HVACR: A Wall Street View

HVACR: A Wall Street View

The past two years may go down as two of the most volatile in the history of the residential HVAC industry, arguably more surprising and remarkable than the cyclical downturn of 2007 to 2009. The market has been hit by a deluge of cross-currents including government tax credits, rapid price and material inflation, hot weather and two shifts in the refrigerant regulatory framework, all of which increased volatility in what was already a fragile consumer environment. With the dust settling from the past two years, there are plenty of debates to be had on the long-term implications of this year's R-22 demand, but we do see a more stable 2012 ahead with a return to mid single-digit industry growth looking likely.

What happened in 2010-2011?

The last two years have been disappointing for the residential HVAC industry, but to look forward, we first need to understand what drove the recent dislocations. Indeed, the last two years have been instructional and have highlighted that the industry is far more complex than the commonly watched AHRI cooling shipments (which were flat in 2010, up about 10 percent in 2011) would suggest. In 2010, the dominant theme was the transition to R-410A refrigerant, where consumers resisted the higher priced systems (unit shipments flattish off a depressed 2009 base) but where OEM revenues masked this weakness with tailwinds from mix, furnaces and component sales, helped also by the 25C tax credit. In other words, there were fewer condensing units being sold as many consumers chose to repair broken units rather than replace, but the dollar value associated with each condensing unit being replaced was higher as sales of furnaces, air handlers and coils were up dramatically. As a result, we estimate the industry grew revenues in the high single digits despite flattish AHRI shipments.

In 2011, these dynamics flip-flopped, mostly driven by the re-emergence of the low cost, R-22 dry ship units. On the positive side, more consumers began replacing broken units rather than repairing, with AC/heat pump shipments set to finish 2011 with about 10 percent growth. On the negative side, however, most of these replacements were for the outdoor unit only, with an increasing share of the market going to 13 SEER versus the high efficiency units being sold in 2010, as we think R-22 finishes the year representing approximately 30 percent of industry shipments (separately, mix headwinds also crushed profitability at many of the OEMs). Component sales lagged on fewer R-410A system replacements, and furnaces shipments nationally have been down double digits, perhaps the portion of the market most hurt by the tax credit expiration. In short, most of the positives from mix, furnace and components that helped in 2010 were reversed this year, meaning we estimate industry revenues up only low single digits in 2011 despite much stronger growth in AHRI cooling shipments.

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2012: A return to normalcy, where pent-up demand remains intact

Looking ahead, we think the 2012 outlook actually looks better as the share of R-22 stabilizes, meaning a return to the “normal” mid single-digit growth looks achievable even without meaningful improvement at the consumer level. Although some may argue that 2011 shows “pent-up demand is not real,” we think this somewhat misses the point. Keep in mind that despite the tough economy, condensing units continue to break, and even cash-strapped consumers continue to respond to keep their systems running. In 2010, the primary choice was repair, while in 2011 this demand has moved toward the low-cost R-22 units. Either way, we continue to see HVAC as a far less discretionary item than other household durables. Encouragingly, we note that 2011 replacement rates actually improved about 250bps y/y despite an abysmal consumer environment, evidence that the 2009-2010 replacement rates were unsustainably low. Importantly, the noise from furnace/components and mix that hurt revenues so much in 2010/2011 should be steadier in 2012, driving revenue growth trends closer to underlying AHRI shipments. Our industry forecast assumes revenue growth of 6 percent in 2012 and 8 percent in 2013 for AC and heat pump shipments, driven by very modest improvements in replacement rates and pent-up demand and no growth in housing starts (see Figures 1 and 2).

Structural issues re-emerge?

While we think the near-term outlook finally looks more stable, the longer term view is somewhat of a “glass half empty” or “glass half full” debate. On the positive side, we continue to see pent-up demand in the residential market, as consumers' fixing (versus replacing) of units during the past four years has created a base of approximately 5 million repaired units, a full year's worth of shipments, which will break again and eventually need to be replaced. Additionally, much of the flight to R-22 dry ships is probably a function of the weak economy, and appetite for the more expensive R-410A probably returns in a more normal economic environment — indeed, it seems unlikely that consumers can exploit the “dry ship” loophole indefinitely. That being said, the R-22 experience in 2011 will give plenty of ammunition to the pessimists, reigniting debates about whether the ever-increasing efficiency/environmental standards have structurally priced many homeowners out of the replacement market. This is a concern we cannot dismiss.

Note that as recently as 2005, the industry standard was a 10 SEER R-22 product, which on an indexed cost (ignoring inflation) is 30 percent below a comparable 13 SEER R-22 replacement unit today. When you add in the additional component costs of an R-410A system changeout, the effective cost of replacement can be more than three times what the same consumer would have paid several years ago. Also keep in mind that 2011 is not the first time we've seen a preference for value products, as the dry ship demand this year is reminiscent of the pre-buy ahead of the 10 to 13 SEER transition in 2005, where distributors clearly believed that the value delivered by higher efficiency was not commensurate with the higher price.

We recognize that the move to R-410A is probably unavoidable in the long-term, and that more efficient units pay for themselves in energy savings over time, but upfront costs remain the driving factor behind consumer behavior, and there is some evidence that residential HVAC is and will always be a value market. For a dealer base that has for years been oriented toward upselling to premium products, this is where the secular risk is: a stubbornly weak consumer limits the differentiation and impairs business models that have been built on efficiency. With regulators looking toward another minimum SEER increase in 2015, this remains the most interesting long-term issue to watch, as the industry looks to balance rising standards with a still-constrained consumer (see Figure 3).

Stephen Tusa is an analyst with JP Morgan Electrical Equipment & Multi-Industry Equity Research. Contact him at 212/622-6623 or [email protected].

This is an article based on a JPMorgan Research report. For any JPM conflicts with any companies mentioned in this article, please refer to JPM's disclosure websitehttps://mm.jpmorgan.com/disclosures/company/.

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