CARR - How Much Of A No-Brainer Is Carrier Global?

2023-09-20 10:55:50 ET

Summary

• Carrier Global Corporation is undergoing a strategic transformation, focusing on energy management solutions with acquisitions like Viessmann, aiming for significant growth despite short-term heat pump challenges.
• Carrier is targeting substantial aftermarket sales growth, transitioning from $4.5 billion to $7 billion in the next five years. It also focuses on data center cooling growth.
• Despite a strong growth outlook and undervaluation, regulatory uncertainty regarding heat pump adoption remains a significant risk for Carrier's long-term performance.

Introduction

On July 3, 2023, I wrote an article titled Did Carrier Just Become A Must-Own Stock? The Potential Behind The Viessmann Acquisition. It was the second article dedicated to this emerging heat pump giant this year. Since July 3, the stock has surged roughly 8%, including a 10% decline from its 52-week high.

In this article, I will elaborate on the new risk/reward for Carrier Global Corporation ( CARR ) stock, as investors are dealing with a mix of significant long-term tailwinds, including strong heat pump support, massive aftermarket potential, and room for higher margins.

On the flip side, current headwinds include short-term (regulation-related) heat pump weakness and general economic weakness.

For example, on September 19, Bank of America noted weakness in the company's biggest growth market.

As reported by Seeking Alpha (emphasis added):

“While we remain constructive on the longer-term heat pump demand trend in Europe , the concerns about Europe’s near-term heat pump demand is a concern for Carrier ((CARR)) within the context of the recent acquisition of Viessmann,” Andrew Obin, analyst at BofA, said in a September 19 report.

France, Germany and Italy have either reduced incentives to buy heat pumps or backed away from proposing outright bans on installing gas heaters in new households. In Germany, a major market for Carrier ((CARR)), applications for heat pumps fell 50% from a year earlier during the first six months of 2023, according to government data cited by BofA.

In other words, companies that benefit from regulatory tailwinds also have to deal with the risks of changing regulations, albeit shorter-term risks.

Having said that, let's dive into the details!

It's All About Secular Longer-Term Growth

Carrier, known for its air conditioners, is in the midst of a fascinating transition.

The company aims to become a provider of complete energy management solutions in the Americas, Europe, and Asia Pacific, using its core brand, Carrier, and subsidiaries like Viessmann and Toshiba Carrier.

The Viessmann Climate Solutions acquisition is expected to be closed at the end of this year. The company believes that Viessman could generate EUR 4 billion in sales and EUR 700 million in EBITDA this year.

This would translate to a 17.5% EBITDA margin, which is what the combined Carrier company isn't expected to achieve until 2025.

This result is supported by a 40% surge in heat pump sales in the first half of this year.

Although the sales of heat pumps have plummeted in recent months (as discussed in the introduction), this is mainly due to accelerating sales of fossil-fuel systems, as consumers (mainly in Germany) wanted to buy lower-cost systems before the government agreed on a full phase-out of these systems earlier this month.

This aligns with the EU's goal to install an additional 10 million heat pumps by 2027.

This is aimed at reducing fossil fuel imports, doubling the current deployment rate of heat pumps in buildings and speed up deployment of large district heating and cooling network heat pumps. The objective is to install at least 10 million additional heat pumps by 2027 .

In addition, with the phase-out of stand-alone boilers by 2029 under ecodesign rules, a total additional deployment of 30 million or more heat pumps can be expected by 2030 as compared to 2020 , most of them hydronic (including hybrids). This ambition has been expressed in the Green Deal Industrial Plan. To ramp up the heat pumps production and their deployment, more installers and trained staff are needed. Industry estimates that at least 500.000 skilled full-time equivalent employees are needed by 2030 in Europe. - European Commission (emphasis added).

In order to focus on its new business segments, the company is selling parts of its business. During the annual Morgan Stanley Laguna Conference, the company noted that it is progressing smoothly with its planned business exits.

The process of engaging prospective buyers for security and commercial refrigeration has proceeded, with the goal for the industrial fire sector to hit the market next month. Using the company's data, the Fire & Security business is a highly profitable business with leading positions in almost all segments.

Additionally, the decision has been made to combine the commercial and residential fire businesses into a single capital markets transaction, set to be listed in late spring or early summer of 2024.

Having said that, the company also commented on sales dynamics.

According to the company, residential sales are expected to see a slight decline, contrary to the initial forecast of flat sales.

Light commercial sales, however, are surpassing expectations, showing a growth rate of 60% in the second quarter and 35% in the first quarter.

Carrier is actively managing inventory levels to ensure a balanced channel and aims to conclude the year on par with last year.

Despite challenges in some segments like warehouse verticals, Carrier strategically allocates resources to capitalize on strong verticals such as K-12, healthcare, and data centers.

Furthermore, Carrier is preparing for a significant refrigerant transition in 2025, anticipating a 15% to 20% price increase over the next couple of years due to factors such as annual price hikes, cost pressure from new refrigerants like 410A, and the introduction of 454B refrigerant.

The company aims to minimize risk and support customers through a strategic introduction of new units with the new refrigerant while providing more training to secure a smooth transition.

Carrier is also optimistic about the impact of incentives, such as the $2,000 credit for implementing heat pumps in residential areas and the 179D credit for commercial energy efficiency.

These incentives are expected to drive demand and align with Carrier's commitment to energy-efficient solutions. The integration of digital tools, advancements in product efficiency, and a focused R&D investment of $550 million are expected to further propel Carrier's growth and strengthen its position in the market.

Looking at analyst estimates, the company is expected to maintain solid long-term EBITDA growth, although I expect some volatility in expectations due to a volatile regulatory environment in key markets.

Another very important pillar of the bull case is aftermarket sales. Over the past decade, industrial companies have shifted their focus to aftermarket sales. Carrier is one of them. After all, selling new equipment is one way to make money. Benefiting from a massive installed base on a long-term basis is the holy grail of consistent revenue growth!

During the aforementioned conference, Carrier highlighted significant growth in the aftermarket, targeting a transition from $4.5 billion to $7 billion in the next five years, with a mid-teens growth rate achieved midway through the current year.

Carrier also emphasized digital enablement for lifecycle revenues, stressing the importance of sustainability as a major industry differentiator.

As part of offering well-connected services, the company is seeing improvements in connected devices and subscription-based deals, reflecting high satisfaction and success in the aftermarket segment. This also boosts recurring revenues, which investors (like myself) love.

Moreover, the company is looking to increase its footprint in the data center sector.

The acquisition of Nlyte in the U.K. enables them to optimize heat dissipation through advanced algorithms. The commercial applied business is expected to witness double-digit growth this year, with data centers being a significant driver.

Using third-party research, we see that the U.S. data center cooling industry is expected to grow by 9.7% per year through 2030.

The global market is seeing even stronger growth (as it's less mature).

According to Grand View Research (emphasis added):

The global data center cooling market size was USD 15,737.8 million in 2022 and is expected to grow at a compound annual growth rate of 17.1% from 2023 to 2030 . The growing demand for energy-efficient data centers along with planned future investments are expected to create avenues for future growth. Several managed as well as cloud service providers in the industry are planning expansions in the near future to meet the growing demand. Furthermore, the hyper-scale data center industry is also gaining traction.

So, what does this mean for the valuation?

Valuation

Even after surging 31% year-to-date and 63% from its 52-week low, I believe there is a case to be made that CARR shares are 22% undervalued.

Although total sales are expected to grow in the low-to-mid-single-digit range through 2025, consistently rising margins are expected to maintain consistently elevated EBITDA growth rates.

Using these numbers, the company is trading at 13x 2023E EBITDA. That number drops to 11.5x using 2025E numbers.

Since its spin-off from United Technologies (now a part of the RTX Corporation ( RTX )), the company has traded close to 14x EBITDA, which is a fair target for a company that is capable of both boosting margins and exploiting strong secular business trends.

When applying this multiple to longer-term analyst expectations, we get a price target of $66, which is 22% above the current price.

The current consensus price target is $60.

On a long-term basis, I expect CARR to keep outperforming its industrial peers.

Having said all of this, one major issue remains regulatory uncertainty. Nations changing their minds on heat pumps could cause significant fluctuations in growth expectations.

Companies benefiting from government-forced trends face changing plan risks.

I do not expect the heat pump bull case to weaken on a long-term basis, but it remains the biggest risk that needs to be addressed.

Takeaway

The journey of Carrier as it transforms into an energy management solutions provider is very promising.

The Viessmann acquisition brings the potential for substantial revenue and EBITDA growth, aligning with the surging demand for heat pumps driven by regulatory initiatives and environmental concerns.

Meanwhile, the aftermarket sector offers a reliable source of revenue growth, and Carrier's move into data centers is poised to tap into a thriving market.

However, there are potential challenges ahead, particularly in the form of regulatory uncertainties that can impact growth projections. The company's ability to navigate changing government policies will be crucial.

Nonetheless, even after its impressive stock performance, CARR shares might still be undervalued, presenting an opportunity for investors.

While there are uncertainties, the long-term prospects of Carrier appear promising as it continues to adapt to the evolving landscape of energy management solutions.

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