EUR 850.00 For Business Accounts Only

Morningstar | We Still Believe UTC’s Breakup Will Unlock Additional Shareholder Value

After taking a fresh look at United Technologies Corp, we raise our fair value estimate to $149 from $147. While we’ve made slight cosmetic adjustments to our model reflecting first-quarter 2019 guidance, the increase in our fair value estimate was exclusively due to time value of money. Our long-term assumptions in the stock remain the same since before shares were placed under review. We also retain our wide moat, Standard stewardship, high uncertainty (given continuing execution risk), and stable moat trend ratings.

While the stock trades in 3-star territory, we note our three-stage DCF values the firm in its present conglomerate form. Our sum-of-the-parts value, which becomes increasingly relevant since the company is pursuing a break-up with the spins of Otis and Carrier during the front half of 2020, yields a value of $177 (up from $175 previously). While the stock price's 24% discount to SOTP value is considerable, our SOTP value is still below what other activists peg the break-up value of the company (we’re hearing ranges between $190 and $210). We suspect the difference lies in the dis-synergies we project from breaking up the company, which is greater than what management is currently guiding to. Even so, we still think this is ultimately the right (albeit delayed) move for shareholders since both Otis and Carrier had to forgo growth opportunities to support the company’s earnings growth. We also believe the company’s focus was largely honed in on aerospace, and our thesis remains that the company will increasingly trade at comparable aerospace multiples over time.

We further believe the combination of Rockwell Collins and UTC leaves a “remainco” with an unequaled portfolio in terms of breadth of products and services, as well as scale in the aerospace industry. Ultimately, we believe aerospace will continue to be a boon for UTC given industry reports point out that revenue passenger kilometers will grow between 4% and 5% over the next two decades.

Finally, we think that media reports have greatly exaggerated the extent of the issues facing the company’s flagship engine--the geared turbofan--and that the company has largely left these issues in the past. We point out that none of the issues relate to the design architecture of the engine. We also think negative engine margins peaked last year in 2018, slightly ahead of the time period of its LEAP competitor (manufactured by CFM International). As a result, we project Pratt’s segment operating margins will reach 16% by 2022 as the engine moves further down the learning curve, the engine’s discounts begin to erode, and sales mix begins to tip further toward the aftermarket.