United Technologies (UTX, Financial) is a diversified industrial business with a strong presence in the aerospace and building systems markets. While this blue chip dividend stock has numerous well-known brands and entrenched market positions dating back more than 80 years, it seems to have lost its way a bit in recent years.
Like many other large cap companies – e.g., General Electric (GE, Financial), Procter & Gamble (PG, Financial), International Business Machines (IBM, Financial) – United Technologies is facing growth challenges as some of its businesses have become very large, perhaps a little less focused and more difficult to manage.
Generating tons of cash flow isn't the problem –Â it's whether or not the company should be viewed as an industrial "chugger" with strong long-term earnings growth potential or a mature cash cow that has already seen its best earnings growth days.
With the stock trading at about 14.5x forward earnings, the market seems to be voting that United Technologies is now a mature cash cow with limited earnings growth prospects.
A new CEO is trying to resuscitate profitable growth, but several controllable blunders and a handful of macro headwinds have complicated the company's progress over the last year or so, making it difficult to get to the bottom of United Technologies' challenges.
The company's dividend yield (2.7%) and dividend growth look increasingly attractive, but income investors should remember that dividends are only part of the total return equation.
In this piece, we will take a closer look at United Technologies' competitive advantages, dividend growth potential, and the key risks the company must overcome to get back on track for long-term growth.
We already own and like several other dividend stocks – e.g., GE, Boeing (BA, Financial) – that are similar to United Technologies in our Top 20 Dividend Stocks portfolio, but we see plenty of reasons to keep our eyes on this one, too.
Business overview
United Technologies provides a broad range of products and services to the global aerospace and building systems industries. Some of its key franchises are Otis (elevators), Carrier (air conditioning and refrigeration) and Pratt & Whitney (aircraft engines).
By end market, commercial and industrial markets drive about 52% of United Technologies' sales, commercial aerospace accounts for 35%, and military aerospace & space generate the remaining 13% of sales.
Approximately 44% of the company's sales are from aftermarket products and services, with the remaining 56% attributed to original equipment manufacturing. While the company doesn't disclose this information, we wouldn't be surprised if its aftermarket business accounted for more than 70% of segment operating profits.
By geography, United Technologies generated 36% of its sales in the U.S., 29% in Europe, 21% in Asia (China 6%) and 14% in other countries.
Segments
Climate, Controls & Security (29% of sales, 17% operating margin):Â sells fire safety, security, building automation, heating, ventilation, air conditioning and refrigeration systems and services.
Pratt & Whitney (25% of sales): designs, manufactures, and services aircraft engines, auxiliary and ground power units, and small turbojet propulsion products. The company's large commercial engines power more than 25% of the world's mainline passenger fleet.
Aerospace Systems (24% of sales): nearly all aircraft today rely on systems and components from United Technologies' aerospace division, including actuation and propeller systems, electric systems, interiors, landing systems, sensors and more. It is one of the world's largest suppliers of advanced aerospace and defense products for business, military and international customers.
Otis (22% of sales, 20% operating margin): United Technologies is the world's leading installer and maintainer of elevators, escalators and moving walkways. The company introduced the world's first safety elevator in 1853 and maintains over 1.8 million elevators, escalators and moving walkways worldwide.
Business analysis
Many of United Technologies' businesses have been around for a very long time, highlighting its durability and the relatively slow pace of change that occurs in many of its markets. For example, Otis has existed for more than 160 years, and Pratt has operated for around 90 years.
Such longevity has helped United Technologies build a lucrative installed base of equipment, enjoy substantial economies of scale and maintain deep familiarity with customers to fully entrench its products and services.
Not surprisingly, many of the company's businesses enjoy top market shares as a result. Aerospace Systems (24% of sales) is number one in its marketplace; Otis (22% of sales) is number one and is so large that it moves the entire world's population every four days on its equipment; Pratt is number two; and Climate Controls & Security (29% of sales) is number one in North American residential markets, fire products and transport refrigeration and number two in commercial HVAC.
United Technologies has also said that its building systems business, which is around $30 billion in size, is about twice as large as its nearest competitor. With such massive scale, United Technologies can maintain relatively low production costs and leverage its global distribution channels and spending on R&D (about $4 billion annually, including customer-funded R&D).
As seen below, United Technologies' competitive advantages and high-margin aftermarket revenue (44% of total sales) have allowed it to maintain strong and steady operating margins over the last decade:
Source: Simply Safe Dividends
Why is it so hard to displace United Technologies? Many of its biggest businesses are characterized by long and costly product development cycles, strict regulatory or market-driven performance standards, and a focus on cost.
Similar to what we observed with General Electric, United Technologies' large scale and manufacturing excellence allow it to create much of its large equipment at extremely competitive costs. The company isn't interested in the margin it makes on the initial equipment sale, which is often minimal. The real money is made in aftermarket parts and services contracts to keep engines, elevators and other high-value equipment up and running. Aftermarket contracts can run more than 30 years in length and often lock in the customer with United Technologies for many years to come.
Smaller competitors are unable to match United Technologies' pricing for initial equipment sales and don't have the seal of reliability and performance that many of the company's famous franchises have built up over decades.
In certain markets, manufacturing expertise, intellectual property, supply chain expertise and regulations also serve to limit competition. For many of these reasons, the aircraft engine market is largely dominated by General Electric, Rolls-Royce (RR., Financial) and United Technologies.
The company currently loses $1 million on each of its new engines that it is ramping up and expects to generate a loss of about $1 billion from new jet engine sales over the next four years. While the payback period on jet engines is very long, it comes with solid returns because United Technologies will enjoy a lucrative aftermarket revenue stream for the next 30-plus years.
Few competitors have the financial strength to undertake these significant investments that don't break even for a number of years. United Technologies estimates that its new engine technology required about $10 billion in investment. Without an existing customer base to secure future orders, it becomes even more difficult for potential new entrants to throw billions at these projects. New entrants also lack the reputation for quality and safety.
Finally, it's worth mentioning some of the productivity and portfolio management initiatives United Technologies is taking to enhance its growth and profitability. The company's current CEO started in November 2014 after his predecessor abruptly retired.
Some of his key moves have been to bring back certain former executives, eliminate several layers of management, sell off United Technologies'Â Sikorsky helicopter business for $9 billion and engage in meaningful restructuring activities.
The sale of Sikorsky improves United Technologies' organic growth profile, operating margins and cash flow predictability. It also reduced the company's defense exposure from 19% of total revenue to 13%.
Once macro headwinds subside, management hopes to restore organic sales growth back to the mid-single digit range over the long term. Meanwhile, United Technologies' $1.5 billion multiyear restructuring plan, which is focused primarily on manufacturing plant consolidations, is expected to generate $900 million of annualized savings when completed in several years.
It's clear that United Technologies is in a bit of a transitional phase, but the underlying strength of its franchises and recurring aftermarket revenue provide plenty of cushion as the company looks to improve its long-term prospects.
Key risks
United Technologies is facing several challenges at the moment. For the most part, they seem like transitory issues to us – foreign currency headwinds will eventually abate, end markets will grow over time as global GDP growth recovers, and the company is overcoming ramp-up issues at a distribution facility that impacted the profitability of its aircraft engine production by $500 million in the third quarter.
What's less certain is the company's plan to take back market share in its Otis business segment to help drive future earnings growth. This business has seen its market share contract over the last few years as it picked profitability (20%-plus operating margin) over share gains. In China, for example, Otis' market share is estimated to have fallen from 25% to about 15% over the last few years. The broader slowdown in Chinese infrastructure markets has only added to Otis' pains, and United Technologies' business in China is expected to be down 10% next year. Fortunately, China represents just 6% of United Technologies' sales today.
Management expects Otis' operating profit to decline by about $250 million next year as it sacrifices some margin in an attempt to take back market share and generate profit growth, which has largely been elusive over the last five years. We usually prefer to see companies head the other way – sacrificing market share for better profitability – so this new strategy gives us some hesitation.
United Technologies' aircraft engine business will also face pressure next year as it continues boosting production of its new geared turbofan jet engines, which are expected to continue losing money over the next several years. Like many of United Technologies' products, these are long-term investments that pay off as high-margin aftermarket revenue is recognized over the following decades.
Finally, United Technologies' military aerospace business faces plenty of uncertainty caused by sequestration. After divesting Sikorsky, United Technologies' defense exposure dropped from 19% of total company sales to 13%, but that's still a material amount of exposure.
Overall, it seems like it could take at least the next year for United Technologies to overcome the challenges impacting its earnings growth. If execution is weak on jet engine production or restructuring actions and Otis' market share strategy backfires, the stock could see further weakness.
Dividend analysis
We analyze 25-plus years of dividend data and 10-plus years of fundamental data to understand the safety and growth prospects of a dividend. Please note that United Technologies' historical results include its Sikorsky business, which should be divested by the end of 2015 and result in higher profitability and growth.
Dividend safety score
Our Safety Score answers the question, "Is the current dividend payment safe?" We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
With relatively low payout ratios, consistent free cash flow from its aftermarket business, and a reasonable balance sheet, it comes as no surprise that United Technologies earned a high dividend Safety Score of 83.
Over the last 12 months, United Technologies' dividend has consumed 40% of the company's earnings, which provides plenty of flexibility for United Technologies to continue paying and growing its dividend. Looking below, we can see that United Technologies' payout ratio has remained remarkably consistent at around 30% during the past decade. United Technologies appears to generate very predictable earnings and has done a nice job of growing earnings in line with dividend growth to keep the payout ratio steady.
Source: Simply Safe Dividends
Source: Simply Safe Dividends
For dividend companies with enough operating history, we like to analyze how their businesses performed during the financial crisis. Despite meaningful exposure to cyclical markets such as construction, United Technologies' sales and earnings only fell by 11% and 16%, respectively, during fiscal year 2009. The company's large installed base results in a sizable aftermarket business that is less sensitive to swings in the economy – repairs and replacement parts cannot be as easily avoided as new equipment orders.
Source: Simply Safe Dividends
Beyond stabilizing revenue growth, United Technologies' aftermarket business throws off consistent free cash flow and grows with every new aircraft engine or elevator that it puts into business. As you can see, United Technologies' free cash flow per share has steadily increased over the last decade – a sign of a very strong business model and a feat that few other companies can claim.
Source: Simply Safe Dividends
While United Technologies generates healthy and reliable free cash flow, it's still important to analyze its balance sheet. Companies with excessive amounts of debt that hit hard times could find themselves in a pinch and will always cut the dividend before missing an interest payment.
As seen below, United Technologies is in decent financial shape. The company could pay off all of its debt with cash on hand and 1.7 years of its earnings before interest and taxes. With that said, United Technologies' net debt position will rise as it executes on its share repurchase plan, reducing some of its flexibility. Overall, the balance sheet doesn't appear to pose much risk for a company like United Technologies.
Source: Simply Safe Dividends
Dividend Growth Score
Our Growth Score answers the question, "How fast is the dividend likely to grow?" It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
United Technologies scored above average for dividend growth potential with a dividend Growth Score of 65. The company has paid consistent dividends since 1936 and, while it is not on the dividend aristocrats list, the company has increased its dividend for more than 20 consecutive years.
As seen below, United Technologies has increased its dividend at a 7% to 8% annual rate over the last five years and most recently raised its dividend by 8% at the beginning of 2015.
Source: Simply Safe Dividends
Going forward, share repurchases appear to be a much higher priority than substantial dividend increases. Management's plan is to repurchase up to $16 billion of its stock from 2015 through 2017 while paying out around $6 billion in dividends.
Considering management's capital allocation plans and the earnings growth headwinds expected throughout most of 2016, we believe dividend growth could be closer to 4% to 6% over the next couple of years. A 3 cents to 4 cents increase (+5% to 6%) in the quarterly dividend from 64 cents to 67 cents or 68 cents per share wouldn't surprise us next year.
If management can put the company back on track for high-single digit earnings growth, the share repurchases will look intelligent (the stock trades at a 14.5x multiple). Otherwise, our expectations for slightly lower income growth will be especially frustrating.
Valuation
United Technologies trades at about 14.5x forward earnings guidance and has a dividend yield of 2.7%. For a company with very strong market positions, substantial recurring revenue in the form of aftermarket parts and services (44% of sales) and a proven long-term track record, the valuation case looks pretty interesting.
For shareholders who believe management can rejuvenate earnings growth back into the high-single digits or even 10% per year, the stock would appear to offer a total return of at least 10% to 13% per year over the longer term. The potential upside is even greater if the earnings multiple appreciates (which it likely would).
With that said, a long-term time horizon is likely needed for those entering the stock today. Many of the macro challenges (currency headwinds, sluggish growth in China and Europe) and company-specific actions (giving up some margin in Otis to try and take market share, working down the learning curve in the aircraft engine business to improve profitability, restructuring) seem unlikely to bring about improved results for at least several quarters.
There's nothing wrong with taking a much longer investment horizon if you can afford to wait and stomach potential near-term price volatility – it just recognizes the fact that United Technologies might require some extra patience and trust in management's current plan before you can be rewarded.
For those willing to give United Technologies' high quality franchises the benefit of the doubt, the payoff could be worth the wait, especially compared to many other investment opportunities in the market today.
Conclusion
At the end of the day, United Technologies appears to be a high quality company with several enduring competitive advantages. The company's aftermarket business provides dependable cash flow that can be reinvested for growth and help United Technologies outperform other companies during economic downturns.
With that said, the company's execution has been spotty (Otis share losses, engine production challenges, need for restructuring), and several macro headwinds are impacting the business. Should these issues largely move into the rearview mirror over the next two to three years, dividend growth investors will likely be rewarded nicely with double-digit total returns.
Given our ownership of several related stocks that either compete with United Technologies or remain sensitive to many of the same macro factors, we don't own the stock today but are keeping it on our watch list.
Disclosure:Â The author is long GE, BA and PG but does not own any shares of UTX.
