The Quiet Giant
By LAWRENCE C. STRAUSS
United Technologies has a lower profile than some other industrial titans, but its prospects look decidedly bright.
from Barron's Cover | SATURDAY, OCTOBER 2, 2010
WITH STORIED BRANDS LIKE Pratt & Whitney jet engines, Carrier air conditioners, Sikorsky helicopters and Otis elevators, United Technologies stacks up well against other industrial conglomerates like General Electric (ticker: GE) and Siemens (SI). But unlike those companies and its own brands, which are household names in much of the world, UTC is almost anonymous.
This quiet giant, however, has perhaps the trio's most balanced business portfolio—one that includes aerospace operations, fire and smoke alarms and commercial refrigeration. That diversity, and the fact that it generates more than half of its revenue outside the U.S., should help the company in any economic environment.
The commercial and industrial segments of the company accounted for nearly 60% of 2009's sales, versus 42% for aerospace. And a little more than 40% of sales came from lucrative aftermarket businesses—spare parts, repairs, maintenance and overhauls–rather than from original-equipment manufacturers.
"They don't have one big item that's going to knock them out of the water," says Howard Rubel, an analyst at Jefferies & Co. He rates the stock (UTX) a Buy, with a 12-month price target of 88, more than 20% above its recent price. And while the company's fortunes are tied to the health of the global economy, United Technologies' ability to generate double-digit earnings in all kinds of economies–even a sluggish one—should keep its profits rising.
"Ten to 12% earnings growth is a heck of a good number in this environment," says Eric Schoenstein, a co-portfolio manager at the Jensen Fund (JENSX), which holds the stock. "I'm not sure the market has truly embraced that."
Schoenstein views UTC as a bargain at its current price. The diversified manufacturer fetches a reasonable 13.4 times the $5.33 a share that analysts expect it to earn next year, roughly in line with the broader market. But the company "could grow earnings 20%-30% faster than the market, and it should command a premium," says Rubel. And while investors are waiting for the economy to recover, the industrial giant offers a healthy dividend yield of about 2.4%.
THERE ARE SIGNS THAT THE DOWNTURN is starting to ease for United Technologies, as orders in many of its businesses have improved. In its second quarter, which ended June 30, the company earned $1.20 a share, up from $1.05 a year earlier. Revenue was up 5%, to $13.9 billion—its first increase since 2008's fourth quarter.
CEO Louis Chênevert
A bright spot during the quarter was the Carrier unit, whose products include heating, air conditioning and ventilation equipment for commercial and residential customers. Organic revenue, which excludes the impact of any acquisitions, rose 7%, owing to a strong showing in the Transicold transport-refrigeration business, plus sales in the U.S. residential market.
Although management lowered its guidance for this year's revenue to $54 billion, the lower end of its previous range, it did boost its earnings range to $4.60 to $4.70 a share, versus $4.50 to $4.65 previously.
The balance sheet looks solid, with debt a manageable 37% of capital as of June 30. And the company's second-quarter free cash flow totaled nearly $1.25 billion.
Skeptics on United Technologies point to the still-struggling global economy and to pricing pressure on new equipment sales, along with headwinds from a stronger dollar and increased spending on research and development, in aerospace in particular. But the company's businesses are gaining traction, as evidenced by the solid second-quarter showing–although business remains well below 2008's peak levels.
UTC's overarching strategy is to generate strong returns and lots of free cash, which is then used to make growth-enhancing acquisitions, pay dividends, buy back stock or pay down debt. Earlier this year, for example, the company closed a $1.8 billion deal to buy GE Security to bolster its Fire & Security unit–a move that will be accretive to earnings this year. "I have not seen them do anything subpar in terms of generating below-cost-of-capital returns with bad acquisitions," says Peter Vanderlee, co-manager of the Legg Mason ClearBridge Dividend Strategy Fund (GROAX).
The bottom line: Management has done a good job of allocating capital. Some who follow United Technologies liken it to GE without the beleaguered financial division. Another way to conceptualize it is as six separate business units, each with a lot of autonomy but at the same time overseen by a capable management team led by Louis Chênevert, the chairman and CEO.
Chênevert, a 53-year-old native of Canada, was tapped to lead United Technologies in April 2008. He had joined the company from General Motors in 1993, running Pratt & Whitney for seven years before his promotion to president and chief operating officer in 2006. In becoming the chief executive two years later, Chênevert succeeded George David, the charismatic and innovative chief executive who liked to swing for the fences—doing things like starting an entirely new division, the UTC Fire & Security unit—during his 14 years at the helm. David retired as chairman at the end of last year. On David's watch, United Technologies focused on, among other things, becoming more efficient and expanding its portfolio. The Fire & Security unit, launched in 2003, is a roll-up that started with UTC's acquisition of the U.K.'s Chubb (not related to the U.S. insurer with the same name). The operation now has about $7 billion in annual revenue.
So far, Chênevert has earned good marks, in part because he has "kept profitability at a very high level through tough times," says David Rowlett, an analyst at T. Rowe Price, which holds the shares.
Since taking over the top job, Chênevert has been tested. In 2008, a banner year, revenue totaled $59.8 billion. The following year, however, it dropped 11% to just under $53 billion, thanks to the global recession. The company managed to earn $4.12 a share in '09, down from $4.96 the previous year. All in all, however, that was a respectable showing, considering how much cyclical exposure the businesses have. "We always focus on what we can control," says Chênevert.
Balanced Approach
United Technologies has a diverse revenue base. The company, whose revenue totaled $52.9 billion last year, gets more than half of its sales from outside the U.S. Moreover, high-margin aftermarket products and services, such as spare parts and maintenance, account for more than 40% of revenue.
That includes a steady diet of restructuring and investing in new technology.
A key focus for the CEO and his team–as it was for their predecessors—is boosting margins. In the second quarter, UTC's adjusted segment operating margin—which excludes one-time charges and restructuring costs—was 15.7%, versus 11.8% in 2000. There should be more room to fatten those margins, particularly in businesses like Sikorsky, Carrier and UTC Fire & Security.
One reason for the big overall improvement is Otis, the world's largest maker and installer of elevators and escalators. Last year, its adjusted operating margin was just under 22%, up from 12.2% in 2000. Although Otis has sharpened its manufacturing efficiencies, a big driver of the margin improvement has been service contracts, which are extremely profitable. With about 1.7 million elevators under contract, Otis has plenty of scale, particularly in urban areas.
In the second quarter, the unit's adjusted operating profit rose 3%, to $658 million, thanks to the strong service business. However, OEM, or original-equipment manufacturing, was soft. Although orders climbed by 11%, boding well for the future, actual revenue from new equipment fell by 10%. An encouraging sign: Otis had a strong quarter in China, an area of great opportunity for the company.
In fact, the entire company's China revenue totaled about $2.6 billion last year, versus $600 million in 2000. It helps that about 95% of the Otis products sold in China are made there. "That gives us a nice footprint, and scale to really compete," says Chênevert.
The company's margin-improvement story has hit some bumps along the way, however.
A DISAPPOINTMENT FOR INVESTORS over the years had been Carrier, its strong revenue and market-penetration gains notwithstanding. The unit's adjusted operating margin was 10.1% in 2004, but slipped to 7.6% last year. However, Carrier's margins climbed to nearly 10% in the first half of the year, and the division has targeted 12% by 2012–a goal that looks achievable.
To get there, Carrier has been downsizing by selling less-profitable businesses, including Tyler, a commercial-refrigeration manufacturer in the competitive North American market. Carrier's commercial-refrigeration business is much stronger in Europe and emerging markets.
Free-Cash Juggernaut
UTC has used much of its free cash to fund stock buybacks, dividends and strategic acquisitions.
The overall strategy for Carrier is to create higher-quality revenue. So while sales have dropped from previous levels, margins are moving up. Another example of where Carrier has cut costs is a plant it operates in Collierville, Tenn., where it made about two million residential air-conditioning units in 2006. Under the pressure of the Great Recession, the company used various cost-cutting moves to slash its breakeven point from one million units to 500,000, says Gregory Hayes, UTC's chief financial officer.
By 2012, UTC Fire & Security wants to boost its average margin to 15%, versus 10.5% now. The unit, which has a big presence outside the U.S. in countries such as China, sells and installs everything from burglar alarms to systems that control access to buildings. Because Fire & Security was a roll-up acquisition, it lends itself to certain kinds of cost-cutting and consolidation—for example, in overlapping field offices. While Tyco (TYC) dominates the market, it's still fragmented. "There's plenty of room for UTC to be a $10 billion-plus business" in fire and security, says Chênevert.
The company's overall operating margin has been helped by ongoing restructuring, which last year totaled $830 million and includes moves such as divesting underperforming businesses, closing plants, shifting operations to lower-cost regions and cutting staff. Restructuring is expected to cost about $350 million this year.
Another focus for United Technologies has been research and development, on which it spent $856 million in the first half of this year, up from $793 million in the corresponding 2009 stretch. "We have invested aggressively in good times and bad times," says Chênevert.
A CHUNK OF R&D SPENDING has gone into developing internal systems, including power generation and fire suppression, for the 787 Dreamliner, the long-delayed but much-heralded wide-body passenger jet that Boeing (BA) hopes to start delivering to customers by early 2011. UTC's Hamilton Sundstrand unit developed those systems.
On the Up Elevator
United Technologies' efforts to boost operating margins have paid off nicely since 2000.
UTC has spent roughly $1 billion over the past 20-plus years on a family of jet engines being developed by Pratt & Whitney called the PurePower 1000G Geared TurboFan. This is potentially very significant because "in recent years, Pratt has not been as large a player in big commercial engines as Rolls Royce [RR.U.K.] and GE," says Richard Tortoriello, an aerospace and defense analyst at Standard & Poor's Equity Research.
In the mid-1980s, Pratt made a big mistake when it decided not to pursue designing an upgraded engine for the Boeing 737, convinced that the narrow-body aircraft would become obsolete, according to The Wall Street Journal. The 737, however, has thrived and remains a workhorse for airlines such as Southwest (LUV).
Airbus is considering upgrading the engine for its A320, also a single-aisle, narrow-body aircraft, and Pratt's Geared TurboFan is viewed as having a good chance of being one of the engines selected for that program. The GTF features a unique gear system that allows its fan to operate at slower speeds than the compressor and turbine, according to Pratt. This cuts fuel consumption by about 12%-15%, the company says, lowers maintenance costs and reduces noise and carbon emissions. Those attributes, which reflect UTC's efforts to make its products more environmentally friendly, should be attractive to jet-engine customers, especially if oil prices rise significantly.
UTC has plenty of experience with gearbox-engine technology at Pratt & Whitney Canada, which makes engines for smaller aircraft. Although that technology differs somewhat from the GTF, it's one reason "why you see such confidence at Pratt in the gear system," says Chênevert.
Pratt already has a big share of the A320 market with its V2500 engine offered by International Aero Engines, a collaboration of several manufacturers. Although the program's big upfront R&D costs have nicked profitability at Pratt and will do so for a number of years, getting a piece of the upgraded A320-engine market would mean "a big revenue stream for 30 years to come," says Chênevert.
The big profits would come from selling spare parts and providing maintenance and overhauls–not from the initial sale. What's more, if Airbus does upgrade the A320 engine, that would put pressure on Boeing to make a similar move, though whether Boeing would do so is debatable.
Pratt has already made inroads with the GTF in the regional jet market. Bombardier (BDRXF), Mitsubishi Heavy Industries (MHVYF) and the Russian company Irkut have selected various versions to power regional jets that they are developing. The Bombardier CSeries aircraft is tentatively scheduled to fly commercially in 2013 with a PW1524G engine.
The fortunes of Pratt's crucial aftermarket commercial-aircraft business are hitched to those of the airline industry, which is showing some signs of improvement. Standard & Poor's notes that "traffic statistics at many carriers showed improving demand and revenues in the first half of 2010," and it expects that to continue.
Increased traffic would help Pratt's spare-parts business. "Airlines reduced inventories significantly and pulled planes out of service" during the recession, observes S&P's Tortoriello. "There was a much greater drop in parts demand than a decline in air traffic, so everyone expects a spring-back." In the second quarter, Pratt's commercial spare orders rose 8%, a promising sign, after a tough 2009 for Pratt & Whitney Canada, in great part because of the downturn in demand for business jets. Says Tortoriello: "The real dynamic is business confidence."
Pratt also has a strong military jet-engine franchise. It provides engines for the F-35 joint strike fighter, which Lockheed Martin (LMT) has started to build; the F117, which powers the C-17 transport aircraft, and the F100, which is used in the Air Force's F-15 and F-16 fighters.
A concern for the company is the budget pressure facing the U.S. government, thanks to mounting deficits and increasing political sentiment to cut spending–not to mention the winding down of the U.S. military presence in Iraq and President Obama's commitment to begin withdrawing from Afghanistan next year. But while defense spending is flattening for UTC–the government accounted for about 18% of last year's revenue–it won't plunge. "If a program doesn't work well or has problems, it's subject to being canceled," says Rubel of Jefferies. But proven weapons that are heavily used will survive and need to be replaced, he adds, because they are getting worn out.
A big beneficiary of defense spending has been UTC's Sikorsky unit, whose revenues have more than doubled from $2.8 billion in 2005. The Stratford, Conn.-based operation has rolled out about 3,200 Black Hawk helicopters since 1978, mainly for the U.S. armed forces. "This is a helicopter world right now," says Jeffrey Pino, Sikorsky's president. He points out that while military spending is flattening for Sikorsky, it's doing so "at record levels of revenues." And he foresees yearly demand for 140 to 150 Black Hawks over the next 10 to 12 years, providing a solid foundation for the unit's business.
Sikorsky is trying to make more international military sales to countries like Saudi Arabia and Taiwan, along with additional aftermarket business for repairs, maintenance and overhauls. Longer term, Sikorsky is developing the CH-53K helicopter, a heavy-lift aircraft for the U.S. Marines, among other projects.
Rocky Ride
he stock has recovered nicely since the financial crisis, but bulls see 20% or more upside over the next year.
| Recent Price | $71.23 |
| 52-Week High | $77.09 |
| 52-Week Low | $59.31 |
| 2009 Revenue | $52.9 bil |
| Stock-Market Value | $66.8 bil |
| EPS 2010E | $4.72 |
| EPS 2011E | $5.33 |
| P/E 2010E | 15.1 |
| P/E 2011E | 13.4 |
| Sources: Bloomberg and company reports | |
Sikorsky's commercial business has been weak. The helicopter maker, however, is starting to get more interest from oil and gas companies, a key segment of the commercial market. Pino expects commercial orders to start picking up next year–though that could be a bit ambitious unless the economy perks up faster than it has been doing. Sikorsky has been improving its margins, in part by building more components in places such as Poland and China.
IN THIS SLUGGISH ECONOMIC ENVIRONMENT , double-digit earnings growth is a tall order. Nonetheless, Hayes, United Technologies' chief financial officer, says that's attainable from expected organic revenue growth around 3.5% a year, and continued productivity improvements and cost-cutting, plus stock buybacks and strategic acquisitions funded by the company's strong free cash flow. UTC plans to buy back $2 billion worth of stock this year, up from its previous target of $1.5 billion.
And when the economy finally does fully recover, UTC's operating leverage should boost profitability further, owing in part to all the restructuring it has undertaken.
"They are getting steady growth with not all engines operating on eight cylinders, but many of them are," says Rubel of Jefferies. When they do, shareholders will be amply rewarded.
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