Streetwise for Sunday, October 7, 2018
To successfully invest on Wall Street, you will need to undertake some degree of fundamental financial research. So, where do you start? One idea could be United Technologies, a company I have not written about for several years.
The Justice Department just approved the sale of Rockwell Collins to United Technologies on the condition that Rockwell divests itself of its pneumatic ice protection systems business and its trimmable horizontal stabilizer actuator business. However, the $30 billion acquisition still needs approval from Chinese regulators. The deal was approved by the EU Commission in May.
Combining United Technologies and Rockwell will create one of the world’s largest aerospace manufacturing companies. The combined division will be known as Collins Aerospace Systems.
Management recently raised its guidance for 2018 organic sales to increase by 5 to 6 percent, with full-year adjusted earnings projected at $7.10 to $7.25 per share.
However, the earnings increase comes from a lower-than-previously expected full-year adjusted tax-rate of 24.5 percent. That’s worth around $80 million, more than offsetting the $75 million reduction in segment guidance.
Unfortunately, the success in the commercial aerospace aftermarket is being offset by disappointing earnings from Otis and Climate, Controls & Security (CCS). Aerospace Systems and Pratt & Whitney, are outperforming Otis and CCS, strengthening the case for a breakup.
The difference in segment performance highlights the benefit of splitting the company up. Think of United Technologies as separate companies and it becomes clear that they would offer dramatically different investment propositions.
Otis elevators is a turnaround story, with management aggressively trying to increase equipment unit sales in China to develop long-term service revenues.
However, input costs are rising, and United Technologies is working through a backlog of orders taken at extremely competitive pricing. Otis’s operating profit fell seven percent to $488 million in the second quarter.
The CCS segment is positioned in an attractive industry with long-term growth prospects. Nonetheless, the segment’s organic sales growth shows underperformance.
While the performance of the commercial businesses (Otis and CCS) is somewhat disappointing, the aerospace businesses are doing well. Pratt & Whitney has put its technical issues behind it and Greg Hayes, United Technologies CEO, confirmed engine production is on track for 2018.
Aerospace Systems reported another strong quarter of growth in commercial aftermarket, and with the forthcoming addition of Rockwell Collins, it is well positioned.
Separating United Technology into three constituent parts, an aerospace business comprised of Aerospace Systems, Pratt & Whitney and Rockwell Collins, along with Otis and CCS as stand along companies should lead to a valuation of the sum of the parts being valued higher on their own than as a conglomerate.
Managers would only have to deal with the characteristics of one business, enabling greater operational improvements. And, if the separate parts trade at higher valuations, it will be easier for them to undertake acquisitions and raise debt.
How about the costs involved? Hayes has pointed out that United Technologies’ selling, general and administrative (SG&A) costs are already relatively low as a share of revenue and outlined two specific numbers to focus on:
A one-time tax cost of $2.5 to $3 billion from separating around 1,200 legal entities, along with additional overhead costs of $350 million, mostly for setting up independent IT systems.
According to Hayes, the value creation from having the businesses operate as stand-alone companies should more than offset the initial tax cost over time.
If the valuation thesis is correct, then there should be plenty of long-term upside. Throw in the likelihood of increased productivity due to more narrowly focused management teams and a breakup appears to be a good move.
Lauren Rudd is a financial writer and columnist. You can write to him at LVERudd@aol.com. Phone calls accepted between 9 AM and 3 PM at (941) 706-3449. For back columns please go to www.RuddInternational.com.