Life hasn't started out easy for heating, ventilation, air conditioning and refrigeration (HVACR) and fire security company Carrier (CARR 0.18%) since it became a publicly traded company in early April. The company's spin out from the former United Technologies was supposed to usher in a period of change -- the expectation being that management would be unleashed in order to fully realize the potential in Carrier's portfolio. Unfortunately, the COVID-19 pandemic had other ideas, and the company has immediately faced headwinds. Let's take a look at the investment case for the stock as it stands now.
The case for buying Carrier stock
Putting valuation aside for the moment, there are probably two key arguments for the underlying investment case in the industrial stock:
- As a stand-alone company, Carrier is now free to take action to improve margin, and win market share from competitors like Trane Technologies and Johnson Controls.
- Along with its peers, Carrier has a long-term opportunity to benefit from so-called mega-trends favoring HVACR -- urbanization, a growing middle class demanding indoor climate control, rising urban temperatures, and regulation around HVACR.
On the first point, Carrier's plan is to cut costs by $600 million by 2022 -- the so-called Carrier 600 plan -- with around 55% of it coming from reducing supply chain costs by consolidating suppliers. The rest will come from cutting factory costs by increasing automated production, and improving productivity of general and administrative work. Given that adjusted operating profit was just $2.6 billion in 2019, the cost reduction plans look significant.
Meanwhile, the HVACR mega-trends will remain in place leading to mid-single-digit revenue growth over the medium term.
It's a compelling case, or rather it would have been had the COVID-19 pandemic not come along in order to throw a spanner in the works.
Along comes COVID-19
The effect of COVID-19 on the company can immediately be seen in the change in the management's outlook for 2020. As you can see below, there are some hefty reductions in expectations, and the wide range in current expectations reflects the uncertainty in the global economy.
HVAC units. Image source: Getty Images.
In case you are wondering why sales and adjusted operating profit were only expected to make a modest improvement in the original guidance, it comes down to a collection of near-term headwinds in each of its businesses.
For example, HVAC ($9.7 billion worth of sales in 2019) is coming up against a difficult comparison with last year because customers were buying ahead of a regulatory change. Carrier wound down its residential intrusion business in the fire and safety segment (overall sales of $5.5 billion in 2019), meaning sales were going to decline anyway. Finally, the refrigeration segment ($3.8 billion sales in 2019) faces headwinds from the cyclical slowdown in the trucking market (transport refrigeration).
As such, the best way to make a comparison is to look at the prior guidance and then the updated current scenarios.
|
Carrier |
Current Scenarios |
Prior Guidance for 2020 |
2019 |
|---|---|---|---|
|
Sales |
$15 billion to $17 billion |
Up slightly from 2019 |
$18.6 billion |
|
Adjusted operating profit |
$1.7 billion to $2 billion |
Up $25 million-$75 million from 2019 |
$2.6 billion* |
|
Free cash flow |
More than $1 billion |
$1.3 billion to $1.4 billion |
$1.8 billion |
Data source: Carrier presentations. *stand-alone pro forma
Management's actions
In response to the slowdown, Carrier's management took the following actions:
- Increased cost-saving activities, with $425 million expected to be cut from costs in 2020.
- Cut 2020 capital spending plans from $350 million-$400 million to a new range of $200 million-$225 million.
- Deferred and scaled back expectations for initiation of a dividend, but management promised more news on that in the near future.
The last two actions make perfect sense in the current environment, not least because Carrier has slightly more than $11 billion in long-term debt on its balance sheet. In other words, it needs to preserve cash in order to avoid any potential liquidity pressures.
The cost savings are a combination of delivering $225 million in costs savings in 2020 from the Carrier 600 plan (the original expectation was for $175 million) and reducing investment to $75 million from an original plan for $150 million. In addition, management is reacting to the COVID-19 pandemic by cutting a further $300 million in costs (mainly furloughing) offset by a $200 million increase in costs caused by COVID-19.
Air conditioning is regarded as an essential by many families. Image source: Getty Images.
The end result is a net reduction of $250 million in costs in 2020. compared to an original plan for a net reduction of $25 million. That's fine, but note that it implies some deferred investment and capital spending that might need to be undertaken in the future.
Time to buy?
The company trades on just 14 times its projected free cash flow for 2020. If that proves to be the bottom, then even a moderate improvement in the economy from then on would make Carrier an attractive long-term investment at this level.
That said, for most investors the answer has to be "no." The company has a market cap of $14 billion and $11 billion in long-term debt. That's fair enough, but it's also trading in markets that are going to be pressured if the economy turns down. In other words, the downside is significant if things go wrong. Carrier is an interesting value stock, but it's definitely for those who are confident of an economic recovery in 2021.
