August 5, 2011
United Technologies Corp. (UTX)
Sector:!
Industry:!
Industrials
Aerospace & Defense
Business Summary
UTC provides high technology products and services to the
building systems and aerospace industries worldwide. The
companyʼs operations are classified into six principal business
segments: Otis, Carrier, UTC Fire & Security, Pratt & Whitney,
Hamilton Sundstrand, and Sikorsky. Otis, Carrier and UTC Fire &
Security are collectively referred to as the “commercial
businesses,” while Pratt & Whitney, Hamilton Sundstrand and
Sikorsky are collectively referred to as the “aerospace
businesses.”
Investment Thesis
The companyʼs intrinsic value is estimated to be fairly valued at
current levels using conservative assumptions. However, it is fear
and uncertainty that are again driving market prices, rather than
fundamentals. Leading economic indicators are pointing to a
rolling over of the global economy. Also it appears increasingly
likely that the United States, among other developed economies,
is heading into a second recession. Given the companyʼs high
correlation to global economic activity, caution and a lack of clarity
necessitates a SELL recommendation at this time.
Valuation
I believe consensus estimates are too bullish in light of weakening
economic data and do not price in the possibility of a recession.
United Technologies typically trades in a historical range of 8.9x to
17.4x forward earnings. Using a target multiple of 11.3x a
conservative forward earnings estimate of $5.76 (FY12) we arrive
at a price target of $65.00.
Current Risks
Multiple contraction resulting from extreme market pressure
Further deterioration of leading economic indicators
The impact of government austerity in the US and Europe
Unfavorable FX translation resulting from a declining Euro
The possibility of a downturn in Chinese new construction
Extremely bearish technical signals
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Student Investment Management
!
Logan Smyth
smyth.31@osu.edu
703.869.0041
Rating
Current Price
Price Target
Projected Return
Beta
52-Week Range
Market Cap
Dividend Yield
Sell
$74.14
$65.00
(12.3%)
1.03
$64.57 - $91.83
67.37B
2.60%
Consensus Earnings Estimates
4.74
5.47
6.21
6.92
7.28
2010A 2011E 2012E 2013E 2014E
Consensus Revenue Estimates (billions)
54.3
58.2
61.3
65
68.7
2010A 2011E 2012E 2013E 2014E
1 Year Chart
100
90
80
70
60
50
August 5, 2011
Table Of Contents
Company Profile....................................................................................................................! 3
Revenue Breakdown.............................................................................................................! 4
Recent Events.......................................................................................................................! 5
Macroeconomic Climate........................................................................................................! 6
Risks......................................................................................................................................! 9
Financial Analysis..................................................................................................................! 11
Competitor Analysis...............................................................................................................! 12
Sum of the Parts Analysis......................................................................................................! 13
Valuation Analysis..................................................................................................................! 14
Technical Analysis..................................................................................................................! 16
Summary................................................................................................................................! 17
Works Cited............................................................................................................................! 17
Appendix A.............................................................................................................................! 18
Appendix B.............................................................................................................................! 19
August 5, 2011
Company Profile
UTC provides high technology products and services to the building systems and aerospace industries
worldwide. The companyʼs operations are classified into six principal business segments: Otis, Carrier, UTC
Fire & Security, Pratt & Whitney, Hamilton Sundstrand, and Sikorsky. Otis, Carrier and UTC Fire & Security are
collectively referred to as the “commercial businesses,” while Pratt & Whitney, Hamilton Sundstrand and
Sikorsky are collectively referred to as the “industrial businesses.”
The Commercial Businesses
Otis is the worldʼs largest elevator and escalator manufacturing, installation and service company. Otis
designs, manufactures, sells and installs a wide range of passenger and freight elevators for low-, mediumand high-speed applications, as well as a broad line of escalators and moving walkways. In addition to new
equipment, Otis provides modernization products to upgrade elevators and escalators as well as maintenance
and repair services for both its products and those of other manufacturers. Otis serves customers in the
commercial and residential property industries around the world. Otis sells directly to the end customer and, to
a limited extent, through sales representatives and distributors.
Carrier is the worldʼs largest provider of HVAC and refrigeration solutions, including controls for residential,
commercial, industrial and transportation applications. Carrier also provides installation, retrofit and aftermarket
services for the products it sells and those of other manufacturers in the HVAC and refrigeration industries.
UTC Fire & Security is a global provider of security and fire safety products and services. UTC Fire & Security
provides electronic security products such as intruder alarms, access control systems, and video surveillance
systems and designs and manufactures a wide range of fire safety products including specialty hazard
detection and fixed suppression products, portable fire extinguishers, fire detection and life safety systems, and
other firefighting equipment.
The Industrial Businesses
Pratt & Whitney is among the worldʼs leading suppliers of aircraft engines for the commercial, military,
business jet and general aviation markets. Pratt & Whitney Global Services provides maintenance, repair and
overhaul services, including the sale of spare parts, as well as fleet management services for large commercial
engines. Pratt & Whitney produces families of engines for wide- and narrow-body aircraft in the commercial
and military markets. Pratt & Whitney Power Systems sells aero-derivative engines for industrial applications.
Pratt & Whitney Canada (P&WC) is a world leader in the production of engines powering business, regional,
light jet, utility and military aircraft and helicopters and provides related maintenance, repair and overhaul
services, including the sale of spare parts, as well as fleet management services. Pratt & Whitney Rocketdyne
(PWR) is a leader in the design, development and manufacture of sophisticated space propulsion systems for
military and commercial applications, including the U.S. space shuttle program.
Page 3
August 5, 2011
Hamilton Sundstrand is among the worldʼs leading suppliers of technologically advanced aerospace and
industrial products and aftermarket services for diversified industries worldwide. Hamilton Sundstrandʼs
aerospace products, such as power generation, management and distribution systems, flight control systems,
engine control systems, environmental control systems, fire protection and detection systems, auxiliary power
units and propeller systems, serve commercial, military, regional, business and general aviation, as well as
military ground vehicle, space and undersea applications. Aftermarket services include spare parts, overhaul
and repair, engineering and technical support and fleet maintenance programs. Hamilton Sundstrand sells
aerospace products to airframe manufacturers, the U.S. and foreign governments, aircraft operators and
independent distributors.
Sikorsky is the worldʼs largest helicopter company. Sikorsky manufactures military and commercial helicopters
and also provides aftermarket helicopter and aircraft parts and services.
Revenue Breakdown
FY2010 Net Sales
By Business Segment (Billions)
$5.6
$6.5
$12.9
FY2010 Net Sales
By Geography
15.0%
39.0%
20.0%
$6.7
$11.6
$11.4
Pratt & Whitney
Otis
Carrier
Sikorsky
Fire & Security
Hamilton Sundstrand
26.0%
US
Europe
Asia Pacific
Other
Page 4
August 5, 2011
Recent Events
GTF platform
Two significant events occurred in the most recent quarter that will impact the companyʼs Pratt & Whitney
business unit, relating to the new Geared Turbo Fan engine platform in development. The new GTF engine
platform is the result of considerable R&D investment at Pratt & Whitney. The company is investing heavily
upfront in the platform to ensure the program continues to meet checkpoints and stays on schedule.
A significant setback for Pratt & Whitney is Boeingʼs decision to re-engine the 737, rather than to design an
entirely new replacement for the 737 series. The key distinction here is that by deciding to re-engine, General
Electricʼs current contract with Boeing stipulates that Boeing must continue to use GE engines on the 737
series aircraft. This means that despite the technical superiority of the GTF platform, it is unable to compete
with General Electric for the 737 series.
A possible catalyst for the GTF platform, though, is American Airlineʼs decision to begin incorporating Airbus
manufactured aircraft into their fleet. This decision is significant because it signals that major domestic airlines
are willing to begin diversifying their traditionally Boeing aircraft dominated fleet. Of particular significance is
that Airbus has yet to select an engine for the new A320 NEO. If the GTF engine is selected for the A320 NEO,
it is expected to outperform the 737 on a variety of metrics, making it more desirable to other airlines looking to
diversify away from Boeing.
Otis Incident In Beijing
On July 5th there was an tragic accident in a Beijing Metro station involving an Otis escalator. An Otis 513 MPE
model escalator suddenly reversed direction, killing one 13 year old boy and injuring 30 others. Following the
accident, Beijing authorities halted all Otis escalators in operation and suspended additional purchases. United
Technologiesʼ CFO, Greg Hayes, said the accident was caused by a substandard part furnished by a sub-tier
supplier as well as poor maintenance. There are 200 513 MPE model escalators currently in service and all are
expected to be inspected and returned to working order. On its most recent conference call, company
management has said this was a terrible accident and is working to make sure it never happens again.
The impact from this incident on Otisʼ business in China appears to be manageable at this time. The
suspension of additional purchases is limited to escalators in Beijing which management estimates to be less
than 10% of total China revenue. The company is actively working with the local authorities to restore
confidence in Otis products, although some damage to the companyʼs reputation is to be expected.
Page 5
August 5, 2011
Macroeconomic Environment
Overview
One of the most important factors in evaluating a multinational
industrial company, such as United Technologies, is the
strength of the global economy. Industrials as a whole are very
highly correlated to the level of global economic activity, so a
proper understanding of the macroeconomic environment is
key to any investment decision. The main tenet of my
investment thesis is that the global economy is in the early
stages of rolling over into another recession. A host of leading
economic indicators, both domestic and international, are
showing a contraction in global manufacturing, slowing GDP
growth, persistently high unemployment, and a possible
financial crisis in Europeʼs banking sector. The combination of
these factors bodes negatively for United Technologies and
broader equity markets in general.
Domestic Economy
The health of the domestic economy has been deteriorating
for the past three months. Further, the traditional gauges of
economic health have been consistently below expectations,
and in some cases revised even lower than initial reports. The
graphs in Exhibit 1 help to illustrate the current state of the
domestic economy. US GDP growth has been declining for the
past three quarters and the estimate for Q1 was recently
revised lower from 1.8% to only 0.4%. The initial estimate for
the Q2 was only 1.3%, though another downward revision is
possible given the recent trend.
Another major gauge of economic health, the unemployment
rate has risen from 8.8% in March to 9.2% in June. The
unemployment rate has since pulled back slightly to 9.1% for
July. The number of unemployed has remained stubbornly
high and reported figured do not include under-employed
workers.
Exhibit 1
US GDP Growth
US Unemployment Rate
Non-Residential Construction
ISM Manufacturing PMI
With regard to United Technologies construction-facing
businesses, non-residential construction has continued to
decline. Further, the ISM manufacturing index has dropped
from 61.2 in March to 50.9 in July. This means the pace of
expansion in the manufacturing sector is slowing and is very
close to contraction.
Page 6
August 5, 2011
Eurozone Economy
The European economy should be the focus of most
economists and investors right now. The sovereign debt crisis
that the European Union has been battling for over a year now
continues to worsen and is showing signs that it is beginning
to affect the European banking sector.
The least fiscally solvent members of the EU, known
affectionately as the PIIGS have been the subject of many
emergency weekend meetings over the past several months.
Despite the actions of European leaders, the bond yields for
countries like Greece, Italy and Spain have skyrocketed as
nervous investors dumped their bonds. With unsustainable
debt loads and prohibitively high interest rates, some
countries have been unable to access the credit markets and
are turning to the European Central Bank as a lender of last
resort.
The European Financial Stability Facility (EFSF) was set up to
facilitate these emergency loans but is not comprehensive
enough to solve the problem entirely. For example, because of
the EFSFʼs limited reach, the ECB recently signaled that it will
begin actively buying Spanish and Italian bonds in the
secondary market in an attempt to push down interest rates.
Given the ECBʼs rapidly shrinking cash position, they will not
be able to employ this strategy for long without devaluing the
Euro currency.
Exhibit 2
Eurozone GDP Growth
Eurozone Unemployment Rate
3 Month Euribor-OIS Spread (1 yr)
With the exorbitant debt levels and inability to repay debts,
many have called the solvency of the PIIGS into question. A
better question would be which banks own that sovereign debt
and which wrote the CDS insuring it. If one or more country in
the Eurozone defaults it would have tremendous ripple effects
throughout the global banking sector.
All of this uncertainty is creating a climate of distrust among
banks similar to the US financial crisis in 2008. In 2008, the
early warning sign of the impending crisis was the increase in
Libor-OIS spreads, the rate at which banks lend to each other
over the fed funds rate. Similarly, the 3-month Euribor-OIS
spreads are widening rapidly. Euribor is essentially Libor
denominated in Euros so itʼs more relevant for a European
financial crisis. This is very concerning and could be signaling
the beginning of a 2008-esque banking crisis in Europe.
3 Month Euribor-OIS Spread (3 yrs)
Page 7
August 5, 2011
Chinese Economy
Currently the Chinese economy is driving growth for United
Technologies. By managementʼs own admission, business in
the US and Europe is “flattish”. Essentially, the tremendous
growth in China is offsetting weakness in the US and Europe.
For this reason, it is of the utmost concern that demand is
China is maintained, especially in light of deteriorating
economic conditions in the US and Europe. However, the
economic data points to a slowdown in China as well.
Exhibit 3
Chinese GDP Growth
Chinese Premier Wen Jaibao has stated that the countryʼs
target growth rate for GDP is 7.5%. As seen at the top of
Exhibit 3, Chinaʼs GDP growth rate is still north of 9%.
However, the rate of growth has been slowing since February
of 2010. In fact, the political leadership in China is intentionally
trying to slow down the economy to prevent it from
overheating. This can be seen most directly in the consistent
increase in interest rates since 3Q10. In addition to raising
interest rates, the country has been raising reserve
requirements for banks operating in China.
With regard to the level of economic activity, the China
manufacturing PMI index has been inching ever closer to the
50 level and recently hit its lowest level since February 2009.
This indicates that the manufacturing sector in China is
growing slower and is close to contraction. While a recession
in China has almost zero probability, economic expansion is
slowing and that presents a risk to United Technologies. Since
the massive growth in China is driving the company's growth,
any reduction in growth will impact the companyʼs revenues.
On the companyʼs most recent conference call Greg Hayes,
SVP and CFO, said that the growth rate in China is near 30%
for Otis and over 20% for the overall business. However, he
does not think this level of growth is sustainable. He thinks a
more accurate estimate is high single digits over the next few
years.
China Manufacturing PMI
China 1 Year Best Lending Rate
Exhibit 4
Another concern is a possible bubble in the Chinese housing
market. In June, economists for the World Bank warned that a
real estate bubble was among the biggest economic risks in
China. Exhibit 4 shows the Y/Y change in real estate price in
nine major Chinese cities. Since property construction is 13%
of GDP, a real estate bubble is a serious concern.
Page 8
August 5, 2011
Risks
Reversal of Favorable FX Translation
One of the biggest risks to earnings growth in the
short-term is a reversal in the Euro/US Dollar
currency pair. As seen in Exhibit 4, in the most recent
quarter, 4% of the 9% total earnings growth was
attributable to favorable foreign exchange translation.
Because United Technologies is a net exporter, it
benefits from a weaker than expected US Dollar. The
impact of this favorable translation is even more
apparent in business segments that derive a greater
share of their revenue overseas, such as Otis,
Carrier, and Fire & Security.
Both fundamental and technical factors are pointing
to a reversal in the EUR/USD currency pair. Such a
reversal would create a period of unfavorable FX
translation for the company, impeding or reversing
earnings growth.
Exhibit 4
Total
Growth*
Organic
Growth
FX
Translation
Otis
12%
3%
8%
Carrier
10%
11%
5%
UTC Fire &
Security
8%
4%
8%
Pratt &
Whitney
5%
5%
0%
Hamilton
Sundstrand
11%
8%
3%
Sikorsky
6%
5%
0%
9%
6%
4%
Total UTC
*Includes impact of Net Acquisitions & Other
Exhibit 5
A number of fundamental factors are driving this
reversal in trend. Most notably, the US Federal
Reserveʼs quantitative easing program that has been
systemically devaluing the dollar has now ended.
Similarly, the European Central Bank has signaled
that it will begin actively buying Italian and Spanish
debt in secondary markets in an attempt to drive
interest rates lower. This marks the ECBʼs first foray
into quantitative easing and should have a similarly
destructive impact on the European common
currency. Given that the ECB does not have sufficient
capital on its balance sheet to buy sizable enough
quantities of bonds, it will likely be forced to print more Euros, devaluing the currency. In addition to the impact
of quantitive easing, the weak economic fundamentals of the EU member countries are also weighing on the
common currency. Several large member countries have unsustainable debt levels of 100%+ their respective
GDPs and in some cases, such as Spain and Greece, unemployment is north of 20%.
From a technical perspective, if the EUR/USD breaks the major support trendline illustrated in Exhibit 5, selling
would accelerate to the downside. United Technologiesʼ management said on their most recent conference call
that they are assuming a exchange rate of $1.40/Euro for the second half of the year (illustrated as a dashed
red line in Exhibit 5). Given the shift in ECB policy, this exchange rate seems unreasonable and places the
company at risk of negative foreign exchange impact in the coming quarters.
Page 9
August 5, 2011
Impact of Government Austerity
“
The government austerity there is hitting the F&S business significantly
because as you know, U.K. is a pretty big portion of total F&S and
government jobs were higher margin and with them going away there has
been some kind of a negative pressure on the margins.
”
Akhil Johri, VP of Financial Planning and Investor Relations
United Technologies Q2 Conference Call
The above quote represents what will likely be a growing concern for United
Technologies shareholders. When George Osborne took over as the U.K.ʼs
Chancellor of the Exchequer in May 2010, he began an ambitious campaign
to reduce Britain's budget deficit by imposing draconian spending cuts and
hiking taxes. About a year later, these spending cuts are already impacting
the companyʼs top line.
Exhibit 6
Country
Debt
(% of GDP)
Japan
225%
While the impact of government austerity programs appears limited right
now, that is sure to change over the coming months and years. While the
U.K. was quick to implement spending cuts, other debt-burdened nations
have been slow to respond.
Italy
118%
US
93%
France
84%
As seen in Exhibit 6, most major developed economies have large debt
burdens which have been further exacerbated by stimulative government
spending over the past two years. The current situation is unsustainable and
governments will need to begin imposing deep spending cuts to bring budget
deficits in line. Given the nature of government spending, budget cuts will
undoubtably impact United Technologiesʼ core businesses of aerospace,
defense, and construction. Complicating matters, it is difficult to forecast the
timing and size of these cuts. The nature of political process ensures that
cuts are subject to change at any time. Further, each government contract is
different and many give the government the ability to cancel contracts at any
time.
Canada
82%
UK
77%
Germany
75%
Another concern regarding government austerity, illustrated in Exhibit 7, is
the percentage of total revenues that are derived from business with the
United States government. While the budget cuts agreed upon by
lawmakers at the end of the July are fairly minimal, it is reasonable to
assume that greater cuts will follow the November election next year.
Meaningful cuts to NASA, the Department of Defense, or non-defense
discretionary could have considerable impact on revenues.
Exhibit 7
Sales to US Government
FY2010
18%
82%
Page 10
August 5, 2011
Financial Analysis
The first table in Exhibit 8 shows
managements ability to create value for
shareholders. The company is posting high
single digit returns on its assets. Further, its
ROE and ROC are well in excess of its
WACC of 9.4% indicating considerable
value creation for shareholders. Positive
ROCE shows that management is creating
considerable returns on the capital it is
investing in its operations.
Steady gross profit margins highlight
managementʼs ability to manage
consistently manage fluctuating input costs.
The gradual rise in the companyʼs EBITDA,
operating, and net profit margins over the
past five years shows the effectiveness of
managementʼs ongoing cost cutting
programs.
With uncertainty once again creeping into
the global economy as well as credit
markets, solvency ratios are key. While the
current ratio implies the company would be
able to sufficiently meet its obligations, it is
assuming all inventory could be liquidated,
which is debatable. The most realistic
gauge of the companyʼs solvency is the
quick ratio. This ratio has been improving,
likely because of the persistent macro
uncertainty of the past few years.
Perhaps most interesting is the companyʼs
considerable financial leverage, also seen
in its D/A and D/E ratios. Management has
leveraged the companyʼs earnings
considerably through the use of debt and
that is reflected in the companyʼs outsize
earnings growth relative to its revenue
growth. However, if indeed economic
conditions do sour, as in 2009, earnings will
outpace revenue to the downside.
Exhibit 8
Management Effectiveness
WACC: 9.40%
FY2010
FY2009
FY2008
FY2007
FY2006
Return on Assets
7.65%
6.80%
8.42%
8.31%
8.02%
Return on Equity
21.10%
21.37%
25.27%
21.86%
21.77%
Return on Capital
16.16%
15.76%
18.57%
17.48%
17.05%
Return on Capital
Employed
43.69%
41.40%
50.70%
49.58%
52.71%
Profitability Analysis
FY2010
FY2009
FY2008
FY2007
FY2006
Gross Profit Margin
27.45%
26.57%
26.98%
27.10%
27.37%
EBITDA Margin
15.72%
14.59%
14.97%
15.02%
14.91%
Operating Margin
13.23%
12.22%
12.76%
12.87%
12.75%
Net Profit Margin
8.05%
7.24%
7.85%
7.71%
7.80%
Solvency Analysis
FY2010
FY2009
FY2008
FY2007
FY2006
Current Ratio
1.33
1.29
1.24
1.26
1.24
Quick Ratio
0.73
0.72
0.70
0.67
0.67
Cash Ratio
0.23
0.25
0.22
0.17
0.17
Debt/Assets
17.59
17.47
20.19
16.76
16.82
Debt/Equity
45.43
45.56
67.80
41.08
43.74
Financial Leverage
2.76
3.14
3.00
2.63
2.71
Historical Growth Rates
FY2010
FY2009
FY2008
FY2007
FY2006
Revenue Growth
2.7%
(9.8%)
7.2%
14.5%
13.1%
Earnings Growth
15.4%
(16.5%)
14.1%
15.1%
22.8%
Page 11
August 5, 2011
Competitor Analysis
The above table presents essential valuation metrics for several of United Technologiesʼ competitors. Given
the diverse nature of United Technologiesʼ business, it makes more sense to identify the relevant competitors
for each individual business unit. It is also worth noting that many of the competitors listed above are
headquartered outside the United States, so the risks facing United Technologies may not be relevant and may
affect the relative valuation.
For comparative earnings analysis it makes most sense to use EV/EBITDA, as the metric is capital structure
agnostic. By this metric, United Technologies is slightly undervalued relative to the benchmark industrials
index. A quick glance shows the market is assigning lower multiples to defense contractors, possibly a result of
the impeding government spending cuts discussed earlier. Looking at the other five business segments,
though, shows that United Technologiesʼ valuation is fairly consistent with those of its competitors. The two
exceptions are General Electric and TransDigm, likely for company-specific reasons.
With regard to P/B, since it is not a measure of the companyʼs ability generate earnings, it seems sufficient that
the company is in line with the benchmark index. Similarly, its dividend yield is also in-line with the industryʼs
benchmark index. Those companies with comparatively high dividend yields, such as defense contractors, are
likely the result of lower prices and lack of investor demand. With regard to P/CF, it is clear that the market is
assigning higher multiples to HVAC OEMs and aerospace companies. Given the relative size of United
Technologiesʼ Carrier and Hamilton Sundstrand business units, the companyʼs premium relative to the
benchmark index is justifiable.
Page 12
August 5, 2011
Sum of the Parts Analysis
For large, diversified companies that operate in many different business segments, it is useful to establish a
value for the sum of its parts. This valuation methodology helps to establish whether management is creating
positive or negative synergies for shareholders. The competitor analysis on the previous page details the
earnings multiples assigned to competitors in each of United Technologies business segments. Using these
multiples, an average peer group earnings multiple is established for each business segment. This multiple is
then applied to the implied EPS from each of United Technologies business segments to determine an implied
market value for each business segment, as if it were a standalone company. By summing these implied
market values it is possible to establish a fair value for the sum of United Technologies six business segments.
As can be seen above, this valuation methodology determines an intrinsic value of $68.58 for the whole of
United Technologies. Given that the current price of the stock is $74.14, this exercise implies that management
is creating positive synergies for shareholders of about 7.5%. When looking at the nature of United
Technologies business segments and their end markets, these synergies make complete sense. By organizing
the company into industrial-facing businesses and aero/defense-facing businesses they are creating
considerable synergies. For the industrial businesses, it allows the company the ability to cross-sell other
United Technologies products for construction projects. Similarly, the aero/defense business has the ability to
cross sell engines and components to aircraft manufacturers like Airbus. Finally, any process improvements or
technical breakthroughs can be shared across the company when relevant. These natural synergies, combined
with an effective organizational architecture and skilled management, clearly warrant the implied premium to
intrinsic value.
Page 13
August 5, 2011
Valuation Analysis
Sector Valuation
When appraising the current valuation of the industrials
sector it is important maintain a frame of reference for
some perspective of overall market valuation. For this
reason, it makes more sense to evaluate the sectorʼs
valuation relative to the S&P 500, rather than in
absolute terms. As seen in Exhibit 9, the sector is
currently trading at a slight premium to the S&P, but in
line with the historical median. This is typical of cyclical
sectors in times of economic expansion. If however,
economic activity does indeed begin to slow, the sector
would begin to trade at a discount to the S&P.
In absolute terms, the sector is trading at a discount to
historical median multiples. However, the data covers a
ten year time period and investors may simply not be
willing to assign as high of multiples as they once were.
For this reason the relative valuation multiples provide a
better understanding of current sector valuation.
Industry Valuation
As before, when evaluating the industry valuation, it
makes more sense to compare valuation relative to the
S&P, rather than in absolute terms. As seen in Exhibit 9,
earnings multiples for the industry are currently at a
discount to the S&P. This implies investors are less
bullish on the aerospace & defense industry than the
broader market. The current P/B multiple, though
implies that investors are still willing to pay a premium
for the book value of the firm. This makes sense given
the company has considerable tangible assets
compared to say a financial services firm.
With regard to absolute valuation, the industry is trading
at a discount to historical median multiples. Again
though, given the recent macroeconomic uncertainty, it
is understandable that investors would be willing to pay
less of a premium relative to the historical median.
Exhibit 9
Sector Valuation (Relative to S&P 500)
High
Low
Median
Current
P/E (TTM)
1.2
0.66
1.1
1.1
P/FE
1.2
0.82
1.1
1.0
P/B
1.4
0.9
1.1
1.2
P/CF
1.2
0.8
1.1
1.1
Sector Valuation (Absolute)
High
Low
Median
Current
P/E (TTM)
25.4
7.1
18.3
13.5
P/FE
24.3
9.2
16.7
11.7
P/B
4.5
1.4
3.2
2.3
P/CF
15.8
6.0
11.2
8.7
Industry Valuation (Relative to S&P 500)
High
Low
Median
Current
P/E (TTM)
1.3
0.63
0.95
0.94
P/FE
1.2
0.53
1.0
0.90
P/B
1.6
0.7
1.1
1.3
P/CF
1.4
0.7
1.1
1.0
Industry Valuation (Absolute)
High
Low
Median
Current
P/E (TTM)
23.6
7.9
17.3
11.3
P/FE
20.6
8.0
16.5
10.5
P/B
4.0
1.7
3.0
2.5
P/CF
14.9
6.8
11.7
8.3
Page 14
August 5, 2011
Earnings Forecast
The data presented in Appendix A details the assumptions used when forecasting earnings for United
Technologiesʼ fiscal years 2011 through 2013. As can be seen in the model, my assumptions and forecast for
2012 and 2013 deviate considerably from consensus estimates. Generally, consensus estimates are for
revenue growth of around 6% and earnings growth of around 12% for this two year period. The outsize rate of
earnings growth is attributable to the companyʼs considerable financial leverage, discussed on page 11. It is
my belief that consensus estimates for revenue growth are unrealistically high and do not fully reflect what will
be a very challenging macroeconomic climate. If revenue growth is in fact impacted by a weakening global
economy, consensus estimates for earnings growth will be off considerably. For this reason, my forecast for
revenue growth is slightly more conservative than consensus. Likewise, my forecast for earnings growth is
considerably more conservative than consensus to reflect the impact of the companyʼs financial leverage in
what is expected to be a challenging economic environment.
Another assumption worth noting is the shift in revenue mix from products to services. While the shift is
marginal, it seems reasonable given the considerable macro economic headwinds. If global economic activity
begins to recede, it is reasonable to assume that spending will begin to shift from new products to servicing
and maintaining existing ones. Other assumptions built into the model include maintaining the companyʼs pace
of share repurchases, an effective tax rate equal to the five year historical average, and maintaining the
companyʼs dividend growth rate. Also, it is worth noting that my forecast for 2011 is in-line with estimates.
Since management reaffirmed guidance for the second half on their most recent conference call this seems
reasonable.
Discount Cash Flow Analysis
The DCF model presented in Appendix B builds on the assumptions mentioned above to establish a
conservative estimate of intrinsic value. While several assumptions are pulled through from the income
statement model, the key assumptions are the companyʼs terminal discount rate and terminal FCF growth rate.
Given that a companyʼs discount rate is simply its cost of capital, the assumption of 10.4% is the companyʼs
cost of equity from its WACC breakdown. For the terminal FCF growth rate, 4% is assumed to be slightly in line
with the long-run growth rate of global GDP. The forecast intrinsic value is then based on a gradual smoothing
to these terminal growth rates with other variables assumed to be their historical average. With these
assumptions the intrinsic value of United Technologies is estimated to be $73.63 or 0.7% below the current
price of $74.14. Essentially, at current levels the stock price fairly reflects long-term intrinsic value.
Page 15
August 5, 2011
Exhibit 10
Technical Analysis
S&P 500 Index (3 Years)
The the graphs in Exhibit 10 highlight an
extremely significant technical breakdown
that just recently occurred. As can be seen in
the first graph, the S&P 500 Indexʼs 200 day
moving average (red) began to converge
with the major support trendline (white)
dating back to the March 09 lows. The
second graph shows a large head-andshoulders pattern formation (yellow) that has
been forming over the course of the year.
On August 2, the S&P broke decisively
through the 200-day MA, the major support
trendline, and the neck line of the head-andshoulders formation. This is an extremely
significant technical breakdown and signals a
reversal of the recent uptrend in the market.
S&P 500 Index (1 Year)
Similarly, the chat of United Technologies
below shows the same convergence of the
200-day moving average over the major
support trendline. Though there is no headand-shoulders formation on UTXʼs chart, this
would still be considered a rather significant
technical breakdown.
United Technologies (3 Years)
Page 16
August 5, 2011
Summary
The companyʼs intrinsic value is estimated to be fairly reflected at current levels using conservative
assumptions. Most valuation metrics employed show that the companyʼs intrinsic value is fully reflected in the
current market price. The major concerns for investors, though, are uncertainty and the considerable economic
headwinds. In light of these risks, fear is driving stock prices, not fundamentals. While this may seem irrational,
these conditions show no sign of abating anytime in the near future. Further, a significant technical breakdown
will likely exacerbate losses for investors in the short term.
As discussed earlier, leading economic indicators around the world are deteriorating and increasing the
likelihood of a second recession. Also, it appears as if Europeʼs sovereign debt crisis is transforming into a
European financial crisis, similar to the one experienced in the United States in 2008. If this is the case, global
economic activity is likely to be impacted in a similar, if not more severe, fashion. If such a financial crisis were
to occur in Europe, it would likely be detrimental to the Euro, creating negative foreign exchange translation
effects for the company.
In addition to external factors, the companyʼs use of considerable financial leverage means that the company
would drastically underperform in a weak economic environment. Coupled with the typical underperformance
of the industrials sector in weak economic times, United Technologies could be a very risky investment at this
time. With the lack of clarity, macroeconomic uncertainty, and considerable leverage in mind, it is only prudent
to sell the companyʼs equity at this time until the outlook for growth improves.
Works Cited
I, Logan Smyth, hereby attest that the views about the companies and their securities discussed in this report
are accurately expressed. Information contained in this report may be found in the companyʼs annual,
quarterly, and proxy filings with the Securities and Exchange Commission and additional information was
obtained from the sources listed below...
Morgan Stanley Equity Research
Citi Investment Research
CNBC
The Wall Street Journal
The IMF
Thompson Reuters Baseline
Bloomberg (Charts)
Thinkorswim (Charts)
Page 17
August 5, 2011
Appendix A: Selected Financial Data
Page 18
August 5, 2011
Appendix B: Discounted Cash Flow Model
Sensitivity Analysis
Discount Rate
9.4%
9.9%
10.4%
10.9%
11.4%
2.5%
$75.24
$70.18
$65.76
$61.87
$58.41
3.0%
$78.51
$72.89
$68.03
$63.79
$60.05
3.5%
$82.32
$76.02
$70.63
$65.97
$61.89
4.0%
$86.84
$79.68
$73.86
$68.46
$63.98
4.5%
$92.29
$84.02
$77.15
$71.35
$66.38
5.0%
$98.97
$89.25
$81.32
$74.72
$69.15
Growth Rate
Growth Rate
Discount Rate
9.4%
9.9%
10.4%
10.9%
11.4%
2.5%
1.5%
(5.3%)
(11.3%) (16.6%) (21.2%)
3.0%
5.9%
(1.7%)
(8.2%)
(14.0%) (19.0%)
3.5%
11.0%
2.5%
(4.7%)
(11.0%) (16.5%)
4.0%
17.1%
7.5%
(0.4%)
(7.7%)
(13.7%)
4.5%
17.1%
13.3%
4.1%
(3.8%)
(10.5%)
5.0%
33.5%
20.4%
9.7%
0.8%
(6.7%)
Page 19