Carrier Global Corporation (CARR US): Solid franchise going through temporary disruption

In April I wrote an exclusive thesis on VIC about the asymmetric opportunity presented by the valuation dislocation from the spinoff of CARR. Since then the stock has risen by ~70% vs. a range of between 5-20% for Trane, Johnson Control and Lennox. Now that the exclusivity period for VIC is over and I still maintain half the position I am writing a concise version of the thesis which could help anyone gain an understanding of investing in the HVAC industry.   

Welcome to the first post of this blog!

An unfavourable Spinoff dynamic has led investors to shun CARR, providing an attractive opportunity

United Technologies (UTX; now renamed as Raytheon Technologies: RTX) completed the spinoff of its iconic brands Otis (OTIS US Equity) and Carrier (CARR US Equity) into two separately listed companies in early April 2020.

Expectedly, investors interest has skewed heavily towards OTIS (so were we) owing to its high aftermarkets and resilient portfolio but at the same time spurned CARR as the spin-dynamics led the entire upstreaming of cash worth ~$11 bn to RTX by saddling CARR with substantial debt which made it optically look the most unlovable of the three companies. This has been further exacerbated by adverse construction outlook after Covid-19. However, a closer look into the resilient cash flow business model of CARR which is ~75% driven by replacement demand partially mirrors some of the classic “orphaned levered companies at cheap valuations” situations we’ve seen historically including those highlighted by Joel Greenblatt as his favourite hunting ground in his classic book.

Why CARR is misunderstood by the market

We believe that a wrong incentive structure and being a part of a large conglomerate (UTX) led to significant underinvestment in the company in the past. This is typical of spin-offs when capital allocation needs of a smaller segment are mismanaged as management sees it more of a cash cow to support growth in larger segments which can help management earn their incentives or satisfy egos. Our study of the last 15 years of data suggests that an improved capital allocation as an independent company acts as a significant catalyst to improve margins and RoIC thereby creating a strong source of returns for SpinCos. A similar playbook seems to be repeating here.

CARR executives under UTX compensation structure were being paid on sub-par metrics such as OPM and FCF. A strong business model with relatively less need for reinvestment led to the milking of cash flows with little attention to the reinvestment needs for the future. Despite this CARR maintained #1 position in US Residential HVAC and other markets (see below) as internal cash was enough to fund its growth. But going forward a greater focus should help strengthen the economics albeit with challenges of high debt, which we estimate is workable.

II. Competitive Positioning in HVAC

Filled with the legacy of innovation, CARR has been manufacturing HVAC systems in the US for more than a century and has come a long way beginning with its founder—Willis Carrier, who designed the world’s first modern air conditioning system to brand new innings of getting listed as an independently listed entity.

1. Oligopoly: North American HVAC market is dominated by six companies commanding ~85% of residential HVAC market share and ~60% of large commercial HVAC as brand-exclusive distribution base has created barriers to entry from foreign competition.
2. Globally there are around 15 players with top 5 commanding 35% of overall HVAC market share. Hence there is a lot of scope for consolidation, a view echoed by various managements.
3. Pure-plays: From Lennox being the only pure-play NA player a year back, three new NA pure-plays have emerged in the last few months as a) CARR got separated from UTX b) Trane (earlier Ingersoll-Rand) separated non-HVAC into IR through RMT with GDI and c) JCI sold off its power solutions business.
4. Replacement a major driver: Contrary to popular belief that new housing stats drive growth, replacement demand comprises 75% of demand thereby driving low revenue volatility, high margins, and solid pricing power.
5. CARR’s differential strategy: Unlike its competitors, CARR discontinued its business model from selling directly to a distributor-led model in NA, by forming a JV with Watsco in 2009. This gave both the companies flexibility to focus on their core strengths. Additionally, this is not an exclusive partnership which gives flexibility to both the companies to choose a different distributor/company’s products. This could help CARR to penetrate markets where the JV’s reach is weak. CARR dealers are rated 15% higher in customer satisfaction versus the competition, which is a notable metric.

III. Economics of HVAC Landscape

CARR has a diversified exposure to Residential, Commercial unitary, Commercial applied, Transport Refrigeration and Fire & Security. Both CARR and Lennox (LII US Equity) have low exposure to applied while Trane (TT US Equity) and Johnson Controls (JCI US Equity) are market leaders in applied. CARR has ambitions to become #1 player from #3 currently in applied HVAC. Below we highlight the market characteristics of these segments individually:

1. Residential unitary:

a. Oligopolistic nature and use of standardized equipment without the same level of complexities associated with larger commercial HVAC deployments lead to better pricing and margins. A strong distribution-led proven strategy creates better RoICs. CARR’s focused approach made it #1 market player in NA and hence it has the highest margins in overall HVAC (including commercial).

b. The average life of a unit is around 14 years but it gets extended to ~17.5-18 years as a lot of consumers, fix their system rather than replacing. Although new equipment sales constitute ~70% of CARR’s revenue, a large installed base of over ~100m residential units and given the housing boom ~12 years ago which saw peak new installation levels, CARR stands to benefit from the replacement cycle.

2. Commercial HVAC

a. Commercial unitary: economics is like residential with both CARR and LII leading in the race followed by Trane.
b. Applied commercial: has a long service life but more exposed to institutional construction. It is a key play on enhancing building efficiency and reducing emissions which leads to frequent non-scheduled upgrade opportunities. Hence, the presence of field personnel is required, also creating an opportunity for local servicing companies and lower margins relative to residential.
c. ESG: A lower share of applied for CARR means that JCI and TT get major ESG investors to focus. Post spin, management’s focus on applied should help improve this gap.
d. Attachment rates: Attachment rates for CARR is low at 25% compared to 50%+ for JCI and TT since both these companies have greater field personnel on the job providing energy efficiency solutions.
e. Revenue opportunity: Though this also provides an opportunity for CARR to invest and grow as an independent company which we believe is a >USD 1 bn opportunity.

3. Refrigeration

Refrigeration is everything about the cold chain moving perishable goods from the point of production (Transport Refrigeration; TR) to the point of use (Commercial Refrigeration; CR).
a. TR: Both CARR (66% of Refrigeration revenues) and TT are close competitors and market leaders. This is a high-margin business but more cyclical. Rising food consumption is a major driver and NA refrigerated trailer industry backlog serves as a leading indicator (which is expected to have peaked in 2019).
b. CR: More multi-industrials companies such as EMR and DOV are also present but the rise of e-commerce is giving a potential threat on the attractiveness of this sub-industry.

4. Fire & Security:

a. This is a fragmented industry with the presence of many multi-industrial players such as Assa Abloy, Honeywell, Siemens, JCI etc.
b. CARR has leadership positions in fire detection and alarm and access control.
c. CARR has a higher proportion of products vs. services for JCI which creates lumpiness.

IV. Financials/ Valuations
Why we see enough room for CARR’s growth…
While Covid-19 has created uncertainties leading to the withdrawing of prior management guidance, we believe that CARR has a long tail of growth as it gathers focus as an independent company after the spin-off. CARR’s sales have averaged 3% in the last 10 years which is above GDP with management guidance of mid-single digits. Going forward it should be higher than peers as expansion in the aftermarket (30% currently), digitalization (AWS migration), increasing sales force by (500 in 2020), geographic expansion in China, altering strategies in underpenetrated areas such as VRF should aid growth.

…along with significant margin expansion opportunity
While CARR’s targeted goal of ~50bps of annual operating margin expansion may be delayed, we think a lot of low-hanging fruits along with structural cost outs will lead to significant margin expansion over time. In 2019 pro-form income statement, $225 m of standalone public company costs (1.2% of sales) along with $275 m of other individual items were allocated to CARR, which in our opinion is high relative to previous spins in the same sector. The insiders (CEO, CFO and operations head) who have come from UTC have a solid operational track record (more below) in achieving such synergies. Officially management had rolled out “Carrier 600” cost out program (before Covid) targeting $600 m from the supply chain, factory and G&A through 2022. 75% of CARR’s manufacturing hours are in low cost and has 27 low-cost COEs throughout the world.

…and a path for normalized FCF to resume again
Our bear case assumes that $1.8 bn of FCF recorded in 2019 (pre Covid) will not be surpassed at least until 2023. Investors were underwhelmed when the company gave a guidance of $1.2-1.3 bn for 2021 in their investor’s day. We expect CARR will take steps to preserve cash and cut back its guidance to increase capex by ~$100 -150 m. But this will be also the case across industry players. Our estimates suggest that current investment spending will be adequate to counter Trane’s and JCI’s incremental investments over the last few years. FCF conversion rate is below peers as just 75-80% of income from JVs is dividend-ed to CARR. CARR trades at a trailing FCF yield of ~16% but a high debt level implies trailing 7.4x EV/EBITDA. Our bear case assumes that the normalised levels won’t reach until 2023 and therefore applying an EV/EBITDA of 10x and FCF yield of 6% on depressed cash flows, the upside could be anywhere in the range of 30-60% and double in 3 years. While investors would be shunning res/ non-res construction, 2/3 rd of the demand driver for CARR is from the replacement market which would lead to pent-up demand and not demand destruction.

Till debt do us part?
After having upstreamed ~$10.9 bn cash to UTX, CARR has been saddled with a debt of $11.4 bn but a comfortable cash position of $950 m and revolving credit of $2 bn. While it has received an investment credit rating by S&P and Moody’s, CARR is exceeding their criteria by ~1.25-1.5 bn which it will need to repay to maintain the IG status. Additionally, we expect the current net debt/EBITDA at 3.5x to jump to 4.8x by 2021 which is likely to breach covenant for its term loan (maturing in 2023) of maintaining 3.5x to 4x. At worst case we expect the interest burden to increase by a few bps for the term loans. The company might also lose their IG status if the rating agencies don’t see a path for the leverage to fall below 3x. However, we note that the first repayment schedule is far ahead at 2023 which would give it ample time to fix this up.

Bond investors seem to have not been pricing a default with yields almost back to when these were issued after
spiking up in end-March.

V. Catalysts for the stock
• Rebound in demand or recovery like 2008
• Corporate cost (standalone company) pushdown
• Divestment of F&S segment: We remain encouraged by the management’s openness to look through
assessing the portfolio from the lens of an activist

VI. Betting on Insiders track record could not be a bad strategy…

Identifying a good SpinCo often involves tracking the movement of insiders. While none of the main architects of the spin-off jumped onto either CARR or OTIS, we like this fact for a change since we did not appreciate the track record of Greg Hayes (RTX CEO) in shareholder’s value generation. We have been critical of his decision to buy Raytheon at the top of the defense cycle (which resisted us from taking a position before the spin-off) and selling Sikorsky at a low multiple. Nevertheless, seven of the ten CARR’s executive management team, including its CEO (since June 2019), have come from UTX in the past one year, with rich experience in cost-cutting and running operations.

Mr David Gitlin, CEO comes with a strong historical track record of executing the integration of Goodrich with UTC wherein he exceeded the headcount reduction estimate of ~1k employees by ~0.3k. Mr. Tim McLevish, CFO has a rich experience of navigating a couple of spin-offs including that of Conagra/ Lamb Weston in 2016 and Kraft Foods in 2011. Rishi Grover, the current head of operations, was instrumental in helping UTC achieve synergies of $600 m (against a target of $ 375 m) from Goodrich acquisitions. Later in 2015, $500m of cost take-out target was also successfully implemented followed by Rockwell Collins synergies which remain on track. Also comforting is the fact that two Board members including the Chairman belong to global private equity – Advent International which could help CARR in closing deals through tough times.

VII. What can derail our investment thesis:
We would not be comfortable and pull out any money (if invested) at any point of time we see risks emanating from 1) environmental liabilities including asbestos and AFFF liability 2) Audit concerns with JV partners (especially related to AHI) 3) Bankruptcy risk and 4) Inferior capital allocation decision by the new management. Additionally, with construction spending being one of the biggest drivers for the HVAC industry, a prolonged slowdown could turn it to be worse than our bear case estimates as well.