Wider Horizons for United Technologies
In our view, United Technologies (UTX; recent price, $65) has one of the best product portfolios of any industrial conglomerate, with strong exposure to long-term trends of global growth in infrastructure and the demand for increased business and personal travel (aerospace).
Our recommendation is based on our view of the following factors:
• Continued moderately strong global economic growth;
• A continued strong aerospace cycle, which we see lasting for at least three more years;
• UT's approximate 40% of sales from aerospace-related products (through Pratt & Whitney, Hamilton Sundstrand, and Sikorsky);
• UT's strong international exposure, with approximately 60% of sales coming from outside the U.S.;
• UT's significant exposure to the global infrastructure market (through Carrier, Otis, and UTC Fire & Security);
• A continued recovery from an early 2006 strike at Sikorsky, as well as our view of strong demand for Black Hawk helicopters;
• Our expectation of continued double-digit earnings growth in both 2006 and 2007, as well as continued strong return on invested capital;
• Strong free cash flow generation, with our expectation of free cash flow generation per share greater than or equal to earnings per share in both 2006 and 2007;
• Our expectation of continued share repurchases;
• What we view as a reasonable valuation given UT's historical and projected future earnings and cash flow growth rates.
Based on our outlook for each of UT's business segments, as well as what we view as a reasonable valuation, we see the potential for nearly 20% upside in the shares. The stock carries Standard & Poor's highest investment recommendation of 5 STARS, or strong buy.
United Technologies' operating segments include Otis, the world's largest maker of elevators and escalators; Carrier, the world's largest maker of commercial and residential heating, ventilating, and air-conditioning (HVAC) systems; Pratt & Whitney, one of the world's "Big Three" jet-engine makers (the other two are GE Aircraft and Rolls Royce); UTC Fire & Security, a global provider of fire-safety products and services; Hamilton Sundstrand, a large supplier of systems and services to the aerospace and other industrial markets; and Sikorsky, a global provider of military and commercial helicopters.
United Technologies is truly a global company with over 60% of sales coming from markets outside the U.S. in 2005.
The company has paid a dividend each year since 1936. Since 1980, sales have grown at a compound annual rate of 5.1%, operating income at 7.2%, and net income (with the benefit of significant reductions in income tax) at 8.7%. Over the past five years net income has grown at a 12% compound annual rate.
Per-share stockholders' equity—a measure of returns achieved by shareholders—has grown at a compound annual rate of 6.0% since 1980, and dividends per share have grown at a compound rate of 7.7% over the same period. Putting these two numbers together, total shareholder value increased by almost 14% annually over this period. Over the past five years, stockholders' equity per share has grown at a 14.3% compound annual rate and dividends have grown at 16.4% rate.
Since the smallest of UT's business segments (Sikorsky) has annual revenues of nearly $3 billion, and each business unit if traded separately would have a midcap or large-cap market capitalization, a discussion of the segments individually should prove helpful.
Carrier is the largest segment, representing 29% of our 2006 revenue estimate for UT. Carrier is followed in order by Pratt & Whitney, with 23%; Otis, 21%; Hamilton Sundstrand and UTC Fire & Security, each 10%; and Sikorsky, 7%.
Carrier. We're projecting 8% revenue growth for Carrier in 2006, with operating margins rising to 9.4%, from 8.8% in 2005. Carrier has exposure both to commercial and residential real estate. We expect growth in commercial HVAC to offset weakness in residential HVAC in 2006. Also, we see the residential market being helped somewhat by the introduction of new SEER 13 air conditioners, a standard offering improved energy efficiency that comes at a higher initial cost.
Through the acquisition of Linde AG—which has operations in Europe, Asia, and South America—in October, 2004, Carrier expanded its operations in commercial refrigeration, which we also expect to grow significantly this year. Although raw material costs pose an obstacle to higher margins, we believe UT has been successfully passing along raw material costs to customers in the form of price increases (within Carrier and in other business segments).
Pratt & Whitney. We expect 16% sales growth at Pratt & Whitney in 2006 (aided by acquisitions), with operating margins rising to 17.2%, from 15.6% in 2005. We see P&W benefiting from a long-term commercial aerospace cycle, which we believe is currently being driven by the need for larger fleets to accommodate increased business and personal travel, primarily in Asia and other emerging economies.
According to aviation research firm Avitas, world air passenger traffic increased 7.7% in 2005. We look for somewhat lower but still strong increases in 2006 and 2007. As a result, Boeing (BA) and Airbus achieved a combined order rate of over 2,000 aircraft in 2005, which we view as the likely peak in orders. However, with backlogs high and orders continuing at a relatively strong rate, we believe that deliveries, and thus sales, won't peak until 2008. The increase in air travel has also provided a strong aftermarket parts business for P&W, and has boosted profit margins.
Otis. We project sales growth of 5% in 2006, with operating margins rising to 18.8%, from 17.9% in 2005. We also see Otis growing as a result of expansion in global infrastructure (one example of its reach: the company recently announced it will provide elevators and escalators for a large shopping mall in Kuwait). UT sees orders for new equipment increasing at double-digit rates for Otis. Potential risks include the price competition Otis is seeing in Korea, China, and Japan. So far, however, we haven't seen lower pricing cut into profit margins.
Hamilton Sundstrand. We see 11% sales growth at Hamilton Sundstrand, with operating profits rising to 17.3%, from 15.4% in 2005. We see this segment profiting from the same trends as Pratt & Whitney, primarily a strong aerospace cycle.
Sikorsky. We see 10% revenue growth at Sikorsky in 2006, with operating margins falling to 5.0%, from 8.9% in 2005. We project operating margins declining, year to year, primarily as a result of a strike at Sikorsky that was settled earlier this year. We also believe, based on information from suppliers to Sikorsky, that government demand for the company's Black Hawk helicopters is strong, and we view the overall helicopter market positively. We project further recovery by Sikorsky in 2007.
Over the past 10 years, UT has generated compound annual free cash flow (cash flow from operations less capital expenditures) growth of 10.4%. Over the past five years, free cash flow growth has jumped to a 16.8% compound annual rate, due to both strong increases in net income (with net income growing at 11.8%) as well as good working capital management and lower capital expenditures. Cash and short-term investments were 5.9% of assets as of June, 2006, well above UT's 20-year historical average of 3.8%.
As mentioned above, the cash flow has increased, in part, due to a decrease in capital spending relative to sales. Capex to sales fell from 3.5% in 2000 to 2.2% in 2005. We expect UT to maintain capital spending near current levels, as a percent of sales.
Part of the cash that UT is generating is being used for acquisitions. Over the years, a significant part of UT's growth has been generated through acquisitions. In 2005, the company spent $4.6 billion on acquisitions, including assumed debt, across its business operations.
UT is also using some cash for share repurchases. In March, 2005, its board of directors authorized the repurchase of up to 60 million shares of common stock. As of June, 2006, 26.1 million shares remained authorized under the program. Shares outstanding as of June, 2006, were down 1.3% from one year earlier.
Over the past five years, UT has increased its dividend by a compound annual rate of 16.4%, well above the rate of EPS growth for the same period of 11.9%. The company's payout rate, however, was 28% in 2005, leaving plenty of room for future dividend increases, in our view.
We believe the quality of UT's earnings are high and note our S&P Core Earnings estimates of $3.62 for 2006 (vs. our EPS estimate of $3.70) and $4.01 for 2007 (vs. $4.10). In 2005, S&P Core Earnings were $3.05 on EPS of $3.12. Our Core Earnings adjust anticipated pension results to include costs, such as employee service costs, but to exclude gains, such as expected returns on plan assets. We note that S&P Core Earnings for UT were 98% of reported earnings in 2005 and 95% in 2004.
UT's pension plan was underfunded by approximately $2.8 billion as of the end of 2005, and other postretirement benefit plans were underfunded by $1.0 billion. However, over the past three years, UT has generated free cash flows of $3 billion to $4 billion annually, and we expect the company to fully fund the plans over time (UT expects to make voluntary cash contributions to the pension plans of $500 million in 2006).
We believe UT's corporate-governance policies are sound. A majority of board members (11 out of 13) are independent outsiders. The nominating and compensation committees are composed solely of outside directors. A majority of each board member's annual fee is paid in UT stock, and the company has adopted stock-ownership guidelines for directors, as well as for senior management.
The primary negative factor, in our view, is the fact that George David serves as both CEO and chairman of the board. In general, we prefer that a non-executive director should serve as chairman, to better serve the interest of shareholders.
Over the past 10 years, UT's average price-to-book ratio has been about 4.0 times. The current price-to-book ratio is 3.5 times. UT's 10-year average price-to-sales ratio is 1.2 times, and currently it's 1.4 times. On a free-cash-flow-to-sales basis, the shares have historically yielded about 7.5% (average free cash flow as a percent of sales). Currently, they yield 6.8%, using trailing 12-months free cash flow. Over the past 10 years, UT's historical price-earnings ratio, using two-year forward earnings estimates, has averaged 16 times. The current p-e on our 2007 EPS estimate of $4.10 is 15.8 times.
The current average forward p-e ratio for a group of 14 large-cap aerospace and defense-related companies (including GE (GE), Textron (TXT), Boeing, etc.) is 14.1 times on 2007 estimates (vs. 15.8 for UT). However, we note that these 14 companies recorded average compounded annual earnings per share growth of 8.7% over the past 10 years, vs. 19% growth for UT.
Our discounted cash-flow model returns a net present value per share of about $70, with the range rising above $80 if you assume a lower Beta or slightly higher free cash flow growth.
Our 12-month target price of $75 is based on a p-e ratio of 18 times our 2007 EPS estimate, above UT's historical average forward p-e of 16 times. We believe UT can increase EPS at an average rate of 15% over the next three years. Our target price thus values UT at a 1.2 times ratio of p-e-to-growth, about in line with our current estimate of the PEG ratio for the S&P 500-stock index.
We view UT as a low-risk equity due to its history of steady growth in both earnings and dividends, its strong brand names, and its relatively low debt levels. (We note, however, that all equity securities carry a degree of risk of loss of capital.)
Primary risks to our recommendation and target price include an unanticipated slowing in the global economy, problems in any of UT's manufacturing operations, price competition from lower-cost suppliers in Asia (particularly for Otis), and a weakening in demand in the commercial aerospace market (we see this as linked to the direction of the global economy).