Financial Statement Analysis Valuation. By: Ashley Akin, Garrett Nichols, Kyle Shecklls, and Trey Kotarski

Transcription

1 Financial Statement Analysis Valuation By: Ashley Akin, Garrett Nichols, Kyle Shecklls, and Trey Kotarski 11/1/2014

2 Table Of Contents: Executive Summary...5 Industry Overview...6 Accounting Analysis...7 Financial Analysis...9 Valuation Summary Overview of Firm...12 Overview of Industry...12 Rivalry of Existing Firms...13 Industry Growth...13 Concentration...14 Differentiation...15 Switching Cost...16 Economies of Scale...17 Learning Economy...17 Fixed Variable Cost...17 Conclusion...18 Threat of New Entrants...18 First Mover Advantage...18 Distribution Access...20 Relationship...20 Legal Barriers...21 Threat of Substitutes...21 Relative Price and Performance...22 Buyer s Willingness to Switch...22 Conclusion...22 Bargaining Power of Customers...23 Switching Costs...23 Differentiation...24 Importance of Product for Cost and Quality...24 Number of Customers...25 Volume per Customer...26 Conclusion...27 Key Success Factors...27 Industry s Competitive Advantage...29 Efficient Production...30 Innovative Control System...30 Investment in Brand Image...31 Flexible Delivery...33 Conclusion...34 Accounting Analysis...34 Identifying Key Accounting Principles (KAP)...34 Type One Accounting Principles...36 Efficient Production...36 Innovation Control System

3 Brand Image...38 Flexible Delivery...39 Type Two Accounting Policy...40 Research and Development...40 Goodwill...41 Operating Leases...42 Conclusion...43 Actual Accounting Strategy...44 Conclusion...44 Quality of Disclosure...45 Qualitative Analysis...45 Conclusion...45 Identifying Potential Red Flags...46 Goodwill...46 Operating Leases...48 Conclusion...48 Undo Accounting Distortions...49 Financial Statements..49 Income Statement...50 Balance Sheet.54 Conclusion...55 Financial Analysis...55 Liquidity Analysis...55 Current Ratio...55 Quick Ratio...56 Inventory Turnover...58 Day Supply Inventory...59 Accounts Receivable Turnover...60 Working Capital Turnover...61 Days Sales Outstanding...62 Cash to Cash Cycle...63 Conclusion...64 Profitability Ratios...65 Gross Profit Margin...65 Operating Profit Margin...66 Net Profit Margin...67 Asset Turnover...68 Return on Assets (ROA)...69 Return on Equity (ROE)...70 Conclusion...71 Capital Structure Ratios...72 Debt to Equity Ratio...72 Times Interest Earned...73 Debt Service Margin Altman s Z-Score...75 Conclusion

4 Growth Rates...77 Internal Growth Rate...77 Sustainable Growth Rate...78 Conclusion...79 Dividends...79 Dividend Payout Ratio...80 Conclusion...81 Financial Forecasting...81 Income Statement...81 Balance Sheet...85 Dividend Forecasting...85 Statement of Cash Flows...88 Conclusion...91 Cost of Capital Estimation...91 Cost of Debt...92 Cost of Equity...93 Backdoor Cost of Equity...94 Weighted Average Cost of Capital (WACC)...95 Method of Comparables...96 Trailing P/E...97 Forward P/E...97 P.E.G Ratio...98 Price to Book Ratio...99 EV/Revenue EV/EBITDA Conclusion Intrinsic Valuation Models Discounted Dividends Model Discounted Free Cash Flows Residual Income Abnormal Earnings Growth (AEG) Long-Run Residual Income (LRRI) Final Recommendation Appendix References

5 Executive Summary 5

6 Industry Overview Lennox International Incorporated (LII) is a global company who specializes in the heating, cooling, and refrigeration, also known as HVACR, in the diversified machinery industry. When analyzing the diversified machinery industry firms utilize o combination of differentiation and cost leadership. In this industry, differentiation is driven by quality, innovation, and customer service. Below is the five forces model, which breaks down the diversified machinery industry. Five Forces Model Rivalry Among Existing Firms Threat of New Entrants Substitute Products Bargaining Power of Suppliers Bargaining Power of Customers High Low Low High Low When analyzing the level of rivalry among existing firms it is important to consider many factors. These factors consist of industry growth, concentrations, differentiation, switching cost, economies of scale, learning economy, and fixed/variable cost. Rivalry among existing firms is high between the firms of equal size, meaning large firms against large firms, and the same with small firms. This is because the larger firms controls most of the market shares. The threat of new entrants must be considered when analyzing the industry, and we have determined that the level is low. It is low because there are many guidelines to enter the heating and cooling market and it takes time and money before an upstart company can get in. Also, by having a good relationship with suppliers is important because a company can enter into futures contracts that will lock the varying prices of raw materials. For this reason, we have determined that bargaining 6

7 power of suppliers is high. Another factor to consider when analyzing the industry is the threat of substitutes, which we have determined to be low. The reason the threat of substitutes is low is because there is not a direct alternative for the HVACR system. The bargaining power of customers in the heating and cooling sector is low. This is because the products are high priced which deters customers from switching, the products are also not daily consumables that customers have easy access to but rather a luxury item. This means that companies have more power than customers when they provide quality products. Accounting Analysis A company s accounting analysis involves an overview on their key accounting policies. The key accounting policies the company develops needs to follow procedures that the General Accepted Accounting Principles (GAAP) sets forth for all businesses. Under the GAAP, companies have rules to follow that influence how a company reports its financial statements to the public. A company s annual report to the public could be beneficial to an investor. An investor can avoid distortions by first looking at how the company reports its financials and go over the financials carefully to see if any of the financials are misleading, then try to credit or discredit the company s financials. The key accounting policies defined in the report has to deal with type one and type two accounting policies. A company is in charge of disclosing the companies two types of accounting policies. These two accounting policies disclose specific items that are discussed under their key success factors. Based on the key success factors, a company can report their type one policies describing specific activities and their type two accounting policies that deal with the significant line items that cause the financial statements to be off-balance. 7

8 Type One key accounting policies are directly related to the operation activities that add value to the firm. These certain activities involve how they relate the strategies of cost leadership, and differentiation. The only activity related to cost leadership that Lennox primarily focused on was maximizing their production efficiency. Lennox was able to reduce a significant amount of costs by maximizing their efficiency. Lennox focused on other differentiation strategies such as their innovative control systems, brand imaging, and also their delivery flexibility. Type two key accounting policies have to deal with line items on the financial statements that could cause their statements to be off-balance. These type two policies also materially affect how an investor views the company. There are four types of items that materially affect the companies statements. These four significant items are operating leases, goodwill, research and development, and also benefit plans. Lennox had three items on their financials that caused their statements to not match on the income statement and balance sheet. The three items included goodwill expenses and operating leases. Based on the significant line item values, Lennox was forced to restate the statements so investors can have a real look at the true financial health of the company. Every company s annual reports have a certain degree of disclosure, the disclosures have to deal with how much information the company releases to the public. A company can disclose whatever amount of information they want, as long as it meets the standards set by the GAAP. Although companies could release as little information as possible, this would cause investors to have a negative outlook. Based on Lennox s disclosures they release a good amount of material for investors to analyze their company. 8

9 Another part of the accounting analysis is discovering what types of red flags are raised in the company. The red flags can cause investors to miss important information about the companies. This would cause investors to look the other way if they are not notified about the red flags. Some of the red flags include large or unexplained write-offs, large quarterly adjustments, and unexplained changes in strategies. This is why it is important to release red flags to investors, so they know the risks involved. Financial Analysis Financial analysis is an important tool to evaluating a company s performance. The ways an investor can go through analyzing a corporation s financials is by analyzing projects budgets, and other entities related to the company. When the investor analyzes a business they will be able to see if the business is stable, solvent, liquid, or profitable. In the valuation report we focused on the commercial, residential, and refrigeration industry. The companies we analyzed were Lennox and its competitors, which are, AAON, Johnson Controls, and United Technologies. During the financial analysis we used certain ratios to calculate how a company is performing. These ratios included the liquidity, profitability, capital structure, growth rates, and dividend ratios. Based on the liquidity ratios an investor can see how quickly a company can turn assets into cash. The profitability ratios let investors know how well a company can generate earnings compared to generating expenses. Capital structure ratios let investors know how a company finances their operations. A growth rate is another ratio that shows how much a company is growing in the present and also how the company will grow in the future. Lastly dividend ratios are how much companies pay their shareholders such as common and preferred stockholders. 9

10 The liquidity ratios we evaluated were the current ratio, quick ratio, accounts receivable turnover, day s sales outstanding, inventory turnover, cash to cash cycle, and the working capital turnover, days supply turnover. Based on all the calculations we conducted, Lennox s liquidity ratios indicate they are in the average range compared to all the companies in the industry. When conducting the profitability ratios we used the gross profit margin, operating profit margin, net profit margin, asset turnover, return on assets (ROA), and return on equity (ROE). According to our results we found that Lennox has potentially high profitability. The only ratios that have low profitability are the return on assets and return on equity. Under the capital structure ratios we analyzed the debt to equity ratio, time interest earned ratio, debt service margin and also the Altman s Z-score. The capital structure ratio ratios we calculated show Lennox has a high capital structure. Based on the high capital structure Lennox finances its operations instead of paying for their operations themselves. The growth rates we calculated for Lennox and its competitors were their internal growth rate, and sustainable growth rate. When apply these two growth ratios we found that Lennox has low growth rates. This indicates that Lennox is growing slowly throughout The last ratio we calculated was the dividend payout ratio. According to the dividend ratio we concluded Lennox has about an average payout ratio compared to the competitors and the industry. After calculating all the ratios we then needed to forecast the ratios to get a better look into the future. According to the forecasted ratios for Lennox, we found that they will stay consistent with all their past performances. The final step in the process of evaluating the analysis of Lennox s financials was to conduct the cost of capital, which includes all the cost of equity, cost of debt and the weighted 10

11 average cost of capital. After calculating the cost of capital we came up with Lennox s cost of capital of 12.86%, cost of debt came out to be 3.05%, and the weighted average cost of capital to be 8.57% before taxes. All of these percentages are all based off of an as-stated basis according to their financials. Valuation Summary After performing a fully analysis on every aspect of Lennox as it relates to their accounting and financial reports, the analyst team took a look at the industry to find out how Lennox compares to the rest of the firm s. There are two major red flags in Lennox once the accounting policies were examined, goodwill expense and operating leases. From this we learned that Lennox might be overstating the true value of their company. To combat this, we capitalized the operating leases and created a goodwill schedule and then restated the balance sheet and income statement. We then used to different methods to value Lennox, the method of comparables and the intrinsic value method. The method of comparables did help by comparing prices of Lennox to the other companies in the industry. The major fallback with this method was that most of the competition is conglomerates, meaning that the sector that Lennox directly competes with is only a portion of their overall business. For this valuation the intrinsic value method would be the best method to provide the true value of Lennox. These models included discounted free cash flow, discounted dividends, residual income, long-run residual income, and abnormal earnings growth. After analyzing the five models we found Lennox to be overvalued on all models at a very consistent basis. Overall, we have found Lennox to be overvalued as of November 1, 2014 and would recommend selling the stock that you currently holding. 11

12 Overview Of Firm Lennox International is a worldwide company that handles residential and commercial heating, cooling and refrigeration, also known as HVACR. In 1895, Dave Lennox created the first steel-riveted furnace, which started him on the path to being the leading manufacturer it is today in the heating, cooling and refrigeration markets. In 1960, Lennox expanded into Europe but it did not change into LII, Lennox International Inc., until 2002 to reflect global growth. The headquarters are stationed in Richardson, Texas, with factories and offices located in Asia, Australia, Europe, India, Mexico and South America. LII manufactures their own parts and operates over one hundred Lennox PartsPlus stores to offer parts and services to employees and customers. LII has released new, innovative products within the last few years with the help of their research and development division. In 2012, about 45% of the sales was from the introduction of new products. Lennox makes different types of HVACR systems as well as the thermostats used to control the systems, which they call comfort control systems. Some of the HVAC systems they have are furnaces, air conditioners, heat pumps, air quality, and boilers. These systems are good for customers who don t need a whole heating, cooling and refrigeration unit but rather for one specific purpose. Overview of Industry Lennox is in the diversified machinery industry and more specifically in the sector of industrial goods. For the purpose of this valuation, we found that finding direct competitors is difficult since most companies, like GE, have multiple products. When we looked at their annual reports we found that they were not specific enough for us to find the information we were 12

13 looking for. One of the main competitors for Lennox is Trane Incorporated, however, they are privately held and we would not be able to find all of the information needed for the valuation. For this reason, we will be comparing Lennox to the competitors: AAON, United Technologies Corporation, and Johnson Controls. However, we will also compare Lennox to other competitors as the need arises. Rivalry Among Existing Firms The interpretation of the financials by the company and by investors does have significant value, but comparing to similar company s you can determine the true financial health. This industry is different from most because most of the competition is major company s who do more than just heating, cooling, and air conditioning. Company s such as General Electric are not centered on this market, but are active in many markets and therefor are not an accurate benchmark for Lennox. After thorough research of similar competition in an industry, it can be determined how companies market their products, create value within their company, and increase their profit margin in a competitive market. A few elements need extra scrutiny when examining a market competition. These include: industry growth, concentration, differentiation, switching cost, scale and learning economies, fixed and variable cost, excess capacity, and exit barriers. The biggest key, however, is finding each company s competitive advantage within the market. Industry Growth To fully understand a company s revenues, an investigation of the entire industry s growth needs to be analyzed to determine if increase or decline is a result of the industry s market, or if the numbers reflect the unfavorable/favorable condition of a business. If the economy is in a deep recession or depression, seeing a negative profit might not be due to a 13

14 poorly managed company, but the effects of an unstable economy. The table below shows the net sales for Lennox and other competitors. As shown on the table there has been an overall increase in net sales since 2009 within the industry, but no consistent growth pattern has been shown. Lennox and AAON are the only two companies in the past 5 years who have shown growth in every year. This might be a trend because they are the two smallest companies as shown by their net sales. In conclusion, the industry as a whole seems to be increasing and decreasing sales and relatively the same rate, with the larger companies (Johnson Controls and UTC) and the smaller companies (AAON and Lennox) grow at very similar rates. NET SALES AAON Lennox Johnson Controls UTC Industry Totals 2009 $ $2, $12, $15, $ $2, $12, $17, $33, $ $2, $14, $18, $36, $ $2, $14, $17, $35, $ $3, $14, $16, $35, Concentration To find out how concentrated a market is, an analysis of the overall size of a company in relation to the industry is necessary to determine who has the largest portion of sales in the industry. This is important because an investor can determine who is a price setter, the 14

15 companies who determine the overall price of the market, and who is a price taker, the companies who charge a price somewhere around the market average. The concentration of a market can be measured by a company s sales as a percentage of the industry. This shows what percentage of the industry a company has and is critical in determining the power they have over the market as a whole. The graph below shows a significant gap between the large firms and small firms in relation to the sales. With this large gap in the number of sales, it would be much easier for the larger companies to set a price, because with more sales they can have a smaller profit margin, and then the smaller companies would have to accept that smaller price. 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% SALES AS A % OF INDUSTRY AAON Lennox Johnson Controls UTC Differentiation Differentiation is the ability of an industry to separate itself from its competition using various resources, marketing, pricing, and other means to add value. Each company within the industry can determine how they want to create value. Companies can use research and 15

16 development to create more eco-friendly products or create more cost efficient machinery by lowering their variable or fixed cost. This can be done by finding some way to use a natural resource such as wind or the sun to power machinery associated with the industry. This saves customers money in the long run from high electrical cost associated with heating/cooling. Companies can also market themselves to add value without increasing the service or changing the way goods are manufactured. They do this by creating a brand for themselves by making high quality, cost effective, or eco-friendly products that cause a higher demand for their products without necessarily changing the company. Lastly, the company s product price is the easiest way to differentiate one firm from the next. The price at which a company sells its products will determine whether a company can set its price or has to conform to the market price. This influences the consumer because every consumer would rather pay less money than more money if they were going to be receiving the same product. The ability to set a price at which a company is able to succeed is a key factor in determining the health of a company going forward. Switching Cost Switching cost is an avoidable cost that some firms will undergo whenever they choose to use their assets for a different purpose, such as another business. In the heating, cooling, and refrigeration industry, there are many project specific parts that will only have one use. A heating element can only serve one main purpose in regards to generating profit. Due to this, there are limited alternatives to use assets in another manner making switching cost to leave this industry very high. 16

17 Economies Of Scale Economies of scale are when a company can save money by producing more of a product or service. The best example of this is when a company buys its products from a supplier; the company will receive a discount because they will be buying the product in higher quantities. This strategy can be used to lower a company s variable cost and can be very beneficial in manufacturing machinery due to the high number of parts needed for heating and cooling services. The larger the company that is manufacturing and installing the products, the more ability they will have to set their own price due to the small variable cost and the higher profit margin that they will have over other company. Learning Economy A learning economy is an economy that before entering the market requires you to do an extensive amount of research and development. Unlike industry s such as food service, the majority of people do not have the ability or knowledge to be able to create their own HVAC product, and because of this high amount of research and development involved in the manufacturing process that is necessary to start a company in the HVACR industry, a firm will need a large amount of learning economy. Fixed/Variable Cost Due to the high influence cost can have on revenue; firms will assess their cost and find out where they can lower their own expenses. The two major types of cost are fixed and variable. Fixed costs are the cost that the firm will always have, regardless of the amount of goods or services sold. Variable cost, however, will be altered based upon the amount of goods or services 17

18 sold. Firms who can lower their variable cost have a tendency to do better than firms who have a higher variable cost because they have the ability to set the price at a lower cost. A large company with many different products has the ability to buy inventory at a lower cost due to the mass quantities it will purchase and the discount given to larger purchases, thus, lowering its variable cost. Conclusion In conclusion, after examining the firms in the industry, we have determined that it is a competitive industry, but has a large gap between the large firms and the small firms. There is more competition between the firms of equal size than there are large firms against small firms or vise-versa. However, it is competitive among the smaller industries due to the fact that the larger firms control so much of the market shares. Threat of New Entrants This section will describe four topics in the following order: economies of scale, first mover advantage, distribution access, relationships and legal barriers. First, is first mover advantage, which is the benefit a company gets from being the first company to enter a new market. Secondly, distribution access is what intermediaries the company uses to get customers the product. Third, the relationships section is going to discuss the relationship between the company and its suppliers. Finally, legal barriers are any laws or regulations that prevent a new firm from entering the market with ease. First Mover Advantage The company that makes the first move will have the most opportunities when it comes to the new market. The company will be able to negotiate prices with suppliers; it will also be 18

19 able to establish long-term relationships with these suppliers. Being the first mover in a new market can lead to the company obtaining more quality information about the market. This way, the new firm will have superior information than all of the other companies who enter after them. With the superior information, they will understand the market better. They will know what the market is going to do before the rest of the companies, which is a huge advantage. Establishment of manufacturing operations in low-cost countries could provide cost advantages to existing and emerging competitors. Some of our competitors may have greater financial resources than we have, allowing them to invest in more extensive research and development and/or marketing activity and making them better able to withstand adverse HVACR market conditions. Current and future competitive pressures may cause us to reduce our prices or lose market share, or could negatively affect our cash flow, all of which could have an adverse effect on our results of operations. (Lennox International 10-K) This is evident in all of the company s 10-Ks. The fact that all of these companies are worried about the same things shows that this is important. All of these firms have or are trying to obtain operations in low-cost countries. And they all put a large importance on research and development. In the heating and cooling industry, having information that the competitors don t have can make the company have a huge advantage in the market, especially when it comes to a new housing district. The company with the advantage could become the only firm that the housing contractors use for the heating and cooling. This can be huge because it will cut out all of the competitors. While doing this, the company can also build relationships with the contractors. This can provide an advantage by the contractors choosing the same firm for future markets. 19

20 Distribution Access Distribution access can be very important in many industries. Depending on the type of products being sold, the distribution channel may be different. Therefore, there can be many different ways to establish a good distribution network. Lennox chooses to have three to five main suppliers, in which they like to maintain a strong relationship with. In doing this Lennox maintains a good relationship with its suppliers, allowing them to have futures contracts with many of the suppliers to keep the costs lower. This is how many of the firms in this industry work, especially the smaller firms, whereas, the larger firms have much larger distribution channel. The larger firms are more established around the world and are able to obtain more distribution access based solely on their size. The larger firms such as Johnson Controls and United Technologies are able to establish and maintain larger distribution channels because they have the financial means to support many different channels. Relationship Having a good relationship with suppliers will help the firm in many ways. A good relationship between a firm and its suppliers is needed in order for the company to have a good profit margin. Also, having this strong relationship with the supplier might make it so that the supplier is willing to do more for the firm. This is important because with the prices of raw materials varying so often, prices can exceed expectations fast. With a good relationship with suppliers, the firm is able to enter into commodity contracts that lock the prices for those materials. 20

21 Legal Barriers: Legal barriers can include environmental regulations, governmental regulations and licensing. These practices are in place to protect both the companies and environment. The HVAC industry has to be in compliance with many different laws and regulations. Some of the laws in which the HVAC industry have to meet are the following: the National Appliance Energy Conservation Act of 1987, the Energy Policy Act, the Clean Air Act (which require companies to keep the airborne contaminants low based on the EPA regulations), the Clean Water Act, the Resource Conservation and Recovery Act (which controls the disposal of solid waste and hazardous waste), the Comprehensive Environmental Response, Compensation and Liability Act, the National Environmental Policy Act, and the Toxic Substances Control Act (which regulates the introduction of new or existing chemicals). All of these can be a problem for new firms to overcome. In order to be in this industry the new firm will have to meet these standards, which will take time and money. This will give the firms already in compliance a competitive advantage over new entrants. Threat Of Substitutes Substitutes are products that are similar in price and perform the same functions as an existing commodity. Firms are forced to compete on price and brand recognition when there is a high threat of substitutes. However, we found that in the diversified machinery industry there are not direct substitutes for the HVAC but rather a high level of competition. Currently there are many different types of HVAC systems that customers can purchase. These include warm air furnaces, boilers, heat pumps, room air conditioning, humidifiers, dehumidifiers, and a unitary system, which has both heating and cooling in an outside setup. 21

22 Relative Price and Performance Once similar products are on the market, customers turn to price and performance to decide which one to buy. Since there is not a high threat level price becomes almost irrelevant. Price will still matter but a customer is more willing to pay a higher price if the HVACR has a higher performance rate. For performance rates a customer who is looking for a HVAC system examines the efficiency of the system. If there are two different systems from two different companies then price becomes relevant. Buyer s Willingness to Switch A buyer s willingness to switch would mean that there would have to be an advantage to switching to a new product. One advantage to switching to a new product or company would be if they were to receive a higher quality product. Companies have to stay innovative by creating more energy efficient machines to have higher benefits for the buyers. Another advantage to switching would be if the price were lower. However, the heating and cooling sector has high priced products, which deter customers from switching. Conclusion The heating and cooling sector of the diversified machinery industry is not highly affected by the threat of substitutes. Since the industry does not have a direct substitute to the HVACR system but rather a high level of competition, price is not a huge factor. However, it is important for the heating and cooling systems to be high quality or customers won t want to buy the product. To stay competitive in this industry, companies will need to focus on quality and not price. 22

23 Bargaining Power of Customers The customers in this industry are mainly commercial businesses and homeowners. The bargaining power of customers can affect the business s overall productivity. Customers can have a large effect on how a business operates because the customers are the final destination for the product. The more power that customers have will directly change the profitability of a business, because the business will have to cater more directly to the customers. The bargaining power of customers includes the following: switching costs, differentiation, importance of product for cost and quality, number of buyers and volume per buyer. Switching Cost The switching cost for customers can be defined as the customers costs when it has access it has to a competitors products. As previously stated, switching costs in the heating and cooling industry is relatively high for the firms in this industry. But they are also high for the customers. The products offered in this industry are not cheap products, meaning the ultimate reason for a customer to switch products will be determined by the quality rather than price of the product. Switching costs will impact this industry by the parts stores that these firms offer. The individual parts may be purchased at numerous places and the price for these products will be the same in many places. Ultimately, switching costs won t affect the customers decision to switch products as much as differentiation and quality. This is important for this industry because if there our high switching costs, once a customer buys from one company, they will most likely stay with them. With high switching costs, these firms in this industry will maintain more control than the customers. 23

24 Differentiation Differentiation is the way a business offers a unique product in a certain industry. The heating and cooling industry offers many of the same products. One way to use differentiation to gain an advantage in the industry is to use the technology in a new and better way than the competitors. Offering unique quality products in an industry that offers the same products will help a business gain a competitive advantage. With a lack of differentiation, the customers will be more willing to switch businesses or products. With innovative technology and ideas a company can reduce the effect of bargaining power of customers. For example, some of the companies in this industry are offering a green substitute for residential cooling; this can be a way to attract more customers from the competitors. One way some firms are differentiating their products is by offering a substitute product that will involve the use of solar panels instead of electricity. This is an example of the business differentiating their product from the rest of the companies. This is the direction that the industry is headed into now. All firms in this industry have to find new ways to attract and differentiate them from the competitors. With the increasing availability of technology, this industry is beginning to offer many different products that make it easier on the customer through technology. With products like, The Ultimate Comfort System, SunSource Home Energy System, HybridHeat, and Metasys each company is finding new ways to attract customers. Importance of Product for Cost and Quality Cost and quality are some of the most important factors when a customer is choosing which products to use. The heating and cooling industry provide essentially the same products, but this is where brand image comes in. The image of a brand being a good quality product will 24

25 attract more customers. With products like these, quality and cost are directly related. Typically, a higher priced product will be of higher quality. If the customer knows that a more expensive product will last longer and they will gain more benefit, they are more likely to choose the higher priced product. In the heating and cooling industry, innovative ideas and products are the ultimate decision maker. The industry offers products of lower cost, but the majority of their sales come from their middle to higher priced items. There is a high importance in this industry for cost and quality. By looking at what sells for these companies, it is evident that the customers want the more expensive items, because they provide better quality. Number of Customers The number of customers in the heating and cooling industry is directly correlated with the seasons of the year and how the economy is doing. In addition to weather, demand for our products and services is influenced by national and regional economic and demographic factors, such as interest rates, the availability of financing, regional population and employment trends, new construction, general economic conditions and consumer spending habits and confidence. (Lennox 10-K) During the summer and winter months, the number of customers can increase or decrease. If the summer months are cooler than normal, the customer base will not meet expectations. Similarly, if the winter months aren t as cold, the customers will also not meet expectations. Also, the better the economy is doing, the more houses are being bought. With more houses being bought, there is a higher demand for the products. Similarly, if the economy is doing worse, then you will expect to see less heating and cooling products being sold in the residential housing industry. 25

26 In the graph above, the overall net sales have increased since 2009 for not only Lennox, but for the industry as a whole. Since the housing industry has been recovering, sales in the heating and cooling industry has also been increasing. The number of customers is difficult to project, but with the economy becoming more stable, the heating and cooling industry is doing better. Volume per Customer Volume per customer is the number of products that customers purchase per transaction. The customers in this industry typically don t purchase many products at once. Therefore, the 26

27 volume per customer is relatively low. This means the customer has more bargaining power since they only are going to buy one product. In the residential and commercial markets, there will be a different volume per customer. The commercial buildings will require more systems in order to keep the building running. Where as in a residential building, there will need to be one or two systems in place. However, the residential volume may be large at times during new construction. This is because the companies building the houses will buy large amount of products to support the houses they build. But at the same time, the number of units is still going to be one to two per house. However, they have to make a decision on which company to purchase the product from. This is where the companies that differentiate their products and provide quality will gain the advantage. Conclusion The heating and cooling industry is not strongly affected by the bargaining power of customers. Since this industry offers high priced products, there will be high switching costs, which will deter customers from switching. The importance of high quality and differentiation in this industry is what drives customers. Customers are going to be willing to buy the higher priced product because it will provide more benefit. These products are not daily consumables in which customers have easy access to. Instead they are more of a luxury product and the customers will have fewer options and the products will be more expensive. Therefore, the companies have more power than the customers by providing quality products to them. Key Success Factors Every business in the world strives for success and also competes in an industry with other companies. Each business will need to develop key success factors to compete in their 27

28 industry. Key success factors are important competitive advantages that focus on certain activities in the business. These activities allow a company to gain superior power in the industry. To have a competitive advantage the company needs to focus on certain aspects of their industry, such as cost leadership and differentiation strategies. To have cost leadership a company tries to gain industry power by having lower costs compared to other companies in the industry. Another part of the industry that companies focus on developing is a differentiation strategy. Developing differentiation enables the company to show how different their products are to other companies and consumers. Cost leadership is important to any industry, because if an industry is able to lower costs, then companies will be able to improve their profits. Some of the cost leadership components that Lennox and their competitors focus on in the cooling, heating, and refrigeration industry are developing efficient production techniques. Some of the techniques used to efficiently cut their production costs include contracting with few suppliers, improving manufacturing excellence, and focusing on centralizing administrative functions. Contracting with a few suppliers will allow the companies in the HVACR industry develop close relationships with the supplier. Improving the manufacturing excellence of a company is to mainly focus on the production facilities. One last way Lennox, AAON, UTC, and Johnson Controls develop cost leadership is by centralizing and minimizing their administrative functions. A way to improve the administrative functions is by combining operation management and invoicing operations. Another way companies in an industry compete is through the strategy of differentiation. Driving a differentiation strategy means to focus on what drives the customers value to purchase a product. After concluding what customer values are, then the companies can differentiate ways 28

29 of improving the product. In the cooling, heating, and refrigeration industry companies focus on the quality of their products, their variety of innovative products, and also the delivery of their products. Enhancing the quality of the products means improving safety regulations to the customer s satisfaction. Having these safety regulations will ensure the customer s safety from any distress the product might endure. Another way to differentiate from competitors in the industry is involving innovative products. For instance, displaying a variety of products in the field will gain the customers preferences by letting them choose from a variety of products. One other important aspect customers look at in the HVACR industry is the delivery of their products they purchase. Having a fast and on-time approach is critical. Customers want their products on time and no later than the expected delivery date. Implementing these approaches proves to the customers that the company s leading concern is about the customers and not the company themselves. Industry s Competitive Advantage The Cooling, Heating, and Refrigeration industry is very competitive, lucrative, and an intense industry. Customers have a large variety of companies to purchase products from. For this reason companies need to find ways on improving their operating activities so they can cut down costs and spend money where it needs it the most. By improving the company's operating activities, the company s profitability margins will increase and enable them to show the customer who has the most potential in the industry. Some ways Lennox and their competitors utilize this strategy is by signing contracts with a single supplier instead of multiple ones and creating multiple transactions at different costs. This is a way that Lennox gains their efficient production techniques under cost leadership. The other way companies in the cooling, heating, and refrigeration industry compete is by differentiating their products. Currently companies in 29

30 the industry compete by investing the company s money on innovative control systems, branding image, and flexible delivery systems. By enforcing any of these techniques the company drives the customer s value toward the company products. In the next section these parts will be explained further on how Lennox implemented these components based on their 10-K s Efficient Production When competing in the cooling, heating, and refrigeration industry it s vital for the individual companies to have efficient production. By being able to efficiently produce the products, the company will be able to lower the costs and improve their profitability. In 2010, Lennox capitalized on a strategic sourcing plan to reduce their costs in their financial and operation units. The plan involved ordering from various suppliers, about three or five suppliers, then Lennox would order a required amount of raw materials, components, and indirect items across their business segments. After developing these strategies Lennox developed long-term relationships, which led to leveraging their material needs to reduce costs. This approach works because Lennox would already know the price of all the materials purchased, which, would enable them to know how much revenue to set aside for their materials and equipment. Another way Lennox reduced their costs through efficient production was by having joint ventures with their suppliers. The agreement increases their assets and equity in the business, which enables Lennox to be more successful and earn more profits to save for future purposes. Innovative Control System Having a control system focused on innovation is a critical part in the cooling, heating, and refrigeration industry. Thinking of new, innovative products based on the control system will improve the number of customers that will purchase the units from the company. In 2013, 30

31 Lennox maintained their prestige by developing a new way of improving their control system. Lennox developed new criteria that improved how residential customers could control the heating, and air conditioning units. Lennox states the system includes our most advanced controls our iharmony zoning system configured with our new icomfort Wi-Fi to control the entire system by smartphone, tablet, or computer for the most precise, efficient and comfortable heating and cooling in the home. (Lennox K). Producing a new way that lets the customers control their heating, and air conditioning units by smartphones or tablets provides more precise and efficient value for the customers. For example, this allows the customer on a Sunday to control their system while watching television without getting up from their chair. Lennox also produces other innovative control systems for other various customer profile groups. In 2013, Lennox extended their customer base by moving their business to food retailers. Lennox developed a new, efficient, economically friendly platform for food retailers. This new energy-efficient system provides composite mechanical enclosure that utilizes recycled materials, and we introduced an industry-first unit cooler platform (Lennox K). This allows Lennox to improve their profitability through various groups of customers. Investment in Brand Image A company investing in branding their image is crucial for bringing out what the company offers. Advertising the company s brand image will help bring customers in to buy the products offered. Lennox advertises their products through multiple distribution channels. For instance, one of the channels they use is television commercials. Channeling the products through commercials will let everyone know what Lennox has to offer in terms of products and 31

32 services. The demographics they try to focus on are households of residential areas, commercial companies, and refrigeration for both residential and commercial. Shown in the table below are the three business segments, the key products, services and well-known product and brand names within each segment (Lennox K.): Segment Products and Services Product and Brand Names Residential Furnaces, air conditioners, heat pumps, Lennox, Dave Lennox Signature, Armstrong Heating and Cooling packaged heating and cooling systems, Air, Ducane, Aire-Flo, Air-Ease, Concord, Indoor air quality eqipment, comfort Magic-Pak, ADP Advanced Distributor control products, replacement parts Products, icomfort and Lennox PartsPlus Commercial Unitary heating and air conditioning Lennox, Allied Commercial, Magic-Pak, Heating and Cooling equipment, applied systems, controls, Raider, Landmark, Prodigy, Strategos, installation and service of commercial Energence and Lennox National Account heating and cooling equipment Services Refrigeration Condensing units, unit coolers, fluid Heatcraft Worldwide Refrigeration, Bohn, coolers, air cooled condensers, air Larkin, Climate Control, Chandler handlers, process chillers, controls, Refrigeration, Kysor/Warren, Friga-Bohn, compressorized racks, supermarket HK Refrigeration, Hyfra, Kirby and Interlink display cases and systems Two of the products listed above, The Lennox and Aire-Flo brands are sold directly to a network of approximately 7,000 independent installing dealers (Lennox 10-K). Advertising these products and others for the residential households made them the world s largest wholesale distributors in North America. Also, Lennox has been able to market these products by opening up 130 different PartsPlus stores around Canada and North America. By opening up different locations Lennox is able to provide easy access solutions for contractors and independent dealers. For the commercial heating, and cooling, Lennox offers their products to a variety of businesses such as office buildings, restaurants, retail centers, schools and churches. These products provide rooftop units ranging from 2 to 50 tons of cooling capacity and split system/air handler combinations, which range from 1.5 to 20 tons of cooling capacity (Lennox 10-K). 32