HVACR: A Wall Street View

HVACR: A Wall Street ViewAfter a volatile 2009–11 period, trends in the residential HVAC industry have settled with a now-steadier operating environment. Industry sales results themselves have not been spectacular but are still solid, showing steady growth versus the prior year, a few more system sales in place of R-22 or compressor replacements, and the potential for a further lift from new housing in 2013.

Investor sentiment toward HVAC-related stocks has also improved, buoyed by some optimism around a bottom in the housing market, with the returns of related stocks such as Lennox (+51 percent), Ingersoll Rand (+54 percent) and Watsco (+17 percent) outpacing the 4 percent year-to-date increase in the S&P 500. This has been reflected in P/E multiples, with Lennox going to 15.4x versus 13.4x a year ago, a 15 percent change; Ingersoll Rand from to 13.1x from 10.6x, a 24 percent change; and Watsco flat at ~19.5x, while the S&P 500 has gone to 12.1x from 11.4x, a 6 percent change.

2012 a Year of (Relative) Normalcy

We currently forecast that revenues for the residential OEMs will finish the year up approximately 3 percent. This is despite what should be a relatively flattish year for AHRI condensing unit and heat pump shipments. As with past years, however, we have to look beyond just the AHRI data, as the mix of products sold is important. Recall that in 2010, the R-410A transition meant that equipment manufacturers saw extra tailwinds from condensing unit mix (tax credits for high efficiency units), furnaces and component (i.e., coil, air handler) sales. In 2011, this reversed, as the return of the R-22 dry-charged product meant the industry was selling more units but with less revenue, as the attachment rate of indoor units and furnaces dropped dramatically. This year, the mix has again moved in favor of the industry as R-22’s share of the market has moderated and customers opt more for full system R-410A system changeouts. This is the biggest difference between actual 2012 results and our expectations entering the year: a few less outdoor condensing units but a bit better mix, as indoor units sold more. The differences in mix can most easily be seen in OEM results/share. In 2011, value players like Goodman and the other large supplier, Carrier, went with a heavy R-22 strategy, and sales for them were up solidly in the high single digits, while those higher end, more focused suppliers like Lennox and Trane lagged. This year, it’s been the opposite, with Goodman and Carrier lagging, and Trane and Lennox leading.

2013 Should Also Be Normal

Looking into next year, we forecast 6 percent industry revenue growth. Some of this uptick will come from new housing construction, with housing starts tracking up ~40 percent y/y and the better data is becoming tougher to ignore. There is a lag to when this filters into completions (when most HVAC equipment sales take place), so while the tailwind from housing has been mixed this year, it should be felt more broadly next year, helping the ~15 percent of industry sales tied to new construction. The bigger variable for next year comes on the replacement side, always tough to predict, but where the industry will be comparing against one of the hottest 2012 selling seasons on record.

Beneath the surface, some encouraging signs: Looking beyond the near-term growth numbers, there were a few positive signs in this year’s industry trends. One of our concerns coming out of last year was that given the popularity of R-22 dry shipped units, consumers may hesitate to spend the money to transition toward a more expensive, full R-410A system and revert back to compressor replacements (as we saw in 2010). So far, this doesn’t seem to be the case. First, R-22 sales, which we estimate at 20–25 percent of all units sold in 2011, are coming in at more like 15 percent of the industry this year – some are calling for numbers of 10 percent or less. Drivers of the decline in dry ships include concerns about the future price of R-22 refrigerant, which has discouraged many contractors from pushing the product.

At the same time, our distributor survey results suggest that sales of replacement compressors are tracking lower versus a year ago, a sign that consumers are not simply repairing their units but actually replacing them with new R-410A systems. Watsco, the largest U.S. distributor, talked about their parts sales (including replacement compressors) being down in the 20 percent range in the 3Q, the first such decline in several years. Similarly, Emerson’s U.S. Climate sales – principally compressors for residential HVAC – declined 4 percent in the last 12 months, lagging the overall industry.

While the economy is still not strong on an absolute basis, we see these changes as the first sign of a healthier consumer that is willing to spend a bit more money when their air conditioning breaks. Irrespective of weather or housing trends next year, this should be an incrementally encouraging sign for the industry as we enter 2013.

Longer term, there are some interesting market dynamics, including efficiency regulations and consolidation. Looking beyond just the numbers, there are still some variables that may impact growth, market share and mix. There are the upcoming regional efficiency regulations, the first of which, on furnaces, is coming in 2013. This will once again raise the cost of replacement for many consumers and probably result in a pre-buy in the year prior. In the end, when the dust settles, this should be positive, but higher equipment costs have in the past hurt demand for systems as consumers opt for the lowest cost option. Lastly, there was some news of consolidation during the past year, with Goodman going to Daikin. It’s unclear what this combination will bring early on, but we believe this move can only enhance the penetration of the mini-split, now approaching a material part of industry volumes. On the flip side, there could be an opportunity for others to regain some of the share lost over the past decade if the operating focus at Goodman is compromised by transition to a new owner with a different product focus. Stay tuned.

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 website mm.jpmorgan.com/disclosures/company/.

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