Industrials

Brooke Sutherland is a Bloomberg Gadfly columnist covering deals. She previously wrote an M&A column for Bloomberg News.

Well, that's a nice change of pace.

It's been a rather depressing industrial earnings season, with companies including Honeywell, 3M and Roper cutting their 2016 outlooks in some capacity as low commodity prices, the strong U.S. dollar and weak economic growth weighed on results. But then on Tuesday, along came United Technologies with not just a rosier earnings forecast, but a bumped-up sales projection to boot. The shares rose as much as 2.8 percent for the biggest intraday gain since February.

On the Rise
United Technologies' gains on Tuesday on the back of a good earnings report contrasted with Honeywell and GE's slumps last week.
Source: Bloomberg
Intraday times are displayed in ET.

The improved guidance isn't a total surprise given some of the hints CEO Greg Hayes has dropped. It also suggests that the company was setting a pretty low bar for itself at the onset of the year -- probably a smart move after Hayes had to repeatedly cut guidance last year. Even so, this was a big "show-me" moment for United Technologies. A poor performance could have fueled further questions about how exactly Hayes proposed to increase value for shareholders after rebuffing a $100 billion-plus takeover bid from Honeywell. He deserves credit for rising to the occasion.

The contrast between United Technologies' results and those of some of its peers  -- and shareholders' reaction to them -- is also instructive in that it shows what industrial investors are putting a premium on these days and what stocks may be the ones to watch going forward. Honeywell, 3M and Roper have historically outperformed the S&P 500 industrial index because of their focus on efficiency and strong margins. But even the best operators may eventually run out of costs to cut. After that, the only way to boost earnings further is to grow revenue. And with sales growth weak at best and non-existent at worst, that makes it hard for these companies to add to gains. We're starting to see that reality sink in.  

At the Margin
A look at how Honeywell and United Technologies divisions performed in the second quarter relative to Jefferies analysts' operating margin estimates.
Source: Jefferies analysts led by Howard Rubel

Take Honeywell and 3M. After accounting for the impact of currency swings and acquisitions, revenue growth wilted at both companies, signalling investors may be in for a prolonged treading-water period. That caused a drop in their shares. On top of that, the profitability of some Honeywell units -- aerospace and automation and control solutions -- fell short of estimates made by analysts at Jefferies. At 3M, operating margins at the industrial and health-care units were weaker than expected, according to William Blair. 

Ironically, United Technologies' below-average operating margins may actually be an advantage because it means there's still room for improvement. Hayes announced a $1.5 billion restructuring plan last year, and those cost-cutting efforts are still ongoing. At the same time, United Technologies has managed to cling to organic growth, reporting a gain of about 1 percent for the quarter. That's down from a 2 percent increase in the first quarter, but is still no small feat. The company is sticking with its forecast of 1 percent to 3 percent organic sales growth for the year, which looks pretty achievable.

Rebuilding Year
United Technologies is on track to grow revenue in 2016 after declines the previous two years.
Source: Bloomberg

This doesn't mean United Technologies is in the clear. Hayes is still working through the investment-heavy rollout of the company's costly new jet engine. Investors will also want to be sure that the apparent stabilization and improved profitability at the company's Otis elevator unit isn't just a blip after the significant drop-off last year amid China's slowdown. But Hayes has earned the right to bask in this moment for a bit before he gets back to work.

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

To contact the author of this story:
Brooke Sutherland in New York at bsutherland7@bloomberg.net

To contact the editor responsible for this story:
Beth Williams at bewilliams@bloomberg.net