United Technologies (NYSE:UTX) stock is on a tear, up 2% in early Monday trading on the back on a big upgrade (to buy) from analysts at Credit Suisse.
As explained in a write-up on StreetInsider.com this morning, Credit Suisse is upgrading United Tech, and raising its price target to $125 a share, on the theory that: "the stock has lagged this year and in 2015," but "consensus expectations are now low and for the first time in several years, we see little downside to Street EPS estimates." According to the analyst, "several years of heavy investment spend" have depressed United Tech's earnings, but profits are due to recover in 2018 and following years, which will give rise to a "multiple expansion" -- and as much as a 13% profit for shareholders.
Is Credit Suisse right about all this, though? Here are three things you need to know.
1. "the stock has lagged"
Let's put Credit Suisse's assertions to the test one at a time, beginning with the curious impression that United Technologies stock has "lagged this year and in 2015."
That United Technologies had a bad year in 2015 is without question. Over the course of 12 months, United Tech stock lost $21 in share price, or 18% of its market capitalization, falling from $117 a share to close 2015 at about $96 -- but the same cannot be said about 2016. Fact is, United Technologies stock has exceeded the performance of the broader S&P 500 over the past 12 months, returning about 16% to shareholders, against only a 12% rise in the S&P. Add in United Tech's 2.4% dividend yield, and the stock has actually beaten the S&P 500 quite soundly.
That said, if you examine the big picture, at today's share price of just under $111 a share, Credit Suisse is right: From the beginning of 2015 through the end of 2016, United Technologies stock has basically tread water, with the only profits it's delivered to shareholders coming from its dividend.
2. "several years of heavy investment spend"
What is it that's been holding United Technologies stock down? Despite Credit Suisse's concerns about investment spending hurting profits over the past two years, United Tech has actually done pretty well on that front. After earning $6.2 billion in net profit in 2014, United Tech grew its profits to $7.6 billion in 2015. Final numbers for 2016 aren't yet in, but trailing-12-month results show the company still earning about $7.3 billion annually -- not better than 2015, granted, but not much worse.
Focusing on "investment," United Tech's capital spending in 2015, and over the past 12 months of 2016 and late 2015, was about $1.6 billion each. That's a skosh higher than what we saw in 2013 and 2014, granted. But not appreciably so.
Put it all together, and I'm not convinced that increased investment spending has been hurting United Tech's results much at all. To me, it looks pretty "steady as she goes" at United Tech. On the other hand, if Credit Suisse is comparing these past few years' capital spending to, say, the $929 million that the company spent on capex in 2011...well, in that case Credit Suisse may have a point.
3. "consensus expectations are now low"
According to analysts polled by S&P Global Market Intelligence, United Technologies is only expected to grow its earnings at about 8.5% annually over the next five years. Compared to rivals such as General Electric (NYSE:GE) and Honeywell (NYSE:HON), which are expected to grow 13% and 10% over the same period, respectively, expectations for United Tech's growth rate are kind of low.
Should the company return to the capex spending levels of 2011 and previous, this would free up something on the order of $700 million in additional cash that could flow to the bottom line, boosting profits and accelerating the earnings growth rate -- just as Credit Suisse predicts.
Bonus thing: Valuing United Technologies
If that happens, what would it mean to United Technologies' valuation as a stock?
Well, currently, United Tech sells for about 12.7 times earnings. On an 8.5% growth rate, and with a 2.4% dividend yield, this prices the stock at about a 1.1 or 1.2 total return ratio -- a bit pricey perhaps, but not unreasonably so. On the other hand, if Credit Suisse is right, if United Tech can boost its growth rate toward something approaching the 13% growth we're expecting from General Electric, or even the 10% growth rate of Honeywell, then it becomes easier to argue that United Technologies is already fairly priced today -- or even cheap.
I would inject one note of caution into this debate, however: Currently, United Tech's $7.3 billion in trailing net profits are not backed up well by real free cash flow from the business. Free cash flow for the past 12 months is a measly $3 billion, or less than half reported profits. If management is able to scale back investment and divert some of its current capex spending toward the production of cash instead, this would help the free cash flow picture. But it would not fix it completely.
Before United Technologies becomes a clear buy, it must return to its historical habit of generating more cash profit on its cash flow statement, than it reports as net profit on its income statement. United Technologies stock isn't doing this yet, but if it does, I'd agree that it's a buy.
Fool contributor Rich Smith does not own shares of, nor is he short, any company named above. You can find him on Motley Fool CAPS, publicly pontificating under the handle TMFDitty, where he currently ranks No. 346 out of more than 75,000 rated members.
The Motley Fool owns shares of General Electric. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.