CARR - Carrier Global: Rating Downgrade As Share Price Has Reflected Its Fair Value

2023-08-09 23:11:37 ET

Summary

• CARR reported strong 2Q23 financials with $5.99 billion in revenue and 9% organic HVAC growth.
• The share price has reached my target price. Hence, I am downgrading to a hold rating.
• While long-term growth prospects remain positive, the current valuation lacks margin of safety.

Summary

Readers may find my previous coverage via this link . My previous rating was a buy, as I believed Carrier Global ( CARR ) would continue to benefit from the long-term secular tailwinds in the HVAC market. In the short term, growth will see a tailwind from the replacement cycle, driven by a replacement cycle, particularly in the residential sector, as summers are getting hotter and winters are getting shorter, which increases the likelihood of breakdowns and necessitates emergency replacements. I am revising my buy rating to a hold as the share price has reflected my price target.

Financials / Valuation

CARR reported $5.99 billion in revenue for 2Q23, up 15% year over year, as well as $964 million in EBIT and $0.79 per diluted share. Organic growth in HVAC was 9%, while refrigeration was down 6%, and fire safety and security grew by 9%. The HVAC and Fire & Security industries contributed heavily to the 5% quarterly drop in total orders.

Based on my view of the business, CARR should be able to grow as I expected previously, achieving $22 billion in FY23 (as guided by management), followed by increasing growth in the mid-single digits in FY24 and FY25 as it approached historical growth. Margins should also revert to historical levels as things normalize. What has changed since my last update is that the valuation has shot up to 20x forward PE today, and the share price is now $57, 5% above my price target of $55. At 20x forward PE, the margin of safety is no longer as good as I want it to be; hence, I am downgrading to hold.

Comments

I believe CARR somewhat benefited from the easy expectations coming into the quarter, as I think the market was worried about the weather, inventory headwinds in residential, and the integration/policy risk with the Viessmann deal. Nonetheless, CARR delivered a solid 2Q that beat consensus estimates on both revenue and EPS. Thereby driving a strong share price performance.

Light commercial is where the action is when we look at CARR results, as it experienced a whopping 60% increase in sales thanks largely to an increase in volume. On the other hand, the residential market remains weak, as evidenced by a decline in HVAC sales in the mid-single digits across North America. Management noted that splits inventory continues to be higher than what they would consider optimal, and overall residential HVAC volumes were down by the mid-teens. In my opinion, for inventory in the supply chain to normalize further, the weather needs to remain favorable to CARR in 3Q23. Recall that the second half of the year is where the sell-through gets easier ( BofA Global Industrials Conference Mar’23 ). Hence, if the weather aligns well, I expect to see things normalize soon. That said, overall residential HVAC volumes are still expected to be down in the high-single digits.

Interestingly, the HVAC systems in commercial buildings performed much better than I had anticipated. Backlogs for commercial HVAC rose sequentially despite a drop in orders, achieving double-digit growth. This has contributed to the 9% organic growth in HVAC as a whole. Management seems optimistic about the upcoming performance of commercial HVAC, which I have faith in given what early indicators are pointing to. For instance, the Architectural Billing index, which is currently above 50, is supportive of this positive outlook. Keep in mind that less than 10% of CARR's North American applied business is related to commercial real estate. Hence, it is not being impacted by the headwinds that commercial real estate is facing .

All in all, I think this set of results is fine; however, valuation has reached my expected level, as has the price target. At this valuation, the margin of safety is a lot lower as well. For a start, the very near-term (3Q23) performance would be key as it determines the inventory situation for 4Q23. If the weather is not in favor, then 4Q23 and FY23 consensus figures might be at risk. While nothing has changed in the secular trend thesis and I still see growth over the longer term, I am not a fan of the current valuation situation. Hence, I downgrade my rating to hold.

Conclusion

CARR reported solid financials with 2Q23 revenue of $5.99 billion and organic HVAC growth of 9%. However, the share price now aligns with my target, trading at a high forward PE of 20x. While CARR's performance is promising, the reduced margin of safety and valuation concerns prompt a downgrade to a hold rating. While I maintain optimism about long-term growth, current circumstances warrant caution regarding the stock's valuation.

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