United Technologies Bit Off More Debt Than It Can Chew

by Will Ashworth | September 30, 2011 7:30 am

United Technologies (NYSE:UTX[1]) announced Sept. 21[2] that it’s buying Goodrich (NYSE:GR[3]) for $127.50 per share. The total value of the deal is $18.4 billion, including the assumption of $1.9 billion in debt. Paying a 47% premium to Goodrich’s Sept. 15 closing price, many analysts believe the acquisition is a great deal for both companies. Time will tell if they’re right.

I’m skeptical about large acquisitions because they usually never deliver the anticipated synergies. Shareholders likely won’t be able to judge whether the deal is a success until long after CEO Louis Chenevert has departed with a huge retirement package stuffed in his back pocket as thanks for a job well done. United Technologies shareholders beware — it’s easy to throw around money when it’s not your own. Sell now before things get ugly.

Debt to Capital

United Technologies is paying for Goodrich by issuing approximately 57.1 million new shares of its stock worth $4.1 billion as of the Sept. 28 closing price of $71.85 and $12.4 billion in debt. The deal temporarily dilutes earnings per share by 5% and raises total debt from $11.4 billion to $25.7 billion. Its debt-to-capital ratio moves from 32% prior to the deal to 92% after. At no time in the past 10 years has this risen above 42%.

For UTX to digest Goodrich, it’s suspending its share repurchase program, and making no buybacks in 2012 and half as much in both 2013 and 2014. Since most companies are notoriously poor buyers of their own stock, this is a positive when it comes to cranking up the leverage.

Free Cash Flow

CFO Greg Hayes suggests it will repay the additional debt in five years based on annual cash flow of more than $5 billion. Perhaps, but let’s have a closer look. United Technologies and Goodrich had combined free cash flow in 2010 of $5.3 billion. Together they paid $1.5 billion in dividends. United Technologies increased its dividend in each of the past 10 years and will do it again in 2011, paying $1.87 per share.

In 2012, I’m guessing UTX will pay out $2.06 in total dividends for a total outlay of $2 billion. In the past five years, it has  grown free cash flow by an average of 8% a year. Therefore, based on 2012 free cash flow of $5.7 billion, UTX will have $3.7 billion available for debt repayment. In 2013 and 2014, assuming United Technologies sticks to its plan on repurchases, it should have $1 billion less per year available for debt repayment and $2 billion less thereafter.

If United Technologies does everything it historically has done, it will have $15.2 billion available to repay $14.3 billion in debt. That leaves $900 million for acquisitions and capital expenditure increases, which isn’t much. Given the dividend seems sacrosanct, either the share repurchases will be scaled back or UTX won’t meet its five-year goal to repay the debt. Either way, the above scenario assumes everything goes its way the next five years — and we all know that almost never happens.

Goodrich Shareholders

You’re about to receive a handsome payday and probably are wondering what to do with the proceeds. Many of you will be tempted to roll the funds into shares of United Technologies. Don’t. They’re going to have their hands full integrating Goodrich, and large acquisitions almost never work out as planned. Instead, I suggest you consider 3M (NYSE:MMM[4]), a large-cap with a great group of businesses.

3M’s stock’s had a tough go of it lately, down 12.8% year to date — its second-worst performance in the past decade. It hit an all-time high of $98.19 in July and since then has lost 25% of its value. Investors seem to be focusing on its lackluster forecast for 2011 earnings and the 7% decline in sales in the second quarter[5] from its display and graphics segment, which makes LCD film for televisions, smartphones and tablets.

3M’s forecast of $6.10 to $6.25 per share includes an increase in pension and postretirement benefit expenses of 22 cents per share. Back this one-time expense out and you get year-on-year growth of 12% to 15%. As for the LCD films, it’s an ongoing inventory problem that 3M continues to work through. With operating margins of 22.8% in the division, it’s just a blip. Investors are overreacting. With a dividend yield of 2.9% as of Sept. 28, it’s higher than United Technologies both in terms of percentage and dollar value. Furthermore, its forward P/E of 12 is historically low, as are all the other usual financial metrics.

Bottom Line

3M might not be the steal of the century, but it’s a much better deal than United Technologies, especially after the Goodrich deal goes through.

As of this writing, Will Ashworth did not own any of the aforementioned stocks.

Endnotes:
  1. UTX: http://studio-5.financialcontent.com/investplace/quote?Symbol=UTX
  2. announced Sept. 21: http://www.bloomberg.com/news/2011-09-22/united-technologies-to-buy-goodrich-for-16-5-billion-plans-to-sell-stock.html
  3. GR: http://studio-5.financialcontent.com/investplace/quote?Symbol=GR
  4. MMM: http://studio-5.financialcontent.com/investplace/quote?Symbol=MMM
  5. 7% decline in sales in the second quarter: http://www.startribune.com/business/126168003.html

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