HVACR’s 2010 fate may rest with stimulus
BY TALBOT H. GEE
Special to The Wholesaler
I wrote a piece for another publication last year urging HARDI members and their contractor customers to learn fast what it means to be part of a subsidized industry. Much like heavy equipment distributors whose success ebbs and flows annually with federal and state infrastructure spending, so too might that of HVACR businesses with public spending on energy efficiency incentives.
Let’s put aside the debate of how much the government may have contributed to the current economic downturn, and turn the focus to the impact the federal stimulus bill has had — and will continue to have — on the HVACR industry. The rate and amount of federal, state, local and utility spending on residential and commercial energy efficiency improvements, combined with our ability to quickly and efficiently take advantage of such funding, will most likely determine how successful 2010 will be for HVACR distributors and contractors.
First, let’s put any discussion of 2010 into proper perspective by taking a quick look at the recent past. A recent analysis of distributor performance in 2008 versus 2007 prepared by Al Bates at the Profit Planning Group comparing HARDI distributor data with that of other industry’s distributors showed less than 1% sales growth, which still vastly outperformed the average of other types of construction-related distributors. Gross margin performance followed the same pattern, however average HARDI expenses exceeded those of all other distributor categories pulling down return on investment. The 2009 Annual Profit Report (based on 2008 data) revealed a decline in average net profit margins for HARDI distributors for the first time in four years, providing more reason to believe 2009 would be a struggle.
In 2009 according to the HARDI Monthly Sales Trends collected and compiled by the Institute for Trends Research, no HARDI region experienced any month with positive sales growth — and the national average decline was 13% as of October’s data. The Northeast, Mid-Atlantic, Southeast and, most significantly, the West had declines in excess of the average as did the non-geographic segments of distributors with less than $5 million and $15 million to $25 million in annual sales volume. The Great Lakes, Central, Southwest and Canadian regions and distributors with average sales of $5 million to $10 million, $10 million to $15 million, $25 million to $50 million, and $50 million and above all outperformed the HARDI average — although continued to report negative sales growth. It is important to note that 2009’s negative numbers included a robust federal tax credit for residential HVAC equipment upgrades, coupled with unprecedented state and utility efficiency funding across the nation. This might suggest that 2009 could have been far worse, but more likely indicates that government and utility incentive funding has limitations to its market-driving potential.
Perhaps the most relevant question for 2010 is whether 2009 has signaled a bottoming out in which there’s nowhere to go but up. The federal tax credits will remain in effect through 2010, providing a full year with complete product lines of qualifying equipment, a better-educated contractor community and public about those credits, and 2010 utility efficiency funding that is certain to dwarf any previous year. ITR’s most recent quarterly HARDI Targeted and Regional Economic News for Distributor Strategies (TRENDS) forecast released in September included a conservative, but generally optimistic, forecast for 2010. “The rising trends of M1 and M2 [measures of money supply] make us optimistic about credit flows going into 2010 and about the probability of a 2010 rising trend in retail sales. It is true that the money supply trends will likely lead to a new inflation trend in 2011, but a trade-off is being made between liquidity today and inflation tomorrow.” Strangled credit markets are widely regarded as the key factor in 2009’s declines, so any improvement in the 2010 credit market will surely deliver some growth. ITR’s forecast concludes with “Fortunately, there are positive signals coming from the leading indicators. The U.S. Leading Indicator, the Purchasing Managers Index, corporate bond prices, the M2 money supply, and the stock prices 1/12 (S&P 500) confirm our outlook that the economy is exiting the grips of the recession in the final quarter of 2009. A general, albeit mild, recovery is projected for 2010. 2011 looks even better.”
HARDI developed a partnership in 2009 with JP Morgan’s Electrical Equipment & Multi-Industry Equity Research in an effort to increase the value of analyses of the HVACR industry. In their HVAC 2009 Review and Outlook Annual Report, JP Morgan analyst Steve Tusa believes that after an unprecedented four down years, the stage is set for a multi-year period of growth in residential HVAC starting in 2010. The key, he cites, is pent up demand from some ~7 mm older systems that have either been fixed over recent years or sitting idle, as consumers opt for cheaper alternatives to replacing broken units, which had become the norm over the past several decades. For 2010, they see growth, driven by a combination of growth in housing off of a low base, with the more important lever the degree of recovery in consumer sentiment, which is a key to rates of replacement of the aged installed base; a bigger factor at 90% of market volumes. Add it all up, and JP Morgan forecasts market growth of 15% in 2010, with a worst case of 5%.
ITR’s Alan Beaulieu, who serves as HARDI’s chief economist, shares JP Morgan’s generally positive outlook. He cited a Federal Housing Finance Agency report of a 0.2% higher Q3 Housing Price Index compared to Q2 and an improving National Association of Realtors house affordability index. But he also had a clear message of caution: “Having just said that, let’s not get too excited. The banking industry is still reeling, unemployment is high and consumer cash will not be flowing into the housing industry at anything close to the boom levels of 2006 and 2007. Plan on stabilization through the near term followed by mild rise later in 2010.” Beaulieu concluded, “Undoubtedly, low interest rates and tax credits have been a boon to the real estate businesses in an otherwise dour market but be prepared for additional setbacks in the recovery, resulting in a flat 2010 with the potential for fairly mild upside activity later in the year.”
Significant headwinds are restraining a robust recovery in 2010. The American Institute of Architects projects a 16% decline in nonresidential construction in 2009, and an additional drop of almost 12% in 2010. Masonry Construction agrees and projects a 17% decline in 2010 in excess of 2009’s 14% fall. Commodity prices have widely fluctuated, wreaking havoc on distributor inventory values, and have suffered from the sluggish new construction market. John Packard, publisher of the Steel Market Update, a HARDI Service Vendor Member, said, “For those involved in the galvanized sheet and coil business, besides having to deal with a sluggish residential construction market, 2008 and 2009 both were years when steel prices rose rapidly, fell dramatically and, as we enter the first quarter 2010, the domestic mills are pushing steel prices higher again.
“2010 will very likely be another year of turmoil. Steel Market Update expects prices to rise – and the rise could be much higher and faster than many anticipate – during the first quarter of 2010. The reasons for the increase will be the price of steel inputs – scrap in particular – and for those buying galvanized, the price of zinc has essentially doubled in price since the beginning of January 2009 when it traded around $.50 per pound compared to the $1.00 per pound we find it at today. The domestic steel mills have already announced new coating extras on galvanized steel to go into effect during the early days of the first quarter 2010. Many of the mills have also announced price increase on the base metal. Combined, light gauge galvanized used for ductwork could increase by $85 per ton ($4.25/cwt) on 26 gauge G90 galvanized or around 9% from the December mill selling prices.”
Robust incentives for public and private building efficiency improvements have the potential to help the industry overcome these significant barriers. The previously mentioned homebuyer tax credits and residential efficiency tax credits, coupled with current and proposed additional commercial tax credits provide no lack of federal measures intended to offset the significant cost of HVACR upgrades. As published by the Consortium for Energy Efficiency, utility budgets for U.S. and Canadian energy efficiency programs increased from $3.7 billion in 2007 to $4.5 billion in 2008, and 2009 exceeded $6 billion — $5.3 billion in the U.S. alone. Given those incredible positive rates of change, 2010 efficiency funding could be literally off the charts.
Coupling these incentives for geothermal and high-efficiency HVAC systems (and increasingly for refrigeration systems) with JP Morgan’s projection that several years of increased repair rates is creating a demand bubble soon to pop, would indicate that there are significant margin opportunities for unitary equipment distributors in 2010. While this could signal a decline for the parts and supplies wholesalers that have fared best during this period of higher repair rates. Even a modest increase in residential construction should maintain some demand for ancillary products, including ductwork and other air-handling products.
As I complete this article, the U.S. Environmental Protection Agency finally finalized the two rules for the 2010-2014 step in the phaseout of HCFCs, primarily R-22, reducing domestic supplies by 75%. HARDI’s initial analysis of the HCFC Allocation Rule and the Ban on Pre-Charged Appliances Rule indicates as favorable an outcome as could have been expected, thanks largely to a year’s worth of close work with the EPA to amend and clarify the two rules proposed in late 2008 that were wrought with significant problems for HARDI distributors. The final rules make clear that replacement components such as condensing units, compressors, line sets, etc., can continue to be sold beyond January 1, 2010, and used for the repair and servicing of existing R-22 HVAC and refrigeration systems. However, the installation of new R-22 systems in new construction or system expansions will be prohibited.
This would indicate another incentive for legacy system replacements since R-22 prices figure to increase as supplies tighten; however 2009 still saw some equipment lines in which R-410A equipment was more expensive than the R-22 equipment. This will hopefully be a limited phenomenon intended to deplete factory inventories since manufacturers will no longer be able to produce R-22 pre-charged equipment after January 1, 2010. Distributors that are most successful growing a motivated contractor base that is supportive of R-410A equipment will certainly be at a competitive advantage this coming cooling season.
2010’s refrigerant transition affects the commercial refrigeration market as well. Manufacturers can still produce and sell refrigeration condensing units with nitrogen holding charges after January 1, 2010 for servicing purposes, but concerns over the long-term availability of affordable R-22 could help contractors encourage system replacements using alternative refrigerants. Energy efficiency interest and leak reduction mandates and strategies are providing incentives for distributed systems and upgrades to more efficient and tighter components.
In all, just about every indicator points to at least a flat 2010 for the HVACR industry with opportunities for modest growth. This is especially true for the residential markets; however commercial business seems sure to struggle for most of the year. Of course, improvements in the credit markets could save the 2010 commercial market, but access to credit isn’t guaranteed to equal an increase in consumer or commercial demand. Much like last year, the only consistent construction growth is seen in the government and institutional projects that now most often demand some level of high-performance/sustainability/green expertise. Debates are underway on a potential second stimulus and/or a massive jobs bill, both of which would include significant infrastructure and energy efficiency spending. As always in wholesaling, buy low and sell high, but in 2010 be especially careful with your commodity items and be prepared to provide far more technical, sales, incentive administration, and incentive education support than you ever have before.
Talbott H. Gee is vice president of the Heating, Airconditioning and Refrigeration Distributors International (HARDI). Call 888/253-2128 or visit www.hardinet.org to learn more.