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United Technologies Corp. (NYSE:UTX)

Q1 2014 Results Earnings Conference Call

April 22, 2014 9:00 AM ET

Executives

Greg Hayes - Senior Vice President and CFO

Jay Malave - Director, Investor Relations

Analysts

Julian Mitchell - Credit Suisse

Carter Copeland - Barclays

Joe Nadol - J.P. Morgan

Jeff Sprague - Vertical Research

David Strauss - UBS

Howard Rubel - Jefferies

Sam Pearlstein - Wells Fargo

Ron Epstein - Bank of America

Robert Stallard - Royal Bank of Canada

Cai von Rumohr - Cowen and Company

Doug Harned - Sanford Bernstein

Shannon O’Callaghan - Nomura

Myles Walton - Deutsche Bank

Operator

Good morning. And welcome to United Technologies’ First 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 to the queue and we will answer as time permit.

Please go ahead, Mr. Hayes.

Greg Hayes

Thank you, Stephanie, and good morning, everyone. As you saw in the press release this morning a solid finish to the first quarter with earnings per share of $1.32 and 5% organic sales growth. Earnings were little bit better than what we expected driven by the higher organic sales.

Segment operating profit was up 9%, reflecting improvement in all five segments and operating margin expanded by 90 basis points to 15.4%. So a good start to the year, which gives us confidence to increase the bottom end of our EPS guidance range. We now expect 2014 earnings per share of $6.65 to $6.85 that’s growth of 7% to 10% and an increase from our prior guidance of $6.55 to $6.85.

Okay, turning to slide two, organic sales grew 5% in the quarter with growth in all five segments. As the momentum coming out of the fourth quarter of 2013 continued and the commercial businesses we saw 7% growth in the Americas helped by the ongoing U.S. economic recovery and we continue to see signs of improvement in Europe organic, sales were up 3% in the quarter. The commercial businesses also saw 7% growth in Asia led by China where sales were up 14% more than offsetting some softness in other parts of the region.

Looking at aerospace, continued weakness in defense where sales were down 2% was more than offset by strong growth in commercial OE and aftermarket where overall sales increased 8%.

Let’s look at orders now on page three, overall order trends remained positive for the majority of the portfolio. Just a reminder, we will talk orders on a constant currency basis as we usually do.

First, in our commercial businesses, we continue to see traction in North America. Despite some weather related impacts at the beginning of the year, the outlook for housing and commercial construction markets remained encouraging.

North America residential HVAC orders were up 19% versus last year, as the housing market continues to improve and distributors stocks for the summer season. The Architectural Billing Index or the ABI trends are positive and we see that coming through in our order in August, where new equipment was up 39%.

North American commercial HVAC orders were down 4% in the quarter, reflecting an uneven demand for large engineered systems, although, we continue to expect that business to grow for the full year 2014.

In Europe, the economic environment is trending positively, albeit slowly. Eurozone PMI expanded for the nine consecutive month and economic sentiment is at the highest levels since about mid 2011. Unemployment continues to be near all-time highs, the deflation remains a concern.

At UTC, CCS commercial HVAC equipment and fire and security product orders grew 15% and 10%, respectively. While Otis new equipment and CCS commercial refrigeration orders were each down about 2%.

Okay, on China, while reports recently suggested property markets slowdown in parts of the country, we continue to see solid demand in housing and infrastructure in the first quarter. Otis new equipment orders were up 25% in the first quarter, with several large infrastructure project orders coming in the quarter.

CCS commercial HVAC was up 10% and fire product orders were up mid single digits. So our building and industrial systems businesses continue to be well-positioned building on the strength we saw in 2013.

Moving to aerospace, with increasing air traffic and airline profit projected to almost $19 billion this year. We continue to see solid conversions of OE backlogs and good growth in our commercial aftermarket businesses. At Pratt & Whitney commercial spare orders were up 11%, while UTC aerospace systems spares orders were up 9%. So, good broad base orders growth across the portfolio.

We will keep a close eye on China and the other emerging markets, and continue to look for signs of further progress in Europe. The order rates and microeconomic trends broadly support our assumption to organic growth as we move through the year.

Okay, let’s go take a look at the first quarter specifically now on slide four. Full reported sales increased 2%, as 5% organic growth was partially offset by headwinds from net divestitures and FX. On the FX side, the benefits from the year were more than offset by headwinds and other currencies.

Segment operating profit grew 9%, operating margins increased 90 basis points, including the benefit, of course, from pensions. CCS saw solid drop through and continues to drive cost reduction, where operating profit grew 15% with margin expansion of 200 basis points.

Aerospace systems at Pratt & Whitney expanded margins by 170 and 80 basis points, respectively, each on the higher commercial aftermarket benefits from cost reduction actions, as well as pension.

Earning per share $1.32 that’s down 5%, a segment operating profit growth of 9% was more than offset by $0.20 of net restructuring headwinds in the quarter. Recall that in the first quarter of 2013 we had $0.11 sense of net gains, while we saw $0.09 of net restructuring charges in the first quarter of 2014 as we invested in cost reduction initiatives ahead of some expected gains around the middle of year. Absent the impact of gains and restructuring in both this years and last year earning per share were up 10%.

Free cash flow in the quarter was 83% of net income, capital expenditure was $333 million that’s up 13% versus last years as we continue to invest for ramp-up in commercial aerospace and working capital grew by $521 million in the quarter, driven primarily by an inventory build to support sales growth in the year.

We also acquired $335 million stock under share repurchase program and we expect buyback at similar out here in the second quarter. Let me stop there for now, I’d like to talk more about the full year but first let me turn over Jay who will walk you through the business unit results.

Jay Malave

Thanks, Greg. Turning to page five, Otis sales improved 7% at constant currency in the quarter with new equipment sales up mid-teens including solid growth form all areas, most notably double-digit growth in China, the Americas, Eastern Europe and the Middle East, service sales were up slightly.

Operating profit was up 1% at constant currency. The positive impact from higher sales volume was partially offset by continued pricing pressure and carryover cost associated with the North America factory transformation.

New equipment orders were up 11% with double-digit growth in China and North America. EMEA orders were down low single-digit. For the strong order book and near-term completion of the factory transformation in North America, Otis expects to see improving performance as the year progresses. Guidance for the full year remains unchanged with profit expected to increase $100 million to $150 million and mid single-digit sales growth.

On slide six, climate controls and security increase the profits 15% in the quarter on flat sales, resulting in another sharp increase in margins up 200 basis points from prior year to 15.1%.

Organic sales were up 3% in the quarter benefiting from product and marketing investments. On a regional basis, the Americas business was up mid single-digit, driven by 21% growth in the residential HVAC business, some of which was due to earlier stocking by distributors for the cooling season from what we experienced last years.

Europe is turning the corner and was up slightly led by growth in commercial HVAC. China was up high single-digit, while Asia overall was flat driven by softness in other Asian countries and Transicold was up 7%.

Profit growth in the quarter was driven by strong conversion on organic sales, as well as restructuring and net productivity gains driven by ACE and operational excellence. Orders for global commercial HVAC equipment were up low single-digit.

Order for global fire and security products were up high single-digit, partially offset by a decline in the fire and security field businesses. Transicold orders which tend to be more choppy were down high teens. With solid results in the first quarter, we continue to expect profit growth of $225 million to $250 million on mid-single digit organic sales growth at CCS.

Turning to aerospace on slide seven. At Pratt & Whitney, organic sales were up 4% in the first quarter as commercial sales growth across the businesses more than offset declines in military. Including the divestiture of power systems, sales were down 2%. Large commercial after market sales were up 10% over last year’s first quarter which was the weakest of 2013.

Operating profit was up 4% driven by higher organic sales, lower pension cost and restructuring savings which more than offset headwinds from adverse large commercial OE mix, the power systems divestiture in the absence of last year’s contract close out at partnership settlement benefits.

For the full year, we continue to expect Pratt & Whitney’s operating profit to be up $175 million to $200 million on most single digit sales growth. UTC Aerospace Systems delivered a solid quarter with 17% profit growth on 6% higher sales. Sales growth was driven by higher commercial volumes, with OEM up high single digit and aftermarket up 10%.

Overall, military sales were down low single digit with military OEM flattish and military aftermarket down mid-single digit. Year-on-year profit growth was driven by higher commercial aftermarket volumes, continued synergy traction, pension tailwind and higher income from licensing agreements, partially offset by headwinds from higher engineering spend and new program OE growth. Operating margins expanded 170 basis points to 17.3%.

Orders for commercial spares grew 9% on a year-over-year basis with strength in both parts and provisioning. For the year, we continue to expect profit growth of $300 million to $350 million on mid-to-high single-digit sales growth at UTC Aerospace Systems.

Turning to Sikorsky on slide nine. Operating profit grew 8% on 9% higher sales. During the quarter, Sikorsky shipped a total of 48 aircraft including 36 based on military platforms and 12 commercial. The sales increase was driven by higher international military and commercial OE volumes.

Operating profit growth was driven by higher sales volume and net favorable contract performance adjustments in our military business partially offset by unfavorable aircraft and aftermarket mix. During the first quarter, Sikorsky, the Turkish government and key Turkish aerospace suppliers signed a licensing and manufacturing agreement for 109 multimission aircraft to be used by the Turkish government. For the full year, we continue to expect flattish operating profit and high single-digit organic sales growth.

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

Greg Hayes

Okay. Thanks Jay. So solid start to the year. We continue to achieve significant milestones in our programs and secure key wins for the future. At Pratt & Whitney, IAE reached a new production milestone in February when it shipped its 6000 V2500 engines.

We also continue to see strong demand for the GTF engine with new engine offerings wins at ANA and Tiger Air in additional orders at the regional jet market on both the Embraer E2 and the C-Series platform. Customers clearly see the advantage of our engine and have placed firm and option orders for over 5300 engines to date.

On the military side, Republic of Korea announced its selection of the JSF as its next generation fighter jet. Korea’s commitment to purchase 40 F-35A conventional take-off and landing aircraft will bring expected international deliveries to over 700 aircrafts.

At aerospace systems, the segment recently announced a long-term agreement with Lufthansa Technique, maintenance repair, overhaul services for aircraft interiors, products, sensors and integrated systems on the Boeing 787 aircraft. We also recently extended our care program Singapore Airlines which provides repair services, asset management. The airlines expanded fleet of Boeing 777 aircraft.

Also in the quarter, Sikorsky announced the entry into the service of the S-76D. As Jay mentioned, Sikorsky also signed agreements with the Turkish government to supply 109 T-70 helicopters, which are variants of Sikorsky’s S-70i International Black Hawk.

On U.S. government side, prospects for the Combat Rescue Helicopter, VXX Presidential Helicopter program remains positive. The firm decision is expected around the middle of this year.

Okay. Let’s talk about CMH for just a second. We continue to make progress on the CMH program and we’ve recently executed the second Principles of Agreement with the Canadian government which now defines a final configuration for the aircraft as well as the phase delivery schedule which allows for the retirement of the Canadian seeking helicopters beginning in 2015.

We also now expect that the final cost of the aircraft will be significantly higher than previously estimated as a result of additional requirements, retrofit costs and expansion of the program schedule. We continue to negotiate the financial impact of these program changes for the Canadian government but we would expect to record a charge this year associated with the acquisition contract upon the completion of the definitive agreements.

We expect the charge will be largely offset by other one-time gains, beneficial items during the year. We’ll provide an update later in the quarter as we work to finalize the agreements and complete our analysis of total program cost.

BIS or Building & Industrial Systems had a very strong first quarter with combined organic sales growth of 5%. Integration activities continue to progress well and the CCS and the Otis team continue to look for ways to serve our customers more efficiently and offer integrated high value systems.

We’re pleased with the continued CCS momentum, the return of profit growth at Otis and the overall growth prospects for the business. And we continue to win orders in key emerging markets.

Now, this is 25% order growth in China included large orders for the Shenzhen and Chengdu metros. And CCS was awarded major maintenance contracts for the fire safety and HVAC systems of the New Cathay Pacific Cargo Terminal in Hong Kong.

We continue to expect the combined capability of CCS and Otis and the new Building and Industrial System organization to further accelerate top line growth. So, just as you heard from the presidents in March, each of the businesses is well-positioned in our core markets and continued innovation will allow us to drive long-term organic growth.

Okay. Taking a look at the rest of 2014, no real changes when we told you last month. The compares get tougher as you move through the order trends and end markets are essentially in line with our expectations so far. First as we’ve seen with recent development in the Ukraine, things can change quickly. But as I sit here today, we remain confident in our updated guidance range at $665 million to $685 million with the path towards the high end and sales were about $64 billion.

And we continue to expect quarterly earnings per share growth of about 9% to 10% per quarter, absent the impact of gains in restructuring will remain throughout the year. We continue to invest in restructuring. With visibilities to some additional gains and good payback restructuring projects across the business, we now expect to spend about $375 million on restructuring this year, all offset by one-time gains.

In the first quarter, we spend $125 million. We would expect to spend to be relatively level loaded for the rest of the year. Gains however should come largely in the second quarter. Strong cash generation remains a hallmark of UTC. Although pressured by the increase in CapEx and working capital in 2014, we continue to target free cash flow equal to net income for the year. We’re going to maintain our placeholders of $1 billion for each of share repurchase, debt paydown and M&A activities.

Looking ahead, we remained focused on growth and execution in 2014. We’re well positioned in our end markets and we’ll continue to leverage our industry leading franchises in global scale. UTC portfolio is poised to take advantage of the commercial aerospace growth and organization megatrends over the next decade.

So with that, I will stop and open up the call for questions. Stephanie?

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Our first question comes from Julian Mitchell with Credit Suisse. Your line is open.

Julian Mitchell - Credit Suisse

Hi. Thank you.

Greg Hayes

Good morning Julian.

Julian Mitchell - Credit Suisse

Good morning. I just had a question on Otis. Because I guess in Q1, you had organic sales growth in line with the full-year target of 6%. The EBIT was flat, though. So I guess what's giving you the confidence that, with a given organic growth run rate the rest of the year, you can get the EBIT up? Is it just that the U.S. factory relocation costs were again a very big headwind in Q1 and that drops out or is there something in the mix that you're expecting?

Greg Hayes

There’s a couple of pieces here, Julian. I think the Florence factory transformation. It was a headwind but a small, small headwind this quarter. I think less than $10 million so, drove a little bit of headwind. Really the biggest issue was continued pricing pressures that we saw around the portfolio and you think about it, where the growth came in the quarter, we had 16% growth in OE and only 1% growth in the service business.

So it is the pricing pressure around OE that is pushing margins down a little bit and causing us to see, I would say tepid growth on the op profit side here in the first quarter. But it will get better during the course of the year and we expect service to improve, to come down the cost curve and the equipment will get cost reduction in the factories. We will see some of the benefits from the integration of BIS, so all those things give us confidence. We are still on track from $125 million to $150 million of profit growth for the year.

Jay Malave

$100 to $150 million.

Greg Hayes

$100 to $150 million, correct.

Julian Mitchell - Credit Suisse

Great. Thanks. And then within I guess, BIS overall, you were targeting, I think around mid-single digit growth for the year. You did 7% growth in Q1. What’s your sense on the sort of non-residential markets in North America specifically? Is that trending in line or you’ve seen kind of choppiness there through last year?

Greg Hayes

Well, there was really, I would say two different stories in North American non-res. Clearly on the OE side, we are seeing very, very solid growth in the commercial construction side of the business. Again, that’s been driven by again the ABI above 50 here for most of the last year and really solid momentum in the commercial building space.

On the CCS side, specifically on the carrier side I think Jay mentioned a little tougher compare there on the orders for the carrier commercial business and down about 4%. But keep in mind, little different business there, that is primarily 80% of retrofit business and only about 20% relates to new building construction. So we are seeing traction, I think our new buildings. I would also point out that the OTIS new equipment business fell much more dramatically than the carrier commercial business during the last downturn. So, I still think we will see growth in commercial business in carrier for the year, slight growth and we expect the order trend momentum at OTIS to continue as well.

Julian Mitchell - Credit Suisse

Great. Thank you.

Operator

Our next question comes from Carter Copeland with Barclays. Your line is open.

Carter Copeland - Barclays

Hey. Good morning, guys.

Greg Hayes

Good morning, Carter.

Carter Copeland - Barclays

Just a couple of quick ones. One, with respect to the pricing pressure at Otis, I wondered if you might kind of give us some color there. Has that intensified or eased at all, what’s been your sense on that this quarter versus what you talked about last year?

Greg Hayes

Yeah. I wouldn’t tell you there is any trend change there. We continue to see pricing pressure in most of the markets for new equipment as you can imagine. But China remains the most competitive of all of the new markets. We continue to see pricing pressure there. North America, a little bit better. Again, we’ve got new products that have come out and we’ve done very well in terms of market penetration and pricing looks to have stabilized at least in North America. In Europe -- well, it is Europe. I mean, it’s a tough, tough market. So, I wouldn’t say we’ve seen an inflection here but I don’t think we have seen any improvement in pricing.

Carter Copeland - Barclays

Okay. Great. And on the military front with respect to the down 2% number, you quantified the numbers in UTAS, but I wondered if you might speak to the declines you called out in Pratt and then at Sikorsky, given obviously what should be a pretty tough aftermarket compare there?

Jay Malave

Sure, Carter. At Pratt & Whitney, the military business was down low double digits. The OE business was down high teens and the aftermarket business was down low single digits. At Sikorsky, the military business, the O.E. was actually up as well as the aftermarket.

The O.E. was up on the back of the international deliveries to higher international deliveries. The aftermarket was up, as I said in my remarks that there was a performance adjustments, contract adjustments. It impact profit as well as impact sales. So that business including that was up around 10%.

Carter Copeland - Barclays

If you exclude the adjustment, what would the growth rate have been?

Jay Malave

It would have been more, I think flattish.

Carter Copeland - Barclays

Okay. All right. Thanks for the color, guys.

Greg Hayes

Okay, Carter.

Operator

Our next question comes from Joe Nadol with J.P. Morgan. Your line is open.

Joe Nadol - J.P. Morgan

Thanks. Good morning.

Greg Hayes

Hey, Joe.

Joe Nadol - J.P. Morgan

Could you speak a little bit more to our Pratt spares? I guess, first of all, on the mix versus the legacy 4000, 2000. And then just thinking about the year, the comps get a lot tougher starting this quarter and so do you expect to be up as we look and I know you are not going to give quarterly guidance for this one line item but maybe more on the profile?

Jay Malave

So let me start with some of the data points and orders. The PW4000 and V2500 were both up. The PW2000 was down. But if you recall in the fourth quarter, we had a significant amount of orders for the PW2000 for delivery in 2014. So the book-to-bill on 2000 was well above, around 1.5.

As far as going forward, it is really -- as far as what we see is, is really not much of a change in our expectations for mid-single digit growth for the year. As Greg mentioned during his remarks, traffic is still flowing well, airline profitability is still strong. We are seeing a little bit of higher content per shop visit as we start the year, but again these things change. So there will be no significant change to expectations for the full year at this point.

Joe Nadol - J.P. Morgan

Okay. And then just secondly, on Transicold, sales up nicely but orders down quite a bit, Baltic Dry Index was down, was down pretty significantly in Q1, so this is a pretty quick turn business. So when you think about profile, particularly margin profile for CCS for the rest of the year, how is this is going to have an impact?

Greg Hayes

Yeah. Clearly, I think we’ve got some headwind going into Q2 with CCS. I think container was down more than 50% in orders in the first quarter but again sales were up. And so to your point, it’s a very short cycle business. We still see the trend for refrigerator transport on a positive basis, up probably 3% to 4% this year. So it’s lumpy in the orders and I wouldn’t panic about the Transicold as they sit here in April. I think it was a year ago, we went six months without orders in the container business and then all of a sudden, it was gangbuster so. We should really focus on the longer term prospects. I think we are well positioned with great products as well as continue expanding markets.

Jay Malave

Joe, our expectations for the year are not overly aggressive. We are expecting for the total Transicold business to be up low to mid-single digit. So we are not banking on big growth in that business this year.

Joe Nadol - J.P. Morgan

Okay. If I might sneak just one more quick one in, Greg, you have $375 million of restructuring to offset now, plus what seems that it could be couple $100 million - I don’t know in a $100 million range plus of CMH charge, so could you give a little color on the gains that you are expecting to generate?

Greg Hayes

I wouldn’t go -- I would tell you this. We do see gains out there, adequate gains to cover what we think is the range of potential loss on the CMH. The good news of CMH is with this new contract, I think we get a big chunk of the acquisition cost behind us, change in the way we account for this going to a cost-to-cost basis. So it gets it behind us and we have the flexibility with some things that we’ve got in the pipeline to be able to cover most of that costs. So as I think about guidance, $665 million to $685 million, still very confident even with the CMH charge.

Joe Nadol - J.P. Morgan

Thanks.

Operator

Our next question comes from Jeff Sprague with Vertical Research. Your line is open.

Jeff Sprague - Vertical Research

Good morning, folks.

Greg Hayes

Good morning.

Jeff Sprague - Vertical Research

Just a couple of things. Just on resi HVAC in the U.S., just little peculiar that people would be stocking early, it seems that there is something going on there where stocks extraordinarily low and any other color you would shed on that?

Greg Hayes

Well, I think as we talked about most of last year, the dealer stock was relatively low on a historic basis. If you look at inventories today, it looks like they were up about 20% as we headed the first quarter, which is in line with of course 19% growth we saw in U.S. res business. Again, dealers are procuring for what they think is going to be a very strong summer season and despite these weather issues that we saw in the first quarter I think people are generally optimistic.

Housing starts were trending positively in over a million. And keep in mind that this is still an 80% add-on replacement business. Only 20% really goes to res and new construction. As the U.S. economy picks up, I think everybody has got confidence, we are going to see a very strong start to the season here. It’s early though, so I don’t want to get ahead of ourselves here. We still expect good growth but clearly not at that 19%, 20% that we saw in the first quarter.

Jeff Sprague - Vertical Research

And often it's kind of tough to really know what's going on with pricing this early in the season. But what do you see playing out on pricing, both in resi HVAC and in commercial HVAC this year?

Jay Malave

All right. The visibility that we have, Jeff, is little bit of benefit in pricing on residential side. I don’t have visibility on the commercial side but a little bit of an uptick that we saw in the quarter.

Jeff Sprague - Vertical Research

Okay. And then finally from me, I was just wondering if we could come back to Otis and service. Is service price also declining or your comments strictly around OE equipment? And I am wondering if you’re seeing any firming in service in Europe at all.

Jay Malave

Yes. Service is still tough in Europe. We are still seeing some price headwind, especially in the southern markets. I think service was down even in France this time. Again, it was offset, it was good in Germany, it was good in U.K., it was good in Russia. I think what’s most encouraging, as I think about Otis and service, we’ve been talking about this for several years, as we’re getting really good traction in China. Last year the service business in China was up about 20%. First quarter, it was up almost 20% in service. And last year, I think we added about 50 branches or depots for service. We’re going to add another 50 this year. We are getting traction there. I think again this issue of pricing in Europe, again we think it’s going to stabilize as we go throughout the year. We’ve seen signs of that, but the future of service for Otis is going to be in China. That’s where the growth is going to come and that’s where we are focused right now.

Jeff Sprague - Vertical Research

Thank you.

Operator

Our next question comes from David Strauss with UBS. Your line is open.

David Strauss - UBS

Good morning.

Greg Hayes

Good morning.

David Strauss - UBS

Back to Otis again, in terms of the phasing of the quarters as we go through the year, are you expecting it to continue to be all the EBIT growth to come into the second half and Q2 to be relatively flat year-over-year on an EBIT basis?

Greg Hayes

That’s probably right. You might get a little bit of growth here primarily -- again, as you think about where the cost reduction is going to come in the factories, or the cost reduction is going to come in terms of some of the integration activities that BIS is undertaking, we are seeing mostly cost on the front end and then you picked up the benefits on the back end.

David Strauss - UBS

Okay. Back to CMH, so, Greg, are you implying now that the contract -- new contract that we’re going to have here it’s going to be restructured to the point that you can actually charge off the entire loss that you were going to see with new deliveries, so we won’t have this $14 million per unit hit on a go-forward basis?

Greg Hayes

Let me try to explain this as simply as possibly. We’re going to go to a percentage of completion accounting or cost to cost. So we will write off about 70% to 75% of the acquisition cost, or the losses on the acquisition contract this year because we’re about 70% to 75%. There is some small tailwind in the next couple of years as we complete deliveries, but it’s not in the order of -- it’s nowhere near what we’re talking about before kind of it’s $120 million plus a year, it’s substantially lower.

On top of that, we will start to see the benefit of the ISS contract kick in ’15 and ’16 to offset some of the losses. So the goal here is to get most of the bad news behind us I think by adopting this accounting which we think is probably a more realistic look in terms of the way the contract has been restructured gives us the opportunity to do that.

David Strauss - UBS

And just as a last follow-up, what does this due to the Sikorsky guidance for the year, I think the flat EBIT number had baked into that $120 million loss?

Greg Hayes

Yes, obviously they had a $120 million baked in and we run through the segment results. So whatever the charges there, the gains aren’t coming at Sikorsky, but the cost certainly will. So as you think about Sikorsky guidance that we’ve given, it is next CMHP, except for the $120 million that’s baked into the forecast.

David Strauss - UBS

Thank you.

Greg Hayes

Thanks, David.

Operator

Our next question comes from Howard Rubel with Jefferies. Your line is open.

Howard Rubel - Jefferies

Thank you. Actually I want to follow a little bit more with respect to what David said. I mean, Greg, if I understand, you have built almost all the helicopters already. So the charge should be -- I don't know if $350 million, $400 million the way to think about it when you affect this accounting?

Greg Hayes

Yes, I am not going to get into the exact number. The reason is, as I mentioned earlier on, we renegotiated say the scope of the aircraft. So the aircraft will be more expensive because of the increased requirements and the spec changes that we are making. We’ve got some retrofit cost and all of them previously contemplated. So the total cost for the aircraft is going to go up. And as I said, we are 70%, 75% done with the total acquisition contract. So it’s a good trade here. I think we are pretty confident that we’ve got the wherewithal to recover this.

Howard Rubel - Jefferies

I mean forever today, I have been hoping that. I mean, because when you look on the balance sheet, it's over $800 million of sort of capitalized costs, if I'm not mistaken, related to this contract at the moment.

Greg Hayes

Yes, actually over a $1 billion but who is counting. I mean, I guess, but keep in mind, so we are still negotiating with the customer on this contract. We are not done yet. So we got to finish the contract negotiation which should be in a couple of weeks. We’ve got to go through that and do a bottoms up estimated complete for the whole contract. I think when Louis stands up at EPG by the end of May, we should be in a pretty good position to give you guys a number. And clearly if it happens after that, we will let everybody know as soon as we do what the impact is there.

Howard Rubel - Jefferies

I appreciate. That’s a big help. The other thing that’s important has been that you have been working a lower cost in lot of the other businesses. Could you address some of the actions that UTA has done to drive out its cost? I mean, clearly, there were some profitability related to pension and spares, but you are also trying to lower the recurring cost of what you are doing to become even more competitive?

Greg Hayes

UTA, I think you are referring to UT Aerospace Systems as opposed to UT Automotive?

Howard Rubel - Jefferies

You and I have been around too long.

Greg Hayes

Yes, I think so. There is a couple of things I think you mentioned. We’ve got some good news out of pension in the first quarter. We continue to get good news out of cost reduction on the products. We are coming down the learning curve on the 787. I think we are up to 10 ships sets a months on 787. So driving cost down there. Also, we continue with some of the synergy savings. We are going to get about $100 million of incremental synergy savings during the course of the year, but there is probably $25 million sitting in the first quarter. So all those things that Alain and Dave Gitlin and Mike Dumais talked about month ago are all coming to fruition, really good margin expansion. Obviously, the pension was a little bit of a one-timer, we got a benefit here in the first quarter, but still on your line a good solid cost reduction, good execution across the aerospace systems business.

Howard Rubel - Jefferies

And then lastly I noticed you had about $100 million of divestitures or proceeds from divestitures, can you characterize them a little bit, and are there some other businesses that continue to keeping the call busy?

Greg Hayes

I think actually these were keeping us a really busy because primarily this was -- I think, yes, this is part of the whole portfolio rationalization that Geraud has been talking about for the last three to four years and nothing big on the horizon, a couple of small fire and security related businesses, but nothing significant. I think there was a guarding business as well that was divested in the Far East, but there are really nothing terribly significant.

Howard Rubel - Jefferies

Thank you very much.

Greg Hayes

Thanks, Howard.

Operator

Our next question comes from Sam Pearlstein with Wells Fargo. Your line is open.

Sam Pearlstein - Wells Fargo

Good morning.

Greg Hayes

Good morning, Sam.

Sam Pearlstein - Wells Fargo

Greg, you mentioned that the majority of the gains are going to be coming in the second quarter. I know you don’t typically like to give any sort of the quarterly run rate, but how should we be thinking about the size of the gains that are going to exceed the restructuring in the second quarter?

Greg Hayes

While we talked about $375 million of gains for the year to offset the restructuring, all $375 million will come in the second quarter as it relates to the piece that is covering the restructuring. As far as the gains to cover the Sikorsky charge, there will be a little bit in the second quarter, and then some in the third and fourth.

Sam Pearlstein - Wells Fargo

Okay. And then just going back to some of the comments around the Europe, I think the building and industrial systems being up 3%, you’ve guided Europe to being up slightly. And so I am trying to just think you just talked about Otis service really hasn’t improved. So where is that improvement and at what point are you prepared to talk about Europe, perhaps being a little bit better this year than you’ve had in the outlook?

Greg Hayes

Probably in December. I think Europe has been better. Again, we have seen strength in Northern Europe on the new equipment side. I think I mentioned on the service side as well. So a good order traction in Northern Europe. Southern Europe remains a concern. I think orders were down in Spain, Greece, Italy. So again, it’s this balance, but I think generally we’re looking consumer sentiment, it’s up across the continent, unemployment remains high, but things are getting better. I just don’t want to declare victory. I think right now first quarter positive signs. We look at auto sales are starting to pick up. Interest rates remain very low. All of those indicators are there that we should see a recovery. So absent again something bad happened in Eastern Europe to upset the apple cart. I think we feel pretty good about the projections that we’ve got right now.

Sam Pearlstein - Wells Fargo

Okay. And one last question, the $660 million increase in inventory, you said it’s supporting sales growth later in the year. So when we look at the year end, should we expect inventories to be flat with where they were at the end of last year?

Greg Hayes

That is the plan, Sam. I think Inventory was up a little bit, I think the issue will probably be at Sikorsky on the CMH program and continue to add, Pratt’s starting to add inventory as they start to ramp up for production on C-series on the A320neo. So it would be a little bit of inventory growth, but the growth that you saw in the first quarter although was across all the businesses, you should see most of that start to come back in the cash flow as we go through the year.

Sam Pearlstein - Wells Fargo

Okay, thank you.

Operator

Our next question comes from the Ron Epstein with Bank of America. Your line is open.

Ron Epstein - Bank of America

Good morning, Greg. Just maybe a follow-on to Howard’s question, how should we think about M&A? I mean, you hinted at the investor meeting up in Connecticut that you guys like bigger M&A/ How should we think about that over the next say 12 to 18 months? Is UTC contemplating doing something, I mean how do we think about it?

Greg Hayes

Well, in very simple terms, I would say I think there is no big deals this year as we sit here and however this is April, but thought of actually consummating a big deal this year is very unlikely. But we continue to look and I think there will some smaller deals less than probably $1 billion for the total year still, again primarily in the CCS side of the business or the BIS side. And then as we will continue to look for those opportunities of scale, we want to do things that fit into the core, but that will capitalize on the global scale.

We are going to continue to buy back shares this year as we have talked about, and if there is opportunity without an M&A, maybe we will take share buyback up again towards the end of the year. But right now, we are focused on this normal long-term goal, and pricing is very difficult on the M&A market today. We bought Goodrich back in 2011. Timing was very, very good. Interest rates remain low, but today prices are up as you know on in the equity side and everybody wants a 30% premium which makes these deals very, very difficult.

So we are going to continue to look for value, but I can tell you with underlying strength in the business we do organic growth, I am not in a hurry to spend the share or money at deals just to grow, we don’t need to buy growth. We will buy opportunistically, we will buy for value and we will buy on the core.

Ron Epstein - Bank of America

Okay, great. And then just second question, changing gears a little bit. When we think about the gear turbo fan, and you're starting to move into a period here with we are not too far away from the A320neo going into service. And how do you -- how are you guys going to recognize profitability on those engines, right? Because my understanding is you're selling with something like 80% of them was power by the hour contracts. So will it be different -- won't it be different than what we currently see with the V2500, or is that going to go?

Greg Hayes

Yes. Right now, again, it’s a little bit in a state of flux because I think there was a new revenue recognition standard coming out from the FASB in May that’s supposed to be due our last year which is going to cause us to re-look at how we recognize revenue. But as we state here today, we are going to continue to recognize revenue the way we always have to commercial engine business which is, as we ship an engine, we will recognize the revenue or we will recognize the loss on the engine when we ship. We don’t have the ability that Rolls-Royce does to smooth earnings over the life of a aftermarket and OE contract, where you can look at a 20-year aftermarket revenue stream and its normalized margins. That’s just not allowed under U.S. GAAP and it won’t be allowed under the new revenue recognition standard either. But once this new rev rec standard comes out, we will take a look at it. It’s not adopted till 2017 which is just coincident with the big ramp up that we are going to see in the GTF production. So we got time. We will take a look at it and see what the impact is. It will impact some of the other businesses because it will force us to go to percentage of completion of some of the military programs, some of the Black Hawk, but again, little early to worry about that.

Ron Epstein - Bank of America

Okay. And then if I can just sneak in one, quick one. It’s my understand in the quarter, your China orders, I notice were up 27% and in that, I mean, I think you guys have two big China orders. I mean if you were to exclude kind of two major orders out of China, how would we think about of that?.

Greg Hayes

That was about half of the growth came from infrastructure projects and not just those two, but broadly speaking, half was infrastructure , half was on the property side.

Ron Epstein - Bank of America

Okay. Okay. Great. Thanks a lot.

Greg Hayes

Okay, Ron. Thanks.

Operator

Our next question comes from Robert Stallard with Royal Bank of Canada. Your line is open.

Robert Stallard - Royal Bank of Canada

Thanks so much. Good morning.

Greg Hayes

Hey, Rob.

Robert Stallard - Royal Bank of Canada

Greg, just a quick aftermarket question, should we read anything into the slowdown in new order growth in the first quarter is that just the normal timing ahead of the price increase?

Greg Hayes

Yeah. The first quarter is typically the slowest quarter for order growth as you mentioned we increased prices of catalogue prices. January 1, catalogue is published I think October 1. So, yeah, we saw big ramp up in fourth quarter orders across the aero business. So first quarter I think we feel pretty good about it.

Again, this is all driven continued RPM growth, where, I mean, the airlines are flying the aeroplanes, the airlines are making money and they are bringing the engines back to be repaired and we are seeing actually, I think the most encouraging thing is content per shop as they are starting to trend more positively.

So I think it all feels pretty good and look, we don’t expect this trend, we are not going to grow 16%, this for the rest of year, but we still feel very confident of the guidance for spares for the year.

Robert Stallard - Royal Bank of Canada

And then, secondly, on the share buyback, you are also trending ahead of that overall annual amount Q1, you said you are going to see the same in Q2? Is there any sort of strategy behind this or is it just availability of cash?

Greg Hayes

Either early. I think the key of course is, quickly you buy the shares back, the better this average share count is for the year and we got the cash sitting here we took advantage of that, we bought back most of these shares early in the first quarter. We are buying back shares through 10b-5 program today in the marketplace and that we will probably do that again in the third quarter, trying to get ahead of this.

And then if we get to the fourth quarter, where we will probably spend all the share buyback by the end of the third, if cash looks good and there is no other big M&A opportunities out there we will probably take share buyback up again just like we did last year. I am talking a big number but a little bit.

Robert Stallard - Royal Bank of Canada

Okay. Thanks so much.

Operator

Our next question comes from Cai von Rumohr with Cowen and Company. Your line is open.

Cai von Rumohr - Cowen and Company

Yes. Thanks so much. So follow-up on CMH, so, Greg, was the total expected loss higher than it had been before as a result of the new contract?

Greg Hayes

As I said, Cai, the total cost of the aircraft is going to go up and you’ve got new specifications from the customer, a little bit higher retrofit cost and the program is going to last a little bit longer the acquisition. So it will go up and again, I am not prepared to tell you exactly how much because quite frankly we are not done negotiations. I just know as I sit here today is going to be higher and I think we will clarify all that.

Cai von Rumohr - Cowen and Company

Okay. Right. But so before kind of its look like roughly 335 if we kind of do the rollout and for contract of this size, I mean, it kind of sounds like this total number could be in the area of $500 million to $600 million and if the quarter of it is still in front of us, is it unfair to assume that we have got another 100, 150 something in that order of magnitude in front of us in ’15 and ’16?

Greg Hayes

Hey, Cai, you get way ahead of me here. Look until we get the contract actually negotiated and until we know what the total contract value is going to be both the aftermath and the OE all the trades are made, before we get the EAC done, I really can’t comment, all I know is the aircraft is going to be more expensive, as I said, we are 70% to 75% done, again depending upon what this retrofit look like. So I am going to say out of the math work today and I will let my boss do that for you hopefully in May.

Cai von Rumohr - Cowen and Company

Okay. And then just back maybe to the principal, so we basically split those into two contracts, which is kind of equipment and then aftermarket support, so that the aftermarket support portion of this should be profitable? Is that the right way to think of it?

Greg Hayes

That has always been the case, Cai. I think we have already said, money in this contract at least for the last five years, it has been the aftermarket contract that provided the shield if you will for the losses on the OE and that's not going to change.

Cai von Rumohr - Cowen and Company

Okay. And then the last one, the GTF with kind of the slip on the C-Series, how many units are we looking for this year? And give us some color on the expected build in unit production, maybe in ‘15 and ‘16?

Greg Hayes

You talking delivery this year, Cai?

Cai von Rumohr - Cowen and Company

Yes.

Greg Hayes

Yeah, you talking small numbers, you probably in the range of less than 10 shipments this year, its small numbers.

Cai von Rumohr - Cowen and Company

And how does that build in ‘15 and ‘16?

Greg Hayes

Though mentioned -- I'm going to say, if you think about the run rate production is somewhere between 36 and 48 aircraft a year and build over the next several years. Again I think originally planned about 20 aircraft this year or 20 deliveries this year. It will build next year but I got to tell you the real ramp will be starting at the end of the next year on the Neo, whereby 2017 will be delivered 500 plus engines a year. So C-Series is our very important customer but the volumes are going to be very small compared to what we’re going to see on the Neo.

Cai von Rumohr - Cowen and Company

Terrific. Thanks so much.

Greg Hayes

Thank you, Cai

Operator

Our next question comes from Doug Harned with Sanford Bernstein. Your line is open.

Doug Harned - Sanford Bernstein

Hi, good morning.

Greg Hayes

Hi Doug.

Doug Harned - Sanford Bernstein

At CC&S, you had $43 million in restructuring costs in the quarter. And that's higher than we've seen in some time. What's the focus of the restructuring at CC&S and what should we expect to see over the course of the year?

Greg Hayes

The biggest piece of the restructuring for the quarter was actually factor that we had outside of Milan called Villasante where we made commercial -- I’m trying to think what’s the right word for it, (indiscernible). And again, we’ve been downsizing that facility for a number of years. We finally, in the fourth quarter -- first quarter here agreed with the Works Council there on a plan to close that facility. Again that was a relatively large portion of the charge with some other headcount related actions and some smaller things around the globe but Villasante is probably the biggest piece of the restructuring in the first quarter.

Doug Harned - Sanford Bernstein

So they’re going on later in the year, we shouldn’t see that level, I assume?

Greg Hayes

There will be additional restructuring across the CCS. Again I think the most of the factory actions, I think are done. I think what you going to see is more VIS integration related activities as we closed offices and consolidate some of the facilities around the globe. And again, most of that would be Otis but some will leak into the CCS segment as well.

Doug Harned - Sanford Bernstein

Okay. And then at UTAS, you said that E&D was higher in the quarter and what’s driving the increase right now? And how do you look at the E&D trajectory going-forward for UTAS?

Greg Hayes

Yeah. It was higher but we’re talking to small number less than $10 million of growth in E&D for the quarter. Really, if you think about everything that’s on the plate at UTAS, you got obviously the A350, the C-Series, the Neo, the 777X now. I mean, all of these new programs are driving their requirements, thus 787-9 with the -10 coming up. There’s all sorts of fun things to do there and they all are spread a little bit higher engineering expense. So engineering, we think it’s more fun loaded, we think for the full year total across the all businesses will be relatively flat but little bit higher here in the first half.

Doug Harned - Sanford Bernstein

So you’re not looking at a -- sort of as you take the 787-8 up, I mean there’s enough work on 787-9 and 787-10 that we shouldn’t see this come down very quickly over the next 12 months to 18 months, is that fair?

Greg Hayes

I think the pipeline is pretty full at aeropace -- I mean both at the Pratt & Whitney ate the Aerospace Systems Group. I think the engineering pipe is pretty full. Remember we’re going to get done with the C-Series this year, entering into revenue service, hopefully towards the end of the year or early next year. And you’ve got the Neo, you’ve the got the Mitsubishi regional jet, you got Irkut up there and then you got the Embraer airplane coming after that. So engineering spending, it will come down gradually perhaps, as all these aircraft could certify same kind of profile which you’re going to see at the aerospace systems business.

Doug Harned - Sanford Bernstein

Okay. Great. Thank you.

Greg Hayes

Okay.

Operator

Our next question comes from Shannon O’Callaghan with Nomura. Your line is open.

Shannon O’Callaghan - Nomura

Morning guys.

Greg Hayes

Good morning.

Shannon O’Callaghan - Nomura

Hey, Greg. Just maybe a little more on this disconnect between Otis and commercial HVAC in North America. I mean, up 39% on Otis, down 4% on commercial. I mean I hear your point about the retrofit but that's still a pretty big difference. I mean, is there anything else you see going on in terms of the lag in the market or I know you were coming out with some new applied products; is there anything going on there? It just seems like probably even adjusting for this retrofit point, you made a little bit of a wider gap than you would think?

Greg Hayes

Yeah. I think, we continue to have -- see really good traction of the late commercial roof tops. I think again where we are lagging or we have lagged for number of years is on the implied side. To your point, we have new products in the pipeline, new products coming out that we think we’ll address this as we go through the year, that’s why we’re confident as we begin. The sales will pick up on the commercial business as we move through the year, as we get these new products out there but clearly the issue has been on the applied. This is not a new phenomenon. The small rooftops continue to be very good business for us, good share but little bit behind on the applied side.

Shannon O’Callaghan - Nomura

Okay. And then just following up on your point on China service really being the story for Otis going forward, did you have to take any more additional actions there to kind of gain critical mass? And have you seen any meaningful shift in the willingness to pay OEs to do this service?

Greg Hayes

Well, I think this is about investing for the future. I mean, you got to continue to add service technicians. You’ve got to continue to add infrastructure, offices and depots. Yeah, Otis has been making investments for the last two years now. There had a couple of thousands people into the service, little workforce over there. This will just take time. You also have to remember the way we go to market there and China is a little bit different because our biggest business was with Sheitzo.

As we go through agents and we don’t get the same attachment rate or conversion rate there, we are working with the agents to make sure that we can capture more of that service revenue and find a win-win with the agents to capture that going forward. So, I think we’re getting good traction. It’s going to be investment for us for a number of years. But the margins will continue to improve as we get better route density and as we expand the footprint there in China.

Shannon O’Callaghan - Nomura

Okay. Thanks guys.

Operator

Our final question comes from Myles Walton from Deutsche Bank. Your line is open.

Myles Walton - Deutsche Bank

Thanks. Good morning guys.

Greg Hayes

Hey, Myles.

Myles Walton - Deutsche Bank

Maybe one quick clarification on CMH. Just for 2015, as you look at it in isolation by everybody that built in a loss on the delivery of a set of aircraft, is your baseline assumption now that we are in a better position or worse position or neutral position to that, Greg?

Greg Hayes

I don’t think we’re in a worse position, but I really can't tell you exactly where we are. I think, again, the idea here is to get a big chunk of the cost behind us this year to eliminate most of the headwind but I’m just -- I’m very reluctant Myles to go out there until we get this thing negotiated to give you a final number.

Myles Walton - Deutsche Bank

Okay. And then the other clarification or maybe color I wanted was on the F-35, those fan failure and the fix that's ongoing. How is that affecting your deliveries or progress, your recognition on the contracts? And where is the kind of the escape trajectory from here?

Greg Hayes

Yeah. I think, we’re on track with the F-135 engines. We had good deliveries in the first quarter. We continue to come down the cost curve. There was an issue on test stand. We talked about that. And I think, again, we understand the root cause, we are working on all that. So again these things happen. There was an engine that was a long cycle endurance. And we are clearly on track with the development of the technical aspects of that engine. It’s fixed.

Myles Walton - Deutsche Bank

Okay. Great. Thanks.

Greg Hayes

Okay. Thanks, Myles. All right. So with that, let me just wrap up and first of all, I wanted just to maybe a little housekeeping here. And first of all, welcome Casey Forrest to the IR Team. Casey is joining us from Financial Planning Groups. Casey will be on the phone with you guys later today.

I want to thank Josh Banis for his three and a half years of service to the IR Group here. He has done a great job. Many of you know him. I hope you wish him well. He's off to get a real job as a CFO of our Actuation and Prop business over in the U.K. So, wish he and his family well. So with that, thanks very much for listening and look forward to hearing from you guys today. Thanks very much.

Operator

Ladies and gentlemen, that does conclude today's conference. You may all disconnect and everyone have a great day.

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