With annual revenues north of $64 billion, United Technologies Corporation (NYSE:UTX) is one of the biggest players in the Aerospace and Defense Products and Services industry (a subset of the broader Aerospace and Defense industry). But bigger isn't always better.
Put in context, "UTC," as it's commonly abbreviated, lies somewhere in between Boeing and Lockheed Martin in size. But United Technologies is a much more diversified business than either of these aerospace peers. In fact, only about 54% of its revenues derive from aerospace products at all -- and UTC's biggest revenue generator is its Climate, Controls & Security division, which makes HVAC, fire sprinkler systems, alarms, and video surveillance for buildings.
Result: The same cutbacks in global defense spending that have affected revenues at Boeing and Lockheed Martin affect United Technologies' more diversified business less. But that doesn't mean the stock is totally immune to downdrafts. Today, we're going to take a look at three things that could potentially have a negative effect on United Technologies' stock price, starting with...
The F-35 catches fire (in a bad way)
Reason No. 1 to be cautious about United Technologies' stock price is exactly what you think it would be: the June 23 incident in which a UTC-built F135 engine, powering a Lockheed Martin F-35 fighter jet, caught on fire -- severely damaging the plane.
UTC is believed to charge the Pentagon anywhere from $14 million to $34 million per F135 engine (with F135-PW-600 engines for the short take-off and landing USMC-variant F-35B costing about twice the price of an ordinary F135 engine). The average cost at present is working out to be about $29 million per unit -- or about 19% of the cost of the entire plane.
Now, June featured the second such incident with the F135 engine, and subsequent investigations revealed several more planes were at risk of experiencing at least "mild rubbing" between their "integrally bladed rotors" and the engine casing, which could cause excessive friction.
Worries about the quality of the F135 engine's construction have some Congressmen on Capitol Hill wondering if they might want to have General Electric (NYSE:GE) build an alternate engine for the F-35 fighter. So far, only two instances of serious trouble with the new engine probably aren't enough to justify spending the billions of dollars it would cost to develop an alternate engine. But further incidents could change this calculus.
With 3,000-odd F-35s expected to be built and engined by UTC over the next 60 years, we're looking at as much as $87 billion in potential sales revenues (let alone maintenance and upgrades and replacements) put at risk by this issue with the F135 engine. For now, it's not a reason to sell the stock. But it is a reason to keep a close eye on how the F135 story plays out.
Divestitures have consequences
Speaking of General Electric, one month ago, shares of GE were selling for $27 and change. Today, they fetch less than $26. Part of the reason for the drop, one imagines, was GE's decision to sell its storied Appliances division to Electrolux for just $3.3 billion -- a price less than half what GE once thought the division was worth.
Which just goes to show you: Spinoffs aren't always a good thing. Divestitures have consequences. That's something United Technologies stock owners should keep in mind as the company continues to ponder a sale of its own Sikorsky helicopters division.
By my calculations, Sikorsky is currently UTC's smallest division by sales and, at an operating profit margin of just 9.5%, its least profitable. These both sound like great reasons for United Technologies to sell off the division and focus on bigger businesses where it earns fatter profits -- much like GE just did. But here's the thing...
Sikorsky is about more than just money. It's about prestige. One of the world's truly great helicopter manufacturers, Sikorsky has been building helicopters for the president of the United States since 1957 (and it just won a new multibillion-dollar contract to keep doing so). That's publicity that money can't buy, and much more publicity than United Technologies, almost wholly devoted to building elevators and HVAC systems, could hope to receive. So, in addition to losing billions of dollars of (still pretty profitable) revenues from a divestiture, United Technologies stock would also lose some prestige from a Sikorsky sale. You have to imagine that would have an outsized effect on the stock price.
Cash is (not currently) king
The third and final risk factor now: Historically, United Technologies stock has been famous as a reliable generator of cash profits -- free cash flow. As CFO Gregory Hayes recently reminded investors in a conference call, "we typically deliver free cash flow greater than or equal to net income." But that's not been the case this past year.
Over the past 12 reported months, S&P Capital IQ data show that UTC generated only about $5.5 billion in such cash profits -- versus nearly $5.8 billion in net income. And it's getting worse. Through the first half of this year, UTC says its free cash flow has been only sufficient to back up about 81% of reported net income.
Granted, United Technologies does expect this ratio of real cash profits to reported accounting profits to improve as the year progresses. But the future's never certain, and for the time being at least, UTC isn't measuring up to past performance. In addition to the risks grabbing all the headlines this year, the risk that United Technologies will find itself incapable of delivering on its promise to deliver free cash flow equal to "90% to 100%" of reported net income this year -- and to push past the 100% barrier next year -- is one to keep an eye on.
Rich Smith has no position in any stocks mentioned. The Motley Fool owns shares of General Electric Company and Lockheed Martin. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.