Ratings For Investment-Grade HVAC Manufacturers Should Hold, Even If Demand Cools

Heating, ventilation, and air conditioning (HVAC) manufacturers that we rate have varying degrees of buffer to our downside thresholds to absorb potential operating underperformance. Overall, however, we expect they will maintain S&P Global Ratings-adjusted leverage within our downside thresholds over the next few years because of our forecast for industry EBITDA growth. We believe financial policy decisions will largely support leverage remaining at, or declining from, current levels (chart 1).

Chart 1

Carrier

Following Carrier Global Corp.'s announcement of its intention to acquire Viessmann Climate Solutions for about €12 billion (funded with about $8 billion of new debt) in April 2023, we revised our outlook to stable from positive, largely on leverage considerations. We forecast S&P Global Ratings-adjusted leverage, pro forma for a full year of Viessmann EBITDA and including expected incremental debt issuance, to increase to the high-3x area at year-end 2023, below our downside threshold of 4x. We expect the company will focus on deleveraging over the next 12-24 months, supported by EBITDA growth and the maturity or repayment of short-term and prepayable debt included in the financing plans for the Viessmann acquisition. We believe Carrier is committed to reducing leverage given it has publicly maintained its 2x net target. The company also announced it would pause share repurchases until leverage falls toward that target.

As a result, we forecast Carrier will reduce leverage toward the low- to mid-3x area in 2024, providing more buffer against our downgrade threshold. In addition, the company intends to exit its fire, security, and commercial refrigeration businesses. We acknowledge these moves could provide additional cash to repay debt faster than our current forecast. However, the timing and proceeds are uncertain, and we do not incorporate them in our base-case forecast. We could consider raising the ratings if Carrier successfully integrates Viessmann and maintains S&P Global Ratings-adjusted leverage under 3x, including potential acquisitions and shareholder returns. Additionally, before an upgrade, we want to ensure the company's financial policies are consistent with metrics in line with a higher rating.

Lennox

Despite volume softness in residential HVAC shipments in 2023, Lennox International Inc. has benefitted from pricing and product mix. We forecast S&P Global Ratings-adjusted EBITDA to expand in 2023 and that it will maintain S&P Global Ratings-adjusted leverage of about 2x, below our downside threshold of 3x. In addition, we believe its long-term leverage target of 1x-1.5x supports our view that S&P Global Ratings-adjusted leverage will remain well below our 3x downgrade threshold. We could consider higher ratings if we expect leverage to remain near 1.5x and S&P Global Ratings-adjusted funds from operations to debt sustained above 45%, which we do not anticipate over the next two years. We could also consider higher ratings if Lennox significantly expands its product portfolio, end-market geographic diversity, and revenue base while maintaining credit measures aligned with a rating one notch higher.

Johnson Controls

We forecast Johnson Controls Inc.'s (JCI) S&P Global Ratings-adjusted leverage will be in the high-2x to 3x area through 2024, which provides some cushion to our downside threshold of well above 3x and limited prospects for improvement. We could downgrade JCI if its operating performance materially weakens, it pursues greater-than-anticipated shareholder returns, pursues a leveraging acquisition and we do not see a path to deleverage to the 2x-3x range in the next two years, or we take a less favorable view of JCI's business position should it lose its leading market positions or materially reduce scale.

We view higher ratings as unlikely over the next 24 months given our forecast for adjusted leverage to remain at about 3x. Nonetheless, we could consider an upgrade if JCI maintains S&P Global Ratings-adjusted leverage of less than 2x and we believe it's aligned with management's financial policy.

Trane

Following our August 2023 upgrade of Trane Technologies PLC to 'BBB+' from 'BBB', we view the company's credit metrics as comfortably within our rating thresholds. Our upgrade was prompted by operating outperformance against our prior forecast as well as our expectation that the company will continue to follow a disciplined financial policy. Trane has more exposure to the North American commercial HVAC end market than peers, which has translated to strong operating performance. We forecast 2023 year-end S&P Global Ratings-adjusted debt to EBITDA of about 1.5x, below our downside trigger of well above 2x on a sustained basis. We view ratings upside as relatively limited by the company's product and geographic diversification, which remains more concentrated than Carrier, JCI, and other higher-rated issuers.

However, we will continue to monitor the company as it expands organically and through mergers and acquisitions (M&A). Before considering higher ratings, we would also want to ensure that adjusted leverage would remain comfortably below 1.5x on average through the business cycle and including debt-funded acquisitions.

Table 1

Identifying Key Risks To Our Base-Case Forecasts

We see general risks to our HVAC coverage in four key categories: cyclicality, regulation, technology, and liabilities.

Cyclicality

Adjusted credit measures should stay largely within ratings bounds under average peak-to-trough cyclicality of prior recessions. From 1952–2009, average recession peak-to-trough revenue declines for capital goods and building materials companies averaged approximately 8%, with associated EBITDA margin declines of roughly 10%-15%. Assuming an 8% revenue decline and a corresponding compression in EBITDA margin from our year-end 2023 base-case forecasts, JCI, Trane, and Lennox would maintain S&P Global Ratings-adjusted leverage below our downside ratings thresholds, albeit with limited cushion (chart 2). Carrier's S&P Global Ratings-adjusted leverage would likely increase above our 4x downside threshold in this scenario given our forecast for leverage in the high-3x area at year-end 2023 (pro forma for a full year of Viessmann EBITDA), though we expect the company will focus on deleveraging over the near term. We also do not include any proceeds from a potential exit from the fire, security, or commercial refrigeration businesses in our base-case forecast, which could accelerate the deleveraging process.

Our expectations for credit measures in a recession assume no changes to their financial policies, which would support maintaining S&P Global Ratings-adjusted credit metrics aligned with current ratings. We believe that in a recession the companies would look to pare shareholder returns and acquisition spending, to the extent possible, to mitigate impact to EBITDA from cyclicality. More generally, we believe the nondiscretionary nature of HVAC products, replacement-cycle-driven demand, and relatively stable aftermarket parts and service revenue all help to mitigate industry end-market volatility.

Chart 2

Regulation

The International Energy Agency (IEA) estimates that the operations of buildings account for 30% of global final energy consumption and 26% of global energy-related emissions. Given high energy consumption from HVAC products and related emissions, the sector has been in increasing focus as global governments implement new restrictions, requirements, and incentives for lower emission targets. Generally, we view regulation as a tailwind for HVAC manufacturers since many governments have incentives or subsidies for consumer purchases of higher-efficiency units, which tend to be more expensive. Several stimulus programs benefit the HVAC industry in the U.S., including the Inflation Reduction Act and numerous state and utility tax credits for homeowners and commercial buyers to make energy efficiency upgrades.

Even regulation not directly focused on climate goals can support top-line growth for HVAC manufacturers. For example, the Creating Helpful Incentives to Produce Semiconductors (CHIPS) and Science Act will boost construction of U.S. semiconductor and high-technology facilities, which will ultimately need to be fit with commercial HVAC systems. Elementary and Secondary School Emergency Relief (ESSER) funding, part of the Coronavirus Aid, Relief, and Economic Security Act and expanded through the American Rescue Plan Act, provides grants to state educational agencies to address the impact of COVID-19 and allows schools to use funds to upgrade HVAC systems and improve indoor air quality. The SEC is also proposing new climate disclosure requirements, which we believe would further give public companies incentives to invest in higher-efficiency HVAC systems.

Given our expectation for ongoing focus on energy efficiency and indoor air quality, we believe these trends will continue, placing execution risk on adapting to these changes on the manufacturers. We believe managing the changing global regulatory landscape also introduces challenges. One of the most important is meeting product requirements, which differ on a global basis. For example, in the U.S., the Department of Energy and Environmental Protection Agency (EPA) set energy-efficiency requirements that apply to all new residential central air conditioning and air source heat pump systems. In 2025, we expect new EPA regulations regarding refrigerants to take effect, requiring HVAC companies to transition to low-global warming potential (GWP) refrigerants. While we expect this will raise prices given increased product complexity due to the flammability of the new refrigerants, we also note inventory challenges could arise related to managing old versus new refrigerant products.

In Europe, in an effort to lower emissions and reduce reliance on Russian gas, several governments have banned the installation of gas or fossil fuel powered boilers, requiring a transition to clean hydrogen powered boilers, electric heat pumps, or district heating. In the U.S., certain states have enacted similar legislation, including California's 2030 ban on the sale of new gas furnaces and New York's ban on fossil fuel equipment in new buildings being phased in beginning in 2026. These changes encourage investment in research and development (R&D) or M&A budgets toward new technologies or product redesigns in order to stay competitive, ensuring that products meet efficiency requirements while providing value for the consumer. While we generally view regulation as a tailwind, we note that a reversal or wind-down of subsidy or incentive programs due to changes in global government regimes could affect demand for certain products and change customer purchase decisions.

Technology

We believe HVAC technology is increasingly in the spotlight given recent strong performance of the sector, regulatory requirements regarding energy efficiency and sustainability, and an expanding global installed base of heating and cooling systems. As a result, we believe the risk of technological disruption has increased. Beyond the largest global manufacturers, there are new startups receiving venture funding, and several of the manufacturers have venture investment arms of their own. We believe the risks to the manufacturers are greater in the residential market than light and applied commercial HVAC markets given the latter's more technical engineering requirements and stickier customer relationships. Nevertheless, given their large R&D budgets, scale, brand awareness, and M&A flexibility, we continue to view HVAC manufacturers as well positioned to manage a changing technological landscape. Any disruptive technology would likely be a transition over an extended period of time.

Heat pumps, while not a new technology, have garnered more attention in recent years since they are electric, generally more efficient than traditional gas boilers, and do not directly burn fossil fuels. The push toward electrification in Europe (and to an extent the U.S.) has significantly accelerated heat pump shipments in recent years. The IEA reports that heat pump sales rose about 11% globally and 40% in the EU in 2022, and estimated that annual sales in the EU could rise to 7 million by 2030 from about 2 million in 2021. While the IEA estimates that heat pumps only cover roughly 10% of global heating needs in buildings today, they are about 3x-5x more energy efficient than gas boilers.

In 2023, heat pump shipment growth in Europe has decelerated, which we believe is due to several factors: changing regulations, a lower gas/electricity price spread, and a generally softer macroeconomic environment. We anticipate further year-to-year fluctuations over time given regulatory uncertainty related to phasing out fossil fuel equipment, changing subsidies, and general macroeconomic conditions. Nevertheless, we believe the medium- to long-term growth trajectory for heat pump products remains solid because we believe the transition to electric products will continue given the EU's 2030 decarbonization targets.

In the U.S., heat pump penetration varies significantly by region due to their underperformance in extreme climates compared to gas systems. They have other limitations: higher purchase and installation cost, lower efficiency in extreme weather, and reliance on an increasingly strained electrical grid. However, we anticipate technology will continue to improve and support growth. Further, we expect global governments will continue to subsidize the higher cost to help achieve climate goals. The major HVAC manufacturers all have heat pump products, and we anticipate additional M&A to supplement their market positions.

Liabilities

HVAC manufacturers, like other large industrial companies, face environmental risks and related legal liabilities. Our adjusted debt balances include environmental liabilities reported on the balance sheet. We do not include in our adjusted credit measures any amounts beyond what is reported since the ultimate liabilities and potential payments are difficult to estimate. Environmental liabilities in the HVAC sector typically result from legacy operations that produced or used asbestos or polyfluoroalkyl substances (PFAS).

While we believe environmental risks and liabilities pose risks to credit profiles, potential payments may likely be over several years and limit the credit stress. At this point, we continue to believe these liabilities are manageable.

Service Revenue, Supported By Digital Offerings, Should Help Mitigate Cyclicality

We expect good demand trends for nonresidential HVAC channels and improving, although still soft, demand trends in residential channels. But we believe the industry remains vulnerable to cyclicality. Some demand is tied to residential and commercial real estate, which can be highly cyclical. We believe, however, that service revenue should remain stable over time and mitigate potential cyclicality in product demand (chart 3).

Demand for service is typically less affected by economic conditions given the implications of equipment downtime on health and safety factors, or critical applications that require cooling. Further, while the HVAC service market is highly fragmented, manufacturers benefit from their technical expertise, particularly for larger and more complex systems, and from digital offerings.

Digital offerings, supported by artificial intelligence and machine learning, can provide more efficient and proactive servicing of equipment. We believe connectivity will continue to support growth in aftermarket parts and service revenues, which typically carry a higher margin and create a more entrenched position with the customer than equipment sales. While such offerings are not new, manufacturers have placed more emphasis on ensuring most new equipment is digitally connected, particularly in commercial end markets, supporting longer-term servicing revenues. We believe digital connectivity has spurred organic aftermarket service revenue growth in the high-single-digit or low-double-digit percent area in recent years. We expect that digitization and related software platforms will remain an area of focus for R&D spending and bolt-on M&A.

Chart 3

Nonresidential Demand Heats Up While Residential Remains Cool

Revenue trends have diverged modestly for rated HVAC manufacturers this year, in part due to their respective exposures to residential and various nonresidential end markets. We forecast more subdued revenue trends through 2024 for companies more exposed to residential end markets and less to nonresidential commercial channels such as industrial, health care, government, education, data centers, high technology, and commercial buildings. Our 2023 forecasts reflect actual results through the September quarter (JCI's assumptions include actual results through June 2023), our assumption that pricing and product mix partially offset volume declines in residential channels, and that demand remains solid for nonresidential end markets. Our 2024 forecasts incorporate assumptions around the economic environment, housing starts, residential and nonresidential investments, and that residential demand will stabilize as destocking abates. We also assume that for some HVAC manufacturers, backlog conversion will support organic revenue growth at least into 2024.

Nonresidential HVAC markets have demonstrated solid demand over the past several quarters, leading to good growth in light-commercial and large applied systems revenue, and large backlogs for JCI, Carrier, and Trane. This provides good revenue visibility into 2024. We believe these trends will continue over the next several quarters since we anticipate building owners will continue to look toward decarbonization, electrification, and digital solutions to improve building efficiency, comply with changing regulations and reporting requirements, and reduce operating costs. The payback period for newer HVAC products and systems has been shortening as energy efficiency gains reduce operating costs, making these products more attractive to businesses and building managers. We also believe pent-up demand remains for nonresidential HVAC because of delayed project starts or completions the past few years due to supply chain constraints. Further, despite higher interest rates, we believe the nonresidential HVAC industry should benefit from investments tied to the CHIPS and Science act and Elementary and Secondary School Emergency Relief (ESSER) funding.

In contrast, demand for residential products has been on the decline this year in large part due to destocking among HVAC distributors, fewer housing starts and existing home sales, and slowing home remodels in the U.S. We attribute this to elevated interest rates and lower consumer spending. Many distributors have reduced inventory in the past few quarters after they built up inventory in 2021 and 2022 to accommodate good demand, extended manufacturer lead times, and product changes related to minimum efficiency standards. Through the first nine months of 2023, residential volumes were down in the low-double-digit percent area on average, and most major manufacturers expect them to be down at least in the mid-single digit area for the full year. The reduced revenue has been partially offset by price increases and a mix shift toward higher-priced higher-efficiency products.

We assume that over the next few quarters, distributor inventory will continue to reduce and product sales into distribution channels will begin to reflect more normalized seasonal patterns. Supply chains have largely stabilized. We believe a large installed base of generally nondiscretionary HVAC equipment in the U.S. will support demand, as a portion will need replacing each year. Nevertheless, we assume residential volume growth may be muted in 2024 since we believe home remodeling will remain subdued into 2024 as consumers continue to face high interest rates. Further, we believe there was a pull forward in home remodeling activity in 2021 into 2022 as people spent more time at home due to COVID-19 restrictions and likely benefited from stimulus distributions (chart 4).

Chart 4

Rated Manufacturers Differentiate In Scale And Scope

We view JCI's and Carrier's business profiles as modestly stronger than those of Trane and Lennox, largely from larger scale and geographic and product diversity. JCI, Carrier, and to a somewhat lesser extent Trane benefit from large, global revenue bases, which support the ability to spend on R&D and M&A. This is a key competitive advantage since customers seek more efficient and reliable systems, and because manufacturers must meet changing regulatory requirements.

Trane's last-12-months (as of September 2023) revenue base of about $17.3 billion is lower than JCI's $26.6 billion (as of June 2023) and Carrier's $22.1 billion. Its higher S&P Global Ratings-adjusted EBITDA margin of 18.9% compares favorably to JCI's 13.6% and Carrier's at about 15.7%. As a result, Trane's EBITDA base is comparable to Carrier's and modestly lower than JCI's. Lennox is decidedly smaller, with revenue of $4.9 billion concentrated in North America and residential HVAC. Similar to Trane, however, Lennox's S&P Global Ratings-adjusted EBITDA margin is in the high-teens percent area, 19.7%. We believe Trane's and Lennox's higher EBITDA margins come from product mix and more concentrated HVAC operations. Trane also benefits from more higher-margin service revenue. We also note that JCI's significantly larger employee base leads to more selling, general, and administrative costs, which affects EBITDA margins.

Nevertheless, while greater concentration in operations and service revenue supports, in part, higher EBITDA margin, we generally view revenue diversity favorably since it translates to a larger addressable customer base, and an offset to cyclicality particularly among residential and nonresidential channels. JCI and Carrier derive revenue from a more balanced mix of nonresidential, residential, refrigeration, and, in the case of JCI, fire and security revenue. While Carrier plans to exit its fire, security, and commercial refrigeration businesses, we forecast the company's revenue mix, pro forma for the completion of the Viessmann acquisition and the anticipated divestitures, will be about 45% nonresidential HVAC and about 40% residential HVAC, with the remainder from refrigeration. JCI has the greatest product diversity, with about 42% of its revenue from nonresidential HVAC, 13% from residential, 38% from fire and security, and 7% from refrigeration and other. This compares with Trane and Lennox who have revenue concentrations in HVAC end markets. Trane derives about 65% of its revenue from non-residential end markets, and Lennox derives 68% of its revenue from residential end markets.

JCI and Carrier also differentiate by their geographic diversity outside North America (chart 5). This can mitigate revenue volatility from potential adverse regional geopolitical or economic events. We note, however, that the North American market is a large addressable market with a stable operating environment.

Chart 5

Related Research

• Tear Sheet: Carrier Global Corp., Nov. 2, 2023
• Lennox International Inc. Assigned ‘A-2’ Short-Term Issuer Credit Rating; $500 Mil. Commercial Paper Program Rated ‘A-2’, Oct. 25, 2023
• Trane Technologies PLC Upgraded To ‘BBB+’ On Strong Credit Metrics And Disciplined Financial Policy; Outlook Stable, Aug. 18, 2023
• Johnson Controls International PLC Ratings Affirmed On Consistent Performance And Elevated Backlog, Outlook Stable, May 9, 2023
• Full Analysis: Lennox International Inc., May 1, 2023