Carrier’s business transformation creates value (NYSE:CARR)

In the last 14 months Carrier Global (NYSE: CARR) is pursuing an aggressive strategy to streamline its business into a company with a much narrower focus. In early 2023, the company announced a vision to become a pure-play leader in smart climate and energy solutions. Through acquisitions and divestments, Carrier has realized this vision at a remarkably fast pace and now needs to show the market that it can capitalize on this transformation. This article focuses on the background of the transformation, how Carrier compares to its industry peers, and whether Carrier can reward its shareholders in the future.

Viessman Climate Solutions

The cornerstone of Carrier’s vision to enhance its new direction and become the world’s leading provider of heating and cooling solutions was the acquisition of Viessman Climate Solutions in Early 2023. Carrier paid €12 billion in cash and stock for Viessman. Viessman is a well-established premium brand in Europe and significantly enhances Carrier’s presence in Europe. Viessman brings annual sales of around €4 billion as well as a well-established direct sales model that includes more than 75,000 installers in 25 countries. This bolt-on acquisition has grown 15% on a compound annual growth rate basis since 2020, and Carrier expects double-digit growth to continue through 2030.

The key to Viessman’s continued success is the explosion of heat pumps across Europe. The Russian invasion of Ukraine and the subsequent halt of natural gas exports from Russia to Europe prompted Europeans to switch their home heating to electricity to avoid reliance on natural gas and the associated price spikes and fluctuations. In addition, European governments began offering attractive incentives. Due to this continued rapid adoption, Carrier predicts that the current €5 billion heat pump market will triple to reach €15 billion by 2030.

Divestments

To finance Carrier’s acquisition of Viessman, the company has decided to divest all non-core businesses. The company has identified four business units for sale: Global Business Solutions, Commercial Refrigeration, Industrial Fire Solutions and Residential and Commercial Fire Solutions.

Carrier started its divestment wave by selling its Global Business Solutions to Honeywell (HON) for an enterprise value of $4.95 billion. At 17 times 2023 EBITDA, Carrier was able to command a premium for the segment. Just one week later, Carrier was able to sell its Commercial Refrigeration division to Haier for an enterprise value of $775 million. In Q1 2024, the company announced the sale of its Industrial Fire Business to Sentinel Capital Partners for $1.425 billion.

With the sale of three of its four identified business units, Carrier has raised net proceeds of approximately $5.5 billion. This leaves only the residential and commercial firefighting business on the hit list, and management is confident of finding a buyer in the next few months. Since announcing the business transformation, management has made it clear that it will use the proceeds from each business sale to reduce balance sheet pressures. In a recent presentation, CFO Patrick Goris stated:

We said $5.5 billion would go to deleveraging the company. So we’re going to pay down our long-term loans first, which have the highest interest rate. After that, we’ll see what we pay down, what’s most economical. We might actually decide to keep the cash on the books for a while, because in today’s environment, the cash could earn more than some of our debt.

In addition to paying down debt, the company has also announced that it will begin repurchasing shares in late 2024 using free cash flow and proceeds from the sale of its residential and commercial fire protection businesses. Carrier issued 58 million shares to finance the acquisition of Viessman, and the company intends to repurchase any dilution from this transaction.

Carrier’s decision to streamline its business and focus on its core competencies in heating and cooling solutions makes a lot of sense. The move will allow the company to focus on revenue growth and margins much more easily. Carrier expects to realize $200 million in cost synergies by 2026, with savings of approximately $75 million in 2024. In addition, the acquisition will be accretive to earnings per share in 2025.

Investors will need to determine whether Carrier’s business transformation will benefit shareholders going forward. There is no doubt that the Viessman acquisition improved market share in Europe, but can the new, simplified company take market share in the U.S. and outside of the U.S. from industry giants like Lennox (LII) and Trane (TT)?

Rating compared to competitors

Since announcing its business restructuring and acquisition of Viessman, Carrier has significantly underperformed its peers. In contrast to Carrier, Trane and Lennox have undergone significant revaluation. In the past, these stocks have had price-to-earnings ratios of over 10 to under 20 percent. However, over the past 12 months, these valuations have skyrocketed as the shares have rapidly increased in value.

Much of Trane’s outperformance is likely due to its leading organic growth rate of 8-9%, compared to Lennox at 4-5% and Carrier with just 2% organic growth. For 2024, Carrier expects revenue to grow 12%, including acquisitions and divestitures. It will take a few more quarters for investors to get a clear picture of Carrier operating exclusively within its new, slimmed-down company, similar to Lennox and Trane. However, investors can expect Carrier’s adjusted operating margin to be similar to its peers going forward. Carrier expects Viessman’s adjusted operating margin to be about 15.5%, which is in line with its existing heating/cooling solutions.

Buy thesis

Since Carrier is lagging behind its peers and trading at a lower valuation without meaningful differences in growth and margins, Carrier could be ripe for a catch-up trade. Once the company completes its transformation, investors will have to take another look at Carrier and decide if it really deserves such a large discount to its peers.

The HVAC industry is benefiting from numerous tailwinds and megatrends, and Carrier will benefit from them. First, no analysis is complete without a clear picture of the impact of AI on the company and its industry. Obviously, cooling solutions are an integral part of AI data centers, and the HVAC industry is seen as a clear beneficiary. During Carrier’s Q1 2024 earnings call, CEO David Gitlin stated:

Today, AI accounts for about 20% of the load of a typical data center, and some of our customers predict that percentage will rise to 80% in the next few years, resulting in tremendous strain on the grid and increasing need for differentiated HVAC and control solutions.

Accordingly, the data center market for the HVAC business is expected to grow from around $7 billion in 2023 to $15-20 billion in 2027. For us, this area represents a low double-digit percentage of our global commercial HVAC application business.

And we see tremendous opportunity to grow this segment to well over 20% of our commercial HVAC sales over the next few years. We doubled our backlog in the first quarter alone and achieved additional key wins in April as we optimize the use of our global footprint to support our customers.

Carrier expects its data center business to grow from a low double-digit percentage of the commercial HVAC business to over 20% over the next few years. The company expects its data center business to essentially match the HVAC data center potential of 20% annually through 2027.

Another trend benefiting Carrier is the increasing frequency of heat waves affecting large populations around the world. This past weekend alone, heat advisories were issued for over 100 million people on the East Coast of the U.S. This highlights the need for efficient HVAC systems in some areas that may not have always had air conditioning in homes in the past. This also puts more strain on older equipment, leading to mechanical failures sooner than expected. Ironically, as I began writing this article in Central Texas over the weekend, my air conditioner suddenly stopped working, setting off a scramble for replacement parts (for my non-Carrier unit) and bids for new air conditioners. As you might expect, Carrier has an erratic quarterly revenue skewed toward the back, with the majority of revenue coming in the third and fourth quarters. But increasingly earlier heat waves can also lead to a spike in revenue in the second half of the second quarter.

One final trend that can be seen across Europe: heat pumps are quickly becoming the standard in HVAC systems due to government incentives and efficiency. Viessman sees Carrier at the forefront of this trend across Europe. Carrier predicts that the heat pump market will grow by an average of 20% annually until 2030. Even though this trend is not linear and the growth of the heat pump market from €5 billion to €15 billion by 2030 could be erratic, Carrier will be a leader in this space and capture a significant market share.

With its current price-to-earnings ratio of $62/share and 22 forwards, Carrier is trading at the high end of its historical average valuation. I would recommend investors with a 3-5 year investment horizon buy shares slowly to profit from price fluctuations. While the stock could rise and catch up to peers’ valuations, I believe it’s more likely that Trane and Lennox will return to Carrier’s levels. However, as Carrier becomes a pure-play heating and cooling company, the company has numerous growth levers it can leverage over the medium to long term.

As Carrier completes its transformation and increasingly benefits from the above tailwinds, I expect Carrier to see an improvement in organic growth to mid-to-high single digits and stable margins at around 15-16%. Additionally, considering that Carrier will repurchase 58 million shares or 6.5% of total shares outstanding, the company should see EPS growth in the low double digits. Combined with a de-leveraged balance sheet, Carrier’s fundamentals will improve significantly in 2025. Therefore, I would set a price target of $72/share for the next 12-18 months.