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Morningstar | United Technologies Crushes 4Q Consensus and Rockwell Performing Better than Expected; Shares Cheap

United Technologies crushed fourth-quarter 2018 consensus EPS of $1.53 by around 40 cents thanks to taxes and strong performance from recently acquired Rockwell Collins (dilution was 3 cents compared with management expectations of 10 cents). We count the solid outlook for Rockwell’s 2019 cash flow coupled with acquisition synergies already coming through as positives as well. The name rallied 5% post-earnings but our $144 fair value still implies 20% upside. We also updated our sum of the parts valuation, which resulted in a $173 value in a breakup scenario compared with $168 previously.

Strong growth out of the aerospace businesses confirms the logic behind management's plans to spin off the other businesses. Pratt & Whitney registered 22% organic growth due primarily to the GTF; engine shipments were up sequentially and full-year 2018 came in at roughly twice 2017 levels. After controlling for the incorporation of Rockwell late last year, legacy UTAS registered 8% aftermarket growth, and double-digit growth in parts and repairs. While organic growth out of Otis and CCS (now Carrier) during the quarter was respectable at 5% and 6%, respectively, these businesses continue to grow more slowly than aerospace.

Adjusted operating margins compressed year over year across all segments except for Otis. Nonetheless, Otis’ 2018 full-year performance was toward the bottom end of guidance. Pratt’s margins saw the most pressure, contracting nearly 300 basis points in the last quarter of 2018 due to negative margins on GTF. Despite hitting its growth targets and management highlighting strong pricing during the past quarter, Carrier missed on full-year profit growth. Lastly, Collins Aerospace posted performance in line with guidance.

Management issued 2019 guidance calling for an adjusted EPS midpoint of $7.80. The company anticipates 3%-5% organic growth and 2019 free cash flow of at least $6 billion excluding $1.5 billion separation costs related to the breakup.

Improvements in working capital items such as inventory in the aerospace businesses and receivables at Carrier is driving cash flow higher, as opposed to capital expenditure, which will increase about $200 million in 2019 to around $2.1 billion per our estimates. In an attempt to alleviate investor concerns around cash generation at Rockwell, management broke out cash flows for the legacy Rockwell business, which should land at around $1.4 billion per company guidance ($1 billion after accounting for integration and other acquisition costs).

It’s worth pointing out that United Technologies isn't contemplating a significant slowdown in economic growth in its 2019 guidance, which we think would impact Carrier and Otis more than the company’s aerospace segments given the shorter cycle nature of these businesses. Like 2018, United Technologies anticipates stronger growth out of its aerospace activities--Pratt & Whitney up high-single digits and Collins Aerospace up mid-single digits--compared with low to mid-single-digit growth from Otis and Carrier.

Based on this revenue guidance and management’s adjusted operating profit growth targets, the non-aerospace businesses are likely to have flat year over year profit margins in 2019 and Otis may even see margin contraction. We calculate that Pratt should see some margin expansion, but the business will remain well below double digit operating margin levels. Collins Aerospace will register margin expansion in part thanks to Rockwell’s higher operating margins partially offset by costs linked to the acquisition. In Collins Aerospace, management anticipates $100 million of costs linked to the Rockwell deal as well as $150 million of synergies, which represents 30% of the annual cost synergies targeted by management.

Overall, the company’s operating segments should add about $1.85 to 2019 EPS compared with 2018 with a large portion of this driven by the inclusion of Rockwell Collins. Offsetting this $1.85 is $1.26 of interest expense (68 cent headwind) and a higher share count of around 870 million shares (58 cent headwind). Rockwell accretion should be 35 cents in 2019 versus initial expectations of 15-20 cents due to lower intangible amortization and greater synergies. The 2019 EPS guidance includes 50 cents of intangible amortization linked to the Rockwell deal.

Lastly, we updated our SOTP valuation on United Technologies. Based on a refined multiple for Otis (we brought it down a bit due to lackluster profit growth in 2019) and on a what we view as a more normalized operating profit figure for Pratt, we arrive at a fair value estimate of $173. Thanks to some initial balance sheet items in the United Technologies earnings release, this new fair value also includes a slightly refined walk from enterprise value to equity value.

Our SOTP approach reflects the value in a breakup scenario. Management believes it will be operationally ready to execute a breakup of the company by end 2019 but dealing with the tax implications of cleaning up legal entities will take additional time. As a result, management targets the first half of 2020 for the spin-off of Carrier and Otis.