United Technologies: A Great Long-Term Dividend Investment

What’s the great joy of poring through annual reports of individual investments? Knowing that United Technologies exists, and being able to immediately recognize that the stock is a good deal at $86 per share. It’s never really entered the popular imagination of the investing public as it is a large industrial that doesn’t have many products on the consumer side. If you have encountered United Technologies in day-to-day life, it is probably through the Otis subsidiary that makes the Otis elevators, walkways, and escalators which has a true 100% of business monopoly in some areas.

Usually, there are three ways for an investment to catch someone’s attention. It can be a business
that is immediately obvious to the public (Facebook, Twitter, Google, Amazon); it can be a business with an unusually high dividend yield; or it can be a firm with a very high projected growth rate that earns it attention.

United Technologies is none of these things. It is a business behind the scenes of what most Americans know–it makes heating and air-conditioning units, works on elevators and transportation devices, works on the nuts and bolts of security services for buildings, manufactures heating and ventilation equipment through the Carrier brand, and even makes aircraft. Industrial conglomerates have gotten a bad name since the 1960s, but the ones that haven’t broken up have delivered excellent long-term returns (think United Technologies, Honeywell, Illinois Tool Works, and even…General Electric once you isolate the effects of the 1998-2001 high valuation mixed with the 2008 implosion of the lending division).

UTX is probably one of the sturdiest, most underrated compounders through the decades. If you wanted a million dollars in United Technologies stock, you could have done the following: invested $2,300 in 1970 which is an inflation-adjusted $10,200; invested $17,600 in 1980 which is an inflation-adjusted $55,600; invested $37,000 in 1990 which is an inflation-adjusted $84,900; or invested $284,000 in 2000 which is an inflation-adjusted $424,000. The annual compounding rates for 1970, 1980, and 1990 start periods are between 13% and 15% annualized, while the 2000 figure represents an annual compounding rate of 8.6%.

The 2000-2016 comparison is distorted by the unusually high valuation at the start of the period mixed with the unusually low valuation at the ending period. That’s a layer of conservatism that shows up in many of the stocks I profile as candidates for investment–the reason I usually make something a candidate is because it has gotten cheap, and usually this diminishes the long-term track record. For instance, United Technologies compounded at 8.6% annually from 2000 through 2016, but compounded at 11.5% annually from 2000 through the summer of 2015 before the recent drop-off from $124 to $86.

Over the long term, the twenty-five year annual earnings growth rate at United Technologies 10.5%. The compounded annual dividend growth rate over the same time is 11.5%. The earnings growth for the medium term is similar as well–it has grown profits at 9.5% annually since 2005. The dividend, meanwhile, has grown at a rate of 14% annually to raise the dividend payout ratio from the 20% range to the high 30% range.

Before the financial crisis of 2009, it had never yielded above 2%. This probably knocked it off the screens of most income investors, as my impression is that many don’t even consider a dividend growth stock unless it has a starting yield nearing 3% or thereabouts (I don’t endorse this line of thinking if you have a 10+ year time horizon for holding a publicly traded stock, as the capital gains and high dividend growth from some of the low initial yielders can thoroughly thrash a 3% yielder with earnings growth in the 4-6% range).

When you find a large-cap industrial, it is amazing what can happen if you just buy a block of shares and sit still. Back in 2004, United Technologies was trading at $40 per share. The $0.70 annual dividend only represented a starting dividend yield of 1.75%. But here’s the rub: United Technologies was retaining 75% of overall earnings and using that to power the intrinsic value forward at a rate of 9.5%. The recognition of this fact, mixed with a bit of good fortune as the Board decided to boost the payout significantly, meant that the $40 share was pumping out $2.56 per share in dividends for a yield of 6.4%. In exchange for patience–say, not buying AT&T or GlaxoSmithKline for the high dividends right away–you saw the stock price triple (though the recent sharp fall has made it closer to a double). If you had been reinvesting along the way, your yield-on-cost would be north of 8%.

Because the company is cutting $400 million in costs this year, it is incurring a lot of impairments that make the numbers look bad in the short term. There is a very high probability that “Wall Street” will be dissatisfied with this year’s results, as the expected $6.50-$6.70 in profits this year will fall below the $6.82 figure that United reported in 2014. The restructuring costs are part of a plan to reduce costs by almost $1 billion per year for the next five years. The profit margins, which were 13% a decade ago, have grown to 16%, and the new plan aims to grow the profit margins to 19%.

United Technologies does about 20% of its business in China, and it has fueled a lot of the medium-term growth through double-digit gains in the heating, ventilating, and air-conditioning divisions of UTC Climate. As Chinese demand for United’s UTC Climate products have slowed down to low single digit growth since the summer of 2014, United is engaging in heavy cost-cutting throughout the company to offset this blip in demand.

I have been slow to cover United Technologies since I started writing about stocks because the price was always fair. Normally, this isn’t an issue–I think it’s great going through an investing life with the mantra of “I will pick up great companies selling at fair value or less.” But, in the back of my mind, I’m also aware of two other elements: (1) Something else available has always been more attractive than United Technologies, be it an equally high-caliber firm at a better valuation or a lower quality firm selling at an even deeper discount; and (2) industrials have a long habit of getting unusually cheap during any period of bad news, and I figured it’s useless to know this tendency unless I actually planned to put it in fact.

As of yesterday’s close, United Technologies was yielding 2.91%. That catches my attention–at no point in the past three decades has United Technologies even gone a full year yielding more than 3%. The price drop from $124 to $86 gives the company a P/E ratio of 13x expected 2016 earnings. That’s margin of safety stuff right there–the only other time it has traded at 13x earnings came in 2008 and 2009. Back in 2009, the price of 13x earnings offered so much protection that those shares have compounded at nearly 7% annually, an impressive figure considering the compounding period has only been six full years and the stock recently fell 30%.

My expectation for the next five years is that investors will get dividend growth of around 9%. It will probably be closer to the 7% side for the next year or two, then a year or two of double-digit dividend growth as the cost cuts are realized, and then you’ll end up with a blended rate somewhere around 9% by 2020. That means the stock will be paying out around $4 per share in 2020, for a dividend yield of 4.65% on today’s costs without any reinvestment. If you reinvest, depending on the valuations at the time of reinvestment, it wouldn’t surprise me if a batch of UTX purchased in a tax-deferred account ended up yielding more than 6% five years from now. Extend the measuring period to ten years, and there is a reasonable though not likely possibility that you’ll be collecting $1,000 in 2025 UTX dividends for every $10,000 you invest today. I’d put the most likely figure somewhere around $850-$900, though.

If I had to define a good dividend investment at the time of the initial purchase, I’d say this: (1) you want an initial dividend yield that means something when you reinvest it and has a high possibility of growth; (2) you want earnings per share growth somewhere in the 8-12% range; and (3) you want the stock’s valuation to experience P/E expansion over the contemplated holding period. The higher your certainty regarding these elements, the better.

This is a company that usually trades somewhere between 16x and 18x earnings. The 13x earnings valuation is a great discount when you adjust for the quality of the company as reflected by its historical growth, and more importantly, diversity of current global operations. Even if the long-term valuation only moves up to 16x earns, that’s still an additional 22% of compounding, which will mix well with the growing 2.9% dividend and core earnings per share growth that is somewhere around 9% or 10%. The odds are titled in your favor on this one because there are a lot of high-probability sources of wealth creation: growing dividends, core earnings per share growth that routinely increases intrinsic value, and long-term P/E expansion due to the current low valuation. At $86 per share, it’s time to give United Technologies a look. I included a link of the dividend history below so you can see the historical greatness for yourself.

Notice: This article, which I believe may be of interest to readers, is for general information and entertainment purposes only. It only reflects my best understanding of the topic at hand and should not be relied upon as legal or investment advice.

Sources Consulted: http://ir.utc.com/investors/dividends.cfm