United Technologies Poised for Growth

With the $9 billion sale of Sikorsky in the books,

After nearly 20 years and $10 billion of development, Pratt & Whitney will ramp production of its innovative geared turbofan engine, for which it has secured more than 6,000 orders. Through 2020, Pratt's earnings will be pressured as the mix shifts from legacy engines and services toward the GTF, which records a negative margin at delivery. However, this new installed base will secure a long runway of lucrative aftermarket services that will plump segment cash flows for decades. With the acquisitions of Hamilton Sundstrand and Goodrich, UTC Aerospace Systems quadrupled the value of its content per plane from an average $800,000 in 2000 to $3.2 million today. Industry forecasts suggest that the number of aircraft in service could double by 2030 as growth in revenue passenger miles continues to climb. We expect that Pratt's return to the narrow-body market and UTAS' nose-to-tail systems will take advantage of this trajectory.

Worldwide urbanization and economic growth in emerging markets spur commercial building development, which will benefit the Otis and climate, controls, and security segments. A slowing Chinese economy in recent quarters has cast doubt on Otis' ability to gain share as competition intensifies for a piece of this market, forecast to be the world's largest. Nevertheless, we expect that innovation and further penetration of aftermarket services will help Otis stay a step ahead of its competition in China in the long run. In addition, we think CCS' catalog of HVAC, fire, and security products is well positioned to profit from growing interest in the ability to remotely monitor such systems on a single intelligent platform.

Installed Base Powers Wide Moat United Technologies has four main operating segments: Otis; climate, controls, and security; Pratt & Whitney; and UTC Aerospace Systems. The $13 billion Otis segment is the largest manufacturer of elevator and escalator systems in the world, with an installed base of 2.5 million units globally. The $16 billion CCS segment services residential and commercial building markets with branded heating and cooling products such as Carrier and Taylor and fire safety and security products such as Chubb, Kidde, and Edwards. The $14 billion Pratt & Whitney segment boasts an installed base of nearly 13,000 commercial engines on narrow- and wide-body aircraft and 7,500 military engines primarily for fighter jets. The $14 billion UTAS segment sells components spanning nose to tail in commercial and military aircraft, such as landing gear, interiors, propellers, wheels, brakes, and electronics.

Each of United Technologies' businesses manufactures highly engineered equipment, with product innovation, durability, and reliability serving as key differentiators from competitors. The development of a new aircraft engine, for example, can take the better part of 20 years, and the institutional memory preserved through several decades of operating history and technological expertise can provide a competitive edge when creating next-generation technology. The value inherent in United Technologies' intangible assets--its active and historical patent portfolios, long-term customer relationships, and collaboration assets shared by joint ventures--springs from the strength of the firm's engineering expertise, a core competency supported by average yearly spending of nearly 4% of consolidated sales on research and development. In addition, customer-funded R&D can average an amount equal to about 3%-4% of sales.

New product development powers growth of the installed base, which we view as the physical representation of United Technologies' wide economic moat. Global reach in each of United Technologies' four operating segments translates into scale-based cost advantages in sourcing, manufacturing, distribution, and aftermarket service. In addition, customers invest significant amounts of capital in order to install and maintain the vital equipment and systems sold by United Technologies. Unplanned downtime in building and aerospace systems can be incredibly costly or even catastrophic when considering the consequences of elevator or aircraft engine failure. The motivation to protect an installed base of equipment translates into a high degree of customer switching costs. Nearly 44% of United Technologies' consolidated revenue comes from aftermarket maintenance and repair services, which we view as evidence of sticky relationships sustained by customer reliance on the original-equipment manufacturer.

Aftermarket Revenue Lifts Otis, Aerospace Otis built a formidable reputation of safety and reliability since installing the world's first elevator in 1853 at a furniture factory in New York City, exemplifying the brand-building potential of the first-mover advantage. The company enjoys the largest installed base of elevators and escalators in the world, with approximately 1.8 million out of 2.5 million units currently covered by service contracts. As such, approximately 60% of the company's revenue comes from aftermarket service, maintenance, and repair. The useful life of an elevator can easily span decades with proper upkeep, supporting regular renewal of a lucrative revenue stream for Otis with built-in price escalators. The company can cite several examples of customer equipment and service relationships that have endured since the early 1900s. Competition can be fierce on the service side, as third-party technicians attempt to build service portfolios by beating OEM service contract prices. However, service productivity and efficiency improve along with operating density, demonstrating another important advantage inherent in Otis' vast installed base. For example, in large metropolitan areas, one technician has the ability to quickly serve the many elevators and escalators on one city block. This results in a more profitable service organization than smaller competitors who may only serve a handful of units scattered across a geographic location.

United Technologies' aerospace businesses are the other beneficiaries of a lucrative aftermarket revenue model. Qualifying aerospace component suppliers is a complicated process meant to ensure safety and reliability for the useful life of an aircraft; this tends to limit competition as few companies have the experience, manufacturing capacity, and relationships necessary to become one of maybe two suppliers given the right to design systems customized for the unique needs of the next generation aircraft body. As Airbus and Boeing dominate the large commercial aircraft market, both enjoy a high degree of bargaining power and often pit suppliers against each other in order to obtain price concessions and other benefits. Pratt & Whitney, for example, derives more than 40% of its revenue from Airbus alone, whereas Airbus and Boeing represent 29% and 28% of revenue, respectively, at UTAS. Moreover, in each segment, the U.S. government represents approximately 20% of sales, representing another powerful customer relationship with a high degree of bargaining power. As such, margins on aerospace equipment sales are typically quite slim, and in the case of Pratt & Whitney's next-generation geared turbofan engine, can even be negative at delivery of the product.

Nevertheless, winning a platform sets up decades of recurring aftermarket revenue that translates into attractive returns on invested capital over time. Nearly $10 billion of investment will go into developing Pratt & Whitney's GTF; however, Pratt & Whitney won sole-source contracts in five (regional jets Bombardier C-Series, Mitsubishi, Irkut MC-21, and Embraer E170 and E190/195) out of six platforms, with the sole exception being the Airbus 320neo (shared with the GE-Safran joint venture). To date, the attachment rate of long-term fleet management programs on the GTF is 80%, which is above Pratt's historical attachment rate of around 40%-60% on legacy engines such as the PW4000, V2500, and GP7000. GTF's service backlog alone represents about $14 billion in future revenue on existing orders, which are expected to climb over time. UTAS also enjoys leading market share in its eight franchises, holding either the number-one or -two positions in actuation and propeller systems, aerostructures, electric systems, environmental control systems, interiors, space systems, landing gear, and sensor/integrated systems. Currently, aftermarket sales represent about 45% of UTAS sales. However, as the segment intentionally moves away from transactional spare part sales in lieu of replacing contracts with comprehensive fleet management programs, the segment expects aftermarket revenue to represent 60% of sales by 2020.

In our view, CCS' large installed base provides more of a scale advantage than the ability to generate aftermarket service revenue, primarily because the building systems group serves both residential and commercial markets. The pursuit of residential service contracts in the Carrier HVAC business, for example, is unattractive as replacement costs for residential systems are low compared with commercial installations. Furthermore, the residential service market remains highly fragmented and competitive. Fire and safety is more exposed to commercial installations, and as such, the unit estimates nearly one third of sales come from recurring services. In our opinion, the segment benefits most from its scale in distribution, which can prevent smaller competitors from gaining share in developed and emerging markets. For example, at one point, Carrier lagged Asian competitors in developing a variable refrigerant flow unit, which can control a bank of indoor fan coils in a building from one outdoor condensing unit. Competitors were allowed to use Carrier's distribution network in China while Carrier engineers worked to develop a competing product. Now that Carrier has its own complete line of VRF technology, it has the ability to leverage its own distribution network and reduce or eliminate competitive access to it.

Service Revenue Mitigates Risk We assign a medium fair value uncertainty rating to United Technologies, as the cyclicality inherent in each of the firm's businesses is mitigated by a high percentage of aftermarket service revenue, which is either mandated or necessary for safe operations. As such, during periods of slow equipment sales, we expect top-line volatility to be tempered by the recurring revenue stream of services performed to maintain, repair, or upgrade the existing installed base. It is also important to note that nearly two thirds of the company's sales are outside the United States, which subjects the firm to significant currency risk. Top-line growth in the aerospace segments can be reasonably estimated by comparing United Technologies' backlog with OEM production and delivery schedules. However, risk always remains that airlines suddenly cancel unfulfilled orders in the backlog.

United Technologies' capital structure is fairly straightforward, with long-term debt of $22 billion consisting almost exclusively of senior unsecured bonds that mature from 2015 to 2042. The firm also supplements its short-term needs through a commercial paper program of up to $4.35 billion, backstopped by its $5.85 billion revolving credit agreements. Maturities are staggered, with sizable amounts due in 2015 ($1.8 billion), 2017 ($2.5 billion), and 2019 ($1.6 billion). Liquidity is strong. The firm held cash of $5.3 billion as of March 31, 2015, although almost all of this balance resides overseas and is subject to taxation if repatriated.