Carrier Global: 20x FCF; Strong Margin Expansion (NYSE:CARR)

Carrier Global Corporation (NYSE:CARR) announced its Q3 FY23 earnings on October 26th. The management is confident about delivering mid-single-digit organic revenue growth and a 15% adjusted EPS growth for the full year. I believe their cost control initiative is well-positioned for margin expansion in the coming years. Considering the recent market pullback, Carrier’s stock price is currently trading at 20 times its free cash flow. I find this valuation quite attractive and, therefore, maintain a ‘Strong Buy’ rating.

Q3 FY23 Result and Outlook

In Q3 FY23, Carrier delivered 3% organic revenue growth and 21.3% adjusted operating income growth, and the management is guiding 5% organic revenue growth and 15% adjusted EPS growth for the full year of FY23.

It is worth noting that their free cash flow increased dramatically in the first three quarters, reaching $1.3 billion YTD, compared to only $407 million last year. I believe their remarkable margin expansion and free cash flow are driven by the following factors.

Price increases have been a major driver of margin expansion for the company. The pricing of their 454-B system has risen by 15%-20% over the past two years, as mentioned in the earnings call. This increase is partly due to their annual price adjustments and partly because of additional costs associated with 454-B, including leak detection and sensor control. The management indicated they expect a price increase of around 10% this year, and they plan to adjust the annual price in 2024 and 2025 as well. R-454B is the new refrigerant replacing R-410A, with R-410A scheduled for elimination from all new systems in 2023. For readers interested in 454-B, please refer to this article.

Additionally, Carrier has been working on a cost management initiative, which has shown positive outcomes in the past two quarters. Their operating income increased by 11.8% in Q2 and 21.3% in Q3 this year, which is quite remarkable. In the last quarter, they raised the target for cost synergies with Toshiba Carrier from $100 million to $200 million. These cost initiatives have helped Carrier manage their operating expenses and improve margins.

In my opinion, the price increases and cost initiatives are the two main reasons for their margin expansion. Regarding the full-year guidance, there have been slight updates as follows. The new guidance aligns closely with the financial projections in my model. I am confident that they can achieve a 5% organic revenue growth and generate $1.9+ billion in free cash flow for the full year.

Viessmann Climate Solutions

As I mentioned in my introductory article, the heat pump market is poised for structural growth in the coming years. Carrier’s management emphasized during the earnings call that residential heat pump penetration is only 8% in Europe. Furthermore, 21 countries offer subsidies to support their 2030 and 2050 decarbonization goals. Viessmann Climate Solutions is strategically positioned to capitalize on this trend, with the company well-positioned to gain market share. Viessmann also has a competitive edge by providing solutions for all energy classes, including heat pumps, gas boilers, and hydrogen boilers, while some competitors specialize exclusively in heat pumps or boilers. In FY23, Viessmann’s revenue increased by 18% year-to-date, with heat pump sales growing by 35% year over year.

According to a report by Grand View Research, the heat pump market is expected to grow at a compound annual growth rate of 9.3% from 2023 to 2030. I believe that favorable government policies serve as the primary growth driver for heat pumps. The European Heat Pump Association published a report titled ‘Subsidies for Residential Heat Pumps in Europe‘ in March 2023, revealing that major EU countries provide government subsidies for low-carbon emission heat pumps. Given the ongoing energy crisis caused by Russia, I anticipate that these government subsidy policies will remain in place for several years.

Business Exits Timeline On Track

I discussed Carrier’s business exits for their Fire & Security and Commercial Refrigeration businesses in my initiation article. Their management expressed that all the exit timelines are on track, and they expect to sign a definitive agreement by the end of Q1 FY24 for Security, Industrial Fire and Commercial Refrigeration businesses. In addition, they are going to create a stand-alone company for their Residential and Commercial Fire business.

I view these business exits as catalysts to their stock price for the following reasons. The refrigeration business is quite cyclical in nature, as it is tied to commercial capital expenditure cycles. The organic revenue for refrigeration was -1% in FY19 and -12% in FY20. Therefore, the exit of the refrigeration business could reduce Carrier’s overall cyclicality. Regarding the Fire & Security business, the average organic revenue growth has been only 1% over the past four years. Basically, there is not too much growth in this business. In short, the exits of refrigeration and Fire & Security and the addition of the heat pump business make total sense to me.

Key Risks

They disclosed that North America residential HVAC sales were down low single digits in the quarter, and residential volume was down low double digits. In addition, they expect North America residential HVAC volumes to be down mid-teens for the full year.

The volume decline in North America is not surprising. The overall new residential housing market is facing several headwinds from the high-interest rate. The residential housing starts dropped 15.7% in August 2023, and another 7.2% in September 2023 on a year-over-year basis, according to the United States Census Bureau. Additionally, the distribution channel is destocking residential HVAC products currently as their management indicated in the earnings call. They expect the destocking to continue in Q4 FY23. It is quite clear that the North America residential HVAC market is facing near-term growth challenges.

Valuation

I updated the FY23 assumptions in the DCF model and revised the organic revenue growth to 6% and M&A growth to 5% due to the Viessmann Climate Solutions acquisition. The free cash flow in FY23 is forecasted to be $1.928 billion, pretty much in line with their guidance of $1.9 billion plus. The rest assumptions are kept intact.

The fair value of the stock price is calculated to be $60 per share as per my estimates. Currently, the stock price is trading at 20x of free cash flow, and I believe it is quite cheap for a double-digit earning grower.

Conclusions

Carrier’s pricing increase and cost management initiatives are contributing to their margin expansion and free cash flow growth. The stock price is undervalued due to the recent market sell-off. I maintain the “Strong Buy” rating with a $60 per share fair value.