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Investors Should Be Patient with Pratt & Whitney’s Engine Investments

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Aug. 2 2016, Updated 8:06 a.m. ET

United Technologies’ free cash flows

United Technologies (UTX) achieved 100% conversion of net income into cash flows in 2Q16 compared to 76% in 2Q15 as the strong working capital performance was partially offset by increased investments in the Pratt & Whitney program. Cash flow from operations increased 29% year-over-year (or YoY) to $1.8 billion, and free cash flows increased 35.5% YoY to $1.4 billion. For the whole year, the company expects to convert 90%–100% of its net income to free cash flows. Capital expenditures were $363 million in 2Q16 compared to $332 million in 2Q15.

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Pratt & Whitney investments

Pratt & Whitney has taken a dozen years and $10 billion for its engines to be brought to the market. These engines are recording a negative margin at delivery, and according to company estimates, they are expected to increase further. Despite the increase in production rates bringing down costs, UTX is likely to see $10 billion in negative engine margins over the next ten years with $1 billion of that $10 billion expected to be recorded by 2018. So what exactly is the investment rationale behind these investments? It’s the aftermarket.

The engine (XAR) programs are slated to last for 30 years and as they enter the timeframe of 6–8 years, they need to be overhauled, which brings UTX’s aftermarket services into play. These trends were visible in the V2500 engine aftermarket sales in 2Q16. The average of V2500 is now nine years, and it’s in the so-called “sweet spot” for UTX. Therefore, it’s important to see these investments from a long-term perspective and their ability to return the cost of capital over time. The newly developed geared turbofan engine (ITA) is currently an exclusive engine for the Airbus 320neo (EADSY), Bombardier C Series (BDRBF), Embraer E-jets (ERJ), and Mitsubishi Regional Jets.

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