Lennox International Equity Research

While the pickup in the housing market has become a widely accepted investment theme, Foolish investors might favor taking a look at investing in the commercial construction market. One area of interest is the heating, ventilation, and air conditioning, or HVAC, market. The pick of the sector is Lennox International  $LII , with A.O. Smith $AOS also deserving of an honorable mention.

Lennox and A.O. Smith look set to grow earningsWhy is commercial construction considered next year's hot sector? The key argument is that the commercial sector tends to follow the residential sector, so stocks exposed to the former are likely to produce more upside in 2014.

You can think of the commercial construction sector as experiencing a rough five to six years where it grew lower than GDP growth, but is now set to grow faster than GDP, as the economy recovers. Indeed, it certainly seems that way if you look at consensus earnings-per-share growth forecasts for Lennox and A.O. Smith. Both companies are forecast to have high compound annual growth rates, or CAGRs, over the next four years.

Company	2013	2014	2015	2016	CAGR
A.O. Smith	34.9%	12.3%	12.7%	12.8%	17.8%
Lennox	35.8%	21.5%	16.6%	9.4%	20.5%

Source: Nasdaq.com

In the case of HVAC specialist Lennox, the market has clearly priced in a recovery due to its residential market exposure. However, it also has upside potential from a future recovery in commercial construction.

Lennox's management estimates that its 2013 revenue split will likely include residential HVAC contributing 49%, commercial HVAC 27%, and refrigeration 24%. Given the strengthening housing market, it's no surprise that 75% of the increase in overall segment profits came from the company's residential markets. Furthermore, Lennox generates around 85% of its business in North America, so it's very much a U.S. market play. Where it gets interesting is in the fact that Lennox's commercial operations tend to have a higher profit margin.

Source: company presentations

Essentially, if Lennox's commercial HVAC sales come in better than expected then there is an opportunity for a positive shift in the overall margin mix. Moreover, Lennox's management recently gave its 2014 forecast and outlined the key assumptions behind its 3%-7% revenue growth forecast. Management is estimating that North American residential units will be up "mid-single digits" from 10% in 2013. Meanwhile, its commercial units are forecast to rise in "low-single digits" from a paltry 2% in 2013. Frankly, Lennox's commercial forecast looks a little bit conservative, so you should see some additional upside.

Lennox's cash flow advantage
Lennox stands out for its cash flow generation. For example, A.O. Smith's management recently forecast $100 million in free cash flow, or FCF, for 2013, but this is not particularly impressive when compared to its enterprise value, (market cap plus debt minus cash) of around $4.6 billion.

In contrast, Lennox has converted 110% of net income into FCF over the last four years, and is forecasting 90% conversion in 2014. However, A.O. Smith has converted around 60% of adjusted net income into FCF over the last three years. 

For illustrative purposes, lets assume Lennox converts 100% of income into FCF and A.O Smith converts 60%. Using these rates and analysts' EPS forecasts we get an idea of future FCF per share. For the sake of simplicity, assume that enterprise value is equivalent to current values.

Source: Nasdaq.com, author's estimates.

Lennox looks to be fairly valued, but as discussed above, it offers upside potential if you are bullish on commercial construction. Meanwhile, A.O Smith doesn't look like as a good value, but it's likely to outperform if the sector picks up.

The bottom line
A.O. Smith and Lennox are not cheap stocks, but they both have good earnings leverage should the commercial construction market improve next year. Lennox is probably the choice pick, but don't be surprised if A.O. Smith starts increasing margins and cash-flow generation if its end markets pick up. HVAC is an indispensable part of a commercial construction project, and bulls on the sector should take a closer look at both stocks.

Commercial Construction Is Looking Hot For 2014

If history is a useful guide, the housing recovery should lead into a pickup in commercial construction. With this in mind, well-known companies like building materials specialist CRH  or water heater manufacturer AO Smith  should be obvious beneficiaries. 

Why commercial construction will be strong in 2014
While a lag between an increase in residential activity and commercial construction is only to be expected, it's fair to say that the recovery in the latter has been somewhat disappointing in 2013. However, industry surveys and construction data are suggesting that commercial construction could be about to turn.

This chart compares U.S. new housing starts to how many months' supply of new houses the U.S. has. The lines should mirror each other, because if the housing market is seeing strengthening demand, then the months supply of housing available (blue line) should be falling. Consequently, home builders should be induced to build new housing (orange line) so that line should be going up. With around five months supply at present, history suggests that housing starts should be a lot higher going forward.

U.S. Months Supply of New Single Family Houses data by YCharts

And while residential housing is recovering, commercial construction appears to be finally kicking in. For example, here is the Architectural Billings Index, or ABI, from the American Institute of Architects. It's the most closely followed construction index. Fortunately, its indicating that commercial activity has finally picked up after a weather-affected spring.

source: American Institute of Architects

In addition, the banks are starting to report increased commercial real estate loan demand.

The following chart represents the net percentage of domestic banks that are reporting increased demand for loans.

Source: Federal Reserve

Note that commercial real estate demand has been strong, and outweighed Commercial and Industrial, or C & I, loans this year. This is unusual, and it could be a negative sign. But it could also owe to the strong state of U.S. corporate balance sheets, plus some reticence to invest thanks to political uncertainties.  

Which stocks to look at, and what they are sayingCRH is one of the world's leading building-materials companies, and its recent results perfectly matched the ABI data above. Its first-half U.S. sales were down 1%, mainly due to poor construction weather, but it recorded a 4% like-for-like increase in the third quarter, and it's expecting "a continuation of an improving trend in the U.S.". In an added plus,  it even discussed some stabilization in Europe.

While CRH is focused on building frameworks, Armstrong World Industries  is a leading flooring and ceiling company. In its third quarter, Armstrong saw its wood flooring rise 20.9% on the back of increased new residential construction. Meanwhile, its ceilings business (which is more affected by commercial office construction and represented 46% of sales in the quarter) saw sales up only 2.9%. If the commercial market improves next year then it's reasonable to expect better conditions for Armstrong.

AO Smith's water heating solutions are seeing strong demand. Its sales were up 16% in the third quarter, causing it to raise its full-year guidance for a third time this year. Moreover, its commercial unit sales surprised on the upside. From its recent conference call:

we've continually raised our estimates on commercial, and we just have much more difficulty kind of estimating that. I think last quarter, we set 154,000 units compared to last year's 147,000. And now, because of a very strong third quarter in commercial, we're going back to the drawing board and we've raised it to 157,000 units.

Heating, ventilation and air conditioning, or HVAC, is another vital component of any commercial building, and Foolish investors might be interested to look at stocks like Lennox International    or Regal Beloit. Lennox recently reported 13% constant currency growth in its residential business, and 8% in its commercial. Moreover, on its conference call, its management spoke of an "acceleration in in our commercial business in the third quarter". 

Lighting is another area that Foolish investors should look toward. Stocks like LED play Cree or North America's leading lighting company, Acuity Brands     look set to benefit from the secular move toward LED lighting, as well as a pickup in commercial building. Acuity has been doing very well this year; largely from the residential market. But its true strength is in the commercial and industrial sector. Analysts already have it on nearly 10% revenue growth to Aug. 2014, but those estimates could easily be taken higher if my thesis right.

The bottom line
In conclusion, anecdotal evidence from companies exposed to the sector as well as industry data are suggesting that commercial construction is likely to improve in 2014. Of the stocks discussed above, Armstrong World Industries looks the best value.

AOS P/E Ratio (Forward 1y) data by YCharts

Its also the stock with the strongest gearing toward the commercial construction sector. Its wood flooring margins will suffer with if lumber costs go up, so keep an eye on that. However, should end demand pick up as expected -especially with its commercial ceilings- then the stock has good upside in 2014.