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United Technologies Corp. (NYSE:UTX)

Q2 2014 Earnings Conference Call

July 22, 2014 9:00 am ET

Executives

Gregory Hayes – Senior Vice President, Chief Financial Officer

Jay Malave – Director, Investor Relations

Analysts

Jeff Sprague – Vertical Research

Joe Nadol – JP Morgan

Julian Mitchell – Credit Suisse

Doug Harned – Sanford Bernstein

Peter Arment – Sterne Agee

Robert Stallard – RBC Capital Markets

Cai Von Rumohr – Cowen & Co.

Howard Rubel – Jefferies

Ron Epstein – Bank of America Merrill Lynch

Noah Poponak – Goldman Sachs

Deane Dray – Citi Research

Carter Copeland – Barclays

David Strauss – UBS

Myles Walton – Deutsche Bank

George Shapiro – Shapiro Research

Operator

Good morning and welcome to the United Technologies Second Quarter conference call. On the call today are Greg Hayes, Senior Vice President and Chief Financial Officer; 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 permits.

Please go ahead, Mr. Hayes.

Gregory Hayes

Okay, thanks Kevin, and good morning everyone. As you saw in the press release today, UTC reported second quarter earnings per share of $1.84. That’s up 12% excluding the impact of restructuring and one-time items. Adjusted segment operating margins expanded by 90 basis points to 17.1% in the quarter. That concludes a solid first half with 4% organic sales growth and earnings per share up 11%, excluding the impact of restructuring and one-time items. All that gives us confidence to increase the bottom end of our EPS range, so we now expect 2014 earnings per share of $6.75 to $6.85 – that’s growth of 9 to 10% versus our previous guidance of $6.65 to $6.85.

Okay, turning to Slide 2, organic sales – organic sales grew 3% in the quarter, led by strong growth at aerospace systems and Otis. In the commercial businesses, we saw 3% growth in the Americas led by 15% growth in Otis. In Europe where the economic recovery remains tepid, organic sales were down 1% in the quarter; however, Asia saw 5% growth. In China specifically, commercial sales grew by 10% led by Otis, which was up 15%.

Looking at aerospace, continued weakness in defense where sales were down 4% was more than offset by strong growth in commercial OE and the aftermarket, where overall sales increased 7%.

Moving to Slide 3, order trends – overall trends remain positive for a majority of our portfolio; and just a reminder, we’ll talk to the commercial businesses on a constant currency basis, as we usually do. In our commercial businesses, we continue to see traction in North America. U.S. consumer confidence hit a six-year high in June, and the outlook for commercial construction remains encouraging. ABI trends are positive and we continue to see that coming through in our orders at Otis, where North American new equipment orders were up 44%. Commercial HVAC orders were up 3% in the quarter. North American residential HVAC orders were down slightly versus last year, and you’ll recall we had a very strong first quarter as distributors ordered ahead of the summer cooling season; but residential orders year-to-date are essentially in line with our expectations for the year.

In Europe, as I said before, the economic recovery remains slow. Euro zone PMI and economic sentiment eased some in June on concerns over rising oil prices and the situations in the Middle East and Ukraine, but both indicators remain in positive territory and growth is expected to pick up in the second half. We saw that reflected in UTC’s order rates in the region. Otis’ new equipment orders were up 10% led by strong growth in eastern Europe, where orders were up more than 20%, while in developed Europe orders grew at a 4% rate. CCS fire and security product orders grew 18% and commercial refrigeration orders were up 5%, and commercial HVAC grew at 2%.

In China, as you know, the government has recently stepped up spending on infrastructure projects and eased banks’ reserve requirements to shore up growth. In the second quarter, orders for CCS commercial HVAC were up 7% and fire products were up 10%. Otis new equipment orders were flat on a tough compare from last year. You’ll recall that last year, Otis saw orders up 39% in China in the second quarter partly due to a large order for the Goldin Finance 117 Tower in Tianjin. China new equipment backlog is up 20% versus the prior year, and on a unit basis new equipment orders were up 12% in the quarter, so our building and industrial systems businesses continue to be well positioned as we head into the back half of the year.

Moving to aerospace, with airline profits projected to be almost $18 billion this year and ongoing growth in air traffic, we continue to see solid conversion of new equipment backlogs and growth in our commercial aftermarket businesses. At Pratt & Whitney, commercial spares orders were down 6% due in part to a strong first quarter. Total large commercial engine aftermarket sales were up 10% in the quarter on the back of a continued trend of heavy overhauls going through our shops, and this continues to support our expectations for full-year aftermarket growth of about 5%.

At UTC Aerospace Systems, commercial spares orders were up 28% driven primarily by strength in provisioning. While some uncertainty still exists in the global economic outlook, order rates and macroeconomic trends continue to support our assumptions for organic growth of about 4% for the full year.

On Slide 4, taking a closer look at the second quarter, total reported sales increased 7% as 3% organic growth and the $830 million cumulative sales adjustment for the Canadian Maritime program were partially offset by net headwinds from net divestitures. Segment operating profit grew 8% and operating margins increased by 90 basis points, including the benefit from pension. CCS saw the benefit of restructuring and product cost reduction initiatives where operating profit grew 9%, leading to margin expansion of 210 basis points. Pratt & Whitney and Aerospace Systems expanded margins by 150 and 70 basis points respectively, each on the benefits from cost reduction actions and lower pension expense.

Earnings per share in the quarter were $1.84 – that’s up 8%. Restructuring costs and other one-time items, which include the CMHP charge in the quarter, were fully offset by favorable tax-related items. You’ll recall the second quarter of 2013 had $0.05 of net gains. Absent the impact of the prior year net gains, earnings per share were up 12%.

Free cash flow in the quarter was 80% of net income. Capital expenditures were $406 million – that’s up 10% versus last year as we continue to invest for the ramp-up in commercial aero, and working capital grew by more than $400 million in the quarter. We acquired $335 million of our stock under our share repurchase programs, and we expect to buy back a similar amount in the third quarter.

Let me stop there for now. I’ll be back to talk more about full-year, but first let me turn it over to Jay to take you through the business unit results.

Jay Malave

Thanks, Greg. Turning to Page 5, Otis sales improved 7% in the quarter with new equipment sales up mid teens, including solid growth from all areas, most notably in China, the Americas, and the Middle East. Service sales were up slightly. Operating profit was up 3% constant currency. Strong new equipment volume, most notably in Asia and the Americas, drove the increase in operating profit moderated by continued pricing pressure. New equipment orders were up 3% with double-digit growth in the Americas and Europe. As Greg mentioned earlier, orders in China were flat for the quarter against a tough compare to last year, which included the Goldin Finance 117 in Tianjin project. While new equipment activity in China is normalizing to levels in line with our expectations for the year, we were encouraged in the quarter with solid growth in new equipment unit bookings. Based on year-to-date trends, we now expect operating profit for the full year to increase $100 million to $125 million from a prior expectation of $100 million to $150 million on mid-single digit sales growth. Otis expects to see improving performance in the second half from strong new equipment sales growth and continued improvement in factory performance in North America.

On Slide 6, Climate Controls and Security increased profit 9% in the quarter on 3% lower sales, resulting in margin expansion of 210 basis points to 19%. Organic sales were down 1% with mixed results across regions. Organic sales in Asia were down low single digits, including slower backlog conversions in the commercial HVAC business, Transicold was flattish, and Europe was up slightly. U.S. residential HVAC was flat for the quarter following a solid first quarter which included the benefit of early distributor stocking. For the first half, the residential HVAC business reported high single digit sales growth, in line with the full-year expectation.

Profit growth in the quarter was driven by restructuring and integration savings, lower commodity costs, as well as continuing product cost reduction effort. Equipment orders were up 2% with global commercial HVAC equipment up low single digits, led by China. Orders for global fire and security products were up mid-single digits, more than offsetting the decline in the fire and security field businesses. Transicold equipment orders were up mid-single digits. Based on first half results, we continue to expect profit growth of $225 million to $250 million for the full year at CCS, now on low single-digit organic sales growth from our previous expectation of mid-single digit.

Turning to aerospace on Slide 7, at Pratt & Whitney operating profit was up 11% on 1% lower sales, resulting in margin expansion of 150 basis points. Organic sales were up 1% as 10% growth in large commercial aftermarket more than offset declines in commercial OE and military. The operating profit growth was mainly driven by lower pension costs and restructuring savings, and the absence of last year’s contract closeout benefit was partially offset by a gain on the sale of product line this quarter. For the full year, we continue to expect Pratt & Whitney’s operating profit to be up $175 million to $200 million on low single-digit sales growth.

UTC Aerospace Systems delivered another solid quarter with 14% operating profit growth on 9% higher sales. Sales growth was driven by higher commercial OE and aftermarket volume up a combined 16%, partially offset by a low single-digit decline in military sales. Year-on-year profit growth was driven by higher commercial aftermarket volume, the favorable impact from a customer contract settlement, continued synergy traction and pension tailwind partially offset by higher engineering spend on new OE programs. Operating margins increased 70 basis points to 16.7%.

Orders for commercial spares grew 28% on a year-over-year basis led by strength in provisioning. Commercial spares in the first half of the year are up 18% on a year-over-year basis with year-to-date book-to-build just north of 1.0. 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 9, operating profit decreased by 10% on 1% lower sales. During the quarter, Sikorsky shipped a total of 63 aircraft, including 46 based on military platforms and 17 commercial. The sales decrease was driven by lower U.S. government, OE and aftermarket volumes partially offset by higher international military and commercial OE sales. On profit, the headwinds from net unfavorable contract performance adjustments primarily in the military business more than offset benefits from restructuring, pension, and other cost reduction actions.

During the second quarter, Sikorsky was awarded two significant contracts for the development of the VXX Marine 1 replacement aircraft for the U.S. Navy and a combat search-and-rescue helicopter for the U.S. Air Force. These contracts in total exceed $2.5 billion with follow-on production orders expected to exceed $10 billion. Based on the CMHP contract amendments and other contract performance adjustments as well as aftermarket trends through the first half, we now expect higher year-over-year operating profit of about $25 million on low single-digit sales growth from a prior expectation of flattish profit on high single-digit sales growth.

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

Gregory Hayes

Okay, thanks Jay. So overall, another solid quarter for UTC and we continue to achieve important program milestones and secure key wins for the future. Some highlights in the quarter: we announced several significant wins at the Farnborough Air Show last week. At Pratt & Whitney, we continue to see strong demand for the GTF engine across platforms, including recent wins on the A320 Neo, C-series, Embraer E2, and MRJ. Customers clearly see the advantage of the GTF product and have placed firm and option orders for 6,000 engines. In May, Pratt delivered the first chipset of geared turbofan engines to Airbus and is ready to support the first flight of the Neo later this year.

As you’ve no doubt heard, we’ve had a couple of engine-related development issues in the quarter. While certainly disappointing, these things do happen in development programs, which is why we put the engines through such a rigorous test process. The good news is that the issues are unrelated and in the big picture, the fixes will be relatively minor. We’re pleased that the Pentagon has approved the JSF for resumed flying on a limited basis. The F135 engine has accumulated more than 26,000 ground and flight test hours, but we continue to learn and develop the technology to provide our customers with the capability and reliability they require. On the C-series, we understand the root cause of the incident and we’re working closely with Bombardier to resume flight testing as soon as possible. The fundamental architecture of the geared turbofan engine remains sound, and with nearly 10,000 hours of ground and flight testing it’s the most mature of the new generation of advanced commercial engines entering the market. With significant testing behind us, we look forward to bringing the GTF engine family into service in 2015.

Also in the quarter on the Aerospace Systems segment, we were selected to provide wheels and carbon brakes for both the Boeing 737 Max and the Airbus A320 Neo platform. They also secured new long-term MRO contracts from several airlines and they celebrated the delivery of the 10,000th Boeing 737 nacelle.

At Sikorsky, they were selected on two key U.S. DoD programs in the quarter. It was awarded the engineering and manufacturing development contracts to build the next generation Marine 1 Presidential helicopter and to develop new combat search-and-rescue helicopters for the U.S. Air Force. Combined, these two programs represent over $12 billion of future sales opportunity. On the commercial side, the Civilian Aviation Administration of China recently issued a type certificate for the S76B, which allows Sikorsky to begin delivering the helicopter to customers in China. We’re also pleased that Sikorsky and the Canadian government concluded contract amendments in the second quarter which define a final configuration for the CMH aircraft and a phased delivery schedule allowing for the retirement of Canadian Sea King helicopters beginning next year.

We recorded sales of $830 million and a charge of $438 million in the quarter, reflecting the cumulative effect of progress to date towards completion of the modified program. This puts the CMHP OE losses largely behind us. Under percentage of completion accounting, we will have some small charges as we progress on the program, but they are manageable within the Sikorsky numbers going forward.

The building and industrial systems businesses had a solid second quarter with a combined 7% profit growth. Integration activities continue to progress well with Otis and CCS teams finding a way to serve our customers more efficiently. A recent example of this was in Hong Kong where UTC Building and Industrial Systems was selected to provide building systems for the i-Square shopping and entertainment complex. This project will include intelligent building management systems, chiller plant optimization, and remote monitoring. i-Square is also equipped with Otis escalators.

So each of the businesses is well positioned in our core markets and we’re delivering real value to our customers and securing key orders that will drive top line growth well into the future.

Taking a look at the rest of the year, not much really changed from the last time we spoke. As you know, the compares get tougher as we move through the year, but first half order rates and end market trends continue to be broadly in line with our expectations, and we’re confident in the revised guidance range of $6.75 to $6.85 with a path towards the higher end on sales of about $65 billion, up from our prior expectation of about $64 billion primarily on the Q2 CMHP sales adjustment. We now expect quarterly earnings per share growth of about 7% to 10% in the last two quarters of the year, absent the impact of gains and restructuring.

On restructuring, we’re investing about $375 million for the year and we spent $180 million in the first half, so you can expect to see about $100 million of restructuring spend in each of the next two quarters. As we committed, we expect the restructuring and one-time charges, including the second quarter CMHP charge, will be offset by gains during the course of the year. We also continue to anticipate pay down of about a billion dollars this year, and we now expect share repurchase of $1.25 billion for the year – that’s an increase of $250 million from our prior expectations. On the M&A side, we expect spend will now be a little bit less than a billion dollars.

As you know, at UTC we typically deliver free cash flow greater than or equal to net income. Through the first half, free cash flow is 81% of net income and cash flow is generally stronger in the second half; but as I sit here today, I think 90% to 100% for 2014 is more realistic based on the continued investments we’re making on the aerospace side to deal with the aerospace cycle. Looking forward, we remain focused on growth and execution in 2014. We’re well positioned in our segments and will continue to capitalize on our industry-leading franchises and global scale. The UTC portfolio is poised to take advantage of the commercial aerospace growth and urbanization megatrends over the next decade.

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

Question and Answer Session

Operator

[Operator instructions]

Our first question comes from Jeff Sprague with Vertical Research

Jeff Sprague – Vertical Research

Morning everyone. Greg, I was wondering if you could address a little bit cash flow into next year, at least at a high level. Obviously the working capital burden may remain heavy, but you still feel that you’re at kind of a peak level for capex, and how might those items trend in the next year?

Gregory Hayes

Yeah, I think as we’ve said before, Jeff, I think capex definitely peaks this year just shy of $2 billion – that’s up from about $1.7 billion last year, and then next year we’ll see that come down $200 million, $300 million again as the ramp, or the facilitization for the ramp is pretty much complete by next year. Again, we’re going to start delivering these engines at the end of next year and we have to be ready, so the money is going out now. It’s part of the working capital build as well. We’ll continue to target 100% of free cash flow to net income both this year and next year. I think we’re just acknowledging now that it’s going to be really difficult to do it this year, just given the big capex ramp and the working capital ramp associated with the GTF launch.

Jeff Sprague – Vertical Research

I was wondering if you could provide a little more color on U.S. commercial HVAC trends, both around the applied and unitary markets.

Jay Malave

Jeff, total commercial HVAC orders were up low single digits. The applied was actually up higher, mid to high single digits, and the light commercial was up a little bit, low single digits.

Jeff Sprague – Vertical Research

Those are order numbers, or--?

Jay Malave

Those are orders.

Jeff Sprague – Vertical Research

And do you have sales?

Jay Malave

Sales – I do not have sales in front of me. I’ll have to get back to you on that, Jeff.

Jeff Sprague – Vertical Research

Great, thanks. I’ll pass the floor.

Operator

Our next question comes from Joe Nadol with JP Morgan.

Joe Nadol – JP Morgan

Thanks, good morning. On the UTAS spare side, obviously some pretty good numbers, and I know it’s provisioning but does that give you more confidence in your profit guidance for the year for UTAS, or how is all that flowing through?

Gregory Hayes

There’s a lot of elements to the profit growth at the Aerospace Systems group in the back of the year. There’s a big chunk of synergies coming through. Obviously the aftermarket is supportive of the guidance. Clearly it’s a big number for UTAS, and back half is going to be big; but generally, I think we’ve guided to about high single digits, I think Jay, for Aerospace Systems aftermarket growth. This is obviously a little bit better than that, so yeah, I think it all just goes through the back half of the year and everything should be pretty much in line.

Joe Nadol – JP Morgan

Okay, and then over at CCS, you brought the mid-single digits down to low single digits for expected organic growth. Can you give some color on not in the quarter but just in terms of the guidance for the year which end markets that’s lower in?

Gregory Hayes

So first half of the year, organic growth at CCS was about 1%. Back half of the year, we’re expecting about 4%, so we’ve got a little bit of a hill here in the back half of the year. Again, still confident we’re going to hit that guidance number out there – 225 to 250 – even on the lower sales expectations.

I think generally things are in line with what we expected. Resi was a little soft in the second quarter, but that really just relates to the big pre-buy we saw in Q1, so I think it’s about up 9% year-to-date. We expect it to be up kind of high single digits in that range in the back half of the year as well. Order rates on the commercial HVAC has improved. Order rates at Transicold have pretty much stabilized; so again, I think all the pieces are in place to get to that 4% growth, and obviously there’s cost reduction initiatives and other things that give us confidence to hit that number. But generally speaking, I think (indiscernible) we’re pretty well on track to deliver that back half growth.

Joe Nadol – JP Morgan

Okay, thank you.

Operator

Our next question comes from Julian Mitchell with Credit Suisse.

Julian Mitchell – Credit Suisse

Thanks. If I look at the Pratt EBIT guidance for the year, I think it implies growth of about $120 million in the second half. You did about plus-70 in the first half, and I guess if you look at what’s gone on in Q2, you’ve had weaker commercial spares orders but also you mentioned maybe there might be some extra E&D needed for the engine fixes. So what gives you the confidence that you’ll see a big step up in year-on-year EBIT growth in Pratt in the second half?

Jay Malave

Well Julian, what we have—for the year for Pratt, a substantial part of their profit growth is restructuring savings, which is pretty much baked – a lot of that was taken last year – as well pension benefit. Again, that’s pretty much going to be reflected in their results. Aftermarket, as Greg said, is up 10% year-to-date. That will moderate a little bit in the back half.

The other piece of it is that we’ll actually get a little bit better performance out of the military business, a little bit lighter on shipments on the military engines, particularly in the JSF. We’ll see that ramp up in the second half of the year, and we’ll also get a little bit of lift out of Pratt & Whitney Canada, who is off to a pretty reasonable start year-to-date. So those two businesses will help offset some moderation, I’d say, in the large commercial aftermarket.

Gregory Hayes

Yes, I’d also just point out we’re in the process of definitizing the lot for LRIP 7 with the JSF, so there were a number of engines that could have or should have gone out the door here in the second quarter. There is more than 12 of them that will go out here in the third quarter, so you’re going to see a bump in military OE coming into the third quarter, which is going to help as well.

Julian Mitchell – Credit Suisse

Thanks. My follow-up is in BIS, your China sales in the first half were up about 12%, I think in total. What do you expect that second half revenue growth number to be?

Gregory Hayes

I think on Otis, what we’ve guided to is mid-teens – about 15%, which is exactly what we saw here in the second quarter. The CCS side, a little bit lighter than that, just a little less than 10% in the back half. And again, order rates as we look at the GST business and the other businesses, commercial HVAC, are all supportive of that back half.

Julian Mitchell – Credit Suisse

Great, thank you.

Operator

Our next question comes from Doug Harned with Sanford Bernstein.

Doug Harned – Sanford Bernstein

Morning. On Otis, what was it that lowered your guidance outlook for profit for the year? Has the outlook changed at all in terms of pricing or demand?

Gregory Hayes

It was small tweak – I think we took down the top end by about 25 million. We’ve grown earnings just under $30 million in the first half of the year. We saw a nice return to profitability, profitability growth in the second quarter, but it’s just the realization that we’re probably not going to get to the top end of the range. We continue to make investments in new products – I think we saw that when we were in China a couple of weeks ago. But you know, we’re going to get that factory transformation. It’s pretty well complete, you’re going to get some tailwind from that. It’s probably not going to get to the top end – in Europe, pricing is still a little choppy, and it’s just the realization that we’re more likely towards the middle of that range.

Doug Harned – Sanford Bernstein

Okay. Then on UTAS, when you look at how the 787 program is going, can you comment on progress there? And as you look forward, presumably the program will become a bigger contributor to UTAS margins. How should we think about the trajectory for the 787 in terms of profitability?

Gregory Hayes

Well clearly, 787, we’re still in a negative margin situation across all of 787. I think we talked last year, we mentioned we were losing about $3 million a ship set. That number is coming down significantly. Within, I think, 2015 or 2016, we’ll be close to a breakeven point on 787, so we are coming down the learning curve as we expected. Still a lot of work to do. Reliability is improving on the aircraft systems that are out there. We’re close to our contractual goals that we’ve got with the Boeing company, continuing to work with Boeing on product improvement opportunities. So the program is going well, and there’s really no surprises there.

Jay Malave

Yes, also Doug, we’ve got the Dash 9 coming on line here, too; and don’t forget, part of the growth and provisioning this quarter was on the back of 787, so you’re seeing nice profitability and provisioning, which helps offset at least a portion of the negative margin associated with the OE.

Doug Harned – Sanford Bernstein

And is the Dash 9 leading to some significant change activity for you in this that sort of pushes the trajectory back a little?

Gregory Hayes

No, it was a few of the systems that are different on the Dash 9 – the environmental controls, the ECS system was upgraded, but most of the other systems are the same so it’s actually helping in terms of the learning curve on the product.

Doug Harned – Sanford Bernstein

Okay, great. Thanks.

Operator

Our next question comes from Peter Arment with Sterne Agee.

Peter Arment – Sterne Agee

Yes, good morning, Greg. First, a clarification – on the GTF engine fix, I assume that’s applying out to all the models. Is that going to affect the certification timeline?

Gregory Hayes

No, in fact really this particular fix we think is just related to the C-series engine itself. Each of the architecture is a little bit different, and we have not seen a similar issue on any of the other models that are out there.

Peter Arment – Sterne Agee

Okay, and then just a quick one on Pratt & Whitney Canada, are you seeing any ready change regarding the lower end of the business jet market? Just—I think that’s 40% of your mix up there.

Gregory Hayes

No, it’s—I guess the best way to describe it is it’s still a little choppy. Deliveries are picking up a little bit, but there’s still a lot of used inventory out there. Orders have really not picked up. I think the best news there is flying hours have picked up a little bit, and as you know, most of that business is on power by the hour so we’re still seeing a decent cash inflow, but really not seeing a bit step change in terms of the growth of the market.

Peter Arment – Sterne Agee

Thank you.

Operator

Our next question comes from Robert Stallard with Royal Bank of Canada.

Robert Stallard – RBC Capital Markets

Good morning. Greg, I was wondering if you could kick off on China, on the orders trends you’ve seen there. Have you seen any shift in market share in your various products?

Gregory Hayes

Nothing dramatic, I would say. I think again, Otis has regained its—or is regaining, I guess I should say, the share that we had lost in previous years, which is really a trend that started last year, it’s continuing into this year, getting a little bit more traction on the commercial HVAC side, and GST continues to gain a little bit of share. But again, generally everything is improving about as we had expected in China there.

Robert Stallard – RBC Capital Markets

And secondly on the Aerospace Systems aftermarket, did you actually say what the aftermarket revenue growth was in the quarter? It would be helpful if you could spell out how much was provisioning.

Jay Malave

Total aftermarket revenue growth was up around 10% in the quarter. It was led by—again, spares were up low teens—spare sales were up low teens in the quarter.

Robert Stallard – RBC Capital Markets

And the amount that was provisioning?

Jay Malave

Provisioning sales – let’s see. Those—I have orders, Robert. I’ll have to get back to you on the sales element of provisioning versus parts.

Robert Stallard – RBC Capital Markets

Okay, but I imagine this could be quite lumpy, this provisioning.

Jay Malave

Yes.

Gregory Hayes

Provisioning is very lumpy, so that 28% growth that we saw here in Q2, don’t look for that to repeat. But again, it’s primarily 787 related, which is good news. A lot of airlines out there are taking new aircraft, which leads to all of this provisioning. The trend will continue, but just not at that 28% rate.

Robert Stallard – RBC Capital Markets

Great, thanks very much.

Operator

Our next question comes from Cai Von Rumohr with Cowen & Company.

Cai Von Rumohr – Cowen & Co.

So you had a flat compare in orders in Otis China against a very stiff compare, but if you look at the monthly data on residential housing prices, it looks like it’s rolling over. What’s your expectation for orders in the third and fourth quarter, and for growth in China Otis next year?

Gregory Hayes

I wish I had a crystal ball, Cai, to answer that question. Generally I think the thing to think about in the back half of the year is backlog, which is up about 20%, so we’re expecting about 15% sales growth. So we’ve got, I would say, the backlog to carry us through, at least through this year and even into next year. Orders have continued to be good. Last year, orders in the second quarter were up 39%, obviously on the back of that one large order, but when you take out the Tianjin 117 order last year, orders were up about 14 or 15% this year on an apples-to-apples basis, so the trends have remained positive in the business.

Back half of the year, is it going to slow? Probably. I think again, is it going to be somewhere between 5 and 10%? Perhaps. We’ve seen the Chinese economy is cooling a little bit, but we still expect growth of 7.5%. Residential prices, we know have been moderating and even coming down in some markets, and that’s a big piece of our business; but infrastructure has more than taken up the slack where we’re seeing the drop on the residential side.

Cai Von Rumohr – Cowen & Co.

Terrific. Then kind of getting back to spares, Boeing is saying they’re going to have about 16 to 18 new customer introductions this year and the same next year; and next year, we also have the A350 coming online, so maybe give us some color on the expectation for continuing vigor in provisioning – I mean, maybe not at 28% this year and next year.

Gregory Hayes

Look, that’s all baked into what we consider to be the guidance for this year, which was high single digits – you know, 9% kind of growth in the Aerospace Systems aftermarket. Clearly the introduction of the 787 to all these new customers is what’s driving the provisioning growth this quarter and will continue to drive it into next quarter, so it’s great that this plane is going to so many new customers. It really does support a lot more provisioning, although not everybody gets provisioning – some people go on our total care package, where we’re actually providing the spares for them.

But again, I think the trends that we’re seeing this year, there’s nothing out there that would tell me those trends should not continue into next year, but I think it’s a little early to start talking about ’15 guidance.

Cai Von Rumohr – Cowen & Co.

Thank you.

Operator

Our next question comes from Howard Rubel with Jefferies.

Howard Rubel – Jefferies

Greg, you’ve had a lot of restructuring items, and I appreciate some of the walk; but could you talk a little bit about tax rates for the second half of the year? I mean, we know a 16% rate in this quarter is not sustainable, and then I’ll have a follow up.

Gregory Hayes

Yeah, I would ignore the ETR – the effective tax rate – in this quarter because, again, all these one-time tax-related items that we had – you know, the settlement of the ’09 and ’10 tax years, a couple of other minor adjustments – the rate wanted to be about 31% in the quarter on an operating basis. Back half of the year, we’re expecting about 29%, so again a little bit of better news in taxes coming up but not a lot. The wild card out there, of course, is extenders, which we still don’t have in the guidance; and whether that happens this year or not, I think nobody knows, but obviously it still gives us upside if it does.

Howard Rubel – Jefferies

To follow up, that 29 does not include some of the benefits that you’ve outlined that you’re likely to recoup or record as gains during the balance of the year, right?

Gregory Hayes

Yeah, there’s about $0.25 of additional gains we’re going to see in the back half of the year on top of the $0.28 that we picked up in Q2 on the tax rate. So when I’m talking about that 29% rate, that is operational – that’s not, I would say, the reported rate. We will pull all those gains out of the math for you so that we can try and keep it clean in terms of operating result.

Howard Rubel – Jefferies

So those gains also include the Watsco benefit that will show up in the third quarter?

Gregory Hayes

The Watsco benefit – you’re talking about the option exercise?

Howard Rubel – Jefferies

Yes sir.

Gregory Hayes

Yes, it’s small. It’s not very big at all.

Howard Rubel – Jefferies

Then the last thing is, just to go to Pratt, we’ve had these collaboration intangible benefits for some time that have helped the numbers. How do you sort of see that playing out, and doesn’t that sort of help the reported results at Pratt over the intermediate term before you transition to the GTF?

Gregory Hayes

So you’re talking about the collaboration benefits associated with the IAE transaction, Cai—or I’m sorry, Howard?

Howard Rubel – Jefferies

Usually I get confused with George!

Gregory Hayes

Sorry, Howard.

Howard Rubel – Jefferies

That’s all right – thanks, Greg. Yes, I am. I mean, some of them, I know, are installment payments in effect to Rolls, but the balance reflects, I think, pricing of engines. Doesn’t that sort of help the Pratt numbers?

Gregory Hayes

Well in fact, you really need to go back to the original IAE transaction where as part of the consideration for Rolls transferring its share of IAE to Pratt, we agreed to give them higher pricing on the OE side, so that was really part of the purchase consideration. So the losses on the engines actually go up as a result of that, but under the purchase accounting rules, that becomes an intangible. As we ship those engines, those losses go into intangible asset, really part of the purchase price.

And also, it starts to shrink dramatically because those are only engines that were in backlog as of the day that we closed on the IAE transaction. All the new orders for these that we’ve had don’t reflect any of that benefit, although they do reflect the higher price we pay to Rolls Royce on their share of the engine. So yeah, it’s out there. It was all contemplated, at least the collaboration piece, all contemplated as part of the overall consideration, just like the flight hour payments.

Howard Rubel – Jefferies

Thank you.

Operator

Our next question comes from Ron Epstein with Bank of America.

Ron Epstein – Bank of America Merrill Lynch

Good morning. Just two quick ones for you. Your prior guidance, I believe, had $0.05 in it for the Canadian Maritime helicopter. Now that that’s out of the guidance, how come you guys didn’t take up the higher end of your range by a nickel or so, which had the previous guidance for the Canadian Maritime in it? Make sense?

Gregory Hayes

Yeah, your precision exceeds our accuracy, though. The fact is you’re right – we did have $120 million baked in for the CMH. The back half of the year, there will still be about $50 million of CMH-related costs in addition to the charge, so nominally we could have picked up a little bit. We did take Sikorsky’s guidance up about $25 million, but they’ve had some much slower military aftermarket sales than what they had expected and they had some EACs that have gone against them in the first half of the year, so they’ve consumed about $50 million of the good news associated with what should have been guidance on the CMHP.

So really, we’ve only increased by $25 million, which is a couple of pennies, and we just didn’t feel like we were going to take up the top end of the range for two cents.

Ron Epstein – Bank of America Merrill Lynch

Okay, great. And then switching over to Climate Controls and Security, in the quarter the margins were really good, right – 19% before the one-time stuff. How should we think about that for the remainder of the year? That’s a pretty darn good trend, right?

Jay Malave

Yes, it’s a great trend, Rob, but don’t forget the second quarter is typically the heaviest, particularly on the U.S. residential side, so you’ll always see a stronger margin percentage in the second and third quarters. That will come down sequentially. There will still be margin expansion over last year, but you’re talking probably on average in the range of, say, 17% in the back half of the year.

Ron Epstein – Bank of America Merrill Lynch

Okay. Was there any one-time positive things in there, big sales or something that—

Gregory Hayes

No, it was a very clean quarter, no one-timers or anything like that. Everything got pulled out that would have been a one-timer, so a very clean quarter. Just, again, good performance on the cost side, good traction really around the whole business from a cross standpoint.

Ron Epstein – Bank of America Merrill Lynch

Okay, great. Thank you.

Operator

Our next question comes from Noah Poponak of Goldman Sachs.

Noah Poponak – Goldman Sachs

Good morning everyone. Greg, I wondered if you might be able to just actually provide more detail on what the C-series engine fix and resolution is and how the implementation of that is going to play out, because what we can see in the press has been fairly high level and it sounds simple, but I guess the aircraft has now been grounded almost two months, so any more detail there would be really helpful.

Gregory Hayes

Yes, I didn’t get my engineering degree, unfortunately, so I’m not going to be able to give you probably the technical answer that you’re looking for. We do know—I mean, we identified a root cause of the engine oil seal leak early on in the investigation. We have a fix in place. We’re continuing to work with the customer – Bombardier – to work with the Canadian airworthiness authorities to get the plane flying again. We expect it will be a couple of weeks.

Again, this is not a big, big deal in terms of the architecture. It’s happened back in the turbine section and has nothing to do with the gear up front, and really a relatively minor fix. It’s unfortunate that it happened when it did in the testing program; but again, not a big fix in terms of engineering development costs.

Noah Poponak – Goldman Sachs

Okay, but it’s seeming like another couple of weeks before the aircraft are back in the air, it sounds like?

Gregory Hayes

Yeah, I can’t give you anything better than that. I think that’s what we heard earlier this week, and I know the folks at Pratt and Bombardier are working as hard as they can to get that thing flying again.

Noah Poponak – Goldman Sachs

Okay. Jay, you were about to give the Aerospace Systems spares order provisioning versus parts breakout. Can you actually just provide those numbers in the quarter?

Jay Malave

Yes, the provisioning was quite high – you’re talking in the range of 80%, and the parts were flat.

Gregory Hayes

Sales or orders?

Noah Poponak – Goldman Sachs

Orders.

Jay Malave

Parts were flat—I’m sorry.

Noah Poponak – Goldman Sachs

Okay, thanks a lot.

Operator

Our next question comes from Deane Dray with Citi Research.

Deane Dray – Citi Research

Morning everyone. I might have missed this, but for Otis China orders, what was the attachment rate, and maybe some broader context of where you expect to see that trend over the next year or so with the new regulations.

Gregory Hayes

Yes, I think the conversion rates, or the attachment rates as you’re referring to them, I think are pretty consistent with what we’ve seen where we’re getting somewhere around 60% or so on the Otis China brand, and a much lower conversion rate on the XOEC and the Sigma brands. Again, you’ll recall we sell direct at the Otis China Limited and we’re selling through distribution, so attachment rates in total are still around 25%, I think, across the portfolio, nudging upwards a little bit as we’re trying to make a big push towards the aftermarket. I think aftermarket there, or service there, grew 20% last year. We expect it to grow another 20% this year, and we added 50 branches last year and are in the process of adding another 50 branches this year. So we’re putting the infrastructure in place to support the continued growth in the service, and the real key will be for us to work with our distributors through the distribution model to make sure that we can capture more of the aftermarket or conversion from the XOEC brand.

Deane Dray – Citi Research

Great, and then on capital allocation, just the update that you’ve given us this morning, boosting buybacks and maybe cutting back on that placeholder on M&A, just put this in context for us. And also, how are you funding the buybacks? Most of your cash is offshore, so what’s the expectation in terms of funding those?

Gregory Hayes

Well again, we’re working to get some of that cash back as tax efficiently as we can, but as I sit here today, I think we spent less than $90 million on M&A through the first half of the year, and it’s just a realization as we’re sitting in July, we’ve got a couple of smaller deals in the pipeline, but you’re talking less than $250 million or $300 million each, so hard to imagine we’re going to get towards that billion-dollar placeholder. So we just took it down directionally, and we’ll give you more guidance at the end of September.

Again, we’re taking up the share buyback, and looking at the price over the last month or so, we’ve obviously been trading down. It’s a very attractive investment in terms of our M&A dollars, so we’re going to put more there and we’re going to be patient on the M&A side.

Deane Dray – Citi Research

Great, thank you.

Operator

Our next question comes from Carter Copeland with Barclays.

Carter Copeland – Barclays

Morning guys. Just a couple of quick ones. Greg, you said the CMH, the charges going forward would be manageable, but I think last quarter you said the charge you were going to take was going to be about 70 to 75% of the total loss, which would imply if that didn’t change kind of $125 million or so to go. Is that still the right order of magnitude, and how should we think about the phasing of that over that next two years?

Gregory Hayes

Yes, so just to be clear, when we took the charge for the $438 million, that included all the losses going forward on the program and included an extension of the initial in-service aftermarket training and support, which actually drove the loss higher because instead of putting these aircraft in service in ’15 and ’16, it’s going to take it out through 2021 before we’re done, so that drove about another $100 million of losses that we’re going to recognize as part of this whole charge.

If you think about it, back half of the year we’ll probably see, as I said, $50 million, about $25 million a quarter. Next year, the total number goes—it’s around $20 million a quarter, not quite, and then really after that it becomes noise because the aftermarket starts—they start to accumulate hours on the aftermarket, which more than offsets any of the losses that we’re going to have as we complete.

So we’re about 70% done. We’ve incurred about $700 million of losses on that program, so you can nominally think there’s about $300 million to go between now and 2021; but the real headwind is third and fourth quarter this year and then next year, and then it’s really behind us.

Carter Copeland – Barclays

Okay, great. That’s great color. Thanks. Then just as a quick follow-up, Jay, you mentioned in you remarks the difference in unit order growth versus dollar bookings at China Otis. Could you give us those numbers?

Jay Malave

Yes, the unit bookings were up – I think Greg mentioned it in his remarks – were up 12%.

Carter Copeland – Barclays

Okay, thank you very much, guys.

Gregory Hayes

Thanks Carter.

Operator

Our next question comes from David Strauss with UBS.

David Strauss – UBS

Good morning. Greg, in terms of organic growth in the second half, you mentioned the comps get a lot tougher yet you’re forecasting organic growth for the most part in line with what we saw in the first half. Can you just talk about kind of at a high level what’s going to drive that?

Gregory Hayes

Yes, there’s a couple of things. I mentioned before we didn’t get a bunch of the JFS engines out the door at Pratt. That contract should be done here in another month or so, LRIP 7, so that’s going to help on the military side at Pratt. We continue to see a ramp on the Aerospace Systems side, aftermarket is going to continue to grow. I think again, as I look at the backlog today, it really supports the back half sales forecast. Orders down 6% at Pratt in the aftermarket, but total aftermarket was still up 10%. We’re seeing heavy overhauls going through the shops. It looks like it should be pretty achievable to get to that 4% growth. I think clearly Otis has the backlog, not just in China but around the world – you see new equipment orders continue to grow. CCS has good backlog in its businesses and really no—again, could bad things happen? Absolutely, but really as we sit here today, I feel pretty good about the overall economic growth in our markets.

David Strauss – UBS

Okay. On GTF, you mentioned some of the wins at Farnborough, but looking at versus your competitor, it looked like your competitor actually announced more orders and it looks like market share has kind of shifted a couple points in favor of the Leap. So could you just talk about how you think GTF is doing overall in the market and what kind of pricing you’re seeing on GTF relative to what you’re realizing on B2500s? Thanks.

Gregory Hayes

I think again it was a big air show. I think GE announced a lot of orders in conjunction with G-cast. We’ve got right now about 6,200 engines, I think, on order – we said 6,000, I think right now it’s about 6,200, and we’ve got just about 50% market share. It’s lumpy – I mean, these campaigns happen sporadically where you’ll be 100 or 200 engines that get awarded at a time. GE has been successful in the last couple of weeks.

At the end of the day, I think the market will decide which technology is best, and we still think the GTF architecture in terms of what it does for fuel efficiency, from a noise, from an emission standpoint, is going to outperform the Leap in the marketplace, and that will ultimately be the determinant of what the market share is.

In terms of pricing, pricing is tough, but it’s always tough in this entry into the service space, so I would say there’s not much difference that we have seen in terms of market pricing dynamics, but it’s a tough market out there.

David Strauss – UBS

Thank you.

Operator

Our next question comes from Myles Walton with Deutsche Bank.

Myles Walton – Deutsche Bank

Just a couple of clean-ups. The order rates at Pratt in particular, can you just help us with the split between the Vs and maybe the 2000 and 4000, 4000 in particular?

Jay Malave

Yes, the order rates, the Vs were up high teens. The 2000s were down substantially – 70%-plus, again on that tough compared. The 4000s were down around 10%, in that range, and again a little bit of just timing of shop visits there. We actually saw—on some of the older models, we’re seeing nice content per visit and we actually saw nice growth on the older models, so it was actually some of the newer models that showed a little bit more weakness, and that again is more of a function of just timing.

Myles Walton – Deutsche Bank

As you look out to ’15, can you give a rough proportional mix – is it still about 50/50 between Vs and other, or is it going to be 60/40 by that point in time?

Gregory Hayes

The Vs are essentially growing at 10 to 15%, and I would say the older engines would be flattish going forward so you’re going to see that mix shift continue to where it’d probably be 55% and going towards 60%.

Myles Walton – Deutsche Bank

Okay. Then the other clean-up – Jay, the contract benefit size on UTAS, can you size that?

Jay Malave

Yes, it’s about $0.03.

Myles Walton – Deutsche Bank

Okay, all right. Thanks guys.

Operator

Our next question comes from George Shapiro with Shapiro Research.

George Shapiro – Shapiro Research

Yes, good morning. The aero margin looked weak to me, particularly with what you size as the gain. I mean, you were down sequentially from the first quarter and revenues were up a couple hundred million, so can you just tell me what was going on there?

Jay Malave

George, it was basically the E&D. They were up—in E&D, this was the highest quarter of E&D at UTC Aerospace Systems, and we expect that to come back down in the back half of the year.

Gregory Hayes

Yeah, they accounted for all of the increase in E&D in the quarter.

George Shapiro – Shapiro Research

Okay. Then how much was the gain at aero in the quarter?

Jay Malave

That was—

Gregory Hayes

You’re talking about the contract settlement?

George Shapiro – Shapiro Research

Yes.

Gregory Hayes

Three cents.

Jay Malave

Three cents.

George Shapiro – Shapiro Research

Okay. I meant to ask this – Pratt, you had also mentioned there was some gain. How big was that one?

Jay Malave

Oh, less than $20 million.

George Shapiro – Shapiro Research

Okay, thanks very much.

Jay Malave

Thank you.

Operator

This concludes the Q&A portion of today’s conference. I’d like to turn the conference back over to our hosts for closing remarks.

Gregory Hayes

Okay, thanks Kevin, and thank you everyone for listening in. A solid quarter and we’re on our way to a solid year at UTX, and look forward to taking your calls this afternoon. Thanks again. Take care.

Operator

Ladies and gentlemen, this does conclude today’s presentation. You may now disconnect and have a wonderful day.

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Source: United Technologies' (UTX) Q2 2014 Results - Earnings Call Transcript

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