Nearly two years ago, with its Sikorsky sale still ahead of it, and a bright future selling everything from elevators to airplane engines, United Technologies (RTX 1.77%) stock won a big buy rating from the analysts at Citigroup. Two years later, United Technologies stock has increased its net profits, but sold off Sikorsky, watched its cashflow shrink by half, and lost 16% of its stock market value.
It's also lost the support of Citigroup.
This morning, StreetInsider.com reports that Citi has pulled its buy rating from United Technologies, and downgraded the stock to neutral. The analyst's new price target -- $109 -- is not only $30 lower than the target it assigned two years ago. It's actually $11 below where the stock was trading back when Citi first recommended it.
Here are three things you need to know about the downgrade.
1. Limited upside
Two years ago, with United Technologies shares selling for $120 and change, Citi saw a reasonable chance of the stock turning into a 15% gainer. As explained on TheFly.com this morning, however, Citi now thinks that chance has evaporated, and United Tech now has limited "upside over the next twelve-plus months."
The analyst's price target of $109 a share suggests the stock might gain 8% at best, which would be below average annual returns on the stock market over the last 60 years.
2. What's holding shares back?
Citi sees two main reasons United Technologies stock will be unable to outperform the market over the next year or so -- and they're intertwined. First, the banker says that other analysts have "too high" expectations for United Tech's earnings in the coming year. According to data from S&P Global Market Intelligence, the consensus estimate for this year's earnings is $6.27 per share, and for next year, $6.74 per share -- a modest 7% pace of growth, which is below the long-term consensus that the stock will grow earnings at 9%.
So right off the bat, you see that expectations are low -- and now Citi thinks they will go lower.
3. Things could be worse
Furthermore, Citi expects United Tech management to attempt to reset expectations at its annual investor day in March 2017. (In fact, Citi thinks management will reduce guidance for earnings and revenue through 2020 -- so the depressive effect of such a pronouncement could last for years.)
Indeed, management has already begun resetting expectations, warning last week that it will soon be taking a charge to earnings of $400 million to $530 million. United Technologies hopes to lighten its long-term pension obligation by offloading pension responsibilities to Prudential (PRU 4.13%) through the purchase of a group annuity contract. That may be good news for Prudential, which will get about $775 million worth of new business from United Tech (in the form of pension benefit obligations it's taking over, and 36,000 United Tech retiree and beneficiary accounts). But for United Tech, this transfer will come at a cost in the form of depressed near-term earnings.
The most important thing: Valuation
So what does all this mean for investors? I have to say that it's more than a little concerning.
Investor expectations for United Technologies' growth rate were none too strong before Citi upset the apple cart this morning. But at 9%, those expectations did seem barely sufficient to support United Tech's 11.7 price-to-earnings ratio -- at least once you factored the stock's 2.6% dividend yield into the mix. Now, however, Citi is saying 9% growth may be a pipe dream -- and United Technologies stock may be more expensive than it looks.
In fact, I think it is more expensive than it looks. Way more.
Consider: United Tech's 11.7 P/E ratio is derived from dividing the company's market capitalization ($84.2 billion) by its last reported trailing-12-month earnings ($7.2 billion). But this calculation doesn't consider the effect of United Tech's $15.7 billion debt load. Nor does it take into consideration the deteriorating quality of the profits United Tech is earning.
Over the past 12 months, United Technologies' free cash flow (FCF) of $1.9 billion backed up only 27% of the company's reported $7.2 billion profit. Valued on its free cash flow, and divided into its enterprise value, United Technologies actually sells for an EV/FCF ratio of 52.5.
Admittedly, this disconnect in valuations -- 52.5 times FCF versus 11.7 P/E -- can be traced back to an abnormally weak (for cash production) quarter in Q1. Hopefully, United Tech will get its cash machine back on track and resume producing free cash flow more in line with reported earnings soon. But the impending hit from the pension plan shift suggests this improvement won't be as soon as investors might hope. All indications right now suggest that United Technologies stock could look overvalued and unattractive for some time to come.
And Citi is right to downgrade it.