Great Brands and a Ton of Cash

05/18/2009 1:00 pm EST

Focus: STOCKS

James Stack

President, Stack Financial Management

James Stack, president of InvesTech Research and Stack Financial Management, has become more and more bullish, and he recommends a diversified industrial power.

For most people, United Technologies (NYSE: UTX) is a behind-the-scenes powerhouse, providing many of the everyday industrial components we rarely think about.

Whether it’s Otis elevators, Carrier heating and cooling products, or any of the aerospace products of Pratt & Whitney or Sikorsky, you probably seldom realize how often you rely on UTX products.

Typically, a company that sells nearly $60 billion worth of products per year would be a household name. [Instead,] the company’s diverse line-up of underlying products and brands are the household names. In addition, UTX derives roughly 40% of its revenue from after-market services. After-the-sale servicing provides a great balancing component, supplying a consistent source of revenue and helping offset economic downturns.

Not only have revenues grown at an annualized pace of 9.5% over the past ten years, but average sales per employee have skyrocketed. In 2000, sales per employee were $165,000. By 2007, [it was] $240,000 per employee—a 45% increase in seven years, [indicating] cost controls and operating efficiencies.

This has transitioned into annualized ten-year earnings per share (EPS) growth of 14.5%. [And its] efficiency program, the driver of recent improvements, is still less than 50% complete, providing further opportunity for cost savings and potential margin expansion.

Another key component of the UTX story is the company’s financial strength and discipline. Management is very cognizant that, as recent events have highlighted, credit markets can be fickle. Without healthy liquidity (specifically cash reserves), a sound financial position and contingent funding lines, even profitable companies can be forced into inopportune financial decisions during economic crises.

During the past 18 months, UTX has continued to issue debt when needed [and] access the commercial paper markets when opportune, all the while maintaining a high investment grade credit rating from both Moody’s and Standard & Poor’s.

For UTX, cash flow is king. Over the past three years, UTX has had an average free cash flow (FCF = net cash from Operations, less capital expenditures) of $4.3 billion per year. [So], at a current share price of $51.17, FCF could repurchase 9% of outstanding UTX shares annually. No growth needed—just by reducing shares outstanding one would theoretically realize a 9% return on investment.

Currently, UTX doesn’t use all of its FCF to repurchase shares. Instead, the company pays investors a healthy dividend yield of 3%, equivalent to $1.54 per share. They use the remaining FCF to repurchase shares in the open market, pursue attractive acquisitions, or generate internal “organic” growth—whichever avenue appears to provide the highest return on investment.

Based on price to cash flow, valuation is near the lowest point in more than a decade. Other valuation metrics, including price to earnings, price to sales, and dividend yield, all show similar attractive levels.

Although the current economic environment is one of continued uncertainty, an enviable line-up of dominant brands, outstanding profitability, financial strength, and attractive valuation make UTX a compelling [stock].

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