雷神技術公司 (RTX) 2016 Q3 法說會逐字稿

Good morning and welcome to the United Technologies third-quarter 2016 conference call. On the call today are Greg Hayes, Chairman and Chief Executive Officer and Akhil Johri, Executive Vice President and Chief Financial Officer. This call is being carried live on the Internet and there is a presentation available for download from UTC's website at www.UTC.com.

Please note, except for otherwise noted, the Company will speak to results from continuing operations, excluding restructuring costs and other significant items of a nonrecurring and/or non-operational nature often referred to by management as other significant items. The Company also reminds listeners that the earnings and cash flow expectations and any other forward-looking statements provided in this call are subject to risks and uncertainties. UTC's SEC filings, including its 10-Q and 10-K reports, provide details on important factors that could cause actual results to differ materially from those anticipated in the forward-looking statements.

Once the call becomes open for questions, we ask that you limit your first round to one question per caller to give everyone the opportunity to participate. You may ask further questions by reinserting yourself into the queue as time permits. Please go ahead, Mr. Hayes.

Okay, thank you, Karen and good morning, everyone. You guys all saw in the press release another good quarter in what is a still challenging macro environment. I never get tired of talking to good results, but I do get tired of discussing this challenging macro environment. The good news is that we have businesses that are built to deliver in good times as well as tough times.

So Q3 2016 adjusted EPS was $1.76; that's up 5% year-over-year on $14.4 billion of sales and that includes 5% of organic sales growth. That's driven by the aerospace units. So year-to-date adjusted EPS is up 6% with 3% organic sales growth.

With three strong quarters behind us, we are going to raise the bottom end of the 2016 EPS outlook range by $0.10. That's on top of the $0.15 we raised the bottom end last quarter. We now expect adjusted EPS of $6.55 to $6.60. We are also raising the low end of our organic growth outlook and we know expect organic growth to be 2% to 3% rather than the 1% to 3% previously. We continue to expect full-year sales of about $57 billion to $58 billion.

We will end 2016 at the high end of the EPS range that we had originally provided in December with solid organic growth and importantly, we remain on track to our 2020 goals. Once again had solid cash flow in the quarter while continuing to invest in the aerospace ramp to support future growth. Overall free cash flow was 108% of net income with strong cash generation at each of our business units.

These results demonstrate the positive impact from our focus on the key priorities we laid out earlier this year -- flawless execution, structural cost reduction, disciplined capital allocation and of course, innovation. And there is no better example of innovation than our Geared Turbofan Engine. The GTF is performing exceptionally well in the field. We now have eight operators flying 22 GTF-powered aircraft across the globe. As of last week, the GTF engines have flown over 30,000 revenue hours and more than 20,000 take-off and landings. The GTF is experiencing 99.9% dispatch reliability on the Airbus A320NEO. That's extraordinary performance for a new engine that is meeting and in some cases exceeding all of its key performance targets.

VivaAerobus, which is a low-cost operator from Mexico, recently took delivery of their first GTF-powered aircraft and the final leg on the delivery flight was over 9.5 hours, the longest flight by an A320 in history, which was made possible by an 18% reduction in fuel burn for the aircraft. That is truly remarkable performance.

The good news, of course, is that customers are excited about the engine. Our order book now stands at over 8,400 engines positioning us for top and bottom-line growth for years to come. The issue, of course, has been that our deliveries have been slower than what we had planned. The good news is we know how to fix this. We are aggressively adding capacity; we are improving yields and perfecting processes.

We also continue to make good progress at Otis. Our trend of new equipment orders and units were up 2% in the third quarter and 3% year-to-date. This is in the face of an overall market, which is down more than 5%. I would remind you though that pricing pressure remains intense, so despite unit orders being up, new equipment orders on a sales basis in general were actually down 10% in the quarter.

A tough market right now, but we remain focused on increasing our installed base and converting those units into our service portfolio, which will deliver recurring revenue for decades to come.

We are also starting to see the impact from the strategies that Philippe discussed in March. We are increasing our salesforce, which is helping us on the new equipment side; we are addressing product gaps through higher engineering spend and we are leveraging the scale of Otis to reduce cost and deliver better service to our customers. But, as always, more to do at Otis and across UTC.

We also continue to focus on cost control. Nowhere is this more evident than in our overall SG&A rate, which at 9.7% of sales remains the lowest in the peer group. On the capital allocation front, we just completed the $6 billion accelerated share repurchase program that we launched last November. We continue to believe UTX is trading significantly below its intrinsic value and we are buying back shares beyond the ASR. This is an example of our disciplined capital deployment strategy. We remain on track to return $22 billion in cash to shareowners from 2015 through 2017. While big acquisitions make headlines, we believe that our disciplined approach to capital redeployment will consistently grow shareowner value for the long term.

Okay, let's pivot to organic sales growth. This is on slide 2. Before I talk specifics, let me just briefly talk about how the world looks from our perspective. In summary, no major change in trends that we've seen from the second quarter and largely in line with what we had planned for the year. While the US economic indicators remain mixed, we continue to see strength in most of our US end markets.

In Europe, we have seen a slowdown in construction activity in the UK, we think as a result of the Brexit vote, but the rest of Europe appears to be improving slowly, more than compensating for the slowdown in the UK. Middle East projects remain under pressure, as you would expect, but Asia, excluding China, continues to see robust growth.

Our commercial businesses saw strong growth in the Americas driven by Otis, which was up 9%, which is consistent with first-half performance. Sales at CCS were also up and that was driven primly by continued strength in the residential HVAC business. In Europe and the Middle East, sales were down slightly, largely from the commercial HVAC business in the Middle East, which was down almost 25%.

For Asia overall, sales were down 3%. Of course, that was driven by Otis new equipment sales in China. Aerospace markets remain resilient. The airlines are now into their sixth consecutive year of profitability, and traffic growth remains ahead of long-term trends and air framers continue to have years of backlog, particularly for the new more fuel-efficient aircraft in the narrowbody space where we have great content.

In the third quarter, our aero OEM businesses, both commercial and military, saw very good growth, although that is partially due to an easier compare from the challenges we had last year with the new logistics center startup. At Pratt & Whitney, both military and commercial aftermarkets were strong in the quarter.

With that, let me take it over to Akhil to take you through the details.

Thanks, Greg. Before I start, just a quick note. I'd like to welcome Carroll Lane as the new Head of Investor Relations at UTC. Carroll joins us from Pratt where he was most recently a Vice President at the large commercial engine aftermarket business. Paul Lundstrom has decided to pursue an opportunity as the CFO of a public company on the West Coast and we thank him for his many years of service at UTC.

Moving to slide 3, total reported sales of $14.4 billion were up 4% versus the prior year and included 5% organic growth offset by 1 point of FX headwind. Adjusted EPS of $1.76 was up 5%. On a GAAP basis, EPS was $1.74, up 8% and included $0.02 of restructuring and other significant items.

As you have seen in our press release tables, included in the $0.02 is a provision for ongoing customer contract negotiations at Pratt, largely offset by a benefit from the conclusion of a tax settlement. As Greg mentioned, we had another strong quarter of free cash flow, which was 108% of net income. Year to date, free cash flow to net income is a solid 86%.

As we have said before, due to continuing investments in the areo ramp, we will likely be towards the lower end of the 90% to 100% free cash flow to net income guidance range for the full year. We have high confidence in our increased EPS guidance of $6.55 to $6.60. With three quarters of strong performance behind us, we have narrowed the earnings range for our business units.

Collectively, Otis, CCS and UTC Aerospace Systems should generate around $40 million higher earnings at their new midpoint and we expect an additional $20 million benefit from corporate expenses and eliminations from what we were thinking before. These high expectations will be offset by Pratt & Whitney where we expect full-year earnings to be between $1.750 billion and $1.775 billion. The reduction in Pratt expectations was largely driven by higher E&D spend and lower margins on legacy engine fleet management contracts. This was partially offset by contribution from higher commercial transactional aftermarket and lower net negative engine margin.

We are still in the middle of our planning process for 2017 and we will give specific guidance later. However, there are two points I'd like you to understand. First, even with some recent improvements at current discount rates, pension looks to be a headwind of around $200 million in 2017, about half of that at Pratt. Second, as we more than double the GTF deliveries in 2017, we anticipate negative engine margin to increase by over $300 million year-over-year from approximately $650 million in 2016. We anticipate an additional $100 million of negative engine margin headwind in 2018 and continue to expect negative engine margin to level off at roughly $1 billion level at Pratt large commercial engines.

But this is all part of the near-term investment necessary to return Pratt & Whitney to a leadership position in the commercial engine narrowbody segment. The offsets to negative engine margin through 2020 are still intact. E&D will come down; Pratt Canada and military engine business will grow; and net commercial aftermarket will increase. However, these offsets are unlikely to be a significant factor in 2017. As a result, Pratt earnings will decline next year. We are actively looking to reduce our pension exposure. You saw earlier this month that we took a couple of measures to reduce our liabilities by approximately $2 billion, or 6%. These moves will generate significant economic savings and reduce our exposure going forward.

Due to these actions, however, we will take a non-cash settlement charge in the range of $400 million to $530 million in the fourth quarter. We should also see the benefit of lower share count in 2017, net of higher interest expense, and CCS should deliver solid earnings growth even in the face of a slow macro environment and the absence of commodities tailwind. However, net-net, it is difficult to see earnings growth at UTC levels in 2017.

As we have consistently said, our aerospace units have captured significantly higher content on new platforms, which results in higher-than-normal E&D upfront and low to negative margins on original equipment deliveries. But we also know this content will generate very profitable aftermarket over time and cost reduction will improve margins on new products sequentially year after year. In other words, this short-term pain will deliver very attractive returns over the long term.

With that, let me go through the business unit results for a very solid third quarter. Turning to Otis on slide 4, I will be speaking to the segments at constant currency as we usually do. And as a reminder, there is an appendix on slide 12 with additional segment data as a reference. In the quarter, Otis sales were $3 billion, flat to prior year at constant currency. Profit at $594 million was down 9% at constant currency. Contributions from higher service volume, improved productivity and lower commodity costs were more than asset by continuing price pressure in China and EMEA, additional E&D investments and the absence of prior-year favorable mark-to-market foreign exchange adjustments. Foreign exchange translation was a 1 point headwind to sales and earnings.

New equipment sales were down 2% driven by a 13% decline in China. We continue to see strong growth in North America with new equipment sales up 21% and this is on top of over 40% growth in Q3 of 2015. Service sales were up 3% with continued solid growth in modernization and repair, while maintenance sales were up slightly. New equipment orders were up 2% in the quarter and up 8% outside of China. Orders in EMEA were up over 20% with broad-based growth.

In Asia, outside of China, new equipment orders were up double digits, while orders in North America were up slightly even off a very tough compare. Remember that last year in Q3 we had the Hudson Yards order, the largest private real estate development ever in the US.

So with three quarters behind us, we feel comfortable raising the bottom end of Otis profit guidance and now expect profit to be down $150 million to $175 million at actual FX, up from the already increased guidance of down $150 million to $200 million.

On slide 5, climate control and security sales were up 4% at constant currency, all due to acquisitions. Profits were up 7% at constant currency. FX translation was a 1 point headwind to sales and earnings. Organic sales at CCS were flat this quarter primarily due to the continuing weakness in transport refrigeration. That was down 8% year-over-year. North America residential HVAC, as Greg Said, was up mid-single digit.

CCS delivered solid profit growth from lower commodity costs, restructuring savings and other productivity initiatives. Operating margin expanded by 40 basis points. This quarter represented the 18th consecutive quarter of year-over-year operating profit growth at CCS.

Total equipment orders at CCS were flat, an improvement from the trend we saw in the first half. The transport refrigeration equipment market continues to be under pressure from low freight rates and a declining North America truck trailer refrigeration market after several years of robust growth. Global commercial HVAC equipment orders were down low single digits driven by the Middle East, which was down about 40%. However, we saw strong growth in the Americas where commercial HVAC equipment orders were up 10% on top of high-single digit growth the prior year.

Residential HVAC continued to be robust with equipment orders up 11%. For the full year, we now expect organic sales to be flat at CCS. However, we are increasing the bottom end of the profit range and expect to deliver operating profit growth of $125 million to $150 million, up from the $100 million to $150 million at actual FX previously.

Turning to aerospace on slide 6, Pratt & Whitney sales of $3.7 billion were up 13% organically. This was partially driven by a year-over-year increase in large engine deliveries. As you will recall, we experienced delays in engine deliveries in Q3 of last year due to the startup challenges we experienced at a new logistic center.

Throughout the third quarter, Pratt has delivered 76 GTF engines across all platforms. We continue to expect to deliver approximately 150 engines this year. Pratt also saw strong aftermarket growth in both commercial and military. Commercial aftermarket was up 11% despite a 5 point headwind from the absence of last year's favorable customer contract settlements. Military aftermarket saw growth across all the engine models.

Pratt & Whitney operating profit at $414 million was down 6%. Pratt benefited from higher commercial and military aftermarket, as well as favorable pension and FX. These tailwinds were more than offset by lower Pratt Canada OE dropthrough, additional ramp-related costs, higher E&D expenses and a $0.04 headwind from the absence of last year's contract settlements. For the full year, based on the factors I described before, we now expect operating profit to be down $125 million to $150 million at Pratt & Whitney, revised from the prior guidance of down $50 million to $100 million.

At Aerospace Systems on slide 7, operating profit increased 4% on 6% organic sales growth in the quarter. Sales growth was led by commercial original equipment, which was up 17% off of an easy compare and accelerating growth on next-generation platforms. Commercial aftermarket volumes were up 2%. As you may recall, last year's sales included a customer contract closeout. Excluding that benefit, commercial aftermarket sales were up 6%. The military business was down 6%. The low teens decline in military aftermarket was driven by the completion of the C5 nacelle retrofit program that we have talked about before. This happened at the end of the first quarter. Military OE sales were impacted by lower legacy programs.

Operating profit growth was driven by dropthrough on higher commercial aftermarket sales, continued cost-reduction progress, pension tailwind and approximately $0.02 from the gain of the sale of a non-core asset. This was partially offset by lower military volumes and the absence of prior year's contract adjustments and license agreements. With solid year-to-date execution, we have raised the low end of the Aerospace Systems operating profit range. We now expect full-year operating profit to be flat to down $25 million from the prior expectations of flat to down $50 million. With that, let me turn it back to Greg.

Okay, thank you. Thanks, Akhil. So overall very good performance in the quarter and a strong year so far and while we are addressing some near-term challenges with the GTF production rampup, our Pratt Canada and Pratt military businesses continue to perform well. We've also seen solid performance out of our UTC Aerospace Systems business, Otis and CCS, all of these guys picking up the slack. In the end, balance still works at UTC.

I am very confident of both our updated guidance of $6.55 to $6.60, as well as UTC's long-term outlook. We've got a growing aero backlog and we continue to invest in all of our businesses, and the entire organization remains focused on our four key priorities -- flawless execution, innovation for growth, structural cost reduction and disciplined capital allocation.

We've got a great portfolio of four franchises of global scale and resilient business models, and all these businesses are supported by solid market fundamentals -- growing revenue passenger miles, continued urbanization and a middle-class expansion globally. All of these things position UTC to deliver earnings growth well into the future and to create significant shareowner value. With that, let me go ahead and open up the call for questions. Karen.

Thank you. (Operator Instructions). Nigel Coe, Morgan Stanley.

Thanks. Good morning. The color on the OE losses at Pratt is very helpful. A topic that comes up a lot with investors is the market is not doing a very good job of valuing these initial losses. The $1 billion is probably carried at a negative value right now. So I know you've addressed this in the past, Greg, but how long are you prepared to carry this kind of multiple given that the market can't value the Pratt losses? It doesn't seem to do a very good job of valuing these losses. How long are you prepared to suffer a discount before you think about maybe something structural on the portfolio?

Well, let's not go there quite so quickly, Nigel. Let me say, look, the negative engine margin is not a new issue with Pratt Whitney. We've been talking about this $1 billion peak of negative engine margin in 2018, and clearly next year will be the biggest challenge as production ramps up significantly, even from this year's level. So, as Akhil said, there's about $300 million of additional negative engine margin out there.

I think once we start delivering on a regular cadence on the GTF, people will start to understand that the GTF really will deliver long-term value, and I think, today, there's a lot of show me out there and quite frankly, we haven't performed this year as well as I would have liked to have seen in terms of deliveries, but it's going to get fixed and it's going to be fixed this quarter. It's going to get better next year and continue to get better. And so I think I'm not going to worry so much about the multiple. People will eventually understand that the GTF truly is game-changing technology. And if you talk to the customers, what you are going to see is they love this engine. They love the takeoff power. They love the noise and it's environmentally-friendly. All the things that we set out to do with this engine are on track.

As far as portfolio, look, we will always look at what's best for the shareowners over the long term. I would tell you right now keeping the businesses together makes a lot of sense in terms of supporting some of these losses on the aerospace side with some of the goodness out of the commercial is certainly helpful, but portfolio is always something we look at. Right now, we are focused on continuing to buy back shares. It's the right thing to do. We are trading significantly below intrinsic value, as I'm sure you guys know. So a little frustrating, but it's okay. It's a long-term story here.

We have $22 billion that we are returning to shareholders over three years, Nigel. I think that clearly says a lot about us putting our money where our mouth is and believing fully in the intrinsic value of the Company. $16 billion of share buyback over three years, that's a lot for a company our size.

Yes, absolutely. And the point I was trying to make was some of the parts discount is the widest that we see across our coverage, so this is more of a friendly question than anything else.

It just means a lot more opportunity for growth at UTX, right? That sooner or later the market catches up with reality.

Let's hope so. But the math you just gave, Akhil, and this is my last question, how does that change under IFRS 15, the new revenue accounting standards?

Well, I think there will be a little bit of impact from that as we go through the adoption of the new revenue standard. The biggest impact would probably be in the form of -- as you know, we are doing excess over average over a contract value of the engines, which means there is a little bit of the cost, which is being put on the balance sheet. That will probably get flushed out on 1/1/18. Beyond that, we don't expect a huge amount of change because our accounting, as we have discussed before, on negative engine margin does not change under the new rules. We also have a little bit of adjustment from the POC -- adoption of the percentage of completion -- as opposed to completed contract. We will give you an update on all that as we go through the next year and come up with more precise numbers.

Yes, there will be some E&D that might get capitalized as well. I would just say there's not going to be a big, big impact from the rev-rec standard. Although there will be a lot of work to do, not a huge impact. And we will lay all that out when we put the K out early next year.

Okay. I will leave it there. Thank you very much, guys.

Carter Copeland, Barclays.

Good morning, gentlemen. A quick clarification on something you said, Akhil and a question. The first on the -- I think you said lower margins on legacy fleet management contracts. Did you lower the profit rates on a particular program due to experience on the overhaul costs or any of that? I just wanted to clarify that. And then I wondered if you could help us a little bit with the EBIT bridge at Pratt in terms of it looks like it was probably $100 million, $150 million of holistic GTF year-over-year headwind there. How much of that would you say is real negative engine margin versus maybe extra costs that we might call one-time versus E&D? Any color you can give us there?

Sure. So two separate questions. On the second one first, the bridge for full-year guidance for Pratt is as follows. The changes that we made to the latest guidance had two elements of good news.

Oh, no. I was talking about the quarter.

Oh, just for the quarter? Okay. So, also there is a couple of pieces, things moving. We had good news in the form of higher commercial aftermarket. So that was about $70 million year-over-year, which was offset partly about $50 million from the contract settlements that we had last year. So net benefit in commercial aftermarket of about $20 million. We had good news on pension and FX. That's about $60 million year-over-year good news. So that's together $80 million. And then on the negative side, E&D was up about $30 million; and then Pratt Canada and GTF startup costs were about $80 million. So that's the net math, Carter, to explain the quarter.

Okay. And on the booking rates on the legacy FMPs?

So, on the FMPs, the change is essentially with regard to our V2500 engine program and that's the good news that we are seeing on the transactional side to some extent is being driven by the service bulletin that had come out, which was on the hub that we had talked about before. That, unfortunately, has a negative impact on the engines on the Fleet Management Program. So it's just the other side of the good news that we are seeing on transaction spares and that is basically what is being reflected in the full-year guidance.

Okay. Thanks, guys.

Slight reduction. Slight reduction there. Not much.

Doug Harned, Bernstein.

Good morning. You are talking about delivering 350 to 400 of your turbofans next year. Can you talk a little about the approach you are taking to improve the yield and speed the blade production process and how do you expect the cadence of deliveries to move as you address the fan blade production issues?

It's a great question and it's probably the key to fourth quarter, as well as the key to next year is to improve fan blade production. Let me just put it in perspective for you. At the beginning of the year, the total leadtime on a fan blade was about 100 to 105 days. That is from the time we started it to the time we got it all the way through the test process. It was taking more than three months. And frankly, our first-pass test yield, that is the number of fan blades that were coming out at the end of the process that were acceptable, was about 30%.

Today, that 100 to 105 days is down to 55 days of leadtime. So that has been a big, big benefit to us in terms of throughput in the factories. We've also seen first-pass test yield going up to about 75%. We are continuing to automate. We are continuing to improve the processes out in Lansing. The team has done a great job. This is a brand-new -- as you guys know, it's a titanium aluminum fan blade; never been used before. We will get there.

I think two things to keep in mind is we are going to get significant additional capacity. One of our partners, IHI, will be coming online here in November with additional capacity. They will start delivering fan blades at full-rate production we think in January. We are also standing up a brand-new factory about four miles away from the current factory in Lansing, which will be mostly automated processes. That will start full-rate production in April. So between the process improvements, the yield improvements, the leadtime reductions and the additional capacity, you are going to see step changes in fan blade deliveries really through the first half of next year.

Again, to put this in perspective, this is the first time anyone has ever built one of these titanium aluminum blades and it was a learning process; more difficult than what we had anticipated. But if I go back to 1994, for those of you that have been following the Company a long time, you will remember we had the same issue when we built the hollow titanium fan blade for the PW4000. And we had the same yield issues. We had the same producibility issues and today, it's not an issue at all. We stamp them out -- I wouldn't say on a regular basis -- but we still make them much more efficiently than we initially did and it will be the same on this fan blade. So confident we are going to get there. We are on top of this. We are following production yields on a -- I hate to say this -- a daily basis, but we are following it and I am encouraged by the progress the Pratt team has made.

And then earlier, about a month ago, you had said that you had five critical parts that you were concerned about in the supply chain. When you look at those, are those things that, when the blade issue is resolved, would you expect those to have any additional impact on delivery timing?

So we have line of sight to complete engine builds for this year well beyond the 150. The pacing item this year is going to be fan blades. There is a couple of other critical parts that we continue to work with the suppliers on where we have seen yields improving. We've seen added capacity and we are out adding additional capacity to try and make up some of the slack. So I would think we have the right processes in place in the supply chain to ensure we've got all those parts. It's one of these things where as long as there's no surprises at a supplier, we are going to be just fine. But as you know, we've also put in place a strategy where we have no single point of failure in the supply chain. So we've got two key suppliers for each of the key parts of the GTF.

I also talked about we have added capacity. We are perfecting processes. We also brought back Shane Eddy, who will be leading operations at Pratt. Shane joins us from GE, but more recently he was at Sikorsky as head of operations. So I think Shane and the whole team over at Pratt will get their arms around this and we are highly confident in the outlook for next year.

Okay. Thank you.

Deane Dray, RBC Capital Markets.

Good morning. This is Andrew Krill on for Deane. I just wanted to ask what impact you guys are expecting from the recently passed Montreal Protocol Amendment in relation to refrigerants and for example, any product redesigns that could happen as a result of this and when they might go to market. Thanks.

Yes, Andrew, we have been obviously working with the regulatory authorities on the changes required by the Montreal Protocol. We are in the process of redesigning several of the systems. I think the good news is we are actually ahead of the curve on our commercial refrigeration systems and our transport refrigeration systems. We actually offer a CO2-based coolant solution, which has got a zero global warming potential. So we are on top of this.

I think the one issue that you've got with this additional, or some of these new refrigerants will be cost, which is always a challenge in terms of trying to pass that on. But from a design standpoint, from a market standpoint, I would say that the team -- and we just completed the technology review with the Carrier folks a couple weeks ago -- they are on top of this from what needs to be done from a regulatory standpoint.

Okay. Got it. Thank you. And then as my quick follow-up, can you update on the contingency that's in the guidance? I think as of last quarter, you guys sized it at $75 million?

Now that we have raised the bottom end of the range by $0.10, Andrew, the contingency is about $25 million, essentially, because the business units net-net are about the same.

All right. Great. Thank you.

(Operator Instructions). Cai von Rumohr, Cowen and Company.

Yes, thank you very much. So Akhil indicated the large uptick in Pratt's new engine loss next year and reiterated -- you've made this point, Greg -- of the challenging EBIT outlook, but two-part question. A, with the lower share count and other factors, do you foresee any EPS growth next year with those pluses offsetting the challenges to EBIT? And secondly, given it looks like you are going to have much less uptick in GTF losses in 2018, should we also anticipate a much stronger snapback in 2018?

Let me start and I will let Akhil bail me out at the end. Right now, as we look at Pratt, we wanted to be very specific. There's $300 million of additional negative engine margin on top of probably $100 million, or half of that pension headwind that Akhil mentioned, so a $400 million headwind. It's just hard to see, even with better aftermarket next year and better military, hard to see how Pratt is going to grow earnings. So we actually expect them to be down.

E&D I think is the other challenge at Pratt where we had expected it to be down next year. With the timing of all these programs moving to the left a little bit, we are continuing to see pressure on E&D. So one of the offsets that we are just not going to see until probably 2018 and 2019 is E&D.

As far as overall UTC, again, we are not quite ready to give guidance as you can imagine. We are still going through the detail of the plans from all the units and there's a lot of moving pieces. Clearly, we are going to get a benefit from share buyback, but it's probably not going to offset the negative engine margin and the big pension headwind that we have. I think that's why, as we look at it today, it's hard to paint a picture where we could see earnings growth at UTC next year.

Right. And my comment, Cai, was about EPS, not so much just about segment EBIT because obviously with the pension of $200 million, the negative engine margin Greg talked about; keep in mind the interest expense will be higher next year by about $100 million as well just based on the fact that we need to be in the market to borrow money to fund the share buyback. So even the share buyback will be a significant benefit year-over-year. In terms of lower share count, we will lose some of that through higher interest expense.

And then the second part of the question, 2018?

My crystal ball gets really cloudy beyond about six months. I would tell you, Cai, we are on track with what we've laid out for the 2020 goals, which would show profitability starting to improve in 2018 and 2019. And as you know then first aftermarket, or first big overhauls on the GTF are around 2020. So we expect earnings growth to pick up in 2018. I'm not going to give you a number here, but clearly with the aerospace ramp continuing, there's going to be some challenges, negative engine margin and the mix at UTAS, but those things should be overcome by lower E&D and higher aftermarket as well as growth on the commercial side.

Keep in mind, on the Otis side, we are also going to be investing for the next couple of years. Philippe has laid out a plan to restore some growth to Otis, top-line growth. That's going to require some investment in the salesforce. It's going to require some significant investment in E&D to refresh the productline and from a system standpoint, we need to spend money on these digital initiatives. So there is going to be headwind next year beyond just what we've laid out. All of those things would start to pay off in 2018 and 2019. So, again, we are trying not to surprise anybody with the 2017 outlook, but we are on track to exactly what we talked about back in March about the 2020 outlook.

Thank you.

Jeffrey Sprague, Vertical Research Partners.

Thank you. Good morning, everyone. If I could through a two-parter out there also. Just back to the GTF, just a little bit of pause on my part, just thinking about only a $100 million delta in headwinds in 2018 relative to 2017 given the further volume ramp that you have. So if you could address that. It must be around learning curve and other things, but anything you could provide there.

I was also just wondering if you could give us a little bit of color on working capital and cash flow into next year. It sounds like you might be building engines in front of fan blade deliveries, etc., and just wondering if that puts any inordinate pressure on the cash flows.

Great questions, Jeff. So, on the first one, the math for 2018, there is growth in the negative engine margin on GTFs clearly, but they will benefit from us coming down the cost curve. But the fact which you may not be thinking about is that the CEO engines, or the V2500s, will be coming down significantly from 17 to 18 as will be the GP7000s and both of those carry negative engine margin as well. So while GTF will grow, the others will come down and that's not something that's happening in 2017 as much. So that's the other fact which will keep the incremental GTF incremental negative engine margin at Pratt within the $100 million range.

On the second question on working capital, again, I think we have been very clear about this. There is probably a year or two more as we ramp up as we take the engine productions up at Pratt net-net. There is going to be demand on inventories. We will continue to see some improvement as the supply chain stabilizes in inventory terms, but, in absolute dollars, there will be some demand on that, as will there be demand on CapEx for another year or two where we will probably spend significantly ahead of our depreciation. But after that, we start to feel -- we are back to the 100% of net income or more.

The fundamental thing, Jeff, to keep in mind is that each and every one of our business units has the structure to deliver 100% or more free cash flow to net income. It's just this temporary phase of significant investment we are making to meet the production requirements coming up and that's keeping some pressure on it. Otherwise we are in very good shape. 90% or close thereabouts this year, about 100% last year in face of these investments is not a bad number.

No, indeed. Thank you very much.

Howard Rubel, Jefferies.

Thank you very much. I will try the same two-part. One on North American residential. Very solid numbers. Could you talk about some of the characteristics and what you think in terms of -- is driving the market and the sustainability of that demand?

You've got a second part to it, Howard, or are we going (inaudible)?

Yes. The second part. Thanks, Greg. It's a little bit more structural cost reduction that you are talking about and could you -- you talked about it philosophically -- could you provide some other examples of it and how you think about that?

Yes, sure. Well, let's start out on the North America residential. Obviously, it was a good year. It's interesting, the weather was very hot throughout the summer and yet we really didn't see much traction in residential until September when the dealers were forced to restock inventory. So it was a good quarter, but I think there is still some concern out there about the legs left in the housing market.

As we look at it, household formation continues to be very, very strong at about 1.2 million a year. That's going to grow. If you think about 1.2 million housing starts, 20%, 25% of the resi business is for new construction and I think that should remain on track. I think more importantly, it's the aging of the installed business out there that is going to really drive growth. There's over 100 million split systems installed in the US. Average life is somewhere between 10 and 15 years depending upon where you live and how much you use the equipment and that is again the big increases that we saw back in the early 2004, 2005 when the market was 7.5 million units a year. Those units are approaching the end of their useful life. So I think we should continue to see well above GDP growth in resi for a couple more years here. So I'm not at all discouraged here. I think it's a really -- we are in a very good place. We've got great products; very high efficiency systems and there is a big push I think to continue to gain share there.

As far as the structural cost reduction, Howard, there's always things to do. I think Dave Gitlin and the team down at the Aerospace Systems business in Charlotte have been focused on it. I'm reminded, since we acquired Goodrich back in 2012, four years ago, we've realized about $600 million of synergies. We've closed more than 30 factories. There are still more factory consolidations to come. I think there's also structural cost opportunities in the aftermarket down at the Aerospace Systems business. We have a very large number of overhaul and repair shops around the world. I think Dave is working on opportunities there. So more to do at Aerospace Systems.

Clearly Bob McDonough and team are looking at ways to continue to reduce costs in the very competitive markets that we are. Probably no more big plant closings there, but still executing on what they've got out there already. And the same is true on Otis. I think they are consolidating their engineering footprint to three major engineering centers from over 15 today. That will help reduce structural costs. We are also focusing on trying to consolidate the service supply chain. We've got over 60,000 suppliers in Otis's service network and there's a huge opportunity there to reduce costs structurally.

The one place I'm not going to be reducing structure is probably Pratt over the next couple of years. They've done a heck of a job over the last six or seven years taking overhead costs out. Their SG&A is like 5%. So, right now, for Pratt, it's about probably adding capacity. But we are going to continue to look for ways to take costs out everywhere from the corporate office, to the aftermarket, to the supply chain.

Thank you very much, Greg.

Noah Poponak, Goldman Sachs.

Good morning, everyone. Could you guys provide a little bit more detail on what you saw in the aerospace aftermarket in the quarter? It seems like the discussion around airline inventory pulling and used parts sales that had been headwinds has faded. Curious if that's actually faded in your business and any ability to speak to what the growth rates were, excluding anything you'd consider to be nonrecurring, whether it's provisioning, or year-over-year comps or anything like that?

Sure, Noah. So I think the reported numbers would say UTAS aftermarket grew by -- commercial aftermarket -- grew by about 2%, but we had the benefit of 4 points from last year's contract closeouts. So I think the trend rate would be about 6%, which seems more in line with the normal world. We've always said that the long-term growth rate for commercial aftermarket in the UTC Aerospace Systems business should be mid-single digit and this quarter felt like that. There was some benefit in provisioning that we saw with some new programs coming in, but that's in the range of a point or so. So I think I would say very normal type of a quarter. The trends seem reasonably okay and good. Obviously, for the full year, we are expecting low single digit growth at UTAS and we still feel comfortable with that.

On the Pratt side, a lot of the growth has been coming on the V2500 engine. As we've talked about before, there are two factors driving it. One is the service bulletin, but more importantly it is about time now that the first overhauls for the V2500 select five engines start to come in. We have seen the average age of a V2500 at about eight years, and 50% of those engines had not come for overhaul. So they are starting to come into the shops now, which is helping on the commercial aftermarket there. I think overall I would say it's a normal, what you would expect kind of a trend in commercial aftermarket.

Okay. Thank you.

Steve Tusa, JPMorgan.

Good morning. So it basically sounds like Pratt is essentially down 400 full stop. And I guess if that's the case, and you have a little bit of extra pension going against you, will you guys do your normal contingency and stuff like that? Why wouldn't the -- with that profile, it's tough to get to even a high end of the range in EPS that's above flat. It just seems like the magnitude of headwinds now is pretty dramatic to overcome even at the high end of the range.

Well, let's start with Pratt, Steve, and again, not to be more specific than we already have been, there is $400 million of headwind, but there will be growth in some of the other parts of the business to offset some of that at Pratt specifically. So we are not going to just mail in Pratt and say they are going to be down $400 million to start. We've got work to do there and we will continue to work through the end of the year to make sure we've wrung out every penny we can in terms of their forecast for next year.

The other headwind, the pension headwind is real, but it's real today. We will have to see where rates are at the end of the year. It moves us around a lot, as you can imagine. Obviously, this pension transaction that we did earlier this quarter is just our way to start trying to reduce that big liability that we got out there. We got $1.7 billion off the books, but, as I say, there's more to come there. I think we are going to continue to look for ways to immunize the plan to try to avoid some of the pressure that interest rates put on us.

And interest rates, it's not just pension. It's all the other long-term liabilities also add cost. So we've got a long way to go on the plan. Clearly, we should see growth at CCS. We are pushing obviously the Aerospace Systems business to grow. They are going to have a pension headwind though as well. And Otis, again, probably a tough year next year as we continue to invest in E&D and systems and all of that. But we will see. We are going to get benefits out of share count. We will see. I think there's just a lot of moving pieces yet.

Yes. Steve, we generally have this specific discussion later in the year and we will still have that. We are in the middle of our planning process right now, so I wouldn't necessarily make a comment on where the high end of the range would be, but I can tell you that definitely we would like to have a contingency because I think that plays well for us. Bad things do happen in the year and we just want to make sure we don't surprise the investors in any way.

No, no, I think that's smart too, obviously. I'm just adding up all these -- you've highlighted $700 million of -- or $0.70 of year-over-year and it just doesn't seem like there's a lot of good guys out there. So just wanted to make sure that I was not missing any kind of major good guy moving parts. What was the revenue adjustment at Pratt & Whitney in the quarter? Some customer contract (multiple speakers)?

It's also part of that ongoing customer contract negotiations, Steve, so that's pretty normal for us to see that where the sales adjustment comes as part of the collaboration accounting that happens on the risk revenue sharing partners.

Okay. And then one last question. What's the delivery forecast for GTF next year? Units?

I won't give you a specific number. I will tell you that we expect more than double, so probably north of 300, 350 units.

Okay. Great. Thanks a lot.

Myles Walton, Deutsche Bank.

Thanks. Good morning. Was wondering if I could follow up on Pratt for a second. So the implied margin rebound in the fourth quarter, a couple hundred basis points plus given you will be delivering more GTFs. What's giving you confidence that you can get out of the 11s you've been putting up for the last few?

Well, I think you're right about the negative engine margin. I'm not sure how you are calculating the fourth-quarter margin rate?

Down low single digits? I'm sorry, up low-single digits for sales?

Yes.

Okay. And then fourth-quarter implied [$470 million] of EBIT?

Right, right.

Okay.

We can talk more off line, Myles, on that one, but I think there is -- you know the factors which are going to impact Pratt in the fourth quarter. The negative engine margin is one. We don't see E&D coming down that much in the fourth quarter. There is obviously some benefit at Pratt Canada. We continue to see FX good news, pension good news. Net-net the math would get you to the fourth-quarter number, which is easy to calculate now.

All right. And then the only other one, Akhil, clarification on the pension. So $200 million of a headwind, is that a headwind net of the $150 million that pension was supposed to decline in 2017? So it is only a (multiple speakers)?

Yes. It is net, Myles. It was supposed to decline by $100 million, not $150 million. I think we talked about that before. So this is the net because -- just the discount rate change in UK and US is pretty significant, as you know. It's not just US. UK has seen significant reduction in discount rates as well and we have a pretty significant pension liability in the UK markets as well. So it's a combination of that. The $200 million is the net number based on discount rates today. As Greg said, that can change, again, depending on what happens with the Fed and what happens on December 31.

Great. Thank you.

David Strauss, UBS.

Thanks. Good morning, Akhil. Was looking for a bit of an update at Otis on the price actions you've taken, where you think we are; how much more there is to go and what impact, Greg, you think you've seen on marketshare as a result? Thanks.

So in terms of marketshare, the key thing, David, there is -- the biggest market, as you know, is China. We see China is about 50% of the new equipment market still. In terms of units, it's even larger and there, based on the data that we have talked about for the three quarters, our unit orders have been up 3% where we firmly believe the market has been down 5% or more. So, clearly, we are seeing some benefits in the marketshare in the China business. I would say even though the data is not quite there from industry overall, but given the strength we have been seeing in our orders in Americas, we have been doing extremely well there and I would venture that we are gaining significant share in Americas. And then in Europe, the order rates are up 21% this quarter, which suggests that, again, we are probably doing better than market. So net-net, the initiatives that Philippe has laid out, particularly on the new equipment side, are starting to show up this year.

And just to follow up, in terms of further price actions, how much more do you think there is to go, I guess thinking about 2017 relative to 2016?

Yes, I think pricing has been very, very difficult for the last couple of years in China. We've been talking about that. We actually started to see some stability here in the third quarter on pricing as the market continues to be relatively robust, especially in the tier 1 and tier 2 cities. Pricing is an issue really across the Otis portfolio, but is obviously most acute in China.

US, I think we are doing a little bit better. Pricing in Europe continues to be tough and I think we continue to lose a little bit of pricing on the service portfolio every quarter. So the key for us and for Otis to turn this around is to make sure we get that service stickiness, so we see the cancellation rates come down, and we also improve the productivity of the field workforce. So there's a lot to do at Otis. It's not just about pricing. There's some structural things we need to do, but I think Philippe and team are on the right track.

And keep in mind, David, that the China team for Otis, particularly, is very good at taking cost out from the supply chain as well. While we see pricing pressure every year, they have also been able to extract cost reductions from supply chain. So they will continue to do that. They continue to push productivity in the factories there and they will offset at least part of the pricing pressure that we have seen. Q3 pricing was not any worse than what we had seen year-to-date, so it seems to be stabilizing a little bit. Still much higher than what we saw last year, but down 7% to 9% as opposed to the 4% to 5% that we used to see before.

Got it. Thanks for the color.

Julian Mitchell, Credit Suisse.

Thanks a lot for squeezing me in. I guess one of my questions would be around Aerospace Systems. You gave a lot of color obviously on Pratt, the commercial OE headwind there for next year. How are you thinking about Aerosystems, particularly around the nacelle side?

So, great question, Julian. We've always said that, for Aerospace Systems, the adverse mix would be the biggest headwind in 2017. It starts to become better from 2018 onwards, but the UTAS team is also working very aggressively on cost reductions. You can see it from this year's performance. They are doing extremely well with regard to the plan that Dave Gitlin laid out. They are very much on track with it, and I think the same thing will hold for next year. They will be offsetting a large part of this adverse mix issue that they have with the changeover from legacy platforms to the new generation aircraft with the lower margin products replacing high-margin legacy products. But we do expect UTAS to do very well in terms of being able to offset a large part of that mix in 2017.

Thank you. Then just my last one -- I know it's running late -- is just around Otis again. The implied guidance for Q4, you've got much less of a decline in EBIT than what you've seen so far this year. Is that just a result of the easy comp because the margin last Q4 was so weak or do you feel that you are getting around the bulk of the headwinds now on E&D and reinvestment in that business?

No, I think it's more of what you said first, which is easier comps in fourth quarter. If you remember this quarter, we had the negative adverse impact of the FX mark-to-market adjustments. Last year in fourth quarter it had gone the other way. So, therefore, we get some easier compares, which are relatively easy to forecast and that's why we feel comfortable with the Otis guidance for the year.

And I think just to add just a bit of color there, Julian. The fact is these fixes that we are talking about at Otis, this is nothing you are going to see come through in the P&L right away. Even if we improve on the new equipment side, it takes us 18 months to install the elevators. We give free service for a year. You are really talking two to three years out before you really start to see big traction on the new equipment side. Service productivity will be a little bit faster, but again we are making more investments than we are seeing on the productivity site initially. So a little bit of patience on the Otis side, I think, but on the right track.

All right, I want to thank everybody for listening in today. I appreciate that. As always, Akhil and the investor relations team will be available all day to answer your calls. I would ask that you go easy on our new guy, Carroll Lane, as he comes up to speed, but I'm sure he's looking forward to meeting with each and every one of you. So thank you very much and have a wonderful day. Take care.

Thank you. Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program and you may now disconnect. Everyone have a great day.