The first encouraging note is the report’s statement that the HVAC market hit bottom in 2009. The report said, “We believe the global HVAC industry is now beyond its collective bottom, hit in 2009 (residential and commercial). After four straight down years, residential HVAC is poised for solid double digit growth in 2010.” In addition, the commercial segment “is set to turn the corner in the next six to 12 months, with potential greater upside than residential.”
According to Talbot Gee, vice president of the Heating, Airconditioning & Refrigeration Distributors International (HARDI), the J.P. Morgan report is one of the most comprehensive reviews of the HVAC industry. However, he noted that HARDI and its members have some reservations about the 2010 report’s forecast, which he acknowledged is based primarily on data from a handful of companies that may not be entirely reflective of the industry as a whole.
RESIDENTIAL OUTLOOKIn its predictions for the residential market, J.P. Morgan noted that key drivers for growth include a historical pattern of 5 percent growth in the installed base, a return in consumer confidence, and pent-up demand to replace systems that were repaired or deferred during the downturn.
The report specifically noted that new housing is not considered to be a driver for the residential market, and assumed “flat starts” for new housing.
HARDI’s Gee agreed that new housing starts are not expected to rise, since they currently remain below historical levels. However, he expressed concern about relying on the theory that pent-up demand for replacement units will substantially boost the residential market.
The report said that replacement demand will stem from both core demand and pent-up demand. It defined core demand as including “(1) growth in the replacement base and (2) the impact of improving consumer confidence.” Pent-up demand was estimated separately: “We continue to believe a pent-up replacement cycle exists as a result of the sales declines from 2007-2009.” Assuming that many residential consumers have chosen to repair their systems rather than replace them during the downturn, J.P. Morgan also conducted a survey to estimate how long repaired systems typically last. According to its survey, more than 70 percent of contractors “estimated that the repairs would only last 1-3 years, implying that there will be a significant number of units that will break again in the next few years and need to be replaced.”
J.P. Morgan’s model for forecasting replacement demand predicted that repaired systems could start being replaced as soon as 2010.
HARDI’s summary of the market outlook, however, stated, “Estimates of 6.91, 8.16, and 9.12 million residential units replaced in 2011, 2012, and 2013 respectively may be overly optimistic since the 2012 estimate would be the industry’s second largest unitary production in history, and 2013’s estimate would exceed the current peak of 2005’s 8.61 million units by nearly 6 percent. It is unclear what percentage of these replacements would be covered by warranties and therefore delivering little to no revenue growth to the industry.” Gee also noted that those previous peaks were strongly aided by unprecedented growth in residential new construction, which will not be the case over the next four years.
COMMERCIAL OUTLOOKFor the longer term outlook, the report stated that it prefers investing in residential HVAC. However, on the commercial side, the report favored near-term investment in commercial HVAC. According to the report, the commercial HVAC segment “is set to turn the corner in the next six to 12 months, with potential greater upside than residential.”
Furthermore, the report added, “We expect commercial sales to turn positive in 2011, with growth potentially exceeding residential starting in late 2011 and into 2012, which should favor commercial players over residential.”
Citing recent trends in commercial as more positive, the report said, “As of now, order trends are beginning to turn (less bad) in commercial; however, we expect sentiment to become significantly more favorable in coming quarters.”
In contrast to this, Gee said that HARDI’s chief economist, Alan Beaulieu of the Institute for Trend Research (ITR), does not share this positive forecast for the commercial market. “Our commercial outlook is not aligned with this rosy picture,” Gee said, noting that he is concerned someone might skim the J.P. Morgan report and “think there’s going to be a broader commercial recovery sooner than we think.”
Beaulieu said, “The differences between J.P. Morgan and ITR are most likely found in employment expectations and the related vacancy rates. We believe employment levels will only slowly improve, and thus vacancy rates will be problematic for longer than J.P. Morgan does. Overall, they must be expecting a stronger general economic recovery than we are.”
Gee noted that HARDI solicited responses from its member distributor companies about the report, and no one reported feedback that correlated as positively with J.P. Morgan’s commercial forecast. When considering commercial vacancy and foreclosure rates, in addition to the tighter credit market, Gee said, it’s hard to see how commercial could turn around and make such positive gains so quickly.
“In light commercial, where more of our members play, you run into even more commercial finance issues,” he said. “Just like the contractors are seeing today, small businesses are not getting access to capital credit for expansion.
“Since our products are also disadvantaged in terms of tax depreciation, there’s just not a lot of incentive (outside of state or utility programs offering rebates) to do a whole system change-out in a commercial setting.”
Gee added, “It is possible, however, that J.P. Morgan is basing their commercial projections on growth of the larger, applied systems which is not a large part of most HARDI distributors’ businesses.”
POLICY OUTLOOKJ.P. Morgan also noted that the continuing trend by government to focus on increasing energy efficiency is “good for the industry,” and it sees “several regulatory drivers that serve to drive demand” for HVAC equipment.
This includes the switch to R410-A, which J.P. Morgan claims “should be a positive for mix (more full system sales) as should the new regional SEER regulations.”
HARDI cautioned, “It remains to be seen how homeowners will accept full system replacements that will now be required and what long-term impacts that could have on unitary sales.”
Gee added that the regional regulations have not been finalized or enacted yet, and there are many complex variables which could upset the positive outlook contained in the J.P. Morgan scenario. According to HARDI, “Increases in federal minimum efficiency standards in 2006 have proven to be a net negative in terms of unitary shipments, raising questions about JP Morgan’s rosy outlook if higher, regional standards are enacted. 2012 could see some furnace replacement pull through in advance of a new furnace standard(s) in 2013, but furnace sales could suffer after the new standards go into effect.
“Changes in cooling standards wouldn’t take place earlier than 2015, so there should be no effect on 2011-2013 a/c and heat pump sales.
“Further, HARDI has repeatedly expressed to the U.S. Department of Energy concerns over the long-term negative impact increased minimum standards could have on energy efficiency incentive programs, which have played a significant role at improving the mix of high-efficiency unitary sales. There are other factors at play regarding reasons for changes in minimum standards, but one of them should not be an expectation that such a change would boost unitary sales.”
As a final note of restraint, Gee added that the 25C tax credits are set to expire at the end of this year. HARDI stated, “The outlook does not appear to take into account the potential drop-off of equipment sales and margins which could occur if the $1,500 25C residential tax credits are not extended beyond 2010.”
Overall, Gee said, HARDI does forecast an industry recovery, but at a much slower pace. “We are in recovery, but it’s a modest one, not a record-breaking one,” he said. “We’ve had a very cautious optimism this year, and we’re easing off our expectations for 2011.” HARDI is promoting a three-year extension of the 25C tax credits and a reduction in the depreciation period for commercial HVAC systems as two essential measures needed to sustain growth in the HVAC industry.
J.P. Morgan publishes its report annually with the intent to provide a guide for investors. As a disclaimer, the firm disclosed that it does and seeks to do business with the companies covered in its research.