Earlier this month, in previewing the Q1 earnings report for defense contractor United Technologies (NYSE: UTX ) , I highlighted growing inventories as the one dim bulb in a generally shining company. Today, I see that bulb in an entirely different light; I think the firm's inventory picture is clearing up.
For several quarters running, United Technologies has struggled with inventory growth that outpaced sales growth. This tends to tie up cash in unproductive forms, depressing free cash flow. There's also the danger of obsolescence, leading to write-offs or discounts of unsold goods, which in turn can affect the bottom line.
CEO George David addressed this issue head-on in the earnings release, almost seeming to apologize for inventories that were up "seasonally" at Carrier and "remain high" in the aerospace businesses. David promised to reverse these trends in the second half of the year, in order "to meet our net income standard for cash flow less capital expenditures."
While I'm pleased to see David addressing the issue, after reviewing the firm's earnings and 10-Q filing with the SEC, it no longer looks like a problem to me. In Q1, UT only grew its earnings 8%, because of one-time items dragging down the net. Meanwhile, revenue rose at twice that rate. Comparing that number with the latest rise in inventory, we see that the sales and inventory growth rates were roughly equal at 16%. David's reticence notwithstanding, inventories are no longer outpacing sales growth.
Another thing I find reassuring here is the resurgence in two of UT's businesses. Sales nearly doubled at Sikorsky, and Otis (which makes elevators, escalators, and the like) grew sales 16%. Of the two segments, Otis gives us the best news. It's not just UT's most profitable business segment (21% operating margins in Q1, or 18% minus a one-time benefit from a land sale). It also seems to have the most potential for significant near-term growth. According to David, while Otis' sales rose 16% in the quarter, its new orders grew 27% year over year, promising even more growth in the future.
To recap: The firm's most profitable business was its second-fastest grower in the quarter, and more growth is coming. That doesn't just promise good things on the bottom line. It also helps to explain why UT might need to bulk up its inventories: to meet the expected demand in this segment.
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Fool contributor Rich Smith does not own shares of any company named above.
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