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Analysts see foreclosures, price volatility and tight money stalling HVAC’s return to health until 2012


With construction industries still challenged by tight credit markets and weak demand, a more-stable, climate-controlled atmosphere doesn't appear to be in the immediate cards for the heating, ventilation and air conditioning (HVAC) sector.

HVAC is inextricably tied to construction, providing the ductwork necessary in any new building. And even if residential projects pick up this year, the commercial side of the business is still seeking bottom.

Slow sales, high inventory levels and a weak pricing environment are still plaguing residential construction, according to the Portland Cement Association (PCA), a Skokie, Ill.-based construction trade group. "Despite recent data suggesting increased sales activity, foreclosure improvement and inventory reduction, the environment for a sustained improvement in single-family housing starts may not be as positive as it seems," PCA chief economist Ed Sullivan said. "Homebuilders are unlikely to accelerate construction activity until two critical conditions are met low inventory levels of unsold new homes and stable or rising home prices."

Residential construction continues to be sidelined partially by volatility in housing prices and foreclosures still making their way to the market. "Homebuilders have no guarantee of an adequate return on investment," he said, "and there is little to suggest that this will change in the near future."

Not only are foreclosures prevalent, their pace could accelerate this year. Sullivan expects a "tepid" increase in residential construction to materialize in the second half of 2010, but slow job growth and tight lending standards could hinder sales. "More substantive gains (are) expected in 2011 and beyond," he said.

"The residential construction market is probably going to be flat as opposed to last year as new housing starts has kind of hit a bottom," John Packard, publisher of Steel Market Update, said. "Commercial construction, particularly areas that do not use government funds, is very weak this year—2010 is worse than 2009 in the commercial sector. The only part of the construction industry that may be doing well is hospitals, schools and public projects, where funding is available."

Packard, who spent nearly three decades selling galvanized coil earmarked for HVAC use, said residential construction "should slowly start to come back in 2011 and commercial construction will bottom out—fingers crossed—this year and start to recover in 2012." But the improvements will be slow, and he doesn't see a return to the 2006-07 boom levels for quite some time.

As a result, he believes that galvanized steel buyers will continue to exhibit cautious buying patterns. "Everybody is being more conservative and only buying what they need."

A number of nonautomotive galvanizing mills are heavily tied to the HVAC market, including Steel Dynamics Inc. subsidiary The Techs in Pittsburgh; Sharon Coating LLC, Sharon, Pa.; CSN LLC, Terre Haute, Ind.; and Severstal Sparrows Point, Baltimore, Md.

UBS Investment Research analyst Timna Tanners agrees that nonresidential construction is still seeking its bottom and won't recover until 2012. "Nonresidential construction demand may not have seen the worst of the downturn. We see a less-severe retreat than witnessed in residential construction, where oversupply was more problematic, but we think it is pretty clear nonresidential construction spending will not return to recent peaks until at least 2015," she said.

"Macro data and company commentary show lack of credit as a leading reason construction demand will be slow to recover," she added. "Because many projects take at least 18 months to finish, today's weak credit markets can stifle spending well into 2011. Construction cycles tend to move slowly so we would avoid preempting a rebound."

Retail is the most heavily challenged nonresidential construction sector, and there appears to be nothing on the horizon to improve vacancy rates, said Tanners, who considers lending patterns and vacancy rates leading indicators.

"Peak losses in 2010 from commercial construction and commercial and term commercial real estate losses not peaking until 2011" provide another sour note, Tanners said, although she does suggest that more stability in public-sector spending appears to be brewing and there is further potential for increased infrastructure spending. "Investors looking for a return to more peak spending levels should be prepared to wait until 2014-15."

The UBS analyst sees "a delayed recovery amid anemic financing for the commercial and industrial sector. The residential side is showing signs of improvement and could see a small recovery by year's end."

Residential spending is poised to improve, and even if nonresidential construction does begin to rebound "we think 2012's total construction spending will still only return to 2003 levels, prior to the 2004-08 boom cycle," Tanners said.

UBS has already trimmed its assessment of 2010 housing starts and is forecasting a 25-percent improvement over last year compared with its earlier assessment that home construction would increase 43 percent this year.

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