Geoff Gannon April 22, 2020

Carrier (CARR): A Big, Well-Known Business that Just Spun-off as a Cheap, Leveraged Stock

Carrier (CARR) is a recent spin-off from United Technologies. The company has leading brands in Heating, Ventilation, and Air Conditioning (HVAC), fire & safety, and refrigeration. The best known brand is the company’s namesake: “Carrier”. About 60% of profits come from HVAC. About 30% of  profits come from fire/safety. And about 20% of sales and profits come from refrigeration. Although you may be familiar with the Carrier name in terms of residential air conditioning – there are just under 30 million residential Carrier units in the U.S. right now – the company is skewed much more toward commercial, industrial, and transportation uses than some of its competitors. Carrier’s market position is strongest in “the Americas” where it gets over half of all sales (55%). About three-quarters (72%) of sales are for new equipment and the rest (28%) are some form of parts, maintenance, or other “after-market”. Gross margins for both sales and services are basically the same at around 29%. Gross margin variability seems very, very low here. Return on capital is high. If we use only tangible assets excluding joint ventures accounted for under the equity method of accounting – more on this later – Carrier’s pre-tax return on net tangible assets invested in the business would be greater than 100%. After fully taxing these results and then adjusting for a slightly less than 100% conversion (I’ll assume 90% conversion as the possible low-end of a normal 90-100% of EPS converting to FCF range for the company) you’d still be left with unleveraged cash returns on net tangible assets employed greater than 50%. By any measure, the business is incredibly profitable. But, does that matter?

Does Carrier grow?

The company’s investor relations team thinks it does. They explicitly model faster than the market organic growth. There is, however, no proof of this in the five years of financial data included in the spin-off documents. After adjusting for changes in currency, acquisitions, and one-time pick-ups and drop offs of big business in various units – I really can’t tell if this business was or wasn’t growing under United Technologies. Organically, it looks like it was flattish over the last 5 years. Earnings Before Interest and Taxes (EBIT) ranged from about $2.5 billion to $3.7 billion. The central tendency – to the extent there is one – seems like about $3 billion in EBIT. Just to keep us dealing with nice, round numbers I’ll assume Carrier as a spun-off entity will average about $3 billion in EBIT. Obviously, you shouldn’t expect $3 billion in EBIT during 2020 or 2021, because of the virus. Purchases of everything Carrier makes are very easy to defer. This is all cap-ex. If you don’t need a new refrigerated truck – you don’t need to buy from the refrigeration business unit this year. If you aren’t building new stand alone homes, new townhomes, etc. – you don’t need to put in residential Carrier units. Commercial customers who run everything from retail to office and so on may also be husbanding their cash. A good way to keep more cash on hand for a while is to avoid any cap-ex that would have to be done using cash. The businesses Carrier sells through often use credit as an important part of their dealings. In a recession, availability of credit may be scarcer. So, overall, I’ll just stick to talking about what Carrier might be averaging in earnings in let’s say 2022-2026 or something like that as opposed to what it’ll actual earn this year or next year.

My initial impressions of this spin-off were not good. However, I followed my usual spin-off practice of analyzing the company before checking the stock price. A cheap price can offset a lot of issues with an investment. And Carrier stock spun-off cheap. In fact, the stock portion of the market cap isn’t very different from the debt portion of the market cap. And the company is actually rated investment grade by both Moody’s and S&P.

Carrier paid a dividend of about $11 billion (all funded through new borrowings) to its former parent, United Technologies. So, $11 billion in debt / $3 billion in EBIT = 3.7 times Debt/EBIT. That’s close to 4 times Debt/EBIT. And I expect the company will sometimes be at 4 times Debt/EBIT. The debt is beautifully spaced. There’s bank debt in addition to bonds. But, the bonds make up most of the debt. Carrier has notes maturing in 2023, 2025, 2027, 2030, 2040, and 2050. About 75% of the company’s debt is due in 5 or more years. Cash on hand is meaningful. I don’t know the exact number. But, as of the spin-off documents – it would’ve been close to $1 billion. The company’s cap-ex needs are minimal: about 1% to 1.5% of sales a year on average. R&D is higher at 2% to 2.5% of sales. Like I said, gross margins are very stable. So, the main fixed costs uses of cash for the company will be interest on its debt, repayments of its debt (only in certain well-spaced years), and payment on leases.

Carrier is actually pretty complicated and not very well explained in its SEC filings. For example, the company does lease a lot of property. But, it actually owns a ton of property. My best guess is something like 25 million square feet. It’s a big company with 53,000 employees. A little under 50,000 of them are non-engineers – the rest are engineers. A meaningful portion of the U.S. workforce is unionized – and there are collective bargaining agreements that expire all the time. There’s a pension plan, environmental liabilities (potentially quite extensive), and litigation risks. The company also has joint ventures all around the world – some of these are presumably dodgy. For example, Carrier mentions that it identified $380 million (in U.S. dollar terms) of payments made from an affiliated company in dealing in countries that were formerly members of the Soviet Union. It does not say if these payments were merely improper or illegal. However, $380 million over 10 years is a material amount of money to have a poor grasp of. It’s not clear to me that Carrier had a poor grasp on what this money was being used for – or, if the company just accepts that as the cost of doing business in some countries around the world. The company may not be directly responsible for the actions of companies it owns only 20-49% of. However, doing business in these countries and with such poor control over where large payments are being sent does expose the company to risks associated with U.S. anti-corruption laws. Carrier does bid for business. This can include government business. It seems likely that some companies associated with Carrier engage in bribery. And it’s not out of the question that Carrier will have to pay anti-corruption fines in the U.S. for actions it or others took around the world.

The company also has litigation associated with two different substances: one is asbestos (this was included in installations of the company’s products though Carrier itself didn’t produce the asbestos), and a firefighting foam (“aqueous film-forming foam”). Both of these things have been the subject of lawsuits alleging long-term health effects. So, lawsuits in these areas could linger for a long time. The company doesn’t provide much legal disclosure compared to the risks it may face. In fact, it doesn’t provide a lot of disclosure in several important areas such as “properties”. I think the company owns a lot of properties that may be worth a lot more than they are carried on the books for. But, the company’s own filings are little help in this regard. In terms of the number of sites – environmental liabilities are also not low here. There are a number of superfund sites, other clean-up sites, etc. The companies Carrier owns have a long history of manufacturing inside the U.S. – often dating back more than 100 years – and, so, there’s little doubt the company has heavily polluted all around the country. There are estimated amounts for all of these liabilities carried on the balance sheet. As estimated, this stuff is not worrying. It is very small compared to the $10-$11 billion in net debt.

I don’t like the corporate governance here. The board is made up of a lot of people who don’t own much stock in the company. They seem to be generally overpaid. They also seem to have a lot of outside commitments. It’s a very standard board for a huge U.S. company. They have little skin in the game. They will be compensated with plenty of stock. But, if you look at what the bonuses are tied to – it’s really just being awarded based on hitting earnings levels. The company expects to pay a dividend of about 65 cents a share. That’s a 4.4% dividend yield on the current stock price ($14.67). The idea this stock is going to spin-off with a yield of like 4-5% really surprises me. Everything about the price at which this thing spun-off surprises me.

Management’s “medium-term” plan is pretty simple. They expect sales to grow faster than the markets they are in. They expect profits to grow faster than sales. They expect adjusted EPS to grow faster than profits. And then they expect free cash flow per share to grow faster than adjusted EPS per share. The result of this would be that very mid-single digit growth in sales could drive double-digit returns in the stock. In fact, given the price at which this thing spun-off – it’d have to drive double-digit growth in the stock.

While most people prefer using approaches like EV/EBITDA or EV/EBIT – I’m okay with the less correct (in fact, technically, it’s wrong) approach of just using what free cash flow I think the company (if unleveraged) would produce and then what enterprise value that deserves. It seems to me that if this thing was capitalized with 100% equity and 0% debt – we’d expect it to have no problem doing $1.75 billion a year in actual free cash flow. In other words – without debt – your buybacks and dividends could be $1.75 billion a year. If that’s true – we need to consider the debt. The net debt is between $10 billion and $11 billion. Let’s call it $11 billion. And then we need to ask how much free cash flow generating ability has to go to covering the debt. We’ll just use 7%. That’s what I’ll assume you need to make interest payments and retire debt. That works out to about $770 million a year earmarked for the $11 billion in debt. The remainder over that – about $1 billion a year – goes to the shareholders. The stock spun-off with 866 million shares. A steady, reliable free cash flow of about $1 billion a year should be worth no less than about $15 billion. Take $15 billion and divide by 866 million shares. You get $17.32 a share. And yet the stock trades at only $14.58 a share. It’s cheap.

That doesn’t sound astoundingly cheap. But, the estimates I made above are not very aggressive. I am assuming that 7% of the face value of debt in actual free cash flow has to go to servicing that debt. It doesn’t. The company isn’t borrowing at anywhere near 7% a year. And it’s borrowing pre-tax – not after-tax. Actual free cash flow could be more like $2 billion than $1.75 billion. Blue chip industrial companies often trade above 15 times free cash flow.

If we do a calculation using EV/EBIT – the cheapness of Carrier may be more obvious. Market cap is 866 million times $14.58 a share equals $12.6 billion. Debt on a gross basis is $11.4 billion. The company has cash – but let’s ignore that. So, $12.6 billion plus $11.4 billion equals $24 billion. The company’s 5-year average EBIT had been about $2.9 billion. But, its worst EBIT in the last 5 years was $2.5 billion. So, let’s use $2.5 billion. That gives an EV/EBIT of $24 billion / $2.5 billion equals 9.6 times. Most of the company’s business is in “the Americas” with the U.S. being a very big part of that. I’ll use a 25% tax rate instead of the U.S. federal rate of 21%. So, that’s  9.6 / 0.75 = 12.8.

In other words, the most conservative methods I could use for checking to see if the stock is overpriced still gave me a P/E less than 13 times. And – you’re effectively buying the company on margin: 50% debt and 50% cash when looking at that 13 times P/E. The bondholders are providing half the financing here. And – what’s a lot better than buying on margin – is that the financing is mostly in place for over 5 years.

Nothing stood out to me as especially good about Carrier.

I didn’t get a good feeling about the company, its management, etc.

But the company is big and old.

And the stock is cheap on a unleveraged basis.

And yet it’s actually leveraged – very, very economically and for a very, very long time.

Carrier looks like a good spin-off.

Geoff’s Initial Interest: 70%

Geoff’s Re-visit Price: $11/share