A United Tech Carrier Deal Points One Way

(Bloomberg Opinion) -- United Technologies Corp.’s stipulations for a sale of its Carrier climate controls unit point to Johnson Controls International Plc as the likeliest potential partner. To justify scrapping a planned spinoff of Carrier, any divestiture would need to be tax free to United Technologies shareholders, CEO Greg Hayes said Wednesday at a Barclays Plc conference. The most obvious way to do that is through a reverse Morris trust, whereby United Technologies would skirt the high levies typical of sales of legacy assets by instead merging the business with another of roughly equal size. Johnson Controls is the only competitor with sufficient scale to make the math work. The company, which merged with Tyco International in 2016, is focusing on building controls after agreeing last year to sell its car-battery business. Its building-efficiency unit generated $3.1 billion in operating income in its most recent fiscal year, compared with $3.8 billion for Carrier. Ingersoll-Rand Plc’s climate division and Lennox International Inc. are smaller, with $1.8 billion and just over $500 million in 2018 operating income, respectively.

Johnson Controls has played coy on the topic of consolidation. CEO George Oliver has said the battery sale increases the company’s ability to take advantage of strategic options in the HVAC industry, and Johnson Controls is keeping up to $8 billion of its proceeds from that deal available for M&A. But separately at the Barclays conference, Oliver said his company had already made the investments needed to create a competitive advantage. Hayes has other criteria that could complicate a deal: having just endured a surprisingly long regulatory review of United Technologies’ $30 billion takeover of avionics maker Rockwell Collins, he wants to be sure of a smooth antitrust process; and he wants full value, which in his mind is a multiple of “12 times or 12.5 times.” Assuming he was using Ebitda multiples, that would imply a valuation for a standalone Carrier business of nearly $50 billion, based on Bloomberg Intelligence’s estimate of $3.9 billion in 2020 adjusted Ebitda. For reference, Johnson Controls commands a multiple of 11.4 times its estimated 2020 Ebitda with a building-products business that’s a profitability laggard. So a multiple that starts with a 12 seems reasonable for Carrier, but this would obviously be a gargantuan and complicated combination.

One caveat is that analysts once thought United Technologies would have to spin off or broker a reverse Morris trust for its Sikorsky helicopter unit to avoid a hefty tax bill. Instead, it sold Sikorsky to Lockheed Martin Corp. for $9 billion with the buyer paying a premium to compensate United Technologies for the tax burden and finding a way to book a tax benefit for itself. So alternatives are possible, but more of a long shot. Also of note from Hayes’s presentation was his disclosure that United Technologies had submitted a “competitive” bid to supply engines for a middle-market aircraft that Boeing Co. is contemplating. When General Electric Co. CEO Larry Culp was asked about the potential project last month, he said that the company was in conversations about new platforms but that it would be premature to discuss the cash-flow hit such an investment would entail. It’s early days for the middle-market aircraft, and Boeing may yet decide to scrap the idea, but based on the CEOs’ statements, United Technologies seems more prepared. While GE’s aviation unit has been a stronghold, the cash crunch wrought by the issues in its power and finance units risks hamstringing it.

STEP BY STEP
GE is adding Catherine Lesjak, the former chief financial officer of HP, to its board, effective March 1. This is the second director appointment since Culp became CEO, following the addition of Paula Rosput Reynolds, a former utility and insurance executive, in December. Like Reynolds, Lesjak’s skillset seems well-suited for GE’s challenges. She helped guide HP through a major breakup and, according to the Wall Street Journal, argued against the ill-fated $10.3 billion acquisition of Autonomy Corp. in 2011 because of the damage it would wreak on HP’s balance sheet. She was right —  HP later took an $8.8 billion writedown on the deal and has fought a years-long legal battle accusing Autonomy of inflating its finances — and her reward was to help clean up the mess. Her experience will be useful as GE deals with its own troubled balance sheet and the ramifications of poor capital allocation choices. But the appointment of Lesjak comes nearly five months after the ouster of former CEO John Flannery reduced the board to 11 members. Reynolds replaced John Brennan, who had previously announced his retirement. There’s a method to this kind of piecemeal change, but the reality is that GE needs a deep-rooted cultural overhaul and Culp doesn’t have the luxury of time. Separately, GE may release its 10K filing as soon as Friday evening, if history is a guide, and the company has promised more disclosure on its long-term care insurance headaches.

EVERYONE WANTS TO BE AN INDUSTRIAL INVESTOR 
New research from RBC Capital Markets found that machinery and equipment makers have supplanted the so-called FAANG group of technology stocks and drugmakers as the trade of choice among hedge funds. Read the full write-up from Bloomberg News’s Lu Wang here. To that end, the $11 billion Industrial Select Sector SPDR Fund, ticker XLI, experienced an inflow of more than $565 million on Wednesday, its largest since November 2016 when investors wagered President Donald Trump’s election would herald a wave of infrastructure investments (still waiting on that). The surge in interest may have been driven in part by Caterpillar Inc.’s comments that equipment replacement demand in China is at normal levels and that the company isn’t seeing a meaningful impact from trade issues. China’s top trade negotiator, Vice Premier Liu He, extended his visit to Washington after hammering out an agreement on currency with the Trump administration, saying through an interpreter that a deal was likely to happen.

Apart from trade tensions, Bloomberg Intelligence analysts Scott Levine and George Ferguson detect an underlying slowdown in China’s economy and highlight the aerospace, construction and automotive markets as among those that could be hit hardest. At conference presentations this week, executives from 3M Co., Ingersoll-Rand and United Technologies were cautious on China, using phrases such as “softer”, “eyes wide open” and “warning sign.” And should one trade war end, another may enter a new chapter: Caterpillar trucks are on the list of items the European Union is prepared to slap with retaliatory tariffs should Trump act on a threat to impose duties on cars imported from the region. Put another way, be careful in crowded places. 

DEALS, ACTIVISTS AND CORPORATE GOVERNANCE UPDATE
Warburg Pincus is reportedly considering a sale of Consolidated Precision Products Corp., which makes castings for jet parts made by GE, Honeywell International Inc. and United Technologies. Warburg acquired CPP in 2011 and augmented the business with acquisitions including the takeover of Selmet Inc. last year. The time seems right for an exit, with aerospace suppliers increasingly looking to add scale to counter Boeing and Airbus SE’s push for cost cuts. I do wonder about the long-term future of middle-men suppliers as additive manufacturing gains more traction, but CPP’s products are highly engineered.

Rockwell Automation Inc. and Schlumberger Ltd. are forming a joint venture — dubbed Sensia — to develop oilfield software and automation tools. Rockwell will pay $250 million to Schlumberger for a 53 percent stake in Sensia, while Schlumberger is contributing 100 petrochemical engineers and access to its Avocet software platform, among other things. The appeal for Rockwell is that the joint venture’s operations will be less concentrated in North America than its existing businesses and will have an Ebitda margin similar to its own 20 percent range. It’s not cheap: Stephens Inc. analyst Rob McCarthy estimates Rockwell’s investment implies an Ebitda multiple of about 15. But one prior criticism of Rockwell was that it wasn’t spending enough for growth in the industrial internet of things. The other is that its focus on providing assembly-line equipment for the automotive and electronic industries made its profits subject to volatility. This deal — and a deeper relationship with Schlumberger in general — will give Rockwell a helpful leg up into process automation tools for the petrochemical industries. The irony of this is that the idea of a one-stop-shopping automation company was the driver for Emerson Electric Co.’s takeover pursuit of Rockwell in 2017, which the target company vigorously rebuffed. Sometimes you have to take the scenic route.

Toro Co., a $7.3 billion company whose equipment has been used to maintain the turf at Torrey Pines Golf Course and the Wimbledon tennis courts, is buying closely held Charles Machine Works for $700 million. It’s the largest takeover in Toro’s 105-year history, according to data compiled by Bloomberg. Charles makes equipment for underground utility construction, including Ditch Witch directional drills and vacuum excavators, and its products are used in the water, telecom and utilities markets, among others. It’s a true diversification play, which we rarely see anymore in this age of industrial breakups. But it makes sense: Toro’s lawn and garden focus had made its results subject to the whims of the weather gods, and there’s manufacturing and materials purchasing overlap between the two companies, with Toro estimating $30 million in annual cost savings. Toro’s experience with a small specialty construction business and the oligopoly Charles enjoys in the underground construction market should also ease the integration risk. The price looks reasonable at about 8 times Charles’s 2018 Ebitda, including synergies. Separately, Toro surged 7 percent on Thursday after reporting better-than-expected first-quarter earnings.

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To contact the editor responsible for this story: Daniel Niemi at dniemi1@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Brooke Sutherland is a Bloomberg Opinion columnist covering deals and industrial companies. She previously wrote an M&A column for Bloomberg News.

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