United Technologies (UTX) has excellent exposure to the burgeoning commercial aerospace cycle, but that alone doesn't necessarily make it a good investment. Savvy investors know that the valuation of a company is critical to assessing whether it is an attractive investment opportunity. That's why we perform a rigorous discounted cash-flow methodology that is a critical component of our Valuentum Buying Index. Let's dig into United Tech's valuation.
But first, a little background to help you understand our article. Our Valuentum Buying Index ranks stocks on a scale from 1 to 10, with 10 being the best. Essentially, we at Valuentum are looking for firms that overlap investment methodologies, thereby revealing the greatest interest by investors (we like firms that fall in the center of the diagram below). Valuentum followers know the '12 Steps to Understand the Stock Market' and understand the importance of others eventually coming around to one's investment thesis on a company.
If a company is undervalued both on a DCF and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. United Technologies posts a VBI score of 6 on our scale, reflecting our 'fairly valued' DCF assessment of the firm, its neutral relative valuation versus peers, and bullish technicals. We compare United Technologies to peers 3M (MMM), Honeywell (HON), and Tyco Intl (TYC). In the spirit of transparency, we show how the Valuentum strategy has performed:
Our Report on United Technologies
• United Technologies earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. We expect the firm's return on invested capital (excluding goodwill) to expand to 36.8% from 34.5% during the next two years.
• United Tech's commercial businesses are Otis elevators and escalators and UTC Climate, Controls & Security. The firm's aerospace businesses are Sikorsky aircraft and UTC Propulsion & Aerospace Systems, which includes Pratt & Whitney aircraft engines and UTC Aerospace Systems products.
• United Technologies has a good combination of strong free cash flow generation and manageable financial leverage. We expect the firm's free cash flow margin to average about 8.7% in coming years. Total debt-to-EBITDA was 2.3 last year, while debt-to-book capitalization stood at 31.9%.
• We're big fans of the company's decision to pick up Goodrich to augment its commercial aerospace portfolio. Revenue passenger miles (air travel) are expected to expand at a rapid pace in coming decades, and annual aircraft deliveries should follow suit.
• The firm sports a very nice dividend yield of 2.5%. We expect the firm to pay out about 40% of next year's earnings to shareholders as dividends.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. United Technologies's 3-year historical return on invested capital (without goodwill) is 25.2%, which is above the estimate of its cost of capital of 9.6%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. United Technologies's free cash flow margin has averaged about 9.2% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At United Technologies, cash flow from operations increased about 23% from levels registered two years ago, while capital expenditures expanded about 19% over the same time period.
Our discounted cash flow model indicates that United Technologies' shares are worth between $69.00 - $115.00 each. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $92 per share represents a price-to-earnings (P/E) ratio of about 16.8 times last year's earnings and an implied EV/EBITDA multiple of about 10.3 times last year's EBITDA. So, in other words, we think United Tech is fairly valued at current levels. Our model reflects a compound annual revenue growth rate of 7.3% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of - 0.3%. Our model reflects a 5-year projected average operating margin of 12.8%, which is above United Technologies's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 3.1% for the next 15 years and 3% in perpetuity. For United Technologies, we use a 9.6% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $92 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for United Technologies. We think the firm is attractive below $69 per share (the green line), but quite expensive above $115 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate United Technologies's fair value at this point in time to be about $92 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of United Technologies's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $117 per share in Year 3 represents our existing fair value per share of $92 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.