Undervalued Dividend Growth Stock of the Week: United Technologies Corporation (UTX)

Boy, what a crazy two weeks we’ve had.

The event known as Brexit has brought about a lot of drama.

Many people thought that it was going to be a non-issue, with the UK likely voting to stay in the European Union.

The status quo is easy and known.

This anticipation saw the US stock market steadily march toward all-time highs.

Gains evaporated overnight, with markets around the world crashing after UK voters shocked almost everyone with a vote to leave the EU.

With the long-term implications being unknown, uncertainty has pervaded.

Thus, volatility is upon us.

This kind of stuff is exactly why I stick to a very simple path to wealth: I live frugally and invest my excess capital regularly into high-quality dividend growth stocks trading for attractive valuations.

I don’t worry about Brexit, or whatever new acronym that may pop up next week.

Buying great businesses that provide quality products and/or services that people, governments, and/or other businesses demand regularly is a great and simple way to build growing wealth.

But it can be even better if those businesses share their growing profit with their shareholders, because then you’re also looking at a great and simple way to build growing income.

And growing dividend income is almost completely passive, allowing one with enough of it to become financially independent and able to take on whatever work, opportunities, or leisure they see fit.

High-quality dividend growth stocks like those you’ll find on David Fish’s Dividend Champions, Contenders, and Challengers list – a compilation of more than 700 US-listed stocks with at least five consecutive years of dividend increases – are great examples.

Once you begin to focus on your growing dividend income, the daily fluctuations of stock prices don’t matter much anymore.

But just in case price fluctuations bother you, many of these stocks feature low beta, meaning they don’t bounce around as much as the broader market.

So while the US market was seeing one of its biggest crashes since the financial crisis, my portfolio was holding up relatively well.

As great as high-quality dividend growth stocks are, though, one doesn’t want to go out and buy any stock at any price.

As aforementioned, one should aim to buy dividend growth stocks that exude high amounts of quality, and then they should be purchased only when they’re attractively valued.

A longstanding track record of growing dividend income is in itself a litmus test for quality (though not the only test).

After all, can you imagine how difficult it would be to run a low-quality business that is routinely unprofitable, yet still send out larger and larger dividend checks to your shareholders?

It practically cannot be done, at least not for decades on end.

But valuation is just as important as quality, in my view.

While the price of a stock simply represents how much it costs, the value of a stock tells you how much it’s worth.

Stocks are just like anything else in life in that you want to seek out the deals while avoiding overpaying.

Just like you don’t want to pay $20 for a cheeseburger worth $10, you don’t want to pay $40 for a stock worth $20.

Likewise, it’s extremely beneficial to find those stocks worth $20 that are only trading for $10.

What’s great about dividend growth stocks, though, is that we’re talking about real businesses with real cash flow and real dividends that are paid in real cash.

All of this is measurable; it’s quantifiable.

And so we’re able to anchor expectations to these results, which allows us estimate a stock’s intrinsic value.

There are a lot of ways to go about estimating a stock’s valuation, but one approach that was proposed by fellow contributor and dividend growth investor Dave Van Knapp, part of an overarching series of lessons on dividend growth investing, is a great method to use.

I personally use a dividend discount model analysis, which I’ll go over a bit later.

But an undervalued dividend growth stock can be very appealing for a variety of reasons.

A dividend growth stock that’s undervalued is likely going to come with a higher yield, stronger long-term total return prospects, and less risk.

The higher yield is obviously wonderful because it means more cash flow in your pocket both today and for the long haul.

Since yield and price are inversely correlated, a stock’s yield will always (save a dividend cut) be higher when its price is lower.

And this higher yield functions to also boost your long-term total return prospects since yield is one of two components to total return.

The other component, capital gain, is also given a big potential boost right from the start by virtue of the upside that exists between the (lower) price you paid and the (higher) value of the stock.

And this all combines to work in your favor regarding risk.

Risk is reduced by the margin of safety that’s present when you pay much less than a stock is worth.

So if you pay $20 for a stock worth $40, you then essentially have a $20 margin of safety there – the company would have to do many things very wrong in order for the value of the company to shrink below what you paid.

Moreover, a sizable margin of safety also allows for a margin of error. You can be off a bit on the fair value estimate and still come out ahead.

Well, one high-quality dividend growth stock seems to be hitting all of these marks.

It appears to be well undervalued, offering a larger yield than it usually does. That yield should boost the long-term total return prospects. And there seems to be a sizable margin of safety present…

United Technologies Corporation (UTX) is a diversified conglomerate that manufactures and markets a variety of products across the building systems and aerospace industries.

While perhaps not a household name in and of itself, United Technologies manufactures premier and well-known products like Otis elevators and escalators, Carrier air conditioners, and Pratt & Whitney aircraft engines.

What’s great about these businesses is that they’re individually perfectly placed to capture long-term growth from global megatrends – increasing urban density and air travel.

That long-term growth shows up not only in the company’s underlying results but also in its dividend: United Technologies has increased its dividend for the past 23 consecutive years.

Financial crisis? Great Recession? Economic cycles? All have been no problems for the company’s dividend for more than two straight decades.

And I suspect that kind of reliability to continue for many more years to come; the company expects adjusted earnings per share to come in between $6.30 and $6.60 this fiscal year (FY 2016), meaning their $0.66 quarterly dividend per share is far from onerous.

That dividend represents only about 40% of the midpoint of the company’s expected adjusted earnings this year, on a per-share basis.

In fact, it’s highly likely that the strong dividend growth that’s already been demonstrated by the company continues – the 10-year dividend growth rate is 11.3%.

CaptureThat’s obviously well in excess of inflation, and you’re getting that growth on top of a fairly appealing yield of 2.57%.

That yield, by the way, compares favorably to the five-year average yield of 2.3% for the stock.

The stock allows a prospective investor to “lock in” a yield that’s more than 20 basis points higher than what it’s usually been, on average, over the last five years.

Of course, that five-year average obviously then includes periods where the yield has been below that 2.3% – so you’re looking at a point, right now, in which things have swung in the opposite, more favorable, direction.

Solid yield? Check.

Great track record of dividend growth? Check.

Dividend sustainability that allows for more dividend increases? Check.

The dividend looks great here, but let’s take a look at the underlying top-line and bottom-line growth of the company to see what we’re really working with.

After all, a company’s ability to grow its dividend over the long run is largely determined by its ability to grow its profit.

Moreover, it’s vital to know what kind of growth has already occurred in order to formulate an estimate of what kind of growth to expect in the future, which then helps determine what the stock might be worth.

The company’s revenue has increased from $47.829 billion to $56.098 billion from fiscal year 2006 to FY 2015. That’s a compound annual growth rate of 1.79%.

Not really what we want to see; however, revenue took a big dip in FY 2015.

This drop off can be explained to some degree by a major transaction that occurred last fiscal year.

United Technologies sold off its Sikorsky helicopter unit, which accounted for about 11% of its revenue in FY 2014. So this is a pretty hefty loss on the top line. However, Sikorsky only accounted for about 2% of FY 2014 operating profit. The margins here just weren’t that great.

Sikorsky was sold for $9 billion to Lockheed Martin Corporation (LMT).

United Technologies has indicated that much of that will be directed toward buybacks, reducing the outstanding share count. This will help offset the revenue loss.

And we already see some of the benefits of this showing up on the bottom line: EPS grew from $3.71 to $6.30 (adjusted) over this stretch, which is a CAGR of 6.30%. A lower outstanding share count and improving profitability explains much of this excess bottom-line growth.

That’s still a bit lower than the dividend growth rate over the last decade, so I would expect dividend growth to moderate unless EPS growth improves. Indeed, the most recent dividend increase was just a bit over 3%.

Looking forward, S&P Capital IQ anticipates that United Technologies will compound its EPS at an annual rate of 11% over the next three years, reflecting a stronger US residential construction market and accelerating global air traffic growth. These tailwinds are likely to be somewhat offset by foreign currency concerns and uncertainty in Europe.

If realized, this would result in a marked improvement in EPS growth. As such, dividend growth could also surprise to the upside.

The company’s balance sheet is strong, but there is room for a little improvement here. The long-term debt/equity ratio of 0.71 and the interest coverage ratio sits at 7.84.

Profitability, as mentioned just above, has improved over the last few years. And I believe that will continue to be the case now that Sikorsky is no longer part of the company.

Over the last five years, the firm has averaged net margin of 8.68% and return on equity of 19.63%.

This is, in my view, a really strong business across the board. And I think it’s only going to improve with long-term tailwinds and stronger margins working in their favor.

What’s interesting, though, is that while the company has improved and is now paying out a larger dividend relative to where things were at this time last year, the stock is down almost 10%.

That’s led to a P/E ratio of 16.28, which is well below the broader market. Plus, you’re getting a yield here that’s much higher than the broader market, not to mention fairly attractive in this environment of low rates. The business is improving and the stock is priced lower.

What’s the stock worth? What’s a good estimate of its intrinsic value?

I valued shares using a dividend discount model analysis. I used a discount rate of 10%. And I assumed a long-term dividend growth rate of 7.5%. This is well below the 10-year dividend growth rate. And it’s also low when looking at the forecast for EPS growth over the next three years. But I’m factoring in margin of safety, including the disappointing dividend raise this year. The DDM analysis gives me a fair value of $113.52.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide. The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today. I find it to be a fairly accurate way to value dividend growth stocks.

This stock looks to be undervalued to me. It’s not often in this market that you’ll find a high-quality dividend growth stock selling for a price well below what it’s likely worth. And I’m not the only one who thinks this stock is cheap here…

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system. 1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates UTX as a 4-star stock, with a fair value estimate of $120.00.

S&P Capital IQ is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line. They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

S&P Capital IQ rates UTX as a 4-star “buy”, with a fair value calculation of $106.80.

I came out right about in the middle. Averaging out the three valuation estimates gives us a final valuation figure of $113.44, just pennies away from what I figured. That indicates this stock is potentially 11% undervalued right now.

scBottom line: United Technologies Corporation (UTX) is a high-quality dividend growth stock with a number of huge tailwinds working in its favor. More than two consecutive decades of dividend increases and an appealing yield are there to boost the investment case for this wonderful business. On top of all of that, the stock looks to offer 11% upside from here. This is a great long-term investment candidate, in my opinion.

– Jason Fieber

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