If the market has had a bad case of the sniffles in recent weeks, housing stocks have caught the flu.
The iShares U.S. Home Construction exchange-traded fund (ITB) fell 12% in October, worse than the overall market. The year-to-date picture is equally grim, with the ETF down 26%, even as the S&P 500 (.SPX) is barely in the green.
Higher mortgage rates and raw-material costs are two big issues weighing on housing sentiment, and with the Federal Reserve likely to continue raising rates, investors can’t be blamed for avoiding the sector. Homes are bought on credit, so mortgage costs directly impact all housing related activity like replacing cabinets and floors.
In August, home prices had their smallest year-over year gain in 20 months, according to the S&P CoreLogic Case-Shiller 20-City index.
Yet the broad selloff has left a few stocks looking like bargains. The heating, ventilation, and air-conditioning group—HVAC for short—is a high-quality niche that can still deliver upside, despite recent housing concerns. Ingersoll-Rand (IR) and Lennox International (LII), in particular, look ready to rally.
Homeowners will soon need to replace their old units. HVAC units last 12 to 15 years, says Baird analyst Tim Wojs, which means that time is running out for systems installed from 2003 to 2006—the height of the housing boom. “We probably have a couple more years of strong replacement demand,” he says. About 80% of residential HVAC sales are for replacement units.
Higher costs are the other issue facing many industrial stocks, including housing. But here again, air-conditioning suppliers have it better because they have an easier time passing along raw-material costs. “You only buy one or two of these things [central-air systems] in your lifetime, so customers have been less sensitive to price increases,” explains KeyBanc Capital Markets analyst Jeffery Hammond.
HVAC isn’t just a residential story. HVAC also serves the commercial construction industry, and numbers there have remained strong. New nonresidential construction growth has averaged 8% over the past three months.
What’s more, the trend toward smarter homes makes HVAC systems well-positioned for innovation. Investors hear a lot about the Internet of Things, but monetizing connectivity has proven difficult. HVAC manufacturers are working on making systems smarter. Whether that translates into recurring revenue is another story, but at minimum, it should help the companies raise prices. “Remote-monitoring initiatives are table stakes for these players,” Wojs says.
In addition, activist investors have taken an interest in HVAC. Dan Loeb’s Third Point has acquired a $1 billion stake in United Technologies (UTX), which owns the Carrier brand, and wants to break the large industrial conglomerate into three stand-alone companies. That could lead to more industry consolidation. “The feeling is that there is another round of industry consolidation coming, not just in the U.S., but globally,” explains Baird’s Wojs.
Lennox could attract the most interest by an acquirer because of its size and its U.S. residential focus. Morgan Stanley suggested Friday a Lennox and Carrier deal would make sense. Lennox is an $8.6 billion midsize pure play on residential HVAC markets and has reported the strongest return on capital among the HVAC players, mainly through solid execution that has fostered consistent market-share gains. The company also has been a reliable buyer of its own stock, and its shares outstanding have fallen 11% over the past three years.
At 18 times 2019 estimates, the stock trades at a premium to the market, but consider that Lennox has increased earnings by 24% annually over the past five years and earnings growth in 2019 is expected to accelerate. On a stand-alone basis, the shares could hit $240, a nearly 15% gain, over the next 12 months, based on profit gains alone. We aren’t relying on M&A to drive return, but Lennox could sell for more than 16 times Ebitda (earnings before interest, taxes, depreciation, and amortization). A deal could push the stock north of $250.
Ingersoll-Rand, our other pick, is a $24 billion conglomerate providing HVAC and refrigeration solutions. (It also makes golf carts.) The stock has returned more than 17% annually since CEO Michael Lamach took over in 2010, about four percentage points better than the overall market. Ingersoll trades at 15 times 2019 estimates—in line with industrials overall, but the stability and growth provided by the HVAC replacement cycle are underappreciated.
Ingersoll could beat 2019 estimates and trade closer to 19 times earnings, as it did earlier this year. That implies about a 25% upside to the current share price. Ingersoll management also has shown a willingness to divest assets to generate value. Management spun off its lock business as Allegion (ALLE) in 2013.
Lennox and Ingersoll reported earnings in late October. Lennox cut its 2018 guidance because of tornado damage at a plant. The stock slid on that news, but recovered later to end flat, as insurance will cover the losses. Ingersoll raised its 2018 guidance and said that order trends indicate another strong year in 2019. Its HVAC bookings were up 12% in the third quarter.
After the year that U.S. housing has had, it may not be easy to jump back in. But HVAC stocks offer an attractive way to add exposure to a bruised sector.
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