March 21, 2017

At current valuations, UTX is priced for perfection, but fundamental headwinds and management sentiment signal otherwise


  • Markets expect UTX to see Adjusted ROA expand to cycle-high levels over the next 5 years
  • However, the firm has only reached these profitability levels once since the turn of the century, indicating these expectations are already for a best-case scenario
  • Management  also appears concerned about service margins, sales volumes, and interest payments
  • Even if the firm meets expectations, upside may be limited, and given management concerns about fundamental headwinds, downside could be likely

 

Performance and Valuation Prime™ Chart

United Technologies Corporation (UTX) is a global leader in the building systems and aerospace industries. Their business is broken into four segments: Otis (elevators, escalators, moving walkways), Pratt & Whitney (aircraft propulsion), UTC Climate, Controls & Security, and UTC Aerospace Systems. Their goal is to provide smart, sustainable solutions that help make cities greener, people more secure and travel more efficient.

With their end markets in somewhat cyclical industries, UTX has seen cyclical profitability, with Adjusted ROA improving from 9% in 2001 to a peak of 15% in 2006-2007, before compressing back to 11% in 2010. Then, profitability subsequently expanded to a new high of 17% in 2013, before falling back to 13% in 2016. Meanwhile, Adjusted Asset growth has been more volatile, positive in 10 of the past 16 years, while ranging from -8% to 8%.

For context, the PVP chart below reflects the real, economic performance and valuation measures of United Technologies Corporation (UTX) after making many major adjustments to the as-reported financials. This chart, along with all of the charts included in this article, as well as the detail behind the graphics, can be found here.

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The four panels above explain the company’s historical corporate performance and valuation levels plus consensus estimates for forecast years as well as what the market is currently pricing in, in terms of expectations for profitability and growth.

Performance Drivers – Sales, Margins and Turns

It can be helpful to break down Adjusted ROA into its DuPont formula parts: UAFRS Earnings Margin and UAFRS Asset Turnover. These are cleaned up margins and turns metrics used to calculate Adjusted ROA. The chart below details both Adjusted Earnings Margin and Adjusted Asset Turns historically, to help us better understand the drivers of the firm’s profitability and performance.

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Cyclicality in profitability has been driven by cyclicality in both the firm’s UAFRS-based Earnings Margins and Asset Turns. From 2000-2006, Adjusted Earnings Margins improved from 9% to 10%, before returning to 9% in 2010. Subsequently, Margins expanded to a new high of 15% in 2013, before fading to 11-12% levels in 2015-2016. Meanwhile, Adjusted Asset Turns increased from 1.0x in 2001 to a high of 1.5x in 2007, before declining back to 1.1x in 2016.

Impact of Adjustments

This analysis uses Uniform Adjusted Financial Reporting Standards (UAFRS) metrics, or adjusted metrics, which remove accounting distortions found in GAAP and IFRS to reveal the true economic profitability of a firm. This allows us to better understand the real historic economic profitability of a firm as well as allows for better comparability between peers. To better understand UAFRS, please refer to our explanation here.

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The chart above highlights via a common-size financial statements the impact UAFRS adjustments have on UTX’s asset base and earnings. A material adjustment to the firm’s Adjusted Net Asset base and Adjusted Earnings comes from UAFRS capitalization of research & development. UTX has regular material investments in R&D each year that as-reported financial statements treat as expenses. This violates one of the core principles of accounting, which is that expenses should be recognized in the period when the related revenue is incurred. R&D investment is an investment in the long-term cash flow generation of the company. Because as-reported metrics treat R&D investment as an expense, as opposed to an investment, net income is artificially decreased. Net income is then materially understated relative to UAFRS-based Earnings.

 

Embedded Expectations Analysis

As investors, understanding what the market is embedding in the stock price in terms of expectations is paramount to making good decisions. Without understanding what the market is pricing in, it is impossible to claim that the market is wrong. We derive market expectations for the firm from valuations and historical performance trends, to give a clearer picture into what the market is projecting for the firm.

UTX is currently trading at a 20.5x UAFRS-based P/E, which is near historical highs. At these levels, the market is pricing in expectations for improving Adjusted ROA, from 13% in 2016 to 16% in 2021, accompanied by 1% Adjusted Asset growth. This would represent the higher end of the company’s historical profitability, which has only been reached once since the turn of the century, and a material reversal of recent profitability declines.

 

Peer Analysis – Valuations Relative to Profitability

A major benefit of adjusting as-reported financial statements is to clear away accounting distortions to allow for more accurate peer-to-peer comparisons. We have included a scatter chart below that plots UTX against its peers based on their Adjusted Price-to-Assets ratio (V/A’) and Adjusted ROA (ROA’).

Looking across industries, markets, and time, there has been a very strong relationship between a company’s ROA’ relative to the corporate average (6%) ROA’, and the multiple the market will pay above the value of the company’s Asset’ base, in terms of a UAFRS-based P/B (V/A’) multiple. A company that generates a 6% ROA’ will tend to trade at a 1.0x Adjusted P/B, and a company that generates an 18% ROA’ will trade at a 3.0x Adjusted P/B, etc.

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Relative to its peers, UTX appears fairly valued at best, with its 2.6x UAFRS-based P/B and 13% Adjusted ROA. In order to justify current valuations, UTX would need to see ROA levels closer to 15%-16%, which would be more than a 25% expansion from current levels, or significant growth prospects, which analysts are not currently projecting. As such, UTX appears to be fairly valued at best relative to peers, or even overvalued at the moment, indicating that equity upside is likely limited.

Analyst and Management Expectations

Analysts have less bullish expectations than the market, expecting Adjusted ROA to remain at current 13% levels though 2018, accompanied by no Adjusted Asset growth.

Furthermore, Valens’ qualitative analysis of the firm’s Q4 2016 earnings call highlights that management appears concerned about the impact of Chinese regulation on their service margins, and may be concerned about their ability to improve service margins in the short-term. Moreover, they appear concerned about decreasing unit sales in their Otis business, and may be concerned about rising interest payments. Additionally, management appears concerned about their outlook for engine margins in 2018, and may also be concerned about the durability of their GTF engine.

Given management concerns surrounding margins and volumes, as well as macroeconomic uncertainty, UTX may be facing headwinds not currently priced in by markets.

Valuation Matrix – ROA’ and Asset’ Growth as Drivers of Valuation

When valuing a company, it is important to consider more than a singular target price, and instead, the potential value of a firm at various levels of performance. The below matrix highlights potential prices for UTX at various levels of profitability (in terms of Adjusted ROA) and growth (Adjusted Asset growth). Prices that are in excess of 10% equity upside are highlighted in black, and prices representing an excess of 10% equity downside are highlighted in red.

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To justify current prices, UTX would need to see Adjusted ROA expand to cycle-high Adjusted ROA levels not seen since 2013, accompanied by sustained Adjusted Asset growth in line with 2014 levels. Given the unlikelihood of the firm surpassing these expectations considering historical performance, markets appear to be pricing in the best-case scenario, limiting near-term equity upside.

Moreover, when considering fundamental headwinds and management communication signals, the firm may disappoint on expectations, potentially driving equity downside going forward.

 

To find out more about United Technologies Corporation (UTX) and how their performance and market expectations compare to peers, click here to access the open beta of the Valens Research database.

Our Chief Investment Strategist, Joel Litman, chairs the Valens Equities and Credit Research Committees, which are responsible for this article. Professor Litman is regarded around the world for his expertise in forensic accounting and “forensic fundamental” analysis, particularly in corporate performance and valuation.