It's a Great Time of Year for Investors to Look at HVAC Companies

In this podcast, Motley Fool host Deidre Woollard and analyst Sanmeet Deo dive into the business of staying cool.

They discuss: 

• The major players and macro landscape for HVAC companies. 
• Carrier's transformation.
• Growth expectations for heating and cooling companies.
• One industry that is incredibly difficult to disrupt. 

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on August 19, 2023

Sanmeet Deo: I love these companies that are like the slow, steady growers that have a nice mid-single-digit sales growth with a double-digit profit growth. Those are the ones that, you're not relying on high sales growth to drive their business and their earnings.

Ricky Mulvey: I'm Ricky Mulvey and that's Motley Fool Senior Analyst Sanmeet Deo. Deidre Woollard caught up with him to look at the companies keeping us cool during a very hot summer. They discussed some of the less-considered tailwinds for HVAC businesses. How long-term investors can think about these companies and the challenges and benefits of investing in a family-run business.

Deidre Woollard: I'm really glad that you brought up this topic because it's important and it's also fascinating. A July was the hottest month ever recorded on Earth, according to the Worldometer Ecological Society. I was looking at some stats, about 90% of homes in the U.S. now use air conditioning, and two-thirds of that is either central air or a heat pump. As you might guess, the Northeast is where we see less of that activity. But I think I feel like that's changing. What are you seeing in the air conditioning business? Because it seems like it's something that is evolving so quickly.

Sanmeet Deo: Who knew like a boring industry like this could actually be pretty fascinating once you dig into it a little bit and it's something that all of us need heating, ventilation, cooling for our houses, for our cars, for other things. There's a lot of innovation going on in the industry as well. Just to take a step back, the HVAC industry in North America is very large, is about 45 billion in 2021. Generates about 150 billion annual revenue and employs over one-and-a-half million people in United States. It's expected to grow about 4% from 2023 through 2028 over the next five years. In each year in the U.S., over three million heating and air conditioner systems or replaced, and $14 billion is spend on HVAC services or HVAC repairs. Any of us that own a home know that once the AC unit breaks down, you're going to spend a lot of money to get it repaired. You're probably going to spend a lot of money just to get it maintained so that you're not suffocating in the heat that we've had as of late from what you've said in terms of the hottest time. But not only, is the HVAC industry doing these things, but the U.S. Department of Energy is investing heavily to improve energy efficiency standards. That's something that's also driving the industry getting more efficient in terms of heating, cooling because so much of the reason we're having such hot temperatures and climate change is because of heating and cooling, which consumes so much energy. Some of the major drivers in the industry are rising disposable incomes, increasing applications in smart homes, growing demands for heat pumps, which I didn't even know about heat pumps before I started looking into this more, I have a traditional AC unit and in my home. The way I looked at this industry is there's the manufacturer's, people, the companies that make the units, the products and services that help us keep the heating, ventilation, and cooling.

Then there's the distributors which are the ones that get those products and services to contractors and do-it-yourself-ers. In the manufacturing space, it's a pretty concentrated market, the top 10 manufacturers comprised about 85% of the total market. Some of the big names are Trane, Lennox, Carrier, Rheem, York, and then there's a bunch of others among those. Some of the challenges facing the industry are aging infrastructure, skilled labor shortage, and rising energy costs. The air conditioning market share by service. It comprises about 50% of residentials, 30% commercial, and 20% industrial as a percentage of total sales. Some of the interesting tech trends in HVAC, which you wouldn't think of innovation and technology in HVAC industry is indoor air quality. If you've lived in the Northeast and you've had to deal with some of those smoggy conditions from the wildfires coming from Canada or if you're on the West Coast where there's wildfire, smog constantly, it's not even a new thing unfortunately, indoor air quality is very important. Especially also having gone through the pandemic where we got very attuned to having clean quality air in our homes that filters out pollution and viruses and bacteria and things like that. The indoor air quality industry is worth about $9.8 billion now and is projected to grow to almost $12 billion in 2027. Then also smart thermostats, which like you have your Google Nest and you have your other products that help regulate your temperature on a more efficient way. I've actually noticed -- I moved from an apartment to a home. In the apartment, a lot of the heating and cooling was controlled by either a heating vent that we had in our apartment or a central system for the whole apartment building. But in our home, we have a smart thermostat. I've noticed that you can set it so that your energy is efficiently distributed throughout the day. If you're not in the home, you can have it lower or use less. Then the Google Nest is what I have does a pretty good job of that. That industry is worth about $1.2 billion, is projected to grow to almost 3.8 billion in 2029.

Deidre Woollard: I want to talk a little bit about Carrier because they're really interesting. You've got this older, recognizable name in air conditioning you mentioned it's one of the biggies. But they're making some changes as a company. They are owning their focus. They talked about this on their earnings call. A fair chunk of their business is refrigeration and fire safety, but they're getting out of that. They're getting out of both the commercial refrigeration and security businesses. Those are going on the market in September. Residential fire they're starting that a month after that. They're planning to exit those businesses. It sounds like there may be turning into more of a pure play. I know they've also done some acquisitions including Viessmann Climate Solutions, which is a heat pump company. Is Carrier shifting a little bit?

Sanmeet Deo: Yeah. Carrier is one a name of heard before it's I started digging into it as we discussed digging into this industry. It's about a 45 billion-dollar company. They're one of the big manufacturers of HVAC products, operate through the HVAC. They have three segments, HVAC, refrigeration, and fire and safety. Like you said, they're looking to divest the refrigeration fire security segments to become a more of a pure-play HVAC company, which also puts them more aligned with Trane, which is the market share leader in HVAC manufacturers. Trane actually ironically is about the same market cap of about $45 billion. They're trading almost in line. Carrier the stock has come up as of late, but they've grown their earnings at close to 20% on average over the past three years. They're transforming their business into more of a pure play. Their projections are far, this isn't a home run high-growth industry or a company, but their projections are for about 5% annual average sales growth after the acquisition and EPS growth over the next five years of about 10%. It's a good quality company. The acquisition of Viessmann Climate Solutions, I hope I said that right, is going to be about $13 billion in cash that they're paying for. Viessmann makes heat pumps, which is becoming a more popular trend in the HVAC industry, sales of heat pumps grew by 11% in 2022, 40% in Europe. Interesting stat in the United States, heat pumps have overtaken gas furnace sales in 2022. There's also financial incentives and subsidies that are driving heat pump growth because they are seen as a more energy-efficient way of heating and cooling. That's an area that they're growing and adding to their business with that acquisition. It's an interesting company. It's trading at fairly reasonable valuations, for the next year, it's about 20 times PE, 4% free-cash-flow yield. For next year, they're looking at growing the revenue at 10%. They have an EPS about 12%. Their margins are almost in line with Trane's. Carrier's at about 60 and 1/2%, Trane's at a little about 18%. They're very close. It'll be interesting to see how the acquisition pushes carrier forward and how it competes with train. But very interesting company for sure.

Deidre Woollard: The heat pump thing is interesting to me because I hadn't really thought about it. But Watsco too, which you mentioned is one of the distribution side. They talked about that a lot as a growth area for the company. Traditionally for them, smaller part of the business because they're so concentrated in the Sun Belt. But like you said, the move away from gas furnaces, it is carrier seeing it too so this ongoing electrification, that should be a positive thing for the heat pump part of the business, right?

Sanmeet Deo: Absolutely another thing that I was going to mention about carrier Global too, is not only in the US. I've been focused a little bit more on the US. But even in globally, you have like countries like India with a growing middle class. I was reading about how they're growing middle-class is expected to lift the number of ACs in that country to roughly 5.5 billion by mid-century, from about 2 billion today. India, China, and internationally are going be huge areas where they want to put in energy-efficient systems.

Deidre Woollard: Let's talk a little bit about Watsco. It's a Fool favorite because I know like Bill Mann and some of our other friends that come on the podcast just love this business. It's the tradition of this business gets me you've got this family business. The Chairman, Albert Nahmad, his son AJ's the president of the company. The elder Nahmad. He'd been the chairman and CEO since 1972. He runs his earnings call, like you're just hanging out with him somewhere. It's a very homey earnings call. I really loved it, but how do you think about this business as that older family business evolving into something else.

Sanmeet Deo: Family businesses are interesting. They can be tricky because sometimes it can be pretty positive given that you have the Founder and owners that have been there for a long time. This is their livelihood, this what they've created from scratch and they are very vested, not only financially but emotionally into the business and to see it thrive. You know that they have the best interests of the company at heart. But then sometimes in family businesses, families argue families Vicor, you could have disagreements within the family that could cause some other issues that the takeaway from the operations of the business that aren't business-related. They're more squabbling and other factors that have happened at other family businesses. It really depends on something that you have to keep an eye on for sure.

Deidre Woollard: With with Watsco, you mentioned earlier those distribution side of the business is the much more fragmented end of things. I noticed Watsco, they're tending to do a lot more of that. Of the gobbling up those smaller organizations. I'm wondering if this entered the business feels a little to me like self-storage in that you had these smaller companies that maybe we'll get gobbled up and we'll see more consolidation over time. Does that seem like where it's headed as an industry?

Sanmeet Deo: Yeah. Watsco is the market share leader in HVAC distribution. Ferguson is another company which we'll probably talk about later. They're No. 2, but it's very fragmented. There's Watsco itself has made about three small acquisitions in 2021 and now they control about 13% of the $50 billion market for distributed HVAC parts. It is a fragmented industry and you could see Watsco making more acquisitions to control more of the market.

Deidre Woollard: Absolutely. We've talked a little bit about, you mentioned in the beginning. We've got the commercial side which we experienced as office buildings and the lovely coolness of a mall, things like that. We've got the residential side, which is all of us trying not to crank our AC this summer. But there's also the other part that I find interesting as a growth area which is industrial and we tend to think of HVAC, just cooling spaces where we are. But the other thing that I've been thinking about for a while is the cold chain, which is the idea of keeping things cold. We saw it during the pandemic because the vaccines needed to be kept at a certain temperature. There was a lot of focus on the cold chain then. I'm invested in a couple of REITs that do cold storage, Americold and Prologis, but things have to be kept cold all along the journey. I know Trane, they've got Thermo King, that's their cold transport business. That's about 15% of their revenue. Carrier, they have Transicold. I feel like this is going to be a bigger part of the HVAC story going forward. What do you think?

Sanmeet Deo: Absolutely. As you have these bigger, faster, hotter technologies that need to be cooled, like computers and all the growing data centers that are powering the AI networks and technology companies that we're hearing about so much. All that technology causes a lot of heat and that heat needs to be cooled. It's definitely an area that would be a bigger part of their businesses.

Deidre Woollard: Because you've got two things. You've got the coal transport, which is like keeping food, medicines, things like that, cold as we go along. Then the other part of it, you just mentioned, the data centers. Data centers are more and more in the news lately because they take a lot of water because they have to be cooled a lot. And on the most recent earnings call Trane, they went really into this about the growth of data centers and AI, because like you said, AI chips that use more power, that means more heat. It's this big challenge for data centers, especially because data centers are sometimes like in the middle of nowhere in these small towns are dealing with this thing that comes in and uses a lot of water, which is a whole other issue. But I know train is working with their customers on some of those solutions. They're looking at this emerging cooling technology. It's something called LiquidStac, which sounded really cool. I'd had not been indented again, but how do we separate the data centers section of the business out from the rest of it because it seems like that's a really interesting area. But it also given what we know about the core industry, it's probably not a big part yet right?

Sanmeet Deo: It's always fun to hear about AI in almost every when we were talking about doing this segment and then we were talking about AI for HVAC like how do you link those two AI and HVAC? How does that even go? It's almost so easy just to throw AI in your conference calls or your business meetings and strategy and help get interest in your business. But I think the best way to separate the hype is just focus on the core businesses for these manufacturers and distributors and see that without these different new technologies, they are slower, steadier-growing businesses that will grow it like a single-digit clip in terms of revenue. They could grow a little higher in terms of operating profits and EPS as they shave off expenses and manage their businesses prudently. But keep in mind that the AI in these innovative things could be potentially additive to what they're doing and keep that as not a core part of your thesis, is how I would think about it.

Deidre Woollard: Yeah, you got to level set that because the AI stuff is exciting, but this is not the main thing they do. I mean, data centers and the industrial part are a big portion of it, but not fully the business driver. The full business driver still is just the business of keeping the humans cool.

Sanmeet Deo: Yeah. I would say that if AI in that area didn't even take off and didn't even become any part of their business, these companies will still survive and do well. So, it's not something that they're relying on to power their business. It might be an area that they're looking for more growth, but it's not an area that's going to keep their businesses steady and growing over a long-term clip.

Deidre Woollard: That makes sense. Well, we've been teasing that we're going to talk about Ferguson. I was looking at this one is the one that's maybe hardest for me to understand in terms of the business because their distributor, but it's also seems like they're doing supplies as well. It's got a $32 billion market cap. Nice to 2% dividend yield feels a little bit to me like one of my building material favorites, which is Fastenal, which is supplies, basically all of the little pieces of buildings. But, Ferguson, I think, has a more attractive price. What should we know about Ferguson?

Sanmeet Deo: So Ferguson, it's about a $32 billion market cap. It's the No. 2 HVAC distributed by market share in addition to heating, ventilation, and air conditioning, they do plumbing, which I liked the plumbing aspect in there because that adds another key important piece of the home maintenance, and repair, and construction business of home. So, their customers are contractors, maintenance professionals, and a little bit of do-it-yourself-ers. In 2022, they generated $29 billion in revenue and almost $3 billion in operating profit. This is one of those companies that over the past five years, grown sales a little over 6% have about 30% gross profit margins on average and have grown EPS around 17%. Now, I love these companies that are like the slow, steady growers that have a nice like mid-single digit sales growth with a double-digit profit growth. Those are the ones that you're not relying on high sales growth to drive their business and their earnings. Those are attractive businesses. They sold their European businesses in 2021 and now solely focused on North America. The other thing I've mentioned about Watsco, but similar to Ferguson. So Ferguson, gets 60% of their business from the repair, maintenance, and improvement areas of the business. So when you think of new construction and new housing, that also includes plumbing, heating, HVAC stuff, but then the repair, maintenance of all that stuff. That's a bigger portion of their business which is more recurring and same with Watsco. Watsco's business actually is about 85% of sales from repair and replacement parts. So, that's attractive because those are more steadier recurring revenue streams for these businesses. Then 10% are from municipalities, which is a little less tied to the economic cycle. Ferguson is actually and also reasonably valued. It's trading at about 17 times forward, 20-23 PE, about almost a 7% free cash flow yield, and is projected to grow revenues at about 3% next year and have strong margins. So it's an interesting business in it. Again, I do like the plumbing aspect in there. It encompasses a little bit more broad exposure. Very interesting name.

Deidre Woollard: I've always said that the plumbing is the one industry that hasn't been disrupted yet [laughs] because no one has figured out how to innovate it. I wish they would. But the other thing I think that you mentioned there, which is really important, is the repair aspect because one of the things I've noticed from the residential real estate side is the age of houses keeps increasing because we aren't building enough housing to keep up with supply. So we've got aging homes all across America and it's going to be a bigger and bigger problem that I think we're seeing. So I think that that is another long tail here, too.

Sanmeet Deo: These things like ever again, everyone that has houses knows plumbing, HVAC systems, have cycles. There's replacement cycles that they go on so the longer you're in thehouse, the older the house goes. Some of the plumbing needs work, some of the HVAC is upgrading or improvement, or maybe you do want to upgrade to some of the newer, more energy-efficient technologies that are out there, so you might be looking into doing those. Yes. It's businesses that are not going to cease to exist. That's for sure, although I would love to find out a little bit more about AI and plumbing if I could, that might be my next research project.

Deidre Woollard: Maybe that's the disruption we're looking for.

Sanmeet Deo: AI in Plumbing. 

Deidre Woollard: Yeah, absolutely. You mentioned the municipalities part too, which makes me wonder if given the infrastructure focus with U.S right now and the money going toward that, Is that also another thing with Ferguson that might really pay off for them long-term?

Sanmeet Deo: Yeah, I think so. It's nice to have a good diversity in the business where they're not just tied to businesses or consumers. They also have a little bit of something else in there to diversify the revenue and keep them a little bit more resilient.

Deidre Woollard: Yeah, absolutely. So we've talked about a bunch of different companies. It seems like they all do something different. We've got the distributors, we've got the makers. So if you're trying to invest in HVAC, we've seen it's a nice industry not going to be your massive grower, but you're going to get some decent returns here. How would you think about it? Is this basket approach? Is this a pick your favorite? What do you think?

Sanmeet Deo: I think a basket approach is a good approach here because we were talking that there's the manufacturers, distributors that are a little different. Their businesses are a little different, their financials will look a little different. But, it's one of those things where you can find the opportunity is when the companies are valued at a reasonable price, maybe their stocks get hit a little bit and you say, all right, I'm going to pick up a manufacturer and a distributor. Then these both, all of these companies are driving their businesses hard innovating. There's plenty of opportunity for all of them.

Ricky Mulvey: As always, people on the program may own stocks, mentioned in the Motley Fool may have formal recommendations for or against. So, don't buy or sell anything based solely on what you hear. I'm Ricky Mulvey. Thanks for listening. We'll be back tomorrow.