In the fourth quarter of 2017, Third Point initiated a significant stake in United Technologies Corporation (NYSE:UTX) (“UTC” or the “Company”), a $100 billion industrial conglomerate organized into four business units: Otis Elevator Company (“Otis”), UTC Climate, Controls & Security (“CCS”), UTC Aerospace Systems (“UTAS”), and Pratt & Whitney. UTC has strong franchise assets with leading market share within each segment but the Company’s shares have lagged its industrial peers (XLI Index) by approximately 45% over the last five years. UTC fits a pattern of many underperforming conglomerates where value is diminished by the ill effects of a “one size fits all” approach to corporate strategy, incentive compensation, and capital allocation. At UTC, this has led to a well-documented history of poor management execution – exemplified most recently by the botched ramp-up of the next-generation geared turbofan (“GTF”) engine – as well as market share losses and underinvestment in key business areas. We have initiated a dialogue with UTC’s Board of Directors to express our concerns about the Company’s weak operating performance and the inherent disadvantages of its conglomerate structure.
To reverse its years of underperformance and realize the full potential of its franchise assets, we believe UTC should split into three focused, standalone businesses: Otis, CCS, and an aerospace company (“Aerospace RemainCo”) encompassing UTAS and Pratt & Whitney. In assessing the potential success of any such split, we ask ourselves two key questions: 1) are the business units and their key stakeholders better off as standalone entities; and 2) does the split create sustainable long-term value? The answer to each of these questions is clearly yes. We are encouraged that the Company’s CEO, Greg Hayes, has indicated that the Board is undertaking a portfolio review. We expect that an honest process will lead the Board to the same inescapable conclusion that UTC should be split into three.
The Case for a Split
As standalones, each of these businesses will benefit in the long run from a bespoke corporate strategy, more flexibility in allocating capital, better alignment of management incentives, a dedicated board of directors with relevant industry experience, and greater strategic optionality. The value creation from spin-offs has been well documented in academic studies and has many relevant precedents in the industrial sector including Danaher/Fortive, Ingersoll-Rand/Allegion, Northrop Grumman/Huntington Ingalls, ITT/Xylem/Exelis, and Tyco/Covidien/TE Connectivity. Beyond these spin-off benefits, we believe the split would also highlight to the market the overlooked value of the GTF program currently hidden within UTC.
The profitability of the GTF program will inflect positively as the GTF moves down the manufacturing learning curve and the highly profitable service revenue stream ramps with the installed base. Management has assessed the net present value of the GTF program at approximately $15 billion1 or $19 per share. Giving credit to GTF’s NPV rather than capitalizing today’s ramp-up losses of $1.2 billion would lower UTC’s headline valuation multiple of 11x forward EV/EBITDA to just 9x forward EV/EBITDA. The average forward EV/EBITDA multiple for the US large-cap multi-industry peer group is 13x or ~40% higher.
We believe such a significant disconnect exists because – in addition to issues with management execution – UTC’s current investor base is misaligned. Multi-industrial investors (a sector defined by low earnings volatility) value companies primarily on multiples of next year’s earnings and cash flow. Aerospace investors, on the other hand, tend to look through new program start-up losses once they are comfortable that peak losses and subsequent profit improvement are in sight. One clear example of this is Rolls-Royce. If Rolls-Royce were a subsidiary of UTC, it certainly would not be valued currently at $23 billion or 36x forward P/E.
Even before giving credit to GTF’s NPV, a three-way split would unlock in excess of $20 billion of value (>20% of market cap), net of separation costs. All three standalone entities will likely trade at higher multiples than the lowest common denominator assigned to the current UTC conglomerate. Otis peers Kone and Schindler trade on average at 15x forward EV/EBITDA. CCS peers, Allegion, Ingersoll-Rand, and Lennox2, trade on average at 13x forward EV/EBITDA.
The remaining aerospace company would be the only liquid, US large-cap aerospace supplier other than TransDigm, which trades at 15x forward EV/EBITDA. Other US large-cap aerospace investment opportunities are limited to Boeing and Honeywell (only ~40% aerospace), which trade at 14x and 15x forward EV/EBITDA3, respectively. The Aerospace RemainCo will warrant a premium multiple due to synergy potential from Rockwell Collins and Pratt & Whitney’s depressed earnings. If Pratt & Whitney achieves an 18% EBIT margin by 2025, which management cited as a target, it will generate approximately $6 billion in EBITDA, which compares to $2.3 billion this year. Assigning a 13x EV/EBITDA multiple to Aerospace RemainCo after stripping out the GTF losses yields a UTC sum-of-the-parts valuation over $190 per share4 by year-end 2019. We see further upside to $210 per share if investors give credit to GTF’s positive NPV.
UTC’s management has acknowledged the disconnect between the Company’s intrinsic value and share price but it seems less open to a three-way split solution than shareholders might expect. Management’s initial assessment of dissynergies and one-time separation costs was surprisingly high, particularly considering that at the Investor Day in March 2018, Greg Hayes described each business unit as having “all the infrastructure and all the SG&A they need to run on a day-to-day basis.” He claimed that the one-time separation costs “could be $2 billion to $3 billion”, citing debt refinancing costs as the largest contributor. However, after reviewing UTC’s credit documents, we believe that the Company’s debt with maturities between 2020 and 2027 could be refinanced with total costs (make-whole payments and fees) of approximately $200 million, and that the Company could elect to keep the post-2027 maturities with the Aerospace RemainCo for no additional costs. Debt to be issued for the Rockwell Collins deal also can be structured to minimize refinancing costs.
As far as dissynergies are concerned, Hayes has also given imprecise numbers ranging from $100 million in 2015 to as much as $250 million in 2017 to set up standalone businesses5, showing a lack of precision that belies a serious approach to considering how best to create shareholder value. Our assessment of dissynergies is significantly lower based on both a top-down review of precedent spin-off transactions as well as a bottom-up assessment of required new public company costs to replicate treasury, tax, pension, and shared services provided by UTC corporate. For example, Danaher’s separation of Fortive resulted in less than $50 million of incremental corporate costs between the two entities. Honeywell stated that new public company costs for its two spin-offs will not exceed the existing corporate cost allocation. Furthermore, Honeywell has committed to eliminate any stranded corporate costs at its RemainCo within two years. UTC management ought to adopt best practices and demonstrate lean leadership in order to create shareholder value.
Third Point did not invest in UTC for what it is today but for what it could become. We intend to work constructively with the Company to see the portfolio review conclude successfully. We have shared our views in a more detailed letter to the Board. We are confident that, as fiduciaries focused on creating long-term value, they will come to agree that a separation into three major business lines will create focused companies better able to adapt to the challenges within their respective industries and encourage proper investment, driving meaningful value for all of UTC’s stakeholders.
From Daniel Loeb (Trades, Portfolio)'s first quarter 2018 shareholder commentary.
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