Shares of United Technologies (UTX) fell over 1% after hours after management offered guidance that is best described as disappointing (press release here). The industrial giant and Dow component has had a solid run, rallying more than 31% in 2013 to beat the major indices. Should this guidance be taken as a sign to exit the UTX trade or does there remain further upside?
Management now expects to earn $6.55 to $6.85 in 2014, which suggests 7-11% annual EPS growth. On the revenue side, there will be organic growth in the 3-4% range for a $64 billion total. For comparison, analysts had been looking for $6.84 on $66.25 billion in sales. Revenue growth is exceptionally disappointing with analysts looking for twice the organic rate, and based on the EPS range, an earnings miss also seems likely. Given the stock's 16.4x forward multiple, it was not pricing in such a miss and slow growth. Importantly, the company does not appear to be sand-bagging results with management calling 2014's outlook "stretched but achievable" in an accompanying presentation (available here).
In fact, looking through the assumptions in UTX's guidance, it is clear that the company is being pretty optimistic. In the macro-economy, UTX is assuming 2.3% growth in the U.S. (in line or slightly below most estimates), but the company expects significant improvement in Latin America to 3% from 2%, which would be impressive considering problems in Brazil. The company is also bullish on Europe with a forecast for 1.1% growth up from the current 0.1% pace despite signs that countries like France are slipping back into recession. Importantly, management does not have major concerns over China where growth is expected to decline modestly to 7.4% and the rest of Asia Pacific accelerates to 3.5% from 2.3%, which would require some pretty significant improvement in Japan.
All in all, I would not consider United Technologies' view of the world to be pessimistic. While I think the U.S. could be poised to better its expectations, the company is banking on significant improvement in the rest of the world, particularly Europe and Latin America. I fear that on average UTX may be overestimating the strength of the global economy, which makes me view the company's $6.70 EPS midpoint as a fair if not slightly aggressive target.
Going forward, the U.S. government will continue to be a drag on business as the defense budget will be constrained even after the Ryan-Murray budget deal with 70% of sequester cuts remaining in place. There is also a natural decline in the budget as the U.S. continues to extricate itself from the war in Afghanistan in the hopes of maintaining something more akin to a training and peace keeping force beyond 2014. Increased fiscal austerity could bite $0.12 out of earnings in 2014, and given long-term defense spending restraint, I expect government to be a drag on UTX's growth for some time.
Additionally, in 2014, United Technologies will benefit from a pension that is in a better funded position and rising interest rates, which discounts future payments more favorably. These factors will provide United Technologies with a year over year $0.30 boost to EPS while on the whole UTX is guiding to a $0.55 EPS increase at the midpoint. Looking to the operations excluding pension impacts, UTX will grow EPS by a pretty paltry 4% next year. With a previous declared $5.4 billion buyback cutting the share count, actual income growth from operations will be even lower.
The only bright spot in this report was the company's estimate that free cash flow would roughly equal net income, which should help the company return cash to shareholders. UTX currently yields 2.2%, so after the dividend, the company will have about $3.9 billion in excess cash generated. Despite the sizable authorization as of the last quarter, the company has only spent $664 million repurchasing shares. With this excess free cash flow, management could increase the speed of the buyback, though with $23 billion in net debt management may focus some cash on paying down debt rather than maximizing the share buyback.
United Technologies provided some pretty gloomy guidance despite offering a generally optimistic view of the global economy. This combination is especially troubling, given that the company has some sizable exposure to the booming commercial aerospace industry. After this guidance, I find UTX unattractive at 16.4x next year's earnings despite minimal revenue and core earnings growth. I would take profits after the solid 2013 run and wouldn't be interested until 15x earnings or around $100. Investors would be better off focusing solely in the commercial aerospace names that have much less government exposure like Boeing (BA). After this seriously disappointing 2014 guidance release, it is time to sell UTX.