EUR 850.00 For Business Accounts Only

Morningstar | Aerospace Businesses Flying High in United Technologies' 2Q Results. See Updated Analyst Note from 24 Jul 2018

We're planning to raise our $137 fair value estimate for wide-moat United Technologies by $3, following second-quarter earnings that featured an earnings beat and a full-year adjusted EPS guidance upgrade to $7.10-$7.25. We note that this new outlook excludes 10-15 cents of anticipated dilution from the pending Rockwell Collins deal and that we are already including Rockwell in our estimates.

Most of the items we flagged last quarter are clicking into place with aftermarket growth powering the aerospace businesses, GTF deliveries finally turning a corner, and the Climate, Controls, & Security top line continuing to show strength (up 7%). On the other hand, Otis continues to test investors' patience and while the unit grew year over year and posted solid new order growth of 10%, it turned in 230 basis points of margin contraction due to legal costs and weak pricing. Tariffs and input costs continue to weigh on CCS and to a lesser extent Otis plus United Technologies' other businesses. Management stated that they anticipate tariffs only creating 5 cents' headwind EPS this year.

Consolidated revenue rose approximately 9% (6% organic) with the aerospace aftermarket--both at Pratt & Whitney and Aerospace Systems--pushing the top line higher. GTF engines at Pratt also contributed to growth and deliveries more than doubled this quarter on a sequential basis. Unadjusted segment operating margins came in at 18.1% up 350 basis points but after controlling for the gain related to the Taylor sales as well as other items, operating margins contracted year over year. Indeed, all businesses--except Aerospace Systems thanks to cost reductions--registered adjusted operating margin contraction this quarter. Free cash flow came in flat versus last year at $1.7 billion and United Technologies confirmed its outlook for $4.5 billion-$5.0 billion of free cash flow.

Management anticipates a Rockwell closure in the third quarter of this year, noting that as late as April of this year the company was still mentioning possible closure in the second quarter. The $500 million of net synergies was mentioned again by management and we note that this includes $100 million of synergies related to Rockwell's acquisition of B/E Aerospace, which was conducted just prior to United Technologies acquisition announcement of Rockwell.

Management touched briefly on the possibility of a breakup, restructuring, or other corporate action and confirmed our expectation that it will announce something toward the end of this year. We thought a breakup was more likely late last year but our sense is that the strong start to 2018 has alleviated some of the pressure on the board to announce drastic measures to unlock value and the probability of a plain-vanilla restructuring has increased, in our opinion. Our sum-of-the-parts valuation comes in at $145-$150 per share, which is only 11%-15% above where shares are currently trading.

Aside from a possible restructuring or breakup, we continue to monitor both tariffs and input cost increases. The CCS business is the most exposed to tariffs with approximately half of the impact this year being felt in this business. Management flagged input costs as a headwind as well, citing rising commodity prices and, in our view more important, labor shortages as concerns. Going into 2019 these items will likely continue to weigh on CCS. But Otis may be able to offset these costs more effectively next year as 2018 orders with improved pricing convert to sales (backlog conversion is around nine to 12 months) and thanks to improvement in its European aftermarket activities, which saw unit revenue stabilize for maintenance activities. All else being equal, we think tariffs will create a more significant headwind to profits than the $50 million impact management is citing for 2018, and if the trade war spreads we think revenue could take a hit.