2023-04-11 15:13:24 ET
Summary
- Carrier is a fascinating dividend growth stock with a 1.7% yield and strong double-digit dividend growth.
- While Carrier was founded more than 100 years ago, it benefits from strong secular tailwinds and its focus on aftermarket sales.
- The company has a healthy balance sheet and a plan to consistently generate outperforming sales growth and higher margins.
- CARR shares are attractively valued. If macroeconomic conditions provide us with another correction, I will likely be a buyer.
Introduction
It's time to talk about the Carrier Global Corporation ( CARR ) , the company known for its heating, ventilation, and air conditioning systems ("HVAC"), which has been a standalone company since its spin-off from United Technologies in early 2020, has turned into an impressive dividend growth stock. While its below 2% dividend yield does not seem very attractive to income-oriented investors, we're dealing with a company that has high free cash flow, a healthy balance sheet, and high growth opportunities in aftermarket sales on top of secular tailwinds like heat pumps. We're also dealing with management eager to let shareholders participate in its success.
So, without further ado, let's get to the numbers!
What's Carrier?
Carrier was founded in 1915 as an independent company manufacturing and distributing HVAC systems. Back then, it produced air conditioning systems for companies working with textiles, paper, flour, and pharmaceuticals.
In 1979, the company was bought by United Technologies. More than 40 years later (in 2020), the company was spun off as United Technologies merged with Raytheon, creating a pure-play aerospace & defense company called Raytheon Technologies ( RTX ) - I recently covered it in this article .
In order to become a pure-play company, United Technologies spun off Carrier and its elevator business run by Otis Worldwide ( OTIS ).
That said, Carrier still does what it did over 100 years ago. It's just a lot more advanced and larger. The Florida-based company has a $35.3 billion market cap.
In 2022, the company generated sales worth $20.4 billion with operations in more than 160 nations, supported by 52,000 employees.
HVAC sales dominated with $13.4 billion in total sales last year. Moreover, 60% of total revenue came from the Americas, followed by EMEA nations with 23% of total sales.
New equipment accounted for 77% of total sales.
It's also worth mentioning that the company is the market leader in almost every single product and service.
So far, this is just the basics. It gets way more interesting when digging deeper.
The Power Behind Carrier's Dividend Growth
Carrier currently pays a $0.185 per share per quarter dividend. This translates to $0.74 per year, which is 1.7% of the company's stock price, also known as the dividend yield.
1.7% isn't a juicy yield. However, it's backed by a lot of earnings power and a fantastic business model.
In December 2022, the company hiked its dividend by 23%. In December 2021, management approved a 25% hike. One year prior to that, investors were rewarded with a 50% hike.
While these growth rates aren't sustainable on a long-term basis, I have little doubt that CARR dividend growth will remain strong for many more years.
Why?
Because CARR is a fast-growing cash cow.
This year, the company is expected to generate $2.0 billion in free cash flow (operating cash flow minus capital expenditures). This translates to a 5.7% free cash flow yield. Next year, that number could rise to $2.5 billion, which indicates a 7.1% free cash flow yield.
This year, free cash flow is expected to grow by 40%. Next year, growth is expected to be 26%. Even in 2025, free cash flow is still expected to grow by 13%. The company is on track to double its 2022 free cash flow in just three years.
Don't worry. I didn't mess up my Excel file. These numbers are for real.
However, doubting these numbers does make sense. After all, a company founded in 1915 shouldn't have this kind of growth - one might assume.
The good news is that the company is indeed growing this fast, backed by strong demand and its ability to turn high demand into high free cash flow. That's easier said than done!
Carrier's value creation framework is based on a number of levers, starting with 6% to 8% annual organic revenue growth. When adding consistently rising margins, the company is in a position to convert almost all of its net income into free cash flow, used to distribute dividends, repurchase shares, and acquire companies.
The overview below shows CARR's capital deployment priorities. The biggest priorities are organic and inorganic growth, which makes sense. This includes annual CapEx of roughly 1.75% of total sales and a free cash flow yield that exceeds the company's weighted average cost of capital and a risk premium. After all, the company needs to protect its balance sheet and provide a healthy foundation for higher M&A-related spending. Based on 2023E numbers, the company has a healthy 1.5x net leverage ratio and a BBB-rated balance sheet. Next year, this leverage ratio is expected to drop to just 1.1x EBITDA.
Moreover, the 30% payout ratio target will make sure that the expected surge in free cash flow will end up accelerating dividends down the road.
Going back to the aforementioned high organic growth targets, the company sees multiple tailwinds related to the wellness economy, higher sustainability-related investments, digitalization, and a growing middle class. Note that these tailwinds are expected to come with double-digit long-term annual compounding revenue growth.
Carrier updated its investors and analysts on these trends during the Bank of America Global Industrials Conference . They highlighted the secular tailwinds that are driving their business, including healthy indoor environments, the move towards electrification, and digital transformation. These factors are benefiting their HVAC and transport refrigeration businesses, as well as enhancing their capability to provide aftermarket service and recurring revenue streams.
Additionally, the company mentioned a recent increase in government incentives and regulations in the U.S. and Western Europe to drive the adoption of their technologies, such as the Inflation Reduction Act in the U.S. and incentives for heat pumps in Western Europe. These incentives are further boosting the secular tailwinds mentioned earlier, and the company believes they are well positioned to benefit from them. I agree with that.
That said, the company mentioned aftermarket sales. As I reported earlier in this article, aftermarket sales accounted for less than 25% of 2022 sales. That's not a lot, especially not given the increasing size of that market.
Hence, the company is now increasingly focused on that market.
As the slide above shows, the company highlighted the aftermarket business during the conference. While it's just a quarter of its current business, Carrier believes that the annual revenue potential from its installed base globally is about 4-5 times its current aftermarket business, indicating that they are underrepresented in its own aftermarket.
The company acknowledged that it had a late start in focusing on the aftermarket, but in recent years, they have placed significant emphasis on this segment of its business, resulting in double-digit growth in its aftermarket business. They highlighted the advantages of the aftermarket business, including higher gross margins compared to the company average, recurring revenue streams, increased customer intimacy, loyalty, and pull for their equipment.
The aftermarket business is considered a top internal focus from a commercial standpoint across all of their businesses, given the large installed base they have globally. Overall, the company expressed positive sentiments about its aftermarket business and its potential for growth and profitability.
So, what about the price tag? After all, good things rarely come cheap.
Valuation
CARR is trading at 11.5x 2023E EBITDA. This is based on its $41.5 billion enterprise value, consisting of its $35.3 billion market cap, $5.5 billion in net debt, and $670 million consisting of minority interest and pension liabilities.
I believe that CARR should be trading closer to 15x EBITDA, as it does have the (expected) revenue growth and margin expansion plans to back it up.
This would put the fair value at $56 per share, roughly 35% above the current price. The current consensus estimate is $50. The most recent recommendation on my screen came from Oppenheimer on March 28 (Outperform, PT $51).
That said, on a long-term basis, I expect CARR to outperform the industrial ETF ( XLI ) by a wide margin.
Over the past 12 months, the CARR performance was similar to the XLI performance. I believe that this is mainly because of the significant CARR outperformance in 2020 and 2021.
Takeaway
In this article, we discussed Carrier Global, a fascinating industrial stock with a mature business model and strong secular growth benefits.
The company is attractively valued and poised to deliver high long-term results.
Moreover, while the dividend yield is just 1.7%, it comes with high historical dividend growth and a high likelihood of strong double-digit dividend growth for many more years to come.
While I have close to 50% industrial exposure already, I am very tempted to buy CARR in the next few months. I put the stock in a model portfolio and on my personal watchlist.
That said, going forward, I wouldn't bet against a correction opportunity. The Fed's hiking cycle is now meeting slowing economic growth and tremendous pressure on commercial real estate. If housing and construction markets weaken, we could see some weakness in industrial and related stocks. Such a correction would be a terrific buying opportunity for CARR shares.
For further details see:
Carrier Is A Fantastic Dividend Growth Stock