Bloomberg recently came out with an article indicating that United Technologies (UTX, Financial) was one of the companies in its industry that is undervalued.
(Bloomberg)
Market performance
Year to date, shares of the undervalued company returned an outstanding 17% while the broader Standard & Poor's 500 index provided 12.87% (1). United Technologies, however, underperformed the market on a five-year average with 9.76% versus 14.9%.
Valuations
United Technologies had a trailing 12-month price-earnings (P/E) ratio of 12.8 times (industry median 21.3), price-book (P/B) multiple of 3.1 times (industry median: 2.1) and price-sales (P/S) multiple of 1.65 times (industry median: 1.2; 2). The company also had a trailing dividend yield of 2.43% with a 56% payout ratio and a 3% buyback ratio.
Earnings performance
United Technologies reported its third quarter results on Oct. 25. The $90 billion Aerospace & Defense company reported 1.9% sales growth to $42.6 billion and 6.7% profit loss to $4 billion nine months into its fiscal 2016.
As observed, company expenses related to cost related to services and products sold increased at an average of 3.7% and resulted to lower profits. Despite the lower bottom line, the market still rewarded United Technologies’ shares with positive 1.85% change post-earnings announcement while the broader Standard & Poor's 500 index closed down 0.38%.
"Organic growth across the aerospace units and solid cash generation across all businesses, even with continuing investments in the aerospace related ramp-up, give us high confidence in meeting our commitments to shareholders. Based on our year-to-date performance, we now expect slightly higher organic sales growth, and we are raising the low end of our adjusted EPS outlook by 10 cents and now expect 2016 EPS of $6.55 to $6.60 per share*." – UTC Chairman and CEO Gregory Hayes
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Outlook
United Technologies now expects fiscal 2016 total sales growth of 2 to 3%, compared to a five-year average of 0.64%. The company also increased its estimation for its adjusted earnings per share (EPS) to $6.6 from $6.45, compared to $6.30 adjusted EPS in fiscal 2015.
Meanwhile, United Technologies had a five-year profit growth average of 11.7% (1).
United Technologies
United Technologies is an 82-year-old American multinational conglomerate headquartered in Farmington, Connecticut. The $90 billion conglomerate provides high technology products and services to the building systems and aerospace industries worldwide.
United Technologies had four segments: Otis, UTC Climate, Controls & Security, Pratt & Whitney and UTC Aerospace Systems.
Otis
Otis is the world’s largest elevator and escalator manufacturing, installation and service company (3). As observed, Otis is the most profitable segment among United Technologies segments, averaging 20.2% in operating margin for the past three fiscal years.
In fiscal 2015, the segment grew -7.7% year on year while delivering 19.5% operating margin. Nine months into fiscal 2016, Otis grew negative 0.63% while delivering an 18.5% operating margin compared to 20.2% in the same time period last year.
UTC Climate, Controls and Security
The segment is a leading provider of heating, ventilating, air conditioning (HVAC) and refrigeration solutions, including controls for residential, commercial, industrial and transportation applications (4).
According to United Technologies, the products and services offered are sold under the Carrier name and other brand names to building contractors and owners, homeowners, transportation companies, retail stores and food service companies. In addition, UTC Climate, Controls & Security is also a global provider of security and fire safety products and services.
UTC Climate, Controls & Security was and has been the largest contributor in United Technologies sales. In fiscal 2015, the segment contributed 29%, or $16.7 billion, in sales for the company while delivering a 0.7% loss year on year and an operating margin of 17.6%. Nine months into fiscal 2016, the segment grew 0.14% and had an operation margin of 18.1%, compared to 18.5% in the same period a year ago.
(Annual Report)
Pratt & Whitney
Pratt & Whitney is among the world’s leading suppliers of aircraft engines for the commercial, military, business jet and general aviation markets (5). According to United Technologies, its Pratt & Whitney Canada is a world leader in the production of engines powering general and business aviation as well as regional airline, utility and military, airplanes and helicopters.
Pratt & Whitney shares interest with other third party companies in developing new engines to mitigate risks. Approximately 14% to 50% are being shared with other parties in Pratt & Whitney-directed commercial jet engine programs.
In fiscal 2015, Pratt & Whitney sales contributed a quarter, or $14.1 billion, in total United Technologies sales while losing 2.9% year on year. The segment also delivered an operating margin of 6.1%. Nine months into fiscal 2016, the segment grew 6.4% and delivered 10.4% operating margin compared to 12.9% last year.
UTC Aerospace Systems
UTC Aerospace Systems is a leading global provider of technologically advanced aerospace products and aftermarket service solutions for aircraft manufacturers, airlines, regional, business and general aviation markets, military, space and undersea operations (6).
UTC Aerospace Systems’ largest customers are Boeing (BA, Financial) and Airbus (XPAR:AIR, Financial) with a combined 31% of total UTC Aerospace Systems segment sales in fiscal 2015.
In fiscal 2015, the segment also contributed a quarter of total United Technologies sales and lost 0.9% while having a 13.4% operating margin. Nine months in fiscal 2016, UTC Aerospace Systems grew by 2.16% and had a 15.8% operating margin compared to 16.2% last year.
Cash, debt and book value
As of Sept. 30, United Technologies had $7.1 billion in cash and $22.7 billion in debt with a debt-equity ratio of 0.74 compared to $20.4 billion debt and 0.70 ratio in December 2015.
The company also had 48% of its $90 billion assets in goodwill and intangibles while having a book value of $31 billion compared to $29 billion in December 2015.
Cash flow
(10-Q Filing)
United Technologies grew its cash flow from operations by 12% despite the profit reduction. As observed, there was an increase in inventories and contracts in progress, accounts payable and accrued liabilities during the recent nine month operations.
Capital expenditures were about similar to last year’s with $1 billion, leaving United Technologies with $3.49 billion in free cash flow. Despite this good amount of free cash flow, United Technologies still borrowed $2.49 billion through long-term debt issuance.
As observed in its filings, United Technologies discontinued and sold its Sikorsky business to Lockheed Martin Corp. (LMT, Financial) for $6 billion in November 2015.
(Sikorsky by Lockheed Martin)
In review, Sikorsky, other than an English-language respelling of a Slavic surname Sikorski, is otherwise known as Sikorsky Aircraft Corporation. Sikorsky is an American aircraft manufacturer and has some of the key products illustrated below.
(Sikorsky Key Products by Lockheed Martin)
In United Technologies’ previous annual filings, Sikorsky has been growing steadily in sales, such as a 19% year-on-year growth in fiscal 2014, but had been delivering low operating margins in recent years, such as 2.9% in fiscal 2014.
Nine months into fiscal 2016, United Technologies took in a $2.5 billion cash flow charge in relation to the discontinued business it had with Sikorsky, thus probably explaining the need of much debt intake for the period.
United Technologies allocated 59.8%, or $2 billion, of its free cash flow in dividends and share repurchases for the period.
On average, the company allocated 140% of its free cash flow in shareholder payouts in the past three years. Observably, United Technologies spent a huge amount in buybacks in fiscal 2015, amounting to $10 billion, while issuing $1.1 billion worth of shares in the same year.
Conclusion
Despite tepid sales growth over the years, United Technologies was able to deliver consistent profitability brought by its steady margins and buyback activities – in terms of its EPS growth.
Cash flow seemed a bit disrupted since United Technologies, prudent enough, to have sold its less profitable business late last year and rather to focus more on its "portfolio of aerospace and building systems businesses."
United Technologies’ balance sheet also seemed able to absorb any possible further debt intake to support its cash flow in the upcoming year or two while having a good amount of it in goodwill and intangibles.
Valuation, in terms of earnings multiples, does seemed to undervalue United Technologies compared to its peers.
(Google Finance)
In its 52-week high, analysts in Citigroup (C, Financial) called for a downgrade in United Technologies’ shares in mid-October pre-earnings release; UBS ranks the company’s shares as a buy, nonetheless, with a lowered price target to $115 a share, from $118, in late September.
Given United Technologies' recent business changes, I would personally try to refrain from buying its shares given its all-year high status and cash flow challenges.
In summary, United Technologies is a pass.
Notes
(1) Morningstar data.
(2) GuruFocus data.
(3) 10-K: Otis designs, manufactures, sells and installs passenger and freight elevators for low-, medium- and high-speed applications, as well as a broad line of escalators and moving walkways. In addition to new equipment, Otis provides modernization products to upgrade elevators and escalators as well as maintenance and repair services for both its products and those of other manufacturers. Otis serves customers in the commercial and residential property industries around the world. Otis sells directly to the end customer and through sales representatives and distributors.
(4) 10-K: UTC Climate, Controls & Security segment services also provides electronic security and fire safety industries include systems integration, video surveillance, installation, maintenance, and inspection services.
In certain markets, UTC Climate, Controls & Security also provides monitoring and response services, to complement its electronic security and fire safety businesses. Through its venture with Watsco, Inc., UTC Climate, Controls & Security distributes Carrier, Bryant, Payne and Totaline residential and light commercial HVAC products in certain parts of the U.S., Canada and certain territories in the Caribbean and Latin America.
UTC Climate, Controls & Security sells directly to end customers and through other joint ventures, manufacturers' representatives, distributors, wholesalers, dealers and retail outlets.
(5) 10-K: Pratt & Whitney also provides fleet management services and aftermarket maintenance, repair and overhaul services, including the sale of spare parts, auxiliary power units and industrial gas generators.
Pratt & Whitney produces families of large engines for wide- and narrow-body and large regional aircraft in the commercial market and for fighter and transport aircraft in the military market.
(6) 10-K: UTC Aerospace Systems’ product portfolio includes electric power generation, power management and distribution systems, air data and flight sensing and management systems, engine control systems, electric systems, intelligence, surveillance and reconnaissance systems, engine components, environmental control systems, fire and ice detection and protection systems, propeller systems, aircraft aerostructures including engine nacelles, thrust reversers, and mounting pylons, interior and exterior aircraft lighting, aircraft seating and cargo systems, actuation systems, landing systems, including landing gears, wheels and brakes, and space products and subsystems.
Aftermarket services include spare parts, overhaul and repair, engineering and technical support and fleet management solutions.
Disclosure: I do not have shares in any of the companies mentioned.
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