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Building a Greener Future: Urbanization, Smart Buildings, and Their Impact on the Industrials Sector

By Greg Sumner, CFA
October 2018

Residential and commercial construction are by nature very cyclical industries, with GDP growth, interest rates, and consumer confidence often impacting growth and profitability. Despite the cyclicality of these industries, we believe that suppliers of heating, ventilation, and air conditioning (HVAC), fire safety, and building automation systems will likely enjoy strong secular demand tailwinds, which should result in relatively attractive growth, over the next economic cycle. Many of these tailwinds are emanating from emerging markets, where consumers are migrating to cities and increasingly demanding more comfortable office and apartment buildings. While our selection process is driven by bottom-up, fundamental research with a strict valuation discipline, finding attractive companies that will also benefit from long-term macroeconomic trends can give us multiple ways to win.

Long-Term Growth Tailwinds

Some of the strongest demand growth for suppliers of HVAC, fire safety, and building automation systems in the coming years will be driven by the rising standards of living in emerging market countries. Emerging markets are experiencing unprecedented rates of urbanization as their citizens increasingly migrate to rapidly growing cities in search of more attractive employment opportunities. More than 1.5 million people are being added to the global urban population every week, with 90% of growth occurring in emerging markets.1 China alone hopes to relocate 250 million people from rural areas to cities by 2026.2 Currently, about half of the world’s population lives in urban areas, but this number is expected to increase to two-thirds by 2050.3 Historically, urbanization has led to increased GDP per capita due to significantly higher productivity, so the migration trend to cities should drive growth of the middle class. More than 1.2 billion people are expected to join the middle class by 2025,4 and the middle class is expected to grow from 27% of the global population today to 60% in 2030.5 These newly middle-class consumers will naturally demand a higher standard of living and given that cities tend to be hotter than rural areas, and much of this growth will be concentrated in emerging markets that tend to have warm climates, the air conditioning industry will be a primary beneficiary of this demand. Furthermore, as standards of living increase, citizens also tend to demand safer living and working conditions. As a result, security systems are often installed and fire codes become stricter, with governments beginning to require both passive and active fire detection and suppression systems in apartments and public buildings. With increased disposable income, consumers will expect safe and air conditioned shopping centers, movie theaters, restaurants, and hospitals in addition to apartments, all of which will have increasingly advanced building technology installed. This growth will be augmented by growth in high-tech environments such as data centers, which have specific temperature, air flow, and humidity control needs, as well as specialized fire suppression needs.

While there are numerous benefits to urbanization and a rapidly growing middle class, there are also some downsides. Despite housing only about 50% of the world’s population, cities consume 75% of the world’s natural resources and produce 80% of its greenhouse gas emissions.1 Today, about 16% of total U.S. electricity demand comes from air conditioning, and according to the IEA global energy demand from air conditioners will more than triple by 2050.6 This will contribute to an estimated 48% increase in world energy consumption by 2040 and will likely lead to greater demand for energy-efficient HVAC units and green building technology in both developed and emerging markets.7 The larger HVAC manufacturers will benefit most from this trend, as they’ll have the ability to leverage their economies of scale to invest in research and development to build increasingly efficient HVAC systems. This will also provide an additional demand driver as existing buildings look to save energy, upgrading their HVAC systems to more energy-efficient models.

Smart Buildings

Besides installing more efficient HVAC systems, building owners can make their buildings greener, and save on their energy bills, by making them smarter. Smart buildings use sensors and intelligent automation systems to integrate and automatically control the facility’s core systems, such as HVAC and lighting. Smart buildings can reap savings by more efficiently managing these systems, such as using load-shedding programs to keep less critical systems from operating at peak energy demand times or chilling water hours before the mid-day heat arrives. Sensors can be used to lower shades during sunny periods to keep the building cool, or use motion detectors to turn off lights and HVAC in rooms that aren’t being used. Using multiple systems at the same time can provide even more savings. For example, an existing security system with radio-frequency enabled ID cards can be used to see how many people have gained access to a building, which helps determine not only which rooms are occupied, but how many people are in the room. Based on this data, the system can automatically adjust the HVAC settings so that the room’s temperature and air flow are efficiently controlled based on capacity. It is estimated that more than 30% of the energy used in commercial buildings is wasted, so the potential savings from smarter systems could be dramatic. However, even small improvements in energy efficiency can have a notable impact on a property owner’s bottom line since large buildings, such as hotels, can easily spend 5-10% of revenue on energy costs.

Compelling as they are, the advantages of automated smart buildings extend beyond reduced energy costs, as this technology can also make buildings more comfortable, safer, and easier to manage. Sensors can monitor carbon dioxide and particulate matter in the air and adjust ventilation systems accordingly. Hooking equipment up to the network can allow for remote monitoring of their performance, allowing building management to find devices that are not functioning properly and perform preventative maintenance, resulting in less downtime. Fire safety systems can be integrated with HVAC systems to augment a building’s emergency smoke exhaust system, while the lighting system can be used to provide emergency lighting to illuminate escape routes. Security systems can be integrated in to a retailer’s software to help track customer traffic, capturing which displays spark the most interest while simultaneously tracking inventory. Over the long term, smarter buildings and the convergence of the various systems within them could potentially lead to entirely new products and services, which could prove to be lucrative opportunities for suppliers of building technology.

Investment Opportunities

We believe the aforementioned secular trends have created long-term growth tailwinds for providers of HVAC, fire safety, and building automation systems. These tailwinds, combined with some company-specific issues, have created an attractive opportunity to own shares of Johnson Controls and United Technologies. United Technologies’ Climate, Controls, and Security segment is a leading provider of HVAC, fire, security, and building automation solutions under the Carrier, Chubb, and Kidde brands, among others. Their Otis business is also the world’s largest elevator and escalator provider. Johnson Controls’ Building Technologies and Solutions business is also a leading provider of HVAC, building control, fire, and security systems under the YORK, Metasys, Simplex, and Grinnell brands.

As new, multi-system smart building products become available, we believe that companies such as United Technologies and Johnson Controls, both of which provide a full suite of building services, will be well-positioned to integrate these various systems in ways that add value for their customers and ultimately gain market share. Historically, building owners have not purchased their fire, security, HVAC, and building controls in a bundle, but we believe this could change over time as the new products and services made possible by integration become more attractive.

While both Johnson Controls and United Technologies are in enviable positions and are poised to benefit from these secular trends, our primary reason for owning them is more company specific. Johnson Controls’ 2016 merger with Tyco created significant cost cutting opportunities that we believe are not fully reflected in the current stock price, while their more recent management change is providing the opportunity to correct the prior regime’s mistakes and regain some lost market share. United Technologies’ aircraft engine business appears to be an underappreciated gem, which has caused the company to trade at an attractive valuation. Currently, both United Technologies and Johnson Controls are reviewing their portfolios and could potentially spin off or sell other unrelated businesses, creating smaller, more focused companies to serve the building technology market. These more nimble companies would be in an excellent position to capitalize on favorable industry trends and participate in a new round of industry consolidation, which could create significant synergy opportunities and lead to leaner cost structures.

When an industry enjoys attractive long-term growth tailwinds, the stock market is often quick to recognize the potential and the valuation of the companies involved fully reflects the opportunity. However, there are times when that opportunity is overshadowed by company-specific missteps, or is hidden due to a conglomerate structure. These types of situations can create compelling opportunities for management teams to create significant value for their shareholders, creating attractive opportunities for patient value investors like Diamond Hill.

As of September 30, 2018, Diamond Hill owned shares of Johnson Controls and United Technologies.

1 PWC UK: A New Urban Agenda: Accommodating 2 billion New Urban Citizens.
2 Business Insider: Here’s China’s Genius Plan to Move 250 Million People From Farms to Cities.
3 United Nations Department of Economic and Social Affairs: 68% of the world population projected to live in urban areas by 2050, says UN.
4 Honeywell International, Inc. March 2016 Investor Day.
5 United Technologies, Inc. March 2018 Investor Day.
6 International Energy Agency: The Future of Cooling.
7 Honeywell International, Inc. March 2017 Investor Day.

Originally published on October 23, 2018.

The views expressed are those of the research analyst as of October 2018, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.

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