Description
UTX is a provider of technology products and services to the building systems and aerospace industries worldwide. The Company’s operating units include businesses with operations throughout the world. Otis, Carrier and UTC Fire and Security serve customers in the commercial and residential property industries worldwide. Carrier also serves commercial, industrial, transport refrigeration and food service equipment customers. Pratt and Whitney, Hamilton Sundstrand and Sikorsky serve commercial and government customers in both the original equipment and aftermarket parts and services markets of the aerospace industry.
Source: Reuters
Valuation
I estimated the intrinsic value of UTX to be $104.25. Key assumptions included:
Core growth rate: 10.0%
Terminal growth rate: 3.0%
Risk-adjusted discount rate: 12.0%
Cost of sales: 73.0%
Selling, general, & administrative costs as % of sales: 11.2%
Research & development as % of sales: 3.0%
CAPEX as % of sales: 2.5%
Depreciation as % of sales: 2.0%
Effective tax rate: 28.0%
Day sales in receivables: 60
Day sales of inventory: 75
Days payable outstanding: 45
Given the current market price of $86.18 UTX is undervalued by 17.3% to its intrinsic value. The risk-adjusted margin of safety was calculated to be 14.2%. Since the actual margin of safety (17.7%) is greater than the risk-adjusted margin of safety (14.2%), this stock should be considered a buy.
Dividends
The dividend appears to be growing faster than earnings growth, but has slowed in recent years. From 2000 to the 2010, the dividend has grown from $0.41 per share to $1.70 per share. The compound annual growth rates for the past ten-, five-, and three-years are:
Ten years: 17.0%
Five years: 17.9%
Three years: 13.3%
Although growing faster than earnings, the dividend appears to be sustainable. Based on either net income or free cash flow, the dividend payout ratio has not exceeded 50%. A dividend payout ratio of less than 50% is a positive allowing for sustainable growth and a cushion for short-term earnings volatility. From 2006 to 2010, the dividend payout ratio based on net income has grown from 25.5% to 33.9%. Below is the dividend payout ratio for the past five years:
2006: 25.5%
2007: 25.6%
2008: 25.8%
2009: 35.4%
2010: 33.9%
In the book, The Ultimate Dividend Playbook, Josh Peters discusses a model to calculate a stock’s prospective return. The model is called the Dividend Drill Return Model (DDRM). It is based on the premise that the dividend total return is equal to the yield plus dividend growth. Dividend growth is then broken into core growth (the rate of growth for total profits) plus share change (reduction of shares due to share repurchase).
Given a core growth rate of 10.0% and current dividend yield of 2.2%, UTX’s cost of growth is $2.49 per share. After reducing this amount and dividends of $1.92 per share, the funding surplus is $0.40. UTX can use this $0.40 per share to reduce outstanding shares; this amount is forecasted to have a 0.5% impact on share price. As a result, the DDRM forecasts the projected total return for UTX to be 12.6%. Below is a breakdown of the total return:
Core growth rate: 10.0%
Dividend yield: 2.2%
Funding surplus: 0.5%
Total return: 12.6%
Summary
Based on a valuation $104.25, shares are trading at a 17.3% discount to the intrinsic value. UTX has a history of stable dividend increases and the dividend appears sustainable as the payout ratio is less than 50%. Based on the DDRM, the projected total return for UTX is 12.6%.
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