on HVAC. Their price today of $24.47 is down from a high of $34.76 in about a month. What could have happened?

Revenues are up from the year ago period by 14%. Gross margins are slightly better. Expenses seem under control. There is nothing spectacular in the news to call for such a dramatic drop. Yes, some of the quarter’s income was due to hedging (buying futures on raw materials such as copper and aluminum that are used in manufacturing), but that was true last year and should be true next year as well as the company indicates it is hedged into 2007. Yes, the company had to restate prior year’s earnings due to lack of internal controls on the hedging operation, but it looks like they have that under control.

Near as I can tell there are two possibilities:

1. The drop was largely due to a huge build up in inventory, from $31.3 million to $99 million, and a corresponding drop in available cash.
2. The company, which is classified by some as a building supplier, may have been hit along with housing manufacturing stocks (new home builders have been heading down recently).

A sudden rise in inventory is something to wonder about – especially if sales are dropping. But in this case sales are increasing. And a drop in new home starts a few months ago isn’t going to be reflected in a drop of air conditioning sales for some time (since AC is the last thing to go in to a new home). Finally, Lennox gets much of its revenue from remodel and replacement units.

So why the sudden increase in inventory?

Recent legislation required AC manufacturers to redesign their lines for higher efficiency. Manufacturers aren’t allowed to ship any unit built after January with an efficiency rating of less than Peer 13.

Lennox has completed its redesign and launched a line of these efficient models, but still has less efficient models in stock (On 3/31 they listed under 20,000 units). These can still be sold, but for what price? We don’t know. But my guess (and it’s just a guess) is that they’ve been building inventory in preparation for a very hot summer season and that they will be able to sell the older units if not at a profit, than at least not at a major loss.

Conclusion

Investing in Lennox isn’t a no-brainer. That inventory can come back and haunt them. Insiders aren’t selling much (mostly option exercises) but they aren’t buying either.

But there are some things I like:

• The recent drop brings the company’s P/E ratio to 11, which is comfortably low for this market.
• A dividend yield of about 1.8%. It’s no CD, but that should lend some support to the price.
• Lennox has gradually been buying back shares.
• Increased temperature extremes make any HVAC company a potentially strong investment.

It’s possible I’m missing something, but if I am please let me know, because it’s not easily discoverable. Right now it looks like a good medium to long term investment with very little downside risk.

This entry was posted on Thursday, June 22nd, 2006 at 5:55 pm and is filed under Investing. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.