United Technologies' (NYSE:UTX) execution hasn't been flawless in the last few years, but that doesn't seem to worry leading hedge fund managers Dan Loeb and Bill Ackman. Apparently they see a value opportunity, enough to cause them to take large positions in the stock. Actually, there are three key reasons to own the stock, and they all directly relate to valuation. Let's take a look at them.

Cartoon of two men in suits standing next to lifesize versions of a magnifying glass and a page filled with charts.

United Technologies stock offers compelling value. Image source: Getty Images.

Valuation-based arguments for owning United Technologies stock

The key points:

  1. The stock trades at a discount to its peers, including poorly performing General Electric (NYSE:GE) as well as outperforming companies like Honeywell International (NYSE:HON).
  2. The company is going through a period of suppressed earnings due to transitioning several businesses toward long-term earnings growth -- it should trade at an earnings premium rather than a discount.
  3. Management is actively looking at breaking up the company, and there's significant value to be released if it does so.

Discount to peers

Looking across its industrial conglomerate peers, it's clear the stock trades at discount on an EV-to-EBITDA -- enterprise value (market cap plus net debt) to earnings before interest, tax, depreciation and amortization -- basis. (EV-to-EBITDA is a very commonly used measure that helps compare companies with different debt loads.)

UTX EV to EBITDA (Forward) Chart

UTX EV to EBITDA (Forward) data by YCharts.

On the downside, United Technologies continues to face headwinds from issues as diverse as China's construction markets (in its Otis segment), technical difficulties and production ramp-ups on its geared turbofan aircraft engine (Pratt & Whitney), and raw material cost increases (UTC Climate, Controls & Security, or CCS). Furthermore, Boeing continues to pressure suppliers (affecting UTC Aerospace Systems, or UTAS). 

However, not every industrial conglomerate is going to have all of its segments firing on all cylinders at all times. Unlike General Electric, United Technologies isn't facing cash flow issues or structural decline in its core segment (GE power). Furthermore, GE missed its production target on the LEAP engine (produced as part of a joint venture with Safran) in the first quarter. 

Honeywell's aerospace operations also face pressure from Boeing. Honeywell was forced to grant significant incentives to original equipment (OE) manufacturers in 2016 and 2017 in order to be on new aircraft programs, and a slowdown in construction in China would also hurt Honeywell.

All told, does United Technologies really deserve to trade at such an obvious discount to its conglomerate peers?

Position in its business cycle

United Technologies is positioning itself for long-term growth, but three of its four segments are suffering near-term headwinds as a consequence. Otis has been more price-competitive in order to win market share in the elevator equipment market in China, in turn generating more profitable long-term services revenue growth.

Meanwhile, Pratt & Whitney is ramping up production of its geared turbofan engine with a view to maximizing long-term aftermarket and service revenues, while UTAS' commercial OE sales have been weak as the company transitions from selling equipment on legacy aircraft toward newer aircraft from Boeing and Airbus

All of these things are holding back near-term earnings, but analysts are seeing EPS growth moving from zero in 2017 to single digits in 2018, and then double digits in 2019. Given that the best is yet to come for United Technologies, it should arguably trade at a premium.

Breakup value

While the stock is perhaps a good value in any case, there's also some significant upside from a possible breakup of the company. Hedge fund managers Loeb and Ackman may have grabbed the headlines with calls to separate the company into three different parts -- CCS, Otis, and an aerospace company comprising UTAS, Pratt & Whitney, and the soon to be acquired Rockwell Collins -- but the reality is, CEO Greg Hayes has already told investors that he's considering doing it. 

United Technologies won't move until the Rockwell Collins deal is completed -- hopefully by the summer -- but don't be surprised if Hayes announces a breakup after this.

The case for splitting up is based on the idea that each separate part of the company trades at a discount to its specific competitor. Moreover, there is little overlap between, say, Pratt & Whitney's aircraft engines and Otis' elevators or CCS' air conditioners, so breaking up the company shouldn't create dis-synergies. 

Meanwhile, the challenges created by Boeing on its suppliers mean that a combined United Technologies aerospace segment would receive the management focus and investment it might lack as part of a conglomerate.

The key takeaway

Investing in United Technologies offers a value proposition with a kicker from the potential for a breakup. General Electric and Honeywell have both won plaudits for their plans to sell and spin off businesses in 2018, and a similar move by Hayes would likely be rewarded, too.

If Hayes and the board elect to split up the company, then shareholders can expect its constituent parts to start closing the valuation gap between each business and its peers. That would be good news for investors.