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United Technologies (NYSE:UTX)

Q4 2008 Earnings Call

January 21, 2009 10:00 am ET

Executives

Gregory Hayes – Senior Vice President, CFO

Akhil Johri – Vice President Investor Relations

Analysts

Nicole Parent – Credit Suisse

Joseph Nadol – JP Morgan

Joseph Campbell – Barclays Capital

Cai von Rumohr – Cowan and Company

Jeff Sprague – Citi Investment Research

Douglas Harned – Sanford Bernstein

David Strauss – UBS

Ronald Epstein – Bank of America Securities

Nigel Coe – Deutsche Bank Securities

Robert Stallard – Macquarie

Howard Rubel – Jefferies

Heidi Wood – Morgan Stanley

Myles Walton – Oppenheimer & Co.

Operator

Welcome to the United Technologies fourth quarter conference call. On the call today are Greg Hayes, Senior Vice President and Chief Financial Officer and Akhil Johri, Vice President, Investor Relations. This call is being carried live on the internet and there is a presentation available for download from UTC's home page. at www.utc.com.

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

Gregory Hayes

Good morning everyone. As we've said many times over the past few months, we are certainly living in interesting times. As we read the headlines every morning there seems to be little if any good news and market demand is changing daily, normally not in a positive direction.

At UTC, we're not immune from the market forces, but we are I believe, uniquely prepared and positioned to outperform in these difficult times. If you saw the press release this morning, UTC closed out a strong 2008. Our full year revenues were just under $59 billion, up 7% year over year. Earnings per share were $4.90, up 15% versus 2007.

Cash flow, very strong, 105% of net income. But despite the world wide economic slowdown, we continue to make investments in the long term growth of this business and to reduce costs engineering the development spending total of $1.8 billion last year. That's up nearly $100 million over 2007.

We also continued our aggressive restructuring actions preparing for tougher times ahead. Total restructuring expenditures was $357 million, strong evidence I believe that UTC can continue to outperform.

We began 2008 with most markets in a relatively good position with the exception of the U.S. residential market. Early concerns about commercial construction slow down in the U.S. and Western Europe ended of course in the broad based slowdowns across all industries and geographies.

The net rate of decline accelerated in those end markets in the last couple of months and combined with a strong U.S. dollar, has created unique challenges with global businesses. Despite this, UTC reported fourth quarter EPS at $1.23. That's up 14% over last year.

Foreign exchange translation combined with Canada's currency hedging adversely impacted UTC by $0.06. Third quarter results also includes $0.06 net benefit of one time gains of excess of restructuring costs. Last year's quarter had a net $0.04 charge for restructuring and other costs in excess of gains. S&G impact of these items, results for both quarters, EPS was up 4%.

Revenues were $14.5 billion in the quarter, a 1% decline versus a year ago. Foreign currency translation reduced revenue by $700 million or 5%. Organic growth was 3%. You see that once again the balance works for UTC.

Sikorsky was the highlight in the quarter with 25% organic revenue growth, delivering 204 large helicopters through the year, a 17% increase from 2007 consistent with its commitment of delivering more than 200 aircraft a year. On the other hand, our short cycle businesses, [inaudible] carried organic revenues declined by 7%.

First quarter order rates indicate that revenues will decline at a faster rate in the first half of 2009. In addition to the weaknesses anticipated in the developed regions of the world, we also saw slowdowns in China, Russia and other emerging economies.

Otis new equipment orders declined 14% globally including the impact of foreign currency. Carrier's commercial HVAC equipment orders declined 7% worldwide, also including the impact of CapEx. As discussed at the investor meeting back in December Otis transport refrigeration orders declined over 50% in the quarter.

Now turning to aerospace, Pratt & Whitney booked a bill for large commercial spares was just below one and a quarter. Commercial spares revenues were down just slightly. Hamilton Sundstrand commercials spares book to bill on the hand was just above normal.

While the business environment is challenging, we continue to focus on taking out costs through restructuring. We spent $136 million on restructuring in the quarter and as I noted before, a total of $357 million for the year.

Aggressive cost control and benefits from early restructuring led to market expansion of four of the six business units adjusting for restructuring of one time gains. As Akhil will talk about in a minute, Otis margins were down in the quarter but would have been up slightly except for accounting adjustments related to a subsidiary.

Cash flow in the quarter was strong as I noted, with free cash flow at 147% net income, a result of seasonal inventory reductions and to strong collections. We repurchased $690 million of our shares in the quarter bringing the year to date total to $3.2 billion. I should also note that we contributed $250 million of our stock to our pension plan in December.

In 2009 we will begin targeting share repurchase and acquisition at $2 billion each, although we will be opportunistic and we may adjust these targets just as we did in 2008.

Acquisitions ending the quarter was $724 million including [inaudible]. This was primarily a carrier and fire and security consistent with our strategy in expanding our presence and service installation markets.

As we've said many times, liquidity is not an issue at UTC. In December, we successfully issued $1.25 billion of debt at a coupon rate of just over 6%, evidence that the debt markets are functioning for companies with good fundamentals and strong cash flows. With about $1 billion of debt maturing in 2009 and look back at the December offering, we have announced early redemption of $500 million to take advantage of the slight interest rate differential.

We'll come back and talk about 2009, but for now, let me turn it over to Akhil to take you through the business units.

Akhil Johri

Before I get into the business unit performance, let me talk about the non recurring items in the quarter. As shown on Page 3 of the web cast, we had about $0.10 of one time gain generated by sale of certain investments and businesses. These gains were offset by comparable amounts of restructuring charges.

In addition, the IRS supplement gain during the quarter has a pre tax equivalent of about $100 million as anticipated. This settlement met the discrete taxes on the one time gain added $0.06 earnings per share.

Turning to Page 4, let me remind you that our Otis segment results adjusted for restructuring and the non recurring items that I just implied. At Otis, revenues in the quarter were down 3% and operating profit was down 7% including the untypical impact of foreign exchange compensation which accounted for approximately seven points of decline in both revenue and profit.

Operating profits were also negatively impacted by approximately $30 million of provision of inventory and other account balances which occurred over several years at the Otis facility in Brazil. These adjustments resulted from an investigation initiated by Otis headquarters.

At constant currency, revenues increased 4% driven by high service sales globally. New equipment sales increased in North America and Europe but were partially offset by a high single digit decline in Asia driven by the postponement by over 5,000 units in China typically from the slowdown in the residential housing market.

Excluding currency and the provisions related to the Brazil activity, profits grew 5%, had higher volume, increased installation efficiencies and continued cost containment more than offset the higher steel and [inaudible] costs. For the full year, Otis revenues were up 10% and operating profits were up 12%. Margins expanded by 30 basis points to 19.3%.

As anticipated, the global financial crisis has begun to adversely impact commercial construction markets. As Greg said new equipment orders that focused declines were 14% including the impact of currency translation and 8% in the quarter at constant currency. Asia including utilities was flat, America's down by single digits and Europe down high teens.

We expect continued softness in new equipment sales until governments world wide begin to have an impact. Although the backdrop remains strong, up 9% versus the prior year, including the impact of foreign currency compensation and 12% at constant currency.

Turning to Carrier, as commented at the December investor meeting, Carrier's fourth quarter operating profit increased 42% on 15% lower revenues. Operating margins are on track for more than 200 basis points. Foreign currency compensation contributed about six points of the revenue decline and five points of the profit decline in the quarter.

In addition, about half of the EBIT and margin drop in the quarter came from the impact of the market currency changes on constant transactions. Revenues at the refrigeration business were down high single digits, in Europe, down double digits. The U.S. residential business was down high single digits in a tough market, shipments outperformed the industry.

Commercial UTC business was up low single digits all from acquisitions, strong earnings and margin expansion. For the year Carrier earnings were flat on 2% revenue growth. Approximately $150 million on benefits from restructuring and other cost reduction actions offset the adverse impact of commodity headwinds and unfavorable mix.

The slowing global economy has had an immediate impact on shop type of businesses and as Greg mentioned we are also seeing a slowdown in commercial HVAC order rates as well as significant declines in refrigeration orders. This half for Carrier will be very challenging given the weak end markets and stronger U.S. dollar.

On Slide 6, UTC Fire and Security provided strong performance in the quarter despite significant headwind. Our revenue growth of 3% was more than offset by two points of negative impact from productivity initiatives along with four points of unfavorable foreign exchange translation. Fire and Security organic growth was high single digit growth in Europe and Asia.

Operating profit and Fire and Security increased 5% or $9 million. Fire organic revenue along with the benefits of restructuring, integration and continuing productivity initiatives generated approximately 21% profit growth. Foreign exchange translation adversely impacted profits at 16% in the quarter. Operating margin expanded 180 basis points to 11.8%.

Fire and Security delivered profit growth of 26% on a revenue increase of 4%, resulting in 100 basis points of margin expansion for the year, organic revenue and operating profit growth of 15% and 18% respectively.

Turning to the Aerospace segment on Slide 7, Pratt & Whitney revenues increased 3% in the quarter. Over 10% growth in commercial engines revenue from higher shipments and after market services was partially offset by lower development revenues and engine delivery. Canada revenue was about flat as higher engine shipments offset weaker after market sales.

Commercial engine sales were down slightly in the quarter. Fourth quarter commercial sales included the benefit from the previously announced Pratt & Whitney distribution agreement.

Operating profit improved 80% in the quarter on bigger commercial engine mix and after market performance, lower net commodity headwinds and a favorable adjustment of $0.02 through our commercial engine program. This increase was partially offset by lower military engine orders. E&D was essentially flat in the quarter and lower than expected efficiencies and changes in program timing.

For the full year Pratt & Whitney operating profit grew 9% on 7% higher revenues. Pratt & Whitney Canada shipped 4,000 engines in 2008, up 34% over 2007. In the quarter revenues were up 3% with solid organic growth of 6%. On an organic basis, aerospace OEM revenues were up high teens, industrial businesses were up mid single digits and aerospace after market revenues were down high single digits.

Commercial stage revenue was down mid single digits in the quarter [inaudible]. Orders for the industrial businesses were down 16.

Operating profit grew 14% primarily from high volumes and mix both in the OEM and industrial businesses from sharp performance and favorable adjustment growth about a penny toward acquisition related liability. These increases were partially offset by the impact of lower after market revenues. Operating margin at 19% was up 180 basis points from fourth quarter of 2007.

For the full year Pratt & Whitney increased revenues 10% and delivered on its guidance of $100 million operating profit growth.

At Sikorsky on Slide 9 operating profit grew 38% on 25% higher revenues. During the quarter, Sikorsky shipped a total of 54 large helicopters; 38 based on military platforms and 26 commercial. As Greg mentioned before, Sikorsky met its 2008 commitment of 200 plus deliveries with a total of 240 shipments for the year.

Operating margin expanded 90 basis points in the quarter to 9.5% from higher helicopter shipments. For the full year, gross operating margin of 8.9% reflects a 120 basis point improvement from 2007 and is on tract to meet the target of 10% operating margin by 2010.

During the quarter, Sikorsky also achieved the first flight for the Canadian made helicopter and executed an agreement and successfully base lined the program. This will be the most sophisticated maritime helicopter in the world and first delivery is scheduled for the fourth quarter of 2010.

With that, I'll turn it over to Greg to wrap up.

Gregory Hayes

I'll spend a minute here on 2008 before we get to 2009 because I think it's important to focus on what a good year 2008 really was for UTC. Despite the deteriorating economic conditions, earnings per share were up 15% over 2007 to $2.90 a share and revenues ended the year just under $59 billion, up 7% over 2007 with five full point's organic growth.

Free cash flow was $4.9 billion or 105%. On ACE, our operating system, we reached 49% ACE gold and silver sites across the business at year end 2008 and we're confident we can meet Louis targeted 70% growth ACE gold and silver sites by the end of 2009.

We're also making progress in rolling out ACE to our supply base. Recall that this past December we set another goal at 70% of our use supplier stats ACE gold performing levels at the end of the year 2011. Business unit presidents will provide an update on both our internal and supplier basis initiatives at our February 24 investor meeting.

2008 was also an exciting year for product innovations and accomplishments. Pratt & Whitney has continued testing its PurePower gear engine which based on testing to date is expected to achieve 12% reduction in fuel consumption and 55% reduction in nitrous oxide emissions, 50% in engine noise versus today's engines.

At Sikorsky beside the Canadian Maritime, the revolutionary twin motor X2 technology demonstrator achieve first flight in August in further flight is expected to demonstrate that the helicopter can cruise comfortable at 250 knots while retaining excellent velocity handling and efficient hovering capacity.

At Carrier and Otis, their energy efficient products performed flawlessly. As noted earlier, we continue to invest in the future, spending $1.8 billion on engineering and development and 2009 will be no different. We continue to invest in the business and spend another $1.8 billion.

Let's talk about 2009 for a couple of minutes. In December, Louis provided EPS guidance range for 2009 of $4.65 to $5.15 plus or minus 5%, leaving acquisition related costs or implementation of FAS141(NYSE:R). We're reaffirming that full year guidance today.

We also want to point out a couple of developments since December that has put pressure on the high end of the range. First, expansion expense. As expansion expense headwinds increases compared to our guidance. Discount rates came down from 7% in early December to 6.1% at December 31. Although our investment performance was slightly better than anticipated, the resulting impact of the sharp discount rate moves the incremental pension expense was about $125 million on top of the $100 million already contemplated in our guidance. As a result, we're now anticipating making a $400 million contribution to our U.S. pension plans in 2009.

Also since early December, end market conditions have clearly deteriorated for all businesses. The order rates we mentioned earlier have put more pressure on Carrier's outlook. Otis has also seen pressure from projects, particularly in virgin markets. On the aerospace side, while there is optimism that the world's commercial airlines will be profitable in 2009, due to lower jet fuel prices, global air traffic may be down 3% to 4% versus the range of plus or minus 1% we anticipated in December.

The business jet market is also weakening with fewer departures, reduced OEM order rates and more pressure with Pratt & Whitney Canada. In response to this, we've accelerated our restructuring plans. We now anticipate $150 million restructured financing in the first quarter, with about $50 million of that offset by gains.

UTC's leadership team is working aggressively to initiate additional cost reductions beyond that of cost of businesses to right size each of our businesses for this challenging environment. You'll be hearing more about specific business unit actions at our February investor meeting.

Just a few words on currency impacts, we provided a 2009 guidance, we mentioned an adverse impact than the stronger U.S. dollar was expected to have on UTC's revenue and earnings. About $600 million of earnings was half of that from the Euro decline alone. And of course the first half of 2009 will see a disproportionate impact on the average year over 2008 where $1.49 to the dollar in the first quarter to $1.56 in the second quarter, the rates that we've seen over the last several months

As a result of these adverse FX compares under market conditions and the $100 million of restructuring in excess of gains, we expect first half results to be below the bottom end of the full year range, plus or minus 5%. We continue to watch all of these trends carefully. Based on the extensive global efforts underway today, we still expect a modest recovery in the later part of 2009.

As for our normal practice at the February meeting, the business unit presidents will update you on market conditions, strategy and cost related actions.

What you've come to expect from UTC, our ACE operating business restructuring expertise and experienced management team will allow the company to navigate through these turbulent times. Doing more with less is the way of thinking at UTC that has consistently delivered market leading results.

Operating discipline, market leading franchise, balanced global presence gives us confidence in the future to help us continue to outperform even in these uncertain times. We'll stop there and open up the call for questions.

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from Nicole Parent – Credit Suisse.

Nicole Parent – Credit Suisse

It was hard to hear you. Could you just restate what the size of the Brazilian adjustment was in the quarter and then with respect to the call on the backlog at Otis, I think you alluded to in your comments on the fourth quarter and '09 some push up in emerging markets. Did you have any cancellations in the U.S.? And then maybe give us a sense of the comfort level/visibility with the backlog and did you have any emerging market cancellations or push ups that you think become cancellations.

Gregory Hayes

Let's start with the Otis Brazil. That was about $0.02 in the quarter. That is behind us we believe. It was one of things that unfortunately happen in a business with about 5,000 people, but about $0.02 in the quarter. Obviously we adjust out for that. Otis's part was up slightly two point basis.

As for new equipment backlog and orders, we did not see any significant cancellations in any of the business or in any of the regions, but we did see significant deferrals, especially in China, also in Russia. The emerging markets were probably hardest hit and I think the biggest surprise to us as well looked at this, was over 5,000 units and China was deferred out of 2008. Not cancelled, just deferred.

So backlog is still up there about 9% for Otis for the year so we still think that 2009 will be a good year. We expect revenues to be up at Otis again for new equipment, but obviously these challenging times are putting some pressure on that. I think you should also remember, I already mentioned the fact that some of these issues in China are probably of our own making as we tried to avoid extending credit to some of our agents there so a few of our orders were actually deferred at our request because we didn't want to take additional credit risk. But the market did slow in China.

Nicole Parent – Credit Suisse

Do you have the split between service and equipment revenue growth at Otis in the quarter? You might have given it. And then with respect to just the nature of deferrals actually moving into cancellations, maybe give us a sense of the comfort level of sustained deferrals or moving into cancellations as we go through 2009.

Akhil Johri

With regard to the growth rate for both service and new equipment service grew mid to high single digits between 6% and 7%. As the new equipment orders between 2% and 3% and that's the first part. The second part, I don't think we have really seen any cancellations beyond normal at this point at Otis. Usually Otis does see some cancellations as part of normal business, and those are the kind of things we try to figure as Greg mentioned and I think emerging markets, we'll wait and see what happens.

We don't think the underlying demand driven by urbanization is going to go away. Maybe it's just a matter of time as the Chinese government stimulus tax comes back in place and the residential market demand expands. It might take three months, six months, nine months, that's up for debate but we do expect the backlog to be as solid and come back at some point in equipment to resurface.

Nicole Parent – Credit Suisse

On the commercial business, it's probably more on the Carrier short cycle and also maybe Hamilton Sundstrand Industrial, how would you characterize the inventory levels that are out there? I guess when you think about the massive deceleration everybody saw in November and December, could you characterize where you think the inventory levels are out at the customer?

Gregory Hayes

I think on Carrier specifically when you take a look at channel inventory, channel inventories are down in line with the markets. We don't think there's any big inventory overhang out there and not a tremendous amounts to bleed down. On the industrial side at Hamilton, orders were down to low double digits there. Most of that was on the pressure side.

We're still seeing good order growth at Sun dyne, especially in the oil and gas industry, but I would say on the compressor side we expect pretty slow growth here in the first half. Definitely the view on inventory out there we do see order rates coming down pretty significantly at Solaire.

Operator

Your next question comes from Joseph Nadol – JP Morgan.

Joseph Nadol – JP Morgan

What would you say specifically on the first half? Was it that EPS would be below the bottom end of the full year range meaning below 5% down?

Gregory Hayes

That's exactly what I was trying to get across. 5% is the full year range at the bottom end. Clearly first half is going to be below 5% at best.

Joseph Nadol – JP Morgan

I guess you're maintaining the $150 million restructuring placeholder but it's all in Q1. It would be unthinkable I would think that you wouldn't have any more during the rest of the year. How do we think about, what kind of incremental restructuring your EPS guidance can withstand?

Gregory Hayes

If you're thinking about, we've talked about $150 million of restructuring in the year assuming that was all going to be offset by gain. That is a number we started 2008. End of the year 2008 was $357 million. Right now, I can tell you we are looking actively at doing additional restructuring across most of the businesses. There was contingency at both the mid point of the range and the bottom end of the range to absorb some additional restructuring.

I don't want to give you that number today. I'll tell you we're working hard on each of the businesses to quantify that and will give you a lot more detail when we stand up in February for each of the businesses.

Joseph Nadol – JP Morgan

What's your early look at the gain outlook this year? I guess the $150 million, how much of that do you have kind of buckled down and are there other bigger items out there?

Gregory Hayes

We have visibility to as I said about $50 million here in the first quarter and these gains, they kind of pop up from unexpected places just they did in the fourth quarter where gains were a little better than we had anticipated. But right now, I think we've got a clear line of sight of $100 million to $150 million of gains, a little bit in the first half and more in the back half of the year. More than that, not much visibility.

Joseph Nadol – JP Morgan

On the aero site, your Pratt spares were surprisingly good. They actually outperformed Hamilton which hasn't happened for awhile and given the mix a little bit surprising. I'm just wondering if you could give some color. I guess Hamilton was kind of where I thought they might be and Pratt was surprisingly good.

Akhil Johri

In Pratt we talked about the distributor agreement which we announced late in the third quarter. That has helped that situation a little bit so as they were down slightly on a quarterly basis, if you adjust for the pick up of the restocking at the new distributor that would be in more in line with the decline which is more consistent with the third quarter.

Joseph Nadol – JP Morgan

So it's more like somewhere in teens?

Akhil Johri

No, low double digits.

Joseph Nadol – JP Morgan

As we think forward through the next few quarters, I guess you'll only annualize that in the fourth quarter so maybe the first nine months of the year, you continue to see stocking? How do we think about that?

Gregory Hayes

I wouldn't actually draw that conclusion just yet. I think what we saw in the back half of 2008, especially at Pratt spares was a response to the rather significant curtailment in capacity, especially in the U.S. carriers. The spare order rates obviously are driven by RPM's and the available piles and I would hope that we've kind of stabilized now and we're going to see a run rate.

Again, we're not predicting spares are going to be up at Pratt this year. I think it will be down a little bit but I don't think we're going to see a major decline unless we see a much bigger drop in either capacity or RPM's.

Akhil Johri

Keep in mind as we talked about before, the capacity reductions impact the [inaudible] more than the other engines and that has become a much smaller part of the overall Pratt stream, as it generated $50 million in 2007, more than that in 2008 compared with $1 billion that it used to be, in the last cycle like this.

Joseph Nadol – JP Morgan

What were the Pratt Canada spares down in the quarter?

Akhil Johri

They were down double digits.

Operator

Your next question comes from Joseph Campbell – Barclays Capital.

Joseph Campbell – Barclays Capital

In the December meeting we had a slide that talked about the commercial businesses having revenues down to that operating profit growth five to six and I gather that that outlook is now worse. I wondered if you could looking at that slide or the number that we had which was basically commercial businesses offset by aerospace businesses you've now kind of said the commercial business outlook looks like its getting worse. The aerospace traffic numbers have been revised down perhaps spelling an airbus lower deliveries in 2010 which might affect shipment in the back half of the year. How does this turn now look which once upon a time was sort of 3% negative growth, a 3% positive affects and 3% negative after it affects?

Gregory Hayes

Let me start on the commercial segments. Clearly there's pressure on the Carrier top line here and a little bit of pressure even on the Otis top line because of the order trends that we saw in Q4. I don't know that we're ready to revise guidance on any of these businesses quite yet. I have to tell you that with only two weeks under our belt here in January, it's hard to draw any trend line.

But clearly there's pressure on guidance on the commercial side.

As far as on the aerospace side, as I mentioned we've got pressure there from lower RPM's and lower biz jet volume at Pratt Canada so I'd say both Carrier and Pratt are probably the most challenged as it relates to the guidance we gave just about five weeks ago. But it is early in the year so we'll watch these things another month as we get some better data points.

Akhil Johri

Let me just remind you I think we talked about in December; all these businesses met the guidance that we provided in December. They were clearly at the top of the range and we did say these are plans and that's why we have the [inaudible] at the range.

Joseph Campbell – Barclays Capital

Could you comment a bit on what the impact is at PWC, biz debts? Precisely what's the exposure there? Which models are going up and down?

Akhil Johri

We are still awaiting the discussions with our customers to give you a firm idea on the specific models. Obviously the 3W600 has had some stress as you would imagine. The schedule changes are still not finalized and we will have further input for you in February. But overall, you should think about $1.5 billion roughly of revenues associated with business jets for UTC out of the $57 billion to $58 billion and that's a number to keep in mind.

Joseph Campbell – Barclays Capital

To make sure I understand what's happening here. On all of these businesses that have constant FX have deteriorated since December, but of course those were the stretch goals. When we look at the slide that had the individual businesses, you didn't change any of them in the slides we had today. Should we expect that in March that these will get revised to reflect what we are already seeing but which you've left alone?

Gregory Hayes

As we said, there is pressure clearly on the Carrier end of Pratt guidance here. Frankly they were stretch goals to start with and there hasn't been a lot of good news in the Carrier markets or the Pratt markets since the December meeting. So I think there's going to be pressure on the guidance on at least those two units.

Akhil Johri

Just one other point. [inaudible] of action, you saw the Euro move from $1.46 to $1.29 just in the last 30 day and each Euro has a $15 million impact on our earnings. So if you recall all those things and the commodity is the other factor which is nine, obviously it is much easier to give up guidance.

Operator

Your next question comes from Cai von Rumohr – Cowan and Company.

Cai von Rumohr – Cowan and Company

Can you tell us, where are you looking now for R&D in 2009 and kind of how is it still going to be up, are all the quarters up? Is there any kind of pattern we should look for there?

Gregory Hayes

R&D is going to be flat year over year, about $1.8 billion as I said before. I would expect you would see a little bit of a headwind at Pratt on E&D. You're also going to see a little bit of tailwind at E&D and Hamilton as the 787 program goes through first flight. But overall, I would say quarter to quarter and year over year, not any significant changes.

Cai von Rumohr – Cowan and Company

So it will still be with a ramp and the final quarter would be the timer?

Gregory Hayes

I think again more consistent with what we saw in 2008 in terms of the spending profile. This all depends of course on program timing. Pratt's got some relatively big programs like the regional jet and C series. Both of those as I said earlier have some of the program timing slip a little bit to the right. We don't expect any deferrals out of 2009 so it's not a big change.

Cai von Rumohr – Cowan and Company

You said $100 million to $150 million of gains, and the total restructuring number for the year?

Gregory Hayes

Right now we're still at $150 million, but as I said earlier, we're going to launch $150 million a year in the first quarter, so only about $50 million of gains. I would expect before we're done and perhaps even before the end of February you'll hear about more restructuring.

Cai von Rumohr – Cowan and Company

As you look at the offsets between your guidance and achieving your guidance and bolstering 2010 if this goes longer as it looks like it will, where you do come out?

Gregory Hayes

Help me with that question one more time.

Cai von Rumohr – Cowan and Company

If you look, clearly it looks like you're going to spend more than $150 million. It looks like you have the trade off of coming in at the absolute bottom of your range and kind of bolstering 2010 for instance, if it looks like its weaker and kind of delivering a little bit more. Where do you put the trade off in terms of where you set the restructuring?

Gregory Hayes

I will tell you, we're looking at this on a long term basis. I think the restructure opportunities across most of the businesses and I think as you'll see here in the coming months, we'll take additional actions based on what we see happening in the markets because here we want to outperform this year and outperform next year and even beyond. So we're going to right size the business for the markets as they exist today and we want to be proactive as opposed to reactive with this restructuring. I think that the $150 million is meant today a sense of urgency on our part to get on with it. More to come beyond that.

Cai von Rumohr – Cowan and Company

Could you give us some help in terms of what types of restructuring are you looking at doing here? What sectors? If you could help us there. What types of things are you looking at doing?

Gregory Hayes

Clearly the $150 million that we're launching here is all quick pay back. It's primarily head count related restructuring. It's taking out structure. It's taking G&A, taking out overhead across the businesses. In fact all of this $150 million as we look at it has a pay back of less than a year. Even if we didn't see all the gains in the back half, I'm still confident that we can cover this just through the restructuring phase.

Operator

Your next question comes from Jeff Sprague – Citi Investment Research

Jeff Sprague – Citi Investment Research

Maybe just switch from the P&L to the balance sheet for starters. I assume its pension, but your equity took roughly a $5 billion hit sequentially in the quarter. Could you give us some color on what's going on there and where the funded status actually played out at the end of the year?

Gregory Hayes

It's almost a $6 billion charge of other comprehensive income out of the equity section. $4 billion of that related to pension plan performance. We ended the year down about 27% on a return basis and on a recent basis, I think we're 91% funded at the end of the year, so just a little bit under the target of 94% funding this year.

The other major change in the equity section is the charge related to these currencies, translation adjustment. As the currencies move, obviously against us in the back half, that was a big swing of the equity section as well.

Jeff Sprague – Citi Investment Research

On the flip side of that equation the big move and other long term liabilities is pension moving around also?

Gregory Hayes

That's exactly right.

Jeff Sprague – Citi Investment Research

Switching gears back to a restructuring question, as you look deeper and go for more in the slowdown, do you get more into heavy manufacturing restructuring actions, tougher to do, longer to play out, slower payback. Maybe just some line of sight on how this might progress over the next year or two.

Gregory Hayes

I think the first project of restructuring we're going to launch as I said is going to be very quick payback and as we dig further and further into this restructuring, obviously the payback is not quite as good. Eventually you do have to start taking out capacity. Right now everything that we're looking at has pretty good payback.

These G&A actions are less than a year. Some of the branch office restructurings around the world, the payback is a year, two years. And then we get into the big factory closures if we come to that, when we're moving volumes, we're going to be pressed for a long time. Those are more like four year payback so you're right on track. It's dependent on how we see the markets develop here. We'll tell you how deep we'll have to cut.

Jeff Sprague – Citi Investment Research

On this question of deferrals a couple of people poked around it. I'm just wondering if there's anything different in the complexion of what's going on. In other words, are you seeing deferrals once projects have already started and people kind of killing stuff mid stream or are these deferrals that are happening kind of earlier before ground breaking and how does that compare with what you've seen in the past?

Akhil Johri

I think a lot of the deferrals are in China, the emerging markets there. There is not much when a project starts or before ground breaks. Some of these deferrals are before these projects have even the ground is broken. They do have some deferrals with us and the reality is the underlying demand will not go away because there is going to be the demand for people to move to cities in China and maybe a gap for a year or six months, but then the transition trend will start again and some of these projects will be back on track. A lot of deferrals are in the emerging markets are more distant than what we're seeing in the Western Europe and Asian market.

Jeff Sprague – Citi Investment Research

What's the color for the tax rate in '09?

Gregory Hayes

It will be just about 28% is the targeted tax rate as it was for the last few year.

Operator

Your next question comes from Douglas Harned – Sanford Bernstein

Douglas Harned – Sanford Bernstein

On Carrier, if I look at Q4 you would have had benefits from copper. It should have helped the margin and I would expect the average currency that you dealt with was not as weak as you thought it was going to be at the time of the December dinner. Could you talk about the margins in each of the four units there? I know you said commercial was up. What happened in each of these that got you to this lower margin in Q4?

Gregory Hayes

Just a couple of point here. If you think about copper, copper actually averaged about $3.37 for us for the fourth quarter at Carrier. As we said, we've got about six months of long term agreements in place. Typically the significant decline in copper down to $1.50 a pound we saw towards the end of the year really didn't benefit and won't benefit Carrier until sometime in the second quarter or the second half of 2009.

As far as currency, I think one of the biggest surprises was the challenges that Carrier faced was this unprecedented move in currencies. I'm not talking about U.S. dollar versus Euro. I'm talking about Japanese Yen versus Argentinean Peso or Brazilian Real, and we actually about have of the margin decline that we saw in the residential international business was actually related to these abnormal or displacements between these currencies.

We're producing product in Japan or Thailand and shipping them to South America and other places, and typically we would hedge those transactions, but then again we've never seen currency shifts the way we saw in the fourth quarter. That was really the biggest headwind that Carrier saw in the quarter.

Douglas Harned – Sanford Bernstein

But when you look at the margin, you're saying that operating leverage was not a particularly important issue here? What I'm wondering is as you go into '09, and I know you're expecting weaker revenues, are we looking at an issue here with capacity and operating leverage that will put some additional stress on margin?

Akhil Johri

I think if you go back to the map that we already laid out in December, we expect high single digit declines, maybe a little bit worse than what we have seen in the fourth quarter. That would give about $375 million headwind of contribution point of view. We have an additional $150 million of headwind from FX, so that's a $525 million upheaval headwind.

Of that, that means on the other side the commodity which has started to give some benefits, maybe more in the later half as we get the benefits of long term agreements going away and these new rates starting to come into play, that's actually $100 million to $125 million. Carrier has some aggressive cost reduction actions that they have taken this year which will be another $100 million to $125 million and the restructuring actions should give another $150 million.

That is the largest chunk of the restructuring dollars in this year so that will all go back to the $100 million roughly guidance that we gave out year over year. Is there more to spend? As we see the order rates and certainly in the first quarter and first half as we look at the more profitable Carrier business order rate, the guidance, yes. The income we expect in as Greg mentioned earlier, that's basically the manpower from [inaudible].

[Douglas Harnett – Sanford Burnstein]

So is it fair to say that there will be pressure basically of an operating leverage nature that you're going to be able to offset that pressure with restructuring, commodity prices and product cost reduction. Is that fair?

Gregory Hayes

That is the game plan.

Operator

Your next question comes from David Strauss – UBS.

David Strauss – UBS

What are you assuming for the next commodity cost benefit in 2009 businesses in total?

Gregory Hayes

We're expecting about $150 million in actual tailwind in the year, a little over $100 million at Carrier and the rest at Otis and Pratt Whitney.

David Strauss – UBS

What is that assuming for price?

Akhil Johri

We assume relatively flat price in the case of Carrier and Otis so the pricing still remains exactly what we have seen in 2008. But there is not a huge amount of metric pricing.

David Strauss – UBS

About the aerospace, I think in the December meeting you were talking about a slightly lower aftermarket in total lower in aerospace. Obviously with taking down your traffic forecast from flat to now down 3% to 4%, I would imagine it would be materially worse than that.

Gregory Hayes

Obviously if RPM's do in fact come in down to 3% to 4% that's going to put pressure on the aftermarket both in Pratt Whitney as well as at Hamilton.

David Strauss – UBS

Any sort of guidance on what the aftermarket would look like under that scenario for you?

Gregory Hayes

I'm not comfortable giving an updated guidance to that. I think we closed out Q4 okay and the first couple of weeks have been okay, but I think it's too early to really give you any specific guidance. Again at Belmar, we'll have a change to update you on all this. We'll have a little bit more results under our belt here.

David Strauss – UBS

I think for Carrier you talked about a 10% organic revenue decline in '09. What are you assuming at Otis and Fire & Security? That's excluding currency.

Akhil Johri

Otis decline was based on high single digit organic growth and Fire & Security was low to mid single digit.

Operator

Your next question comes from Ronald Epstein – Bank of America Securities.

Ronald Epstein – Bank of America Securities

When you go back to the Pratt & Whitney Canada, should we expect some sort of charge or something related to the demise of the eclipse program because it's not going to launch customer the PW600?

Gregory Hayes

It was indeed the launch customer for the PW600 but we've actually taken care of in the fourth quarter any exposure that we had related to the eclipse program. It was a few cents and I think that's pretty much all behind us now.

Ronald Epstein – Bank of America Securities

Is there an upcoming labor negotiation in Sikorsky and if there is, what's your expectation for that?

Gregory Hayes

We do. Actually with the National Brotherhood of Teamsters, that contract expires February 15 and we are cautiously optimistic that we will be able to reach a settlement with the Teamsters before that and not go through another work stoppage like we have just three years ago.

Operator

Your next question comes from Nigel Coe – Deutsche Bank Securities.

Nigel Coe – Deutsche Bank Securities

On the pension, you mentioned $400 million of funding. Is that going in stock or are you going to put cash into that fund?

Gregory Hayes

It will be primarily in cash of that $400 million.

Nigel Coe – Deutsche Bank Securities

On the inventory, you had a big reduction this quarter. I'm assuming that's from Carrier. Did that have any outside impact on the margin?

Gregory Hayes

If you think about it, inventories were down about $700 million from September through December. Carrier was the biggest piece of that, down about $300 million, but we actually saw inventory reductions at each of the businesses for the first time in a long time. Pratt was the other one, down almost $250 million.

I think it's just good inventory management that we've been focused on for the last year or so as you know, and it's just a typical, normal fourth quarter behavior.

Nigel Coe – Deutsche Bank Securities

Do you have any targets for inventories maybe at 2009 year end target inventories?

Gregory Hayes

Let me just tell you that a 50 basis point improvement in inventory turns each year, so if you think about that, I think our inventory turns at the end of the year around 4.8. Obviously that's not engraved, but there's clearly upside there, so we hope to drive inventory turns at least towards the mid fives towards the end of next year.

Nigel Coe – Deutsche Bank Securities

On everything Carrier, how would you describe your lines of communications with your customers there? Are they giving you any color on the end markets?

Akhil Johri

Nothing exceptional other than what you are hearing or reading every day. There is concern about the capital expenditure on the commercial side. All of the orders have held up relatively well I think driven by our energy efficiency. On the residential side the market has been so weak for such a long time that I don't think anybody is taking it back.

Louis had mentioned our expectation that the housing starts in 2009 would be 662,000. I think the most recent number is 606,000. It's just hard to believe that those numbers could keep going down but that's the doom and gloom out there in the market place.

Nigel Coe – Deutsche Bank Securities

On shipments, you said orders were down 50% during the quarter. What about shipments?

Akhil Johri

There is a little bit of a lag between order and deliveries. Shipments were down in [inaudible] in the fourth quarter and there was a decline towards the end of the year in December so we expect to have some greater impact in first quarter profit. That business is one where the back happens relatively quickly as well and when the economy starts to recover that business will snap back.

Operator

Your next question comes from Robert Stallard – Macquarie.

Robert Stallard – Macquarie

A couple of questions on Otis. Looking at auto trends, you're down 8% on a like for like currency rate in the fourth quarter. Obviously it's early days in Q1 but what are your sales people saying you could expect for this first quarter of the year?

Akhil Johri

It's too early. I think we should wait for when you have the data in front of you in February. We can have six weeks at that time and that would be the time to really talk about it. A lot of the companies are looking out there and pushing hard, including our customers focusing on their year end and the first two weeks of January have never been indicative of what's to follow.

Robert Stallard – Macquarie

On the deferrals issue which we've talked about, when these customers are deferring, are they just deferring 2008 or 2009 deliveries?

Gregory Hayes

Most of it is 2008 deferring into 2009.

Robert Stallard – Macquarie

So they have relatively short window of time here between them making the decision and the actual impact on you. We're talking a couple of month's maybe.

Gregory Hayes

That's exactly what happened. I think in the fourth quarter, we saw these deferrals accelerate especially in China. They were not cancelled; they were just simply deferred into 2009.

Robert Stallard – Macquarie

But if the market conditions for your customers in China remain weak for the next six months, is it conceivable that Otis OEM production could actually turn out to be lower than your forecasting because of these deferrals?

Gregory Hayes

Yes it could be. If these deferrals continue or if we continue to see more deferrals, right now we're forecasting at a high single digit new equipment growth at Otis for 2009. Clearly that will put pressure on if we continue to see deferrals.

Operator

Your next question comes from Howard Rubel – Jefferies.

Howard Rubel – Jefferies.

Just to come back to your balance sheet, in this market that has much more uncertainty than we've seen in awhile, why not not buy back the stock and wait for a little more clarity?

Gregory Hayes

I guess what I would point to you is the fact that the $5 billion of free cash flow that we had last year. We all continue to think that the UTX is probably the best investment we could make with the free cash flow dollars and we're not going to stop the acquisition either. But as we see the visibility the strong cash flows and the fourth quarter is a great example.

Despite everything going on in the world, we generated 141% net income of free cash flow so unless we see some major change in the markets, I would think that UTX shares are going to be the place that we continue to invest.

Howard Rubel – Jefferies

I understand the acquisition agenda, and could you provide a little color in terms of are you close to finding suppliers or horizontal transactions that would add to the business in a material way? Are discussions more lively than they've been or are people still holding out for the same argument that you just made with your stock?

Gregory Hayes

Obviously I think everybody's got the same view in terms of the valuations today. I think Louis said about a willing buyer, willing seller. We are clearly in the market. We think there's some great values out there. We want to add to the core. We still have strong cash flows. I think we have a good currency that we could do a year this year.

But again, willing buyer, a willing seller. These things take time. I can't comment on anything more specifically than that as you know, but we'll keep looking.

Howard Rubel – Jefferies

You've talked a number of times; a lot of the tone of the call has been the challenge of predictability. Are there any signs you have that, you talked about positive or negative, what you're looking for that would give you some comfort that in fact that whenever you reset guidance that this is rock solid bottom. We've seen the worst and sort of just to complete the thought is that if the number turns out to be below the low end, are you prepared to say, "Look this is a number that's rock solid and it was just hard to get there?"

Gregory Hayes

I think you're a couple of steps ahead of us here. We're not going to change the guidance. I think the part of the slide we talked about; we still see that as guidance for the year. There's a lot of things out there that are happening in the market every day and I can't point to any one thing that's going to give us the confidence that the markets won't get worse.

We're going to focus on those things that we can control. That is, overhead costs and efficiency within the supply chain and the factories and we're going to continue to focus on those things and we're going to work to outperform. It's a tough question. I think it's something that we'll continue to focus on.

We don't know how bad the markets are. I think we're actually cautiously optimistic. There's lots of stimulus out there. We have the biggest stimulus package passed here shortly I think here by the U.S. Congress that's going to be signed into law by the new President and once consumer confidence starts to recover as well all know, that's what drives the U.S. economy and eventually the world economy.

So I don't want to throw out any guidance or anything else, so you know, stand by what we said in December and we'll see what happens.

Operator

Your next question comes from Heidi Wood – Morgan Stanley.

Heidi Wood – Morgan Stanley

I wanted to get a sense of a better understanding of your economic assumptions embedded in 2009 guidance and a sense of a change of revenue visibility you're seeing kind of versus usual. If you think of the profile of the visibility and kind of year one and year two for sales, how does that differ for you as you think ahead of not only 2009 but 2010. Because I'm just wondering on 2010 given your combination of long cycle and shorter cycle businesses, some of 2009 sales would be somewhat cushioned but I'm wondering how much cushion you have in 2010 sales.

Gregory Hayes

My crystal ball is not very clear beyond about tomorrow and as we get out to 2010 it's really pretty cloudy. I will tell you that the backlogs are still very strong in all of the businesses. If you think about Otis as I said before backlogs were up 9% for the year and the shorter cycle businesses obviously backlogs I don't think is really as much difference as just these general economic conditions that we're experiencing in the world.

We've got very strong backlog in Sikorsky. I think we've got good backlog in the Fire business, Fire & Security. The OEM's businesses at Hamilton and Pratt all look pretty good. But there's obviously pressure on all things. I was asked that of the military spending. Aftermarket will continue to be strong. People still use elevators every day even if they're not building new buildings.

40% of our revenues come from the aftermarket so I'm not trying not to generalize here, but we feel pretty good about the revenues for this year and not so bad about the revenue outlook for next year.

Heidi Wood – Morgan Stanley

On you assumption for the first half being weak in 2009 and the second half recovery, is that embedded in that? Are you predicating a global recovery in the second half so that your earnings kind of rise along with that rise in consumer confidence that you talked about?

Gregory Hayes

I think what we're anticipating is there will probably be a late 2009 recovery. We'll probably be led by consumer confidence and I think mostly that will happen in the U.S. And we will see that first at Carrier. Carrier is the first to see the pain of an economic slowdown and first to see the benefit of an economic expansion.

As well, think about comparison from 2008 to 2009, the back half will be easier because it was a pretty tough back half of 2008. We'll see what happens. Right now, I think we're cautiously optimistic as I said that you should see an economic rebound with these masses in those packages.

Heidi Wood – Morgan Stanley

Turning to Hamilton Sundstrand, are the Sundstrand systems that you've delivered on the 787, are they presently able to fully interface with all the other systems on the aircraft or are you having troubles there. Can you talk to us a little bit about that?

Gregory Hayes

I think in fact all the systems that we have delivered including electric power systems are up and operating and we are fully ready to go for first flight here. I think we're still working with the Boeing company, has a final certification of the electric power system. That's done by the end of the month, but right now I think everything is good to go.

Heidi Wood – Morgan Stanley

And that includes being able to operate within the other system, not just on a stand alone basis?

Gregory Hayes

Yes.

Operator

Your last question comes from Myles Walton – Oppenheimer & Co.

Myles Walton – Oppenheimer & Co.

You mentioned a couple of times this stimulus package. I'm just wondering is there any direct benefit that you could see or could capitalize from it or more talking about the indirect in consumer confidence issue you alluded to.

Gregory Hayes

Obviously the consumer confidence piece is the easiest to point to but I think some of the proposals that we've seen in the stimulus package especially as they relate to energy efficiency products fit right into the Carrier, Fire & Security and Otis businesses, so we are actually optimistic that we will get a little bit of a bump just from those particular programs.

Myles Walton – Oppenheimer & Co.

Any way to quantify that?

Gregory Hayes

I wish I could. I think it's just a general feeling. You are going to see investments in energy efficiency and continue to see investments in green buildings. That is part of the new Presidents agenda. I think that's all generally good for UTC.

Myles Walton – Oppenheimer & Co.

Could you give an update on the F35 engine development and your schedule for delivering the redesigned third stage engine to Lockheed?

Gregory Hayes

We are still on schedule. We've had a couple of testing issues over the last month. We had some foreign object enter one of the engines. We had another engine shutdown. But other than the kind of typical, normal development problems that you would have on a high tech engine like this, I think we're pretty much on track.

Myles Walton – Oppenheimer & Co.

So that could happen in the next few weeks to the next month or so?

Gregory Hayes

I don't have an exact date. Let me get back to you on that. Right now, word from Pratt is we're on schedule.

Thank you everyone. We appreciate your time. It has certainly been a very good 2008 and we should not forget the 2008 performance. 2009, it will be challenging. We all realize that but we are prepared and we look forward to speaking to you in another couple of weeks. Thanks very much.

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Source: United Technologies Q4 2008 Earnings Call Transcript
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