Motley Fool
0
All posts from Motley Fool
Motley Fool in Motley Fool,

What's Going Wrong With the HVAC Sector?

Following a strong rise in the past year, Ingersoll-Rand PLC's (NYSE: IR) stock has corrected in recent weeks alongside competitors in the heating, ventilation, and air conditioning (HVAC) space such as United Technologies Corporation (NYSE: UTX) and Lennox International Inc. (NYSE: LII). Clearly, something about the HVAC sector has spooked the market, so let's take a look at the underlying dynamics in all three companies' earnings, and specifically Ingersoll-Rand as an investment proposition. Is it a structural problem that's set to last or merely a temporary issue?

IR data by YCharts

Sales are rising, but so are costs

It's no secret that the global HVAC market has been strong in 2017 -- particularly U.S. residential and China commercial and residential -- and all three have reported strong sales and bookings growth. Moreover, Ingersoll-Rand and Lennox International, both primarily HVAC companies, raised their full-year revenue and earnings expectations in their recent second-quarter earnings presentations. United Technologies' climate, controls, and security (CCS) segment also reported a strong quarter. 

A quick summary of the key highlights from each company's HVAC-focused earnings shows strengthening year-over-year end-market conditions.

Company

Key Metric

Q4 2016

Q1 2017

Q2 2017

Ingersoll-Rand PLC

Climate segment full-year sales guidance

4%

4%

5.50%

United Technologies Corporation

CCS segment organic equipment orders

2%

7%

11%

Lennox International

Full-year revenue guidance

3%-7%

3%-7%

4%-7%

Data source: Company presentations. All data pertains to growth.

In a nutshell, the U.S. residential market remains strong, and stronger-than-expected GDP growth in China in the first half of 2017 has helped results in the HVAC sector. For example, residential HVAC organic sales for United Technologies North America were up 11% in the second-quarter, while Ingersoll-Rand's residential revenue and organic bookings growth were both up in the high teens in the second-quarter, with CEO Mike Lamach claiming on the earnings call that the "North American and China Commercial HVAC and our North American Residential HVAC markets exceeded our initial expectations." Meanwhile, Lennox International's second-quarter residential revenue was up 14% in the second quarter.

So if revenues are strong and the sales outlook is strengthening -- leading all three companies to raise their full-year adjusted EPS guidance in their results -- why did the HVAC sector, and Ingersoll-Rand in particular, sell off after their earnings reports?

Image source: Getty Images

Sales rising, but so are costs

The defining characteristic of the earnings season in the industrial sector was the impact of rising costs on margins. A slew of industrial companies reported rising costs on materials, such as steel and copper, which negatively affected earnings growth. From industrial-supply companies to 3M Company to our three companies under discussion, it's been an issue.

United Technologies' management gave a bunch of reasons its CCS segment's adjusted operating margin declined in the second quarter. Meanwhile, Lennox International now expects "commodity headwinds of $20 million in 2017, up from our prior guidance of $10 million," according to CFO Joe Reitmeier on the earnings call.

Turning attention to Ingersoll-Rand, it's notable that the operating-margin guidance ranges for the climate segment and total company were left unchanged at 14.6%-15.1% and 12.4%-12.8%, despite the rise in revenue growth expectations. In fact, total company full-year reported revenue growth guidance was increased from 2% to 4.5%.

Image source: Ingersoll-Rand PLC

That margin guidance was left unchanged is somewhat disappointing, for two reasons:

  • It's reasonable to expect companies to expand margin as sales rise, particularly industrial companies that have a fixed cost base.
  • Expanding HVAC margin to the levels of peers such as Lennox and United Technologies is a key growth opportunity for Ingersoll-Rand. 

Although total company adjusted operating margin increased 40 basis points (where 100 basis points is 1%) from 14% in last year's second quarter to 14.4%, it was due to a 250-basis-point rise in the much smaller industrial segment. Climate segment adjusted operating margin fell 10 basis points to 16.8%. We can hope that's not part of an ongoing trend.

Moreover, for the second quarter in a row, "price/material inflation" shaved 50 basis points of total adjusted operating margin. The company is "planning around the assumption that price realization will be below our prior forecast in the second half," Lamach said on the earnings call. "We believe it's prudent to plan for a negative price/material cost spread similar to what we saw in the first half of the year."

Time to sell?

For all the problems we're seeing, it's not time to sell yet. First, the increased volume in the quarter was partly responsible for the climate margin decline, as Ingersoll-Rand bought a higher percentage of commodities at current prices than normal. Second, the negative impact of price and material discussed in the guidance is already built into the full-year adjusted EPS guidance of $4.50, itself an increase on prior guidance for $4.34 to $4.50. Third, if the economic strength that caused higher raw-material pricing continues, then it's reasonable to expect Ingersoll-Rand, Lennox, and United Technologies to gain more pricing power in the future.

All told, the raw-material cost rise is definitely a net negative, but it's too early to tell whether it's going to have any impact on Ingersoll-Rand's overall earnings growth or its ambitions for long-term climate margin expansion.

10 stocks we like better than Ingersoll-Rand
When investing geniuses David and Tom Gardner have a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has tripled the market.*

David and Tom just revealed what they believe are the 10 best stocks for investors to buy right now... and Ingersoll-Rand wasn't one of them! That's right -- they think these 10 stocks are even better buys.

Click here to learn about these picks!

*Stock Advisor returns as of August 1, 2017

Lee Samaha owns shares of United Technologies. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.