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Edited Transcript of UTX earnings conference call or presentation 23-Jul-19 12:30pm GMT

Q2 2019 United Technologies Corp Earnings Call

HARTFORD Jul 24, 2019 (Thomson StreetEvents) -- Edited Transcript of United Technologies Corp earnings conference call or presentation Tuesday, July 23, 2019 at 12:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Akhil Johri

United Technologies Corporation - Executive VP & CFO

* Carroll Lane

United Technologies Corporation - VP of IR

* Gregory J. Hayes

United Technologies Corporation - Chairman, CEO & President

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Conference Call Participants

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* Cai von Rumohr

Cowen and Company, LLC, Research Division - MD & Senior Research Analyst

* Carter Copeland

Melius Research LLC - Founding Partner, President and Research Analyst of Aerospace & Defense

* Charles Stephen Tusa

JP Morgan Chase & Co, Research Division - MD

* Jeffrey Todd Sprague

Vertical Research Partners, LLC - Founder and Managing Partner

* Julian C.H. Mitchell

Barclays Bank PLC, Research Division - Research Analyst

* Myles Alexander Walton

UBS Investment Bank, Research Division - Research Analyst

* Nigel Edward Coe

Wolfe Research, LLC - MD & Senior Research Analyst

* Noah Poponak

Goldman Sachs Group Inc., Research Division - Equity Analyst

* Peter J. Arment

Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst

* Rajeev Lalwani

Morgan Stanley, Research Division - Executive Director

* Ronald Jay Epstein

BofA Merrill Lynch, Research Division - Industry Analyst

* Sheila Karin Kahyaoglu

Jefferies LLC, Research Division - Equity Analyst

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Presentation

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Operator [1]

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Good morning, and welcome to the United Technologies Second Quarter 2019 Earnings Conference Call.

On the call today are Greg Hayes, Chairman and Chief Executive Officer; Akhil Johri, Executive Vice President and Chief Financial Officer; and Carroll Lane, Vice President, Investor Relations.

This call is being carried live on the Internet, and there is a presentation available for download from UTC's website at www.utc.com.

Please note, except where otherwise noted, the company will speak to results from continuing operations, excluding restructuring costs and other significant items of a nonrecurring and/or nonoperational nature, often referred to by management as other significant item.

The company also reminds listeners that the earnings and cash flow expectation and any other forward-looking statements provided in this call are subject to risks and uncertainties. UTC's SEC filings, including its forms 10-Q and 10-K, provide details on important factors that could cause actual results to differ materially from those anticipated in forward-looking statements.

In addition and connection with the merger to be discussed today, UTC has filed with the SEC a registration statement, which will include a perspective of UTC and joint proxy statements of UTC and Raytheon that will contain important information about UTC, Raytheon, the merger and related matters. (Operator Instructions)

Please go ahead, Mr. Hayes.

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Gregory J. Hayes, United Technologies Corporation - Chairman, CEO & President [2]

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Okay. Thank you, Sonia. Good morning, everyone.

As you saw from the press release, Q2, another strong quarter for UTC. As you can see, we reported adjusted EPS of $2.20, and that's up 12% versus last year and a continuation of the strong performance we saw in the first quarter of this year.

Sales were up 18% with 6% of that organic driven by contributions from all 4 of the businesses. I think, importantly, free cash flow is really solid at $1.6 billion in the quarter.

Just a couple of highlights. Pratt & Whitney, they booked nearly 1,000 GTF firm and option orders at the Paris Air Show. And the Pratt team continues to execute on the GTF cost reduction initiatives and, importantly, are meeting the customer delivery requirements.

At Otis, nice to see that they're on track. 50 basis points of margin expansion in the second quarter. And a continued focus on the service transformation initiatives are starting to pay off in the business.

So based on the strong first half of 2019, we're going to raise both the top and bottom end of our adjusted EPS outlook. So we now expect earnings this year between $7.90 and $8.05. That's up from our previous expectation of $7.80 to $8. We're also going to raise the low end of our organic sales outlook. So we now expect 4% to 5% of organic sales growth. That's up from our last look at 3% to 5%. And we continue to expect free cash flow somewhere between $4.5 billion and $5 billion. But keep in mind, that includes a $1.5 billion placeholder for the onetime portfolio separation costs. We'll talk more about that later.

Beyond the quarter, maybe just a few comments. I know there's some things that people are wondering about, so let me just go through the other big things that are going on, starting with the integration of Rockwell Collins. Q2, again, a great quarter for Rockwell. Post acquisition, the business continues to exceed our expectations. We saw, like, $0.15 of accretion in the quarter. And for the full year, we now expect about $0.50 of accretion from Rockwell Collins deal. That's up from $0.35 from the start of the year. As I also highlighted last month, we now expect to see about $600 million in cost synergies related to Rockwell by year 4. That's up $100 million from our original guidance.

And as you know, Kelly Ortberg, as he discussed in Paris, the team has identified more than 100 projects, which are expected to drive over $1 billion of revenue synergy opportunities. So really a great start to the year for Rockwell, a great start for Kelly Ortberg and the whole team at Collins Aerospace, and we see great things in the future.

Maybe just a minute on the spin transactions. They are on track as we have noted before to be completed in the first half of 2020. And as you know, we're targeting completion at the first half -- end of the first quarter of next year, subject to the timing of the tax rulings in a couple of jurisdictions.

As you saw in early June, we named the CEOs for both Carrier and Otis, and we're making good progress on the Board formation for both companies. So everything continues to be on track with all of the portfolio separation activities. We have about 600 people working. We've got about 13,000 tasks yet to complete, but we will get this done. And we're confident, by the early part of next year, we'll be ready to go with the spins.

Finally, maybe just a word on Raytheon. As I said in Paris, the combination of Raytheon and United Technologies Aerospace largely completes our strategy to become the leading platform agnostic provider of high-tech systems to the aerospace and defense industry. We're really confident that this proposed merger capitalizes on the unique opportunity to create significant long-term value for our shareowners, for our customers and employees. And we believe that we will redefine the A&D industry for decades to come. In the near term, you can also expect to see over $1 billion of gross cost synergies by year 4 and allow for accelerated capital returns to shareowners in the form of dividends and share repurchase. As we said last month, you can expect $18 billion to $20 billion returned to shareowners in the first 3 years post close. The transaction, we expect, will be immediately accretive to UTC earnings. And we expect to see $0.20 to $0.30 of EPS accretion on an adjusted basis in the first full year following the close. You'll see a few exhibits in the appendix that highlights some of the key attributes of the deal.

So with that, let me turn it over to Akhil and Carroll to take you through the results. I'll be back at the end for wrap-up, and then we'll take your questions. Akhil?

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Akhil Johri, United Technologies Corporation - Executive VP & CFO [3]

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Thanks, Greg. So I'm on Slide 2. For Q2, reported sales of $19.6 billion were up 18%, including 6% organic growth, 13 points of M&A benefit, largely Rockwell Collins acquisition. Foreign exchange was a 1 point headwind in the quarter. Adjusted EPS of $2.20 was up $0.23 or 12% versus the prior year.

Coincidentally, on a GAAP basis, EPS was also $2.20, down 14% versus prior year and included $0.06 of restructuring charges offset by $0.06 of net nonrecurring gains. The nonrecurring items included $0.37 of gains associated with finalization of some tax audits. The good news is legacy UTC is now current with the IRS through 2016. This was partially offset by $0.28 of charges related to the UTC portfolio separation activities and $0.03 of net other charges.

Now just as a reminder, last year second quarter included a $0.74 gain associated with the sale of the Taylor business, which is why we are down year-over-year on a GAAP basis.

Free cash flow for the first half was $2.8 billion, up more than 50%, or approximately $900 million, compared to the first half of 2018. That puts us exactly in line with our expectations and on track to deliver on our full year outlook, as Greg noted.

So on Slide 3, you see the drivers of our organic growth. Looking at the commercial businesses, in the Americas, sales were up 4%. Nonresidential construction indicators remained positive. However, housing starts are now expected to be down low single digits in 2019 versus the low single-digit growth we expected coming into the year. We've also seen a slower start to the summer with cooling degree days in weather sensitive states down 18% through Q2 compared to 2018.

Within EMEA, sales were down 3% in the quarter. In Europe, excluding Middle East, Carrier was down mid-single digits, while Otis was up slightly. The economic outlook across Europe remains mixed and, overall, is weaker than the expectations coming into the year. In the Middle East, activity levels remained very low for both Carrier and Otis. In Asia, sales were up 8%. China sales were up 10%, including mid-teens growth at Otis. We continue to see modest price increases and favorable mix in Otis new equipment orders in China.

On the Aerospace side, commercial OEM sales were up 8% driven by Pratt & Whitney, which was up more than 20%. At Collins Aerospace, commercial OEM sales were up only slightly on an organic basis as higher sales and content on new platforms, like Boeing 787, Airbus 350, 320neo and 220 were largely offset by lower legacy platform-related sales.

For commercial aftermarket, sales were also up 8%. We continue to see high traffic demand and strong utilization. Commercial aftermarket sales at Pratt & Whitney were up 2%. At Collins Aerospace, commercial aftermarket sales were up 18% organically. Provisioning for the legacy UTAS business was up over 30% driven by MRO stocking activity, which is not likely to continue at these levels in the second half. For the year, Collins now expects organic provisioning sales to be up low teens due to the strength we saw in the first half.

Organically, military sales were up 15% at Pratt & Whitney and 9% at Collins Aerospace primarily driven by the ramping JSF production.

Now before I hand over to Carroll, just a few comments on our improved 2019 outlook and the moving pieces. At the operating segment level, a reduced outlook at Carrier is more than offset by the strength at Collins Aerospace. We have included a chart in the appendix on Slide 12 with updated sales and profit walks for both businesses as a reference.

At Carrier, while market fundamentals remain healthy, particularly in the U.S., we are not seeing growth at the levels we expected coming into the year. Soft order rates in the first half, particularly in the refrigeration and global HVAC end markets, have led us to reduce the full year top line growth expectations by $350 million to $400 million. This translates to around $100 million of earnings headwind, which is what you see dropping out of Carrier's operating profit outlook. So while Carrier is still expected to grow the top and bottom line, the growth will be less than what we expected coming into the year. Dave Gitlin and the Carrier team continue to drive cost reduction and other productivity initiatives to offset under absorption and other impacts related to volume shortfalls in 2019. More importantly, Dave is reinvigorating operational excellence initiatives at Carrier, which will strengthen the business for long-term success as an independent company.

On the positive side, we see $150 million improvement in the full year operating profit outlook for Collins Aerospace. This is driven in equal parts by higher cost synergies, better legacy Rockwell Collins performance, primarily in the Avionics business, and the strong aftermarket results we saw at the legacy UTAS business in the first half.

No significant changes below the line. We continue to expect the adjusted effective tax rates to be between 23% and 24% in 2019. Bottom line, we feel very good about our improved organic sales and adjusted EPS range for 2019. And for those who are keeping score, at the midpoint of our improved adjusted EPS range, we still have approximately $60 million of contingency.

With that, let me turn it over to Carroll to take us through the business unit details. Carroll?

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Carroll Lane, United Technologies Corporation - VP of IR [4]

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Okay. Thanks, Akhil. I'm on Slide 4. I'll be speaking to the segments in constant currency, as we usually do. And as a reminder, there is an appendix on Slide 15 with additional segment data you can use as a reference.

Otis. Otis sales were $3.3 billion in the quarter, up 4% organically. On a constant currency basis, new equipment sales grew 4%. Mid-teens growth in China and low single-digit growth in the Americas were partially offset by mid-single-digit declines in EMEA and low single-digit declines in Asia, excluding China.

Service sales were up 5%, with growth in all regions driven by mid-single-digit growth in maintenance and repair as well as modernization.

New equipment orders declined 6% in the quarter and are down 1% on a 12-month rolling basis. Orders in North America were down high teens driven in part by the timing of major orders. Now despite soft orders in the first half, backlog in North America is up low single digits this year versus the prior year. And the overall activity level in North America, including project awards, remains stable.

Asia orders, excluding China, were down mid-teens on tough compares, while Europe was up slightly. China orders were up 5%. That's the fifth consecutive quarter of value growth with orders benefiting from favorable pricing and mix.

Operating profit was up 9% at constant currency driven by strong volume growth in both new equipment and service. This marks the third consecutive quarter for operational profit growth at Otis largely driven by continued improvement in the profitability of the service business.

Foreign exchange translation was a 4-point headwind to sales and a 5-point headwind to earnings.

So given slightly better-than-expected first half performance, we remain confident in Otis' full year operating profit growth of $25 million to $75 million at constant currency.

Turning to Slide 5. Carrier sales were up 2% organically. Global HVAC was up 3% with North America residential up 2% and commercial HVAC up 4%. Refrigeration and Fire & Security were both up 1%.

Carrier equipment orders contracted 12% organically in the quarter. Transport refrigeration orders were down 63% on tough compares in North America truck trailer. You'll recall that orders were up more than 100% in Q2 of 2018. In Europe, truck trailer orders were down more than 25%. Commercial refrigeration orders were down 11% in the quarter as European markets have softened. Commercial HVAC orders were down 4% with EMEA down 10%, reflecting the market dynamics that Akhil noted earlier. North America residential orders were down 3%, also on tough compares. For the first half, North America residential orders are up 1%, including the impact of the cooler than expected start to the summer.

At constant currency, operating profit grew 2%, excluding the 1-point impact from the divestiture of Taylor. Earnings growth from a higher volume and the pricing more than offset commodity and tariff increases as well as investments in productivity initiatives.

So looking ahead, we expect Carrier earnings growth in the second half of the year driven by cost reduction actions, productivity initiatives and easier compares on commodities, tariffs, logistics expenses and foreign exchange. However, given the revised outlook for Carrier's end markets, we are lowering Carrier's outlook for the full year. We now see low single-digit organic sales growth and earnings growth in the range of $25 million to $75 million at constant currency.

Okay. Shifting to Pratt & Whitney on Slide 6. Sales of $5.2 billion were up 9% on an organic and reported basis. Commercial OEM sales were up 22% on higher Pratt & Whitney Canada engine shipments and the favorable mix of large commercial engine sales.

Commercial aftermarket was up 2%. Pratt & Whitney Canada aftermarket saw growth from higher content and favorable mix. This was partially offset by unfavorable contract re-estimates related to PW4000 engines. V2500 overall inductions in Q2 were up 5% versus Q2 of 2018 and up 20% sequentially from Q1 as capacity in the overall MRO network increased. That follows a temporary induction delays that we discussed in the first quarter.

Military sales were up 15% driven by the continued ramp of the F135 program. Adjusted operating profit of $427 million was up 7%. Favorable large commercial engine sales mix and continued GTF cost reduction more than offset the impact of the PW4000 contract re-estimates and higher E&D.

Looking ahead, we continue to expect Pratt & Whitney to grow full year operating profit by $200 million to $250 million.

Turning to Collins Aerospace Systems on Slide 7. Sales in the quarter were $6.6 billion, that's up $2.6 billion, and operating profit of $1.2 billion was up $538 million. On a pro forma basis, including results for Rockwell Collins in the second quarter of 2018, Collins Aerospace delivered strong operating profit growth of 21% on 8% higher sales. The pro forma sales growth reflects strength across the combined Collins Aerospace business.

Commercial OEM sales were up mid-single digits and commercial aftermarket sales were up 16% with double-digit growth across all sales channels.

Passenger traffic and demand for modifications and upgrades, including Avionics sales related to the ADS-B mandate remained strong. And we saw another quarter of above-trend provisioning sales.

Military sales were up mid-single digits driven by higher F-35 volume and an overall strong order book. Operating profit growth was driven by the contribution from the Rockwell Collins business, drop through on higher organic sales and synergy benefits. This growth was partially offset by mix headwind and higher E&D spend.

As a result of continued strength in sales volume and aggressive cost synergy capture, accretion from the Rockwell Collins acquisition to UTC earnings was approximately $0.15 in the quarter. Given the strong first half of the year, we now expect Collins Aerospace operating profit to be up $1.7 billion to $1.75 billion for the full year with the Rockwell Collins acquisition delivering $0.50 of accretion to UTC earnings.

And with that, I will hand it back over to Greg.

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Gregory J. Hayes, United Technologies Corporation - Chairman, CEO & President [5]

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Okay. Thanks, Carroll. Maybe just a note here. These second quarter results really above our expectations, but really a testament to the teamwork across UTC. These results don't just happen. Truly, the efforts of all of our employees, from the leadership of Bob and Kelly and Judy and Dave and the corporate folks right down to the folks on the shop floor, people that are building air-conditioners, servicing elevators, assembling engines and aerospace systems, it's a great team. And it's that team that gives us confidence on our full year improved adjusted outlook for 2019, and there's more good things to come.

On the macroeconomic side, obviously, the outlook varies region to region. Each business is expected to grow both top and bottom lines in 2019. And as Akhil noted, some of Carriers' end markets have not grown at the rates we expected going into the year. However, we're confident Dave Gitlin and team are taking the actions to deliver on Carriers' revised outlook. Dave Gitlin, as you know, has a strong background in optimizing operations. We have high confidence in his leadership as well as the rest of the Carrier team.

Across all of UTC, we remain laser-focused on our key priorities, which are unchanged: that's execution; innovation; structural cost reduction; and disciplined capital allocation. And I remain confident, both in near and long-term prospects for each business. And we're excited about the future as we transform the portfolio over the coming year.

With that Sonia, why don't we go ahead and open it up for questions?

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Questions and Answers

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Operator [1]

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(Operator Instructions) And our first question comes from Sheila Kahyaoglu of Jefferies.

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Sheila Karin Kahyaoglu, Jefferies LLC, Research Division - Equity Analyst [2]

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Greg, as part of the proxy, you provided some long-term forecasts for Pratt. Specifically in 2023, EBIT margins for the large commercial business are expected to generate 7% margins. I guess how does this compare to today? And how should we think about the moving pieces with the GTF ramp on production or mix of aftermarket?

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Akhil Johri, United Technologies Corporation - Executive VP & CFO [3]

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So Sheila, good question, good point. The number you quote is the large commercial engine business so not Pratt overall. That also has the impact, as we have talked about, the decline from the legacy aftermarket businesses that has a negative impact. And that's a highly profitable business, as you know today. So as the PW4000 fleet start to go down, as the V2500 will remain stable, but some of the other PW2000 and 4000 fleets go down, that aftermarket will come down and that comes with a high margin.

On the other hand, the GTF aftermarket would not have started kicking in to a great level at that point, which is why you see the suppressed margins. We expect fully, as you fast forward that and going to the late 2020s or the 2030s, you'll see the LCE business, large commercial engine business profitability improve significantly.

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Sheila Karin Kahyaoglu, Jefferies LLC, Research Division - Equity Analyst [4]

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And so is it fair to say it's a low single-digit margin business at moment, large -- Pratt large commercial engines?

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Akhil Johri, United Technologies Corporation - Executive VP & CFO [5]

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Today, yes, based on all the investments that had been made and the negative engine margin in the GTFs, which is all in that business.

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Gregory J. Hayes, United Technologies Corporation - Chairman, CEO & President [6]

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Yes. You think about that, we're spending over $1.2 billion in negative engine margin, plus nearly $1 billion in R&D still across the commercial business. So it's a -- it's definitely a low single-margin business. But as Akhil said, once the aftermarket kicks in, '24 or '25, that's when the margins really tick up.

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Operator [7]

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Our next question comes from Steve Tusa of JPMorgan.

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Charles Stephen Tusa, JP Morgan Chase & Co, Research Division - MD [8]

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Can you just talk about now what you expect for kind of the market for resi HVAC? I mean, low single-digit revenue is not bad. Orders there can turn pretty quickly. So you see anything in July that makes you a little more positive on that front and what you now expect for kind of the total market to be in 2019 for resi?

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Akhil Johri, United Technologies Corporation - Executive VP & CFO [9]

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Yes. So obviously, I think the early part of the summer has not been great, but the heat last couple of weeks should help the movement of the residential business in the U.S. As you know, we are a 2-step distribution, right? So our data is the shipment to our distributors, then the distributors have to sell it out to the consumers. We expect the market -- the replacement market still to be good with this late summer coming in. Hopefully, that helps with that. But overall, market may be flat to slightly down now. We were expecting it to be up sort of mid-single-digit -- low to mid-single-digit when we came in. With us, with Carrier growing at a slightly faster rate than that, we still expect that trend to continue, that Carrier growth will be a little faster than the market, but the market probably flat to down.

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Charles Stephen Tusa, JP Morgan Chase & Co, Research Division - MD [10]

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Got it. And then in Otis, just as a follow-up. You said timing of orders in North America, there have been a few project delays driven by tariffs and labor inflation, perhaps. Is that kind of what you're referring to? Any kind of read on U.S. nonresi from that? What's your take on that front?

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Akhil Johri, United Technologies Corporation - Executive VP & CFO [11]

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I think it's slightly different, Steve. I think it's more about the strength of the orders last year. We saw some really good orders. If you remember, last year Otis North America, orders were up 10% on a year-over-year basis, which was off a strong 2017. So '18 was exceptional. And we kind of expected our orders in North America this year for Otis to be slightly down. That's not a reflection on the market. It's just this extraordinary strength that Otis saw last year in the orders. We do still see good award level activity. So the nonresidential construction activity, still pretty robust and strong. Awards are pretty good. We -- but I think the market is probably the best way to characterize it. It is stabilizing at the high levels in North America. There is a little bit of margin pressure. But overall, market is stabilized.

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Charles Stephen Tusa, JP Morgan Chase & Co, Research Division - MD [12]

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And then one last quick one. You mentioned E&D was up at Pratt. I think the guidance for the year has it being a bit of a tailwind. Is that related to middle of the market or anything like that? Or why is E&D up there?

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Gregory J. Hayes, United Technologies Corporation - Chairman, CEO & President [13]

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So E&D is up really across Pratt. It includes both Pratt Canada as well as the large commercial engine business. For the full year, we still expect E&D to be flat, so it will be a tailwind in the back half of the year for Pratt. But there is, I would say, minimal spending, although a little bit on the NMA, but that's not driving this. This is just other programs that we've got in the hopper.

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Operator [14]

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And our next question comes from Ron Epstein of Bank of America.

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Ronald Jay Epstein, BofA Merrill Lynch, Research Division - Industry Analyst [15]

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When you think about the investments that you can make across the entire franchise, I mean, what is the appetite to make new investments on new programs? Specifically, I mean, where do we stand on NMA? Where do we stand on maybe the replacement of 737, that kind of stuff?

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Gregory J. Hayes, United Technologies Corporation - Chairman, CEO & President [16]

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Look, Ron, I think you can't look at investment in a single year and make any type of determination. We're going to continue to invest across the aerospace portfolio. In those markets where we think we have a significant advantage, the GTF is one of those, we're prepared to invest in the NMA. I think we put in an offer to Boeing, which we hope is compelling. But if it that doesn't happen, we're going to continue to invest in the GTF technology, so that we're ready for the next-generation single-aisle, which we don't really think will get launched until probably 2025. So I would expect overall E&D to kind of remain flattish at Pratt until such time as we have a brand new engine program.

We're also -- as I think about E&D, it's not just Pratt. It's also across the Collins Aerospace business. We've got a lot of great products there, be it Avionics or electric power, the Aerostructures business, all of which represent opportunities. And what we're really focused on is how do you innovate and have the next generation of technology ready when the aircraft manufacturers are ready.

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Akhil Johri, United Technologies Corporation - Executive VP & CFO [17]

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Just one point to add on the Pratt side, Ron. I think Pratt Canada is a business we shouldn't ignore when we talk about investments because that really a crown jewel, as Greg has often mentioned. And that's a business where we continue to refresh our product line and continue to make sure that we have the latest product available for our customers because that generates significant installed base and aftermarket on a continuous basis. So that's another area where investment continues.

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Gregory J. Hayes, United Technologies Corporation - Chairman, CEO & President [18]

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And look, we're not going to step down the pace of E&D spend. I think, and maybe as a percentage of sales, that would go down a little bit as we continue to see solid growth on the top line. But the absolute level of E&D, I would expect to remain relatively flat as we look to continue to stay ahead of the curve.

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Ronald Jay Epstein, BofA Merrill Lynch, Research Division - Industry Analyst [19]

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And if I may as a follow-on, just quickly.

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Gregory J. Hayes, United Technologies Corporation - Chairman, CEO & President [20]

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Sure.

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Ronald Jay Epstein, BofA Merrill Lynch, Research Division - Industry Analyst [21]

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How does having Raytheon in the portfolio, if you will, or the combination, change your thinking about that, right? I mean Raytheon should be a fantastic source of additional capital, so on and so forth, I mean, right? So I mean, how does that -- how does having Raytheon change that versus not having Raytheon?

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Gregory J. Hayes, United Technologies Corporation - Chairman, CEO & President [22]

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Well, look, I think when you look at the cash flows of the combined company, as you understand that some of these decisions as a standalone commercial aerospace business, it's a much bigger deal then as a combined aerospace and defense industry. But also, I think it gives us the ability to capitalize on their technologies and for them to capitalize on our technologies. And with 60,000 engineers between the 2 companies, I got to believe we're going to find some savings on some of these programs as we're able to capitalize on each other's technology. But I think, fundamentally, what Raytheon gives us is the scale to compete anywhere, any time in any program that we choose to. And again, it's not that we're going to go chase everything. That's not the idea. We're still going to be disciplined in where we put our capital. But I think, again, it's a -- it's just a great opportunity for us to be able to continue to invest, but also to give a lot of cash back to shareowners over the next 3 to 5 years. And I think that's the beauty of the Raytheon merger.

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Operator [23]

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And our next question comes from Jeff Sprague of Vertical Research.

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Jeffrey Todd Sprague, Vertical Research Partners, LLC - Founder and Managing Partner [24]

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Just a couple of cash flow-related questions. First, do you expect to fully spend that $1.5 billion separation placeholder in 2019? And is that grand total number moving around at all as we look into 2020?

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Akhil Johri, United Technologies Corporation - Executive VP & CFO [25]

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Still a little early, Jeff, to comment on the total number. But on the $1.5 billion, a lot of that, as you can imagine, it relates to the tax cost as we do our legal entity restructuring. The good news is the team is working really, really hard and is on track as of now to achieve the steps that were critical. You'll see probably a larger amount in Q3 associated with that as we do a lot of these legal entity restructurings. But will the exact number be $1.5 billion for the year? I don't know. And that's part of the reason why we didn't change our guidance for the $4.5 billion to $5 billion for the year, even though, on operational side, we feel better about our outlook. The uncertainty associated with the separation cost-related cash flow is why we have kept it where it is. But I'm still hopeful that, overall, we see little better news on cash flows than we have in the guidance.

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Jeffrey Todd Sprague, Vertical Research Partners, LLC - Founder and Managing Partner [26]

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And then also just coming around to the S-4, I understand the unlevered free cash flow that we see there is different than the free cash flows defined typically in the -- world we operate in. But the numbers there do suggest that, perhaps, there's some upside to that kind of $8 billion number you laid out for 2021 post merger for the combined aero company. Am I interpreting that correctly? Can you address that at all?

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Akhil Johri, United Technologies Corporation - Executive VP & CFO [27]

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You are absolutely interpreting that correctly. There would be about $1 billion difference, at this point, if you do the math. I think it's easy for anybody to do that. But what I tell you is 2 things. One is what is -- what you see in the S-4 and what was used for valuation purposes were our internal plans. As you would expect, any reasonable management team to do is to not necessarily put that out as guidance. So we would -- when we gave you the $8 billion number, that had a little bit of conservatism baked into as a -- because I knew you would ask me that question in 2021. So I just wanted to make sure that, that number was something we could absolutely deliver on. And the second point is that there is still that discussion we were having earlier. Even though these separations may happen by 2020, which are likely to happen by 2020 first quarter, or second quarter at the latest, there may be some lingering tax payments associated with the separation activities, which may go into 2021 as we file returns in foreign jurisdictions and actually make cash payments in 2021 associated with the separation. So we kept a little room for that. So -- but net-net, you're right, operationally, it should be higher.

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Gregory J. Hayes, United Technologies Corporation - Chairman, CEO & President [28]

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I think the key thing there, Jeff, is that when we did the valuation of UTC Aerospace, we had full up cash flows of the businesses forecasted. You've uncovered Akhil's little hedging technique there, which is probably not a surprise to anybody that knows Akhil. But the fact is we think we got full and fair value for all of those cash flows going forward. And we'll see what the other cash looks like as it relates to the separation activity. But really, it was just our own conservatism in terms of what we put out to The Street versus how we actually value the business.

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Operator [29]

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And our next question comes from Carter Copeland of Melius Research.

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Carter Copeland, Melius Research LLC - Founding Partner, President and Research Analyst of Aerospace & Defense [30]

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Just a follow-up quickly on that S-4 cash disclosure. I noted, just from a methodology standpoint, there was, I guess, some difference in there and how it treated non-operational aerospace investing cash flows. Can you help explain what those were and maybe how much we should think that impacted that number that you -- that we see in the S-4?

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Akhil Johri, United Technologies Corporation - Executive VP & CFO [31]

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So Carter, this is something that we have talked about a little bit over the last couple of years. As people have been looking at items below our free cash flow definition, the investing cash associated with the payments we make to Rolls-Royce, the leased pool assets that we have put in place every year, some cost -- limited amount of customer financing that we do, right, all that stuff shows up in our investing cash flow below free cash flow number. So for purposes of relative valuation, since that is a relatively reliable number or outflow, it was only fair to reflect that in the unlevered cash flows for purposes of valuation of the company because that number will stay going forward. Now that will come down over time as we have talked. This year, it's probably between $1 billion to $1.5 billion. That number goes down below $1 billion as we move forward in time. Leased pool assets won't be as high as they are. Customer financing will be a little bit less. And the Rolls-Royce payments have a finite life to it. They go away after 2027. So we took all that into account, but it was a fair cash call on our aero future cash flows.

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Carter Copeland, Melius Research LLC - Founding Partner, President and Research Analyst of Aerospace & Defense [32]

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So it's reasonable to assume that the Rolls payment, as we know, it's always been you've got a leased pool build and then you've got leased pool sales presumably at the back end of that forecast period?

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Akhil Johri, United Technologies Corporation - Executive VP & CFO [33]

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Well, leased pool sales, I would say, is not something to rely on because if you think about it, the installed base will continue to grow. So the best way to think about that is that we won't necessarily add to the leased pool assets at the same rate that we have done in these first 2 years. But we typically don't see sale of leased pool assets until very late in the program. It's more about not continuing to build it at the same rate.

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Operator [34]

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And our next question comes from Julian Mitchell of Barclays.

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Julian C.H. Mitchell, Barclays Bank PLC, Research Division - Research Analyst [35]

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Maybe just circling back nearer term, give a little bit of color as to how much of a slowdown in order intake, in general customer activity you've seen in those global HVAC and refrigeration markets. Was this something that fell off late in Q2? Or is it a steady sort of deceleration for 3 or 4 months?

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Akhil Johri, United Technologies Corporation - Executive VP & CFO [36]

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So broadly speaking, Julian, I think the only place where I would say we have been negatively surprised is Europe, broadly speaking, for the HVAC business, right? For the HVAC business or for the refrigeration business is the number Carroll quoted for Europe truck trailer orders down over 25%. Commercial refrigeration business was down near double digit on that as well in Europe, specifically, which is where a big part of the business is. Commercial HVAC was also down in Middle East. As you know, it's down over 25%, I think, in terms of that area. So I think Europe has been the one where the order decline had been greater than what we expected and probably a little bit of a surprise.

The other places, I would say, is more of a compare issue than really a fundamental market issue at this point. It doesn't feel like that. North America residential, lots of people have talked about it, you understand it well. That's probably a cool start to the summer. I don't think there's fundamentally anything wrong with the market. The replacement cycle is still pretty strong. Housing starts, down this year, but we expect that to continue to grow as we go forward into the next year. So I think fundamentals still okay there. It's the Europe market, which is probably a little weaker than we expected.

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Julian C.H. Mitchell, Barclays Bank PLC, Research Division - Research Analyst [37]

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And then just my quick follow-up. Tying that maybe to Otis, where you have seen very good improvement in service profitability for several quarters, Europe is obviously the biggest profit pool for that service business at Otis. So are you concerned at all if broader construction is slowing in Europe, that, that may start to impinge on pricing in service at Otis and eat into that service profit improvement?

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Gregory J. Hayes, United Technologies Corporation - Chairman, CEO & President [38]

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I think the -- we have been through a long cycle of pricing pressure in Europe on service. And I think we have finally started to see that stabilize here in the last 6 quarters or so. And the focus is really going to be on how do we get productivity out of the technicians to offset whatever pricing pressure there is out there. But again, as these more modern machines get put into service, the ability of the independent service providers, the ISPs, to service the elevators becomes less and service becomes, in our words, a little bit more sticky. And I think, again, the more technology, the more we can offer the customers in terms of Internet connectivity or predictive maintenance on these elevators, all of that goes to our ability to retain customers. And look, people typically don't change just for pricing. They change because of poor service. And what we found is that the better our service quality is, the better -- the lower our turnbacks or callbacks, the lower issues -- the fewer issues that we have with the machines, the better our retention rate is for those elevators. So I don't view this as a near-term or even a medium-term pricing issue. I think that we just have to continue to focus on the fundamentals of service in Europe, and that will drive profit growth there.

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Akhil Johri, United Technologies Corporation - Executive VP & CFO [39]

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Yes. I think to put a data point that we talked about in the first quarter call as well, I think the most heartening data point for me in Europe service for Otis was that the hours per unit came down by about 5% in this quarter after a decline in first quarter as well, and that's Europe, right? So Europe service is seeing productivity. Part of that is the growth in the repair business, in the -- outside of the maintenance, so that's helping as well. But certainly, the service transformation initiatives that Otis has been working on for a long time is -- are starting to bear fruit now.

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Operator [40]

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And our next question comes from Peter Arment of Baird.

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Peter J. Arment, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [41]

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Greg, just on Collins Aerospace, just specifically on the commercial aftermarket. The higher outlook that you're giving there now, high single-digit growth, obviously, a very strong first half. Just maybe some insight onto how you're thinking about the second half. I mean, it seems like are you expecting ADS-B volumes start to fall off? Or how are you thinking about what provisioning demand will be just given this outlook? Appreciate it.

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Gregory J. Hayes, United Technologies Corporation - Chairman, CEO & President [42]

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Maybe a couple of points there. In terms of ADS-B, as you guys know, the mandate is that by the end of this year, all of the U.S. operators have to have the upgrade of ADS-B. That will be some carry on into next year, as some of the other smaller operators, the European operators also get their upgrades. I think you have to look at provisioning not just as a single quarter though. We said -- I think Akhil said it, provisioning was up over 30% in the quarter. And while that's wonderful, it is not sustainable. And so I think we would try to put a reasonable back half forecast in front of people understanding that you're not going to get 30%-type provisioning increases year-over-year. But we still feel very good about the market. I think what we're seeing, repair input is good on the Collins side, spare parts sales are still good and people are flying a lot. And I think, while it's bad news that 737 MAX isn't flying, it means that some of the older aircraft have to remain in service a little bit longer. And that's also driving some of this volume. So as we think about this, I wouldn't get too excited about the first half. It's great performance across the business, but it's not going to repeat at this level in the back half. If it does, great. You'll see it. You'll see it in the earnings. You'll see it in the top line. You'll see it in the bottom line. But in terms of our guidance, we're not expecting this level of activity to continue.

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Operator [43]

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And our next question comes from Rajeev Lalwani of Morgan Stanley.

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Rajeev Lalwani, Morgan Stanley, Research Division - Executive Director [44]

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Greg, Akhil, when coming back to the S-4 and some of the information in there, clearly, you're providing some pretty good numbers as far as growth going forward. I think it implies, once you take into account, capital returns somewhere in the mid-teens. One, is that right? And then two, what's the risk to all of that? You obviously caveated it in terms of maybe some potential incremental investments on engines and so on. So just trying to get comfortable with, one, is that opportunity really that big? And then two, what's the risk to it really materializing?

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Akhil Johri, United Technologies Corporation - Executive VP & CFO [45]

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I think the biggest point that you made, Rajeev, is the risk associated, and Bob Leduc mentioned this, so this shouldn't be a surprise to anybody is NMA investment, right? If we were fortunate enough to win the NMA, if NMA is to be launched and we win the engine on that, that would definitely be an investment not contemplated in those numbers. What is also not contemplated to some extent, this is business as usual internal plans that were put out there, right? There is also incremental near term. There could be some pressures associated with restructuring investments that we need to make in the business to continue to drive margins in the long term. And as Greg said, if there is additional opportunities that come in front of Collins Aerospace that are associated with NMA or something else, you could see some. So this is business as usual, internal plans, driving the businesses to better performance, as you would expect us to do, but there are always risks out there, or investments needed, which can sometimes dampen that outlook a little bit.

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Gregory J. Hayes, United Technologies Corporation - Chairman, CEO & President [46]

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Yes. I would just add to that, I think this was a -- our best, most reasonable forecast that we put forward that we shared and felt comfortable sharing with Raytheon and the bankers as we went through the valuation. We tried not to put everything, including the kitchen sink into this valuation. It -- we wanted it to stand on its own. At the same time, I believe, there is both upside as well as some downside risk. And the upside, as Akhil said, is we have more to do on margins at Pratt. We have to invest in automation. We have to invest in the factories. We have to invest to take the cost down even further than what's laid out on these plans. And all of that should lead potentially to higher margins, but it also would require higher capital investments, higher cash investments and the restructuring, which are not in there. So we think it's a very balanced view of the business going forward, taking full benefit of course for the GTF investments that we've made over the last 10 or 12 years.

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Rajeev Lalwani, Morgan Stanley, Research Division - Executive Director [47]

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Okay. Just one quick clarification, but is my characterization in terms of that growth potential once you take into account capital returns, something sort of mid-teens or so over the next 5 years? Or could it be that high?

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Akhil Johri, United Technologies Corporation - Executive VP & CFO [48]

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You don't do mid-capital returns from a point of time, right, because, I mean, that would be ignoring all the investments we have made in the business, in GTF, for example. I mean obviously, looking forward, I think we have talked about this before, Rajeev. If I look at engine campaigns for GTF to pick one example, we generally have low to mid-teens returns on every engine campaign. That's our goal. But when I factor all of the investments in E&D and capital and everything else made, the GTF program overall is not a mid-teens return. It's above cost of capital, but it's more close to double-digit type of thing, right? So I think it depends on what you're starting point is and what investments you want to consider. The returns will change. I think the good news is that all these investments generate returns in excess of cost of capital. And if you look isolated just on a look forward, it would be in the low to mid-teens type of thing that you're talking about or could be higher.

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Operator [49]

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And our next question comes from Nigel Coe of Wolfe Research.

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Nigel Edward Coe, Wolfe Research, LLC - MD & Senior Research Analyst [50]

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Akhil, I just want to go back to your comments about the resi HVAC market flat to down. Is that a volume unit forecast? Or would that be revenues? And this gets to my question about pricing. Are we seeing pricing discipline continuing in light of the weaker conditions in the -- in that market?

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Akhil Johri, United Technologies Corporation - Executive VP & CFO [51]

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Good -- very good point, Nigel. What I was talking about was volume, so units essentially is what I was talking about. When you take pricing into account, you do see maybe some -- a positive number on the market from a value perspective. But yes, in terms of units, it's flat to down.

Pricing has been reasonably good. I think second quarter, as Carroll mentioned in his comments, we saw pricing more than offset -- significantly more than offset actually the commodities, logistics and other input cost increases. So we are seeing the pricing state at this point. Obviously, a lot depends on how the summer plays out, as you know this market well and also what happens in the future with any tariffs or anything else. So it's something we watch on a day-to-day basis. But the good news is that, at least through the first half, we have seen pricing stick and fall through to the bottom line.

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Nigel Edward Coe, Wolfe Research, LLC - MD & Senior Research Analyst [52]

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And then my follow-on is really about the back-half guidance. You're pointing towards, I think the math is 50 to 100 of EBIT growth in the back half for Carrier. How much visibility do we have around when we're sure of deflation benefits or specific cost actions that get us -- give us confidence that we can generate that level of growth in the back half? And I'm curious whether transportation business could be a headwind given the negative development there. Do we have a headwind from transportation in the back half of the year?

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Akhil Johri, United Technologies Corporation - Executive VP & CFO [53]

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At this point, I think the backlog was still okay for the transportation, to answer your second question first. So I think we're still relying on some level of growth in the refrigeration business in the back half. Clearly, we will need orders to get a little bit better than what we have seen in the second quarter. So definitely, the good news, it -- or the expectation of earnings and sales growth in the second half rely on improving order trends. The things which are positive for Carrier as we look in the back half is improving raw material headwind, as you point out, commodities, tariffs. All that becomes a little easier. Logistic costs on a year-over-year basis comparison become easier. Plus Dave and Bob McDonough, before him, have done 1,000 people headcount reduction that you -- that we see some benefits of coming through as that headcount action took place in Q2, et cetera. We see the benefits of that coming through in the second half as well. So restructuring actions, easier compares on commodities, logistics, tariffs, et cetera, FX as the other element, when you take all that into account, some things to rely on as we look at second half, but clearly, also relying on improvement in the order trends.

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Operator [54]

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And our next question comes from Cai von Rumohr of Cowen and Company.

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Cai von Rumohr, Cowen and Company, LLC, Research Division - MD & Senior Research Analyst [55]

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So your guide assumes high-teens commercial aero aftermarket at legacy UTAS, which would imply, I think, mid-teens or mid-to low teens in the second half. Give us some color on the sequential trend over the last couple of months in aftermarket? And at one point, you guys talked of $0.10 negative hit if the MAX is out for the entire year. How does that factor into your thinking currently?

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Akhil Johri, United Technologies Corporation - Executive VP & CFO [56]

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Yes. I think, to answer your second question first, Cai, it's still the same estimate. We -- I think you've heard from Boeing as well. They're assuming 42 per month type of production through the end of the year. We had calibrated that in our first quarter call as up to $0.10, and that number still stands. So that is baked into the forecast. And Collins was able to raise its outlook in spite of that headwind. So that's certainly good news.

With regard to the aftermarket, I think for the point I'll come back to, and Greg mentioned this a little bit as well, is if you look at provisioning, Cai, a lot of the strength we saw in the second quarter at the heritage UTAS business came from stocking orders from the MRO shops, right, with some constraints on supply, with the grounding of 737 MAX and no new supply coming in for that aircraft. Clearly, the incentive is -- and with the traffic still staying robust, the incentive is for all airlines and MRO operators to ensure that the existing fleet is not on the ground for very long at all, if at all, right? And the one way to ensure that is to make -- to be clear that all the parts that may be required for repairing something are available on site and where it is needed. So we saw some stocking orders, which drove exceptional performance, which is great to see and helped us raised our full year. But to count on that to happen again and repeat itself in the second half would probably not be appropriate and would not be the right call to make. So that's what we have assumed that second half slows down a little bit, still grows nicely. And as Greg said, if it comes in stronger, you'll see it in our numbers.

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Cai von Rumohr, Cowen and Company, LLC, Research Division - MD & Senior Research Analyst [57]

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I guess my question was it has to slow, it would look, like, to a level still slightly above 10%. That's still pretty good if we have any slowing and destocking and more impact from the MAX.

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Akhil Johri, United Technologies Corporation - Executive VP & CFO [58]

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Yes, I think part of that is exactly -- what you said, Cai, I think, because of the MAX, you -- we continue to expect a reasonably strong second half relative to first half, it will be smaller. But relative to year-over-year or normal trends, it will be stronger. So that's the benefit that will definitely be there. You're exactly right.

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Operator [59]

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And our next question comes from Myles Walton of UBS.

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Myles Alexander Walton, UBS Investment Bank, Research Division - Research Analyst [60]

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I want to ask about the Pratt aftermarket. And maybe Akhil, could you give us what the aftermarket growth would have been without the PW4000 adjustments?

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Carroll Lane, United Technologies Corporation - VP of IR [61]

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Yes. Myles, the aftermarket is doing very well overall. If you think about the organic demand for V2500 shop visit, it's still 1,000 shop visits or better. And if you think about the step-up in inductions that we saw sequentially, very strong, obviously.

You take out the PW4000 contract adjustment, you're probably at that mid-single-digit overall aftermarket growth. So really, the question in terms of getting to the full year mid-single-digit is just one of execution in the back half. Can you get as many V's through the shops worldwide? As -- is there a demand? The demand remains very strong.

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Myles Alexander Walton, UBS Investment Bank, Research Division - Research Analyst [62]

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And that 4000, look, was that customer-specific driven? Or is that an overall look at the market and kind of your kind of forward look as to the demand profit looking on that specific engine platform?

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Carroll Lane, United Technologies Corporation - VP of IR [63]

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No. I mean, we look at individual customer fleets on a regular basis, assess the cost of the individual contracts. And the case of this quarter, when we look at some PW4000 contracts, which is obviously a smaller fleet than the V's, we had a bit higher cost on several contracts. So the good news is we have repair development going on continuously to reduce any additional wear modes on some of these older engines because what's they are. These are engines that are in the later stages of their life. So it's a part of doing business. And we feel very good about the Pratt aftermarket overall.

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Myles Alexander Walton, UBS Investment Bank, Research Division - Research Analyst [64]

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Okay. Got it. And just one clarification on the slide that talks about favorable large commercial engine mix. Is that implying that you had lower GTFs year-on-year as proportional to the mix? Or is that implying something specific to the contracts in the GTF deliveries?

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Akhil Johri, United Technologies Corporation - Executive VP & CFO [65]

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No. It's more about a lower GTFs because, if you remember, last year second quarter was a very strong. It was a bit of a catch-up quarter, right, after the issue we had in the first quarter last year with the knife edge seal. The recovery from that took place in the second quarter, so there was a much higher volume of shipments. There is also a mix issue in terms of -- there is the second element, which is probably a smaller contributor to the whole thing. It's the customers to whom the sales were made, right? That's point we are making about contract. I think that -- there is a little contribution from that as well. And the third element, I would say, is sales of some spare engines, right, because as customers are getting confidence in the configuration that we have out in the market now, they are willing to invest in some leads and some spare engines themselves as opposed to requiring us to hold all of the spare engine tools.

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Carroll Lane, United Technologies Corporation - VP of IR [66]

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Myles, the other thing we had going on at Pratt this quarter, we don't talk enough about is Pratt Canada. You had shipments up and really shipments up across all the categories. Regional was up. Corporate was up. Rotorcraft was up. So just feeling pretty good about things at Canada, which was a contributor to the -- at the OEM line this quarter.

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Operator [67]

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And our next question comes from Noah Poponak of Goldman Sachs.

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Noah Poponak, Goldman Sachs Group Inc., Research Division - Equity Analyst [68]

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Just one quick follow-up to that Pratt aftermarket topic, which is, is the V2500 inspection issue that you had at the 2 MRO shops that started last quarter, is that fully 100% resolved? Or does it linger slightly? And then I wanted to ask on Collins. The synergy increase on a percentage basis is pretty large for year 1. Maybe you could elaborate a little bit on where you're finding that. And is there a new multiple year out synergy number?

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Carroll Lane, United Technologies Corporation - VP of IR [69]

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Yes. So I'll start on the V question. We've redeployed those engines. And we have the capacity that we think we need. Really, the question is just getting them through the shops, right, because you had delayed inductions and it's a tightly coupled system. So I think the issues that kind of precipitated the disruption have been resolved. But we still have a lot of work to do to get the engines through the shop from an execution standpoint.

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Akhil Johri, United Technologies Corporation - Executive VP & CFO [70]

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And the Collins increase, Noah, that's -- again, it's great to see us looking at about $200 million synergies in the first year, and so the $600 million number that you're referring to, which was the increased number that Kelly showed in Paris, could have some upside hopefully. That's what Kelly and team are driving to. I am highly confident that they're not stopping at $600 million. Like we did in the case of Goodrich, we will continue to drive these synergies.

The good news is that we're seeing that level of cost benefits in the first quarter itself. It's in 2 areas. SG&A, as you would imagine in the first year, generally that's where you get it. And then the -- its indirect supply. That's where the other part of the benefit comes from. So I think the team is focused on driving as high a synergy number as we can and the $200 million is a good start for first year.

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Operator [71]

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And ladies and gentlemen, this does conclude our question-and-answer session. I would now like to turn the call back over to Greg Hayes for any closing remarks.

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Gregory J. Hayes, United Technologies Corporation - Chairman, CEO & President [72]

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Okay. Thanks to you, Sonia. First of all, thanks for listening today. As always, Carroll and the whole IR team will be available all day to answer your questions. Please feel free to give them a call. And thanks to all for listening. Take care.

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Operator [73]

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Ladies and gentlemen, thank you for participating in today's conference. This concludes today's program. You may all disconnect. Everyone, have a great day.