You'll Be Surprised By United Tech's Future Organic Growth

Jan.29.14 | About: United Technologies (UTX)

Industrial conglomerate United Technologies (NYSE:UTX) recently reported solid fourth-quarter results. During 2013, earnings per share and net income attributable to common shareholders advanced 16% and 17%, respectively, over the prior year period. Though most of it was acquired expansion, sales jumped 9%, while the company's adjusted segment operating margin increased 90 basis points, to 15.7%. Cash flow from operations came in at $7.5 billion for the year and capital expenditures were $1.7 billion, resulting in free cash flow of $5.8 billion (or 9.3% of sales). We were particularly pleased with CEO Chenevert's comments about witnessing an acceleration of organic growth throughout the year. Fourth-quarter organic sales growth was 4% (better than the 1% pace recorded for the entire year), and order growth during the fourth-quarter was solid:

"New equipment orders at Otis increased 8 percent over the year ago quarter. UTC Climate, Controls & Security equipment orders increased 5 percent organically. Large commercial engine spares orders were up 20 percent at Pratt & Whitney and commercial spares orders increased 19 percent at UTC Aerospace Systems."

Strong order growth, accelerating organic expansion, and a relentless focus on cost controls speak to potential upside to its 2014 targets for earnings per share of $6.55-$6.85 on sales of approximately $64 billion. We like United Technologies quite a bit on a fundamental level, especially given its material aerospace exposure. For one, the strength of 'Pratt & Whitney Large Commercial Spares' and 'Aerospace Systems Commercial Spares' orders in the quarter was the highest in some time.

But earnings results don't tell the whole story.

As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In United Technologies' case, the company is trading at $114 per share, which falls in line with our fair value range. Let's learn more.

At Valuentum, we think a comprehensive analysis of a firm's discounted cash-flow valuation and relative valuation versus industry peers is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best. Essentially, we're looking for firms that overlap investment methodologies, thereby revealing the greatest interest by investors.

United Technologies posts a VBI score of 7 on our scale, reflecting our 'fairly valued' DCF assessment of the firm, its attractive relative valuation versus peers, and bullish technicals. We compare United Technologies to peers 3M (NYSE:MMM), Danaher (NYSE:DHR), and Honeywell (NYSE:HON). In the spirit of transparency, we show how the performance of our VBI has stacked up per underlying score:

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Investment Considerations

Investment Highlights

• 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. Return on invested capital (excluding goodwill) has averaged 27.7% during the past three 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 11% in coming years. Total debt-to-EBITDA was 2.4 last year, while debt-to-book capitalization stood at 47.3%.

• 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 experienced a revenue CAGR of about 2.9% during the past 3 years. We expect its revenue growth to be better than its peer median during the next five years.

Business Quality

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 - WACC. The gap or difference between ROIC and WACC is called the firm's economic profit spread. United Technologies' 3-year historical return on invested capital (without goodwill) is 27.7%, which is above the estimate of its cost of capital of 10.1%. 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' free cash flow margin has averaged about 8.3% 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 At United Technologies, cash flow from operations increased about 8% from levels registered two years ago, while capital expenditures expanded about 239% over the same time period.

Valuation Analysis

The estimated fair value of $102 per share represents a price-to-earnings (P/E) ratio of about 19.1 times last year's earnings and an implied EV/EBITDA multiple of about 13.6 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 5.9% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 2.9%. Our model reflects a 5-year projected average operating margin of 15.3%, which is above United Technologies' 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 10.1% weighted average cost of capital to discount future free cash flows.

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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 $102 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 $77 per share (the green line), but quite expensive above $128 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' fair value at this point in time to be about $102 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' 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 $132 per share in Year 3 represents our existing fair value per share of $102 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.

Pro Forma Financial Statements

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.