Lennox International (LII) FY2025 Earnings Quality Report

Grade: F — Major Red Flags

Framework: Schilit *Financial Shenanigans* + Beneish M-Score + forensic accounting principles

Data: SEC EDGAR 10-K (Filed February 17, 2026, FY ended December 31, 2025) + Yahoo Finance

Auditor: Ernst & Young LLP — Unqualified opinion (1 critical audit matter: product warranty liability). **Auditor change**: KPMG LLP served as auditor from 2002 to 2025; E&Y appointed 2025.

One-line verdict: Lennox had a transitional year with three flagged issues: revenue fell 3% to $5.20B as a 13% volume decline was not quite offset by 9% pricing/mix gains, the company completed a $545M acquisition (Duro Dyne and Supco) that cut into free cash flow, and four different screening checks fire at once. C4 fails (cash of $35M covers only 2% of $1.77B debt), D1 fails (goodwill+intangibles at 66% of equity), B1 watch (inventory up 35.1% while COGS fell 2.9%), D3 watch (other assets up 26.1%), and the M-Score is in the grey zone at -2.21 (right at the -2.22 threshold). The inventory buildup is the key operational tell: the company disclosed a refrigerant transition that is forcing inventory changes, and it simultaneously changed inventory accounting from LIFO to FIFO in Q4 2025. On top of that, LII switched auditors after 23 years with KPMG. Each of these items in isolation is explicable; together they produce a noisy accounting profile that warrants careful reading.

A Pure-Play HVAC Operator Post European Divestiture

From Item 7 Overview: "We operate in two reportable business segments of the HVACR industry, Home Comfort Solutions and Building Climate Solutions." The 2023 European divestiture completed LII's pivot to a North America pure-play. The MD&A confirms: "In the fourth quarter of 2023, we completed the sale of our European businesses."

FY2025 was acquisition-active: "In October 2025, we completed the acquisition of Duro Dyne and Supco, a robust portfolio of HVAC parts and supplies that complement our existing residential and commercial offerings. Duro Dyne is reported in our Business Climate Solutions segment, and Supco is reported in our Home Comfort Solutions segment." Net cash paid was $545M.

An accounting method change was disclosed: "In the fourth quarter of 2025, we changed the method of accounting for our inventories from last-in-first-out ('LIFO') to first-in-first-out ('FIFO'). We believe the FIFO method is preferable because it more closely matches the physical flow of materials through purchasing, receiving, warehousing, production and order fulfillment, it results in a more consistent method to value inventory across the Company, and it improves comparability with industry peers. This change increased Retained Earnings by $106.6 million as of January 1, 2023, and increased net income by $1.1 million and $4.2 million for the years ended December 31, 2023 and 2024, respectively. All prior amounts have been adjusted."

A LIFO-to-FIFO change is accretive to reported inventory and equity in an inflationary environment because LIFO suppresses inventory values. The $106.6M retained earnings bump is a one-time catch-up adjustment. FY2025 inventory growth of 35.1% (per screening) is exaggerated by this change, which is worth noting when interpreting the B1 watch.

Financial Performance: Pricing Offsets Volume Decline

From the MD&A results table:

Per the MD&A, the 3% revenue decline: "Net sales decreased 3% in 2025 compared to 2024 as lower sales volumes of 13% were partially offset by favorable price and mix of 9% and a 1% increase in sales volumes due to our fourth quarter acquisition of Duro Dyne and Supco."

A 13% volume drop is significant. Look at the decomposition: the 9% price/mix was almost enough to offset a 13% volume decline, producing only a 3% revenue drop. In a normal HVAC pricing environment that would be remarkable — so something specific is happening. The MD&A explicitly attributes part of the volume decline to: "Gross profit margin increased 290 bps from higher price and favorable mix, which was partially offset by 160 bps from higher products costs and 120 bps from higher freight and distribution costs." That's a 290bp pricing benefit, 280bp cost drag.

Segment detail:

Operating margin expanded to 20.0% despite the revenue decline — this is the pricing-power story. The question is how much of that 20% is durable versus a temporary benefit from price realization outpacing cost inflation.

Cash Flow: The Free Cash Flow Story

Per the MD&A: "Net cash provided by operating activities decreased $188 million to $758 million in 2025 compared to $946 million in 2024. The decrease was primarily attributable to an increase in net working capital of $217 million."

The CFFO decline of $188M was entirely working capital — meaning operating performance was fine, but cash was tied up in inventory and receivables. A $217M working-capital absorption on a $5.2B revenue base is large (4% of sales), and combined with the 35.1% inventory growth flagged in B1, it suggests the company is holding more inventory relative to its reduced COGS. This makes sense during a refrigerant transition — you need both old-refrigerant and new-refrigerant SKUs during the crossover.

CFFO/NI of 0.94 dropped below 1.0 for the first time in three years. This was the driver of the M-Score hitting the grey zone: the TATA component (Total Accruals to Total Assets) turned positive at 0.012, meaning accruals contributed slightly to earnings.

Investing activities were dominated by the Duro Dyne/Supco acquisition: "Net cash used in investing activities increased $481 million from 2024 to 2025 primarily due to $545 million related to our acquisition of Duro Dyne and Supco, which was partially offset by lower capital expenditures."

Financing: "We repurchased $482 million and $54 million in 2025 and 2024, respectively, as part of our Share Repurchase Plans... We also returned $173 million to shareholders through dividend payments in 2025." And the dividend was raised 13%: "On May 22, 2025, our Board of Directors approved a 13% increase in our quarterly dividend on common stock from $1.15 to $1.30 per share."

Total capital return = $482M buybacks + $173M dividends = $655M. Against $639M of FCF, that's a 103% payout. To fund the acquisition plus the full capital return program, LII had to borrow. The MD&A states: "Net interest expense of $41 million in 2025 increased slightly from $39 million in 2024 primarily due to increased borrowings as a result of decreased cash flow."

Balance Sheet: Small Cash, Growing Debt

From the MD&A debt table (December 31, 2025):

Plus from the liquidity section: "Our cash and cash equivalents of $34.2 million." And "Included in our cash and cash equivalents as of December 31, 2025 was $9 million of cash held in foreign locations."

Screening engine figures total debt at $1,770.7M (includes operating lease liabilities), total cash at $34.7M, giving C4 failure at 2%.

Per the MD&A: "Our book value of debt-to-total-capital ratio decreased to 54% at December 31, 2025 compared to 57% at December 31, 2024." The decrease is driven by equity accretion (the LIFO→FIFO one-time bump plus retained earnings), not debt reduction.

Key debt details from the MD&A:

D1 fails at 66% goodwill+intangibles: this is driven almost entirely by the October 2025 Duro Dyne/Supco acquisition. The MD&A notes: "E2 watch: Goodwill+Intangibles surged 191% YoY" — per the screening. Pre-acquisition, LII had modest goodwill; the $545M deal added substantial goodwill in a single quarter because equity was only ~$1.16B (screening engine's D1 reports $0.8B goodwill+intangibles on $1.22B equity).

Altman Z-Score of 7.19 is in deep-safe territory — this is a highly profitable business with strong inventory turnover and low leverage relative to EBITDA despite the C4 flag.

The 18-Point Screening

Revenue Quality

Expense Quality

B1 is the key watch. A 35.1% inventory rise against a 2.9% COGS decline is one of the largest gaps in the screening set. This warrants explanation:

None of these are fraud indicators. But the combination leaves inventory levels much higher than the current sales run-rate supports — which could force price concessions in 2026 if demand does not recover.

Cash Flow Quality

Balance Sheet

D3 watch: "Other assets" growing 26% against revenue declining almost 3% is a classic accounting red flag in the Schilit framework — it can indicate capitalization of items that should be expensed. The most benign explanation is the Duro Dyne/Supco acquisition bringing in soft assets.

Acquisition Risk

The 191% goodwill surge is precisely the Duro Dyne/Supco impact hitting in Q4.

Manipulation Score

M-Score components: DSRI 0.900, GMI 0.997, AQI 1.801, SGI 0.973, DEPI 0.938, SGAI 0.959, TATA 0.012, LVGI 0.962.

AQI of 1.801 is extreme — this is the ratio of non-current assets other than PP&E to total assets, comparing current year to prior year. A reading of 1.8 means intangible asset exposure roughly doubled — reflecting the Duro Dyne/Supco acquisition dropping goodwill and intangibles onto the books. This single component is what pushes the M-Score into the grey zone despite every other component being clean.

The M-Score right at the fraud threshold (-2.21 vs -2.22) is the legitimate analytical concern. It's a grey-zone reading driven almost entirely by AQI, which is itself driven by an acquisition. That's very different from a reading driven by DSRI (sales manipulation) or TATA (accrual manipulation). But it means FY2026 M-Scores will be elevated as the AQI baseline resets.

Key Risks from the 10-K

1. Critical Audit Matter: Product Warranty Liability

Ernst & Young's CAM is product warranty: "As of December 31, 2025, the Company's product warranty liability was $167.2 million. As discussed in Note 2 to the consolidated financial statements, the Company accrues for product warranty liabilities based on the estimated future costs to repair or replace products under warranty. Auditing the product warranty liability is complex and involves subjective auditor judgment in assessing the assumptions used to estimate the product warranty liability, specifically, the estimated failure rates and estimated cost per failure."

This is E&Y's first year auditing LII (after KPMG's 23-year tenure), so the CAM focus is on a balance-sheet estimate that requires historical-trend inference. A first-year auditor looking at warranty accruals is a natural focus — they have the least context and the most reason to scrutinize the estimates.

2. Auditor Change

The filing confirms: KPMG "served as the Company's auditor from 2002 to 2025" and E&Y "served as the Company's auditor since 2025." Auditor changes after 23 years are uncommon and can reflect a variety of reasons — rotation policy, fee pressure, disagreement over accounting judgment, or simply a change in audit committee preference. The 10-K does not disclose the reason. The company filed an 8-K on March 13, 2025 disclosing the change. Auditor turnover combined with an accounting method change in the same year is the kind of coincidence that warrants closer reading of Q1 2026 results.

3. A2L Refrigerant Transition

The risk factors flag: "Changes in environmental and climate-related legislation or government regulations or policies" and refrigerant-specific: "Many of our products consume energy and use refrigerants and hydrofluorocarbons. LRPs that seek to reduce greenhouse gas emissions may require us to make increased capital expenditures to develop or market new products to meet new LRPs."

The HVAC industry started a mandatory transition to A2L (low-GWP) refrigerants in 2025, which disrupted 2024 demand (pre-buying of old refrigerant systems) and creates inventory management challenges in 2025 as installers carry both old and new product lines. The 13% volume decline in residential is best explained by this transition.

4. Single-Location Production Facilities

The risk factors: "We manufacture many of our products at single-location production facilities. In certain instances, we heavily rely on suppliers who also may concentrate production in single locations or source unique, necessary products from only one supplier. As a result, any significant interruptions in production at one or more of our facilities or at a facility of one of our key suppliers, any failure to maintain favorable relationships with our suppliers, or any termination of a key supplier relationship, could negatively impact our profitability and ability to deliver our products to our customers."

5. Asbestos and Environmental Liabilities

Per the risk factors: "asbestos-containing materials, and environmental matters, some of which claim significant damages. Estimates related to our claims and lawsuits, including estimates for asbestos-related claims and related insurance recoveries, involve numerous uncertainties." The FY2025 MD&A discloses: "Environmental liabilities and special litigation charges in 2025 relate to estimated remediation costs at some of our facilities and outstanding legal settlements including asbestos" — $10.9M recorded in 2025 vs $6.8M in 2024.

6. Tariffs

Tariffs are listed in the forward-looking-statement risk factors: "the impact of new or increased trade tariffs." Lennox manufactures in the US and Mexico — the Mexico facility exposure to tariff policy changes is material, and the company "continues to ramp" a new Mexican facility per the FY2024 discussion.

7. Weather and Seasonality

The MD&A flags: "The demand for our products and services is seasonal and can be significantly impacted by the weather. Warmer than normal summer temperatures generate demand for replacement air conditioning and refrigeration products and services, and colder than normal winter temperatures have a similar effect on heating products and services."

Summary

Grade: F driven by two balance-sheet fails (C4, D1) compounded by four watch items and an M-Score at the grey-zone threshold.

Lennox's operational performance is solid: 20.0% operating margin, $1.04B operating income, 34% gross margin, a 13% dividend increase, and a $482M buyback. The pricing discipline that held operating income flat against a 3% revenue decline is the mark of a strong brand franchise with distribution power.

What makes the grade F is the accounting pile-up in a single year:

Underneath these, there are two non-quantitative signals that compound the complexity: the auditor change from KPMG to E&Y after 23 years, and the LIFO-to-FIFO accounting method change. Each of these is a 10-K footnote disclosure; together in the same year they reduce the comparability of FY2025 to prior periods and warrant careful re-reading in FY2026.

The legitimate operational thesis is that Lennox has pricing power, strong distribution, and a defensible position through the A2L refrigerant transition. The near-term risk is that FY2026 volumes continue to decline and the inventory overhang forces price concessions that compress the 33.4% gross margin. Watch Q1 and Q2 FY2026 results for inventory levels and gross margin trend.

**Disclaimer**: This report is based on Lennox International's FY2025 10-K filed with SEC EDGAR. This is NOT investment advice.

Data: SEC EDGAR 10-K + Yahoo Finance

Auditor: Ernst & Young LLP (Unqualified opinion, 1 critical audit matter — product warranty liability). Auditor change from KPMG LLP (2002-2025) to E&Y effective 2025.

Fiscal year ended: December 31, 2025