United Technologies Corporation (NYSE:UTX)
United Technologies is a leading industrial holding company which owns a number of high-quality businesses which benefit from favorable long-term growth trends and recurring long-term cash flows. The company operates in three distinct principal divisions: 1) Aerospace systems (UTAS) and engines (Pratt & Whitney), 2) Otis Elevator Company, and 3) Climate, Controls and Security.
UTX is a market-leading provider of mission-critical aerospace systems and engines for commercial, military and business aircraft. The business can be best described by analogy to the razor blade business, in which initial sales of new equipment are sold at prices close to breakeven (a modest profit for aerospace systems and a loss for engines), but generate highly profitable aftermarket sales of spare parts and services that persist for decades. The aerospace business has significant barriers to entry due to the large upfront required investments in research & development and manufacturing, the long-term nature of the new product development cycle, and high switching costs due to stringent regulatory requirements and the IP-intensive nature of the products.
The growing demand for global air travel should generate a strong tailwind for the aerospace business as a large number of new aircraft will be required to satisfy future passenger demand. The existing backlog of commercial aircraft orders is nearly a decade long at current production levels, which should reduce the business’ cyclicality, and serve as a sustainable source of future growth. UTX will shortly acquire Rockwell Collins, a leader in avionics systems, subject to the completion of antitrust review, which will further enhance UTAS’s competitive position by allowing it to compete in nearly all major aircraft sub-systems and provide a more integrated product offering.
Pratt & Whitney is one of two large engine manufacturers in single-aisle, commercial aircraft, and the leading engine provider for military and small aircraft. Pratt & Whitney recently introduced its new engine platform, the geared turbofan (GTF), which provides material improvements in fuel efficiency and noise reduction versus competitive offerings. Despite several high-profile stumbles during the GTF’s initial launch, which have largely been addressed, the engines’ seven-year order backlog is indicative of its commercial success. Pratt & Whitney’s profit margins, which are currently depressed due to the initial losses associated with the ramp-up of the GTF program, should meaningfully expand as the GTF begins to generate lucrative aftermarket revenues.
Otis is the leading elevator manufacturer and service provider with 30,000 technicians maintaining more than two million elevators. The elevator business benefits from global urbanization trends which support continued long-term growth of new elevator sales and servicing. Otis’ large scale and highly dense route networks enable it to cost effectively and efficiently provide on-site service to its customers. While new elevator sales are modestly profitable, the lifetime value of an elevator sale comes primarily from the associated service contract, which is typically very long-term and highly profitable. We estimate that more than 70% of Otis’ profits come from its service contracts, which represent a growing cash flow annuity as the installed base of elevators grows. While profit margins have declined over the last several years due to increased investments to reignite growth and weakness in China and certain markets in Europe, Otis’ margins are likely to improve as revenue growth accelerates and recent technological innovations improve the efficiency of its service technicians.
UTX’s Climate, Controls and Security (CC&S) business is a market leader in HVAC, refrigeration and fire and security products and services. CC&S offers products under highly regarded brands including Carrier (HVAC), Transicold (refrigeration), Kidde (fire) and Chubb (security). Carrier is number one in HVAC in both the U.S. residential and global commercial markets. Carrier’s leading market share in residential HVAC provides it with a significant advantage as it distributes products to dealers who typically stock only one or two brands according to demand from brand-loyal contractors. Carrier’s residential HVAC business has exhibited pricing power and strong volume growth from the current replacement cycle, which we believe is likely to continue for the foreseeable future. In commercial HVAC, Carrier provides a highly engineered product offering and benefits from the secular trend towards urbanization. The refrigeration business sells solutions for global trucking, shipping, and retail, with growth driven by cold storage transportation in urban markets, and an increased focus on food safety in emerging markets. The fire and security division maintains market-leading positions in product sales due to the strength of its brands, and benefits from high barriers to entry due to the complexity of local regulatory codes and standards.
Despite having one of the most advantaged business portfolios in the multi-industrial sector, UTX is currently trading at about 16 times our estimate of this year’s earnings (pro forma for the acquisition of Rockwell Collins and its associated cost synergies). This valuation is significantly below our estimate of the company’s underlying value based on the overall quality and future earnings growth potential of UTX’s operating subsidiaries.
We have had a constructive engagement with UTX management who appear focused on unlocking shareholder value. UTX management has publicly stated that they will complete a review of strategic alternatives for its business portfolio following the acquisition of Rockwell Collins this summer, and announce the results of the review by year end. The review may result in a three-way separation of Aerospace, Otis, and Climate, Controls and Security. As each of these businesses has materially different capital requirements, competitive characteristics, and investor constituencies, we believe that they will be more likely to achieve fair value as independent companies. In a separation, management focus and alignment will also likely improve as compensation can be more easily designed to meet shareholder objectives, and entrepreneurial zeal is unleashed from the IPO-like nature of corporate spinoffs. Furthermore, by separating the three businesses, each company’s capital structure can be engineered to meet its competitive and long-term capital requirements.
From Bill Ackman (Trades, Portfolio)'s first-quarter 2018 shareholder letter.
