Investors in United Technologies (NYSE:RTX) should prepare for some pretty big changes at the conglomerate. It's been a long time coming, but the company's acquisition of Rockwell Collins (NYSE:COL) should be completed by the end of September, and within a couple of months, management will publicly outline the results of its review of strategic options. They are widely expected to deliver a breakup plan. Here's the lowdown, and why splitting up the business makes sense.
A serially undervalued stock
It's been over a year since Chairman and CEO Gregory Hayes first said that the board would be evaluating strategic options once the Rockwell Collins deal was closed. It can hardly be surprising that a breakup is being considered because as far back as autumn 2015, CFO Akhil Johri was arguing that the "intrinsic value of the company is far greater than the stock has been in the last two months or so."
While the stock has risen 44% since then, the gains have been roughly on par with those posted by the S&P 500, and notably behind the 62% rise of peer Honeywell International. Moreover, United Technologies' valuation remains lower than companies that compete with its constituent parts.
The following chart shows the company's valuation discount to Honeywell, and Ingersoll-Rand (which competes with UTX's climate, controls and security, or CCS, segment), KONE and Schindler (which competes with Otis elevators) and Transdigm (aerospace).
The valuation discount is even more surprising when you consider that UTX's earnings have been temporarily suppressed by actions it took to secure long-term profit growth -- meaning the stock should arguably trade at a premium to reflect its prospects.
Given the recent history of both absolute and relative undervaluation, it's understandable that management is looking at a breakup. In addition, high-profile hedge funds such as Third Point and Pershing Square have taken positions in United Technologies, and they're actively advocating for the company to be split apart.
Three reasons a breakup makes sense
Let's consider the potential benefits of separating the company into three constituent parts -- an aerospace business comprising UTC Aerospace Systems, Pratt & Whitney and Rockwell Collins, and stand-alone companies for its Otis and CCS divisions -- as the activist investors suggest.
First, it could lead to the market valuing the sum of the parts higher on their own than it values them as a conglomerate.
Second, during a recent investor conference, Hayes discussed the feedback he'd had from investors. "What we have heard is that people prefer focus," he said. In other words, there is a view that managers who only have to deal with the characteristics of one of those three significantly different businesses will be better able to deliver operational improvements.
Indeed, a look at United Technologies recent results only strengthens the case for a breakup -- aerospace is notably outperforming CCS and Otis.
Third, if the separate parts trade at higher valuations, it will be easier for them to make profit-boosting acquisitions and raise debt.
Aside from the risk that the postulates above won't play out in practice, there is the tricky issue of potential dis-synergies. Investment analysts usually predict synergies of scale when two companies merge; it's common to pencil in an estimate for cost savings of 5% of combined revenue.
In the case of a break up, investors need to think about extra costs that will be incurred as a consequence. And Hayes has pointed out that United Technologies' selling, general and administrative (SG&A) costs are already relatively low as a share of revenue.
Hayes outlined two specific numbers to focus on:
- One-time tax costs of $2.5 billion to $3 billion from separating around 1,200 legal entities United Technologies has globally.
- Additional overhead costs of $350 million, primarily for things like setting up independent IT systems for each company.
The tax costs amount to roughly 2.4% of UTX's $113 billion market cap -- but 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.
However, the estimate for additional overhead costs is more of an issue. That forecast has risen by $150 million from the $200 million figure suggested by Hayes in February. Hayes thinks capitalizing the current estimate would lead to a figure of around $3 billion to $4 billion, or around 2.7% to 3.5% of the current market cap.
Investors should welcome a breakup
Splitting up the company would cost money, and probably more than many investors envisioned earlier this year. However, on balance, if the constituent parts of United Technologies really are as undervalued as is implied in the first chart above (by 20%-50%) then there should be plenty of opportunity for share price appreciation following a breakup.
All told, the company and its future spinoffs would take a hit from one-time tax bills and higher ongoing SG&A expenses, but if the valuation thesis is correct, then there's plenty of long-term upside. Throw in the likelihood of increased productivity thanks to more narrowly focused management teams running their respective businesses better, and a breakup appears to be a good move.