Loren Thompson - Pratt And Whitney Poised To Become Engine Of Growth For United Technologies

Connecticut-based United Technologies (UTC) is one of the biggest industrial conglomerates in the world. The basic logic of conglomerates is that they combine operations in multiple industries so that revenues and returns do not depend on demand for particular product lines. The synergy of the enterprise thus is mainly financial rather than functional. Although some investors prefer "pure-play" companies concentrated in specific sectors, multi-industry enterprises like UTC, Boston-based General Electric, and Providence-based Textron tend to be more resilient.

If a conglomerate is really big, like United Technologies, it can still be a dominant player in each of its addressed markets. UTC's Otis brand is the leading elevator supplier in the world, its climate, control & security unit subsumes a dozen well-known product lines such as Carrier air conditioners, and UTC Aerospace combines the legendary legacy enterprises of Hamilton Standard, Sundstrand and Goodrich. Each of these business units generates operating margins of 15-18%, which is unusually robust for U.S. manufacturing.

And then there is Pratt & Whitney, perhaps the most storied brand in the entire UTC portfolio. Pratt, which is mainly engaged in making aircraft engines, barely reached an operating margin of 10% last year. It was 6% the previous year. However, the reason for this seeming under-performance is that Pratt & Whitney is gearing up to become the most important provider of both military and commercial aircraft engines in the world. It has brought to market disruptive technologies that will make it the dominant engine maker for a generation.

Pratt & Whitney manufactures the afterburning turbofan used on the single-engine F-35 fighter, the biggest military production program in history. Pratt has cut the cost of the Air Force engine variant -- the most widely used -- by 50% since 2009, so that it now costs no more than the legacy engine from which it was derived despite delivering 20% more thrust. 

Pratt & Whitney manufactures the afterburning turbofan used on the single-engine F-35 fighter, the biggest military production program in history. Pratt has cut the cost of the Air Force engine variant -- the most widely used -- by 50% since 2009, so that it now costs no more than the legacy engine from which it was derived despite delivering 20% more thrust. 

Although most people who follow the industry realize that Pratt is already one of the big-three global producers of turbofans and that it provides propulsion for the biggest military aircraft program in history -- the F-35 fighter -- relatively few grasp how it will dominate its markets in the years ahead. So I'd like to use the balance of this commentary to explain why Pratt & Whitney isn't just becoming the most important maker of aircraft engines, but also an engine of growth for its parent company.

I should mention up front that United Technologies gives money to my think tank, and that I am a shareholder -- a decision I made largely on the basis of where I see Pratt going in the years ahead. In fact, United Technologies is the sole company with extensive aerospace exposure in which I am invested. But Pratt only generates about a quarter of UTC's revenues today, so why would that make the parent company's shares so appealing to me?

Obviously, I am beginning with the assumption that CEO Greg Hayes continues to generate impressive returns in the company's other operations. Against that backdrop, though, Pratt & Whitney looks poised to be a breakout performer due to several factors that aren't often associated with U.S. manufacturing these days. First of all, its "geared turbofan" technology being applied on the Airbus A320neo and several regional aircraft is so much more efficient than alternatives that Pratt's rivals will be playing catchup for the foreseeable future.

The basic idea behind a geared turbofan is that it introduces reduction gears onto the engine shaft so the fan at the front doesn't turn as fast as the turbine and compressor in the back. What that means in practical terms is that each part of the engine can operate at optimum speeds, a feature that isn't feasible using conventional turbofans. The enhanced fuel efficiency that results -- 16% today, probably more in the future -- is a key selling point with customers. The engine also generates much less noise than a conventional turbofan, and less exhaust.

I'll avoid going into a technical description of what it means to have a higher bypass ratio than other engines or why the technology took over a decade to perfect on large commercial engines, but the bottom line is that geared turbofans are a generational leap in propulsion for commercial transports, regional aircraft and new Gulfstream business jets that competitors won't be able to match anytime soon. More sales up front means bigger revenue streams in aftermarket parts and support that will continue through mid-century.

A second factor positioning Pratt & Whitney for breakout in the years ahead is the F135 engine used on the Pentagon's F-35 fighter. About 4,000 of the single-engine fighters will eventually be produced in multiple variants for three U.S. military services and at least a dozen allies, making it by far the biggest military production program in the world. Pratt is the exclusive supplier of the plane's engine, which is acquired by the government separately from the airframe contract it has with Lockheed Martin.

Like the geared turbofan on the commercial side, the F135 engine had teething problems when it was first introduced, but is now performing quite nicely. Pratt delivered the 300th engine in December, and for a price roughly equal to that of the F119 engine from which it evolved. That's pretty impressive when you consider the F135 generates 20% more thrust. The program manager for the fighter program, not generally known for complimenting industry, has acknowledged that Pratt delivered on its commitment to reduce the price of the engine.

In fact, Pratt has cut the cost of the engine on Air Force and Navy variants 50% since 2009, and the cost of the more complex Marine variant (which must be able to take off and land like a helicopter) by 35%. But that's just the beginning as far as Pratt's military side is concerned, because it will also be supplying high-performance engines on the Air Force's next-generation aerial-refueling tanker and on its future bomber, just as it already does on the Air Force's most capable strategic airlifter (the C-17).

 

In fact, Pratt supplied engines for most of the Air Force's fleet, which includes thousands of Cold War planes requiring parts and service for decades to come. The aftermarket revenues from all those fielded engines won't just continue through mid-century, but will likely grow as the airframes age -- even as production of the F135 engine ramps up to meet increased domestic and foreign demand. As if all this were not good enough news, military aftermarket revenues tend to surge when commercial sales soften, smoothing out returns over time.

A third factor bolstering Pratt's outlook that has gone largely unnoticed on Wall Street is the way in which the unit has thoroughly transformed its business culture. The last time Pratt & Whitney did a major ramp-up of production in the 1980s, it manufactured nearly 50% of its engine parts internally. That percentage is now down to 20% as it focuses on core competencies while relying on a carefully monitored supply chain to provide most parts. In other words, it has transitioned from vertical integration to what might be called an "extended enterprise" model.

The shift in strategy has coincided with digitization in every facet of the company, so that suppliers now can be rigorously tracked to assure that quality standards and just-in-time delivery schedules are met. Pratt generally prefers to have more than one supplier for each part and component that it outsources, but by reducing fixed costs it has freed up money for product development and investment in new manufacturing systems at places like its Columbus, Georgia plant. Pratt is investing heavily at its U.S. production sites.

Roughly a third of the 25,000 new workers it will hire to ramp up commercial and military production over the next several years will be in its home state of Connecticut. Additional hiring will likely occur in Florida, Georgia, Maine and other states, giving it a significant domestic political footprint -- even before its hundreds of U.S. suppliers are included in the calculation. Having an extensive domestic workforce helps the company to win support in Washington for tax and regulatory policies vital to its profitability.

There is a lot more to this story, such as the role played by Pratt's Canadian operations in powering business aircraft, regional airliners and military airframes, and the roster of foreign military customers (over two dozen) Pratt has assembled for its offerings. Pratt & Whitney has managed to leverage U.S. technology and skills into the global economy without losing its distinctly American identity, and now looks poised to dominate its industry in the years ahead. United Technologies' engine business is fast becoming an engine of growth.