Shares of United Technologies (NYSE: UTX) had largely been stuck in neutral over the past year as the company awaited approval for its $30 billion acquisition of Rockwell Collins. The deal finally closed in late November, but the company's Nov. 26 announcement that it plans a three-way split adds a new layer of uncertainty that appears likely to linger well into 2020.
UTC's decision to split its aerospace business, Otis Elevator, and Carrier HVAC into three independent entities has long been discussed, and there is logic to the move. The three companies enjoy few economies of scale from working together, have different capital requirements and debt profiles, and issues at one business in the past have led investors to ignore successes elsewhere.
Workers on the line at a Pratt & Whitney engine center. Image source: United Technologies.
But the conglomerate model has provided some shelter for highly cyclical operations, and the independent units might be more vulnerable to market swings than the combination ever was.
What's an investor to do while the split plays out? Here's a look at the three companies that are set to emerge from United Technologies.
A one-stop aerospace shop
UTC paid a full price for Rockwell Collins, with the company going on the defensive to counter efforts by Boeing and Airbus to squeeze their supplier base and bring more work in-house. Combined with Rockwell Collins the UTC aerospace business, which will keep the United Technologies name, has greater exposure to key commercial platforms and more negotiating power.
The aerospace business with Rockwell Collins is by far the biggest segment inside the conglomerate, with pro forma annual sales of $39 billion. It supplies a range of electrical, mechanical, and software products, interior seats and cabin equipment, and Pratt & Whitney engines.
Honeywell, itself a mini-conglomerate but perhaps the most similar publicly traded entity, trades at about 2.6 times sales and 18 times expected 2019 earnings. TransDigm, a more focused aerospace supplier, meanwhile trades at about 22 times expected earnings. If the new United Technologies falls somewhere in that range the aerospace business alone would be worth about $100 billion, or a significant portion of the combined company's current $131.38 billion enterprise value.
It's worth noting that in addition to pressures from Airbus and Boeing commercial aerospace is benefiting from a now decade-long new plane buying binge, and Pratt & Whitney has had issues bringing its promising geared turbofan engine to market as promised. A fall-off in orders or continued engine problems could cut into valuation. But the post-split portfolio should have enough aftermarket exposure to make the new United Technologies a strong business even when new plane purchases inevitably decline.
Carrier M&A talk could heat up
Carrier, with $17.8 billion in sales, though best known for air conditioning, is a supplier of a range of HVAC, refrigeration, fire, security, and building automation products with a portfolio of brands including Kidde, Edwards, and Automated Logic and a global distribution network. United Technologies has reportedly been considering buyers for much of the business's fire and security businesses, which would create a HVAC and refrigeration specialist with both residential and commercial building exposure.
Should the fire business find a home elsewhere, Carrier could be an attractive partner for a rival like Johnson Controls or Lennox International. There is a huge variance in valuations in the sector, with Lennox trading at 2.3 times sales and 24.7 times expected earnings, conglomerate Ingersoll-Rand at 1.7 times sales and 18.8 times earnings, and Johnson Controls -- which like Carrier has a lower-margin fire and security unit -- at 1 times sales and 18 times earnings.
If an independent Carrier was to fall somewhere in the middle of that range it would be worth at least $30 billion, either as a stand-alone post-split or perhaps as part of a merged entity should United Technologies find a way to do a tax-efficient deal.
More down than up
Otis is the leading name in elevators, with an estimated 9% of the $22 billion global market according to research company Ibis World, but the company's share and margins have been on the decline for nearly a decade. The company in recent years has been willing to cut prices to try to gain marketshare in China, hoping to benefit from future servicing revenue.
Otis, with $12.3 billion in 2017 sales, generates strong cash flow via a portfolio of more than two million elevators under maintenance. But it was also the worst-performing part of UTC in the most recent quarter, with adjusted operating margins down 2.4% to 15.2%. United Technologies warned that it now expects Otis operating profit to fall year over year and said its 2020 profit goal is in doubt.
It's hard to value this business, as most of Otis' publicly traded rivals are smaller but have reported stronger growth and healthier margins of late. Kone Oyjs and European-traded Schindler Holdings are valued in a range of 2 to 2.4 times sales and 20 to 25 times forward earnings. Assume a similar range for Otis and you have a stand-alone valued at between $25 billion and $30 billion.
This business could also be ripe for a private equity buyer with some expertise in cost-cutting, or to participate in consolidation if regulators were to allow it.
No reason to jump in
There's a lot to like about United Technologies' portfolio, and evidence to suggest that the company is, as some activists have suggested, suffering from a conglomerate discount. The very rough comparables listed above would suggest that UTC's sum-of-the-parts valuation could be between 15% and 20% above its current enterprise value.
But considering all the work UTC management must do between now and 2020, and the risk of a turn in the business cycle between now and then, there isn't much reason to buy in ahead of the split. A report by Barclays analyst Julian Mitchell concluded that in 13 recent splits involving industrial companies, the shares of those companies on average underperformed the market by 4% from announcement until close. Given the uncertainty surrounding UTC, it would be no surprise if the market takes a similar wait-and-see approach to this breakup.
Within two years, investors will be able to choose between three distinct entities with very different free cash flow and growth profiles, and all tied to different markets. They'll also get to make that choice knowing exactly how the overall economy, the commercial aerospace cycle, and the construction cycle have held up as the split played out.
There's likely to be real value to come out of the United Technologies split. But now is not the time to buy in in anticipation of that value. The UTC split is best watched from the sidelines.
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