United Technologies (NYSE:UTX) isn't the only company whose management believes its stock is intrinsically undervalued, but in this case, there's a sound argument to justify that belief. Furthermore, management is backing up its claim by promising to buy back $16 billion worth of stock in the 2015-2017 period. Let's take a look at what's going on, and why investors in General Electric (NYSE:GE) also have cause for optimism.
Both United Technologies and General Electric have aviation segments that manufacture aircraft engines, and they are competing for orders on the Airbus A320neo.
In a nutshell, the A320 family is Airbus' best-selling single-aisle aircraft -- the class that's the workhorse of commercial aviation -- and the A320neo is a more fuel-efficient update to a line that has already generated more than 4,300 firm orders.
In case you're wondering, the "neo" bit stands for "new engine option," and refers to the choice of two different engines. Specifically, the LEAP-1A engine made by CFM International (a joint venture between General Electric and SNECMA), or the PurePower PW1100G-JM, built by Pratt & Whitney (a United Technologies subsidiary). For reference, the PurePower PW1100G-JM is a geared turbofan engine, and you will often hear United Technologies refer to it as such.
With the first customer delivery for the A320neo set for the fourth quarter of 2015 , both engine manufacturers are gearing up to increase production rates in the coming years. According to its most recent pronouncements, General Electric is claiming a 55% market share on the A320neo program for its LEAP engine. It's pretty safe to assume that Pratt & Whitney has a 45% share, but recall that these figures refer to the airlines that have chosen an engine -- so these figures aren't set in stone.
That said, what does all of this have to do with United Technologies being undervalued?
Aircraft engines attract all the attention, but they aren't the major money spinner in themselves. It's the aftermarket revenue from services and spare parts that generates the bulk of profits for aircraft engine manufacturers. However, you can't generate aftermarket revenue without first establishing an installed base of aircraft engines -- and this is where things get tricky.
Simply put, more engines sold equals more long-term cash flows generated from services and spare parts. However, the problem/blessing is that as United Technologies sells more engines, it incurs more "negative engine margin" -- the loss a manufacturer takes on selling new engines before aftermarket revenue kicks in to offset it.
It's a problem because it will cause "short term pressure on our earnings and cash flows," noted United Technologies CFO Akhil Johri, speaking at the recent Goldman Sachs Industrials Conference. CEO Gregory Hayes forecasts that negative engine margin will peak at $1 billion in 2019, a year in which Pratt & Whitney should be producing 1,500 engines. To put this figure into context, Pratt & Whitney generated $1.3 billion in operating profit in the first nine months of 2015 -- so the loss will be significant.
However, it's also a blessing because the company needs a large installed base in order to generate the "very, very solid aftermarket revenue stream for the next 30 years" predicted by Hayes on the recent third-quarter earnings call.
Essentially, Johri believes that the "intrinsic value of the company is far greater than the stock has been in the last two months or so" because the market is worrying unduly about the near-term hit to earnings and cash flow it will take from selling the geared turbofan engines. Given the short-term focus of the market, it's hard not to think he has a point.
Analysts forecast that United Technologies' earnings will grow 5.3% and 8.8% in 2016 and 2017, respectively, but these earnings estimates only tell part of the story. Long-term investors should also focus on how the company is de-risking the planned future earnings from aftermarket sales from the geared turbofan engine -- sales that Hayes sees as continuing for 30 years. For example, General Electric and United Technologies investors could monitor management commentary on production schedules and engine orders, as well as looking at Airbus A320neo orders.
The initial signs are positive, but don't panic unduly if estimates for negative engine margin are increased (therefore reducing near-term earnings estimates) due to higher engine sales -- that's exactly what you want to hear from the company for it to prosper in the long term.
Lee Samaha has no position in any stocks mentioned. The Motley Fool owns shares of General Electric Company. 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.