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AMM Dividend Letter 43 United Technologies
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Welcome to the 12th episode of the AMM Dividend Growth Podcast. If this is your first time listening, I’m Glenn Busch a portfolio manager at American Money Management. And this podcast is all about our dividend growth strategy. What we’re buying, what we’re selling, and how were managing a concentrated portfolio.
This episode is about United Technologies a recent addition to our Dividend Growth Strategy. I’ll cover its dividend growth, dividend safety, its upcoming spin-offs that should unlock value, the risks to our investment, and our estimate of fair value.
A lot has changed in the world and the stock market since we first invested in United Technologies and since we published our thesis. So some of things I talk about in this episode like risks and valuation will be different from my original write-up.
If you want to read my original write-up there is a link in the show description.
So let’s do the disclaimer and get into it.
[disclaimer]
This episode was a long time in the making. United Technologies was added to the portfolio back in October. Our investment thesis was all there and all I had to do was convert it into a Dividend letter and then I could turn around it make it a podcast episode for you.
But for some reason I had the worst writers block and I just couldn’t write the letter.
But I finally got the letter done and now I can make it a podcast episode. And then of course the coronavirus has to upend everything and I’ll add some updates to our thesis and risks on the podcast.
As always if you want to subscribe to our email newsletter there’s a link in the show description.
We have three categories that we use to classify our positions. Dividend Stalwarts. This our equivalent to the Dividend aristocrats. Companies that have paid a dividend for a very long time and have raised their dividend every year too.
The next category is new dividend payers. Companies that recently started paying a dividend, within the last 5-10 years, and have the ability to grow their dividend year-in and year-out. They usually have above average dividend growth too.
The last category is special situations. Usually this is a spin-off. But sometimes it’s like the Fox and Disney merger and a little bit more complicated. Either the parent company pays a dividend or the company it is spinning off plans to initiate a dividend. Usually it’s both. There’s value being unlocked and the upcoming corporate restructuring is the catalyst. Our ideal situation is a special situation turns into long-term holding with the parent or the spin-off company turning into a consistent dividend grower.
United Technologies falls into two of our categories. It is a dividend stalwart and a special situation. This year it was added to the Dividend Aristocrat list. To make the list a company has to have paid a dividend for at least the last 25 years and grown its dividend every year too.
Since 2001 United Technologies has grown its annual dividend at a compound annual growth rate of 10.76%.
Over the last 10 years its annual dividend has grown at compound annual growth rate of 6.27%.
And its dividend is safely covered.
Its dividend payout ratio is below 60%.
Its cash dividend payout ratio is also below 60%.
The free cash flow to equity coverage ratio is well over the 100% we’re looking for.
Its interest coverage ratio is well over 2x too.
The only drawback is United Technologies’ debt to equity ratio is over 1.
This due in part to its purchase of Rockwell Collins for $30 billion in 2018. We’re comfortable with the debt to equity ratio because its interest coverage ratio of 7 times.
The upcoming spin-offs, the catalysts to unlock United Technologies’ value, will happen on April 3.
United Technologies is spinning off Carrier, its HVAC business. Otis Elevators, I think its business is self-explanatory, and the remaining United Technologies will house Rockwell Aerospace and Pratt & Whitney.
Other than the remaining aerospace company the prize spin-off is Otis Elevators. The elevator business is an oligopoly. The top ten manufacturers account for about 83% of the total revenue and the bulk of that coming from a few top players. Otis accounts for 16% of global elevator revenue. Schindler is second and ThyssenKrupp is third.
The elevator business – which also includes escalators and people movers – is not a high growth business. Global Market Insights predicts a 4.5% compound annual growth rate for the elevator business from 2019-2026. The bulk of the growth will come from the Middle East and the Asia Pacific regions.
Just under half of Otis’ sales are from actually selling elevators. The rest comes from service contracts. And the service contracts are the real drivers of profits. 20% of Otis’ operating profits come from selling new equipment and 80% from the service contracts.
Otis usually generates high operating margins and high returns for an industrial company. Back in 2014 its operating margin was 20.34% and its return on assets were 28.35%. But over the years their margins declined to around 15 and return on assets declined to 20%.
This happened because Otis made some short-term strategic errors in China. The Irony is their profitability declined because they focused too much on keeping their profit margins high in the short-run at the expense of grabbing as much new business as possible which would lead to more long-term service contracts. They focused too much on China’s commercial sector while ignoring its residential construction. This allowed Kone, a Finnish company, to grab market share from Otis. Adding to this was the fact the Otis had an aggressive growth projection for Chinese construction. Then China slowed, especially its commercial construction, and Otis took a hit.
It’s taken a couple years for the company to re-calibrate its efforts and now after that multi-year decline Otis’ quarterly operating margins are seeing sequential and year over year improvements.
What’s helping is the new equipment sales that drove business before the slowdown are rolling over into higher margin service contracts. The recent slow-down hasn’t changed the urbanization of China. It’s estimated that 12–50 million Chinese move into the city each year. Where labor goes companies follow. Residential construction will continue and commercial construction too.
Construction in the U.S. picked up replacing some lost China revenue. The rest of Asia is booming too.
A long-term compound annual growth rate of 4.5% for the elevator industry combined with a leading position and increasing margins back up to 18-20%, will push returns on operating assets back up above 20% and produce significant shareholder value after the spin-off.
The next spin-off is Carrier.
Carrier operates in the HVAC industry.
Carrier has strong brand recognition and has been in business for 100+ years. Its brand and ability to help build and service out complex commercial HVAC projects give it a small business moat.
Investing in a HVAC company is not sexy and the HVAC business has endured a bit of a slowdown recently. Our guess is that after Carrier is spun-off its shares will sell off for a few reasons.
Usually, the companies being spun-off are not the businesses investors wanted to invest in. A newly spun-off company’s size may not fit within the mandates of the institutional funds holding it. So they will sell their shares.
A standalone Carrier is not the investment we usually make. We might be one of those early indiscriminate sellers. But if Carrier pays a dividend we will most likely hold onto our shares until a better investment presents itself.
The jewel of the restructuring is the remaining United Technologies Company. It will house Collins Aerospace Systems and Pratt & Whitney.
The big trend in air travel is the rise of the narrow body aircraft, single aisle jets. Narrow body aircraft were once primarily used for short to medium length flights. Recent advances make it possible to fly narrow body aircraft further with increasing fuel efficiency. This opened up longer-distance flights to secondary airports that couldn’t handle large wide body planes. It also made these routes profitable to serve.
The other trend is the rise of the global middle class and their desire to travel. Airlines are increasing their routes and low-cost budget airlines are popping up to service these routes too. Narrow body aircraft allow airlines to better match supply with demand.
Two main aircraft manufacturers produce the majority of the world’s narrow body aircraft, Boeing and Airbus. Boeing’s main model is the now infamous 737 Max and Airbus has the A321 and A220. Demand for their narrow body aircraft is booming.
Boeing uses GE engines and Airbus uses the Pratt & Whitney GTF engines. The Airbus A321 is the more popular of the two models with about 60% market share.
Over half of the RemainCo’s revenue comes from Pratt & Whitney and half of Pratt & Whitney’s revenue comes from its commercial engine business. Around 25+% of the RemainCo’s revenue will come from the rise of narrow body aircraft.
The added bonus is narrow body aircraft have longer service lives. The real profit in aircraft engines are the service contracts and aftermarket parts. Engine manufacturers will sell engines at a discount to gain access to the high margin service and parts business. Longer service lives combined with a large growing base of airplanes means Pratt & Whitney’s revenue and profits have a long run growth runway ahead of it.
We want to invest in businesses that can grow their returns on invested capital. Pratt & Whitney invested a lot of upfront capital to build out the manufacturing and service lines for its GTF engines. With engine sales ramping and long service lives, we expect ROIC to continue grow for the foreseeable future.
We don’t have enough segment information to build out the invested capital solely for Pratt & Whitney but we can use operating return on Pratt & Whitney’s assets as a rough estimate.
Based on past investment cycles and the expected profitability of the GTF engine, we estimate that Pratt & Whitney can at least reach mid to high teen levels of ROIC.
I know what you were thinking while I outlined the bull case for the RemainCo. Um hello, the coronavirus is killing air travel. Less air travel demand leads to airlines going out of business and new narrow body aircraft orders will disappear.
Yeah, I don’t have a clear picture as to what is going on with the airlines around the world. It’s a pretty competitive industry and I would expect there are a good amount of airlines that were just skating by because of the state of the economy, easy access to capital, and increased global travel demands.
Now with basically a full stop on air travel. A weird EU rule that airlines need to keep flying their planes even if they’re empty to maintain ownership of their routes will push some carriers into bankruptcy and others to cut capacity and ground planes to shore up their financial positions. Delta just reduced their capacity by 40% and is grounding 300 aircraft. And they are cutting back on excess capex to try and save $2 billion a year.
Maybe governments step in and offer some sort of lifeline. Reuters has a story that United Airlines is in talks with US officials about financial help. Maybe Warren Buffett steps up in the US as the lifeline or as an acquirer.
Travel and travel demand has dropped off a cliff. It will come back. People, I’m talking about people as a society and as a whole, have short memories. The desire to travel and explore will not go away. It will come back like it did after 9/11 but it will take some time for this global pandemic to fade.
The timing becomes the issue.
How long does it take to come back?
It determines whether new aircraft orders are just delayed or outright canceled.
Airbus has a huge backlog of orders for their narrow body planes and they’re actually having trouble keeping up with the timeline on their orders because they have so many. Which should be good for Pratt & Whitney. Airlines are pretty conservative. Once they place an aircraft order they rarely cancel them. Airlines can sometimes reduce or adjust their orders but if they cancel completely and then want to restart later, they’ve lost their place in line. They’ll need to start over or pay hefty fees to cut in front of others. Airlines also don’t like switching airplane manufacturers. They’ve invested a lot of capital into the infrastructure and the parts needed to service their chosen family of airplanes. Their pilots and staff are also certified for that specific family of aircraft. Airlines have immense aircraft switching costs.
That all being said. A full stop to travel demand can flip the math and make it more economical to cancel new aircraft orders and then get back inline when demand comes back.
This is our big concern now with Pratt & Whitney and it’s what we’re watching the most.
For Otis elevators a risk is their competitor Kone.
ThyssenKrupp is selling its elevator division. Potential acquirers include Kone, the Finnish elevator builder, who has partnered with CVC Capital Partners, Blackstone and Carlyle Group (joint bid), and 3G.
Surprisingly Otis hasn’t made an offer.
Letting a key competitor get bigger and better is not a good strategy. Especially Kone who was one of the big reasons why Otis lost global market share.
ThyssenKrupp’s management hasn’t decided if it is selling a stake or all of the division. Management is also looking for a quick close to the deal and to avoid any long anti-trust review. This may be why Otis hasn’t made an offer. Otis can always buy it later from a private equity holder. Unless Berkshire Hathaway teams up with 3G to buy the whole business. And then maybe Berkshire Hathaway buys Otis to merge the two businesses.
While we wait for our Berkshire-Hathaway fan fiction to happen, Otis will have a stronger competitor going after Otis’ business.
China is a reward and a risk.
A small economic slowdown in China already hurt Otis Elevators. A larger slow down or recession would cause bigger issues for Otis. And now we had the coronavirus basically shut down China and China latest PMI was in the 30s. A contraction has happened for sure and the next couple of months will let us know if China is going into a recession.
In the previous slowdown, a larger percentage of Otis’ Chinese revenue was from selling elevators. Those previous new equipment sales are converting into the more profitable and consistent long-term service revenues.
Will the changeover be enough this time to mitigate some damage from a larger economic contraction in China.
China’s growth also affects the Aerospace remain co. The country with the largest growing group of middle class global travelers and the greatest travel demand is China. What I originally wrote was, if there is a recession or something worse in China, their middle class will cut their discretionary spending. The first item usually cut is travel.
That something worse came.
Like I said earlier. Travel will come back. The knock on effects to the air travel industry including an engine manufacturer life Pratt & Whitney is based on how long this goes on for.
Back to the spin-offs.
The big reason to do this is remove the conglomerate discount and unlock the true value of the different business divisions.
Before any spin-off actually occurred, United Technologies announced that the aerospace remainco will merge with Raytheon in a merger of equals. The new company will be called Raytheon Technologies.
United Technologies’ management breaks up its conglomerate to create a new conglomerate.
Raytheon is a quality company and at the time of the deal it was trading at a discount to our estimate of its fair value.
Buying high quality companies cheaply is usually a recipe for success. The pro-forma put out by management shows significant synergy cost reductions, increased cash flows, and a large return of capital back to shareholders through increased dividend and share buybacks.
Pro-formas tend to be very optimistic and integrating two large companies usually takes longer than estimated and is ripe for potential problems.
Our main issue is the profits and returns from the investment in GTF at Pratt & Whitney will be hidden again inside a large conglomerate. It will still create value but at a much lower percentage of the combined company.
But now with the turmoil in travel maybe it’s a good thing. The new Raytheon Technologies can weather the uncertainty in the Pratt & Whitney division better.
When we made our investment we believed the value of the spin-offs were still worth the investment and the merger with Raytheon could surprise us further to the upside.
When we made our original investment in United Technologies we did a sum of the parts analysis to get a value for the whole company before the spin-offs. We arrived at $165 per share.
We then valued Raytheon Technologies at a 15% discount to what the pro-forma was implying.
United Technologies is currently trading at $105.40. A big discount to our previous sum of the parts analysis but given the uncertainty with China’s economy and the current state of air travel the bigger discount is warranted.
As I record this I haven’t updated my model and the scenarios for an updated price. With all the action this week with setting up trades and updating cash flow models on potential new positions, I fell behind the curve.
I do believe my 2020 price target will be lower. 2020 EBITDA estimates will have to come in just given the shift in the global economy. But for the long-term, at the current price of $105.40 were being offered a good risk/reward for Otis, Carrier, and the RemainCo before they split up.
Thank you for listening. If you’re an individual investor interested in our dividend growth strategy or a financial advisor interested in our dividend growth strategy as a separately managed account, give me a call at 858-755-0909 and visit us at americanmoneymanagement.com to learn more.
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Until next time.
