United Technologies: End Markets Are Helping, but There's Still Work to Do

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On the whole, United Technologies Corporation's (NYSE: UTX) earnings were a net positive, but they still left investors with plenty of answered questions. Although management raised full-year sales and earnings guidance, the reasons behind it --strengthening end markets -- was largely anticipated following earlier results from companies such as Honeywell International (NYSE: HON). It's the company-specific commentary that may have left investors concerned.

End-market backdrop

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Going into the earnings report, there were three things likely to have a positive impact on United Technologies' earnings.

First, China's GDP growth was 6.9% in the first two quarters, compared with 6.7% in 2016   and the parliament's target for 6.5%, and it showed in the earnings for industrial companies such as Honeywell and Illinois Tool Works, whose China revenue was up 13.4%. Although Honeywell doesn't formally break out its growth by region its home and building technologies segment had growth "well North of 20%" in the quarter according to CEO Darius Adamczyk. , he went on to describe Honeywell's growth in China as being "spectacular" in the quarter. This is all good news for United Technologies, as winning market share for new equipment sales with Otis in China is a key aim.

Second, Honeywell's commercial aviation aftermarket sales grew at a stronger-than-expected 5% clip in the first two quarters, indicating a strong aerospace aftermarket for United Technologies. Indeed, UTC aerospace systems President Dave Gitlin signaled a strong aerospace aftermarket in a presentation at the Paris Air Show.

Third, the second-quarter results from Lennox International (NYSE: LII), released in April, suggested a strong heating, ventilation, and air conditioning (HVAC) market in the United States. Lennox's overall revenue was up 8%, with residential HVAC revenue up 14%, suggesting that United Technologies' climate, controls, and security (CCS) segment would see strong sales growth.

All confirmed with United Technologies

All three earnings drivers came through and contributed to management's decision to raise full-year sales guidance for organic sales growth of 3%-4%, compared with 2%-4% previously. In addition, full-year adjusted EPS is now expected to be in the range of $6.45-$6.60, up from a previous estimate of $6.30-$6.60.

First, CCS organic equipment orders were up 11% in the quarter, as the company continues to achieve its aim of growing CCS sales again, with North America residential HVAC up 11%.

Second, United Technologies' aerospace systems (UTAS) commercial aftermarket sales increased 7% in the quarter, in line with Honeywell's aftermarket sales growth.

Third, economic growth in China helped Otis achieve its aim of growing unit orders so as to expand market share and grow long-term service revenue. China sales were down 12% in the quarter; however, orders grew 3% in dollar terms and 7% in terms of unit orders. Pricing is still a negative, but less so than in the first quarter, when a 1% increase in unit orders translated into 10% decline equipment orders in dollar terms.

Company-specific issues

It's hard to be too critical on a set of earnings that saw management raise guidance, but there are three company-specific considerations:

First, as mentioned, CCS equipment orders growth was good, but adjusted operating margin of 18.9% in the quarter was lower than the 20.4% reported in the same period last year. Management outlined a number of reasons, including adverse product mix, geographic mix, and new product sales, which tend to be lower-margin initially.

Second, UTAS aftermarket sales were fine, but original equipment (OE) sales were down, with management citing declines on legacy programs, particularly "the end of the Boeing 777 landing gear production," according to Vice President Carroll Lane on the earnings call -- Boeing has sent that work to another company. CFO Akhil Johri thinks UTAS commercial OE to be "flattish" for the full year.

Third, and arguably most importantly, the tone of the commentary on the geared turbofan (GTF) was somewhat concerning. Readers already know its long-term importance to the company.

Although management confirmed its target for 350 to 400 GTF engine deliveries in 2017, only 134 were delivered in the first half -- around 145 were built -- with CEO Greg Hayes explaining that "if we do 205, that takes us to the 350" and adding. "Clearly, we see line of sight to 350-plus."

In addition, the negative engine margin -- losses taken as GTF sales increase before profitable aftermarket sales start to offset them -- are forecast to peak at $1 billion in 2018. However, Johri spoke of operating-margin pressure at Pratt in 2018, and Hayes added: "We still believe 2018 is going to be the peak for negative engine margin at Pratt. Whether it's going to peak at exactly what we thought six months ago, I'm not sure."

The bottom line

We had a good set of results from United Technologies, and management is largely achieving its aims for 2017. However, investors need to keep an eye out for CCS margin, UTAS OE sales growth, and GTF production rates and guidance on negative engine margin. United Technologies was definitely helped by its end markets in the quarter, but management needs to keep delivering.

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Lee Samaha owns shares of United Technologies. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.