Ignore The Noise: United Technologies Is A Long-Term Buy

| About: United Technologies (UTX)

Summary

UTX is down 8% in September amid some bad news in the Pratt & Whitney division.

UTX is sacrificing profitability in order to position itself for long-term growth.

Based on how UTX derives its competitive advantages, and how the firm has executed in the past, we are optimistic about the long-term outlook.

Profit margins have lots of room to expand, and UTX is a buy for long-term investors at these levels.

Shares of United Technologies (NYSE:UTX) are down roughly 8% so far in September. More bad news from the Pratt & Whitney division in recent weeks is the reason. Key customer Bombardier cut its full year delivery forecast in half from 15 to 7 due to jet engine delivery delays from Pratt, and just last week UTX cut its engine delivery outlook from 200 to 150. UTX is having issues meeting strong order demand for its new geared turbofan engines (which are more fuel efficient, lower emissions, and reduce noise), and has needed to increase investments to support the ramp-up. But investors are too focused on short-term headwinds and are ignoring the bigger picture. UTX is positioning itself for future growth in multiple divisions, and we think the company is a compelling buy for long-term investors at these levels.

UTX is basically implementing the same strategy in three of its four divisions. In a nutshell, it involves sacrificing profit margins in the short term in order to grow market share, which should translate into higher aftermarket and service revenues (which carry higher margins) in the long term. The geared turbofan engine ramp up in the Pratt & Whitney segment has led to concerns about profitability. These engines are very costly to produce, and actually generate negative margins in the year of sale. However, most of the ROI on these engines comes from aftermarket revenues. These revenues come in the form of fees, and tend to be stable and recur over time. By growing the installed base, UTX will be able to generate more higher-margin service revenues in the long-run. The long-term outlook is very promising. UTX has won orders for approximately 8,200 units, and expects sales to grow organic sales in this segment at a 10% annual clip through 2020.

In the Otis segment, which produces elevators and escalators, UTX is shifting to a more price competitive strategy in order to grow market share, with a particular focus on China. This will cause sales to decelerate and weigh on margins in the short term, but as is the case with Pratt, it should translate into higher service revenues and margins in the long-run. In the Aerospace Systems segment, UTX is upping investment to drive sales on newer aircraft models to expand market share. Again, this weighs on profitability in the short term because parts on newly sold parts generate lower margins. But it grows the installed base, which improves the growth outlook for higher-margin service revenues.

We are optimistic that this strategy will work because of the way UTX carves out its competitive advantage. The source of UTX's wide moat comes from the firm's massive installed base and entrenched customer relationships. This raises barriers to entry or success: as customers grow accustomed to using UTX's products, they are unlikely to switch to a rival producer with whom they are less familiar, and possibly risk defects and performance issues. So, once UTX establishes its market position, it tends not to lose share. Thus, UTX has every incentive to take a little pain in the short term because it puts the company in a more favorable position in the long term.

Conclusion:

Investors are too focused on the short-term profit margin headwinds to see the big picture. UTX is positioning itself for the long term, and based on how the company has executed in the past, we are optimistic about the outlook. UTX's TTM operating margin is 12.4%, almost 200 basis points lower than the company's 5-year median operating margin. We model normalized (mid-cycle) operating margin at roughly 15%, and think there is plenty of room for margin expansion at these levels as higher-margin aftermarket revenues comprise an increasing portion of consolidated sales over the next five years. UTX trades at a forward P/E of 14.6 and offers a dividend yield of 2.6%. This is an attractive price to pay for one of the best companies in the industrial space.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in UTX over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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