Beyond stabilizing revenue growth, UTX’s aftermarket business throws off consistent free cash flow and grows with every new aircraft engine or elevator that UTX puts into business. As you can see, UTX’s free cash flow per share has steadily increased over the last decade – a sign of a very strong business model and a feat that few other companies can claim.
Source: Simply Safe Dividends
While UTX generates healthy and reliable free cash flow, it’s still important to analyze its balance sheet. Companies with excessive amounts of debt that hit hard times could find themselves in a pinch and will always cut the dividend before missing an interest payment.
As seen below, UTX is in decent financial shape. The company could pay off all of its debt with cash on hand and 1.7 years of its earnings before interest and taxes. With that said, UTX’s net debt position will rise as it executes on its share repurchase plan, reducing some of its flexibility. Overall, the balance sheet doesn’t appear to pose much risk for a company like UTX.
Source: Simply Safe Dividends
Dividend Growth Score
Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
UTX scored above average for dividend growth potential with a dividend Growth Score of 65. The company has paid consistent dividends since 1936 and, while it is not on the dividend aristocrats list, the company has increased its dividend for more than 20 consecutive years.
As seen below, UTX has increased its dividend at a 7-8% annual rate over the last five years and most recently raised its dividend by 8% at the beginning of 2015.
Source: Simply Safe Dividends
Going forward, share repurchases appear to be a much higher priority than substantial dividend increases. Management’s plan is to repurchase up to $16 billion of its stock from 2015 through 2017 while paying out around $6 billion in dividends.
Considering management’s capital allocation plans and the earnings growth headwinds expected throughout most of 2016, we believe dividend growth could be closer to 4-6% over the next couple of years. A $0.03 – $0.04 increase (+5-6%) in the quarterly dividend from $0.64 to $0.67 or $0.68 per share wouldn’t surprise us next year.
If management can put the company back on track for high-single digit earnings growth, the share repurchases will look intelligent (the stock trades at a 14.5x multiple). Otherwise, our expectations for slightly lower income growth will be especially frustrating.
Valuation
UTX trades at about 14.5x forward earnings guidance and has a dividend yield of 2.7%. For a company with very strong market positions, substantial recurring revenue in the form of aftermarket parts and services (44% of sales), and a proven long-term track record, the valuation case looks pretty interesting.
For shareholders who believe management can rejuvenate earnings growth back into the high-single digits or even 10% per year, the stock would appear to offer a total return of at least 10-13% per year over the longer-term. The potential upside is even greater if the earnings multiple appreciates (which it likely would).
With that said, a long-term time horizon is likely needed for those entering the stock today. Many of the macro challenges (currency headwinds, sluggish growth in China and Europe) and company-specific actions (giving up some margin in Otis to try and take market share, working down the learning curve in the aircraft engine business to improve profitability, restructuring) seem unlikely to bring about improved results for at least several quarters.
There’s nothing wrong with taking a much longer investment horizon if you can afford to wait and stomach potential near-term price volatility – it just recognizes the fact that UTX might require some extra patience and trust in management’s current plan before you can be rewarded.
For those willing to give UTX’s high quality franchises the benefit of the doubt, the payoff could be worth the wait, especially compared to many other investment opportunities in the market today. The stock’s 2.7% dividend yield isn’t enough for investors living off dividends in retirement, but it does offer investors above average long-term dividend growth potential (assuming business conditions recover).
Conclusion
At the end of the day, United Technologies Corporation (NYSE:UTX) appears to be a high quality company with several enduring competitive advantages. The company’s aftermarket business provides dependable cash flow that can be reinvested for growth and help UTX outperform other companies during economic downturns.
With that said, the company’s execution has been spotty (Otis share losses, engine production challenges, need for restructuring), and several macro headwinds are impacting the business. Should these issues largely move into the rearview mirror over the next 2-3 years, dividend growth investors will likely be rewarded nicely with double-digit total returns.
Given our ownership of several related stocks that either compete with UTX or remain sensitive to many of the same macro factors, we don’t own the stock today but are keeping it on our watch list.
Disclosure: None
