Carrier Global (CARR)

Stock Price: $17.07
Market Cap: 14.7B
Enterprise Value: 17.8B
While Carrier trades at a heavy discount to its peers, it has a lot going for it. Unlike its peers, Carrier is a growing diversified HVAC, refrigeration, & security solutions manufacturing. In the long-run, it has established a quality reputation despite its concentrated customer base, and it’s an ideal outsourcer. Despite headwinds from the cyclical peak in installation to its large debt burden (which can become a permanent issue), Carrier continues to benefit from secular trends in the current COVID-19 environment, and beyond.

Positive Developments During COVID-19
Carrier Global should benefit from wholesale centers, airports, and hospitals adopting HVAC and chiller products amid the pandemic. Carrier’s Commercial Refrigeration provided natural refrigerant systems for METRO AG, a European wholesale center operator. This agreement involves CCR installing high-efficiency remote cabinets and cold-room equipment using CO2. Carrier will in effect aid METRO’s commitment to 50% carbon reduction until 2030, so this arrangement is long-term.

Carrier Hong Kong won a long-term (four-year) service agreement at Hong Kong International Airport to provide chiller refrigerating. This covers all 52 chillers at the airport. Carrier is also responsible for all the maintenance, repairs, and refurbishments, which means Carrier will receive aftermarket revenue as well as installation revenue. Carrier had an existing relationship with Hong Kong International, which is emblematic of their loyal customer base, and has allowed them to gain contracts of similar stature.

Most importantly, Carrier is providing HEPA filters for hospitals across the US to help slow the spread of COVID-19. The machine allows for cleaning the air in rooms that originally were not intended to house patients with infectious diseases. It will allow for an increase in the number of isolation rooms. Currently there are less rooms than COVID-19 patients. Development began in late March, and the company successfully tested prototypes, then began field trials. They are expecting to ship units of the OptiClean Negative Air Machine shortly. However, a setback that Carrier may face is that they have to work with suppliers to secure additional raw materials. The machines are portable; they plug into a normal wall outlet, and sit on wheels that enable hospitals to move them into rooms as needed. The machines use existing Carrier fan coil technology. The device cleans contaminated air and prevents it from spreading to different sections of the hospital. It contains an air management system and flexible ducting to exhaust the filtered air. Negative pressure is created so that when the hospital room door is opened, air is pulled into the room from the outside instead of letting potentially contaminated air out of the room. The machine also offers uses beyond the pandemic and hospitals. Potential future uses include in homes, businesses, and assisted living facilities.

Positive Secular Trends
In terms of climate change, regulation benefits Carrier because there will be a higher demand for energy efficient HVAC and refrigeration systems, next-gen low-GWP refrigerants, battery powered transport solutions, and fire detection systems compliance, all of which Carrier currently offers.
A growing middle class translates to increased installation of HVAC and fire security systems, as well as cold chain solutions, within homes and apartments. Urbanization also lends itself towards driving technology for life safety solutions and the rapid adoption of HVAC.

In terms of manufacturing, onshoring can present a possible opportunity for Carrier. There are a variety of benefits to domestic production including lower shipping costs (esp. when energy costs rise) for using freight and trucking, lower inventory costs and increasing availability to inventory (close proximity to raw materials), closer proximity to suppliers, shorter service and response times, greater quality control of products, protection against import tariffs, and tax breaks as well as lower taxes. Close-to-market manufacturing also helps keep warehouse capacity issues in balance for the distributors they serve. Transportation costs are the biggest factor for Carrier that would drive this decision, as HVAC and refrigeration falls under lower value density products, which are hurt the most by higher transport costs.

Carrier is a diversified manufacturer of HVAC, refrigeration, fire & security solutions, and building automation products & services for residential, commercial, industrial, and transportation applications. It was spun-off as a result of the break-up from the UTC-Raytheon Tech consolidation.

Revenue Drivers
Carrier’s growth is driven by its sizable and aftermarket business. Approximately 28% of net sales in 2019 were generated by aftermarket services. It has one of the largest installed bases in many of the industries served. This enables Carrier to drive recurring revenue streams from the sale of repair and maintenance services, parts, components, and end of lifecycle product replacements that are required for installed products. The sales of other value added recurring and non-recurring services provide additional revenue streams over and above sales derived from our equipment business.

This leaves over 70% to new equipment sales, which is highly cyclical. Carrier leverages its large installed base to grow sales with its steadier aftermarket business, and to reduce its reliance on new equipment. Carrier contracts on a product-by-product basis, unlike some competitors who contract on a company-by-company basis. Additionally, Carrier does not compete on price like its peers, but on quality. This allows them to command a premium that is justified and one that customers will still pay for.

Demand for new commercial refrigerators and cabinets installation depends on the food-retail industry (i.e. grocery and convenience stores) and the food service industry (i.e. restaurants and cafeterias). The availability of credit is crucial to sales of commercial kitchen equipment since most restaurant improvement/expansion is financed by credit. Trucking and shipping industries also depend on products wholesaled by Carrier to move perishables across the United States. Food, pharmaceuticals, and chemicals require temperature-controlled transport.

Segment Information-
HVAC (51% of revenue; 15% operating profit margin)
The segment provides air conditioners, heating systems, control, and aftermarket components for residential and commercial customers. Its brands include Carrier, Bryant, Automated Logic, and HEIL.

Refrigeration (20% of revenue; 14% operating profit margin)
The segment provides transport and commercial refrigeration products and solutions, including monitoring systems for trucks, trailers, shipping containers, intermodal and rail. Other types include containers with generator sets, direct-drive truck units, and marine container refrigerators. The monitoring systems enable the safe, reliable transport of food and beverages, medical supplies and other perishable cargo. Commercial refrigeration equipment incorporates next-gen technologies (Sensitech) to preserve freshness of retail food and beverages. Commercial refrigeration is also offered through products such as refrigerated cabinets and freezers. Its brands include Carrier, Transciold, and Sensitech.

Fire & Security (29% of revenue; 13% operating profit margin)
The segment provides residential and building systems, including fire, flame, gas smoke and carbon monoxide detection. Products offered include portable fire extinguishers, fire suppression systems, intruder alarms, access control systems, and video management systems. Services include installation and system integration, as well as aftermarket maintenance, repair, and monitoring services. Security solutions range from advanced physical security, including access control, video surveillance, key management, electronic locks, and mobile credentialing. Security has end market applications in corporate, healthcare, government, hospitality, education, real estate, property management, industrial, and automotive industries. Its brands include Kidde, Marioff, Supra Onity, Edwards, Det-tronics, LenelS2, Austronica, Chubb, and GST.

Competitive Position:
Carrier has leading positions for all three of its segments.
HVAC ranks #1 in US residential and US Light commercial, and #3 in Global applied. Carrier’s HVAC market share (14.6%) trails Ingersoll-Rand’s (15.1%), and has overtaken Johnson Controls International’s (14.1%), as of 2019. However, unlike its peers, Carrier’s market share has been growing steadily over the past five years. Ingersoll’s has been declining from its plateau in 2017, and Johnson’s exhibits definitive stagnation for the past four years.
Refrigeration ranks #1 in Global Transport and Europe Commercial.
Fire & Security ranks #1 in Global residential fire detection & alarm and Global access control, and #2 in Global commercial fire detection & alarm and Global fire & security field.

75% of Carrier’s manufacturing is low-cost, and more than 50% is low-cost sourced.

There is not much labor involved in manufacturing unitary equipment. Labor costs are not critical (two-tier wage structure lowers labor costs by hiring lower wage workers, and provide incentives for older employees to retire early). Carrier’s existing factory in Monterrey is state-of-the-art and was the first HVAC manufacturing facility to earn LEED Gold certification.

Carrier currently trades at a P/FCF of 8x (yield = 12%), a P/E of roughly 7x, and an EV/EBIT of 7x (industry: 18x). Carrier is priced at no growth, but it’s clearly growing in share and revenues unlike its peers.

Carrier generates stable, positive free cash flows, and has been for at least the past three years. EBITDA margins (14-15% range) are better than its HVAC competitors like Johnson Controls, Ingersoll Rand, Lennox international. The expectation is that Carrier will be able to generate $700-800M of FCF over next several years. This is well below what it had been doing in 2019 and in previous years, so the expectation is rather conservative (vs. $1.7B for each of the past three years). Management’s goal is to use a substantial percentage of FCF to pay down debt get from 5x net debt/EBITDA to 3x by 2022.

Another strategy for price appreciation may be to restructure Carrier’s portfolio. Competitor Ingersoll Rand became a pure-play HVAC company, and Johnson Controls became a pure-play fire & security solutions provider. The argument against this is the lack of growth both companies have experienced since their transition, but it may be worth considering if Carrier seeks one of their segments lagging. Until that happens, I believe debt reduction should be priority number one.

Conversely, the target price can be achieved if Carrier can materially diversify its product/service offering within its segments, and significantly decrease its reliance on cyclical new equipment sales, while reducing volatility in its revenue base. This would improve EBITDA margins to 19-20% (I am using 2018-2017 ranges as a proxy), and EBIT to 17-19% (again, using previous years’ as a proxy). I wholeheartedly agree with this approach, and believe this should be a concurrent focus with easing the debt burden, as it would aid the stabilization of FCF.

Below is a Relative SOTP analysis, contingent on if Carrier executes the above strategies appropriately, and does not do the converse.

Target price range: $41-$50

Debt Review:
On February 27th (2020), Carrier issued $9.25B worth of unsecured, unsubordinated notes. The S-1 stated that they can expect to have as much as $11.4B in aggregate principal amount of outstanding indebtedness by the time distribution (to parent UTC) is complete.

$2B term loan credit facility to be drawn in full prior to distribution (5-year, 2025)
$500M, 1.923% due 2023
$2B, 2.242% due 2025
$1.25B, 2.493% due 2027
$2B, 2.722% due 2030
$1.5B, 3.377% due 2040
$2B, 3.577% due 2050

Carrier can cover its contractual obligations for the next five years using only FCF, including yearly interest payments that are associated with its loan credit facility. It’s a testament to the stability of their cash flows, but Carrier’s balance sheet may come under duress before 2025 if the company decides to take on additional debt. 2025 itself will be a pivotal year, with $4B of principal payments reaching maturity.

In the future, Carrier’s debt burden may be alleviated if management gives importance to deleverage and restructure. Substantial opportunities will be opened up to improve margins by paying down debt. This should be priority number one.

If Carrier cannot reduce its leverage ratio and debt burden as planned or it remains at high 3x range at end of 2021 (or doesn’t fall to low 3x by end of 2022), target price appreciation will not be achieved. Other impediments include the undertaking of a sizeable leveraged acquisition, a debt-funded merger with a competitor (which may also jeopardize supplier relations), or deploying FCF towards share buybacks instead of paying down debt.

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