Another set of earnings from United Technologies (NYSE:UTX) brings another demonstration that its breakup plan is probably a very good idea. In a nutshell, the aerospace businesses (Collins Aerospace and Pratt & Whitney) keep on outperforming, while Carrier (a collection of commercial construction businesses) underperforms expectations and Otis (elevators) has its own specific industry dynamics to deal with. Let's take a look at what it all means for investors.
Guidance raised on the back of the aerospace businesses
As a reminder, management plans to spin off Carrier and Otis as two separate companies by the first half of 2020 and retain the aerospace businesses (Collins Aerospace and Pratt & Whitney), which will then be merged with defense contractor Raytheon (NYSE:RTN).
Clearly, the merger-and-acquisition activity at the company has been focused on aerospace -- management is still busy integrating the $30 billion acquisition of Rockwell Collins -- and the Raytheon deal promises to keep management busy for years to come. Investors should welcome these moves, because right now, the aerospace businesses are driving United Technologies earnings growth. In addition, they are the reason management raised its full-year adjusted EPS guidance to $7.90 to $8.05 from $7.80 to $8.00 previously.
Two reasons aerospace is outperforming
First, the commercial aviation industry remains in solid growth mode, with peers like Honeywell International (NYSE:HON) reporting its fourth straight quarter of double-digit revenue growth in its aerospace segment. Similarly, Collins Aerospace grew organic sales at a 9% rate in the second quarter, and United Technologies' management upgraded its full-year expectations for an operating profit increase of $1.7 billion to $1.75 billion from the previous $1.55 billion to $1.6 billion, largely on the back of an improving outlook for commercial aviation aftermarket.
Second, it's not just about end markets. In fact, the integration of Rockwell Collins is going better than many might have expected. Speaking on the earnings call, CEO Greg Hayes said: "[F]or the full year, we now expect about $0.50 of accretion from the Rockwell Collins deal. That's up from $0.35 at the start of the year." In addition, he confirmed that "we now expect to see about $600 million of cost synergies related to Rockwell by year four. That's up a $100 million from our original guidance."
Upside potential from the United Technologies/Raytheon merger
It gets better. There's evidence that management was being conservative when it laid out guidance for the financial performance of the future merger. For example, Vertical Research analyst Jeff Sprague asked if, based on the unlevered free cash flow (FCF) forecasts in a recent SEC filing, "perhaps there is some upside to that kind of $8 billion number you laid out for 2021 post-merger for the combined aero company?"
Indeed, a figure for $8 billion in FCF "by 2021" was given in the presentation in June. However, adding together the forecasts from the recent filing shows unlevered FCF of around $9.3 billion in 2021. In response, CFO Akhil Johri agreed with Sprague's interpretation and said, "There will be about $1 billion difference at this point" and then outlined that he'd baked in some conservatism in the forecast and that it also somewhat depended on the timing of the separations.
Given that the outlook for United Technologies aerospace operations is improving, the upgrade to estimate for cost synergies from the Rockwell Collins acquisition, and Johri's "conservatism," it looks likely that there's upside potential to earnings and FCF estimates given at the time of the merger announcement.
Carrier and Otis
Unfortunately, things aren't so rosy for Carrier (heating, ventilation, air conditioning, fire security, and refrigeration), where management was forced to cut its full-year organic sales growth expectations to low single digits from low to mid-single digits previously. Carrier is now expected to improve operating profit by just $0 to $50 million in 2019 compared to a previous forecast of $100 million to $150 million.
Carrier's disappointing outlook comes as "soft order rates in the first half, particularly in the refrigeration and global HVAC end markets" mean that the segment won't hit its previously expected profit forecasts.
Otis, however, is on track for its full-year earnings guidance range of a reduction in operating profit of $25 million to a $25 million increase, but given the segment's exposure to China and evidence of slowing economic growth in the country, it's hard to be fully confident in the midterm outlook.
What it all means for investors
It's a familiar story of aerospace outperforming and lackluster results from Carrier and Otis, all of which makes United Technologies even more of an aerospace play in the near term to the midterm. The upshot is that if you prefer to own the aerospace business of United Technologies, and are cautious on the other two businesses, then the best thing to do it is to wait at least until the spinoffs have taken place before buying the stock.