Global and US HVAC (Heating, Ventilation and Air Conditioning) Market Analysis & Opportunity to 2018

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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.

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.

Technology: VRF and inverter technology are factors, but legacy business models have proven resilient; IOT an increasing focus.

Ductless remains a key strategic theme, and we continue to think it should represent ~15% of the industry for both resi and commercial. However, growth rates appear to have cooled somewhat over the past year or two, more in the low DD range than 20%+, and while Asian partnerships are critical, the US remains solidly a ducted market. After VRF, the next wave of hype around the industry has been inverter technology, with almost all OEMs talking up capabilities at the premium end of the market, with some making noise around bringing this technology to more mainstream products. Similarly, the hype here is probably a bit ahead of reality, with inverters representing

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