Carrier Going All

Mar 28, 2023

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There are a lot of attractive aspects to the HVAC sector, including opportunities from energy-efficient building retrofits, new refrigerant standards, and the growth of heat pumps (especially in Europe). Those positives have been at least somewhat offset by sentiment, though, as the market has often bid these stocks up to robust valuations – something I thought was risky ahead of a downturn in residential HVAC and possible weakness in commercial on slowing new-build activity.

I was cautious on Carrier (NYSE:CARR) a year ago for some of the reasons above, and the shares have underperformed both the broader industrial space and other HVAC names (like Trane (TT), Lennox (LII), and Daikin (OTCPK:DKILY), though I believe that underperformance has had more to do with the non-HVAC businesses.

Now Carrier is moving forward with a major business transformation that will see the company emerge as a pure-play in HVAC and one with even more exposure to promising European heat pump markets. Transformations carry risk, though, and I also see some potential risk to the commercial retrofit thesis. Even with all of that said, though, I find today's valuation quite a bit more interesting.

Carrier's first quarter results were pretty good and the company continues to benefit from a commercial market that has proven quite resilient. I suppose a lack of upside to guidance is a mark against the quarter, and I do still see some risks from a slowing economy, but I would say the core of the business remains healthy.

Revenue rose 4% in organic terms, good for a nearly 5% beat versus sell-side expectations. Revenue from the HVAC business was up 6%, beating by more than 5%, with upside coming from the commercial operations (light commercial up more than 30%, core commercial up double-digits) and in-line residential (down high single digits) on ongoing destocking. Refrigeration declined 5%, beating by 1%, as weaker container and commercial offset strong truck and trailer. Fire & Security revenue rose 9%, beating by 5%.

Gross margin declined 170bp year over year but rose a similar amount quarter over quarter (to 26.1%), missing by about 30bp. Operating income declined 1%, but still beat expectations by more than 4%, with margin down 180bp to 12.2%. Segment income was flat; HVAC income rose 3% (margin down 260bp to 13.5%), beating by 6%, Refrigeration income fell 1% (margin up 90bp to 12.4%), beating by 19%, and F&S income fell 8% (margin down 190bp to 12.4%), missing by 4%.

HVAC orders rose about 5% in organic terms, with growth in residential, light commercial, and commercial, while refrigeration orders declined modestly due to a significant decline in commercial refrigeration orders.

Respectable first quarter results were largely inconsequential next to what I consider to be management's announcement of transformative M&A plans that will see the company essentially become a pure-play in climate control (HVAC plus refrigeration).

Carrier announced that it intends to acquire the HVAC operations of Germany's Viessmann for $13 billion in a cash ($10.5B) and stock (58.6M shares) deal. The deal values Viessmann at around 17x EBITDA excluding targeted synergies, or around 13x if those synergies are achieved.

Viessmann is a meaningful player in Europe's residential and commercial HVAC market, including a significant presence in the heat pump market. Although Viessmann has been stronger in markets like Germany so far and not as strong in France (the largest heat pump market in Europe so far, and a strong market for Daikin), the company has been making progress and integration with Carrier's existing European business could accelerate that effort.

As part of this transformation, Carrier also intends to sell the remainder of its Fire & Security operations and its commercial refrigeration operations. Management intends to keep some of the controls businesses within Fire & Security and the transport refrigeration operations, but the overall goal here is to make Carrier effectively a pure-play on HVAC and refrigeration.

How good of a price Carrier can get for these operations remains to be seen. While Fire & Security should be worth over $5B based upon comparable valuations, the reality is that everyone in the market will know that Carrier is a motivated seller – selling Fire & Security isn't essential to closing the Viessmann deal, but Carrier will be carrying a lot of debt after the transaction. Moreover, the need to indemnify potential buyers for PFAS litigation exposure could be a meaningful factor in the valuation Carrier gets.

Every deal comes with some degree of integration risk, but I don't think the Viessmann deal will prove all that problematic for Carrier. Considering this deal in the context of the proposed business sales, I see this as trading off roughly similar amounts of revenue for better margins (Carrier is expecting Viessmann's HVAC business to generate 18% EBITDA margin in FY’23) and better long-term growth potential. I see significant potential in the electrification of European residential and commercial HVAC, particularly with heat pumps, and I think Carrier is essentially trading up in terms of both growth and margin.

A weak housing market remains a meaningful near-term headwind, as both new-builds (about 25% of Carrier's residential business) and replacement activity are soft. I don't expect this weakness to last all that long, though, and new refrigerant standards in 2025 should support a healthier replacement market as servicing older HVAC systems is going to become meaningfully more expensive over the next five or so years.

On the commercial side, I do still see meaningful retrofit/upgrade opportunities – according to the most recent Commercial Buildings Energy Consumption Survey, the vast majority of U.S. commercial buildings qualify for incentives due to their age, and only about 20% of buildings have control/management systems in place (and the number that use advanced digital and IoT tools is in the single-digits).

That opportunity is attractive, but may also be at risk of overstatement. The market for lower-grade commercial office properties (Class B and below) is eroding significantly and many of these properties could end up worth little more than the land they sit upon. If that happens, I don't see building owners shelling out for HVAC upgrades, and roughly half of the commercial office market is Class B or below.

Given the strength I do expect in commercial upgrades (even allowing for weaker office demand) and institutional upgrades (schools, health care facilities, et al), as well as opportunities like heat pumps in Europe, I believe Carrier's long-term revenue growth rate can accelerate toward 6% if it executes on the planned transactions. I can also see a little upside to my long-term free cash flow margin assumptions, but I’m taking more of a "show me" stance for now until I see those post-deal synergies emerge.

Looking at Carrier on a pro forma basis (assuming the planned transactions take place), I expect around 6% long-term revenue growth and 8% FCF growth. That supports a fair value around $50 today, and I get a similar valuation ($49/share) using a 15x multiple on my 2025 pro-forma EBITDA estimate discounted back two years. This is a higher multiple than I’ve used in the past, but one that I believe is fair given what the new Carrier's margin, return (ROIC, et al), and growth profile should be after the deals are closed.

I do still have some concerns about paying up too much for HVAC companies given how popular the space has been and how well-understood many of the underlying trends are (namely, governments incentivizing retrofits as well as the benefits of increased automation). Likewise, weakness in the office sub-sector may be underappreciated by at least some bulls. I don't think long-term growth in the mid-to-high single-digits is conservative, but I do think it's attainable and given where these shares are today, I think this is a stock worth another look.

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