HVACR: A Wall Street View

The next 12 to 18 months should prove even more interesting than the last in the residential HVACR market, with a variety of factors at play. This includes stable retail end-market demand at the consumer level that remains weak, but pretty close to the trough; the expiration of the 25C tax credit; the potential for a significant exploitation of a loophole in the new refrigerant law, which was supposed to be environmentally friendly; and lastly, raw materials-driven price increases, all of which will continue to drive volatility in monthly shipment data (from AHRI). Our starting point for next year is underpinned by the premise that there is some pent-up demand for an industry that remains stubbornly close to trough levels (2009) and that the economy is getting gradually better — meaning we should see some growth off of the bottom, which we peg at around 5 percent. How we get there, however, has many moving parts and, as always, depends somewhat on the weather, which, with all humility, is tough to call.

To understand where we are going in 2011, it's important to take a look back at 2010, which was influenced by several economic (unemployment, consumer spending and confidence trends) and nonfundamental (tax credit and R-22 changeover) factors, as well as hot weather. Relative to high expectations, 2010 was disappointing, as condensing unit shipments, which we estimate represent 70 percent of industry value, are probably going to end up only about 1-2 percent. With the installed base growing as it has for decades, this meant the condensing unit replacement rate actually went down from a record low level. However, sell through/retail sales, as measured by HARDI and corroborated by independent distributor Watsco, which includes parts and equipment sales, appear to have been up steadily throughout the summer, an important dynamic, which suggests there were machines breaking down and consumers were spending more money, albeit cautiously. In the end, we believe consumers continued to fix equipment (compressor/motor replacement) instead of replace their machines, a dynamic evidenced by the 10 percent increase in Emerson compressor sales. We believe that this was driven by sticker shock from the high cost of replacement, mostly due to the changeover to R-410A that dramatically raised the price of system replacement, an unwelcome development in a challenging consumer economy. (See Figures 1 and 2.)

To expand on this a bit, R-410A further changed the historical dynamic of fix-versus-replace that used to be a nondecision. This is an important dynamic to understand. Previously, in an all-R-22 world, a fix would cost around $1,800-2,000, lasting three years, while a replacement cost $1,800 to 2,500, lasting around 12 years, coming with an extended warranty. This made the decision to replace easy. The R-410A replacement, however, is $4,000 to 6,000 ~2.5x the old R-22 replacement, not necessarily all because of system cost, but because the entire system, including coil and air handler (AHU), has to be changed out, adding mostly labor cost. In the end, we think this drove some demand destruction for the equipment manufacturers, which we incorporate into our longer term market model. This could be a lingering issue in the years ahead, but certainly makes more of a difference as tough economic times linger.