EUR 850.00 For Business Accounts Only

Morningstar | United Technologies Posts Solid 2Q Results; Spin-Offs Are on Pace

Wide-moat United Technologies reported solid second-quarter results, but they don’t alter our long-term fundamental view of the firm. Even so, we plan to raise our fair value estimate to $150 per share from $149, which implies a nearly 19 times multiple to our raised adjusted EPS assumption of $8 for full-year 2019 (toward the upper range of management’s revised guidance). We did tweak some near-term assumptions in our model--slightly higher top-line expectations for aerospace offset by slightly lower ones for commercial--but the $1 fair value increase was driven entirely by time value of money. At about $135 currently, shares continue to trade at a slight discount to intrinsic value, as indicated by both our DCF-derived fair value estimate and our sum-of-the-parts valuation of $175 per share.

UTC’s sales rose to $19.6 billion, up 18% year over year, including an impressive 6% on an organic basis. Management raised its outlook for organic growth to 4%-5% from 3%-5% previously. No doubt UTC’s strong top-line results were in large part driven by its aerospace portfolio. Both Pratt & Whitney’s and Collins Aerospace’s organic sales rose by 9%. Pratt’s commercial original-equipment manufacturer sales were up 22% thanks to P&W Canada engine shipments, and while the segment’s adjusted operating profits rose 7% year over year. Pratt has had some favorable geared turbofan engine cost reductions as the program comes down the learning curve, along with some favorable large commercial engine mix from the older-generation V2500. Pratt booked nearly 1,000 GTF firm and option orders at the Paris Air Show.

Encouragingly, based on management’s comments regarding Pratt’s rejected IndiGo bid, strong order growth appears to not have come at the expense of pricing: Commercial aerospace engines are heavily discounted, particularly during their ramp-up. This is important because engine manufacturers typically aim for low to midteens returns on invested capital with any engine program, and any discounts can affect the program’s underlying assumptions. However, even with the benefits of the GTF’s innovative technology (in terms of fuel efficiency and noise reduction specifically), some customers have begun to express concerns about UTC’s focus in the upcoming months.

Specifically, Delta CEO Ed Bastian called out UTC for “some distractions along the way” about a month ago during a CNBC interview. While we like how UTC is reshaping its portfolio (pure plays are generally more focused, and we suspect Otis and UTC may have suffered from some underinvestment at the expense of preserving margin), like its early June announcement that it plans to merge with defense contractor Raytheon, it’s no doubt hard to juggle so many balls. That said, given the similar levels of undervaluation in both UTC’s and Raytheon’s stock at the time the deal was announced and the added scale and R&D benefits, we still believe the deal makes both financial and strategic sense over the long run (even as it may come at the cost of shorter-term shareholders looking to benefit from the spin-off catalysts).

Finally, sales in Europe, the Middle East, and Africa slumped amid a difficult macroeconomic backdrop, which we consider largely outside of management’s control, even as it appears to have taken the firm by surprise. EMEA commercial sales fell 3% year over year. Even so, we think the wide moat around this business remains intact. Service hours per unit actually fell 5% year over year, which means productivity is flowing through to the segment’s bottom line. Europe is a big profit pool for Otis’ higher-margin service revenue, and the segment has a market-leading installed base there. While we still believe location-density cost advantage remains the segment’s primary moat source, management provided some details on the switching costs in the business—switching rarely occurs because of price in the elevator business; they occur because of service. Otis has used some new predictive maintenance technologies that both minimizes its costs (less maintenance technician callbacks) and helps with customer stickiness, as evidenced by retention rates.

Overall, we believe our UTC thesis remains intact.