Seeking Alpha
Long/short equity, special situations, value
Profile| Send Message|
( followers)  

Investors in United Technologies (NYSE:UTX) are slightly disappointed with the guidance for next year, despite the fact that the company believes it is well-positioned to benefit from two megatrends: aerospace and urbanization.

I agree with investors and believe the valuation is full at current levels amidst modest organic growth and a sizable debt position. I remain on the sidelines.

Investors And Analyst Update

United Technologies updated the market with this year's guidance, but more importantly, it issued an update for 2014. For the year of 2013, United Technologies sees earnings at $6.15 per share, the high end of the previously communicated range of $6.10 to $6.15 per share. The sales guidance at $63 billion has been unchanged.

Earnings for next year are now seen between $6.55 and $6.85 per share, up to 7-11% from 2014. Organic sales growth is seen between 3-4%, yet revenues are only seen up by a billion on the back of divestitures. Consensus estimates for next year's earnings stood at $6.84 per share on revenues of $66.2 billion.

CEO Chenevert notes that strong order momentum towards the end of 2013 allows for an acceleration of growth into 2014 across most of its business units.

Key growth areas are the Building & Industrial Systems business, which is positioned to benefit from further global urbanization, while the acquisitions of Goodrich and IAE make sure the company capitalizes on the growth opportunity within the aerospace industry.

Valuation

Back in October, United Technologies reported its third quarter results. The company ended the quarter with $4.6 billion in cash and equivalents. Total debt stands at a sizable $21.2 billion following the company's acquisition spree. As such, United holds a net debt position of $16.6 billion.

Trading around $107 per share, the market values United Technologies around $98 billion. This values the equity in the firm at 1.6 times annual revenues and 17-18 times annual earnings.

United Technologies currently pays a quarterly dividend of $0.59 per share for an annual dividend yield of 2.2%.

Some Historical Perspective

Long term holders in the firm have seen decent returns. Between 2004 and 2007, shares have doubled towards $80. Shares gave up those gains in 2009, but ever since, have seen an impressive recovery to highs of $112 per share in recent weeks. Ever since, shares have seen a very modest pullback to levels around $106 per share, still marking year to date gains of 30%.

Between 2009 and 2013, United Technologies is set to increase its annual revenues by a cumulative 20% to $63 billion. Earnings are guided to increase by roughly 50% to $5.6 billion.

Investment Thesis

Investors are not too pleased with the guidance for 2014, as both earnings and revenues come in a bit soft versus consensus estimates. United Technologies aims to benefit from two megatrends, being the urbanization of the world's population and the continued growth of the aerospace industry. Despite these strong tailwinds, the guidance for 2014 appears a bit soft, partially on the back of US austerity which will shave off one full percent point in revenue growth.

Yet earnings growth will continue on the back of past acquisitions, notably that of Goodrich in 2011. Aerospace synergies already total some $250 million in 2013, and are seen to increase towards $500 million per annum in 2016. With operating cash flows expected to at least equal next year's earnings, United Technologies aims to pay out $2 billion in dividends, repurchase $1 billion worth of shares, and allocate a billion to both debt repayments and mergers and acquisitions.

Yet all of this, combined with divestitures, will lead to very modest revenue growth. The fifty five cent earnings per share accretion is furthermore of modest quality. Higher pension funds returns result in a pension cost tailwind of thirty cent per share, which alone explains more than half of the total earnings growth.

At the end of October, when United Technologies reported its third quarter results, I last took a look at the prospects for the firm. I concluded that the valuation was fair amidst solid execution with shares trading at similar levels at the time.

I concluded that United Technologies is slowly transforming from a traditional industrial conglomerate towards an aerospace supplier, even as key industrial segments like Otis elevators remain core assets. This consolidation in the aerospace supplier industry has been widely applauded by Boeing (NYSE:BA) which urges suppliers to consolidate to avoid delays during production. Given the leverage incurred following the deal, and the momentum ever since, current payouts are very modest, while the leverage position does not allow for a significant hike in shareholder payouts anytime soon.

While estimated synergy increases towards 2016 could boost earnings by some 4-5% going forwards, the current valuation and slower organic growth limit short to medium term appeal. This is especially the case given the high leverage position of the firm. All in all, this makes me cautious, and I stay on the sidelines.

Source: United Technologies - Fair Valuation And Leverage Create Limited Appeal