United Technologies: Uniquely Positioned to Capitalize on the Future
While the financial performance of many industrial companies is at the mercy of the economic cycle, those with the ability to identify and exploit long-term opportunities are able to successfully navigate short-term cyclical volatility and reward shareholders over the course of multiple cycles. United Technologies Corp. (UTX) designs, builds, and supports complex and costly equipment with long life cycles, and its products (aircraft engines/components/systems, air conditioners, elevators, etc.) are critical components of large and expensive customer projects. The company holds a privileged position in these markets as few players can replicate the scope of technological expertise, manufacturing and support infrastructure, and funding capacity necessary to reliably serve them. Accordingly, UTX enjoys a durable revenue stream with high barriers to entry and attractive margins. In addition, the company’s revenue growth outlook is bolstered by a product portfolio well positioned to benefit from long-term global population trends. Combined with a business operating system effective at wringing profitability and free cash flow from the revenue line, UTX has a business model built to produce solid growth and profitability years into the future.
The United Technologies product portfolio generates a revenue stream that is both more stable and lasting than many industrial companies. The large long-term capital commitments required in commercial construction and aircraft production generate a relatively firm and long-duration backlog for the company. This effectively reduces the impact of cyclical volatility and provides management with a reasonably predictable book of business allowing for more informed and efficient decisions regarding production and distribution. The company’s products are also more insulated from competitive pressures thanks to technological, regulatory, manufacturing, and support hurdles not easily overcome by competitors unable to muster the large financial and intellectual capital required. Finally, the company’s aftermarket parts and services business extends the revenue opportunity beyond the initial equipment sale to a large installed base with a lengthy product life. These revenues are based more on equipment usage than discretionary spending plans and are therefore more secure, more profitable, and less volatile than initial equipment sales.
A good example of the revenue profile for UTX products is the new Geared Turbofan (GTF) aircraft engine. The successful launch of this advanced engine technology has generated a backlog of approximately 5,300 engines to date, including roughly a 50% share on the Airbus 320neo. Consequently, UTX has reasonably visible and secure commercial engine production growth of 60% built in for the next five years. In the future, aftermarket parts and service will provide an additional steady and profitable source of revenue in the out years of the engine’s life – for example, the older V2500 engine is just starting to hit its first round of heavy maintenance at an average fleet age of eight years. This extended product offering also provides UTX greater flexibility in securing business. UTX will lose money on the initial GTF engine sale to book customer orders, but we believe total profitability on the sale over the long life of the engine will be attractive as future aftermarket and service revenue is recognized. In the meantime, those high-margin aftermarket sales and service revenues from the V2500 are being realized to smooth the transition.
United Technologies’ revenue also benefits from positive growth dynamics in global population trends. The company breaks its business into two broad segments: Aerospace (approximately 55% of revenue) and Building and Industrial Systems (approximately 45%). Both air travel and commercial construction are profiting from the growth and change in composition of the world’s population, especially its urban population. The world’s urban population is growing faster than the population at large and even more in less developed regions where it is growing twice as fast1. This trend is shifting the labor force to higher paying industrial and service sector jobs resulting in greater discretionary income and an expanding middle class. By UTX estimates, the incremental increase in the urban population will have a run rate of 65 million per year or roughly an additional Mumbai, New York and Shanghai. Through 2030, the global middle class is expected to expand annually by approximately 5%. As increased discretionary income leads to increased demand for products that facilitate a higher standard of living – air conditioning, elevators, and air travel for example – UTX is advantageously placed to benefit from this trend.
UTX management also has a solid historical track record of converting revenues into profits and free cash flow. Its Achieving Competitive Excellence (ACE) business management process is a rigorous, data-driven system that pushes systematic efficiency, customer service, and cost reduction initiatives throughout the organization. The productivity gains of individual business units are substantial as they progress through the ACE designations of Bronze to Silver to Gold. For example, through the deployment of ACE initiatives, a Climate, Controls and Security (CCS) facility in Monterrey, Mexico improved cost per hour by 41% and inventory turnover by 76% over just three years. The cumulative impact of successes similar to Monterrey’s across the entire CCS segment, coupled with selective pruning of underperforming assets, helped bring about a doubling of profits and margins from 2009 through 2013 despite flat revenues. The 2012 Goodrich acquisition has expanded the ACE application opportunity. The addition of Goodrich facilities lowered the total percentage of UTX facilities rated Silver or Gold from 83% to 68%, effectively resetting the bar for productivity improvement as the company seeks to re-attain the 80% level. An even greater opportunity exists for external suppliers, which account for roughly $30 billion in supply-chain spending. Through a combination of new Goodrich suppliers and more stringent standards, the company saw the percentage of suppliers hitting targeted performance levels drop from 75% to 38%. The company expects its suppliers will re-attain the 75% targeted level by 2016. We believe this expanded runway for ACE implementation should yield material structural cost benefits and enhanced opportunities to leverage future revenues to the bottom line.
Durable long-term revenue generation, a secular growth tailwind from global population trends, and strong profitability and free cash flow generation will give UTX the capital to pursue a number of options to enhance shareholder value. Based on existing backlog and assuming a normal global growth environment, the company projects a “clear path” to 5% organic growth through the end of the decade. At that rate of revenue growth, coupled with modest incremental margin improvement, the company can expect to generate roughly $50 billion in free cash flow over that time. Historically, management has deployed free cash in a shareholder friendly mixture of dividends, share repurchases, and carefully considered acquisitions. We believe this is likely to continue in the future. Given the company’s long-term operating outlook, the estimated future cash flows available for shareholder-friendly investments, and the stock’s current discount to our intrinsic value calculation, we believe UTX remains an attractive investment opportunity at current levels.
1United Nations, New York; World Urbanization Prospects - The 2011 Revision, March 2012; http://esa.un.org/unup/pdf/WUP2011_Highlights.pdf
The views expressed are those of the research analyst as of June 2014, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. DIAMOND HILL® is a registered trademark of Diamond Hill Investment Group, Inc.
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