Dividend Report Card: United Technologies

All dividends are not created equal.

We learned this lesson the hard way in recent years. In the first quarter of 2009 alone, a record 367 firms cut their dividend payouts only to be followed by another 233 in the next quarter. Because dividends are at the board of directors' discretion, when times get tough, a firm's dividend payout can meet the corporate chopping block.

Avoiding the executioner
Certainly things have gotten better since those dark days, but with many concerns remaining about the global economy, investors would be wise to ask the following three questions of their companies' dividends:

1. Over time, has this company steadily increased its payouts?
2. How sustainable is the dividend?
3. Does the company have room to further increase the dividend?

To help you out, I've created a proprietary dividend report card, which seeks to answer these questions by analyzing a company's financial statements. It's not intended to be a Magic 8-Ball, but it will hopefully get you pointed in the right direction.

Today's pupil is industrial conglomerate United Technologies (NYSE: UTX), which posts a 2.5% yield.

Dividend history
Income-minded investors prefer a good track record of rising dividend payouts. Not only is it a sign that management is dedicated to returning shareholder value, but also that the board of directors expects future profitability.

Let's see how well United Technologies has increased its dividend over the past five years, relative to its earnings growth:

Source: Capital IQ, as of July 23, 2010.

United Technologies has clearly rewarded shareholders by growing its dividend at a rate above earnings growth. It also has a strong track record of paying dividends, having paid them for 74 consecutive years.

Past returns don't guarantee future results, however, so dividend history is only 10% of the final grade. That said, for this category, United Technologies scores a 5 out of 5.

Sustainability
Finding companies with solid financial footing, backed by a strong balance sheet, sufficient profitability, and plenty of free cash flow is at the root of successful dividend investing. There's no point buying a stock yielding 5% if you don't believe the dividend is sustainable. For this reason, sustainability gets a 50% weighting in my formula.

To analyze dividend sustainability, I look at three factors:

1. Interest coverage ratio (EBIT / interest expense)
2. Earnings dividend payout ratio (dividend per share / earnings per share)
3. Free cash flow dividend payout ratio (dividends paid / free cash flow to equity)

It's worth noting that in my definition of free cash flow to equity, I also back out any acquisitions the company has made over the past 12 months. Hey, that's cash that could have been paid out as a dividend! Plus, serial acquirers may cut a dividend to help fund a new acquisition, so we want to be sure there's still plenty of cash to go around after all investments have been made.

For United Technologies, the results are:

Source: Capital IQ, as of July 23, 2010.

These are all encouraging signs that the current dividend level is sustainable -- United Technologies generates more than enough operating profit to cover its interest payments to creditors and the dividend itself is well-covered by profits and free cash flow.

Growth
Once you know that a dividend is sustainable, you'll want to see how much room the company has to raise its payout. It may not be quite as important as dividend sustainability, but it's still an essential factor for income-minded investors who want their payouts to increase at rates well above inflation.

For this reason, growth makes up the last 40% of the final grade.

In this section, I once again use the earnings and free cash flow payout ratios. Only this time I'm not just looking to see if there's more than enough profits and cash to sustain the dividend -- I want to see how much the payout can grow, so the lower the payout ratios, the better.

I also consider a firm's implied sustainable growth rate, defined as return on equity times its retention ratio (the percentage of profits it keeps to reinvest in the business). This is the highest achievable growth rate the company can have without changing its capital structure.

Here's how United Technologies scored on these metrics:

United Technologies appears to be in a strong financial position to continue to increase its dividend payouts over the next several years. Because I subtract cash acquisitions from free cash flow, the free cash flow payout ratio is higher than it would have been without the $1.8 billion purchase of General Electric's (NYSE: GE) fire detection and electronic security business. As a result, United Technologies scores a "3" for that category, when it most likely would have scored a "4" without that acquisition.

Bonus factor
An "ungraded" section of the dividend report card is to see how a stock's current yield stacks up against direct competitors'. If it's too high relative to competitors' yields, the board could be tempted to slow the growth rate, or vice versa, to bring it more in line with the industry average.

Solid dividend yields are a common sight among industrial conglomerates like these and United Technologies' 2.5% yield isn't too high or too low relative to its peer group. General Electric recently increased its payout 20% and spoke of improvement in its industrial businesses, which is a good sign for all of these companies.

Pencils down!
With all the numbers in, here's how United Technologies' dividend scored:

A "B+" is a great grade for a company that saw sales in most of its business segments fall in 2009 as a result of the recession. Fortunately, business conditions have stabilized a bit here in 2010, and United Technologies' dividend appears poised for continued stability and growth.