There are two main themes to United Technologies Corporation (UTX +0.97%) coming year. The first is the completion of the acquisition of Rockwell Collins, Inc (COL +0.00%) and the second is the continuation in development of United Technologies's long-term strategic objectives.
The investment thesis for the stock isn't really about its near-term earnings potential -- analysts are expecting just 3% EPS growth in 2018 -- but rather how the company is positioning itself for long-term earnings growth. Let's take a look at current progress and what the company needs to do in 2018.
The geared turbofan is the key to United Technologies' long-term aviation growth. Image source: United Technologies.
Rockwell Collins acquisition
It's no secret that The Boeing Company (BA +4.17%) and Airbus are trying to cut supplier costs while also taking more work in-house. That's not good news for major suppliers like United Technologies and Rockwell Collins. United Technologies no longer produces landing gear on the Boeing 777 and Boeing 777X after the airplane manufacturer asked for a price reduction that United Technologies "could not accommodate, which would have ended up us losing money on a product with no aftermarket," according to CEO Greg Hayes.
The Rockwell Collins deal is seen as a way to counter such pressures as it would create a leading supplier with stronger negotiating power. Rockwell Collins and United Technologies Aerospace systems (UTAS) are already planning how they can add value and generate cost synergies across their aircraft platforms. For now, United Technologies expects $500 million in costs synergies by the fourth year -- completion is due in the third quarter of 2018 -- and investors will be hoping that estimate can be improved upon as the deal nears completion.
Data source: United Technologies Corporation presentations.
Pratt & Whitney
United Technologies' third-quarter earnings showed the key ongoing objectives for Pratt & Whitney's geared turbofan (GTF) engine. The good news is most of them are on track. After missing its target of shipping 200 engines in 2016, by building only 138, Pratt's production of 254 engines in the first three quarters -- with 120 in the third quarter alone -- means it's well on track to hit the target of 350 to 400 for 2017.
Meanwhile, two problematic GTF technical issues are being dealt with. Specifically, an upgrade of a combuster liner will be available as planned in the fourth quarter and the carbon seals retrofit were completed as planned earlier this year.
Turning to the issue of negative engine margin -- losses taken as GTF engine sales increase before aftermarket sales kick in and offset them -- CFO Akhil Johri still expects it to peak at around $1.1 billion in 2018.
Moreover, the GTF received a de-facto vote of confidence from Airbus recently. The GTF is already one of the two engine options on Airbus A320Neo, and Airbus's decision to partner with Bombardier on the latter's C Series -- an aircraft with the GTF as its sole engine option -- implies Airbus has confidence in the GTF.
UTC Aerospace Systems
UTAS has had near-term earnings headwinds due to the raft of new aircraft programs pressuring sales of original equipment (OE) on legacy aircraft. As you can see below, the trend of weak commercial aerospace OE sales continued in the third quarter but was nicely offset by ongoing strength in aftermarket sales. Going into 2018, UTAS needs to see an improvement in OE sales.
The segment's long-term prospects depend on establishing OE sales so that aftermarket sales can follow.
Data source: United Technologies presentations.
Otis in China
For Otis, the key strategic objective is to win equipment market share in China in order drive long-term services growth. The good news is Otis is increasing unit orders in China, up 1%, 7%, and 8% in the first three quarters respectively. But due to severe pricing pressure, equipment orders in dollar terms declined 10% in the first quarter, increased just 3% in the second, and were flat in the third quarter. Johri spoke of "a little bit better pricing discipline in China, and we are hopeful that we will see some of that result into better price/mix going forward."
Looking ahead
The key things to look out for in 2018 and beyond are:
- Completion of Rockwell Collins and development of product positioning with Boeing and Airbus.
- Resolution of technical issues in GTF and production expansion while cutting unit production costs in order to drive sales and long-term profitability..
- A recovery in UTAS OE sales, particularly on new aircraft programs.
- Better pricing environment in China for Otis and ongoing improvement in unit sales.
Next year promises to be another year of transition for United Technologies, but provided it achieves the objectives discussed above, investors can expect good growth. It's likely to be another year of patient development at United Technologies, but the company is on the right track to release value for shareholders.
