United Technologies Should Hold Up Well in a Recession

by: David Powell March 25, 2008 | about stocks: UTX    

David Powell

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Now that we are in a recession, I am looking at buying shares of industrial and aerospace companies, which have been beaten up of late (I’m a bit of a contrarian). One company I am looking at is United Technologies (UTX), a business in which I already own shares. I bought last year when the stock was at $73. As I think this company has strong long-term prospects, it might be worth buying more. The recent arrival of the company’s 2007 annual report in my mailbox gave me a reason to dig into its financials. Below is a chart of UTX over the last three years:

click to enlarge

United Technologies (UTX) is a diversified blue chip with a market cap of $68 billion. The company has six businesses which fall into two types: commercial and aerospace. You’ve probably heard of these major UTX brands: Otis Elevator, Carrier Corporation, Pratt & Whitney, and Sikorsky. Otis is the world’s leading elevator manufacturer; Carrier the world’s largest HVAC manufacturer. Pratt & Whitney builds aircraft engines, while Sikorsky builds helicopters.

Over the last three years, United Technologies has met or exceeded analyst estimates, and 2007 turned out to be another great year for the company. Fourth quarter earnings of $1.08 were above the consensus estimate of $1.06. Earnings were up 15% for the year to $4.27 per share. Free cash flow (cash from operations less capital expenditures) was $4.2 billion, down slightly from 2006, but up 22% over 2005. Dividends were about 30% of free cash flow; the rest of this money was used for acquisitions and to buy back shares ($2.0 billion worth).

Despite all the good news, UTX shares are currently down, trading at $69. This is a decline of 16% down from the October high of $82. Of course, the Dow is also down considerably; however, as UTX is an industrial/aerospace company, its performance of UTX can be cyclical. Knowing this, an investor would like to buy at the bottom of a cycle. But when exactly will we hit bottom?

I think most people would agree with me that the US is entering, or is already in, a recession. And United Technology’s annual report warns that “2008 may be a tougher environment and that only single digit revenue growth is expected.” I will take them at their word, as UTX has been straightforward with information and consistent about meeting or beating earnings estimates in the past. For now, however, declines in domestic revenues are being made up by international growth. Carrier’s North American revenues, for example, were down 10% in 2007, but the company won 69% of the air conditioning contracts for the Beijing Olympics. The fact that UTX is diversified geographically, with operations around the world, should continue to help “smooth out” any decline in its earnings near term. The US represents 38% of revenues, while Europe is 29% and Asia 19%.

Also, after reading the annual report, I think management realizes the challenges ahead of the company, especially if there is a global recession. Last year, UTX initiated cost containment programs. The company made workforce reductions and consolidated some of its manufacturing facilities ahead of the recession curve. Selling and administrative costs, as a percent of sales, dropped 30 basis points as a result.

Although inventory levels have risen slightly from 2006 to 2007, this is something you would expect in a recession, and overall the balance sheet still looks strong. Long-term debt is 15% of total assets ($54.5 billion), about the same ratio as last year, while the current ratio is a respectable 1.3. Below is a table comparing UTX to its primary competitors:

Over the last 10 years, UTX shares have appreciated at a faster rate than its competitors. In fact the annual report states that “Over the last decade, our total shareholder return is five times that of the S&P 500.” And while Boeing’s numbers (above) look good, I believe the company is less diversified than either GE or UTX. GE, on the other hand has a higher level of long-term debt.

What are the other risks to UTX?

Other than being cyclical, United Technologies receives a good share of its revenues from government contracts. US government work has represented 13% of UTX revenue over the last three years, but that could change if the federal budget is trimmed. Still, in 2007, Sikorsky received a five-year government contract for delivery of 537 helicopters.

What About the Management?

United Technology’s CEO is George David, who began his tenure with Otis Elevator in 1975. He was named CEO of the year by Industry Week in 2003. For the last three years, Institutional Investor Magazine had named him the Best CEO in America for the aerospace and defense sectors, and Barron’s just named him one of the top global CEOs.

What About Valuation?

At $69 per share, UTX is down 16% from its high. The analyst consensus earnings per share for 2008 is $4.86. Using the consensus as a starting point in a discounted cash flow, with 8% growth the next three years and a 10% discount rate, I get a value of $70.51 per share. Using a lower earnings per share figure of $4.61, which is only 8% above last year’s number (remember management said “single digit growth” for 2008), followed by 8% growth the next three years and a 10% discount rate, I get a value of $67 per share.

So how low can the stock go in a recession? I don’t know. But I do like to look at past recessions as an indicator. In 1990-91, shares went down about 24%, while in 1999-2000 they went down about 20% before recovering. Using the recent high of $82, a 24% decline would be about $62 per share. It seems to me that getting shares of UTX in the mid 60’s would be a very defensible entry point with the potential for ling term upside. And, adjusted for splits, UTX has increased its dividend by 300% over the last 10 years.

Disclosure: Long UTX

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This article has 2 comments:

  •  
    Mar 25 05:06 PM
    I'm always baffled by this sort of article. If you're worried about a global recession, surely you don't want to own any stocks? Why not just 100% to cash?
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  •  
    Mar 25 08:54 PM
    Because markets are efficient. Stocks are just as likely to go up as they are to go down, because a lot of the economic risks (recession, subprime writedowns, slowdown in construction, etc.) are "priced in" to the market. Don't let anyone tell you it's a certainty that stocks will go down - this is false.
    Reply | Link to Comment
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