United Technologies Corporation Stock Drops Despite Earnings Beat, Raised Guidance

Stocks were mostly in the "green" Tuesday, with both the Dow and the Nasdaq ending up a bit less than a percentage point. One big defense contractor that sat out the rally, however, was United Technologies Corporation (NYSE: UTX  ) . With the shares down 2% on the day, you have to figure that United Technologies stock missed earnings expectations pretty badly, right?

Well actually, no. Wrong. In fact, UTC "beat earnings" with a stick.

Here's how the quarter went down:

  • Earnings per share at UTC increased 8% year-over-year, rising to $1.84 and beating expectations for $1.71 EPS. Earnings would have been even better, and showed 12% growth, but for one-time charges such as the cost incurred for delays in UTC's Canadian Maritime Helicopter Program.
  • Sales were up 3% to $17.2 billion, again topping expectations for $16.8 billion.
  • Free cash flow for the quarter was a respectable $1.3 billion.

Putting icing on the cake of a fine financial performance in Q2, UTC then proceeded to increase guidance for the rest of the year. Previously on record promising per-share earnings of between $6.65 and $6.85 for fiscal 2014 (so $6.75 at the midpoint), UTC has now raised the floor on that projection. UTC now expects to make a minimum of $6.75, and says $6.85 is still not out of the question.

All of which begs the question: If everything went so right, then why did United Technologies go down?

Well, the answer is that not quite "everything" did go right. Take cash production for example. Calculated according to generally accepted accounting principles, UTC earned $1.7 billion last quarter. But the company's cash flow statement confirms that real free cash flow generated during the quarter was only $1.3 billion. That's a pretty significant difference for this historically strong free cash flow generator.

That $1.3 billion is also about 16% less cash then UTC produced in Q2 of last year. So while "earnings" may be increasing at the company, actually cash production declined pretty significantly.

Unfortunately, this too is a trend that UTC expects to see continue through the balance of the year. "Earnings" may come in better than previously expected, but UTC says it anticipates needing to increase capital spending "to support the aerospace upcycle." As a result, management says that free cash flow could be as low as 90% of reported net income by year-end. (Last year, free cash flow also came in below reported income, at about 91%).

Valuation
So where does all this leave owners of United Technologies stock? Viewed in the most positive light, new guidance on earnings suggests that at $110 and change, UTC shares now sell for a little more than 16 times this year's expected earnings per share. That seems a bit pricey for a stock expected to grow earnings at slower than 12% annually over the next five years (let alone the 8% growth rate that UTC posted in Q2).

Meanwhile, valued on free cash flow, UTC's P/FCF ratio could rise as high as 18, and if debt is factored into the picture, the stock's enterprise value-to-free cash flow ratio could end up as much as 20% more expensive than that.

Seeing as none of these scenarios suggest the stock is trading at a particularly attractive valuation, I think investors were right to sell United Technologies stock today.

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