Motley Fool Hidden Gems Investing - Stocks to Stay Cool

Episode Date: August 19, 2023

Air conditioners have had a busy summer. This July was the hottest recorded month since the year 1880.  Deidre Woollard and Motley Fool Senior Analyst Sanmeet Deo dive into the business of staying cool. They discuss:  - The major players and macro landscape for HVAC companies.  - Carrier’s transformation.     - Growth expectations for heating and cooling companies. - One industry that is incredibly difficult to disrupt.  Companies discussed: CARR, WSO, TT, LLI, FERG Host: Ricky Mulvey  Guests: Deidre Woolard, Sanmeet Deo Producer: Ricky Mulvey Engineer: Rick Engdahl Learn more about your ad choices. Visit megaphone.fm/adchoices

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Because we have your number. I love these companies that are like the slow city growers that have a nice mid single digit sales growth with a double digit profit growth. Those are the ones that, you know, you're not relying on high sales growth to drive their business and their earnings. I'm Ricky Mulvey, and that's Motley Fool senior analyst Sam Mitdeo. Deidre Willard caught up with him to look at the companies keeping us cool during a very hot summer. They discuss some of the less considered tailwinds for HVAC businesses, how long-term investors can think about these companies, and the challenges and benefits of investing in a family-run business. I'm really glad that you brought up this topic because it's important and it's also kind of fascinating. July was the hottest month ever recorded on Earth, according to the World Meteorological Society.

And I was looking at some stats, about 90% of homes in the U.S. now use air conditioning, and two-thirds of that is either central air or a heat pump. As you might guess, the Northeast is where we see less of that activity. But I think, I feel like that's changing. What are you seeing in the air conditioning business? Because it seems like it's something that is evolving so quickly. Yeah. Who knew a boring industry like this could actually be pretty fascinating once you dig into it a little bit? And it's something that all of us need, heating, ventilation, cooling for our houses, for our cars, for other things. And there's a lot of innovation going on in the industry as well. So just to take a step back, the HVAC industry in North America is very large. It's

about $45 billion in 2021. It generates about $150 billion in annual revenue and employs over 1.5 million people in the United States. It's expected to grow about 4% from 2023 through 2028 over the next five years. Each year in the U.S., over 3 million heating and air conditioner systems are replaced, and $14 billion is spent on HVAC services or HVAC repairs. Any of us that own a home know that once that AC unit breaks down, you're going to spend a lot of money to get it repaired. And you're probably going to spend a lot of money just to get it maintained so that you're not suffocating in the heat that we've had as of late from what you've said in terms of the hottest time. But not only is the HVAC industry doing these things, but the U.S.

Department of Energy is investing heavily to improve in energy efficiency standards. So that's something that's also driving the industry, getting more efficient in terms of heating, cooling, because so much of the reason we're having such hot temperatures and climate change is because of heating and cooling, which consumes so much energy. So some of the major drivers in industry are rising disposable incomes, increasing applications in smart homes, growing demands for heat pumps, which I didn't even know about heat pumps before I started looking into this more. I have a traditional AC unit in my home. So the way I kind of looked at this industry is there's the manufacturers and the companies that make the units, the products and services

that help us keep the heating, ventilation, and cooling. And then there's the distributors, which are the ones that get those products and services to contractors and do-it-yourselfers. So in the manufacturing space, it's a pretty concentrated market. The top 10 manufacturers comprise about 85% of the total market. Some of the big names are Trane, Lenox, Carrier, Rheem, York, and then there's a bunch of others amongst those. Some of the challenges facing the industry, or aging infrastructure, skilled labor shortage, and rising energy costs. And the air conditioning and heating market is shared by service. So it comprises about 50% of residentials, 30% commercial, and 20% industrial. This is as a percentage of total sales.

Some of the interesting tech trends in HVAC, which you wouldn't think of innovation and technology in the HVAC industry, is indoor air quality. If you've lived in the Northeast and you've had to deal with some of those smoggy conditions from the wildfires coming from Canada. Or if you're on the West Coast where there's wildfire smog constantly, it's not even a new thing, unfortunately. Indoor air quality is very important, especially also having gone through the pandemic where we got very attuned to having clean quality air in our homes that filters out pollution and viruses and bacteria and things like that. So the indoor air quality industry is worth about $9.8 billion now and is projected to grow to almost $12 billion in 2027. And then

also smart thermostats, which you have your Google Nest and you have your other products that help regulate your temperature on a more efficient way. I've actually noticed I moved from an apartment to a home and in the apartment a lot of the heating and cooling was was controlled by either a heating vent that we had in our in our in our apartment or like a central kind of system for the whole um apartment building but in our home we have a smart thermostat and i've noticed that you can set it so that you your energy is efficiently distributed throughout the day so if you're not in the home, you can have it kind of lower or use less. And the Google Nest is what I have. It does a pretty good job of that. So that industry is worth about $1.2 billion. It's

projected to grow to almost $3.8 billion in 2029. I want to talk a little bit about Carrier because they're really interesting. So you've got this older recognizable name in air conditioning. You mentioned it's one of the biggies, but they're making some changes as a company. They're honing their focus. They talked about this on their earnings call. So a fair chunk of their business is refrigeration and fire safety, but they're kind of getting out of that. They're getting out of both the commercial refrigeration and security businesses. Those are going on the market in September. Residential fire is going. They're starting that a month after that. So they're planning to exit those businesses. It sounds like there may be turning into more of a pure play. I know they've also done some acquisitions, including Wiesman Climate Solutions, which is a heat pump company. So is Carrier kind of shifting a little bit? Yeah, you know, Carrier is one name I've heard before.

I started digging into it as we discussed digging into this industry. It's about a $45 billion company. You know, they're one of the big manufacturers of HVAC products, operate through the HVACs. they have three segments, HVAC, refrigeration, and fire and safety. Like you said, they're looking to divest the refrigeration and fire security segments to become a more of a pure play HVAC company, which also puts them more aligned with Trane, which is the market share leader in HVAC manufacturers. Trane actually, ironically, is about at the same market cap of about 45 billion dollars so they're trading almost in line so carrier has has the stock has come up

as of as of late but you know they've grown their earnings at um close to 20 percent over the pat on average over the past three years um and they're they're transforming their business into more of a pure play and um their project their projections are for you know pretty this isn't you know a home run high growth industry or a company but their their projections are for about 5% annual average sales growth after the acquisition and EPS growth over the next five years of about 10%. So it's a good quality company. The acquisition of Viesman Climate Solutions, I hope I said that right, is going to be about $13 billion in cash that they're paying for. Viesman makes heat pumps, which is becoming a more popular trend in the HVAC industry. Sales

of heat pumps grew by 11% in 2022, 40% in Europe. And interesting stat in the United States, heat pumps have overtaken gas furnace sales in 2022. So there's also financial incentives and subsidies that are driving heat pump growth because they are seen as a more energy efficient way of heating and cooling. And so that's an area that they're growing and adding to their business with that acquisition. So it's an interesting company. It's trading at fairly reasonable valuations. For the next year, it's about 20 times PE, 4% free cash flow yield. For next year, they're looking at growing the revenue at 10%. They have an EPS of about 12%. Their margins are almost in line with Trains. Carrier's at about 16.5%. Trains at about 18%. So they're very close.

So it'll be interesting to see how the acquisition kind of pushes Carrier forward and how it competes with Train. But very interesting company for sure. The heat pump thing is interesting to me because I hadn't really thought about it. But Watsco too, which you mentioned is one of the distribution side, they talked about that a lot as a growth area for the company. Traditionally for them, smaller part of the business because they're so concentrated in the Sunbelt. But like you said, the move away from gas furnaces, it's carriers seeing it too. So this ongoing electrification, that should be a positive thing for the heat pump part of the business, right? Yeah, absolutely. And another thing that I was going to mention about

carrier global too is not only in the u.s and we're focused i've been focused a little bit more on the u.s but you know even in the the the globally you know you have like you know countries like india with the growing middle class i was reading about how you know with their growing middle class um is expected to lift the number of acs in that country to roughly five and a half billion by mid-century from about $2 billion today. So, you know, India, China, internationally are going to be huge areas where they want to put in energy-efficient systems. Let's talk a little bit about Wattsco. It's kind of a fool favorite because I know like Bill Mann and some of our other friends that come on the podcast just love this business.

And it's the tradition of this business kind of gets me. You've got this family business, the chairman, Albert Named. His son, AJ, is the president of the company. He's the elder Named. He's been the chairman and CEO since 1972. He runs his earnings call like you're just hanging out with him somewhere. It's a very homey earnings call. I really loved it. But how do you think about this business as that sort of older family business evolving into something else? Family businesses are interesting. They can be tricky because sometimes they can be pretty, pretty positive given that, you know, you have the founder and, um, and owners that have been there for a long time. You know, this is their livelihood. This is what they've created

from scratch. And they are very vested, um, not only financially, but emotionally into the business and to, to see it thrive, you know, that they have the best interests of the company at heart. Um, but then sometimes in family businesses, you know, families argue, families bicker, You could have disagreements within the family that could cause some other issues that take away from the operations of the business that aren't business-related. They're more squabbling and other factors that have happened at other family businesses. So it really depends on kind of something that you have to keep an eye on for sure. Yeah. And with Watsco, you mentioned earlier the sort of like distribution side of the business is the much more fragmented end of things. So I noticed Watsco, they're tending to do a lot more of that, of gobbling up those smaller organizations. organizations. I'm wondering if this end of the business feels a little to me like self-storage

in that you have these smaller, smaller companies that maybe will get gobbled up and we'll see more consolidation over time. Does that seem like where it's headed as an industry? Yeah. You know, Wattsco is the market share leader in HVAC distribution. And Ferguson is another company which we'll probably talk about later. They're number two. But it's very fragmented. There's, you know, Wattsco itself has made about three small acquisitions in 2021, and now they control about 13% of the $50 billion market for distributed HVAC parts. So, it is a distributed, it is a fragmented industry, and you could see Wattsco making more acquisitions to control more of the market. Yeah, absolutely. So we've talked a little bit about, you mentioned in the beginning, so we've got the commercial

side, which we sort of experience as office buildings and the lovely coolness of a mall, things like that. We've got the residential side, which is all of us trying not to crank our AC this summer. But there's also the other part that I find interesting as a growth area, which is industrial. And we tend to think of HVAC as just cooling the spaces where we are. But the other thing that I've been thinking about for a while is the cold chain, which is the idea of keeping things cold. We saw it during the pandemic because the vaccines needed to be kept at a certain temperature. And so there was a lot of focus on the cold chain then. I'm invested in

a couple of REITs that do cold storage, AmeriCold and Prologis. But things have to be kept cold kind of all along the journey. I know Trane, they've got Thermo King. That's their cold transport business. That's about 15% of their revenue. Carrier, they have transit cold. I feel like this is going to be a bigger part of the HVAC story going forward. What do you think? Yeah, absolutely. As you have these bigger, faster, hotter technologies that need to be cooled like computers and all the the growing data centers that are powering you know the ai networks and and technology companies that we're that we're uh hearing about so much all that technology causes a lot of heat and that heat needs to be cooled so it's definitely an area

that that would be um i think a bigger part of of their of their businesses yeah because you've got two things. You've got cold transport, which is like keeping food, medicines, things like that cold as we go along. And then the other part of it, you just mentioned the data centers. Data centers are more and more in the news lately because they take a lot of water because they have to be cooled a lot. And on the most recent earnings call, Train, they went really into this about the growth of data centers and AI because like you said, AI chips, they use more power, that means more heat. So it's this really, it's this big challenge for data centers, especially because data centers are also, they're sometimes like in the middle of nowhere and these small

towns are dealing with this thing that comes in and uses a lot of water, which is a whole other issue. But I know Trane is working with their customers on some of those solutions. They're looking at like this emerging cooling technology, something called LiquidStack, which sounded really cool. And how do we, no pun intended again, but how do we kind of separate the data center section of the business out from the rest of it? Because it seems like that's a really interesting area, but it also, given what we know about the core industry, it's probably not a big part yet, right? Yeah. It's always fun to hear about AI and almost everything. When we were talking about doing this segment

and then we were talking about doing, talking about AI for HVAC. Like, how do you link those two? You know, AI and HVAC. How does that even go? It's almost so easy just to throw AI in your conference calls or your business meetings and strategy

and kind of help get interest in your business. But I think the best way to separate the hype is just focus on the businesses, the core businesses for these manufacturers and distributors and see that they are without these different new technologies, they are slower, steadier growing businesses

that will grow at like a single digit clip in terms of revenue. And, you know, they could grow a little higher in terms of operating profits and EPS as they, you know, shave off expenses and kind of manage their businesses prudently. But keep in mind that the AI and these innovative things could be potentially additive to what they're doing and keep that as not a core part of your thesis is kind of how I would think about it. Yeah. Yeah. You got to level set that because the AI stuff is exciting, but this is not the main thing they do. I mean, data centers and the industrial part are a big portion of it, but not fully the business driver. The full business driver still is just the business of keeping the humans cool. Yeah. And I would say that if AI in

that, that area didn't even take off and didn't even become any part of their business, these companies will still survive and do well. So it's not, it's not something that, that, that they're relying on to, to power their business. It might be an area that they're looking for more growth, but it's not an area that's going to keep their businesses steady and growing over of a long-term clip. Yeah. Yeah. That makes sense. Well, we've kind of been teasing that we're going to talk about Ferguson. This one was, I was looking at this, this one is the sort of the one that's maybe hardest for me to understand in terms of the business because they're a distributor, but it also seems like they've got, they're doing supplies as well. It's got a $32 billion market

cap, a nice little 2% dividend yield. Feels a little bit to me like one of my building material favorites, which is Fastenal, which is a sort of, you know, supplies basically all of the little pieces of buildings. But Ferguson, I think, has a more attractive price. So what should we know about Ferguson? Yeah. So Ferguson, it's about a $32 billion market cap. It's the number two HVAC distributor by market share. In addition to heating, ventilation, and air conditioning, they do plumbing, which I kind of like the plumbing aspect in there because that adds another key important piece of the home maintenance and repair and construction business of the home. So their customers are contractors, maintenance professionals,

and a little bit of do-it-yourselfers. In 2022, they generated $29 billion in revenue and almost $3 billion in operating profit. And this is one of those companies that over the past five years, grown sales a little over 6%, have about 30% gross profit margins on average, and have grown EPS around 17%. Now, I love these companies that are like the slow, steady growers that have a nice mid-single-digit sales growth with a double-digit profit growth. Those are the ones that you know you're not relying on high sales growth to drive their business and their earnings. Those are attractive businesses. They sold their European businesses in 2021 and now solely focus on North America. The other thing I would mention about Watsco,

but similar to Ferguson. Ferguson gets 60% of their business from the repair, maintenance and improvement areas of the business. When you think of new construction and new housing, also includes plumbing, heating, HVAC stuff. But then the repair and maintenance of all that stuff, that's a bigger portion of their business, which is more recurring. And same with Watsco. Watsco's business actually is about 85% of sales from repair and replacement parts. So that's attractive because those are more steadier recurring revenue streams for these businesses. And then 10% are for municipalities, which is a little less tied to the economic cycle. So Ferguson is actually and also reasonably valued. It's trading at about 17 times forward 2023 PE, about almost a 7% free

cash flow yield, and is projected to grow revenues at about 3% next year and have strong margins. So it's an interesting business. And again, I do like the plumbing aspect in there. It kind of encompasses a little bit more broad exposure. Very interesting name. I've always said that plumbing is the one industry that hasn't been disrupted yet. No one has figured out how to innovate it. And gosh, I wish they would.

But the other thing I think that you mentioned there, which is really important, is the repair aspect because one of the things I've noticed from the residential real estate side is the age of houses keeps increasing because we aren't building enough housing to keep up with supplies. So we've got aging homes all across America, and it's going to be a bigger and bigger problem that I think we're seeing. So I think that that is another long tail here too. Yeah. And these things, again, everyone that has houses knows plumbing, HVAC systems have cycles. There's replacement cycles that go on. So the longer you're in a house, the older the house goes.

Some of the plumbing needs work. Some of the HVAC needs upgrading or improvement. Or maybe you do want to upgrade to some of the newer, more energy-efficient technologies that are out there. So you might be looking into doing those. So, yeah, it's businesses that are not going to cease to exist. That's for sure. Although I would love to find out a little bit more about AI and plumbing if I could. That might be my next research project.

Maybe that's the disruption we're looking for. AI and plumbing. AI and plumbing. Yeah, absolutely. You mentioned the municipalities part too, which makes me wonder if given the infrastructure focus with the US right now and the money going toward that, is that also another thing with Ferguson that might really pay off for them long-term? Yeah, I think so. It's nice to have a good diversity in the business where they're not just tied to businesses or consumers. They also

have a little bit of something else in there to kind of diversify their revenue and keep them a little bit more resilient. Yeah, yeah, absolutely. So we've talked about a bunch of different companies. It seems like they all do something different. We've got the distributors, we've got the makers. So if you're trying to invest in HVAC, we've seen it's a nice industry, not going to be your like massive grower, but you're going to get some decent returns here. How would you think about it? Is this basket approach? Is this a pick your favorite? What do you think? I think a basket approach is a good approach here because, you know, like we were talking about, there's the manufacturers, the distributors, so they're

a little different. Their businesses are a little different. Their financials will look a little different. But it's one of those things where you can find the opportunities when the companies are valued at a reasonable price. Maybe their stocks get hit a little bit and you say, all right, I'm going to pick up a manufacturer and a distributor. And then all of these companies are driving their businesses hard, innovating, and there's plenty of opportunity for all of them. As always, people on the program may own stocks mentioned, and The Motley Fool may have formal recommendations for or against, so don't buy or sell anything based solely on what you hear. I'm Ricky Mulvey, thanks for listening, we'll be back tomorrow.