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United Technologies Corp. (NYSE:UTX)

Q3 2013 Results Earnings Call

October 22, 2013 9:00 AM ET

Executives

Greg Hayes - Senior Vice President and CFO

Jay Malave - Director, Investor Relations

Geraud Darnis - President and CEO, UTC Climate, Controls & Security

Analysts

David Strauss - UBS

Carter Copeland - Barclays

Nigel Coe - Morgan Stanley

Jeff Sprague - Vertical Research Partners

Howard Guguel - Jefferies

Julian Mitchell - Credit Suisse

Myles Walton - Deutsche Bank

Joe Nadol - J.P. Morgan

Shannon O'Callaghan - Nomura

George Shapiro - Shapiro Research

Deane Dray - Citi Research

Operator

Good morning. And welcome to the United Technologies’ Third Quarter Conference Call. On the call today are Greg Hayes, Senior Vice President and Chief Financial Officer; and Jay Malave, Director, Investor Relations. This call is being carried live on the internet and there is a presentation available for download from UTC’s website at www.utc.com.

Please note, the company will speak to results from continuing operations, except where otherwise noted. They will also speak to segment results adjusted for restructuring and one-time items as they usually do.

The company also 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.

Once the call becomes open for questions, we ask that you limit your first round to two questions per caller to give everyone the opportunity to participate. You may ask further questions by reinserting yourself into the queue and we will answer as time permit.

Please go ahead, Mr. Hayes.

Greg Hayes

Okay. Thank you. Good morning, everyone. As you saw in the press release this morning, UTC recorded third quarter earnings per share of $1.55 that’s up 13% versus 2012. We also saw a resumption of organic growth albeit modest and margin expanded to 16.6%.

There’re always a few bumps in the road such as the recent political impasse in Washington that has threatened economic recovery. But our strategy to deliver double-digit earnings growth remains in place.

Following solid year-to-date performance, we are now confident in our earnings per share range of $6.10 to $6.15 that’s growth of 14% to 15%, at the high-end of our previous expectation of $6 to $6.15, that’s despite slower top line growth.

The majority of our end markets are gradually improving but with defense down more than expected, and based on where we are year-to-date we now expect full year sales to be about $63 billion versus our prior estimate of $64 billion.

There are still a couple of puts and takes to the year, and as I said earlier this month, some headwinds at Otis and Sikorsky, but upside at the other segments. Absent this significant external event, we see in fact the high-end of earnings per share range based on our proactive and aggressive restructuring and cost reduction actions, as well as improving end markets.

As you see on slide two, organic sales grew 1% in the quarter with good growth across most of our end markets, tampered by relatively flat European markets and continued significant declines in defense.

Our commercial businesses grew a combined 3%. We saw a continued recovery in North America with sales up 3% led by residential HVAC and Otis new equipment. Europe declined 1%, China was up 11% and continues to be the bright spot in Asia, but overall sales were up only 3%.

Aerospace business continues to see good growth in commercial OEM and recovery in the commercial aftermarket. Revenue passenger miles were up 6.8% in August and were up 5% year-to-date. Oil prices have dampened profitability a bit, but the airlines are still forecasted to earn $11.7 billion this year and $16.4 billion in 2014. So a healthy industry and we see this in our business with our commercial aero sales up 7% in the third quarter. On the other hand, the military business remains a headwind with sales down 14%. We see this impact across our aero businesses, but most acutely at Sikorsky. Given the continued impasse in Washington, we don’t expect this trend to improve over the next year.

Okay, take a look at orders on Slide 3. At Otis, new equipment orders were up 4%, a solid growth off a tough compare with the third quarter of last year which had a major contract awarded in the U.K. North America and China, both saw a double digit increases. Climate, Controls and Securities global equipment orders grew 13% as strengthen in Transicold and commercial spares orders were up 17% at Pratt & Whitney and 5% at UTC Aerospace Systems on a pro forma basis.

All right, Slide 4; total sales increased 3% in the third quarter. Net acquisitions including Goodrich closed on July 26 last year contributed two points while the FX impact was negligible. Segment operating profit grew 14% and operating margins increased 160 basis points. That includes about 100 basis points from the absence of the inventory step up amortization at UTAS last year. As you heard from Geraud at our recent Investor Day in Monterrey, Mexico, CCS continues to drive synergies and leverage their global scale. Operating profit grew 10% leading to margin expansion of 170 basis points.

Pratt & Whitney also expanded margins 290 basis points, on higher commercial aftermarket and aggressive cost reduction. And Sikorsky maintained double digit margins in the face of significant headwinds from sequestration and reduced defense spending. So the third quarter earnings per share grew 13% and we initiated $103 million in restructuring actions. Excluding restructuring and gains for both periods, earnings per share grew 19%. As previously noted, we expect to invest about $500 million of restructuring this year including over a $150 million in the fourth quarter.

For the year, we continue to expect restructuring to be offset by onetime items. Free cash on the quarter was 82% of net income. This was unfavorably impacted by an increase in inventory over $500 million primarily at Pratt & Whitney and Sikorsky as each ramps up their shipments in the fourth quarter. While we continue to see progress on the CMHP with the commencement of pilot training and we’re maintaining our [place order] [ph] eight aircraft in the fourth quarter. In addition to the four aircrafts at the training facility in Shearwater, Canada, we have six aircraft, fully assembled and flight tested at the [Pittsford] [ph], New York storage facility.

Seven are undergoing flight testing at our West Palm Beach facility. The balance of the 20 aircraft are in production. As the program continues to advance, we’ll provide updates as more progress is made.

The quarter capital expenditures were $383 million, a little more than $1 billion year-to-date as we invest with the aero ramp up at both Pratt & Whitney and UTC Aerospace Systems. For the year, we expect CapEx to be in the range of $1.6 billion to $1.7 billion as we noted before. Also in the third quarter we brought back $330 million of stock and we expect to buy back about $200 million in the fourth quarter.

We remain confident that cash flow will equal net income in 2013 and we increased our dividend to $0.59 per share in the quarter a 10.3% increase. I’ll be back to talk about 2014 in just a second, but let me stop there and turn it over to Jay, as he takes you through the business unit results.

Jay Malave

Thanks Greg. Turning to Page 5, Otis sales improved 4% at constant currency in the quarter led by solid high single digit growth in new equipment and continued growth in service sales. New equipment sales were up in all regions led by double digit growth in China, Russia and the Americas. Operating profit was flat at constant currency, but operating margins remained solid at 22%. Continued growth in China was largely offset by transition costs associated with the factory transformation in North America. In developed Europe, the rate of profit decline is slowing, the sequential growth in northern and Central Europe offsetting the continued weakness in Southern Europe.

New equipment order growth was up 4% at constant currency with mid-teens growth in Americas and Asia with continued double-digit expansion in China. Orders in Europe were down high single digits as the prior-year benefited from our major contract award in the U.K. Excluding this award as well as a significant order this quarter, Europe new equipment orders grew 12%.

Given the headwind from the manufacturing and supply chain transition from the Nogales, Mexico to South Carolina and continued weakness in Southern Europe, Otis now expects full-year profits to be up around $25 million, from up $75 million to $100 million and mid-single digit sales growth.

On Slide 6, Climate, Controls and Security increased profits 10% in the quarter on flattish sales, resulting in another sharp increase in margins, up 170 basis points from prior year to 17.1%. CCS is continuing to see slow but steady improvement in organic growth as Q1 was down 3%, Q2 was up 1% and now Q3 is up 2%.

As you have seen all year, organic growth is mixed across geographies. Europe was down low single digit. China was up mid single digit while Asia overall was down about 1% driven by a decline in Australia. Americas was up low single digit driven by 9% growth in the residential HVAC business.

Transicold was up 22% on a robust recovery in the container market after an exceptionally weak period last year. On profit, CCS had another solid quarter of earnings growth, driven by strong conversion on organic sales, restructuring and productivity including continued savings from the consolidation of Carrier and Fire and Security, and lower commodity costs.

Global commercial HVAC equipment orders were up high single digit with growth in Asia and Europe more than offsetting flat orders in North America. Orders for global Fire and Security products were up mid single digit while the field businesses were down high single digit.

Commercial refrigeration orders in Europe were up 2% while Transicold was up 17%, driven by Container and an easy compare over last year. With continued solid results through three quarters and steady sequential organic improvement, we expect profit growth to be around $200 million, the high end of the prior guidance range of $175 million to $200 million and 1% organic sales growth, all resulting in operating margin above 15%, two years ahead of target.

Turning to aerospace on slide seven. Pratt & Whitney delivered solid results with 18% profit growth and 5% lower sales, resulting in margin expansion of 290 basis points. Organically, sales were flat as 22% growth in commercial spares was offset by lower military engine sales.

Reported sales were down due to the power systems business divestiture. Profit growth in the quarter was driven by higher commercial spares volume and restructuring benefits, partially offset by pension headwinds and lower military volume.

As you recall, last year we had the benefit of a supplier settlement that was largely offset by the benefit from licensing agreements this year. For the full year, we now expect Pratt & Whitney operating profit grow $150 million on low single digits sales growth.

We expect profit growth to be at the high end of the prior profit range as large commercial aftermarket has stabilized and the benefits of proactive cost actions are realized.

UTC Aerospace Systems delivered another solid quarter with operating profit of $525 million and sales of $3.3 billion. On a pro forma year-over-year basis, sales were up low single-digit with mid single-digit growth in both commercial OE and aftermarket, partially offset by low single-digit declines in both military OE and aftermarket.

Year-on-year profit growth was driven by the absence of last year’s inventory step-up cost, additional market of Goodrich and continued synergies realization. UTC Aerospace Systems expects to deliver around $250 million in synergies for the year and is well on track towards achieving the $500 million synergies target by 2016.

Orders for commercial spares grew 5% on a pro forma year-over-year basis with improvement in both parts and provisioning. With approximately $1.6 billion of operating profit generated year-to-date, we’re confident in the full-year operating profit outlook of $2.1 billion and sales of around $13.5 billion.

Turning to Sikorsky, operating profit decreased by 21% on 7% lower sales. During the quarter, Sikorsky shipped a total of 61 aircrafts, including 42 based on military platforms and 19 commercial.

The sales decline was driven by lower military OEM and aftermarket volumes, partially offset by strong growth in commercial shipments. The lower overall sales volumes, as well as headwinds from higher pension and compliance costs contributed to the operating profit decline.

Sikorsky continues to see robust demand for its commercial product line with orders this quarter of over $400 million, a strong backlog in excess of $2.5 billion, including approximately $350 million from customers in China as of quarter-end.

For the full year based on continued pressure in military aftermarket, we now expect profit to be down around $150 million, the low end of our prior guidance range and the low single-digit sales decline versus up low single digits previously.

With that, let me turn it over to Greg for wrap up.

Greg Hayes

Okay. Thanks Jay. Before we take a look at 2014, there some other key items to note in the quarter. In late September we announced the creation of our new buildings and industrial systems organizations under the leadership of Urel Denise.

While they will remain separate reporting segments, this will strategically to unite Otis and climate controls and security. This will create the leading commercial building organization in the industry and will allow us to accelerate growth by fully utilizing our unmatched capabilities and scale.

Building on the success of combining our HVAC and fire and security platforms under CCS two years ago. This new organization creates opportunities to unlock further synergies and leverage each organizations field network to service customers in a wider geography. And with 30% of revenues in emerging markets we will focus our innovation on our next-generation buildings and integrating systems, where we see opportunities to create value for our customers.

Also in the quarter Pratt & Whitney and UTC Aerospace Systems supported the maiden flight of Bombardier C Series aircraft on September 16th in Mirabel, Canada. A PurePower geared turbofan engine performed flawlessly on this historic flight of the first next generation narrow body aircraft. We are confident that the flight test program will further validate the performance characteristics, its noise, low emissions, significantly better fuel efficiency.

While we always like to focus on the improved fuel burn of the GTF designs, just as importantly, the GTF noise footprint is up to 75% smaller than today’s engine. And this creates opportunities to fly more direct routes into congested noise controlled airports.

Smaller noise signature also allows to streamlining airport operations to expanded runway usage, as well as expanding current operational curfews at airports and heavily populated areas. This will give airlines the opportunity to work with airports to generate more revenue by opening additional take-off and landing slots, a good example of the value creation that our game changing technologies will bring to the table.

Pratt & Whitney’s performance, its best-in-class technology readiness and program execution is the reason why the GTF has captured orders for more than 4,700 engines. We also saw the first flight of Boeing 787-9 in the quarter as UTC Aerospace Systems continues to support Boeing in the development of this next generation family of aircraft. So a busy quarter and several significant milestones at UTC.

Let’s change gears for a second here and take a look at 2014. We had not surprises that compared to what we talked about just a couple of weeks back. Our strategy remains in place and we continue to target double-digit earnings growth in 2014.

We expect solid growth in commercial aerospace and the commercial construction markets in North America and Asia to more than offset declines in our military aerospace business.

As you all know, Europe remains a question mark. We will take a cautious approach and we are not planning for growth in Europe as we sit here today. The good news is that we finally seem some tailwind from pension next year.

There were approximately $800 million of pension expense flowing through the P&L this year and it will be a welcome relief to see some benefits for lower acquisition charges and a higher discount rates.

On the other side of the ledger we do have about $0.30 of headwinds from three significant items. It’s obviously continued reduction in defense spending, both sequestration as well as the overseas contingency spending.

There is also pressure on the tax rate primarily from the expiration of the tax extenders. And lastly, we will see some headwind from the initial GTF engine deliveries. It will improve as the technology matures but Pratt & Whitney will face some negative engine margin on deliveries of each platform over the next several years. These are great long-term progress that point towards bright future for Pratt & Whitney, but we will need to work down the learning curve as these aircraft enter service.

So as always some pluses, some minuses and question marks as we look towards next year. We continue to leverage our industry-leading franchises and global scale. With the right strategy in place, we’ll remain committed to delivering double-digit earnings growth once again next year.

So with that, let’s open up the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) First question is from David Strauss of UBS. Your line is open.

David Strauss - UBS

Good morning.

Greg Hayes

Hi, David.

David Strauss - UBS

Hi, Greg. In terms of looking at your revenue guidance and what implies for the fourth quarter it looks like in spite of about 4% organic revenue growth the comps were a little bit tougher relative to the third quarter. So can you talk about how you get there, what’s different in the fourth quarter versus your third quarter?

Greg Hayes

I think, David, you are right. I think we will see organic revenue growth of about 3% to 4%, probably closer to 4%, as we sit here today. Again, you are going to see better deliveries at Sikorsky. I think Sikorsky takes up deliveries to about 80 aircraft in the fourth quarter. It delivered about 160 year-to-date, so you get a little bit a bump there, that’s both commercial and the military, you see a little bit better performance at Pratt especially on the military aero side, I think we will ship about 20 JSF engines in the fourth quarter.

And you are going to see on the commercial side an acceleration of organic growth, just because of the orders that we are seeing going into the year. We saw that here in Q3 in orders, I think organic was up 4%. Orders remain strong, so we will see again acceleration of growth at Otis and acceleration of growth at CCS into the fourth quarter.

David Strauss - UBS

And then on the order side, obviously the comps get a lot tougher as well in the [inaudible]. Would you expect order growth will still be positive in the fourth quarter at Otis?

Greg Hayes

Absolutely. I think, Pedro and team would tell you that their order trends remain, booking look very strong. We are still seeing good strength in North America. We are seeing good strength in China and even Europe is recovering. Again, I think as Jay noted before, if you take out that big U.K. Crossrail order for Q3 of last year I think orders actually grew about 12% there. So the economies are recovering and commercial construction seems to be at the leading edge of the recovery here.

The one caveat I would say is Asia, outside of China has not been so great. India has been down, Japan, Korea, Australia. So that may be the dampener on the growth story in the fourth quarter, but we still expect solid orders growth. Same with CCS, again Transicold had a huge quarter. The orders were up 70% in the quarter at Transicold. But again that was off of a very easy compare. Compares will get more difficult but we had good momentum going into the fourth quarter.

David Strauss - UBS

Thanks. I will get back in queue.

Greg Hayes

Thanks, David.

Operator

Thank you. Your next question is from Carter Copeland of Barclays. Your line is open.

Carter Copeland - Barclays

Hey, good morning, guys.

Greg Hayes

Good morning.

Carter Copeland - Barclays

Just a couple of quick ones. First, on the commercial, the spares piece, I wonder if you might provide a little bit more color around that growth rate and what you saw in the Vs versus PW4000s and some of the other engines?

Jay Malave

Sure. Carter, what we saw as growth in the PW4000s as well as the V2500 and that more than offset some declines in the PW2000 in both really sales and orders.

Greg Hayes

If you think about it, I think on a legacy basis, Carter, legacy Pratt spares are up about 10%, even the overall spares were up 17%. So really good strength in the V. Again it’s a young fleet, we are starting to see [shaft] [ph] business pickup as we expected and a little bit of softness on the 2000. But again, legacy businesses is recovering.

Carter Copeland - Barclays

Okay. Great. And on the military side, you talked about fewer engine shipments. Obviously the weakness at Sikorsky on the aftermarket side, but when you kind of look around against some of your peers, the size of the weakness at Sikorsky certainly stands out as anomalous, at least from what we can see so far today. So, are there any other elements of weaker military spending that aren't captured in those two and with respect what you're seeing at Sikorsky, what do you think is making that standout so much more versus what we’re seeing you know elsewhere across defense space?

Greg Hayes

I guess there is a couple of pieces here to look at. I mean, military aero was down across all three of the aerospace businesses. We’ve seen in Pratt again, we stopped the 119 deliveries last year, so we got some headwind from F119s, the F117, that goes on the C-17 that’s going down and JSF is really ramping very, very slowly. So that’s not a great story, although the aftermarket there is okay. At UTAS, we actually saw a reduction in military that surprised us a little bit and this is not sequestration so much as just some of the government agencies just curtailing and cutting back on some of their spending and our sensors business, which was most impacted.

And then we go to Sikorsky. Sikorsky is a -- there is a couple of things there, obviously the aftermarket that we're seeing orders down 15% for the year, which was completely unexpected and we expected it to be down, but not by 15%. And then you've got again just the reduction of the quantities for the multi-year 8 versus multi-year 7 and the timing of some of the international military which is also getting pushed out of this year and into next. So it's been almost a perfect storm at Sikorsky this quarter. And as a result, they are going to be down at the high-end of their earnings range, down about a $150 million for the year earnings.

Carter Copeland - Barclays

As far as the Sikorsky spares go, I mean, on the aftermarket side, how much visibility -- how far out does that visibility go in terms of -- as you think about the impact on next year and how that rolls through, how much longer could this persist or are you just assuming that we get down to this level and stay there, any color would be great.

Greg Hayes

Yes, so a couple of thoughts there, I think, part of this again the bigger ramp that we've seen over the last five years in military spares at Sikorsky was really funded by the overseas contingency spending or funding for the wars in Iraq and Afghanistan. And that is coming down and we expected that to come down. The rest of the military spares piece I would say that was just, we didn’t see the bump in the third quarter that we had expected typically at the end of the fiscal year for the government. We see a large influx of orders as everybody tries to spend their budget, we didn’t see that this year because of the uncertainty I would say around military budgets and what was going to happen in the last quarter of the year.

So I would say we should have about 50% of next year booked and we don’t have much visibility into next year as we sit here today. I think that the good news for Sikorsky is that the commercial businesses is taking off, it's been very, very well, ramping up production, the aftermarket is picking up, but of unfortunately it's 20% of the business versus the [18%] [ph] which is military so Sikorsky is going to have a tough year next year. I think that’s the long and short of it; it’s not unexpected given the next step down in sequestration which I think takes another $12 billion out of defense spending starting in January. So it's a tough couple of years for Sikorsky.

Carter Copeland - Barclays

Great, Thanks for the color Greg.

Operator

Thank you. You next question is from Nigel Coe of Morgan Stanley, you’re line is open.

Nigel Coe - Morgan Stanley

Yes, thanks, good morning. So just looking at the 2014 framework, obviously there is no changes since we published in Monterey. Just looking at the question column and you’ve got [subsidy price] [ph] commodities in there and no surprises in there, but based on the ramp down in copper hedge price for 2014 and I’ve seen that the price remains pretty solid, what do you expect in terms of tailwind for next year, at current levels?

Greg Hayes

There should be some modest tailwind from copper going into next year, copper has come down, but I think it's still trading around $3.50 or so a pound, also we’ve taken down the amount of coppers as we’ve talked about it. We had a visit across all of the CCS I think, 7 years ago there is a 120 million pounds, we’re down to 50 million or 60 million pound. So well copper is an important element of the cost structure, it's not as big as it used to be. We’re also seeing a little bit of headwind on steel, which is going to impact both Otis as well as the CCS, but now it's kind of early. I think generally speaking I would hope that that commodity’s pricing is going to move over into the positives as we get towards the end of the year, when Louis stands up and gives guidance, but we have to wait and see how those last quarter plays out.

Nigel Coe - Morgan Stanley

Okay. And if we could say anything about the pricing side of the equation, it sounds like spares pricing is still pretty good, [inaudible] pricing looks very solid Otis seems quite negative. I'm just wondering, if we look at the backlog build that we see in Otis, what kind of margins do you see in that backlog?

Greg Hayes

The margin in backlog has actually started to improve a little bit in North America, again we’ve got some new products out there. We have been able to get a little bit of pricing but again, not big numbers that we are talking about.

And in China we continue to see pricing pressure at Otis on new equipment, not a surprise. Again, I think, the beauty of Otis is they continue to be able to reduce cost of the factory to offset this pricing pressure and still deliver significant margin on new equipment as a result of the scale of the factories and the relentless focus on cost reduction.

Nigel Coe - Morgan Stanley

Okay. And just a quick one on fab margins, obviously very impressive there, you’ve run through some of the factors. But the deconsolidation or rather the sale of Rocketdyne Power Systems, did they have a positive impact on mix?

Jay Malave

Power Systems maybe a little bit there, Nigel, but again by and large what we saw on that 290 was really the benefit from the aftermarket mix with the spare parts as well as the restructuring benefit.

Greg Hayes

Yeah. Keep in mind, when we took Rocketdyne out we restated the numbers for last year and this year. So the year-over-year doesn’t really have any impact on those discontinued ops.

Nigel Coe - Morgan Stanley

Okay. Good point. Yeah. Thanks a lot guys.

Operator

Thank you. Your next question is from Jeff Sprague of Vertical Research Partners. Your line is open.

Jeff Sprague - Vertical Research Partners

Thank you. Just back to Otis, Greg, just speaking about the South Carolina factory disruption? Can you quantify how much of that kind of played into the Q3 margins and as you look into Q4, obviously the guide kind of speaks for itself? Do you think that fully encompasses the kind of correcting issues and you have that behind you by the end of the year?

Greg Hayes

It’s not going to be completely behind us, Jeff, by the end of the year. I would tell you in the quarter the impact was less than $15 million, let’s call the penny a share from the disruption at Florence.

At the same time, I think they are making good progress. They took overdue from 1,000 units at the end of the second quarter down to about 350 million -- 350 units rather at the end of Q3. Hope they get the overdue all out of the door by the end of the year. But some of the root cause issues, some of the systems issues and some of the other factory issues that we have seen today are still going to take some time to work through.

Having said that, I think, what we are not going to see is a repeat next year all of the additional costs. We kept in the Gallos plant open for additional six months or so this year. That’s close as of the end of September. So that’s going to be tailwind for next year.

I think, the strategy is going to work. We want to have all of the CLC, all the engineering, all the manufacturing, all the procurement all at one place down in Florence. The work force is coming up to speed. It’s getting better. It’s just going to take some time. But I don’t think we are going to see a full run rate savings that we had expected until probably towards the end of next year there.

Jeff Sprague - Vertical Research Partners

So we should have a non-repeat of at least kind of $50 million of costs?

Greg Hayes

Yes. I think that’s probably the best way to think. We probably won’t see big year-over-year savings ex that $50 million of costs that won’t repeat. This – that’s pretty significantly at Otis.

Jeff Sprague - Vertical Research Partners

I just wondered on CapEx also in aggregate. I don’t think you said 1.6 to 1.7 before, I think it was 1.7. Not to split hairs, but are you finding ways to kind of bend the curve a little a bit on that CapEx bubble and what do you think about next year?

Greg Hayes

Yes. So year-to-date, we spent a little over $1 billion on CapEx. So I think we spent $383 million in the quarter, that’s up $65 million. We are trying to, as you say, bend over that curve. I think we are trying to keep that number closer to 1.6 and 1.7, a 75% of that spend is at the Aero units and really goes to the ramp up that we are going to see in production. We have got the 5 GTF engines. We have the big ramp up of UTAS and the consolidation of the Goodrich Hamilton businesses.

So there is pressure on CapEx. So I think next year it will probably be the peak year which could even be up from what we are seeing this year. So, we are doing we can to try and push this capital under the supply chain. We are looking at partners for much of this work. We are doing a lot of things, I think to try and address this. But the bottom line is, there is a lot of CapEx coming in the fourth quarter of this year, you will see even more next year.

Jeff Sprague - Vertical Research Partners

And then finally, can you just give us a little more color on the European building-related businesses both Otis and CC. I think, Jay said field weakness in the Fire and Security organization but equipment orders, I guess, were better at Otis. Just a little more color on the lay of the land there and how things are playing?

Jay Malave

Sure, Jeff. Let me -- I’ll go through sales and I’ll do orders. At CCS, commercial HVAC was down low single digits, Fire and Security was down low single digits and the products were down slightly and the field was down low single digits. Commercial refrigeration was up slightly.

Switching over to orders at CCS, commercial HVAC was up mid-teens and commercial refrigeration was up low single digits. As far as Otis as we said, sales were actually up in the quarter low single digits and orders were down high single digits, but for that big order last year. And again as both Greg and I mentioned, excluding these big one-time orders, it would have been up 12%.

Greg Hayes

If you think about it, it really -- I mean, it looks as if we are positioning for improvement here as we go into the fourth quarter then to next year as we deliver on this. So it’s been a tough year, but we do see signs of stabilization, it’s not getting worse. CCS, I think, we were down 2% a quarter, but again the orders would indicate that there should be recovery here in Europe, although we’re not going to count on a whole lot as we go into next year. At least we don’t think it’s going to get worse.

Jeff Sprague - Vertical Research Partners

Thank you very much.

Greg Hayes

Thanks.

Operator

The next question is from Howard Rubel of Jefferies. The line is open.

Howard Rubel - Jefferies

Thank you very much. More on housekeeping side of things for a moment. Greg, first, R&D for the year continues to trend up. How do you see that flowing out from here? I mean, you talk about a lot of work on GTF and we think you are getting closer to a peak on that?

Greg Hayes

The GTF actually did peak. I think what you saw at Pratt was that E&D was actually flat in the quarter. We were down $50 million year-to-date. You are going to see a further reduction in the fourth quarter at Pratt as engines get certified and we complete much of the testing.

A whole growth in third quarter E&D was at the legacy Goodrich. It’s just the fact that we had Goodrich, it was up $40 million year-over-year, so I think we are right on the plan that we had expected. In fact, Pratt we had said down 75 probably closer to down 100, which will help fourth quarter margins.

Howard Rubel - Jefferies

I have never gotten a tax rate right this year…

Greg Hayes

Me either.

Howard Rubel - Jefferies

But you find things that sort of help matters. So how do you think about a normalized tax rate? I mean I recognize that some of that will be a function of repatriation and every other credit one can find.

Greg Hayes

Yes. I think there is a normalized rate with the tax law as it stands today. I will be very specific there. It should be around 29%. The fear of course is the tax law changes next year and when we lose some of the benefits from the tax extenders like the R&D, tax credit and the CFC look through rules and everyone wants to put upward pressure between a point and a point and a half on the race. So, if you think about next year and we are keeping probably a 30.5% tax rate unless by some miracle the folks in Washington to get those tax extenders passed. But I think that’s unlikely that anything is going to happen down there this year yet.

Howard Guguel - Jefferies

And then finally, you talk about restructuring, I think you said $150 million in the final quarter of the year. Can you sort of, can you outline a bit where you plan to target it and how are you anticipating capturing some gains?

Greg Hayes

But there is obviously a few things out there in terms of the gains. There is probably a little bit on the tax side. We will probably get another couple of one-time items there that will help fund some of these restructuring. But I’m not counting on it. The fact is most of the restructuring in Q4 is actually going to go to Pratt, as they are again preparing for the ramp up, but at the same time they are trying to adjust their cost structure to the reality of today.

UTAS, I think, again, you are going to see further synergy plays there with headcount and further restructuring and the same at Otis and CCS. So there’s, again, that $150 million is pretty well spread across the businesses. Sikorsky is going to be teeing some things up too, I think. And maybe that number probably wants to go up, and if it doesn’t go up in the fourth quarter, it will go up in the first quarter.

Howard Guguel - Jefferies

Okay. Thank you very much.

Operator

And your next question is from Julian Mitch of Credit Suisse. Your line is open.

Julian Mitchell - Credit Suisse

Hi. Thanks a lot. Yeah, I was just curious about the extent of the expansion in your gross margin. That was sort of flat to down in the first half, up almost 190 bps year-on-year in Q3. You mentioned lower commodity cost in CC&S helping. I just wondered if there was anything exceptional in that gross margin in terms of input costs or mix, or it really does reflect kind of the benefits of restructuring and is something that should be sustainable.

Greg Hayes

So there is a couple of pieces there, Julian. I think, again, one of the biggest pieces is the absence of the inventory step-up amortization. Last year, it was, I think, $100 million.

Jay Malave

$150 million.

Greg Hayes

$150 million in the third quarter and again in the fourth quarter. So that really helped the UTAS’ margins improve. As far as Pratt, the big improvement in gross margin was really the recovery in the commercial aftermarket as well as the restructuring savings from all the actions that we took in the first nine months of the year.

Julian Mitchell - Credit Suisse

Got it. Thanks. And then on just following up on R&D. You didn’t put in your sort of outlook for next year. Is the assumption then that it will just track in line with the sales development because you’ve still got lot of legacy Goodrich stuff to catch up on?

Greg Hayes

No. I think there’s -- if anything, E&D should start to trend down, especially on the aero side here. We are completing the 787-9. We are completing the GTF engines. Again, I’m not talking about a huge step-down, but it should generally trend down over the next couple of years, which should be helpful.

Again, there is not a lot of newer platforms, but we do have to complete all the work that’s out there from the Embraer aircraft, the CSeries and the neo. So there is lot of work to do, but I think it’s generally going to trend down slightly.

Julian Mitchell - Credit Suisse

Got it. Thanks. And then lastly just within Otis, so I think your EMEA services revenues were down sort of low single-digit in Q2s, but that was still running at the same trend here in the second half.

Jay Malave

Yeah. It was down slightly in EMEA in this third quarter.

Greg Hayes

Yeah, I think the pressure there is not surprising. Spain is down, Italy is down, but we are seeing good traction. I think France is up a little bit. Germany is up a little bit. So, it’s really the same story that we’ve been talking about for the last year and a half. Southern Europe continues to be a headwind, although much, much less so than in the past 18 months.

Julian Mitchell - Credit Suisse

Got it. Thank you.

Operator

Thank you. The next question is from Myles Walton of Deutsche Bank. Your line is open.

Myles Walton - Deutsche Bank

Thanks. Good morning. The first one is clarification, just on the CMH. So eight deliveries are baked into that dime headwind is in the numbers for the fourth quarter at this point?

Greg Hayes

So to be clear, the eight aircraft we have assumed that we are going to shift those in the fourth quarter. But year-over-year it’s actually tailwind, Myles, because you recall last year, we took $157 million charge. Those eight aircraft would go out with negative margin around the $120 million. So there is actually tailwind in Sikorsky numbers in the fourth quarter from CMH, strange as it seems.

Myles Walton - Deutsche Bank

So, I was just thinking -- I was just saying versus your underlying EBIT guidance down to $150 million?

Greg Hayes

Yes. That’s in there later perhaps.

Myles Walton - Deutsche Bank

Okay. Great. And then, Greg, can you talk about the other operating cash flow line item? I think that $350 million negative swing this year and I think -- and some of it’s the fleet management, some of it’s the total revenue going the opposite direction. But can you talk about the trend for the rest of the year and also into 2014?

Greg Hayes

Yes. I think you saw a little bit of anomaly here in the third quarter. What we saw is some higher costs in some of the fleet management programs as you noted there at Pratt & Whitney where again, we are incurring cost upfront to get these engines up to kind of rebuild to a pristine condition before they go back in the field. So those costs go on the balance sheet, it goes out of the cash flows. There was a couple other minor things in there, Jay.

Jay Malave

Yes. We just had some increases in long-term receivables particularly again in the aero businesses. And then just again some payments in terms of -- on some of the longer-term reserves like a restructuring-type reserves, where we are liquidating those reserves to other payments.

Greg Hayes

Nothing, I would say is structurally different going into the rest of the year or even to next year that I would have been that concerned about.

Myles Walton - Deutsche Bank

Okay. So into ‘14 that become more of a historical trend?

Greg Hayes

Yes.

Myles Walton - Deutsche Bank

Okay. Thank you.

Operator

Next question is from Joe Nadol of J.P. Morgan. Your line is open.

Joe Nadol - J.P. Morgan

Thanks. Good morning, Greg and Jay.

Greg Hayes

Good morning.

Joe Nadol - J.P. Morgan

On UTAS, so your EBIT was -- adjusted EBIT was down a hair sequentially. And just thinking about this, we should have over time. Sequentially, we should be thinking about aftermarket getting I think a bit better. And we should be thinking about synergies from Goodrich getting better. So, was defense the negative sequentially? And if so, could you help quantify that a little bit?

Greg Hayes

Yeah. There was actually a couple of pieces of headwind there. And I think you hit on the biggest piece which was defense and that again, both at the legacy Hamilton business as well as there’s Goodrich in the sensors business. We saw a headwind there. And we also saw additional headwind as sales picked up on 787. There is still negative margin there.

We also booked some loss reserves associated with the CSeries aircraft, which again is a very long-term program. But as you first start up, you are high on the learning curve, so there’s a little bit of loss associated there and I think that gets better over the next couple of years and those are really the three biggest pieces if you will.

Jay Malave

Okay. So as we think going forward into Q4, I mean your guidance implies kind of flattish EBIT again. But as we think about that going into next year, how do you think about those various pieces? Particularly, are you worried more that Goodrich defense business was just a homerun for them in the last couple of years of their independence. Is that somewhere where we could expect or fear more downside?

Greg Hayes

Well, again, the sensors business is not really the DoD business. It’s a U.S. government business, so we’re not selling as much as you might think to DoD, although there is some there. But they are clearly going to be a little bit of headwind, but this is not a huge, huge number for us next year. And I think again, we come down to learning curve on the 787 next year, so that’s going to improve.

We’ll come down to learning curve on the CSeries. Sequestration will be an impact at UTAS, bigger impact in the next year at Sikorsky. But yeah, I think it’s all kind of captured in there. We talked about $0.12 headwind from sequestration and probably a third of that’s going to be the UTAS and two thirds will be at Sikorsky.

Joe Nadol - J.P. Morgan

Okay. And then just one more. I think you tweaked down your cash flow guidance from better than or equal or better than to earnings to just essentially in line with. What were the changes there?

Greg Hayes

Again, I think we’ve always said, we target cash -- free cash flow net income and I didn’t mean to imply that there was anything significantly different. As we get towards the end of the year, we clearly have line of sight to free cash flow or equal to net income. I think we’re 91% year-to-date. Our fourth quarter is typically big from a cash flow standpoint. So, I can guarantee you one thing, it won’t be exactly 100%.

It might be a little lower. It might be a tiny bit less, but we’re targeting in the range of net income, so no surprise there. I think, again, we’re on track to deliver and the same thing with the guidance here. We tightened the guidance range to that nickel. We see a path to the high end, but I don’t see a path above the high end. So, as you guys think about the year, we’re thinking about cash flow will equal to net income at $6.15 and what we’re really focused on right now is 2014.

Joe Nadol - J.P. Morgan

Right. I mean your guidance did change from October 1 to today in terms of what’s in your slides. So, I guess that’s -- it’s just based on where you were.

Greg Hayes

Yeah. It’s just based on the reality. As we get towards the end of the year, we will be a little over net income maybe, but we’re not going to be at 115% of net income and I didn’t want to imply, that’s why we really tweaked the guidance to say it’s going to be essentially equal to net income.

Joe Nadol - J.P. Morgan

Okay. All right. Thank you.

Greg Hayes

Thanks, Joe.

Operator

Thank you. Your next question is from Shannon O’Callaghan of Nomura. Your line is open.

Shannon O’Callaghan - Nomura

Good morning, guys.

Jay Malave

Good morning.

Greg Hayes

Hey, Shannon.

Shannon O’Callaghan - Nomura

Hey Greg, as you looked into this military aerospace weakness, I mean have you been able to sort of get a feel for how much of this could be inventory reductions and when those might sort of play themselves out?

Greg Hayes

And again, I think what we’re really seeing is just a reluctance on the military services to spend on spares alone. What’s most impacting I think is fleet readiness. We’ve seen the BLACK HAWK readiness declined significantly because they’re not working the hours, they’re not doing the repairs.

And right now it seems to be comfortable that they can take down fleet readiness. But that trend cannot go on forever. I think we would expect to see a recovery from kind of more normal aftermarket levels across all of the defense businesses next year once we get this thing with sequestration sorted out.

Shannon O’Callaghan - Nomura

Okay. Okay. And then just maybe a little more color on Europe in terms of the commercial businesses. I mean, Otis and commercial HVAC are seeing these better European orders. What do you make of those? Are those or are you seeing sort of a material swing go on there? Or what color do you have around what you’ve seen drive it?

Greg Hayes

Let’s be careful there, Shannon. I think, again, we are seeing a recovery, but we are still well below peak rates that we saw in 2006, 2007. So orders are coming back. They’re off of really, really low levels. So, recovery is coming. It’s very slow and I am not expecting it. Orders are good. They are good in Northern Europe primarily, but there’s still a lot of uncertainty in Europe. So we’re going to be cautious. But again, I think it’s all trending positively.

Shannon O’Callaghan - Nomura

Okay. Thanks, guys.

Greg Hayes

Thanks, Shannon.

Operator

Thank you. Our next question is from George Shapiro of Shapiro Research. Your line is open.

George Shapiro - Shapiro Research

Good morning.

Greg Hayes

Hi, George.

George Shapiro - Shapiro Research

Greg, if I look at Pratt, you had big drops sequentially and even year-over-year in the large commercial deliveries. I mean, what was going on there? You had a strong second quarter, but what was actually happening in the third to be that low?

Jay Malave

George, that really just normalized. I think you would expect -- in the fourth quarter, we expect that number to probably jump a little bit to the 150 range in that ballpark and the second quarter was just a high quarter.

George Shapiro - Shapiro Research

Okay. And then the 14.4% margin, I mean obviously got helped by the lower deliveries and the higher aftermarket. Was there anything else in there, or is that kind of a sustainable kind of new level margin for a while now?

Greg Hayes

Well, no, again, to the earlier point, commercial OEM is going to go back up in the fourth quarter. The other piece you are missing is the restructuring thing. Pratt has taken out close to a 1,000 people this year in the first nine months and most of that came second quarter. So you are going to see that benefit continue. And again, spares should be better, so that will help. But you get little bit of an offset, as commercial OE picks back up in the fourth quarter.

George Shapiro - Shapiro Research

Okay. Thanks very much.

Greg Hayes

George, thanks.

Operator

Thank you. Our final question comes from Deane Dray of Citi Research. Your line is open.

Deane Dray - Citi Research

Thank you. Good morning, everyone.

Greg Hayes

Hi, Deane.

Deane Dray - Citi Research

Hey. On Fire & Security, could you just give us an update in terms of traction in the quarter? What it means on non-resi side and any developments on the portfolio rationalization? It sounded like there were still some divestitures that could potentially be done on businesses you couldn’t scale.

Greg Hayes

Okay. What I will do -- I can give you some data points just on Fire & Security globally. The products were up low single-digits in sales and orders were up mid single-digits. On the field businesses, those were down high single-digits in both sales and orders in the quarter. So that’s pretty much what we saw on Fire & Security globally.

Jay Malave

Yeah. I think this is not a new trend here. Again, some of the field business, again, we have been mostly deemphasizing, but we’ve been somewhat more selective as Geraud said about not taking some of these installations, which is just installing pipes, if you will, for sprinkler systems or trying to -- by higher margin, higher value add that can pull some of our product along, so making good investment on the product side and we’re seeing that traction in orders. But the service side continues to be a drag especially in Europe.

Deane Dray - Citi Research

Great. And I might have missed this. But on the Canadian Maritime, are you -- have you made progress in the renegotiation of the contract, any closer to that resolution?

Greg Hayes

I’m going to be very cautious here, atypical of me. But I would say that we’re making progress although it’s slow. And I think again, we haven’t really started formal contract negotiations. Good news is the aircraft are up in the Shearwater. They are flying. We’re getting traction with the customer. I think everybody recognizes they want to find solution here both at the Sikorsky and at the Canadian government level.

So we’re making progress. It’s a great helicopter. And we were just down at West Palm Beach the other day I was talking to the test pilot. It’s a phenomenal aircraft, but it’s just going to take a little bit of time. So, I hope when Louis stands up in December that we’ll have some really good news to report.

Deane Dray - Citi Research

Great. Thank you.

Greg Hayes

Okay. So thanks everyone for listening today. As I just said, we look forward to seeing you all at our Annual Investor and Analyst Meeting on December 12th in New York. We’ll do the same. Last year, we’ll be giving guidance on 2014 and look forward to seeing you all there. Thanks very much.

Operator

Ladies and gentlemen, thank you for your participation in today’s conference. This concludes the program. You may now disconnect. Have a wonderful day.

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