Albany, NY -- (SBWIRE) -- 01/08/2019 -- 2017 was another solid year for the HVAC industry, with an ongoing recovery continuing to generate solid MSD type levels of growth in residential with low to MSD growth in commercial. While both cycles are getting longer, we are somewhat more balanced around risks to the upside and downside. We see another few years of above average normalized growth in residential (MSD) as the tailwinds from the housing echo replacement boom are likely at least partially real and pent-up demand from the recession is not quite done yet, while the non-res cycle is shifting to lower growth but still has some legs left to sustain growth. The key risk item, outside of weather or a drastic shift in the US economy, is price/cost, with commodity prices rising and OEMs committing to pass through price to offset, but with some differences in timing which could cause near term hiccups to quarterly earnings. Overall, industry fundamentals remain solid and steady, with a positive setup and mostly stable competitive dynamics with little risk of disruption despite increasing technological evolution in the space.

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US Resi momentum continues amid strong fundamental demand backdrop: little debate near term but focus shifting to length and sustainability of the cycle.

Replacement rates have now reached the high end of historical ranges, and the market has officially regained its long term trend line, as pent-up replacement demand from the recession has consistently bolstered MSD+ type growth over the past several years. Our analysis assumes that there is still some legs left in the pent-up demand story, but with further upside dependent on the handoff to the housing boom echo effect, which most expect to create some level of above average replacement demand as units put in during the housing bubble in the early to mid-2000s are now coming up for replacement. Simple arithmetic would indicate significant upside over the next several years, but we do see caveats as the housing bubble was focused in the South where units may not last as long (and hence upside would have already been realized), the market is now moving past trend line, and rates are rising along with system prices on higher commodity costs.

We continue to see a base case scenario with MSD unit growth out to 2020, which only factors in a portion of the theoretical upside from pent-up demand and the replacement boom, after which we think the industry could return to a more normalized LSD type growth level. Uits are lasting longer nowadays, extending useful life and allowing for extended warranties, which could theoretically extend the HVAC upcycle for a longer period and mitigate a potentially negative impact as the positive tailwind for replacement opportunities from the housing bubble turns into a headwind from the housing crash towards the mid-2020s, but none of this is dialed explicitly into our base case yet. More near term, weather comps are more normal this year after 2016 saw a cooler start with late heat, and we assume MSD growth in housing. Bottom line, we model 5% unit growth in residential for both 2018 and 2019.

US Commercial HVAC steady.

This market remains a more straightforward call, where we see 3-4% growth in 2018/19, following ~5% growth in 2013-17. This assumes ~3-4% underlying construction growth over the next two years, with replacement steady in the ~4% range. We expect unitary and applied to grow at similar rates, with applied potentially growing slightly faster due to strength in institutional non-res verticals. Overall, the commercial HVAC market depends more on the macro and commercial construction than any industry-specific driver, and we expect steady growth here as the market remains well below peak and the non-res cycle remains solid, though getting later in the cycle with less relative upside.

Price/cost the key debate as inflation and tariffs driving incremental commodity headwinds; price should offset in resi/unitary, but risk in large commercial applied.

Overall commentary from companies entering the year had mostly been positive that price increases would be enough to offset rising commodities, but with potential for tariffs and another recent run-up in prices there could be incremental risk. Residential and light commercial unitary pricing should be able to offset higher commodities with potential for another round of price increases later this year to offset any incremental headwinds, while those at the larger end and with more applied exposure sounded incrementally more negative versus standing guidance. We think the point of differentiation here is that applied HVAC business is booked as much as 12 months in advance, with pricing generally locked in at that point and making for a longer lag on the ability to pass through commodity-related price increases, while the nature of bids lends itself to more competition given decades of installed base influence being fought for by three players in a relatively visible manner with a relatively educated buyer.

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Competitive dynamics mostly stable; potential for another round of consolidation but properties limited.

Competitively, dynamics remain stable, overall, but with some incremental share shift and a more pronounced focus on new product introductions over the past year. In terms of share, Trane appears to be the biggest winner near term, growing solidly above market in both resi and commercial, while Lennox continues to grow at or above market as well. Carrier and York have generally underperformed, though they have introduced some new products and relative growth is showing signs of improvement. Daikin appears to be growing about in line, and we have been impressed with what we have seen from Rheem as an up and comer. Trane and Lennox aggressively invested in new products over the past several years, smartly reinvesting during a cycle uptick with low commodity prices, but appear to be switching more to a harvesting mode near term, whereas, Carrier and York had underinvested but are now rolling out new products to address key markets. Daikin is focused on ramping its new facility near term, while Watsco has invested heavily in new technology and EMR remains the technology leader in compressors, deftly navigating an evolving landscape to remain on top. In terms of potential OEM consolidation, we continue to see rationale for another round of consolidation, but we don't view anything as imminent near term given other portfolio concerns at UTX/JCI, and a limited amount of other properties which could be for sale.

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