In a market that remains more focused on growth than value, strong HVAC names like Carrier (CARR) and Trane (TT) have continued to outperform, though another name I like in the space, Japan’s Daikin (OTCPK:DKILY), hasn’t done too badly either. Improved prospects for a COVID-19 vaccine haven’t dented the air quality angle to the HVAC story, nor have investors moved off of the green retrofit story.
While I like the long-term secular story behind HVAC and Trane, including increased global urbanization, increased focus on energy efficiency and building automation, and air quality, the valuations across the sector do still concern me, and the shares are within 10% of even the most bullish sell-side fair value targets. I continue to like this as a secular/trend call, but the valuation makes it harder to recommend at these levels.
Looking Back At Q3 Results
With all of the HVAC companies having reported, Trane’s third quarter earnings still stand out as pretty good. Carrier had a great quarter in U.S. resi, as did Johnson Controls (JCI), but I believe Trane kept pace with the sector overall and outperformed Lennox (LII) and Daikin. Trane managed to beat sell-side expectations by about 12% at the revenue line and 22% at the segment profit line, a strong performance, but not quite as strong as the 15% and 31% outperformances by Carrier.
Revenue was up less than 1% in organic terms, but still up after two quarters of organic contraction. Revenue from the Americas rose 2%, with residential up “high teens”, commercial flat (but services up), and transport down 20%. In Europe (the EMEA region), sales declined 6% on a mid-single-digit decline in commercial and a high-single-digit decline in transport. Revenue from Asia-Pacific declined 2% on a low single-digit decline in commercial HVAC.
Margin performance was strong, helped by mix and past cost efficiency moves. Gross margin improved 40bp, while segment operating income improved 5% with an 80bp improvement in margin. Overall operating income rose 6%, with margin up a similar 80bp. Asia-Pacific segment margins improved significantly (up over four points), while margins in the Americas improved 30bp.
Healthy Orders, With Green Retrofits, Air Quality, And Vaccines Offering Some Opportunities
I was impressed with the 7% overall organic order growth, and particularly the 30%-plus growth in Americas residential. While commercial orders were down, consistent with my view of a shrinking non-resi pipeline in 2021 and 2022, the low-single-digit decline was better than I’d expected. It seems that services are providing more of an uplift than I expected, but I also think core hardware demand is holding up better than I’d previously expected.
As far as drivers go, I think the growth potential in the residential construction market is pretty well understood by the market. The U.S. needs more housing, and interest rates continue to make home ownership attractive. While construction trends have long been volatile (and aren’t immune to risks like COVID-19 lockdowns and consumer confidence), I think this is a driver with some legs for at least another year.
On the non-resi side, I think the green building retrofit opportunity is likewise well-understood. HVAC systems consume more than 40% of the electrical needs of a commercial building, and even if a divided Congress limits federal funding for retrofit projects, the fact remains that tenants are increasingly demanding energy-efficient buildings (and this shows up in rents).
Demand from indoor air quality, though, is still a potential driver. While none of the publicly-reporting companies supports the Credit Suisse analyst John Walsh’s $35 billion addressable market estimate in indoor air quality, Carrier has estimated an opportunity close to $10B, while Johnson Controls has estimated a market opportunity measured in “multiple billions of dollars”.
For Trane’s part, management says it is fielding more and more inquiries, and this could be an offset to weaker new-build trends over the next few years. It looks as though air quality retrofits are going to be an important aspect to companies bringing workers back to the office, but there are complex challenges involved. Not only is cost a factor, but air quality retrofits can create new challenges in airflow and can increase electricity use by 15% to 40%, leading to additional retrofit opportunities for Trane, but also potentially creating near-term budget constraints.
The news of strong efficacy from pivotal vaccine trials is a positive in many respects. While I don’t believe it will negate the demand for improved indoor air quality (which was an under-appreciated issue even before the pandemic), it could also create some incremental demand for Trane’s Thermo King transport business. Several shipping companies (including FedEx (FDX) and UPS (UPS)) have said they’re fine where reefer truck capacity is concerned, but Trane should still have incremental opportunities in areas like air transport, last mile delivery, and cold storage. Investors interested in more of the supply chain cold storage issues may want to also look at Cryoport (CYRX).
I don’t know if the Street will stick with the green retrofit story into 2021 (eventually, these drivers become part of the base-case outlook), but I do think there are strong long-term drivers supporting above-average growth expectations for the HVAC sector. In addition to retrofits in Europe and the U.S., there are long-term trends of global urbanization, electrical efficiency/conservation/automation, and air quality that can continue to drive above-average growth.
Within that bullish sector outlook, I believe Trane can generate mid-single-digit long-term revenue growth (4% to 5%) that is around two points better than what I expect from the average industrial. I also see room for more margin and asset efficiency leverage, leading to modest improvement in FCF margins and high single-digit long-term FCF growth (annualized).
The “but” is that these above-average growth expectations, as well as relatively strong margins, ROIC, and so on, are already reflected in the share price.
The Bottom Line
Trane looks priced to deliver a mid-single-digit total annualized return that is on par with what I see from some of the best industrial names like Dover (DOV). While I don’t underestimate the power of a good secular story, nor the beneficial impact of low rates, it’s hard for me to see how/why Trane rerates substantially higher from here. Less valuation-conscious investors may still do well here, but this is a stock that I’m not going to chase at current valuations.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.