Executive Roundtable: Looking Across the Mahogany Table

Mike Murphy, editor-in-chief, and Joseph Fristik, group publisher took to the road in recent months. Their goal: To glean the perspectives of industry leaders on varied subjects: issues that will affect your HVAC contracting business. Here is the view from the top.

CB: What changes do you foresee because of the 13 SEER energy efficiency standard that will take effect January 23, 2006?

Robert M. McDonough, president and COO, Worldwide Heating and Cooling, Lennox International Inc.: It will cost more to build a 13 SEER unit than a 10 SEER unit. We estimate up to ninety percent of industry sales will compress around the baseline (13 SEER) product. We also believe there will be tremendous margin and price pressure throughout the distribution chain, as this move will tend to consolidate competition at a single point. We’ll all be looking for competitive advantages in order to grow our business.

Until this standard change takes effect, there is a very compelling energy story for many consumers, as the payback between a 14 SEER product and a 10 SEER has looked very positive. However, when you go to a 13 SEER minimum, that payback is gone for many homeowners. Dealers who really want to satisfy their customer’s needs will have to change their selling message. It will need to be about quiet operation, indoor air quality, humidity control, diagnostics, or some other combination of benefits.

David Pannier, President, Residential Systems, Trane/American Standard: Our business supports the new 13 SEER NAECA standard. It will be good for the environment and produce energy savings for the consumer. And yet, the world's most efficient system, improperly applied, installed or maintained, won’t provide consumers with the full value of their investment. As an industry, we must place more importance on the proper design, application, installation, and maintenance of the entire system, including the ductwork.

J.R. Jones, President, Rheem Air Conditioning Division: Contractors are going to face this unusual situation: Today, when an old outdoor unit fails, often the contractor installs a new one but doesn’t change the indoor evaporator coil. That system may not be matched but, often, it can continue to operate. However, if you change an 8 SEER unit for a 13 SEER, the indoor coil absolutely has to be changed out. The system’s balance of internal and external volume won’t work. Are we assured that every indoor unit will be properly replaced? Not likely.

CB: Many industries have sent production abroad. Has this brought any changes to your company? Any issues with quality control overseas?

David LaGrand, President and CEO, Norydne: We’re certainly seeing the trend in the last few years of a migration to Mexico, and more recently, into Asia and especially China. It’s almost predominant among our supply chain that many components are now coming from those areas. We have to recognize we’re no longer working in a regional market — this is a world market.

Competition in the future will come from outside North America. We are, for the first time, seeing manufacturers from Asia attempt to build our type of split systems and import them into North America. It’s very early to say whether they’re going to be successful or not. However, we’re going to assume they will be successful, and we will be prepared to compete with them.

Tom Huntington, President, York UPG: Overseas competitors do have a cost advantage. However, the constant chase for low cost labor may be a general flaw in corporate manufacturing strategy. Costs can change based upon commodity prices, component suppliers, or freight charges. It’s a complicated scenario, one that requires a manufacturer such as York to be very nimble. A good decision you make today could be a bad decision tomorrow. You really have to look at the total cost of manufacturing and the quality systems in place to ensure the right mix.

Even though labor charges are lower offshore, other issues are more important to York. We would be concerned with moving production overseas, and shipping back to the U.S., as it could present problems on lead times. Our customers require very short lead times of as low as three to five days. A company would have to have an inventory strategy that would make overseas production viable.

With respect to quality issues outside the U. S., York has a recently opened facility in Apodaca, Mexico. As a global manufacturer, York International has to have consistency in quality goods and services, regardless of the country in which those products are manufactured. In fact, we’ve seen no variances in quality levels in any of our locations around the globe.

Halsey Cook, Carrier Corporation, President, North America Residential:The sweet spot for the North American HVAC industry isn’t to manufacture abroad. North America is a much better location to manufacture and assemble product for this industry’s domestic use. For the Carrier family of unitary brands, that includes Mexico.

We don’t have two standards for quality. We don’t let one plant off the hook simply because they operate in another location. Our standard operations and quality controls processes are for all manufacturing facilities worldwide. These are proven quality control tools that we believe provide the very best products all the time, regardless of location.

Jones: We’re dedicated to a domestic manufacturing strategy, but we must monitor global options and be open to alternatives if the competitive landscape changes. Foreign products, such as those from Asia, are finding a home here. I think this is the aspect of foreign competition we should be most wary of today.

The quality of a product really depends upon the quality process of the manufacturer. A process can be duplicated in any language. Foreign manufacturing isn’t necessarily inferior in quality simply because it’s built in another location.

McDonough: To ignore the existence of lower-cost manufacturing opportunities in today’s global market would be naïve at best. The sometime premise that production in countries offering lower cost somehow relates to lower quality is not one our company accepts. In fact, we’ve had very positive experiences in countries offering lower-cost production.

The North American residential HVAC industry has had a nice ride in which we haven’t experienced much global competition. Now we’re beginning to see the emergence of non-traditional competitors, including companies from Asia who have leadership positions in HVAC markets we don’t currently serve. We feel a strong responsibility to monitor these competitors to ensure we keep our dealers and distributors competitive.

Pannier: Today, four out of the top seven largest global HVAC manufacturers are Asian. And it's increasingly obvious that for these large Asian manufacturers, the North American marketplace represents a relatively untapped opportunity.

What hinders more active Asian participation in the huge North American market? Fundamentally, the systems used here are different than applied in the rest of the world. The North American residential market is predominantly a ducted system market, whereas the rest of the world is primarily a ductless market. So Asian participation in the North American market is not a natural fit. But our destiny is up to us.

CB: What is your take on government policies, especially as they relate to federal vs. state regulations?

Jones: The HVAC industry has, in recent years, done a reasonably good job thinking about what lies ahead. However, we need to do a better job of unifying the industry. We like how well ARI and GAMA work together, and we support the assistance offered to contractors, wholesalers, and manufacturers by organizations such as ACCA.

We’d like to see our industry have more influence over legislation from a consumer’s perspective. We’re all for efficiency gains, but they must be methodical improvements that consumers will embrace and not create unnecessary financial hardships on them.

Cook: We’d like to see one set of regulations, and one voice for the industry. The only way forward is a lot more dialogue between all industry participants and the governing bodies. More energy could be put into a consolidated approach to our collective efforts.

Pannier: ARI certification has eliminated the need for government regulation of conformance to strict performance standards. Where we do face government regulation (NAECA and the Clean Air Act), the ability to have one federal standard versus a large number of individual state standards is highly preferred.

Certainly we understand the downside of certain federal standards. For example, NAECA makes more economic sense for the extreme southern parts of the U.S. than for the northern extremes. And yet, the ability to enforce state-by-state standards is where the complication really sets in. Unless there are realistic means to prevent inter-state traffic of HVACR equipment, federal standards are the only practical option.

McDonough: It’s an extremely dangerous precedent to let state standards exist. It is essential this industry come together and take a united stand against individual state regulations. Recent evidence would indicate the industry has a long way to go in order to have a unified front with regard to governmental rule making — which is important not just for the benefit of manufacturers, but for the millions of people who ultimately benefit from the use of our products.

CB: Where do you see the HVAC industry heading in the next 5-10 years?

Pannier: Fundamentally, the industry will head where the customer takes us. That's the beauty of a free-market system.

Some of the changing customer needs are tied to the consumers' heightened interest in personal health. This is driven by demographic and psychographic trends related to the aging of our society and increase in disposable income. Our industry needs to respond by offering real, effective solutions, in many cases customized to the unique needs of the consumer.

McDonough: We see a very large emerging opportunity in providing indoor air quality products and solutions for our customers. While many homeowners think buying a portable air cleaner that sits in a corner of a room in the house will deal meaningfully with their indoor air quality problems, it won’t. We have to educate and promote whole house solutions not only with consumers, but with dealers as well. Controlling humidity, sound, and introducing value-added diagnostic capabilities could also become increasingly important.

The companies who are successful in simplifying and educating the dealers, distributors and consumers about these emerging technologies are the ones who will be the most successful.

Cook: It’s been said that a brand is no more than a sum of experiences around a product. For our industry, the relationship is with the contractor and customer — that’s where the experiences are being made. In the future, contractors will be looking for opportunities to make themselves more unique, and more attractive to the customers.

We want to continue to be close to our customers. I think the contractor/consumer relationship will always be the most important link.

LaGrand: As the industry has grown and become more replacement oriented, and as large as the industry is, contractors will have to become more retail focused. They’ll have to realize that they are retailers competing with other dealers and the big box guys.

CB: What landmark changes have made your company a leader in the industry, and how will the future affect your particular niche?

Huntington: Almost four years ago, we started a focus on getting the right people in place at York, then allowing that group of talented people to establish what York's strategy should be and where our company should go. It's a first who, then what strategy that leads to the entire organization buying into the direction.

The result was a strategy that focused first on manufacturing efficiencies to ensure a low cost base for our products, followed closely by new product innovation and brand building. The manufacturing portion of our strategy is complete, and we are now in the process of launching a complete new line of residential products supported by the largest brand building campaign in York's history.

So, it's not a single change but, rather, a well-considered set of initiatives all designed to help York UPG and its channel partners gain market share in a growth market. It's an ambitious multi-year plan, and it's working.

Cook: Carrier Corporation and the associated brands, Carrier, Bryant, and International Comfort Products, invest in new technologies at a rate that sustains a leadership position. In fact, in the last two years Carrier has been issued more U.S. patents than any of our competitors.

We believe that investing in technologies that will shape the future of this industry is part of our commitment. The heritage of Dr. Willis Carrier has brought with it a responsibility to always be pushing the envelope, finding new ways to provide comfort solutions for the public.

Pannier: I don't know that I could point to one or even a series of landmark changes that have made our business an industry leader. Rather, a lot has to do with the value system around which we've built our business and interact with our employees, suppliers and customers.

We have done extensive voice of the customer research in an attempt to reflect the customers' voice in the design of our hardware and ultimately to deliver complete customer satisfaction to our targeted customer base.

While we all know that the customer is getting more sophisticated and more demanding, their number one need is still durability and reliability. The key is to never be satisfied with our performance in this regard because the bar is continually being raised. That's why we've adopted Six Sigma in our business and are in the process of making it part of our culture.

Jones: Rheem is focused and driven by a few, but important, key strategic initiatives: The new management team set our direction by first understanding our place in the industry. We talked with our customers to find out what they liked about us, what they needed, and what product gaps we might have. The outcome was seven new products that we started on a year ago. By the end of this fall all seven will be in production ¯ less than 18 months. That’s pretty nimble. We’ve become good at delivering on time as we say we will.

Our size and structure allows us to listen and respond quickly. We see our privately-held status and supportive ownership as a key defining asset that we intend to fully leverage for competitive advantage. We’re a relatively large manufacturer, yet our organization approaches things simply and reacts quickly to information in the marketplace.

McDonough: Lennox has always tried to provide our dealers with innovative products that help them gain ground in the marketplace. Now we’ve driving product development and research, marketing, and product management across all of our businesses — not just the Lennox brand, but with all our HVAC brands.

This change is increasing our speed to market and allowing us to convert selling opportunities much more rapidly, making us more nimble and responsive to market changes as they happen. In fact, we have recently introduced a record number of new products and have been honored as an ENERGY STAR® Manufacturer of the Year by the EPA and DOE for the past two years. Our changes have been dynamic, and they’re working.

LaGrand: We’ve focused on processes that give us a high degree of flexibility. Many people envision a manufacturing process as being an assembly line building hundreds of thousands of products, over and over again. We’ve actually designed lines to produce a quantity of one: A two-ton product followed by a four-ton, followed by a three-ton isn’t unusual.

Long-run assembly line production isn’t the best way to respond to customer demand. We don’t have long lags between products. We can build every product every day. Our commitment to quality manifests itself on the manufacturing floor. Employees define every task on the assembly line themselves; this keeps them actively engaged in their daily work, and in producing top quality products.

CB: How has the Internet and web-based initiatives changed current business practices?

Cook: We are committed to taking the friction out of business processes to achieve our goal of being the best company with which to do business. The Web is fundamental to this objective. Virtually all business processes are being digitized to give customers 24/7 access to ordering, warranty, technical information, and many other tools.

LaGrand: We started more than 10 years ago with electronic linkage systems that have evolved into eNora, an electronically driven, supply chain communication vehicle. Nearly 99% of the questions, asked of us 10 years ago, are now being answered online. This makes us much more efficient and able to focus on other customer needs. We’re able to link up to our distributor inventories, which provide the opportunity to quickly replenish their stock. The more seamless and efficient we can make our processes, the better we can serve our customers.

Pannier: The World Wide Web has created a means by which the consumer can access and evaluate what's available to them, and be much more informed regarding what they want in a home comfort system. Progressive dealers and contractors are also using their own Website to acquaint existing or potential customers with their history and services, and some even allow customers to schedule routine service or repairs online.

Frequently, contractors are placing equipment and parts orders online and are able to track their delivery, at their convenience. Today, almost 20% of our dealer orders are entered via the Internet. We expect that rate to continue to grow.

Jones: Until recently, consumers relied primarily on the contractor for equipment recommendations. Today, approximately 70% of buying decisions are influenced by contractors. The opportunity exists in the future for that to become diluted. Consumers are now able to perform a much greater amount of product research, on their own, before coming in contact with a contractor.

We will exert a lot of effort, planning and capital investment in our website strategy so we can fully support this trend. Information exchange is going to be significantly different. Probably 30% of our orders are online today compared to less than 10% of our
orders two years ago.

CB: How will the role of distribution change for the industry and for your company?

Cook: I’m not sure that the distributor channels will necessarily consolidate or change tremendously. What we have been able to identify as market segments in the ducted industry, continue to require a stepped distribution process. There is definitely an important place for distributors; however, like manufacturers and contractors, they must become more customer focused in order to maintain their place in the market structure.

We want to have good distributors, whether they’re independent or company owned. We’ve definitely learned some valuable lessons over many years of conducting business with strong distribution partners.

Huntington: The wholesale distribution segment of this industry is now, and will always remain, vital. Good distributors build and maintain loyal, professional contractor networks. It gets down to the value proposition — the service, resources, training, and marketing support that the distributor offers. We have found that distributors who align their goals with ours, and support our programs, grow with us and are successful. The key is for manufacturers and distributors to have strategies that are aligned.

Distributors told us that they needed more differentiation. That’s the reason we’ve developed programs and resources that will help make our distributors the preferred suppliers for contractors. We now have powerful cooperative marketing programs in place for all three brands, including national, seasonal television consumer advertising.

LaGrand: A lot of organizations keep testing the model to see what’s best for them regarding distribution. Our optimum solution is to sell through independent distributors who then sell to independent contractors. For us, we think the traditional model works quite well.

Some feel that by owning the whole channel they can be more successful. I think all the same logistical steps have to occur, regardless. As long as each part of the equation is efficient, either way works. We think our chosen method is the best alternative for us because we don’t compete with our distribution channel. Our distributors and dealers can focus on their part of the equation while we focus on being the best possible manufacturer.

I think it’s very difficult for a manufacturer to be focused on designing, manufacturing, and engineering equipment, while also concentrating on the wholesale and retail requirements of local markets.

Jones: One of the most significant changes that the industry has undergone is the realization that the partnership we’re all involved with is one that serves the customer. The connection is no longer as clear-cut as the manufacturer supports the distributor, the distributor supports the contractor, and the contractor supports the homeowner.

The successful manufacturer, distributor, and contractor will partner better than they have in the past to support the customer. I don’t think anyone in the channel knows everything that a consumer will want. Homeowner demands will drive all of our efforts to satisfy their residential comfort needs.

Pannier: Distribution will need to clearly understand and re-invent itself to provide their customer with exactly what they need. That will require investment in technology, business process improvement, and skills that reflect the changing market. So, while local distributors will be as important in the future as they are today, they will have to evolve with the changing market in order to retain their value in the delivery chain.

CB: What's the most important trend for contractors to be ready for in the coming years?

LaGrand: Our industry has to recognize that image is a big issue, and it’s beginning to drive our actions. Many contractors do a great job, but when we look at consumer surveys, image shows up as the biggest concern. Unfortunately, people say they would rather not have their children aspire to be in this industry.

Pannier: I believe the future success of every contracting business will be increasingly determined by the degree to which they are able to ultimately satisfy and delight their customers. Certainly the contractor's technical expertise will continue to be a critical success factor. In fact, the contractor needs to increasingly be an expert on the entire comfort delivery system to provide maximum value to their customers. But the ability to create effective sales processes, business processes, and customer satisfaction processes in addition to technical expertise will differentiate the successful contractor from the not-so-successful contractor in the future.

Huntington: The evolving retail marketplace will change how dealers approach the add-on
replacement sale. This will become even more critical with the news of the recently revised NAECA standard. Traditionally, a replacement sales story is a discussion about return on invesment (ROI) for 10, 12, or 14 SEER equipment. However, above 14 SEER a different technology, typically two-speed, is required to achieve higher efficiencies. Having said this, with the 13 SEER minimum efficiency as of January 2006, a sell-up story based upon SEER will be limited because of the lack of ROI. Dealers who wish to maximize their opportunities in the add-on replacement market will develop a sell-up story around a broader spectrum, one that will include IAQ products, controls, and multi-capacity equipment. Also, they’ll need to know how to establish and operate a profitable service-agreement business.

CB: How will the movement toward more sophisticated diagnostic capabilities affect your product design planning?

McDonough: We must balance the right amount of diagnostic capability with cost and demand. Many of our products are relatively sophisticated and offer diagnostic capability for the dealer. We have tested products that talk back through a Webserver about system operation. The key will be educating the dealer and homeowner about the value of these tools, so they can understand the difference they can make. Demand will follow the process of education and value creation.

LaGrand: Nordyne intends to embrace proven technologies that enhance consumers’ comfort and make our products easier to service and install for the contractor. We’re constantly evaluating technologies that will improve home comfort.

Huntington: On the light commercial side, diagnostics are especially critical to contractors who have service agreements covering multiple facilities and multiple HVAC units. Remote diagnostic and communication capability are critical. Our Simplicity series control systems, for example, allows the service company to dispatch the right technician to the right location at the right time, and even help make sure he's carrying the tools and parts he'll need to service the unit when he gets there. Historical reports and trending help predict future service points and maintenance needs to reduce unit downtime.

This is a movement that will grow. As diagnostic tools become more sophisticated, we also have to ensure training programs are in place and that the new tools are practical and user-friendly for contractors.

Jones: Our product planning and development team are dedicated to delivering what the market has decided it wants. The more value that consumers see in total home comfort, the more we anticipate that diagnostics will become an important part of our product plan.

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