The entire HVAC-R space has held up relatively well through this downturn, and while there are valid concerns about the strength of non-resi new-builds over the next couple of years, commercial HVAC is more of a replacement market than a new-build market. On top of that, plans aimed at curbing emissions and reducing power consumption should drive meaningful green retrofit activity.
For Carrier Global (CARR), there’s a little more to the story. Largely a hardware play on the HVAC-R and fire/security markets, management is working to build its share in Applied HVAC, as well as in other areas like controls/building management, and Fire/Security field services. If management can execute on what are some ambitious targets, while simultaneously driving better operating margins through the Carrier 600 program, there could still be upside in what has been a recent strong performer in a popular sub-sector.
A Familiar Theme For The Second Quarter
Although HVAC businesses held up a little better than average in the second quarter, Carrier took some hits from its exposure to refrigeration and fire/security. Revenue did beat by 6%, though, and the company did post a healthy beat at the operating profit line, with an $0.11/share segment income beat and mid-20%’s decrementals despite HVAC decrementals in the low 40%’s.
Revenue fell 19% in organic terms, with HVAC down 15% – a little worse than Trane (TT) and Lennox (LII) on slightly weaker performance in residential. Refrigeration revenue declined 25%; while the composition of the business makes straight head-to-head comparisons with either Trane or Dover (DOV) difficult, I don’t see Carrier as underperforming this quarter. In Fire & Security, though, revenue was down 22%, and that did look a little weak next to Honeywell (HON) and Johnson Controls (JCI) this quarter. I believe Carrier’s greater leverage to hardware (relative to installation, monitoring, and other services) largely explains the differences.
Gross margin declined about a point. Operating income fell more than 41%, with segment profits down 38% and segment margin down 370bp. By segment, HVAC margins remain the strongest (down 410bp to 15.7%), followed by F&S (down 330bp to 10.6%) and Refrigeration (down 400bp to 9.1%).
Healthy Resi, An Imminent Transport Turn, And Then What About Non-Resi?
Residential construction activity has remained surprisingly strong during the pandemic, and the entire HVAC sector saw strong orders in June. Looking at the resi space, I don’t see any particular reason to believe this sector won’t remain strong through the remainder of 2020, and Carrier enjoys the strongest share in the U.S. resi market (around 20%). The only “but” is that at 20% of revenue, resi HVAC isn’t a commanding driver for Carrier.
I do also expect the transportation refrigeration market to improve from its current trough, but I’m still uncertain as to whether the recovery will begin in earnest in 2021 or 2022. Class 8 reefer truck orders are certainly improving, but off of a low base and carriers seem to be a little careful about ramping trailer capex back up. I’d also note that, at least relative to Trane, Carrier has some incrementally larger exposure to markets like marine.
Non-resi is a bigger question mark for me where non-residential is concerned. First, I do expect non-residential construction to be weaker over the next couple of years; there will probably be some stronger areas like industrial, and institutional may not fall off as much, but I see core non-resi as otherwise weak. On the other hand, tenants are increasingly demanding green buildings, and the entire HVAC sector could benefit from Biden’s Climate Plan depending upon how the November election goes.
The issue for Carrier is that the company’s commercial HVAC business has long been skewed more toward unitary than applied, and the company doesn’t have a particularly good presence in controls or building management products and services. Management has ambitious goals to become the #1 player in applied HVAC (and has been investing in sales and product development), but I’m concerned that Johnson Controls and Trane may be better-placed to benefit from that green retrofit driver.
Future growth in Fire & Security is likewise tied to internal transformation. Carrier has good share in products (around 10%, versus 7% for Honeywell and Johnson Controls) and well-respected brands like Chubb and Kidde, but their share in services is quite a bit smaller (low single-digits) and companies like Johnson Controls and Stanley Black & Decker (SWK) perform better in the “Field” portion of the business mix. This is fixable, but it will take time and investment.
Like seemingly every company these days, Carrier as a margin-improvement plan in place (Carrier 600), with management targeting familiar areas of improvement (supply chain, automation, headcount). Carrier’s margins aren’t awful today when compared to Johnson Controls, Lennox, or Trane, but the Refrigeration and Fire & Security businesses do pull down the averages and they’re not as strong on a comparables/peer basis as the HVAC business.
It’s also worth noting that United Technologies(now Raytheon Technologies (RTX)) sent Carrier on its way with quite a bit of debt; a little more than 4x my 2020 EBITDA estimate. It’s a manageable debt load given that I believe we’ve seen the worst of the cycle, but I do have concerns that it may put some limits on the company’s ability to invest in share-expanding product development and/or buy its way into some important segments (like controls).
I do expect long-term revenue growth from Carrier of around 3% to 4% – more or less on par with comparables like Johnson Controls, Lennox, and Trane. I do believe Carrier can gain some share in commercial and in Fire & Security, but they’ll have to work for it. I do also expect margin improvement, with FCF margins improving into the low double-digits over time (a little better than JCI, on par with Lennox and Trane), driving double-digit FCF growth.
The Bottom Line
Margin improvement is important to driving value; on a near-term margin/return-based EV/EBITDA approach, Carrier shares look expensive past the mid-$20’s. I do expect longer-term improvement, though, and based on my free cash flow model, I believe Carrier can generate mid-to-high single-digit annualized returns for shareholders that are a little better than what I see from Trane, but not quite as good as what I expect from Johnson Controls. All told, I think Carrier is a decent name today, but I’m more inclined to wait in the hope of a pullback as I feel like the Carrier story is more dependent upon transformational execution than the stories at Johnson Controls and Trane.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.