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A Win for United Technologies?

November 28, 2018

Conglomerates are not as favored for most investors as they used to be. The reason in the past for companies to gather up diverse business units under one umbrella of a single stock was for the safety of diversification.

Conglomerates operate much like closed-end mutual funds. A conglomerate buys and owns individual companies and has specific management teams for each of the business units. The executives of the conglomerate review and manage the underlying unit management as well as making the calls when to buy or sell the underlying business units.

By gathering up varied businesses, conglomerates can provide some synergies in human resources and pension management as well as potentially reducing credit costs while improving cash management with a central treasury operation. And they can bring together their own overall cashflows as cash-cow-type companies can be used to help fund more capital-intensive growth companies in their portfolios.

That diversification was defended as a means of smoothing out returns for the overall collection of underlying businesses quarter by quarter and year by year—conglomerates might have varied businesses, from industrials to financials and consumer goods to technologies, that might be more or less profitable at different times or in different market conditions. So, like a general closed-end mutual fund, a conglomerate can provide a one-stop shop for investors seeking a market basket of companies.

However, in the more current market time, investors have the ability to invest in mutual funds, from closed-end and open-end funds as well as synthetic funds via exchange traded funds (ETFs) and exchange traded notes (ETNs). Also, investors can for diversity buy a collection of different company stocks on their own with the free research all investors have at their fingertips via the internet.

So, there’s less of a need for conglomerates. For investors, it can be harder to value a conglomerate of disparate companies rather than specific stocks of separate companies. This has led some conglomerates to have their stocks valued at a discount in the sum of their parts over the break-up value of the individual holdings.

This brings up the conglomerate United Technologies (UTX) which just “won” the long and drawn-out acquisition of Rockwell Collins (COL) yesterday following last week’s final sign-off by regulators in China. Rockwell Collins is a supplier of aircraft parts and systems that are used by commercial, military and government customers around the globe. It fits nicely into UTX’s aviation and aerospace companies, including Pratt & Whitney (aircraft engines) and Aerospace Systems (parts and systems).

It is the largest acquisition in the industrial space. Following the transaction, for which UTX mostly paid cash at a value of $140.00 per share, United Technologies is moving forward to break up its conglomerate into three separate companies, exactly as I’d been hoping they would. The breakup is projected to be completed in 2020.

The first company will be named United Technologies and will hold the aerospace companies including Pratt & Whitney, Collins and Rockwell.

The second company will be Otis, the eponymous company founded by Elisha Otis and a global leader in the elevator and escalator market.

The third will be Carrier, another eponymous company founded by Willis Carrier, that is focused on the heating, ventilation and air conditioning (HVAC) market.

While there are many moving parts in the potential market valuation of the separated companies, in a company presentation UTX projected that that the end result will be something like an additional $15 to $30 billion in shareholder value for a further gain of 15 to 30% from the current combined value. And that includes projected costs in breaking up the conglomerate, which amount to $3 billion.

The stock was trading nicely up from October 29, rising to over $131.00, but yesterday, after the company presentation, the stock was down some $7.36 and today it is now at a current level of $121.76 a share.

The cause of the drop seems to be that the company is now predicting a more modest bolster of free cash flow (cash from operations minus operating expenditures and capital expenditures) from the initial integration of Rockwell Collins. The consensus was originally for a $1.3 billion increase in free cash flow, but now the company is citing a more modest boost of $750 million.

I think that this is way too harsh a reaction, as the overall unlocking of value in the breakup should mean (all things remaining equal in today’s economy and market) that the overall bolster in the combined share value would be between $138 to $155, with the price to book value set at 3 times underlying assets.

Moreover, the current company is valued at a mere 1.5 times trailing sales—which are on the rise given the strong growth in aviation and building projects. The company has a good history of generating impressive operating margins, which for the aviation unit will only go up from the combined rate of 14.50% for the conglomerate.

Debts are low now at only 28.40% of assets, which means that as the company is broken up, the remaining units should maintain good access to the credit markets for expansion.

The current dividend for the conglomerate is sitting at 73.5 cents per share for a yield of 2.41%. In addition, that dividend has increased at an average annual rate over the past five years of 5.25%.

After the break-up of United Technology, I see the the aerospace company keeping the yield at similar levels. As for the cash-cow businesses of Otis and Carrier, their dividends I would expect to see higher.

In my eyes, the market is giving too much of a short-sighted knee-jerk reaction to the company’s presentation. The companies inside UTX are businesses that will be more highly valued on their own, and they should grow more so into next year.

Not only that, Otis and Carrier would also make for great buyout opportunities for private equity firms, which could more rapidly streamline efficiencies while bolstering free cash flows, all of which would make for higher stock prices in prospective buyouts.