The Long Case for United Technologies

Jul.31.07 | About: United Technologies (UTX)

dillonNewsletter Value Investor Insight carried an interview on June 30 with Ric Dillon of Diamond Hill Investments. Dillon's firm manages $4.5 billion in assets; its flagship Diamond Hill Long-Short mutual fund has earned an average 10.6% per year since July 2000, vs. 2.9% for the Russell 1000.

Here's an excerpt from the interview, where Dillon's colleague William Dierkner discusses United Technologies (NYSE:UTX), which was trading at $70.93 at the time of the interview (current price here):

The company has a fairly diverse mix of businesses. The Otis elevator and escalator business generates 22% of revenue and about 30% of operating profit. Pratt & Whitney, which makes aircraft engines, contributes 23% of revenues and 29% of operating profit. The Carrier HVAC business is the largest by revenue, 28%, but is currently earning only 20% of operating profit. That has to do with headwinds from commodity prices – it uses about 140 million pounds of copper per year, for example – and from going through a learning curve in manufacturing a new line of high-efficiency air-conditioning units. The Sikorsky helicopter business has also been undepressure, from a strike last year and the ramp-up in production in a key military program. Some people think of United Technologies as kind of an old-fashioned conglomerate, but this is very much a high-tech company.

They spend over $3 billion annually on research and development, roughly half of which is funded by customers like the Defense Department. They’re constantly innovating: Otis has developed new elevators that are quieter and more energy-efficient, don’t need a machine room and don’t need to be lubricated. Carrier is already compliant with stricter controls on the use of refrigerants that don’t go into effect for another three to five years. Pratt & Whitney is developing a new aircraft engine in which the fan and turbine spin at different speeds, which should reduce fuel consumption, noise, emissions and maintenance costs. That’s still a long way from commercialization, but it’s an example of the type of innovation that’s going on.

The company has also consistently shown itself to be financially disciplined. In the commercial aircraft engine business, for example, they moved away from bidding aggressively on new engine platforms as the returns became less attractive. They now have two large engine ventures, one with GE to make engines for the Airbus A380 and another with Rolls-Royce and others for the A320. Revenues from spare parts and service are six to seven times the original engine price, so they’re still well positioned to benefit fully from a growing installed base.

The company has historically had difficulty generating organic growth. Is that changing? WD: Very much so. Because of the types of products they manufacture and the fact that they often have leading global market positions, they’re very well positioned as economies expand in China, the rest of Asia and in energy-rich OPEC countries. With a lot of visibility – both from new-product cycles and already booked orders – I’m expecting them to increase revenues at around 8% per year, with only a small portion of that from acquisitions. At the same time they’re growing more quickly, they still have room to improve on the margin side. Part of that will come as they work through temporary issues like those at Carrier and Sikorsky.

Their ACE program, which stands for “achieving competitive excellence,” has also been very successful in going into facilities and figuring out how to run them more costeffectively. In addition, they still have something like 70% of their manufacturing capacity in high-cost countries, so there’s still plenty of opportunity to move the needle...

From revenue growth and an expansion in operating margins – from 13% to 14.5% – we expect earnings to
grow around 11% per year over the next five years. The earnings are very high quality – free cash flow is almost always in excess of net income – so I use an 8% discount rate. Assuming a modest contraction in the multiple five years out, we arrive at an intrinsic value today of around $85 and a target price in five years of more than $115.