It's fair to say that the market wasn't exactly overwhelmed by the announcement that United Technologies (RTX 0.84%) will be separating into three companies. At the time of this writing, the stock is down nearly 6% since the announcement at the end of November versus a slight rise in the S&P 500 index, whereas its closest peer, Honeywell International, is slightly down. What's going on, and has management made a misstep? Let's look at what the announcement means.

Time to break up

Frankly, very few investors would have been surprised by the announcement: CEO Greg Hayes signaled an intent to do as much in the spring. As expected, the remaining United Technologies will comprise Pratt & Whitney (aircraft engines and aftermarket parts and services), UTC Aerospace Systems (original equipment and aftermarket parts), and the just-completed acquisition Rockwell Collins.

Meanwhile, Otis (elevators) and the current climate, controls, and security (CCS) business -- now known as Carrier -- will both be separated within the next 18 to 24 months. Investors who hold UTC stock at the time of the breakup will thereafter own stock in all three resulting companies.

Three hands each holding a white jigsaw puzzle piece against the backdrop of a blue sky and three skyscrapers.

Image source: Getty Images.

Six reasons the breakup makes sense

  1. If you compare each constituent part of the company to its immediate peers, it's clear that the overall valuation of United Technologies stands at a discount to all of them. The argument -- long put forward by leading hedge fund managers -- is that breaking up the company would lead to a positive re-rating for each company.
  2. As Hayes argued, a breakup would create greater management focus and make it easier for each company to invest in mergers and acquisitions.
  3. The increasingly disparate performance of the three United Technologies businesses in 2018 strengthens the case for running each business separately.  In common with peers like Honeywell and General Electric, strong aerospace results have helped offset relatively weaker earnings elsewhere. 
  4. Splitting up the company will create far simpler investment options. You say you don't want Otis' exposure to China's construction market, or are worried about Carrier's relative underperformance to Ingersoll-Rand? Or maybe you're even concerned about the aerospace business's ability to hold margin as Boeing and Airbus muscle in on suppliers. All are reasons in themselves not to hold United Technologies stock. In the future, you will be able to avoid each specific exposure by being able to invest in the businesses separately.
  5. As Hayes outlined in the announcement presentation, Pratt & Whitney is now coming out of a heavy period of investment in its geared turbofan engine -- it competes with the LEAP engine from CFM International (a joint venture between GE and Safran) on the Airbus A320neo. Just as with GE Aviation, Pratt & Whitney will start to generate significant earnings and cash flow from its engines in the coming years -- meaning that the aerospace businesses don't need the support of cash flow from Otis and Carrier anymore.
  6. Just as French aircraft-engine maker Safran bought plane-seat maker Zodiac Aerospace in order to create scale, generate synergies, and better compete in the aerospace sector, it's important for United Technologies to do a similar thing in order to respond to the Boeing and Airbus encroachment on aircraft suppliers.

If it all makes sense, then why is the stock down?

That's a good question, because there wasn't much in the announcement that should have surprised investors. For example, CFO Akhil Johri outlined that management expects the one-time costs to be in the range of $2.5 billion to $3 billion, but Hayes had already discussed this in September. 

The only slight negative came from the estimate of additional overhead costs, where Johri said, "the placeholder we have there is $350 million to $400 million," versus the $350 million figure that Hayes gave in September.

Immediate attention focused on the reduction in earnings and cash flow guidance. Indeed, management did update its full-year guidance and downgrade full-year adjusted EPS guidance to a range of $7.10-$7.20, from $7.20-$7.30. And free cash flow guidance was revised down to $4.25 billion-$4.5 billion, from a previous range of $4.5 billion-$5 billion. But both changes are related to the acquisition of Rockwell Collins -- there wasn't a material change in United Technologies' underlying outlook.

On the contrary, management gave good outlooks for each new business' cash flow conversion. Johri said free cash flow conversion in the aerospace companies would "be at or above 100% of net income" in the coming years. With Otis and Carrier also seen as generating free cash flow in excess of net income, clearly management is not separating an ugly cash-flow duckling from the group.

Sell on the news?

All told, the stock's drop looks like a good old-fashioned case of "sell on the news." The breakup has been so well publicized that it could have hardly come as a surprise, and it's likely that many investors would have been looking for an opportunity to exit the stock after the announcement.

No matter: If you are bullish on the rationale for the breakup and the long-term prospects, then there wasn't much in the presentation to dissuade you from continuing to hold the stock. Ongoing investors will own three different companies that could all see a re-rating due to the separation -- and that would be good news.