While the pickup in the housing market has become a widely accepted investment theme, Foolish investors might favor taking a look at investing in the commercial construction market. One area of interest is the heating, ventilation, and air conditioning, or HVAC, market. The pick of the sector is Lennox International (NYSE:LII), with A.O. Smith (NYSE:AOS) also deserving of an honorable mention.
Lennox and A.O. Smith look set to grow earnings
Why is commercial construction considered next year's hot sector? The key argument is that the commercial sector tends to follow the residential sector, so stocks exposed to the former are likely to produce more upside in 2014.
You can think of the commercial construction sector as experiencing a rough five to six years where it grew lower than GDP growth, but is now set to grow faster than GDP, as the economy recovers. Indeed, it certainly seems that way if you look at consensus earnings-per-share growth forecasts for Lennox and A.O. Smith. Both companies are forecast to have high compound annual growth rates, or CAGRs, over the next four years.
In the case of HVAC specialist Lennox, the market has clearly priced in a recovery due to its residential market exposure. However, it also has upside potential from a future recovery in commercial construction.
Lennox's management estimates that its 2013 revenue split will likely include residential HVAC contributing 49%, commercial HVAC 27%, and refrigeration 24%. Given the strengthening housing market, it's no surprise that 75% of the increase in overall segment profits came from the company's residential markets. Furthermore, Lennox generates around 85% of its business in North America, so it's very much a U.S. market play. Where it gets interesting is in the fact that Lennox's commercial operations tend to have a higher profit margin.
Essentially, if Lennox's commercial HVAC sales come in better than expected then there is an opportunity for a positive shift in the overall margin mix. Moreover, Lennox's management recently gave its 2014 forecast and outlined the key assumptions behind its 3%-7% revenue growth forecast. Management is estimating that North American residential units will be up "mid-single digits" from 10% in 2013. Meanwhile, its commercial units are forecast to rise in "low-single digits" from a paltry 2% in 2013. Frankly, Lennox's commercial forecast looks a little bit conservative, so you should see some additional upside.
Lennox's cash flow advantage
Lennox stands out for its cash flow generation. For example, A.O. Smith's management recently forecast $100 million in free cash flow, or FCF, for 2013, but this is not particularly impressive when compared to its enterprise value, (market cap plus debt minus cash) of around $4.6 billion.
In contrast, Lennox has converted 110% of net income into FCF over the last four years, and is forecasting 90% conversion in 2014. However, A.O. Smith has converted around 60% of adjusted net income into FCF over the last three years.
For illustrative purposes, lets assume Lennox converts 100% of income into FCF and A.O Smith converts 60%. Using these rates and analysts' EPS forecasts we get an idea of future FCF per share. For the sake of simplicity, assume that enterprise value is equivalent to current values.
Lennox looks to be fairly valued, but as discussed above, it offers upside potential if you are bullish on commercial construction. Meanwhile, A.O Smith doesn't look like as a good value, but it's likely to outperform if the sector picks up.
The bottom line
A.O. Smith and Lennox are not cheap stocks, but they both have good earnings leverage should the commercial construction market improve next year. Lennox is probably the choice pick, but don't be surprised if A.O. Smith starts increasing margins and cash-flow generation if its end markets pick up. HVAC is an indispensable part of a commercial construction project, and bulls on the sector should take a closer look at both stocks.
Lee Samaha owns shares of Lennox International. The Motley Fool owns shares of Pentair. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.