Strong Free Cash Flow Powers United Technologies' Dividend

| About: United Technologies (UTX)
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We liked the company's decision to buy Goodrich to augment its commercial aerospace portfolio. Air travel is expected to expand at a nice pace in coming decades.

With Sikorsky no longer a part of its portfolio, management is targeting higher organic growth, an improved operating margin, and better cash flow generation, not to mention lower defense exposure.

United Technologies remains a veritable cash machine, and proceeds from the Sikorsky sale will offer significant financial flexibility.

Let's take a look at the firm's investment considerations as we attempt to uncover the drivers behind its Dividend Cushion ratio.

By The Valuentum Team

We like United Technologies' dividend growth prospects.

United Technologies' (NYSE:UTX) commercial businesses are Otis elevators and escalators and UTC Climate, Controls and Security. The firm's aerospace businesses include UTC Propulsion and Aerospace Systems, which includes Pratt & Whitney aircraft engines and UTC Aerospace Systems products. The company was founded in 1934.

United Technologies parted ways with a valuable asset recently in Sikorsky Aircraft. Lockheed Martin (NYSE:LMT) was the lucky winner, but the $9 billion price tag makes parting with it a little easier for the industrial conglomerate. Buybacks appear forthcoming, and restructuring initiatives aren't over.

United Technologies' business quality (an evaluation of our ValueCreation and ValueRisk ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders with relatively stable operating results for the past few years, a combination we view very positively.

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 commercial backlogs at the airframe makers are simply tremendous.

New equipment orders at Otis in China continue to perform well, and we like the backdrop for large commercial engine spares at Pratt & Whitney. We continue to pay close attention to the pace of order expansion.

Note: United Technologies' annual dividend yield is above average, offering a 2.8% yield at recent price levels. We generally prefer yields above 3% in our dividend growth portfolio, but United Technologies has earned itself a spot high on our watch list. Let's take a closer look at its strengths and weaknesses as it relates to its dividend payout.

Dividend Strengths

We'd be hard pressed to find much wrong with the resiliency of United Technologies' dividend growth prospects. With Sikorsky no longer a part of its portfolio, management is targeting higher organic growth, an improved operating margin, and better cash flow generation, not to mention lower defense exposure, which tends to be fickle and impacted by competing budget priorities (items out of United Technologies' control). Pratt & Whitney's installed base is impressive, and the company's presence in elevators (Otis) and HVAC residential systems is incredible. Management continues to weight share repurchases higher than dividends, however, with $16 billion out of the $22 billion expected to be returned to shareholders during 2015-2017 going to the former.

Dividend Weaknesses

Investors in United Technologies' equity have had their share of ups and downs during the past few years. A deal with Goodrich and the shedding of Sikorsky have represented big changes to the industrial conglomerate's portfolio, for example. United Technologies remains a veritable cash machine though, and proceeds from the Sikorsky sale will offer significant financial flexibility. Though its dividend remains very healthy, it appears as though most of the executive team's focus will be on share buybacks in coming periods. In 2015, the firm announced a massive $6 billion accelerated share repurchase program, cash that could have gone to income investors or used to build an even bigger Dividend Cushion ratio.

From the Comments Section: How to Interpret the Dividend Cushion Ratio - A Ranking of Risk

As for how to interpret the Dividend Cushion ratio itself, it's a measure of financial risk to the dividend, much like a credit rating is a measure of the default risk of the entity. Said differently, a poor Dividend Cushion ratio of below 1 or negative doesn't imply the company will cut the dividend tomorrow, no more than a junk credit rating implies a company will default tomorrow. That said, the Dividend Cushion ratio does punish companies for outsize debt loads because in times of adverse conditions, entities often need to shore up cash, and that means the dividend becomes increasingly more risky.

We think investors should look at a variety of different metrics in assessing the sustainability of the dividend. Because the Dividend Cushion ratio is systematically applied across our coverage, it can be used to compare entities on an apples-to-apples basis. Dividend payers with significant free cash flow generation and substantial net cash on the balance sheet often register the highest Dividend Cushion ratios, as they should. These companies have substantial financial flexibility to keep raising the dividend.

Dividend Safety

We think the safety of United Technologies' dividend is good. Please let us explain.

First, we measure the safety of the dividend in a unique but very straightforward fashion. As many know, earnings can fluctuate, so using the payout ratio in any given year has some limitations. Plus, companies can often encounter unforeseen charges, which makes earnings an even less-than-predictable measure of the safety of the dividend. We know that companies won't cut the dividend just because earnings have declined or they had a restructuring charge that put them in the red for the quarter (year). As such, we think that assessing the cash flows of a business allows us to determine whether it has the capacity to continue paying dividends well into the future.

That has led us to develop the forward-looking Dividend Cushion ratio, which we make available on our website. The measure is a ratio that sums the existing net cash a company has on hand (on its balance sheet) plus its expected future free cash flows (cash flow from operations less capital expenditures) over the next five years and divides that sum by future expected cash dividends over the same time period. Basically, if the score is above 1, the company has the capacity to pay out its expected future dividends and the expected growth in them.

As income investors, however, we'd like to see a ratio much larger than 1 for a couple of reasons: 1) the higher the ratio, the more "cushion" the company has against unexpected earnings shortfalls, and 2) the higher the ratio, the greater capacity a dividend-payer has in boosting the dividend in the future. For United Technologies, this ratio is 1.4, revealing that on its current path the firm should be able to cover its future dividends and growth in them with net cash on hand and future free cash flow.

Dividend Cushion Ratio Cash Flow Bridge

The Dividend Cushion Cash Flow Bridge, shown in the graph below, illustrates the components of the Dividend Cushion ratio and highlights in detail the many drivers behind it. United Technologies' Dividend Cushion Cash Flow Bridge reveals that the sum of the company's five-year cumulative free cash flow generation, as measured by cash flow from operations less all capital spending, plus its net cash/debt position on the balance sheet, as of the last fiscal year, is greater than the sum of the next five years of expected cash dividends paid.

Because the Dividend Cushion ratio is forward-looking and captures the trajectory of the company's free cash flow generation and dividend growth, it reveals whether there will be a cash surplus or a cash shortfall at the end of the five-year period, taking into consideration the leverage on the balance sheet, a key source of risk. On a fundamental basis, we believe companies that have a strong net cash position on the balance sheet and are generating a significant amount of free cash flow are better able to pay and grow their dividend over time.

Firms that are buried under a mountain of debt and do not sufficiently cover their dividend with free cash flow are more at risk of a dividend cut or a suspension of growth, all else equal, in our
opinion. Generally speaking, the greater the "blue bar" to the right is in the positive, the more durable a company's dividend, and the greater the "blue bar" to the right is in the negative, the less durable a company's dividend.

Dividend Cushion Ratio Deconstruction

The Dividend Cushion Ratio Deconstruction, shown in the graph below, reveals the numerator and denominator of the Dividend Cushion ratio. At the core, the larger the numerator, or the healthier a company's balance sheet and future free cash flow generation, relative to the denominator, or a company's cash dividend obligations, the more durable the dividend. In the context of the Dividend Cushion ratio, United Technologies' numerator is larger than its denominator suggesting strong dividend coverage in the future. The Dividend Cushion Ratio Deconstruction image puts sources of free cash in the context of financial obligations next to expected cash dividend payments over the next five years on a side-by-side comparison. Because the Dividend Cushion ratio and many of its components are forward looking, our dividend evaluation may change upon subsequent updates as future forecasts are altered to reflect new information.

Please note that to arrive at the Dividend Cushion ratio, divide the numerator by the denominator in the graph below. The difference between the numerator and denominator is the firm's "total cumulative five-year forecasted distributable excess cash after dividends paid, ex buybacks."

Dividend Growth

Now on to the potential growth of United Technologies' dividend. As we mentioned above, we think the larger the "cushion" the larger capacity the company has to raise the dividend. However, such dividend growth analysis is not complete until after considering management's willingness to increase the dividend. To do so, we evaluate the company's historical dividend track record. If there have been no dividend cuts in the past 10 years, the company has a nice dividend growth rate, and a solid Dividend Cushion ratio, we characterize its future potential dividend growth as excellent, which is the case for United Technologies.

Because capital preservation also is an important consideration to any income strategy, we use our estimate of the company's fair value range to assess the risk associated with the potential for capital loss. In United Technologies' case, we currently think shares are fairly valued, meaning the share price falls within our estimate of the fair value range, so the risk of capital loss is medium. If we thought the shares were undervalued, the risk of capital loss would be low.

Wrapping Things Up

There's a lot to like about United Technologies. We're fans of the decision to add exposure to the commercial aerospace market as all signs point to a material increase in air travel in coming decades. Strong free cash flow generation allows management to be shareholder friendly, but we'd like to see more cash allocated to the dividend in place of share buybacks, the latter of which the firm has emphasized in recent spending plans. We can't rule out further restructuring initiatives, which should be watched closely. Nevertheless, the industrial conglomerate's free cash flow generating ability lands it firmly on our watch list for addition to our dividend growth portfolio. A more attractive entry point may be all we need to pull the trigger. Thank you for reading!

Breakpoints: Dividend Safety. We measure the safety of a firm's dividend by adding its net cash to our forecast of its future cash flows and divide that sum by our forecast of its future dividend payments. This process results in a ratio called the Dividend Cushion. Scale: Above 2.75 = EXCELLENT; Between 1.25 and 2.75 = GOOD; Between 0.5 and 1.25 = POOR; Below 0.5 = VERY POOR.

This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.

Disclosure: I/we 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.