Morningstar - Q4 2020 - 83

and those four firms control the commercial North
American market with 75% share.
Revenue has been down for those guys, because
of the economy. But the air-filtration opportunity
will be big. You can put in HEPA filters, which can
eliminate 99.9% of particulates, including
viruses, but then the efficiency of your system can
drop drastically. The next phase is to retrofit
your system to make it as efficient as it should be.
For these companies' commercial business,
retrofit/replacement is about 60% to 70% of their
revenue, whereas the rest is construction.
Carrier, Trane, and Lennox are the premium
residential brands. People working from home may
be running their HVAC systems 24 hours a day.
The useful life of these things may decrease, given
increased usage, and within the residential
business, 80% of revenue is replacement sales.
Carrier and Johnson Controls also have fire and
security businesses. There will be more
opportunities for touchless security access, and
they also have thermal imaging cameras that can
detect if someone is running a temperature.
Of the four, Carrier is the best positioned, and
it's our top pick in the space. If there were
a pullback there, that's where I would go. They
recently spun off from United Technologies,
and the market's still trying to figure out what their
long-term growth and margins could be. I think
they can outperform expectations.
Aguilar: Going forward, you've got to look at who's
investing into the future and who has the
balance sheet to do that. Honeywell International
HON is willing to lose the battle of preserving
margins now in order to win the war for
top-line growth opportunities. Preceding the
pandemic, they made some VC-like investments
in quantum computing that can perform
extraordinary tasks in a fraction of the time relative
to traditional binary code.

Coming out of the pandemic, they've been
investing in more-ordinary industrial
products, such as ultraviolet light solutions for
aerospace cabin sanitization and temperature
screening solutions for places like airports
and hospitals. There's another exciting opportunity

in their partnership with SAP SAP, building
automation solutions that help with
energy efficiency and air-circulation analytics.
Warehouse automation is a strong opportunity for
Honeywell Intelligrated. It addresses a lack
of available skilled labor, and the social distancing
trend is also going to be an important part
of the equation. Workplace safety is an overriding
concern in some of these facilities.
Rockwell, Honeywell, and Emerson Electric EMR
all have brownfield opportunities associated with
reshoring. It involves moving and installing
equipment, as opposed to new roofs, and all three
have large installed bases of equipment. Once
they sell that equipment, these automation
providers get more than two decades of highermargin aftermarket revenue.
Lallos: Home improvement is a strong opportunity
right now.

Bernard: Everyone's at home, noticing things that
they don't like. During the last recession,
people were less willing to spend on their home
because house prices were plummeting. Today, we
have a strong demand for homes and there's
a limited supply. When people feel good about the
value of their home, they're willing to spend on it.

Many households have unfortunately been
hit hard by the pandemic and are struggling with
mortgages or rent. But there are a lot
of households where everyone's employed,
and they're not spending as much on
other things. That's a perfect storm for home
improvement spending.

Bernard: When we put out our housing
outlook last year, we thought it would be better
than a lot of people expected. Millennials
are no different than any other generation. They're
going to move to the suburbs. But we weren't
bullish enough. We raised our forecast
once, and recent data suggest that it's still too
conservative for 2020.

In March, valuations for homebuilders D.R. Horton
DHI, Lennar LEN, and Toll Brothers TOL were
trading below their book value, which should not
happen for blue-chip builders. It's like saying
that they would have no long-term growth
or would have to write off a significant amount of
their land inventory. Lennar and Toll Brothers are
now fairly valued, in our view, and we think D.R.
Horton is overvalued, probably because they're
the best positioned for the entry-level buyer, which
is the fastest-growing market in the U.S.
We're interested in seeing how working from
home shapes up, how many people are going to
be able to do this permanently. To the extent
that that happens, people will be able to move into
lower-cost suburbs or lower-cost states, and
you're going to need more construction for that.
So, we're still bullish on the housing market.
The fundamentals are there. We're still
vastly undersupplied. And the largest generation
is reaching an age that they want to buy a home.
I think we'll have good growth for a decadeplus. I'd just caution investors that this level of
growth is not sustainable probably over the long
run. Long term, homebuilders grow 3% to 4%.
Lallos: In 2018, we spoke about how industrial

As in past recessions, people are willing to
spend on small projects, like paint. Behr paint from
Masco MAS is doing very well. What's different
today is that people are spending on higherprice-tag items. Decking, for example, is doing
extremely well for Fortune Brands Home & Security
FBHS. That said, the valuations for some of
these names are ahead of reality right now. These
are very well-run businesses, but this activity is not
sustainable for the long term.
Lallos: You've been bullish on housing starts, and now

it sounds like you are even more bullish.

distributors were competing against Amazon.com
AMZN. Has that changed? The pandemic has

helped Amazon solidify its lead in many areas.

Bernard: Back then, we thought that the threat
from Amazon Business was overblown,
and I still think that's the case. Amazon Business
is going after small businesses that don't want
service, just low prices.

The more traditional industrial distributors we
cover serve niche markets that require a level of
service-a sales footprint, a branch footprint-
that Amazon is just not going to go after. Industrial

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Morningstar - Q4 2020

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