UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

Form 10-K

 

 

Commission File Number 001-15149

LENNOX INTERNATIONAL INC.

(Exact name of Registrant as specified in its charter)

 

 

2140 Lake Park Blvd.

Richardson, Texas 75080

(Address of principal executive offices, including zip code)

 

(Registrant’s telephone number, including area code): (972) 497-5000

 

Securities Registered Pursuant to Section 12(b) of the Act:

 

 

Securities Registered Pursuant to Section 12(g) of the Act: None

 

Indicate by checkmark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes þ     No o

 

Indicate by checkmark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Exchange Act.  Yes o     No þ

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the last 90 days.  Yes þ     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o     No þ

 

As of June 30, 2008, the aggregate market value of the common stock held by non-affiliates of the registrant was approximately $1,210,568,000 based on the closing price of the registrant’s common stock on the New York Stock Exchange on such date. Common stock held by non-affiliates excludes common stock held by the registrant’s executive officers, directors and stockholders whose ownership exceeds 5% of the common stock outstanding at June 30, 2008. As of February 17, 2009, there were 55,119,211 shares of the registrant’s common stock outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the registrant’s Proxy Statement to be filed with the Securities and Exchange Commission in connection with the registrant’s 2009 Annual Meeting of Stockholders to be held on May 21, 2009 are incorporated by reference into Part III of this report.

 

 

LENNOX INTERNATIONAL INC.

FORM 10-K
For the Fiscal Year Ended December 31, 2008

INDEX

 

 

 

 

References in this Annual Report on Form 10-K to “we,” “our,” “us,” “LII” or the “Company” refer to Lennox International Inc. and its subsidiaries, unless the context requires otherwise.

 

The Company

 

Through our subsidiaries, we are a leading global provider of climate control solutions. We design, manufacture and market a broad range of products for the heating, ventilation, air conditioning and refrigeration (“HVACR”) markets. We have leveraged our expertise to become an industry leader known for innovation, quality and reliability. Our products and services are sold through multiple distribution channels under well-established brand names including “Lennox,” “Armstrong Air,” “Ducane,” “Bohn,” “Larkin,” “Advanced Distributor Products,” “Service Experts” and others.

 

Shown below are our four business segments, the key products and brand names within each segment and 2008 net sales by segment. Segment financial data for 2008, 2007 and 2006, including financial information about foreign and domestic operations, is included in Note 21 of the Notes to our Consolidated Financial Statements in “Item 8. Financial Statements and Supplementary Data” and is incorporated herein by reference.

 

 

We were founded in 1895 in Marshalltown, Iowa when Dave Lennox, the owner of a machine repair business for the railroads, successfully developed and patented a riveted steel coal-fired furnace, which was substantially more durable than the cast iron furnaces used at that time. Manufacturing these furnaces grew into a significant business and was diverting the Lennox Machine Shop from its core focus. As a result, in 1904, a group of investors headed by D.W. Norris bought the furnace business and named it the Lennox Furnace Company. We reincorporated as a Delaware corporation in 1991 and completed our initial public offering in 1999. Over the years, D.W. Norris ensured ownership was distributed to succeeding generations of his family. We believe a portion of our outstanding common stock is currently broadly distributed among descendants of, or persons otherwise related to, D.W. Norris.

Products and Services

 

Residential Heating & Cooling

 

Heating & Cooling Products.  We manufacture and market a broad range of furnaces, air conditioners, heat pumps, packaged heating and cooling systems, accessories to improve indoor air quality, replacement parts and related products for both the residential replacement and new construction markets in North America. These products are available in a variety of designs and efficiency levels and at a range of price points, and are intended to provide a complete line of home comfort systems. We believe that by maintaining a broad product line marketed under multiple brand names, we can address different market segments and penetrate multiple distribution channels.

 

The “Lennox” and “Aire-Flo” brands are sold directly to a network of approximately 7,000 installing dealers, making us one of the largest wholesale distributors of residential heating and air conditioning products in North America. The “Armstrong Air,” “Ducane,” “AirEase,” “Concord,” “Magic-Pak” and “Advanced Distributor Products” brands are sold through independent distributors.

 

Our Advanced Distributor Products operation builds evaporator coils and air handlers under the “Advanced Distributor Products” brand, as well as the “Lennox,” “Armstrong Air,” “AirEase,” “Concord” and “Ducane” brands. In addition to supplying us with components for our heating and cooling systems, Advanced Distributor Products produces evaporator coils to be used in connection with competitors’ heating and cooling products as an alternative to such competitors’ brand name components. We have achieved a significant share of the market for evaporator coils through the application of technological and manufacturing skills and customer service capabilities.

 

Hearth Products.  Our hearth products include factory-built gas, wood-burning and electric fireplaces; free standing wood-burning, pellet and gas stoves: wood-burning, pellet and gas fireplace inserts; gas logs, venting products and accessories. Many of the fireplaces are built with a blower or fan option and are efficient heat sources as well as attractive amenities to the home. We currently market our hearth products under the “Lennox^tm,” “Superior^tm,” “Whitfield^tm,” “Country ^tm Collection” and “Security^tm Chimneys” brand names.

 

Commercial Heating & Cooling

 

North America.  In North America, we manufacture and sell unitary heating and cooling equipment used in light commercial applications, such as low-rise office buildings, restaurants, retail centers, churches and schools, as opposed to larger applied systems. Our product offerings for these applications include rooftop units ranging from two to 50 tons of cooling capacity and split system/air handler combinations, which range from 1.5 to 20 tons. These products are distributed primarily through commercial contractors and directly to national account customers. We believe the success of our products is attributable to their efficiency, design flexibility, total cost of ownership, low life-cycle cost, ease of service and advanced control technology.

 

Europe.  In Europe, we manufacture and sell unitary products, which range from two to 70 tons, and applied systems with up to 200 tons of cooling capacity. Our European products consist of small package units, rooftop units, chillers, air handlers and fan coils that serve medium-rise commercial buildings, shopping malls, other retail and entertainment buildings, institutional applications and other field-engineered applications. We manufacture heating and cooling products in several locations in Europe and market these products through both direct and indirect distribution channels in Europe, Russia, Turkey and the Middle East.

 

Service Experts

 

Approximately 116 (including seven service centers classified as discontinued operations) company-owned Service Experts dealer service centers provide installation, preventive maintenance, emergency repair and replacement of heating and cooling systems directly to residential and light commercial customers in metropolitan areas in the U.S. and Canada. In connection with these services, we sell a wide range of our manufactured equipment, parts and supplies, and third-party branded products. We focus primarily on service and replacement opportunities, which we believe are more stable and profitable than new construction in our Service Experts segment. We use a portfolio of management procedures and best practices, including standards of excellence for

customer service, a training program for new general managers, common information technology systems and financial controls, regional accounting centers and an inventory management program designed to enhance the quality, effectiveness and profitability of operations.

 

Refrigeration

 

We manufacture and market equipment for the global commercial refrigeration market through subsidiaries organized under the Heatcraft Worldwide Refrigeration name. These products are sold to distributors, installing contractors, engineering design firms, original equipment manufacturers and end users.

 

North America.  Our commercial refrigeration products for the North American market include condensing units, unit coolers, fluid coolers, air-cooled condensers, compressor racks and air handlers. These products are sold for cold storage applications, primarily to preserve food and other perishables, and are used by supermarkets, convenience stores, restaurants, refrigerated warehouses and distribution centers. As part of the sale of commercial refrigeration products, we routinely provide application engineering for consulting engineers, contractors and others. We also sell products for non-cold storage applications, such as telecommunications and medical applications.

 

International.  In international markets, we manufacture and market refrigeration products including condensing units, unit coolers, air-cooled condensers, fluid coolers, compressor racks and small chillers. We have manufacturing locations in Europe, Australia, Brazil and China. We also own a 50% common stock interest in a joint venture in Mexico that produces unit coolers, air-cooled condensers, condensing units and compressor racks of the same design and quality as those manufactured by us in the U.S. This venture product line is complemented with imports from the U.S., which are sold through the joint venture’s distribution network. We also own a 9% common stock interest in a manufacturer in Thailand that produces compressors for use in our products and for other HVACR customers as well.

 

Business Strategy

 

Our business strategy is to sustain and expand our premium market position through organic growth and acquisitions while increasing our focus on cost reductions to drive margin expansion and support growth into target business segments. This strategy is supported by five strategic priorities that are underlined by our values and our people. The five strategic priorities are:

 

Innovative Product and System Solutions

 

In all of our markets, we are continually building on our heritage of innovation by developing commercial, residential, and refrigeration products that give business owners and families more precise control over more aspects of their indoor environments, while significantly lowering their energy costs.

 

Manufacturing and Sourcing Excellence

 

We maintain our commitment to manufacturing and sourcing excellence by driving low-cost assembly through rationalization of our facilities and product lines, maximizing factory efficiencies, and leveraging our purchasing power and sourcing initiatives to expand the use of low-cost components.

 

Distribution Excellence

 

By investing resources in expanding our distribution network, we are making products available to our customers in a timely, cost-efficient manner. Additionally, we are providing enhanced dealer support through the use of technology, training and advertising and merchandising.

 

Geographic Expansion

 

We are growing our international presence by extending our successful domestic business model and product knowledge into developing international markets.

Expense Reduction

 

Through our focus on cost management initiatives, we are lowering our operating, manufacturing, and administrative expenses.

 

Marketing and Distribution

 

We utilize multiple channels of distribution and offer different brands at various price points in order to better penetrate the HVACR markets. Our products and services are sold through a combination of distributors, independent and company-owned dealer service centers, other installing contractors, wholesalers, manufacturers’ representatives, original equipment manufacturers and to national accounts. Dedicated sales forces and manufacturers’ representatives are deployed across our business segments and brands in a manner designed to maximize their ability to service a particular distribution channel. To optimize enterprise-wide effectiveness, we have active cross-functional and cross-organizational teams coordinating approaches to pricing, product design, distribution and national account customers.

 

An example of the competitive strength of our marketing and distribution strategy is in the North American residential heating and cooling market in which we use three distinctly different distribution approaches: the one-step distribution system, the two-step distribution system and sales made directly to end-users. We distribute our “Lennox” and “Aire-Flo” brands in a one-step process directly to dealers that install these heating and cooling products and, in some cases, we sell “Lennox” commercial products directly to national account customers. We distribute our “Armstrong Air,” “Ducane,” “AirEase,” “Concord,” “Magic-Pak” and “Advanced Distributor Products” brands through the traditional two-step distribution process pursuant to which we sell our products to distributors who, in turn, sell the products to installing contractors. In addition, we provide heating and cooling replacement products and services directly to consumers through company-owned Service Experts dealer service centers.

 

Over the years, the “Lennox” brand has become synonymous with “Dave Lennox,” a highly recognizable advertising icon in the heating and cooling industry. The “Dave Lennox” image is utilized in mass media advertising, as well as in numerous locally produced dealer advertisements, open houses and trade events.

 

Manufacturing

 

We operate manufacturing facilities in the U.S. and international locations. We have embraced lean-manufacturing principles, a manufacturing philosophy which reduces waste in manufactured products by shortening the timeline between the customer order and delivery, accompanied by initiatives to achieve high product quality across our manufacturing operations. In our facilities most impacted by seasonal demand, we manufacture both heating and cooling products to balance seasonal production demands and maintain a relatively stable labor force. We are generally able to hire temporary employees to meet changes in demand.

 

Strategic Sourcing

 

We rely on various suppliers to furnish the raw materials and components used in the manufacturing of our products. To maximize our buying effectiveness in the marketplace, our central strategic sourcing group consolidates required purchases of materials, components and indirect items across business segments. The goal of the strategic sourcing group is to develop global strategies for a given component group, concentrate purchases with three to five suppliers and develop long-term relationships with these vendors. There are often several alternative suppliers for our key raw material and component needs. By developing these strategies and relationships, we leverage our material spend for reduced costs and improved financial and operating performance. Compressors, motors and controls constitute our most significant component purchases, while steel, copper and aluminum account for the bulk of our raw material purchases. We own equity interests in joint ventures that manufacture compressors. These joint ventures provide us with compressors for our residential, commercial and refrigeration businesses.

 

Our centrally led supplier development group works with selected suppliers to reduce their costs and improve their quality and delivery performance. We seek to accomplish this by employing the same business excellence

tools utilized by our four business segments to drive improvements in the area of lean manufacturing and six sigma, a disciplined, data-driven approach and methodology for improving quality.

 

Research and Development and Technology

 

An important part of our growth strategy is continued investment in research and product development to both develop new products and make improvements to existing product lines. As a result, we spent an aggregate of $46.5 million, $43.0 million and $42.2 million on research and development during 2008, 2007 and 2006, respectively. We operate a global engineering and technology organization that focuses on new technology invention, product development, and process improvements.

 

Intellectual property and innovative designs are leveraged across our businesses. We leverage product development cycle time improvement and product data management systems to commercialize new products to market more rapidly. We use advanced, commercially available computer-aided design, computer-aided manufacturing, computational fluid dynamics and other sophisticated design tools to streamline the design and manufacturing processes. We use complex computer simulations and analyses in the conceptual design phase before functional prototypes are created.

 

We also operate a full line of prototype machine equipment and advanced laboratories certified by applicable industry associations.

 

Seasonal Nature of Business

 

Our sales and related segment profit tend to be seasonally higher in the second and third quarters of the year because summer is the peak season for sales of air conditioning equipment and services in the U.S. and Canada.

 

The North American HVAC market is driven by seasonal weather patterns. HVAC products and services are sold year round, but the volume and mix of product sales and service change significantly by season. The industry ships roughly twice as many units during June as it does in December. Overall, cooling equipment represents a substantial portion of the annual HVAC market. In between the heating season (roughly November through February) and cooling season (roughly May through August) are periods commonly referred to as shoulder seasons when the distribution channel transitions its buying patterns from one season to the next. These seasonal fluctuations in mix and volume drive our sales and related segment profit, resulting in somewhat higher sales in the second and third quarters due to the larger cooling season relative to the heating season.

 

Patents and Trademarks

 

We hold numerous patents that relate to the design and use of our products. We consider these patents important, but no single patent is material to the overall conduct of our business. We proactively obtain patents to further our strategic intellectual property objectives. We own or license several trademarks we consider important in the marketing of our products, including Lennox^®, Armstrong Air^tm, Ducane^tm, Allied Commercial^tm, Advanced Distributor Products^®, Aire-Flo^®, AirEase^®, Concord^®, Magic-Pak^tm, Superior^®, Whitfield^®, Earth Stove^tm, Security Chimneys^tm, Country Stoves^tm, Service Experts^®, Bohn^tm, Larkin^tm, Climate Control^tm, Chandler Refrigeration^®, Kirby^tm, Heatcraft Worldwide Refrigeration^tm, Lovelocks^tm, HK Refrigeration^tm, Frigus-Bohn^tm and Friga-Bohn^tm.

 

Competition

 

Substantially all markets in which we participate are highly competitive. The most significant competitive factors we face are product reliability, product performance, service and price, with the relative importance of these factors varying among our businesses. In our Service Experts segment, we face competition from thousands of independent dealers, as well as dealers owned by utility companies. Listed below are some of the companies we view as significant competitors in the three other segments we serve, with relevant brand names, when different from the company name, shown in parentheses.

 

 

 

Employees

 

As of December 31, 2008, we employed approximately 13,500 employees, of whom approximately 5,500 were salaried and 8,000 were hourly. The number of hourly workers we employ may vary in order to match our labor needs during periods of fluctuating demand. Approximately 2,900 employees are represented by unions. We believe our relationships with our employees and with the unions representing our employees are good and we do not anticipate any material adverse consequences resulting from negotiations to renew any collective bargaining agreements.

 

Environmental Regulation

 

Our operations are subject to evolving and often increasingly stringent international, federal, state and local laws and regulations concerning the environment. Environmental laws that affect or could affect our domestic operations include, among others, the National Appliance Energy Conservation Act of 1987, as amended (“NAECA”), the Energy Policy Act, the Clean Air Act, the Clean Water Act, the Resource Conservation and Recovery Act, the Comprehensive Environmental Response, Compensation and Liability Act, the National Environmental Policy Act, the Toxic Substances Control Act, any regulations promulgated under these acts and various other international, federal, state and local laws and regulations governing environmental matters. We believe we are in substantial compliance with such existing environmental laws and regulations.

 

Energy Efficiency.  We are subject to appliance efficiency regulations promulgated under NAECA and various state regulations concerning the energy efficiency of our products. The U.S. Department of Energy revised the national residential furnace and boiler standards, which become effective for manufacturers on November 19, 2015. On December 19, 2007, federal legislation was enacted authorizing the U.S. Department of Energy to study the establishment of regional efficiency standards for residential furnaces, air conditioners and heat pumps. We anticipate that the U.S. Department of Energy will consider establishing regional standards for furnaces and air conditioners during future rulemakings. The U.S. Department of Energy commenced its revision of the residential air conditioner and heat pump standards in 2008 with a likely effective date of 2016. We have established a process that we believe will allow us to offer new products that meet or exceed these new standards in advance of implementation. Similar new standards are being promulgated for commercial air conditioning and refrigeration equipment. We are actively involved in U.S. Department of Energy and Congressional activities related to energy efficiency standards. We are prepared to have compliant product in place in advance of the implementation of all such regulations being considered by the U.S. Department of Energy or Congress.

 

Refrigerants.  The use of hydrochlorofluorocarbons, or “HCFCs,” as a refrigerant for air conditioning and refrigeration equipment is common practice in the HVACR industry. However, international and country-specific regulations require the use of certain substances deemed to be ozone depleting, including HCFCs, to be phased out over a particular period of time. Under the Montreal Protocol and implementing regulations, the use of virgin HCFCs in new pre-charged equipment within the U.S. must be phased out by January 1, 2010. We, together with major chemical manufacturers, are reviewing and addressing the potential impact of these regulations on our product offerings and have developed and continue to develop new products that replace the use of HCFCs with the widely accepted hydroflurocarbons, or “HFCs,” and other approved substitutes. The U.S. Congress, Administration and other international regulatory bodies are considering steps to limit the future use of HFCs in our products and

we have been an active participant in the ongoing international dialogue on this subject and believe we are well positioned to react in a timely manner to any changes in the regulatory landscape. In addition, we are taking proactive steps to implement responsible use principles and guidelines with respect to limiting refrigerants from escaping into the atmosphere throughout the life span of HVACR equipment.

 

Remediation Activity.  In addition to affecting our ongoing operations, applicable environmental laws can impose obligations to remediate hazardous substances at our properties, at properties formerly owned or operated by us and at facilities to which we have sent or send waste for treatment or disposal. We are aware of contamination at some of our facilities; however, based on facts presently known, we do not believe that any future remediation costs at such facilities will be material to our results of operations. At one site located in Brazil, we are currently evaluating the remediation efforts that may be required by applicable environmental laws related to the release of certain hazardous materials. We currently believe that the release of the hazardous materials occurred over an extended period of time, including a time when we did not own the site. Extensive investigations have been performed and we are in the process of pilot testing remediation technology on-site. Commencement of full-scale remediation is planned for 2009. For more information see Note 11 in the Notes to our Consolidated Financial Statements.

 

In the past, we have received notices that we are a potentially responsible party along with other potentially responsible parties in Superfund proceedings under the Comprehensive Environmental Response, Compensation and Liability Act for cleanup of hazardous substances at certain sites to which the potentially responsible parties are alleged to have sent waste. Based on the facts presently known, we do not believe environmental cleanup costs associated with any Superfund sites where we have received notice that we are a potentially responsible party will be material.

 

European WEEE and RoHS Compliance.  In the European marketplace, electrical and electronic equipment is required to comply with the Directive on Waste Electrical and Electronic Equipment (“WEEE”) and the Directive on Restriction of Use of Certain Hazardous Substances (“RoHS”). WEEE aims to prevent waste by encouraging reuse and recycling and RoHS restricts the use of six hazardous substances in electrical and electronic products. All HVACR products and certain components of such products “put on the market” in the EU (whether or not manufactured in the EU) are potentially subject to WEEE and RoHS. Because all HVACR manufacturers selling within or from the EU are subject to the standards promulgated under WEEE and RoHS, we believe that neither WEEE nor RoHS uniquely impact us as compared to such other manufacturers. Similar directives are being introduced in other parts of the world, including the U.S. For example, California, China and Japan have all adopted unique versions of RoHS possessing similar intent. We are actively monitoring the development of such directives and believe we are well positioned to comply with such directives in the required time frames.

 

Available Information

 

Our web site address is www.lennoxinternational.com. We make available, free of charge through this web site, our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after such material is electronically filed with, or furnished to, the Securities and Exchange Commission.

 

Certifications

 

We submitted the 2008 New York Stock Exchange (the “NYSE”) Annual CEO Certification regarding our compliance with the NYSE’s corporate governance listing standards to the NYSE on June 9, 2008.

 

The certifications of our Chief Executive Officer and Chief Financial Officer pursuant to Section 302 and Section 906 of the Sarbanes-Oxley Act of 2002 are filed and furnished, respectively, as exhibits to this Annual Report on Form 10-K.

Executive Officers of the Company

 

Our executive officers, their present positions and their ages are as follows:

 

 

The following biographies describe the business experience of our executive officers:

 

Todd M. Bluedorn became chief executive officer and was elected to the Board of Directors of Lennox International in April 2007. Prior to Lennox International, Mr. Bluedorn served in numerous senior management positions for United Technologies since 1995, including President, Americas - Otis Elevator Company beginning in 2004; President, North America — Commercial Heating, Ventilation and Air Conditioning for Carrier Corporation beginning in 2001; and President, Hamilton Sundstrand Industrial beginning in 2000. He began his professional career with McKinsey & Company in 1992, after receiving an MBA from Harvard University in 1992 and serving in the United States Army as a combat engineer officer and United States Army Ranger from 1985 to 1990. He also holds a BS in Electrical Engineering from the United States Military Academy at West Point.

 

Prakash Bedapudi became Executive Vice President and Chief Technology Officer in July 2008. He had previously served as vice president, global engineering and program management for Trane Inc. Commercial Systems from 2006 through 2008, and as vice president, engineering and technology for Trane’s Residential Systems division from 2003 through 2006. Prior to his career at Trane, Mr. Bedapudi served in senior engineering leadership positions for GE Transportation Systems, a division of General Electric Company, and for Cummins Engine Company. He holds a BS in Mechanical/Automotive Engineering from Karnataka University, India and an MS in Mechanical/Aeronautical Engineering from the University of Cincinnati.

 

Harry J. Bizios was appointed Executive Vice President and President and Chief Operating Officer of LII’s Commercial Heating & Cooling segment in October 2006. Mr. Bizios had previously served as Vice President and General Manager, LII Worldwide Commercial Systems since 2005 and as Vice President and General Manager of Lennox North American Commercial Products from 2003 to 2005. Mr. Bizios began his career with LII in 1976 as an industrial engineer at LII’s manufacturing facility in Marshalltown, Iowa, subsequently serving in several senior leadership roles before being appointed Vice President and General Manager of Lennox Industries Commercial from 1998 to 2003. He holds a BS in Engineering Operations from Iowa State University.

 

Scott J. Boxer was appointed President and Chief Operating Officer of LII’s Service Experts segment in July 2003. He served as President of Lennox Industries Inc., an LII subsidiary, from 2000 to 2003. He joined LII in 1998

as Executive Vice President, Lennox Global Ltd. Prior to joining LII, Mr. Boxer spent 26 years with York International Corporation in various roles, including President, Unitary Products Group Worldwide, where he directed residential and light commercial heating and air conditioning operations. Mr. Boxer previously served as an Executive Board Member of the Air-Conditioning & Refrigeration Institute and Chairman of the Board of Trustees of North American Technical Excellence, Inc. He holds a BS in Industrial Engineering from the University of Rhode Island.

 

Susan K. Carter was appointed LII Executive Vice President and Chief Financial Officer in August 2004. Ms. Carter also served as LII Treasurer from August 2004 through September 2005. Prior to joining LII, Ms. Carter was Vice President of Finance and Chief Accounting Officer of Cummins, Inc., a global power leader and manufacturer of engines, electric power generation systems, and engine-related products from 2002 to 2004. From 1996 to 2002, Ms. Carter served as Vice President and Chief Financial Officer of Transportation & Power Systems and held other senior financial management positions at Honeywell, Inc., formerly AlliedSignal, Inc. She also previously served in senior financial management positions at Crane Co. and DeKalb Corporation. She holds a BS in Accounting from Indiana University and an MBA from Northern Illinois University.

 

David W. Moon was appointed Executive Vice President and President and Chief Operating Officer of LII’s Worldwide Refrigeration business in August 2006. Mr. Moon had previously served as Vice President and General Manager of Worldwide Refrigeration, Americas Operations since 2002. Prior to serving in that position, he served as Managing Director in Australia beginning in 1999, where his responsibilities included heat transfer manufacturing and distribution, refrigeration wholesaling and manufacturing, and HVAC manufacturing and distribution in Australia and New Zealand. Mr. Moon originally joined LII in 1998 as Operations Director, Asia Pacific. Prior to that time, Mr. Moon held various management positions at Allied Signal, Inc., Case Corporation, and Tenneco Inc. in the United States, Hong Kong, Taiwan and Germany. He holds a BS in Civil Engineering and an MBA from Texas A&M University.

 

Daniel M. Sessa was appointed Executive Vice President and Chief Human Resources Officer in June 2007. Prior to joining LII, Mr. Sessa served as Vice President, Human Resources for Otis Elevator Company — Americas from 2005 to 2007. From 2004 to 2005, Mr. Sessa served as Director, Employee Benefits and Human Resources Systems for United Technologies Corporation. He previously served as Director, Human Resources for Pratt & Whitney from 2002 to 2004. He holds a holds a JD from the Hofstra University School of Law and a BA in Law & Society from the State University of New York at Binghamton.

 

John D. Torres was appointed chief legal officer in December 2008. He had previously served as senior vice president, general counsel and secretary for Freescale Semiconductor, a semiconductor manufacturer that was originally part of Motorola. He joined Motorola’s legal department as senior counsel in 1996 and was appointed vice president, general counsel of the company’s semiconductor business in 2001. Prior to joining Motorola, Mr. Torres served 13 years in private practice in Phoenix, specializing in commercial law. He holds a B.A. from Notre Dame and a J.D. from the University of Chicago.

 

Douglas L. Young was appointed Executive Vice President and President and Chief Operating Officer of LII’s Residential Heating & Cooling segment in October 2006. Mr. Young had previously served as Vice President and General Manager of North American Residential Products since 2003 and as Vice President and General Manager of Lennox North American Residential Sales, Marketing, and Distribution from 1999 to 2003. Prior to his career with LII, Mr. Young was employed in the Appliances division of GE, where he held various management positions before serving as General Manager of Marketing for GE Appliance division’s retail group from 1997 to 1999 and as General Manager of Strategic Initiatives in 1999. He holds a BSBA from Creighton University and an MS in Management from Purdue University.

 

Roy A. Rumbough, Jr. was appointed Vice President, Controller and Chief Accounting Officer in July 2006. Prior to joining LII, he served as Vice President, Corporate Controller of Maytag Corporation, a position he held since 2002. From 1998 to 2002, he served as Vice President Controller of Blodgett Corporation, a portfolio of food service equipment companies and former Affiliate of Maytag. Mr. Rumbough’s career at Maytag spanned 17 years and included internal audit, financial planning and analysis, and business unit controller roles. Prior to his career at Maytag, he worked for Deloitte and Touche, LLP. He holds a BA in Accounting from North Carolina State University and an MBA from the Kellogg School of Management, Northwestern University.

 

Forward-Looking Statements

 

This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, that are based on information currently available to management as well as management’s assumptions and beliefs. All statements, other than statements of historical fact, included in this Annual Report on Form 10-K constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, including but not limited to statements identified by the words “may,” “will,” “should,” “plan,” “predict,” “anticipate,” “believe,” “intend,” “estimate” and “expect” and similar expressions. Such statements reflect our current views with respect to future events, based on what we believe are reasonable assumptions; however, such statements are subject to certain risks and uncertainties. In addition to the specific uncertainties discussed elsewhere in this Annual Report on Form 10-K, the risk factors set forth below may affect our performance and results of operations. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may differ materially from those in the forward-looking statements. We disclaim any intention or obligation to update or review any forward-looking statements or information, whether as a result of new information, future events or otherwise.

 

Risk Factors

 

The following risk factors and other information included in this Annual Report on Form 10-K should be carefully considered. We believe these are the principal material risks currently facing our business; however, additional risks and uncertainties not presently known to us or that we presently deem less significant may also impair our business operations. If any of the following risks actually occur, our business, financial condition or results of operations could be materially adversely affected.

 

Our Operations are Subject to a Number of Economic Risks due to Global General Business, Economic and Market Conditions

 

As widely reported, financial markets in the United States, Europe and Asia have been experiencing extreme disruption in recent months, including, among other things, extreme volatility in security prices, severely diminished liquidity and credit availability, rating downgrades of certain investments and declining valuations of others. Governments have taken unprecedented actions intended to address extreme market conditions that include severely restricted credit and declines in real estate values. These economic developments affect businesses such as ours in a number of ways. The current tightening of credit in financial markets adversely affects the ability of our customers to obtain financing for significant purchases and operations and could result in a decrease in or cancellation of orders for our products and services as well as impact the ability of our customers to make payments. Similarly, this tightening of credit may adversely affect our supplier base and increase the potential for one or more of our suppliers to experience financial distress or bankruptcy. Our global business is also adversely affected by decreases in the general level of economic activity, such as decreases in business and consumer spending and construction activity. In the HVACR business, a decline in economic activity as a result of these cyclical or other factors typically results in a decline in new construction and replacement purchases, which could result in a decrease in our sales and profitability.

 

While currently these conditions have not impaired our ability to access credit markets and finance our operations, there can be no assurance that there will not be a further deterioration in financial markets and confidence in the major economies where we access credit. If such conditions continue, we may be unable to obtain new debt or equity financing on acceptable terms or at all, or to access amounts currently available under our domestic revolving credit facility. Also, availability under our asset securitization agreement may be adversely impacted by credit quality and performance of our customer accounts receivable. The availability under the asset securitization agreement is based on the amount of accounts receivable that meet the eligibility criteria of the asset securitization agreement. If receivable losses increase or credit quality deteriorates, the amount of eligible receivables could decline and, in turn, lower the availability under the asset securitization.

We are unable to predict the likely duration and severity of the current disruption in financial markets and adverse economic conditions in the U.S. and other countries.

 

Our Financial Performance Is Dependent on the Conditions of the U.S. Construction Industry

 

Our business is affected by trends and uncertainties in the U.S. construction industry. Our sales in the residential and commercial new construction market correlate to the number of new homes and buildings that are built, which in turn is influenced by cyclical factors such as interest rates, inflation, availability of financing, consumer spending habits and confidence, employment rates and other macroeconomic factors over which we have no control. We estimate approximately 25% of the sales of our Residential Heating & Cooling segment is for new construction, with the balance attributable to repair, retrofit and replacement. Beginning in fiscal year 2006, the U.S. housing industry began to experience a significant downturn, resulting in a decline in the demand for the products and services we sell into the residential new construction market. Additionally, adverse economic conditions have caused a decline in replacement purchases. These unprecedented market challenges have affected, and will continue to materially affect, our business, financial condition and results of operations.

 

  Cooler than Normal Summers and Warmer than Normal Winters May Depress Our Sales.

 

Demand for our products and for our services is strongly affected by the weather. Cooler than normal summers depress our sales of replacement air conditioning and refrigeration products and services, and warmer than normal winters have the same effect on our heating products and services.

 

  We Use a Variety of Raw Materials and Components in Our Business and Price Increases or Significant Supply Interruptions Could Have an Adverse Effect on Our Results of Operations.

 

In the manufacture of our products, we depend on raw materials, such as steel, copper and aluminum, and components purchased from third parties. We generally concentrate purchases for a given raw material or component with one or two suppliers. Although we believe there are alternative suppliers for all of our key raw material and component needs, if a supplier is unable or unwilling to meet our supply requirements, we could experience supply interruptions or cost increases, either of which could have an adverse effect on the results of operations. In addition, although we regularly pre-purchase a portion of our raw materials at fixed prices each year to hedge against price increases, a large increase in raw materials prices could significantly increase our cost of goods sold and negatively impact our margins if we are unable to effectively pass such price increases on to our customers. Alternatively, if we increase our prices in response to increases in the prices or quantities of raw materials or components we require or encounter significant supply interruptions, our competitive position could be adversely affected, which may result in depressed sales.

 

  We May Incur Substantial Costs as a Result of Warranty and Product Liability Claims Which Could Have an Adverse Effect on Our Results of Operations.

 

The development, manufacture, sale and use of our products involve risks of warranty and product liability claims. In addition, because we own installing heating and air conditioning dealers in the U.S. and Canada, we incur the risk of liability claims for the installation and service of heating and air conditioning products. Our product liability insurance policies have limits that, if exceeded, may result in substantial costs that would have an adverse effect on our results of operations. In addition, warranty claims are not covered by our product liability insurance and certain product liability claims may also not be covered by our product liability insurance.

 

For some of our HVAC products, we provide warranty terms ranging from one to 20 years to customers for certain components such as compressors or heat exchangers. For select products, we have provided lifetime warranties for heat exchangers. Warranties of such extended lengths pose a risk to us as actual future costs may exceed our current estimates of those costs. Warranty expense is recorded on the date that revenue is recognized and requires significant assumptions about what costs will be incurred in the future. We may be required to record material adjustments to accruals and expense in the future if actual costs for these warranties are different from our assumptions.

  We May Not be Able to Compete Favorably in the Highly Competitive HVACR Business.

 

Substantially all of the markets in which we operate are highly competitive. The most significant competitive factors we face are product reliability, product performance, service and price, with the relative importance of these factors varying among our product lines. Other factors that affect competition in the HVACR market include the development and application of new technologies, an increasing emphasis on the development of more efficient HVACR products, and new product introductions. The establishment of manufacturing in low-cost countries could also provide cost advantages to existing and emerging competitors. Our competitors may have greater financial resources than we have, allowing them to invest in more extensive research and development and/or marketing activity. In addition, our Service Experts segment faces competition from independent dealers and dealers owned by utility companies and other consumer service providers, some of whom may be able to provide their products or services at lower prices than we can. We may not be able to compete successfully against current and future competitors and 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.

 

  There Is No Guarantee That Our Efforts to Reduce Costs Will Be Successful.

 

As part of our strategic priorities of manufacturing and sourcing excellence and expense reduction, we have initiated various manufacturing rationalization actions designed to lower our cost structure. We also have begun to reorganize our North American distribution network in order to better serve our customers’ needs by deploying parts and equipment inventory closer to them. We have also initiated a number of activities that rationalize and reorganize various support and administrative functions in order to reduce ongoing selling and administrative expenses. If we cannot successfully implement such restructuring strategies or other cost savings plans, we may not achieve our expected costs savings in the time anticipated, or at all. In such case, our results of operations and profitability may be negatively impaired, making us less competitive and potentially causing us to lose market share.

 

  We May Not be Able to Successfully Develop and Market New Products.

 

Our future success depends on our continued investment in research and new product development and our ability to commercialize new technological advances in the HVACR industry. If we are unable to continue to successfully develop and market new products or to achieve technological advances on a pace consistent with that of our competitors, our business and results of operations could be adversely impacted.

 

  We May Not be Able to Successfully Integrate and Operate Businesses that We May Acquire.

 

From time to time, we may seek to complement or expand our business through strategic acquisitions. The success of these transactions will depend, in part, on our ability to integrate and operate the acquired businesses profitably. If we are unable to successfully integrate acquisitions with our operations, we may not realize the anticipated benefits associated with such transactions, which could adversely affect our business and results of operations.

 

  Because a Significant Percentage of Our Workforce is Unionized, We Face Risks of Work Stoppages and Other Labor Relations Problems.

 

As of December 31, 2008, approximately 21% of our workforce was unionized. While we believe our relationships with the unions representing our employees are good, the results of future negotiations with these unions and the effects of any production interruptions or labor stoppages could have an adverse effect on our results of operations.

 

  We are Subject to Litigation and Environmental Regulations that Could Have an Adverse Effect on Our Results of Operations.

 

We are involved in various claims and lawsuits incidental to our business, including those involving product liability, labor relations and environmental matters, some of which claim significant damages. Given the inherent uncertainty of litigation, we cannot be certain that existing litigation or any future adverse developments will not

have a material adverse impact on our financial condition. In addition, we are subject to extensive and changing federal, state and local laws and regulations designed to protect the environment including, among others, the National Appliance Energy Conservation Act of 1987, as amended, the Energy Policy Act, the Clean Air Act, the Clean Water Act, the Resource Conservation and Recovery Act, the Comprehensive Environmental Response, Compensation and Liability Act, the National Environmental Policy Act, the Toxic Substances Control Act, any regulations promulgated under these acts and various other international, federal, state and local laws and regulations governing environmental matters. These laws and regulations could impose liability for remediation costs and civil or criminal penalties in cases of non-compliance. Compliance with environmental laws increases our costs of doing business. Because these laws are subject to frequent change, we are unable to predict the future costs resulting from environmental compliance.

 

  Our International Operations Subject Us to Risks Associated with Foreign Currency Fluctuations and Changes in Local Government Regulation.

 

We earn revenues, pay expenses, own assets and incur liabilities in countries using currencies other than the U.S. dollar. Because our consolidated financial statements are presented in U.S. dollars, we must translate revenues, income and expenses, as well as assets and liabilities, into U.S. dollars at exchange rates in effect during or at the end of each reporting period. Therefore, increases or decreases in the value of the U.S. dollar against other major currencies may affect our net operating revenues, operating income and the value of balance sheet items denominated in foreign currencies. Because of the geographic diversity of our operations, weaknesses in some currencies might be offset by strengths in others over time. However, we cannot assure that fluctuations in foreign currency exchange rates, particularly the strengthening of the U.S. dollar against major currencies, would not materially affect our financial results.

 

In addition to the currency exchange risks inherent in operating in foreign countries, our international sales and operations, including our purchases of raw materials from international suppliers, are subject to risks associated with changes in local government laws, regulations and policies, including those related to tariffs and trade barriers, investments, taxation, exchange controls, and employment regulations. Our international sales and operations are also sensitive to changes in foreign national priorities, including government budgets, as well as to political and economic instability. International transactions may involve increased financial and legal risks due to differing legal systems and customs in foreign countries. The ability to manage these risks could be difficult and may limit our operations and make the manufacture and sale of our products internationally more difficult, which could negatively affect our business and results of operations.

 

  Any Future Determination that a Significant Impairment of the Value of Our Goodwill Intangible Asset has Occurred Could Have a Material Adverse Effect on Our Results of Operations.

 

As of December 31, 2008, we had goodwill of $232.3 million on our Consolidated Balance Sheet. Any future determination that an impairment of the value of goodwill has occurred would require a write-down of the impaired portion of goodwill to fair value, which would reduce our assets and stockholders’ equity and could have a material adverse effect on our results of operations.

 

 

None.

 

The following chart lists our principal domestic and international manufacturing, distribution and office facilities as of February 2, 2009 and indicates the business segment that uses such facilities, the approximate size of such facilities and whether such facilities are owned or leased:

 

 

 

 

In addition to the properties described above, we lease over 100 facilities in the U.S. for use as sales and service offices and district warehouses and additional facilities worldwide for use as sales and service offices and regional warehouses. The majority of our Service Experts’ service center facilities are leased. We routinely evaluate our production facilities to ensure adequate capacity, effective cost structure, and consistency with our business strategy. We believe that our properties are in good condition, suitable and adequate for their present requirements and that our principal plants are generally adequate to meet our production needs. However, certain production facilities are operating at less than full capacity due to restructuring activities. See Note 18 to the Consolidated Financial Statements for additional information regarding restructuring activities.

 

In the fourth quarter of 2007, we expanded our manufacturing facility in Tifton, Georgia. We plan to close our facility in Danville, Illinois and consolidate the majority of our manufacturing for Refrigeration in North America into the new facility in Tifton, Georgia. The new facility is immediately adjacent to our existing facility in Tifton and has increased our manufacturing space to 599 thousand square feet.

 

 

We are involved in various claims and lawsuits incidental to our business. As previously reported, in January 2003, we, along with one of our subsidiaries, Heatcraft Inc., were named in the following lawsuits in connection with our former heat transfer operations:

 

 

On behalf of approximately 100 plaintiffs, the lawsuits allege personal injury resulting from alleged emissions of trichloroethylene, dichloroethylene, and vinyl chloride and other unspecified emissions from the South Plant in Grenada, Mississippi, previously owned by Heatcraft Inc. Each plaintiff seeks to recover actual and punitive damages. On Heatcraft Inc.’s motion to transfer venue, two of the four lawsuits (Booker and Crowder) were ordered severed and transferred to Grenada County by the Mississippi Supreme Court, requiring plaintiffs’ counsel to maintain a separate lawsuit for each of the individual plaintiffs named in these suits. To our knowledge, as of February 2, 2009, plaintiffs’ counsel has requested the transfer of files regarding five individual plaintiffs from the Booker case and five individual plaintiffs from the Crowder case. Additionally, we have joined in motions to dismiss filed by co-defendants in the four original lawsuits. These motions, which are still pending, seek dismissal (rather than transfer), without prejudice to refiling in Grenada County, of all cases not yet transferred to Grenada County. It is not possible to predict with certainty the outcome of these matters or an estimate of any potential loss. Based on current negotiations, we believe that it is unlikely that any final resolution of these matters will have a material impact on our financial statements.

 

 

No matters were submitted to a vote of our stockholders during the fourth quarter of fiscal 2008.

 

 

Market Price for Common Stock

 

Our common stock is listed for trading on the New York Stock Exchange under the symbol “LII.” The high and low sales prices for our common stock for each quarterly period during 2008 and 2007 were as follows:

 

 

Dividends

 

During 2008 and 2007, we declared quarterly cash dividends as set forth below:

 

 

The amount and timing of dividend payments are determined by our Board of Directors and subject to certain restrictions under our credit agreements. As of the close of business on February 17, 2009, there were approximately 721 holders of record of our common stock.

 

Comparison of Total Stockholder Return

 

The following performance graph compares our cumulative total returns with the cumulative total returns of the Standard & Poor’s Small-Cap 600 Index and a peer group of U.S. industrial manufacturing and service companies in the heating, ventilation, air conditioning and refrigeration businesses from December 31, 2003 through December 31, 2008. The graph assumes that $100 was invested on December 31, 2003, with dividends reinvested. Peer group returns are weighted by market capitalization. Our peer group includes AAON, Inc., Ingersoll-Rand Company Limited, Comfort Systems USA, Inc., United Technologies Corporation; Johnson Controls Inc., and Watsco, Inc. The peer group changed in 2008 due to corporate consolidations and changes in public company status.

 

Comparison of 5 Year Cumulative Total Return

 

 

Our Purchase of LII Equity Securities

 

On July 25, 2007, we announced that our Board of Directors approved a share repurchase plan, pursuant to which we were authorized to repurchase up to $500 million of shares of our common stock through open market purchases (the “2007 Share Repurchase Plan”). We were a party to a written trading plan under Rule 10b5-1 of the Securities Exchange Act of 1934, as amended, to facilitate share repurchases under the 2007 Share Repurchase Plan. We completed the 2007 Share Repurchase Plan during the second quarter of 2008.

 

On June 2, 2008, we announced that our Board of Directors approved a new share repurchase plan for $300 million, pursuant to which we are authorized to repurchase shares of our common stock through open market purchases (the “2008 Share Repurchase Plan”). The 2008 Share Repurchase Program has no stated expiration date. In the fourth quarter of 2008, we repurchased shares of our common stock as follows:

 

 

 

 

 

The table below shows selected financial data for the five years ended December 31, 2008:

 

 

In 2004, we recorded a non-cash goodwill impairment charge of $208.0 million associated with our Service Experts segment, which is included as a component of operating income in the Statements of Operations Data above. This impairment charge reflected the segment’s performance below management’s expectations and management’s decision to divest centers that no longer matched the realigned Service Experts business model. We estimated the fair value of our Service Experts segment using the income method of valuation, which included the use of estimated discounted cash flows. Based on our analysis, the carrying value of Service Experts exceeded its fair value. Accordingly, we performed the second step of the test, comparing the implied fair value of Service Experts’ goodwill with the carrying amount of that goodwill to calculate the impairment charge.

 

 

Overview

 

We operate in four reportable business segments of the HVACR industry. Our reportable segments include Residential Heating & Cooling, Commercial Heating & Cooling, Service Experts and Refrigeration. For more detailed information regarding our reportable segments, see Note 21 in the Notes to our Consolidated Financial Statements.

 

Our products and services are sold through a combination of distributors, independent and company-owned dealer service centers, other installing contractors, wholesalers, manufacturers’ representatives, original equipment manufacturers and to national accounts. The demand for our products and services is seasonal and dependent on the weather. Warmer than normal summer temperatures generate strong demand for replacement air conditioning and refrigeration products and services and colder than normal winter temperatures have the same effect on heating products and services. Conversely, cooler than normal summers and warmer than normal winters depress HVACR sales and services. 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.

 

The principal elements of cost of goods sold in our manufacturing operations are components, raw materials, factory overhead, labor and estimated costs of warranty expense. In our Service Experts segment, the principal

components of cost of goods sold are equipment, parts and supplies and labor. The principal raw materials used in our manufacturing processes are steel, copper and aluminum. In recent years, a trend towards higher prices for these commodities and related components continues to present a challenge to us and the HVACR industry in general. We partially mitigate the impact of higher commodity prices through a combination of price increases, commodity contracts, improved production efficiency and cost reduction initiatives. We also partially mitigate volatility in the prices of these commodities by entering into futures contracts and fixed forward contracts.

 

We estimate approximately 25% of the sales of our Residential Heating & Cooling segment is for new construction, with the balance attributable to repair, retrofit and replacement. With the current downturn in residential and commercial new construction activity, we are seeing a decline in the demand for the products and services we sell into these markets.

 

Our fiscal year ends on December 31 and our interim fiscal quarters are each comprised of 13 weeks. For convenience, throughout this Management’s Discussion and Analysis of Financial Condition and Results of Operations, the 13-week periods comprising each fiscal quarter are denoted by the last day of the calendar quarter.

 

Impact of Current Economic Environment on Our Business

 

In 2008, we faced unprecedented market challenges, particularly in the latter months of the year. Tight credit markets contributed to lower demand for housing that has resulted in far fewer starts in residential new construction and lower existing home sales. In addition to Residential Heating & Cooling, the global economic downturn also negatively impacted our Commercial Heating & Cooling, Refrigeration, and Service Experts businesses. We continued to execute on our strategic priorities to win new business, capture opportunities in the replacement market, and lower our cost structure for the current market conditions.

 

The reduction in sales volumes has resulted in accelerated efforts in the areas of restructuring of operations throughout our business and implementing cost control measures. These actions will reduce our operating costs, increase our ability to adjust to lower demand levels and changing market conditions while we continue to focus on providing our customers a high level of value and service. We believe that when market conditions recover, we will be well-positioned with significant upside leverage in our business model. During 2008, we recorded restructuring charges of $30.4 million. Manufacturing rationalization has been the focus of our efforts to date and includes the move of the production of value products to low cost locations, such as Mexico and China. New restructuring activities include the reorganization of our North American distribution network in order to reduce costs and improve service to our customers. We continued our focus on controlling administrative costs and implemented measures to realign employee benefits and incentive compensation with current economic conditions.

 

Commodity costs also have fluctuated substantially during 2008, with significant increased costs for copper, aluminum and steel for much of the year and steep declines late in the year. We utilized our commodity hedging program in order to mitigate the volatility in prices. While we benefited from the cost averaging while commodity prices increased, the reverse is true when prices decline. At year-end we posted $37.9 million of collateral for margin calls on our cash flow hedges. The cash flow impact of this hedge collateral should reverse during 2009 as the related hedges expire.

 

During 2008, we were able to return significant amounts of cash to shareholders through our share repurchase programs. While we borrowed a portion of the funds used to execute these repurchases, overall low interest rates make the repurchase attractive. The repurchase also lowers our overall cost of capital. As of December 31, 2008, we are in compliance with all of our debt covenants. Additionally, lower interest rates in the commercial paper market allowed us to utilize our asset securitization facility and we sold $30.0 million of our accounts receivable late in the year. Our cash generation continues to be strong as we were able to adjust to the current market conditions with an emphasis on working capital management through our accounts receivable collections and inventory controls.

 

Although our overall exposure to declines in security market values is somewhat limited, the rapid declines in the overall equity markets had a direct impact on our pension obligation. The market values of our pension plan assets declined substantially as a result of the market decline. As a result of the decrease in the plan assets and an increase in the benefit obligation, the funded status of our pension plans decreased by $74.1 million. In order to mitigate the effects of asset losses, we made an additional voluntary contribution of $20.0 million to our pension

plans during the fourth quarter of 2008 and we currently plan to make additional voluntary contributions of $20.0 million to $40.0 million throughout 2009.

 

Key Financial Statistics

 

 

Results of Operations

 

The following table provides a summary of our financial results, including information presented as a percentage of net sales (dollars in millions):

 

The following table sets forth net sales by geographic market (dollars in millions):

 

 

  Year Ended December 31, 2008 Compared to Year Ended December 31, 2007 — Consolidated Results

 

Net Sales

 

Net sales decreased $253.9 million, or 6.8%, for 2008 as compared to 2007. The decrease in net sales was due to a decrease in sales volumes across all segments, but was primarily caused by lower volumes related to U.S. residential and commercial new construction. Our Residential Heating & Cooling and Service Experts segments experienced decreases in sales due primarily to the weakened U.S. residential new construction market. Our Commercial Heating & Cooling segment experienced a smaller decrease in unit volumes than our Residential Heating & Cooling segment as the decline in the commercial market trailed the residential new construction market. Declines in unit volumes were also partially offset by moderate price increases, a slight favorable change in sales mix and $32.9 million of favorable impact of foreign currency exchange rates.

 

Gross Profit

 

Gross profit margin remained relatively flat at 28.0% for 2008 compared to 28.1% for 2007. Gross profit margins were negatively impacted by the decreased sales volumes and increased commodity costs experienced for much of 2008. Also, 2007 gross margins contained a one-time favorable warranty program adjustment of $16.9 million. Sales mix partially offset these negative impacts as Residential Heating & Cooling customers purchased a higher percentage of our premium product offerings. We also were successful in increasing the price of our products to incorporate increases in costs related to commodities and fuel. The changes in foreign currency exchange rates did not have a material impact on our gross margins. Also favorably impacting gross margins was a $4.6 million reduction in salaries and wages expense related to a change in our vacation policy.

 

While we realized savings from previously announced and implemented restructurings and cost reduction programs, the full effect on gross margins was mitigated by manufacturing inefficiencies that were incurred related to those activities. These inefficiencies were related to the move of certain manufacturing operations to Saltillo, Mexico and other manufacturing rationalization activities.

 

Selling, General and Administrative Expenses

 

SG&A expenses for the year decreased by $49.0 million in 2008 compared to 2007. As a percentage of total net sales, SG&A expenses were 20.8% for both 2008 and 2007. The decrease in SG&A expenses was primarily due to cost control measures and the operation of incentive compensation plans that:

 

 

 

These decreases in SG&A expenses were partially offset by an increase in bad debt expense as a result of increased economic pressure on our customers, the impact of foreign currency exchange rates as the dollar weakened against currencies in some of the foreign countries where we operate, and increased research and development spending.

 

Gains and Other Expenses, Net

 

Gains and other expenses, net for 2008 and 2007 included the following (in millions):

 

 

The changes in gains and losses on futures contracts were primarily due to decreases in commodity prices relative to the futures contract prices during 2008 as compared to 2007. For more information, see Note 9 in the Notes to the Consolidated Financial Statements. Gains on disposals of fixed assets included gains recorded on the sale-leaseback of two properties located in North America.

 

Restructuring Charges

 

As part of our strategic priorities of manufacturing and sourcing excellence, distribution excellence and expense reduction, we have initiated actions designed to improve the delivery of our products to customers and also to lower our cost structure. We have initiated new manufacturing rationalization actions in 2008 and also have begun to reorganize our North American distribution network in order to better serve our customers’ needs by deploying parts and equipment inventory closer to them. We have also initiated a number of activities that rationalize and reorganize various support and administrative functions in order to reduce ongoing selling and administrative expenses. We have increased our focus on restructuring activities as we adjust our cost structure in response to economic conditions.

 

In 2008 and 2007, we incurred restructuring charges consisting of:

 

For further detail regarding restructuring reserves and individual restructuring actions, see Note 18 in the Notes to our Consolidated Financial Statements.

 

Manufacturing Rationalizations

 

The restructuring charges incurred in 2008 related to manufacturing rationalizations included $6.4 million of severance and related charges, $4.0 million of asset write-offs and accelerated depreciation, $3.0 million of equipment move charges and $6.3 million of other costs. These other costs were primarily manufacturing inefficiencies caused by decreased volumes at affected facilities and inventory move costs. Restructuring charges incurred related to manufacturing rationalizations during 2007 related primarily to the closures of the Danville, Lynwood, and Bellevue, Ohio operations. To date and in total, we have incurred $31.0 million of restructuring charges related to manufacturing rationalizations for projects that were in process during 2008. Of that amount, $12.0 million was severance costs, $5.2 million was asset write-offs and accelerated depreciation, $3.7 million of equipment move charges, $2.7 million of pension curtailments, other personnel related charges of $0.6 million, and other charges, including manufacturing inefficiencies and inventory move costs of $6.8 million.

 

In the future, we expect to incur additional charges of $2.7 million related to the projects that were in process during 2008. Of the additional charges expected, $1.0 million is accelerated depreciation and, therefore, a non-cash charge.

 

On February 5, 2009 we also announced plans to consolidate operations from our Blackville, South Carolina facility into our current operations in Orangeburg, South Carolina and Saltillo, Mexico to improve our operating efficiency, eliminate redundant fixed costs and provide customers with improved service. The transition is expected to take place in phases and is expected to be completed within two years. We expect to incur restructuring charges of about $12.0 million related to this consolidation, primarily in the first quarter of 2009. These charges are anticipated to include severance of $3.5 million, losses on disposal of certain long-lived assets and relocation costs for equipment and inventory of about $6.5 million and other costs of $2.0 million. We expect short-term cash outlays of $6.6 million related to this project. Annual savings beginning in 2011 are expected to be approximately $5.0 million.

 

Reorganization of North American Distribution Network

 

In the fourth quarter of 2008, we commenced the transition of activities currently performed at our North American Parts Center in Des Moines, Iowa to other locations, including our North American Distribution Center in Marshalltown, Iowa. The transition is expected to be completed in the first quarter of 2010. To date and in total, we have incurred $2.9 million of restructuring charges related to the reorganization of our North American distribution network. Of that amount $2.8 million was severance costs and $0.1 million was a pension curtailment.

 

In the future, we expect to incur additional charges of $2.0 million related to this project consisting of $0.9 million in severance, $0.4 million in relocation costs, $0.4 million in equipment move costs, and $0.3 million of other costs. Of the additional charges expected, $0.1 million is accelerated depreciation and, therefore, a non-cash charge. We anticipate that we will initiate additional restructuring activities in this area as we seek to further enhance our North American distribution network.

 

Reorganizations of Support and Administrative Functions

 

The restructuring charges incurred in 2008 related to the reorganization of support and administrative functions included $5.8 million of severance and related charges, $0.8 million of asset write-offs and accelerated depreciation, $0.3 million of lease termination costs and $0.9 million of other costs. Restructuring charges in 2007 primarily related to the elimination of the position of chief administrative officer. In connection with this action, we recorded an $8.0 million liability to settle the terms of his employment agreement, of which $6.6 million, net of $1.4 million of previously recorded stock-based compensation expense, was recorded in the second quarter of 2007. The final settlement of this matter occurred and an amount equal to the liability recorded was paid during the second quarter of 2008.

 

To date and in total, we have incurred $18.2 million of restructuring charges related to reorganizations of support and administrative functions for projects that were in process during 2008. Of that amount, $15.4 million

was severance costs, $0.8 million was asset write-offs and accelerated depreciation, $1.1 million lease termination costs, and the remainder of $0.9 million was other charges.

 

In the future, we expect to incur additional charges of $1.7 million related to these projects. Of the additional charges expected, $0.1 million is accelerated depreciation and, therefore, a non-cash charge.

 

Cash Used in Restructuring Activities, Future Charges and Expense Savings

 

Total cash paid for restructuring activities during 2008 was $29.8 million, a significant increase over the 2007 amount of $10.6 million. A significant portion of this amount related to increased restructuring activities and was primarily composed of severance payments related to the elimination of the position of chief administrative officer and severance related to manufacturing rationalizations and administrative reorganizations. We use operating cash as the funding source for restructuring activities.

 

We anticipate incurring approximately $6.4 million of future restructuring charges relating to projects that were in process during 2008. Of that amount, about $1.2 million will be non-cash charges for accelerated depreciation and impairments. Future cash outlays for restructuring activities that are currently in progress are estimated to be $16.7 million. These restructuring charges and cash outlays will be incurred generally within the next year.

 

In 2008 we realized approximately $7.3 million of incremental expense savings from our restructuring activities and we expect to realize an additional $18.8 million of expense savings in 2009.

 

Results from Equity Method and Other Equity Investments

 

Investments where we do not exercise control but have significant influence are accounted for using the equity method of accounting. Income from equity method investments decreased to $8.6 million in 2008 when compared to $10.6 million in 2007 primarily due to the lowered performance of our U.S. joint venture in compressor manufacturing due to a reduction in our volume of purchases from such joint venture.

 

In 2008, we also recorded $9.1 million of impairment charges related to our investment in a joint venture in Thailand. The carrying value of this investment at year-end was $1.8 million and, due to a loss of significant influence over the venture, it will no longer be accounted for under the equity method.

 

Interest Expense, Net

 

Interest expense, net, increased to $13.7 million in 2008 from $6.8 million in 2007. The increase in interest expense was primarily attributable to higher debt balances as the result of increased borrowing related to our share repurchases during the first two quarters of 2008 of $296.7 million. Offsetting the increase in the average amounts borrowed was a decrease in the average interest rate paid on variable rate debt.

 

Provision for Income Taxes

 

The provision for income taxes was $81.2 million in 2008 compared to $89.5 million in 2007. The effective tax rate was 39.4% for 2008 as compared to 34.5% for 2007. Our effective rates differ from the statutory federal rate of 35% for certain items, such as state and local taxes, non-deductible expenses, foreign operating losses for which no tax benefits have been recognized and foreign taxes at rates other than 35%. Our effective rate was also impacted in 2008 by a non-deductible impairment charge and foreign operating losses for which no tax benefits have been recognized. These two items combined add approximately 3.2 percentage points to our effective tax rate.

  Year Ended December 31, 2008 Compared to Year Ended December 31, 2007 — Results by Segment

 

Residential Heating & Cooling

 

The following table summarizes our Residential Heating & Cooling segment’s net sales and profit for 2008 and 2007 (dollars in millions):

 

 

The decrease in net sales was due to continuing weakness in the U.S. residential new construction market and softer replacement business as consumers remain cautious in the current economic environment. We believe that unit volumes were generally lower across the residential HVAC industry. An additional impact on volume for our value product offerings is that a higher number of consumers in difficult market conditions are electing to repair versus replace their HVAC equipment. As a result, unit volumes were down in 2008 as compared to 2007. The decrease related to sales volumes was partially offset by favorable product mix shift towards our premium products and price increases. We believe that customers with disposable income are moving towards higher efficiency premium systems.

 

Segment profit decreased primarily due to the unfavorable impact of lower unit volumes, increased commodity costs and higher freight costs. These unfavorable impacts to segment profit were partially offset by favorable product mix, price increases and lower expenses due to lower sales volumes and also from cost controls and programs that resulted in lower personnel-related and incentive compensation expenses.

 

In 2007, a favorable warranty program adjustment of $16.9 million was not included in our Residential Heating & Cooling segment’s profit as it is considered an unusual and nonrecurring item.

 

While the Residential Heating & Cooling segment realized savings from previously announced and implemented restructurings and cost reduction programs, the full effect on gross margins was mitigated by some manufacturing inefficiencies related to those activities.

 

Commercial Heating & Cooling

 

The following table summarizes our Commercial Heating & Cooling segment’s net sales and profit for 2008 and 2007 (dollars in millions):

 

 

Our domestic operations experienced lower sales volumes on a year-over-year basis primarily due to the softening in our retail national account business as customers extended times between scheduled unit replacements and deferred new store openings. These reductions were partially offset by price increases. Sales mix was slightly unfavorable. Sales mix was positive for the first three quarters due to the relatively high levels of newly introduced premium product during the early part of the year. The favorable impact of changes in foreign currency exchange rates increased net sales by $17.2 million.

 

The reduced segment profit was due primarily to lower sales volumes, increased commodity costs, and higher freight and distribution costs. Sales mix remained relatively flat for the year. The decreases noted above were partially offset by price increases and reduced manufacturing costs primarily in our domestic operations, lower

commissions and selling expenses, and lower administrative expenses from cost controls and programs that resulted in lower personnel-related and incentive compensation expenses.

 

Service Experts

 

The following table summarizes our Service Experts segment’s net sales and profit from continuing operations for 2008 and 2007 (dollars in millions):

 

 

The decrease in net sales was primarily due to the decline in the residential new construction and residential service and replacement markets resulting from the weakness of the U.S. economy. This was primarily due to volume as both price and sales mix were relatively flat.

 

The decrease in segment profit was primarily due to the decrease in sales volume, unfavorable sales mix within the residential service and replacement market, and higher year-over-year customer contact center implementation costs. Sales mix adversely impacted segment profit due to a decrease in replacement sales as customers decided to repair units instead of replace them. These factors were offset by lower commissions due to lower sales volumes, lower advertising expenditures and cost controls and programs that resulted in lower personnel-related and incentive compensation expenses.

 

Near the end of 2008, we announced plans to exit seven unprofitable service centers. As a result, we have reclassified losses incurred related to these service centers in 2008 of $2.0 million to discontinued operations. This compares with losses incurred in 2007 of $0.9 million. We anticipate that theses centers will be disposed of in a relatively short period. Also, included in discontinued operations was a $1.7 million charge for litigation related to the sale of a service center in 2004 that was included in discontinued operations. These amounts have been excluded from Service Experts operating profit in both periods presented.

 

Refrigeration

 

The following table summarizes our Refrigeration segment’s net sales and profit for 2008 and 2007 (dollars in millions):

 

 

Net sales increased due to the favorable impact of changes in foreign currency exchange rates of $14.9 million and moderate price increases implemented primarily in our domestic and Australian operations as a result of higher commodity and component costs. These favorable items were partially offset by moderate decreases in unit volumes in all of the geographic areas where the Refrigeration segment operates.

 

The decrease in segment profit was primarily due to lower sales volumes, increased commodity costs and manufacturing inefficiencies that resulted primarily from manufacturing rationalization activities at affected locations. These unfavorable impacts to segment profit were partially offset by the price increases noted above, favorable foreign currency exchange rates, and lower administrative expenses due to cost controls and programs that resulted in lower personnel-related and incentive compensation expenses.

While the Refrigeration segment realized savings from previously announced and implemented restructurings and cost reduction programs, the full effect on our gross margins was not apparent due to manufacturing inefficiencies that were incurred related to those activities.

 

Corporate and Other

 

Corporate and other expenses decreased to $53.8 million in 2008 from $85.0 million in 2007. The decrease was primarily driven by a reduction in both short-term and long-term incentive compensation due to decreased financial performance, expense reduction in professional fees related to compliance activities, changes in employee benefits, foreign currency gains and overall tight budgetary controls. The decrease in long-term stock-based compensation expense was primarily due to an increase in forfeiture rates and a decrease in the estimated pay-out percentage on outstanding performance share units in 2008 as compared to 2007. A portion of the decrease in Corporate and Other expenses was composed of the favorable catch-up adjustment related to foreign currency in the second quarter and a reduction in salaries and wages expense caused by a change to our vacation policy.

 

  Year Ended December 31, 2007 Compared to Year Ended December 31, 2006 — Consolidated Results

 

Net Sales

 

The favorable impact of foreign currency translation increased net sales by $80.3 million. Additionally, net sales were higher due to increased prices in response to an increase in commodity costs across our segments in 2007. Volumes increased in three of our four business segments, largely the result of favorable international markets. We had favorable product mix in both our Commercial Heating & Cooling and Residential Heating & Cooling segments. These increases were partially offset by a decline in volumes in our Residential Heating & Cooling segment, primarily due to the downturn in the U.S. residential new construction market.

 

Gross Profit

 

Gross profits increased across all business segments, largely due to favorable changes in our product mix and through a favorable combination of price increases, commodity contracts, improved production efficiency and cost reduction initiatives.

 

Gross profit for 2007 contains a $16.9 million benefit from a one-time adjustment to a warranty program in our Residential Heating & Cooling segment. In the fourth quarter of 2007, we made a change to the way we fulfill our warranty obligations on the Pulse furnace, which was produced from 1982-1999. Under the terms of the revised warranty program, the customer pays a discounted price for a warranty replacement unit upon failure of the heat exchanger.

 

Selling, General and Administrative Expenses

 

Included in SG&A expenses in 2007 are $6.1 million related to one-time retirement benefit settlement charges with former executives, higher depreciation, and increased rent and utility costs, as well as an increase due to changes in foreign currency exchange rates. However, these increases in SG&A costs were partially offset by lower advertising and selling costs, as well as other cost management and strategic cost reduction savings.

Gains and Other Expenses, net

 

Gains and other expenses, net for 2007 and 2006 include the following (in millions):

 

 

We utilize a hedging program to mitigate the exposure to volatility in the prices of certain commodities used in our production processes. In 2006, we entered into instruments that economically hedged certain of our risks, even though hedge accounting did not apply or we elected not to apply hedge accounting under Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (“SFAS No. 133”) to these instruments. Changes in the fair value of these instruments were recorded in net income throughout the term of the derivative instrument and are reported in Gains and Other Expenses, net.

 

Beginning in the fourth quarter of 2006, futures contracts that meet established accounting criteria are formally designated as cash flow hedges. The effective portion of the gain or loss on the futures contracts is recorded, net of applicable taxes, in Accumulated Other Comprehensive Income (Loss) (“AOCI”), a component of Stockholders’ Equity in the accompanying Consolidated Balance Sheets. When net income is affected by the variability of the underlying cash flow, the applicable offsetting amount of the gain or loss from the futures contracts that is deferred in AOCI is released to net income and is reported as a component of Cost of Goods Sold in the accompanying Consolidated Statements of Operations. Changes in the fair value of futures contracts that do not effectively offset changes in the fair value of the underlying hedged item throughout the designated hedge period (“ineffectiveness”) are recorded in net income each period and are reported in Gains and Other Expenses, net.

 

Restructuring Charges

 

In 2007, our Australian-based manufacturing facilities in Milperra assumed all heat transfer equipment manufacturing, while the smaller coil production facility in New Zealand was closed. The integration was substantially complete as of the fourth quarter of 2007.

 

In 2007, we announced plans to close our refrigeration operations in Danville, Illinois and consolidate our Danville manufacturing, support, and warehouse functions in our Tifton, Georgia and Stone Mountain, Georgia operations. The consolidation is a phased process and is expected to be completed in the second quarter of 2009.

 

In 2007, we announced plans to close Lennox Hearth Products Inc.’s operations in Lynwood, California and consolidate our U.S. factory-built fireplace manufacturing operations in our facility in Union City, Tennessee. The consolidation was a phased process and was completed at the end of the second quarter of 2008.

 

In 2007, we took steps to reorganize our corporate functions and in the second quarter of 2007 eliminated the position of chief administrative officer. As a result, we reached a negotiated settlement with our former chief administrative officer with respect to our obligations under his employment agreement.

 

In 2005, we relocated Lennox Hearth Products Inc.’s Whitfield pellet stove and Lennox cast iron product lines from Burlington, Washington to a third-party production facility in Juarez, Mexico, discontinued our steel wood stove line manufactured in Burlington, and closed the Burlington facility. During 2006, we recorded a restructuring charge related to an operating lease on the idle facility in Burlington. The charge reflected the net present value of the remaining lease payments on the operating lease, net of estimated sub-lease income on the facility. In 2007, we entered into a sub-lease agreement for the idle facility. As a result, we recorded a restructuring charge to reflect the

net present value of the remaining lease payments on the operating lease, net of sub-lease income on the facility. The operating lease and sub-lease both expire in June 2011.

 

In 2006, we commenced consolidation of the manufacturing, distribution, research & development and administrative operations of Allied Air Enterprises Inc., our two-step Residential Heating & Cooling operations, in South Carolina, and closure of our operations in Bellevue, Ohio. The consolidation was substantially completed during the first quarter of 2007.

 

A pension settlement loss is included in restructuring expense for the year ended December 31, 2007. The pension settlement loss related to our full funding of lump sum pension payments to selected participants in March 2007.

 

A gain related to the sale of a facility in Canada is included in restructuring expense for the year ended December 31, 2006. The sale of the Canadian facility occurred in 2003 and the resulting gain was deferred pending approval of a Canadian regulatory agency, which occurred in December 2006.

 

Also included in restructuring expense for the year ended December 31, 2006 is a gain of $0.8 million related to the sale of a parcel of land.

 

Results from Equity Method Investments

 

Investments in affiliates in which we do not exercise control but have significant influence are accounted for using the equity method of accounting. The increase in income from equity method investments is due to the performance of our unconsolidated affiliates, primarily Alliance Compressor LLC, a domestic joint venture engaged in the manufacture and sale of compressors.

 

Interest Expense, net

 

The increase in interest expense was due primarily to higher debt balances as the result of our share repurchases coupled with a decrease in interest income. Interest income decreased due to lower average investment balances and lower rates of return in 2007 as compared to 2006.

 

Provision for Income Taxes

 

The provision for income taxes on continuing operations was $89.5 million in 2007 compared to a provision for income taxes on continuing operations of $52.9 million in 2006. The effective tax rate on continuing operations was 34.5% and 24.1% in 2007 and 2006, respectively. The increase in our provision for taxes is primarily due to non-recurring tax benefits realized in 2006 from the release of contingency reserves established in prior years and the revaluation of deferred tax valuation allowances. Our effective rates differ from the statutory federal rate of 35% for other items, including revaluation of deferred tax valuation allowances, state and local taxes, non-deductible expenses, foreign operating losses for which no tax benefits have been recognized and foreign taxes at rates other than 35%.

 

  Year Ended December 31, 2007 Compared to Year Ended December 31, 2006 — Results by Segment

 

The key performance indicators of our segments’ profitability are net sales and profit. For more detailed information regarding how we define segment income or loss, see Note 21 in the Notes to our Consolidated Financial Statements. In 2007, a $16.9 million warranty program adjustment was not included in segment profit as it is considered an unusual and nonrecurring item.

Residential Heating & Cooling

 

The following table summarizes our Residential Heating & Cooling segment’s net sales and profit for 2007 and 2006 (dollars in millions):

 

 

Net sales decreased primarily due to reduced unit volumes impacted by the decline in demand in the U.S. residential new construction market. Additionally, we experienced a decrease in volumes in U.S. replacement market sales attributable to softening U.S. economic conditions. Decreases related to sales volumes were partially offset by price increases, which were implemented as the result of increases in commodity and component costs.

 

The decrease in segment profit was primarily due to a decrease in sales volumes that was partially offset by favorable pricing and product mix. Price increases and cost mitigation programs were more effective in offsetting the impact of increases in commodity and component costs in 2007 as compared to 2006. In 2007, a warranty program adjustment of $16.9 million was not included in our Residential Heating & Cooling segment’s profit as it is considered an unusual and nonrecurring item.

 

Commercial Heating & Cooling

 

The following table summarizes our Commercial Heating & Cooling segment’s net sales and profit for 2007 and 2006 (dollars in millions):

 

 

The increase in net sales was due primarily to price increases throughout the segment combined with a favorable product mix in our domestic operations and an increase in sales volumes in Europe. An increase in demand for higher-efficiency units and customized products, as well as a favorable mix in the new construction markets, drove the change in domestic product mix. Volume growth in our European operations primarily related to emerging markets in Eastern Europe. The favorable impact of changes in foreign currency exchange rates increased net sales by $26.2 million.

 

A favorable mix of higher margin products in our domestic operations is the primary reason for the increase in segment profit. Additionally, an increase in volume in our European operations contributed to the increase in segment profit. Price increases effectively offset increases in commodity and component costs.

 

Service Experts

 

The following table summarizes our Service Experts segment’s net sales and profit from continuing operations for 2007 and 2006 (dollars in millions):

 

The increase in net sales was driven by favorable residential service and replacement sales, which provided over half of the total segment sales in 2007 and 2006. Residential service and replacement sales increased year over year, more than offsetting a decline in residential and commercial new construction sales and commercial service and replacement sales. Favorable market conditions increased residential new construction sales in our Canadian operations, partially offsetting a decrease in U.S. residential new construction sales. The favorable impact of the change in foreign currency exchange rates increased net sales by $8.7 million.

 

The increase in segment profit is primarily attributable to a favorable change in sales and service mix and increased sales. In 2007, the higher margin residential service and replacement business was a greater portion of our segment sales as a percentage of total net sales. Our increase in segment profit was partially offset by higher selling and administrative costs in 2007 as compared to 2006.

 

Refrigeration

 

The following table summarizes our Refrigeration segment’s net sales and profit for 2007 and 2006 (dollars in millions):

 

 

The increase in sales was primarily due to increased volumes. An increase in exports in South America from our Brazilian operations and favorable market conditions in both Europe and Australia contributed to growth in volume. Sales also benefited from increased pricing in both international and domestic markets as prices were increased to offset higher commodity and component costs. The favorable impact of the change in foreign currency exchange rates increased net sales by $37.0 million.

 

The increase in segment profit primarily related to increased sales volumes. Additionally, price increases were effective in offsetting the increase in commodity and component costs. The increase in segment profit was partially offset by changes in the geographical mix of the sales of our products.

 

Corporate and Other

 

Corporate and other costs decreased from $97.5 million in 2006 to $85.0 million in 2007. The decrease was primarily due to lower personnel costs, lower professional fees and travel costs, as well as other cost reduction initiatives. These decreases were partially offset by one-time retirement benefit settlement charges with former executives.

 

Accounting for Futures Contracts

 

In 2006 we redesigned our policies, procedures and controls with respect to our commodity hedging activities. Accordingly, futures contracts entered into in the fourth quarter of 2006 that met the criteria to qualify for hedge accounting under SFAS No. 133 were designated as cash flow hedges and were accounted for in accordance with the standard. For more information see Note 9 to our Consolidated Financial Statements.

 

Realized gains and losses on settled futures contracts are a component of segment profit (loss). Unrealized gains and losses on open futures contracts are excluded from segment profit (loss) as they are subject to changes in fair value until their settlement date. Both realized and unrealized gains and losses on futures contracts are a component of Gains and Other Expenses, net in the accompanying Consolidated Statements of Operations. See Note 21 to our Consolidated Financial Statements for more information and a reconciliation of segment profit to net income.

Liquidity and Capital Resources

 

Our working capital and capital expenditure requirements are generally met through internally generated funds, bank lines of credit and a revolving period asset securitization arrangement. Working capital needs are generally greater in the first and second quarters due to the seasonal nature of our business cycle.

 

As of December 31, 2008, our debt-to-total-capital ratio was 48%, up from 20% as of December 31, 2007, primarily due to increased debt to partially fund our repurchase of $311.3 million of our common stock in 2008 under our share repurchase plans. These share repurchases also reduced stockholders’ equity by that same amount and therefore increased financial leverage.

 

Our stockholders’ equity also decreased during 2008 due to changes in AOCI. We incurred comprehensive losses related to foreign currency translation adjustments, net of $84.9 million as the U.S. Dollar strengthened against the currencies in the areas of the world where we operate. We also recorded $55.9 million comprehensive losses, net of tax, related to our pension and postretirement plans as pension plan asset values declined due to overall security market declines. Additionally, we incurred comprehensive losses of $21.3 million, net of tax, on our commodity hedge derivatives as commodity prices declined significantly in the fourth quarter of 2008.

 

The following table summarizes our cash activity for 2008, 2007 and 2006 (in millions):

 

 

Net cash provided by operating activities

 

During 2008 cash provided by operating activities was $183.2 million compared to $239.9 million in 2007 and $200.7 million in 2006. One of the primary reasons for the decrease in cash provided by operations in 2008 was a change in net income which declined to $122.8 million in 2008 from $169.0 million in 2007.

 

There were several other events that significantly impacted our cash flows from operations during 2008. We used cash for our commodity hedges in 2008 of $37.9 million as compared to none in 2007. We posted this as collateral with the counterparty as a result of losses on our commodity hedge derivatives. As a result of the decline in the fair value of our pension plan assets, we also made a voluntary contribution of $20.0 million to the U.S. defined benefit programs in 2008. We also increased the pace of our restructuring activities and the cash use related to these activities increased. Partially offsetting these uses of cash was the proceeds from sales of accounts receivable under our asset securitization program of $30.0 million in 2008 compared to none in 2007.

 

Improvements in working capital had a positive impact on cash flow from operations. Accounts receivable improved with a decrease of $54.4 million in 2008 compared to a $22.4 million decrease in 2007. Inventory improved with a decrease of $15.0 million in 2008 compared to an increase of $6.7 million in 2007. The favorable impacts of inventory and accounts receivable were partially offset by changes in accounts payable, which decreased to a $44.2 million cash use in 2008 from a $0.1 million source of cash in 2007. Other key impacts included a non-cash impairment of an equity method investment in 2008 of $9.1 million and a $16.9 million reduction from a one-time warranty program adjustment in 2007.

 

As of December 31, 2008, we had approximately $14.1 million in unfunded postretirement benefit obligations that relate to our medical and life insurance benefits to eligible employees. We do not intend to pre-fund these obligations at this time. Benefits provided under these plans have been and will continue to be paid as they arise. Our employer contributions were $2.2 million, $2.3 million and $2.7 million in 2008, 2007 and 2006, respectively. Based on current information, we do not expect a significant change in 2009 and future years, nor do we expect the usage of cash required to pay the benefits under these plans to impact our ability to operate.

Net cash used in investing activities

 

Net cash used in investing activities was $66.5 million in 2008 compared to $97.6 million and $95.5 million in 2007 and 2006, respectively. Capital expenditures of $62.1 million, $70.2 million and $74.8 million in 2008, 2007 and 2006, respectively, resulted primarily from (i) purchases of production equipment in our Residential Heating & Cooling and Commercial Heating & Cooling segments, (ii) expenditures for plant consolidations and (iii) spending for our Saltillo, Mexico facility. Net cash used in investing activities for the year ended December 31, 2008 included $5.5 million for net short-term investments compared to $27.4 million in 2007, and $4.7 million for investments in affiliates in 2008 consisting of (i) an acquisition of a third-party entity that is immaterial and (ii) additional investments in unconsolidated affiliates. Net cash used in investing activities in 2006 included additional investments in affiliates consisting of (i) strategic acquisitions of third-party entities that are immaterial both individually and in the aggregate and (ii) additional investments in unconsolidated affiliates. Investing activities for 2008 also included the proceeds from the sale-leaseback from two properties that are part of our North American operations of $5.5 million.

 

Net cash used in financing activities

 

Net cash used in financing activities was $132.0 million in 2008 compared to $152.7 million and $175.5 million in 2007 and 2006, respectively. We paid a total of $32.4 million in dividends on our common stock in 2008 as compared to $35.0 million and $31.3 million in 2007 and 2006, respectively. The primary reason for the decrease in cash dividends paid is the reduction in outstanding shares due to the repurchase of common stock under our share repurchase program, partially offset by the increase in the quarterly cash dividend from $0.13 to $0.14 per share of common stock, effective as of the dividend paid on January 18, 2008. Net borrowings of long-term debt, short-term borrowings and revolving long-term borrowings totaled approximately $178.5 million in 2008 as compared to net borrowings of $98.3 million in 2007. During 2008, we used approximately $311.3 million to repurchase approximately 8,907,650 shares of our common stock under our share repurchase plans. We also purchased approximately 356,731 shares of our common stock to satisfy tax withholding obligations in connection with the exercise of stock appreciation rights, the payout of shares of our common stock pursuant to vested performance share awards and the vesting of restricted stock awards.

 

The following tables summarize our outstanding debt obligations and the classification in the accompanying Consolidated Balance Sheets as of December 31, 2008 and 2007 (in millions):

 

 

 

 

 

 

As of December 31, 2008, we had outstanding long-term debt obligations totaling $414.3 million, which increased from $203.1 million as of December 31, 2007. The amount outstanding as of December 31, 2008 consisted primarily of outstanding borrowings of $359.8 million under our domestic revolving credit facility which matures in 2012 and a promissory note with an aggregate principal amount outstanding of $35.0 million. The promissory note matures in 2010 and has an interest rate of 8.0%. The increase in total debt outstanding was primarily the result of borrowing to fund share repurchases made in 2008 and 2007.

 

On October 12, 2007, we entered into the Third Amended and Restated Revolving Credit Facility Agreement (the “Credit Agreement”), with a group of eighteen investment grade national banks, which contains a $650.0 million domestic revolving credit facility. The Credit Agreement replaced our previous domestic revolving credit facility, the Second Amended and Restated Credit Facility Agreement, dated as of July 8, 2005.

 

As of December 31, 2008, we had outstanding borrowings of $359.8 million under the $650.0 million domestic revolving credit facility and $116.6 million was committed to standby letters of credit. All of the remaining $173.6 million was available for future borrowings after consideration of covenant limitations. The facility matures in October 2012.

 

The domestic revolving credit facility includes a subfacility for swingline loans of up to $50 million and provides for the issuance of letters of credit for the full amount of the credit facility. The revolving loans bear interest at either (i) the Eurodollar rate plus a margin of between 0.5% and 1% that is based on our Debt to Adjusted EBITDA Ratio (as defined in the Credit Agreement) or (ii) the higher of (a) the Federal Funds Rate plus 0.5% or (b) the prime rate set by Bank of America, N.A. We may prepay the revolving loans at any time without premium or penalty, other than customary breakage costs in the case of Eurodollar loans. We pay a facility fee in the range of 0.125% to 0.25% based on our Debt to Adjusted EBITDA Ratio. We pay a letter of credit fee in the range of 0.5% to 1% based on our Debt to Adjusted EBITDA Ratio, as well as an additional issuance fee of 0.125% for letters of credit issued. Our weighted average borrowing rate on the facility was 2.26% as of December 31, 2008.

 

The Credit Agreement contains financial covenants relating to leverage and interest coverage. Other covenants contained in the Credit Agreement restrict, among other things, mergers, asset dispositions, guarantees, debt, liens, acquisitions, investments, affiliate transactions and our ability to make restricted payments. The most restrictive financial covenant requires us to maintain a Consolidated Indebtedness to Adjusted EBITDA Ratio of no more than 3.50 to 1.

 

The Credit Agreement contains customary events of default. If any event of default occurs and is continuing, lenders with a majority of the aggregate commitments may require the administrative agent to terminate our right to borrow under the Credit Agreement and accelerate amounts due under the Credit Agreement, except for a bankruptcy event of default, in which case such amounts will automatically become due and payable and the lenders’ commitments will automatically terminate.

 

In addition to the financial covenants contained in the Credit Agreement outlined above, our domestic promissory notes also contain certain financial covenant restrictions. As of December 31, 2008, we were in compliance with all covenant requirements. Our obligations under the facility and promissory notes are guaranteed by our material subsidiaries.

 

We have additional borrowing capacity through several foreign facilities governed by agreements between us and a syndicate of banks, used primarily to finance seasonal borrowing needs of our foreign subsidiaries. We had

$6.7 million and $5.8 million of obligations outstanding through our foreign subsidiaries as of December 31, 2008 and 2007, respectively. Available capacity at December 31, 2008 on foreign facilities was $26.0 million.

 

Under a revolving period asset securitization arrangement (“ASA”), we are eligible to transfer beneficial interests in a portion of our trade accounts receivable to third parties in exchange for cash. Our continued involvement in the transferred assets is limited to servicing. These transfers are accounted for as sales rather than secured borrowings. The fair values assigned to the retained and transferred interests are based primarily on the receivables’ carrying value given the short term to maturity and low credit risk. The ASA provides for a maximum securitization amount of $125 million or 100% of the net pool balance as defined by the ASA. However, eligibility for securitization is limited based on the quality of the accounts receivable and is calculated monthly. The beneficial interest sold cannot exceed the maximum amount even if our qualifying accounts receivable is greater than the maximum amount at any point in time. The eligible amounts available were as follows (in millions):

 

 

As of December 31, 2008, $7.1 million of cash and cash equivalents were restricted primarily due to routine lockbox collections and letters of credit issued with respect to the operations of our captive insurance subsidiary, which expire on December 31, 2009, and will be renewed upon expiration. These letters of credit restrictions can be transferred to our revolving lines of credit as needed.

 

On July 25, 2007, we announced that our Board of Directors approved the 2007 Share Repurchase Plan, pursuant to which we are authorized to repurchase up to $500 million of shares of our common stock through open market purchases. Based on the closing price of our common stock on July 24, 2007, a $500 million repurchase represented over 20% of our market capitalization. The repurchases under the 2007 Share Repurchase Plan were fully executed by the end of the second quarter of 2008.

 

On June 2, 2008, we announced that our Board of Directors approved a new share repurchase plan, pursuant to which we are authorized to repurchase up to $300 million of shares of our common stock through open market purchases (the “2008 Share Repurchase Plan”).

 

We periodically review our capital structure, including our primary bank facility, to ensure that it has adequate liquidity. We believe that cash flows from operations, as well as available borrowings under our revolving credit facility and other existing sources of funding, will be sufficient to fund our operations for the foreseeable future and the share repurchases during the term of the 2008 Share Repurchase Plan.

 

During the third quarter of 2008, we amended the lease agreement for our corporate headquarters. While the same party continues to be the lessor under the lease, the amendment, among other things, replaced the debt participant and moderately increased the rent payments. The amendment also provides for consistency of financial covenants with our revolving credit agreement and we are in compliance with these financial covenants. The lease will continue to be accounted for as an operating lease.

 

During 2008, we expanded our Tifton, Georgia manufacturing facility using the proceeds from Industrial Development Bonds (“IDBs”). We entered into a lease agreement with the owner of the property and the issuer of the IDBs, and through our lease payments fund the interest payments to investors in the IDBs. We also guaranteed the repayment of the IDBs and entered into letters of credit totaling $15.5 million to fund a potential repurchase of the IDBs in the event that investors exercised their right to tender the IDBs to the Trustee. As of December 31, 2008, we recorded both a long-term asset and a corresponding long-term obligation of $15.3 million related to these transactions.

 

As a result of the recent declines in the securities markets as a whole, the fair value of pension plan assets has also declined. In 2008, we made a $20.0 million voluntary contribution to our plans. A continued decline in fair value of our pension plan assets could result in increased pension contributions.

Off-Balance Sheet Arrangements

 

In addition to the revolving and term loans described above, we utilize the following financing arrangements in the course of funding our operations:

 

 

Contractual Obligations

 

Summarized below are our contractual obligations as of December 31, 2008 (in millions):

 

 

As of December 31, 2008, the liability for uncertain tax positions, including interest and penalties, was $15.8 million. Due to the uncertainty regarding the timing of payments associated with these liabilities, we are unable to make a reasonable estimate of the amount and period in which these liabilities might be paid.

 

Purchase obligations consist of aluminum commitments. The above table does not include retirement, postretirement and warranty liabilities because it is not certain when these liabilities will become due. On December 30, 2008, we made a voluntary contribution of $20.0 million and as a result there are no minimum required contributions for our U.S. qualified pension plans in 2009. However, we currently plan to make additional voluntary contributions of $20.0 million to $40.0 million for our global plans throughout 2009. We also estimate that our 2009 contribution to the postretirement benefit plan will be approximately $1.6 million. For additional information regarding our contractual obligations, see Note 11, Note 12 and Note 13 of the Notes to the Consolidated Financial Statements. Contractual obligations related to capital leases as of December 31, 2008 were included as part of long-term debt in the table above.

 

The majority of our Service Experts segment’s motor vehicle fleet is leased through operating leases. The lease terms are generally non-cancelable for the first 12-month term and then are month-to-month, cancelable at our option. While there are residual value guarantees on these vehicles, we have not historically made significant payments to the lessors as the leases are maintained until the fair value of the assets fully mitigates our obligations under the lease agreements. As of December 31, 2008, we estimate that we will incur an additional $7.5 million above the contractual obligations on these leases until the fair value of the leased vehicles fully mitigates our residual value guarantee obligation under the lease agreements.

 

Fair Value Measurements

 

Effective January 1, 2008, we adopted Statement of Financial Accounting Standards No. 157, Fair Value Measurements (“SFAS No. 157”), which establishes a framework for measuring fair value clarifies the definition of fair value within that framework, and expands disclosures about the use of fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. However, in February 2008, the Financial

Accounting Standards Board (“FASB”) issued FASB Staff Position No. FAS 157-2, Effective Date of FASB Statement No. 157 (“FSP No. 157-2”), which deferred the effective date of SFAS No. 157 for one year for non-financial assets and liabilities, except for certain items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). We are currently evaluating the impact of SFAS No. 157 on our Consolidated Financial Statements for items within the scope of FSP No. 157-2, which became effective on January 1, 2009.

 

  Fair Value Hierarchy

 

The three-level fair value hierarchy for disclosure of fair value measurements defined by SFAS No. 157 is as follows:

 

 

Fair Value Techniques

 

Our valuation techniques are applied to all of the assets and liabilities carried at fair value as of January 1, 2008, upon adoption of SFAS No. 157. Where available, the fair values are based upon quoted prices in active markets. However, if quoted prices are not available, then the fair values are based upon quoted prices for similar assets or liabilities or independently sourced market parameters, such as credit default swap spreads, yield curves, reported trades, broker/dealer quotes, interest rates and benchmark securities. For assets and liabilities with a lack of observable market activity, if any, the fair values are based upon discounted cash flow methodologies incorporating assumptions that, in our judgment, reflect the assumptions a marketplace participant would use. To ensure that financial assets and liabilities are recorded at fair value, valuation adjustments may be required to reflect either party’s creditworthiness and ability to pay. Where appropriate, these amounts were incorporated into our valuations as of December 31, 2008, the measurement date.

 

Our adoption of SFAS No. 157 has resulted in changes to the valuation techniques used when determining the fair value of our derivative instruments. These derivatives are primarily valued using estimated future cash flows that are based directly on observed prices from exchange-traded derivatives and, therefore, have been classified as Level 2. We also take into account the counterparty’s creditworthiness, or our own creditworthiness, as appropriate. An adjustment has been recorded in order to reflect the risk of credit default, but these adjustments have been insignificant to the overall value of the derivatives. The effect of adopting these changes to the valuation techniques was not material.

 

The majority of our short-term investments are managed by professional investment advisors. The net asset values are furnished in statements received from the investment advisor and reflect valuations based upon the respective pricing policies utilized by the investment advisor. We have assessed the classification of the inputs used to value these investments as Level 2 through examination of pricing policies and significant inputs and through discussions with investment managers. The fair values of our short-term investments are based on several observable inputs including, but not limited to, benchmark yields, reported trades, broker/dealer quotes, issuer spreads and benchmark securities. The adoption of SFAS No. 157 resulted in no net changes to the valuations for these securities.

 

Market Risk

 

Our results of operations can be affected by changes in exchange rates. Net sales and expenses in foreign currencies are translated into U.S. dollars for financial reporting purposes based on the average exchange rate for the

period. During 2008, 2007 and 2006, net sales from outside the U.S. represented 29.8%, 27.3% and 22.8%, respectively, of our total net sales. Historically, foreign currency transaction gains (losses) have not had a material effect on our overall operations. As of December 31, 2008, the impact to net income of a 10% change in exchange rates is estimated to be approximately $5.5 million.

 

We enter into commodity futures contracts to stabilize prices expected to be paid for raw materials and parts containing high copper and aluminum content. These contracts are for quantities equal to or less than quantities expected to be consumed in future production. As of December 31, 2008, we had metal futures contracts maturing at various dates through May 2010 with a fair value liability of $39.4 million. The impact of a 10% change in commodity prices would not have a significant impact on our results from operations on an annual basis, absent any other contravening actions.

 

Our results of operations can be affected by changes in interest rates due to variable rates of interest on our revolving credit facilities. A 100 basis point change in interest rates would impact our results of operations by approximately $2.1 million.

 

Critical Accounting Policies

 

The preparation of financial statements requires the use of judgments and estimates. The critical accounting policies are described below to provide a better understanding of how we develop our judgments about future events and related estimations and how such policies can impact our financial statements. A critical accounting policy is one that requires difficult, subjective or complex estimates and assessments and is fundamental to the results of operations. We consider our most critical accounting policies to be:

 

 

This discussion and analysis should be read in conjunction with our Consolidated Financial Statements and related Notes in “Item 8. Financial Statements and Supplementary Data.”

 

Allowance for Doubtful Accounts

 

The overall allowance for doubtful accounts is maintained at a level deemed appropriate based on historical and other factors that affect our cash collections. Such factors include the historical trends of bad debt write-offs and recovery of previously written-off accounts, the current aging of customer accounts, the financial strength of customers and projected economic and market conditions. The evaluation of these factors involves complex, subjective judgments. Due to the challenging market conditions in our end markets in recent years, our bad debt expense and amount of write-offs has moderately increased. We continue to monitor our customers’ creditworthiness and do not believe that we are exposed to any concentrations of credit risk with those customers. Thus, changes in these factors or changes in economic circumstances may significantly impact our consolidated financial statements.

 

Goodwill and Other Intangible Assets

 

We test goodwill for impairment by reporting unit at least annually in the first quarter of each fiscal year. We estimate reporting unit fair values using standard business valuation techniques such as discounted cash flows and reference to comparable business transactions. The discounted cash flows used to estimated fair value are based on

assumptions regarding each reporting unit’s estimated projected future cash flows and the estimated weighted-average cost of capital that a market participant would use in evaluating the reporting unit in a purchase transaction. The estimated weighted-average cost of capital is based on the risk-free interest rate and other factors such as equity risk premiums and the ratio of total debt and equity capital. In performing these impairment tests, we take steps to ensure that appropriate and reasonable cash flow projections and assumptions are used. We reconcile our estimated enterprise value to our market capitalization and determine the reasonableness of the cost of capital used by comparing to market data. We also perform sensitivity analyses on the key assumptions used, such as the weighted-average cost of capital and terminal growth rates.

 

We also monitor economic, legal, regulatory and other factors for Lennox as a whole and for each reporting unit between annual impairment tests to ensure that there are no indicators that make it more likely than not that there has been a decline in the fair value of the reporting unit below its carrying value. Specifically, we monitor industry trends, our market capitalization, recent and forecasted financial performance of our reporting units, and the timing and nature of our restructuring activities. While our recent financial performance is below historical levels, we do not currently believe that there are any indicators of impairment. If these estimates or the related assumptions change, we may be required to record non-cash impairment charges for these assets in the future.

 

Product Warranties

 

The estimate of our liability for future warranty costs requires us to make significant assumptions about the amount, timing and nature of the costs we will incur in the future. We review the assumptions used to determine the liability periodically and we adjust our assumptions based upon factors such as actual failure rates and cost experience. Numerous factors could affect actual failure rates and cost experience, including the amount and timing of new product introductions, changes in manufacturing techniques or locations, components or suppliers used. In recent years, changes in the warranty liability as the result of the issuance of new warranties and the payments made have remained relatively stable. Should actual warranty costs differ from our estimates, we may be required to record adjustments to accruals and expense in the future. For more information see Note 11 in the Notes to the Consolidated Financial Statements.

 

Pensions and Postretirement Benefits

 

We have domestic and foreign pension plans covering essentially all employees and we also maintain an unfunded postretirement benefit plan, which provides certain medical and life insurance benefits to eligible employees. In 2008, we selected 8.25% as the assumed long-term rate of return on assets, which is consistent with our 2007 estimate. These are long-term estimates of equity values and are not dependent on short-term variations of the equity markets. Due to the significant recent declines in security market values in 2008 we experienced a loss in asset values of $59.3 million. The loss does not immediately impact our earnings as it is deferred in AOCI and will be amortized into net periodic benefit cost over the estimated service period of covered employees of 14.2 years. However, the loss is recognized as an immediate increase to our benefit obligations. We also selected assumed discount rates of 6.27% for pension benefits and 6.42% for other benefits. Our assumed discount rates are selected using the yield curve for high-quality corporate bonds, which is dependent upon risk-free interest rates and current credit market conditions.

 

The assumed long-term rate of return on assets and the discount rate have significant effects on the amounts reported for our defined benefit plans. A 25 basis point decrease in the long-term rate of return on assets or discount rate would have the following effects (in millions):

 

Assumed healthcare cost trend rates have a significant effect on the amounts reported for our healthcare plan. For 2008, our assumed healthcare cost trend rate was 8.50%. A one percentage-point change in assumed healthcare cost trend rates would have the following effects (in millions):

 

 

Should actual results differ from our estimates and assumptions, revisions to the benefit plan liabilities and the related expenses would be required. For more information see Note 13 in the Notes to our Consolidated Financial Statements.

 

Stock-Based Compensation

 

Determining the amount of expense for stock-based compensation, as well as the associated impact to our financial statements, requires us to develop estimates of the fair value of stock-based compensation expense. The stock-based compensation expense that we record related to our performance share units is highly dependent upon the achievement of performance goals and forfeiture rates. These objectively determinable performance goals include measures based upon return on invested capital and growth in net income. If we do not achieve the goals specified, the stock-based compensation expense is not recorded or recorded at lower achievement rates and previous estimates may be revised. Similarly, should we exceed our goals; we may be required to record additional stock-based compensation expense. The most significant factors of the stock-based compensation expense related to stock appreciation right awards that require estimates or projections include the expected volatility of our stock price and expected lives of the stock appreciation rights. The expected lives of stock appreciation rights are determined based on historical exercise experience and estimated forfeiture rates are derived from historical forfeiture patterns. We believe the historical experience is the best estimate of future exercise patterns and forfeitures currently available.

 

Self-Insurance Expense

 

We use a combination of third-party insurance and self-insurance plans (large deductible or captive) to provide protection against claims relating to workers’ compensation, general liability, product liability, property damage, aviation liability, directors and officers’ liability, auto liability, physical damage and other exposures. The self-insurance expense and liabilities are primarily determined based on our historical claims information, as well as industry factors and trends. We maintain safety and manufacturing programs that are designed to improve the safety and effectiveness of our business processes and, as a result, reduce the level and severity of our various self-insurance risks. In recent years, our actual claims experience has been trending favorably and, therefore, both self-insurance expense and the related liability have decreased. To the extent actuarial assumptions change and claims experience rates differ from historical rates, our liability may change.

 

Derivative Accounting

 

We use futures contracts and fixed forward contracts to mitigate our exposure to volatility in commodity prices in the ordinary course of business. Fluctuations in metal commodity prices impact the value of the derivative instruments that we hold. When metal commodity prices rise, the fair value of our futures contracts increases and conversely, when commodity prices fall, the fair value of our futures contracts decreases. Late in 2008, metal prices fell significantly and as a result, we recorded derivative losses of $21.3 million in AOCI. We do not expect similar drops in metal commodity prices in the foreseeable future. Historically, hedge ineffectiveness has not been significant. We are required to prepare and maintain contemporaneous documentation for futures contracts to be formally designated as cash flow hedges. Our failure to comply with the strict documentation requirements could result in the de-designation of cash flow hedges, which may significantly impact our consolidated financial statements.

Income Taxes

 

In determining income for financial statement purposes, we must make certain estimates and judgments in the calculation of tax provisions and the resultant tax liabilities and in the recoverability of deferred tax assets that arise from temporary differences between the tax and financial statement recognition of revenue and expense. In the ordinary course of global business, there may be many transactions and calculations where the ultimate tax outcome is uncertain. The calculation of tax liabilities involves dealing with uncertainties in the application of complex tax laws. We recognize potential liabilities for anticipated tax audit issues in the U.S. and other tax jurisdictions based on an estimate of the ultimate resolution of whether, and the extent to which, additional taxes will be due. Although we believe the estimates are reasonable, no assurance can be given that the final outcome of these matters will not be different than what is reflected in the historical income tax provisions and accruals.

 

As part of our financial process, we must assess the likelihood that our deferred tax assets can be recovered. If recovery is not likely, the provision for taxes must be increased by recording a reserve in the form of a valuation allowance for the deferred tax assets that are estimated not to be ultimately recoverable. In this process, certain relevant criteria are evaluated, including the existence of deferred tax liabilities that can be used to absorb deferred tax assets, the taxable income in prior carryback years that can be used to absorb net operating losses and credit carrybacks and taxable income in future years. Our judgment regarding future taxable income may change due to future market conditions, changes in U.S. or international tax laws and other factors. These changes, if any, may require material adjustments to these deferred tax assets and an accompanying reduction or increase in net income in the period when such determinations are made. In addition to the risks to the effective tax rate described above, the effective tax rate reflected in forward-looking statements is based on current tax law. Any significant changes in the tax laws could affect these estimates.

 

 

The information required by this item is included under the caption “Market Risk” in Item 7 above.

 

MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

 

Management of Lennox International Inc. (the “Company”) is responsible for establishing and maintaining adequate internal control over financial reporting and for the assessment of the effectiveness of internal control over financial reporting. As defined by the Securities and Exchange Commission, internal control over financial reporting is a process designed by, or under the supervision of, the Company’s principal executive and principal financial officers, and effected by the Company’s Board of Directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the consolidated financial statements in accordance with U.S. generally accepted accounting principles.

 

The Company’s internal control over financial reporting includes written policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the Company’s transactions and dispositions of the Company’s assets; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of the financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorization of management and directors of the Company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

Management has undertaken an assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Management’s assessment included an evaluation of the design of the Company’s internal control over financial reporting and testing of the operational effectiveness of those controls.

 

Based on this assessment, management has concluded that as of December 31, 2008, the Company’s internal control over financial reporting was effective to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles.

 

KPMG LLP, the independent registered public accounting firm that audited the Company’s consolidated financial statements, has issued an audit report including an opinion on the effectiveness of internal control over financial reporting as of December 31, 2008, a copy of which is included herein.

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

The Board of Directors and Stockholders

Lennox International Inc.:

 

We have audited the accompanying consolidated balance sheets of Lennox International Inc. and subsidiaries (the Company) as of December 31, 2008 and 2007, and the related consolidated statements of operations, stockholders’ equity and comprehensive income and cash flows for each of the years in the three-year period ended December 31, 2008. In connection with our audits of the consolidated financial statements, we have also audited the financial statement schedule. We have also audited Lennox International Inc.’s internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Lennox International Inc.’s management is responsible for these consolidated financial statements, the financial statement schedule, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on these consolidated financial statements, the financial statement schedule and the effectiveness of the Company’s internal control over financial reporting based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the consolidated financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

 

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Lennox International Inc. and subsidiaries as of December 31, 2008 and 2007, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2008, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. Also in our opinion, Lennox International Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008,

based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

 

The Company adopted the provisions of Statement of Financial Accounting Standards No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, effective December 31, 2006, and the Company adopted the provisions of Financial Accounting Standards Board Interpretation No. 48, Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109, effective January 1, 2007.

 

 

Dallas, Texas

 

February 26, 2009

LENNOX INTERNATIONAL INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS
As of December 31, 2008 and 2007
(In millions, except share and per share data)

 

 

The accompanying notes are an integral part of these consolidated financial statements.

LENNOX INTERNATIONAL INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS
For the Years Ended December 31, 2008, 2007 and 2006
(In millions, except per share data)