As I go about my day to day life, I always try to notice products and services that are now and always will be in high demand. I want to be invested in the sectors and sub-sectors that have a long, stable growth runway. It occurred to me recently (after our thermostat kept acting up) that the HVACR or Heating, Ventilation, Air Conditioning and Refrigeration space is one that will always be in demand. People are always going to want to control their climate to keep it at comfortable levels. Currently, 87% of the 126 million households in the US have AC. That is a lot of demand, not to mention the fact that nearly all businesses have HVACR too. Who is going to patron a Starbucks that is sweltering hot in the summer and freezing cold in the winter? Furthermore, most heating and AC units have a lifespan of a decade or two, meaning that there will always be a need for replacement units and parts. The technology is also constantly improving and government regulations regarding efficiency standards for HVACR equipment is pretty tight, so people will need to update their HVACR systems over time. Given these conditions, figuring out the best company involved in the HVACR space could result in a rewarding investment. My intent today is to make that determination and (pending reasonable valuation) put my money where my mouth is. The contenders are AAON Inc. (AAON), Comfort Systems USA Inc. (FIX), Watsco (WSO), and Lennox International Inc. (LII). Now, there are tons of publicly traded companies involved in the HVACR space. I deliberately chose to focus on those businesses whose core is HVACR, instead of being involved in HVACR and sealants and aerospace and car seats, etc. In short, I avoided conglomerates. This is personal preference: I have a hard time understanding conglomerates, so to stay within my circle of competence, I wanted a business that is focused on HVACR so I can take advantage of the above mentioned economics without having to worry about a bunch of other things.
A vitally important thing is to determine how each company is doing financially. Not all metrics are created equal, so I focused on the ones that I believe are most critical. Following is a chart showing said metrics among the four companies:
|5-year revenue CAGR (%)||5.98||6.08||4.82||5.42|
|Gross Margin (current, 5-year avg.)||27.2, 29.8||20.3, 19.9||24.5, 24.4||29.3, 28.4|
|Operating Margin (current, 5-year avg.)||15.5, 18.7||5.7, 5.22||8.2, 8.1||12.8, 11.4|
|5-year FCF per share CAGR (%)||-11.27||34.85||10.07||29.86|
|SG&A as a % of revenue (current, 10-yr avg.)||11.52, 9.77||14.6, 14.46||16.48, 17.53||16.5, 18.17|
*compiled by author
1) AAON has run into margin trouble lately. Everyone else is slightly above their 5-year averages. It has been a perfect storm for them during Q1 2018, with many diverse factors affecting profitability. Raw material costs, one-time bonuses to employees, a larger than normal workforce, a newly launched product line, considerable CapEx for a new R&D facility, and lower margin projects all combined to whack margins. However, in spite of the big downturn in margins, they still stand above peers. Their quality products command a higher price, and it shows up in the financials. This provides a small moat.
2) I don't love companies (when compared to peers) that have a significant spread between their gross and operating margins. That signals to me a lot of expense being required that has little to do with the actual product. AAON has the smallest spread, meaning that operational costs to take the gross product to the customer is lower than peers. The spread is widest at FIX. Their operational level expenses are considerable.
3) FIX has had stunning FCF per share growth, on the back of great revenue growth. I am of the belief that at the end of the day, cash is king. Cash supports all the things that enrich shareholders, so this metric matters. But, it must be considered in context of capital expenditure requirements. Fix has no significant CapEx requirements as they provide a service, not a manufactured product and therefore, don't need as many facilities and equipment. So while they win in this regard and their business model has that advantage, there are good reasons for why that is. It is not necessarily a sign of bad performance at the other companies.
4) SG&A trends speak volumes in terms of efficiency. If a company can grow while reducing SG&A costs, they are double dipping in the best way as they earn more and spend less. LII and WSO have brought their SG&A expenses down healthily over a 10-year time frame.
One thing to keep in mind is that these four companies are involved in three different aspects of the HVACR industry. They are not, therefore, perfectly comparable, and financial performance determinations must be considered in context of which aspect the company is involved in and which aspect the investor believes has the best economics. The aspects are manufacturing of HVACR equipment (LII and AAON), distribution/sales (LII, WSO), and installation/service (LII, FIX).
AAON - By market cap, AAON is the smallest of the four at $1.6 Billion. They engineer, manufacture, and sell a wide spectrum of HVACR products to new construction and replacement markets for commercial and industrial buildings. They deliberately focus on niche markets, those customers "seeking products of better quality than offered, and/or options not offered, by standardized manufacturers." (10-K) In short, AAON is the high-end manufacturer, Maserati of the HVACR world, offering semi-custom and custom units. In order to offer higher quality, custom products, a considerable amount of money is spent on research and development at AAON, more so than the others, 13 million last year or 3.2% of revenue (LII 1.9%, FIX 0%, WSO 0%). They are expecting to complete a new 162,000 square foot R&D facility this year where they will study the acoustic effects of their units (how noisy they are) and how their products operate under adverse conditions (exposing them to simulated severe rain and snowfall, extreme temperatures, and high wind speeds). They have been doing this type of R&D for a long time, but the new facility will have a lot more capacity and therefore, they will be able to get new ideas and new technologies into production faster.
Of their own admission, AAON is the underdog in the space. They compete with much larger companies like Lennox International (who we will talk about later) as well as subsidiaries of huge conglomerates to include Trane at Ingersoll-Rand (NYSE:IR), York at Johnson Controls (NYSE:JCI), and Carrier from United Technologies Corporation (NYSE:UTX). By not having the cost advantages that come with scale and more generic manufacturing, contractors frequently go with their competitors since the initial cost of units is lower. However, AAON claims an advantage in terms of quality and long-term costs (efficiency). That, and they build custom units for unique scenarios that other, bigger companies don't mess with. Again, AAON is trying to fit a niche in the HVACR space. Their operations are primarily domestic, with only 4% of revenues coming from other countries (Canada).
One thing to keep in mind is that AAON could be devastated by acute adverse events happening at one of their plants. They only have two facilities, one in Texas and one in Tulsa, which is where the bulk of their business happens. Were a tornado or any other disaster to occur at either place, AAON would be debilitated. They are insured against such catastrophes, but it would still be a huge setback that would take years to recover from.
WSO - Watsco has a market cap of $6.88 Billion. From their 10-K:
We are the largest distributor of air conditioning, heating and refrigeration equipment and related parts and supplies in the HVACR distribution industry in North America. At December 31, 2017, we operate from 560 locations in 37 U.S. States, Canada, Mexico and Puerto Rico with additional market coverage on an export basis to portions of Latin America and the Caribbean, through which we serve approximately 90,000 active contractors and dealers that service the replacement and new construction markets.
Their retail locations are complemented by an e-commerce platform that boasts 650,000 product SKUs. The website grew transactions by 57% in 2017 and saw greater customer retention and more line items than what typically happens at brick and mortar locations. Their growth has been in large part due to acquisitions, 59 in the past 30 years. Their typical strategy is to buy a distributor and then use their scale to help acquire product at lower prices for those distributors through existing relationships with big manufacturers, thus improving margins. They also flood those distributors with a more diverse array of product, again due to their relationships with many brands, thus making the site more attractive to shop at.
Of note is WSO's relationship with Carrier, a manufacturer of HVAC equipment and parts. WSO has formed three joint ventures with Carrier, of which, WSO has a controlling interest in each at 80%, 80%, and 60%. These relationships accounted for 62% of revenue at WSO during 2017. Another 10% came from Rheem. In total, 84% of purchases in 2017 were done with 10 suppliers. As explained in the Risk Factors section of the 10-K, Carrier, Rheem, and others source a lot of their materials from Mexico. If NAFTA ends up going in the wrong direction and trade relations with Mexico become strained, product costs will rise for them which could harm WSO's business as they would have to raise prices too. Furthermore, if relationships become strained for any reason between WSO and Carrier, there could be some business disruption. To summarize and without expounding on a multitude of possibilities, WSO has considerable concentration risk. Given the vastness of their reach, they could simply tap other suppliers for more product, but the shift would have significant frictional costs.
LII - Lennox International is the biggest company with a market cap of $8.4 Billion. They stand apart from AAON in that their target market includes just about everyone and everything, residential and light commercial (with a small industrial refrigeration component in England). They are the most diversified of all the companies under study today, so if you are looking for an all-in-one investment, LII is it. They design, manufacture, and market a range of HVACR products at several different price points to appeal to different customers. They operate on a wholesale basis, have 230 "PartsPlus" storefronts where they sell replacement parts, provide installation, service, and preventative maintenance under the "Lennox National Account Services" name, and do business via direct sales and through distributors all over North America and a sliver in Europe. Their business mix consists of a 60/40 split between residential and commercial. A big positive for LII is that they have strong relationships with some very sturdy names in the commercial world:
*Investor Presentation, May 2018
The replacement market for these customers is considerable, as I imagine these companies will have very long lifespans, meaning a veritable eternity of business for LII as replacement parts and services are needed, along with any new units for new buildings. Overall, LII has a great balance of residential vs. commercials sales, has strong relationships with big businesses, is involved in each aspect of HVACR market, and has significant scale advantages.
FIX - Comfort Systems is pretty small at $1.7 Billion market cap. They are involved in the installation, routine maintenance, and repairing of HVACR systems, to include duct work. They "perform most of (their) services in industrial, healthcare, education, office, technology, retail, and government facilities":
The diversity of their revenue stream insulates them well from ebbs and flows in economic conditions that affect these different sectors differently. Furthermore, no single customer accounted for more than 2% of their 2017 revenue and their biggest customers routinely change from year to year. Their business mix last year was split about 40/60 between new construction and existing buildings that needed renovation, expansion, maintenance, repair, and replacement services. Given these factors, FIX seems well insulated from events that could severely disrupt their business. On average, their contracted projects take 6-9 months to complete and have a ticket of $504,000. Once contracted, they procure the systems to be installed (from the likes of AAON, WSO, or LII) and then do the work.
My preferred method of valuation is to use historic ratios to see where each company trades today. Five-year average P/E, P/S, P/FCF, and P/B ratios can all offer insight into whether shares trade at a premium or discount. While this method has some shortcomings by not taking into complete account rapid multiple expansion or contraction, no valuation method is perfect. This one makes the most sense to me though as it takes into account historic sentiment, which can be used as a proxy for the future, especially with companies that are involved in more mundane, established industries. With HVACR, there will be relatively mild swings in excitement. Nothing like the high-tech space where one year people can be giddy and the next it's all doom (Tesla (NASDAQ:TSLA), cough cough).
Because these ratios are all derived from different components of the financial statements, I wanted to find a way to synthesize them to get a single value per company and from there see how overvalued they are based on historic multiples. To do so, I simply calculated how many basis points spread there is between current and average values per ratio (a positive number representing bps above their average and negative numbers representing bps below), then average those 4 values. Lower values mean that the company is more affordable, as it represents less of a spread between where they are now and where they have traded over the past five years.
According to these results, AAON is cheapest and LII is most expensive. However, LII's book value has swung wildly in recent years, which skewed results considerably. Making accommodations for such, I assign them a value of 234. Therefore, AAON is the least overvalued and WSO is the most. None of them is a bargain. But all of them have had good results for a while, commanding a higher premium.
As has been said by many, great businesses don't always make great investments. In this section, we will observe how each company has historically used the strength of their business to reward their shareholders and use that information to make predictions about which will be able to do so best in the future. Companies can enrich their shareholders by paying down debt, making wise acquisitions, paying a dividend that grows over time, and buying back stock.
No rose without its thorns. While LII seems to knock out its competitors in nearly every criterion we have looked at so far, their debt ratios are much higher as well:
To be fair, LII had their interest expense covered 15 times last year with cash from operations (10X backing out cash from subsidiaries). No sweat there. However, their debt maturity schedule is kind of lumpy:
While they should be able to handle this load, if they were to have an uncharacteristically bad year for any reason that coincided with a year where principal repayments were heavy, there could be more cause for concern. A bad year plus lots of debt to repay could jeopardize dividends or stock buybacks. These matters are made worse when considered in the context of LII's pension plan. The pension is underfunded by $89 million, and a sharp drop in the capital markets that the plan is invested in would require an even greater obligation by the company. They made $325 in cash from operations last year. Having to pay almost all of that in debt will leave little left over for dividends or buybacks after meeting pension obligations.
In terms of other debt-like obligations or other burdensome matters among the other companies, AAON has no pension obligation, no debt, and no union employees. FIX has some debt, a small smattering of pension-like obligations, and a handful of union employees. WSO has a sliver of debt, a 401-K matching contribution plan, and no union employees. LII has 3,100 union employees. Between the pension, debt, and tons of union people to keep happy, LII looks less attractive.
AAON: In February of this year, AAON acquired all of the assets of WattMaster Controls, Inc. in an effort to "accelerate the development of our own electronic controllers for air distribution systems." (10-Q) This is the only acquisition on AAON's books. Considering the niche strategy, I don't think acquisitions are going to play a major role in AAON's operations in the future.
FIX: Growth via acquisition is the primary route FIX is taking:
We believe that we can increase our cash flow and operating income by continuing to opportunistically enter new markets or service lines through acquisition. We have dedicated a significant portion of our cash flow on an ongoing basis to seeking opportunities to acquire businesses that have strong assembled workforces, attractive market positions and capabilities and other attractive operational, management, growth and geographic characteristics.
They had one acquisition in 2017 and 2016 each, "BCH" in Tampa and an entity called "Shoffner" in Knoxville, TN. The box easily gets checked here, as part of their stated business ambitions and proved by recent activity.
WSO: WSO is always looking for acquisition opportunities. Since 1989, they have averaged two acquisitions a year. It is part of their philosophy:
We have built our network of locations using a 'buy and build' philosophy, which has produced substantial historical long-term growth in revenues and profits. The 'buy' component of the strategy has focused on acquiring or investing in market leaders to either expand into new geographic areas or gain additional market share in existing markets. We have employed a disciplined and conservative approach which seeks opportunities that fit well-defined financial and strategic criteria. The 'build' component of the strategy has focused on implementing a growth culture at acquired companies, by adding products and locations to better serve customers, investing in scalable technologies, and exchanging ideas and business concepts amongst the executive management teams. (10-K)
Of note also is their partial involvement in several companies, buying a fractional interest and then growing their share over time.
LII: According to Crunchbase.com, Lennox's most recent acquisition was in 2011, where they bought Kysor Warren refrigerator manufacturers. The year prior, they bought 'Service Experts', who sells, repairs, and installs HVAC equipment. While nothing recent, LII is not opposed or a stranger to acquiring companies. But it does not appear to be a primary part of their growth strategy. They are instead focusing on their growth markets, seeking margin improvement, and opening more "PartsPlus" stores.
Below is a chart that shows each company's current dividend yield, how that dividend has been growing, payout ratios for 2017, and most recent dividend increase:
|Div. CAGR 2008 2017:||12.51||5.44||11.34||14.93|
|2017 FCF payout ratio:||47%||13%||56%||31%|
*Numbers from Morningstar, compiled by author.
The winner here depends on your priorities. If current income is high on the list of needs, WSO has the highest yield. They have been growing their dividend healthily but with a payout ratio the highest of the bunch at 56%, that growth may mute looking forward. All things taken together, I feel that LII has the best dividend history and is best poised to reward shareholders looking forward. Their dividend has grown the fastest during the period under observation, they have a pretty low payout ratio and the most recent dividend increase was fantastic.
AAON: Since year-end 2013, AAON has retired about three million shares, a 5% reduction in shares outstanding. They also just authorized another $15 million in buybacks. As opposed to some companies who buy back stock every year regardless of where their stock price trades, it sounds like this was a more strategic move given the sharp retreat in AAON's price per share after reporting EPS well below estimates in Q1 in spite of record-breaking revenue (as a result of the bad margins mentioned). Gary D. Fields, President of the Board of Directors said in a press release:
We continually strive to create value for our stockholders and are pleased our current financial strength enables us to initiate the stock buyback program at this time. At current market prices, we believe the stock buyback program provides a compelling way to continue delivering value to our stockholders.
With shares trading ~$31, this would allow AAON to retire 483,870 shares or almost 1% of shares outstanding.
FIX: Recent stock buybacks don't amount to much, 263,097 million in 2017. Since 2007, they have retired 7.6 million shares. Under existing authorizations, 8.1 million shares can be repurchased. Considering the fact that the average price of repurchased shares is $13.75 and current trading is at ~$47, most of those share repurchases happened early on. According to Morningstar, shares have stayed flat at 38 million since 2013.
WSO: They sold $250 million worth of shares in 2017. They have a buyback authorization in place but have not used it in any of the past three full years. Under said authorization, they can buy back 1.1 million shares. (10-K)
LII: Since year-end 2013, LII has reduced shares outstanding by 9 million, a 17.5% reduction. They have authorized $500 million of stock repurchases in 2018, of which, they have $350 million leftover after Q1. At present trading prices, this will allow LII to retire 1.7 million shares or 4% of shares outstanding. Obviously, LII takes the cake in terms of stock buybacks, both historically and what they have allocated to repurchases looking forward.
LII is the objective winner here. The merits of buybacks for dividend-paying companies are two-fold: proportional ownership increase for each share of stock owned and a dividend will obviously not have to be paid on retired shares, freeing up money down the road for bigger dividend increases.
I think there are things to admire about all these companies and which to choose depends on investor preference. Personally, I think AAON is most attractive. Their recent plunge in share price is an overreaction to very temporary problems, and once margins get back on track, I think things will head up very quickly. While their niche business model and small size have a lot of risk attached to it when compared to the massive scale of WSO and LII, that niche focus could, in fact, turn into a moat over time. I think WSO is attractive in terms of business quality and consistency, but they are too overvalued for my taste. Their high payout ratio also goes against my dividend growth style. If their shares went down a bunch, I would be tempted. FIX and LII are probably tied for last. FIX is a pretty low margin business and they don't seem to be too focused on a dividend or buybacks, which are critical components of my investing style. I like their revenue and FCF growth but relying on capital appreciation alone isn't to my taste. With LII, they are knocking it out of the park in almost every way. They check almost all my boxes with great growth, great dividend growth, strong stock buybacks, and the like. If it weren't for their debt and pension issues, I would absolutely give them a #1. If they can take care of those issues (which I will be watching), I will be a buyer. I hope this analysis was useful to you. Please add any comments. Thank you and have a great day.
Disclosure: I am/we are long AAON. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.