What’s so special about United is the vast diversification of its business portfolio: aeronautical parts ($15 billion in turnover), Pratt & Whitney engines ($16 billion), Otis elevators ($12 billion) and air conditioning and fire control systems ($18 billion).
The group originally was quite a specialized player in the civil and military aviation industry. Over the years, it diversified towards a more ‘general public ‘ business where the competition is fierce but the revenue recurrent and less exposed to cycle reversals.
This cyclical dimension, in particular, is less penalizing than before for Pratt & Whitney: this segment of the industry - the design of aircraft engines - has been very fragmented for a long time, especially in the United States. Now, however, it is fully consolidated after decades of mergers and acquisitions made under the impulse of contractors like Boeing, Airbus, and Lockheed in search of economies of scale and a single business partner that is reliable over time.
In this demanding segment only General Electric, Rolls Royce, Safran and, of course, Pratt & Whitney are active. It’s worth noting that the latter has a privileged competitive position in the military aviation since its reactors propel the new generation F-22 and F-35 fighter jets.
Another nice feature, this time shared by all the divisions of United: half of the turnover comes from so-called aftermarket activities, meaning maintenance services and upgrades, where the margins exceed those of traditional manufacturing activities.
This dynamic also allows United to adjust its selling prices in a way that it is as competitive as possible in large calls for tender, only to then remunerate itself nicely on the maintenance contracts - something the clients can hardly avoid due the risk of seeing their fighter jets, their air conditioning systems or their elevators break down.
On a management level, and like many other mature companies in the United States, one of United’s characteristics is its very aggressive capital return policy for its shareholders: all the cash profit has been returned to the latter via dividends ($10 billion for the last five years) and massive share buybacks ($16 billion during the same period).
Share buybacks can sometimes be an excellent capital allocation when a company is undervalued on the stock exchange. However, the buybacks of the past five years have been done at an average price of around $100 per share, more or less 20 times the normalized profit for the past decade - an undervaluation that’s not exactly obvious…
On the one hand, we see that this strategy has largely contributed to maintaining the stability of the profit per share, which would have decreased otherwise, while supporting the share price on the exchange. On the other hand, we could say that the management has entrenched itself behind its very strong competitive position, without taking the risk of a hazardous diversification.
Only time will tell which bet would have been the preferable one.
Let’s proceed with a traditional valuation via a sum of the parts (the hypotheses below are of course adjustable any way you like):
- The famous engine manufacturer Pratt & Whitney is the most capital-intensive division of the group, but also the most strategic one: it’s valued at twenty times its last operating profit - a level that is similar to that of a comparable company like Safran. The division is worth $29.2 billion.
- The aeronautical parts division generates 16% margins and benefits from longstanding relationships with all the big outsourcers. The activity is less cyclical than that of Pratt - because regulatory obligations in the civil aviation business require regular replacements of parts. We can grant the activity a multiple of 12 times its last operating profit meaning a value of $28.4 billion.
- The climate, control and security division generates 18% margins and $3.3 billion of operating profit, with, here too, a brilliant and well-established client base: at a multiple of 12 times the last operating profit, the division is worth $39.6 billion.
- The Otis division, which we won’t introduce again, has a lot in common with the climate, control and security division. At 12 times the last operating profit, the division is worth $24.2 billion.
The sum of these parts comes down to $121.4 billion, of which we subtract the $30 billion of long-term financial obligations - net debt, pension schemes, and minority interests included. This gives a total revalued net worth that’s estimated at around $91.4 billion.
Once we compare this amount to the current market capitalization of the group of $98 billion, we don’t see a clear discount, and by extension guess that the market looks at the current market conditions in a positive way - without a doubt thanks to the new contracts for military equipment.
The analyst consensus aggregated by MarketScreener points exactly in this direction since the former have recently revised their earnings projections upwards. If they’re right, the share buybacks of the past years will have been very timely. This means that, on a several-year horizon, the share price should move positively under the combined effect of growing profits and a decreasing number of shares in circulation.
Investors who are interested but less enterprising - or those who are a little more reserved when it comes to the analyst projections - will perhaps prefer a more wait-and-see attitude, on the grounds that the positive developments outlined above are already included in the current valuation of the group.
(United Technologies is part of the MarketScreener USA Portfolio
. The author isn’t a shareholder.)
Article published on 11/05/2018 | 13:57