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With fears looming over cuts for the Department of Defense (NYSEARCA:DOD), investors should expect elevated volatility among aerospace firms. Based on my DCF model, I find a meaningful amount of upside for high risk-adjusted returns in Honeywell (NYSE:HON) and United Technologies (NYSE:UTX). In addition, the firms are more stable than what the market is acknowledging due to customer loyalty. Accordingly, the Street rates both firms favorably.

From a multiples perspective, United Technologies is the cheaper of the two. It trades at a respective 14.9x and 12.1x past and forward earnings while Honeywell trades at a respective 25.7x and 12x past and forward earnings. While the firms also have low free cash flow yield - 5.4% for United Technologies and 2% for Honeywell - the management at both companies are committed to returning extra cash to shareholders.

On the fourth quarter earnings call, Honeywell's CEO, Dave Cote, noted stellar performance:

"We had another great quarter marked by terrific execution with continued growth in most of our end markets. And then yielded earnings per share above the high end of the previous range. Our reported sales were $9.5 billion, up 8% reported or 7% organic, reflecting continued advancement in our new products and the focus on high-growth regions. We ended the year with segment margins of 15.1%, expanding 90 basis points over the fourth quarter of last year. Then pro forma earnings per share were $1.05, up 21% over last year. Free cash flow was an impressive $1.4 billion in the quarter, reflecting 169% net income conversion prior to a $250 million cash pension contribution. Our 2011 performance underscored our balanced portfolio mix and strength of execution. New products, geographic expansion and traction on key process initiatives, all translated to record organic growth, margin expansion, high-quality earnings performance and strong free cash flow generation. And we did all this while continuing to maintain our seed-planting for the future."

Going forward, analysts are anticipating strong upward momentum in margins, ROIC and net cash. EPS were above the high-end of guidance in the recent quarter and are well positioned to grow from improvements to productivity and solid exposure in turbo and ACS.

Consensus estimates for Honeywell's EPS forecast are that it will grow by 9.9% to $4.45 in 2012 and then by 11.7% and 12.5% in the following two years. Modeling a CAGR of 11.3% for EPS over the next three years and then discounting backwards by a WACC of 9% yields a fair value figure of $71.10, implying 18.8% upside.

United Technologies has been able to successfully turnaround operations at Carrier, expanding operating margins through launch of the geared turbofan. Aircraft engine investments have further helped tap back life in the Pratt and Whitney segments. During the fourth quarter, organic revenue grew sequentially by 200 bps with particularly strong performance at Hamilton Stundstrand. The firm does not have an attractive takeover strategy and remains dependent on internal R&D. With one-fifth of its business coming from the DoD, the risks related to budget cuts are very real. But, again, R&D has helped navigate macro cyclicality.

Consensus estimates for United Technologies' EPS forecast are that it will grow by 1.6% to $5.58 in 2012 and then by 21.3% and 14.5% in the following two years. Modeling a CAGR of 12.2% for EPS over the next three years and then discounting backwards by a WACC of 9% yields a fair value figure of $98.55, implying 20.4% upside.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: 20% Upside For Honeywell, United Technologies