United Technologies Corporation (NYSE:UTX) is a diversified industrial conglomerate that manufactures and markets a diverse array of products primarily for the construction and aerospace industries.
Founded in 1934, they now sport a market cap just north of $87 billion. Their primary branded products include Otis elevators, Pratt & Whitney aircraft engines, Sikorsky aircraft, and Carrier HVAC systems.
United Technologies operates in the following segments: UTC Climate, Controls & Security (25% of fiscal year 2014 revenue), Pratt & Whitney (22%), UTC Aerospace Systems (22%), Otis (20%), and Sikorsky (11%).
The company, however, in July announced the sale of Sikorsky to Lockheed Martin Corporation for $9 billion, meaning this segment will disappear moving forward.
International sales accounted for approximately 63% of FY 2014 revenue.
One reason UTX has long been on my radar is due to the fantastic fundamentals the company exhibits. Although a cyclical company by the very nature of the business model and the industries they serve, their growth is about as secular as it gets for a company with heavy exposure to cyclical areas of the economy.
We’ll first look at growth over the last decade, which allows us to smooth out those aforementioned cycles a bit.
From fiscal years 2005 to 2014, revenue grew from $42.725 billion to $65.100 billion. That’s a compound annual growth rate of 4.79%.
Meanwhile, earnings per share is up increased from $3.03 to $6.82 over this time frame, which is a CAGR of 9.43%. What’s really wonderful here is that during this stretch, EPS growth was fairly steady. It dipped during the financial crisis some, but not substantially. And the results came back pretty strongly thereafter.
That excess bottom-line growth was driven in large part by extensive share repurchasing activity, with United Technologies reducing its outstanding share count by approximately 10% over that 10-year stretch. In addition, improving margins helped.
S&P Capital IQ anticipates that the company will be able to grow its EPS at an 11% compound annual rate over the next three years, citing a strengthening US construction market and accelerating global air traffic growth. This prediction isn’t tremendously different than what UTX has done over the last decade.
Now, it’s one thing to grow at near double digits over a decade and operate at a high level. But that’s all for not, in my opinion, if a company isn’t sharing the growing profit pie with shareholders in the form of an incrementally increasing piece of pie. And it’s in that that United Technologies really impresses.
They’ve increased their dividend for the past 22 consecutive years, which is a solid track in and of itself. But I also think it’s highly likely this activity will continue well into the future (or else I wouldn’t be investing in the company).
A moderate payout ratio of just 36.7% seems to indicate this is a very plausible assumption. That means the company is paying a dividend that amounts to less than 37 cents of every dollar in profit they take in. That’s a fairly low number, leaving plenty of room for future dividend raises. In fact, dividend growth could outstrip EPS growth for the foreseeable future and the dividend would still remain sustainable as long as that growth difference remains reasonable.
We can actually see a growth difference over the last decade, as the dividend grew at an annual rate of12.9% over that period. That spread could continue for a number of years before it would become problematic, but I suspect we’d see a smaller spread going forward.
The stock currently yields 2.58%. Although that’s well over the broader market, it’s also a bit lower than I usually look for. However, UTX rarely offers a very high yield – its five-year average is just 2.2% – and I believe the quality and growth potential offsets that.
Like many companies in the Industrials sector, United Technologies has a leveraged balance sheet. Their business model requires a rather heavy base of manufacturing assets, so this isn’t surprising. However, the leverage is anything but concerning.
They currently sport a long-term debt/equity ratio of 0.57 and an interest coverage ratio of approximately 9.
Profitability is also sound and compares well to the industry. Over the last five years, the company has averaged net margin of 8.86% and return on equity of 21.12%.
So an investment in this company is basically a play on two important, but different, industries: construction and aerospace.
Their primary branded products are dominant in aggregate, affording United Technologies leading positions in every market it serves across escalator and elevator systems, aircraft engines, technologically advanced aerospace products, and HVAC systems.
Most of the company’s primary businesses are very attractive due to limited competition. Pratt & Whitney, for instance, is one of only three major jet engine manufacturers, which leads to rational pricing and joint ventures.
In addition, high switching costs allow the company to profit handsomely from aftermarket and service once systems are installed. Otis is the world’s largest manufacturer and installer of elevators and escalators, and these aren’t systems that are easily removed once installed. Same goes for effectively all of their products.
Moreover, quality and reputation goes a long way with the products that the company manufactures and provides. Reliability and quality is taken pretty seriously when it comes to moving people up and down in tall buildings, or installing jet engines that have to operate at 100%.
The company also enjoys economies of scale by virtue of the sheer size and scope of their operations.
Urban population growth continues to increase year after year and is expected to remain that way, which means that construction (which will surely need HVAC systems) should remain strong for the foreseeable future. Notably, many of the world’s developing nations lie in areas where air conditioning will likely become more prevalent in the future. Furthermore, as cities grow, they’ll likely grow up rather than out. This means there will be a need for vertical transportation systems. These trends bode well for United Technologies.
In addition, airlines expect a sharp increase in rider demand over the next few years, which will increase not only the need for jet engines to keep up with supply, but also the wear and tear on existing pieces. We see this shaking out in the results. Pratt & Whitney’s backlog ended FY 2014 at $50.2 billion, up significantly from the $38.5 billion it finished 2013 at.
United Technologies is a global firm, with a majority of their sales generated abroad. As such, they face currency risks.
Competition, though limited in some of their primary businesses, is fierce in HVAC.
Even after the sale of Sikorsky, the company will still have some exposure to government orders and spending.
Although underlying growth over the last decade was fairly secular, the company is exposed to highly cyclical industries.
UTX’s stock has fallen sharply YTD – it’s down more than 13% – with a sell-off occurring after the company announced the sale of Sikorsky and released Q2 results. I’ll quickly go over why I think the news about Sikorsky is actually rather fantastic and why there could be an opportunity at hand.
Sikorsky’s operating profit margin has fallen substantially over the last couple years, down from 10.5% in 2012 to 2.9% in 2014. The segment is contributing very little profit to the company at this point in time. And I think $9 billion is a very attractive price point for UTX here. Consider this: UTX’s total operating profit for the last fiscal year was approximately $10 billion. This is an $87-billion company. That’s less than nine times operating profit. Sikorsky’s operating profit for FY 2014 was just $219 million. Yet United Technologies is getting $9 billion for it – 41 times operating profit. There’s something to be said for Lockheed likely being able to squeeze more juice out of that lemon, but I think United Technologies did well here. Moreover, this reduces United Technologies’s exposure to government defense spending, which has shrunk as of late. All in all, I applaud this move.
United Technologies will largely be buying back stock with the proceeds, announcing an $8.3 billion share buyback program in conjunction with the Sikorsky sale. If I like the idea of buying this stock at $99, then I certainly like the idea of the company buying stock at $99. Although it shrinks the company’s revenue base in absolute terms, there will be less shares in existence when the buyback program ends, meaning every dollar of profit goes that much further. I think this will more than offset the earnings loss from Sikorsky due to the valuation, as I pointed out above. As such, this should be accretive over the next few years.
The stock trades hands for a P/E ratio of 14.22. This compares very favorably not only to the broader market, but also the five-year average P/E ratio of 16.4 for UTX. Not only is the stock cheaper than usual right now, but I think the quality is actually higher due to the moves they’re making.
I valued shares using a dividend discount model analysis with a 10% discount rate and a 7.5% long-term dividend growth rate. I think that growth rate is fair considering the low payout ratio and recent historical growth in underlying profit and the dividend. There appears to be a margin of safety in that model. The DDM analysis gives me a fair value of $110.08.
United Technologies is a high-quality company across the board. And there are a number of tailwinds at their back, leading me to believe that growth could be rather outstanding over the next decade or so. The company’s competitive advantages are immense and renewed focus on their higher-margin businesses could unleash even more potential than they’ve shown heretofore.
I view the current valuation as rather attractive. There appears to be a sizable margin of safety present even with a conservative analysis, which isn’t something you run into very often with a high-quality company that is otherwise operating at a high level. It’s not like United Technologies is on the operating table here and struggling. Recent guidance was slightly reduced, but they remain extremely well positioned across their other lines.
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