Description

Background

Carrier (CARR) is currently a heating and refrigeration conglomerate that was spun out of UTX in 2020, and has undergone a significant transformation in the last 6 months, turning it into a pure-play residential and commercial HVAC company.

Historically the company operated under three different business lines, HVAC, Refrigeration and Fire & Security under a structure that it inherited from the spin-off. The HVAC business is the crown jewel of the portfolio, growing 7.7% CAGR between 2019 and 2023 with 17% operating margins. Conversely, Fire & Security and Refrigeration grew at 1.7% CAGR and 1.2% CAGR respectively at 100-300bps lower margins than HVAC. As a result, Carrier's growth and margins have lagged peers Lennox and Trane, resulting in a 4x multiple EV/EBITDA discount.

Source: Carrier 2022 Investor Day Slides

However, in April 2023, Carrier announced plans to acquire Viessmann Climate Solutions, a market leader in heat pumps and connected solutions in the Europe to gain exposure to the fastgrowing European heat pump market. In conjunction with the acquisition, Carrier is divesting their non-core business lines and have already announced two major transactions in the last month and expects to complete the remainder of the divestments by mid-2024.

Following the deals, Carrier will be a pure-play HVAC focused company with a HSD mediumterm growth rate with upside if the European heat pump market resumes its secular growth trajectory or the US refrigerant change drives significantly more mix and price benefits than currently expected. Carrier expects Viessmann to be 100bps accretive to revenue and EBITDA growth pro forma for the all the transactions contemplated.

Thesis

Carrier currently trades at 13.3x 2024 EV/EBITDA compared to peers Lennox (LII) and Trane Technologies (TT) who trade at 17.3x & 17.6x 2024 EV/EBITDA respectively. I believe the discount since the spin-offis a result of lower growth and less earnings consistency, driven by the more cyclical and lower margin segments that Carrier is divesting — Security, Fire monitoring and Commercial Refrigeration.

I believe that after the transformation is complete, Carrier will be a pure-play HVAC company with exposure to secular trends in the US and European HVAC markets, leading to a closing of the valuation gap to its pure-play HVAC peers Lennox and Trane.

After the deal was announced, Carrier's re-rating has been hindered by elevated pro forma leverage above 3.0x, uncertainty around divestment timing, valuation and proceeds and potential slowing of the European heat pump market, with issues at Nibe Industries causing majority of the narrative change, which I will elaborate on each later on.

Strategic Transformation

In April 2023, Carrier announced the acquisition of Viessmann Climate Solutions for €12bn (80% cash / 20% equity), valued at 16x pre-synergies and 13x post-synergies. While the transaction was viewed as expensive and would increase leverage (net debt / EBITDA) from 1.2x to 3.2x, the growth potential of the European heat pump market expected at double-digits through 2030 does justify the price paid. The deal is expected to close in 1Q of 2024.

As part of the Viessman acquisition, Carrier announced planned exits of their Security, Fire monitoring and Commercial Refrigeration businesses, to re-focus the portfolio and de-lever.

In December 2023, Carrier announced the sale of Security to Honeywell for $5bn and Commercial Refrigeration to Haier for $775m (including $200m of net pension liabilities). These two transactions would de-lever Carrier from 3.0x to 2.2x. Carrier is under-going a dual-process to sell or spin the remaining Residential and Commercial Fire business.

While there was some concern initially on the timing and valuation of the divestments, Carrier is more than half-way through, earlier than expected and at valuations at or above expectations thus far. Carrier is also committed to using excess cash to repurchase shares from the dilution of the deal.

Viessmann and European Heat Pump Market

Viessmann's exposure to the secularly growing European heat pump market was the primary strategic rationale for the deal. This market is expected to grow at double-digits through 2030 due to regulation, higher efficiency and reduced reliance to natural gas, which has become a significant challenge in Europe.

Source: Carrier Acquisition of Viessmann Slides

While there has been recent negative news and sentiment on the growth trajectory of the market due to a delay in legislation and lower natural gas prices, most of that growth stalling is attributable to Italy and France which were earlier adopters due to significant government subsidies and incentives, which have since been reduced, leading to the decline. Italy and France make up <20% of Viessmann while Germany is —45% of the mix. Germany is also significantly under-penetrated, with the adoption rate under 5% according to the Carrier CEO at the recent Baird conference.

The following diagram shows the penetration rate of Germany relative to France and Italy but also the potential size of the prize, comparing them to the Nordic countries.

Source: https://www.theecoexperts.co.uk/heat-pumps/top-countries

In September 2023, the German government approved legislation for new homes to run on at least 65% renewable energy by 2026, although existing homes will not need to be replaced despite a requirement being originally proposed on the basis of the ruling being to onerous on cost to existing homeowners. That said, I believe that the climate lobbyists will continue to push for government incentives to switch to heat pumps to meet climate goals and reduce reliance on natural gas from Russia. The other attractive aspect of Viessmann is their connected solutions offering, which also fits the secular trend of smart-home adoption.

US Refrigerant Change

Within the US, there is an upcoming regulation mandating the phase out of R-41 OA refrigerants by 2025 to adopt the new R-454B standard, which provides pricing and mix benefits during the adoption of 454B. The R-454B units will require new sensors, control boards and more advanced heat exchangers to maintain energy efficiency ratings that will come at a higher price to consumers.

Given the concentration of the US residential HVAC industry (top 5 control —80% market share), pricing power is likely to hold and could add 2-3% of pricing power on the low end and up to 5-7% of pricing power on the high end, with potential of 10% upside to consensus EBITDA estimates for all HVAC companies in 2025. This secular growth potential of the US HVAC market underpins the 17x multiple that Lennox and Trane are valued at, and I expect this growth to be a bigger portion of Carrier once the transformation is complete. There are also several ESG angles that prop up Lennox and Trane valuations relative to other multi-industrial companies.

Valuation

Carrier is currently trading at 13.3x pro-forma 2024 EV/EBITDA and I believe that it should trade at 17x, similar to Lennox and Trane. The catalyst path to get there would be continued deleveraging from 3.0x post Viessmann down to 1.2x after the completion of the sale or spin of the Fire business, which I value at 12.0x on —$300m of EBITDA.

I believe Carrier is worth $75/sh (21% upside), which equates to 17.3x 2024 EV/EBITDA before any synergies. Suppose the synergies are captured faster, there is upside to $80/sh (38% upside).

Notes:

1. Viessmann acquired for €12bn (80% cash / 20% stock, with 59 million new shares issued to the sellers) at 13x 2023 EV/EBITDA, including €200m of synergies to be realized by year-5

2. Sold to Haier for $775m, including $200m of pension liabilities. Net proceeds expected at $500m.

3. Sold to Honeywell for $4.95bn at 17x 2023 EV/EBITDA.

4. Net proceeds expected at $4bn. 4) Expected sale/spin at -12x 2024 EV/EBITDA.

Risks

Risks to the thesis include significant lack of adoption of heat pumps which could potentially impair Viessmann growth by as much as 20%.

Catalyst

Closing of Viessmann in 1Q24.

Divestiture of Fire segment in mid-2024.