Forget General Electric, United Technologies is a Better Buy

There are two key assumptions that you need to make before buying the stock of General Electric (NYSE: GE). First, investors in GE will be hoping for a favorable commercial aviation market. Second, the strongest bull case for GE relies on the efficacy of a so-called sum of the parts (SOTP) analysis.

But here's the thing: Both of these arguments also apply to United Technologies (NYSE: UTX) as well -- and with United Technologies, you probably don't have as much downside risk. Let's look at both stocks and see why UTX is arguably better on a risk/reward basis.

Why aviation matters

Trends in commercial aviation are crucial for General Electric. Of the company's businesses likely to remain in GE, the aviation segment generated $6.5 billion in profit in 2018 compared to just $287 million from renewable energy and a loss of $808 million from power. There's a case to be made for buying GE stock, but it doesn't hold up well if anything bad happens to the commercial aviation market in the next few years.

Simply put, the earnings and cash flow from GE Aviation are crucial in order to buy time to turn around the troubled GE Power segment.

United Technologies' two aviation segments (Pratt & Whitney and Collins Aerospace Systems) generated a combined 46% of operating profit in the fourth quarter of 2018. And Pratt & Whitney will surely grow profits strongly in the future as its geared turbofan (GTF) engine starts to be serviced. For reference, the GTF competes with CFM (a joint venture between GE and Safran Aircraft Engines) on the Airbus A320neo family of aircraft and is the sole option on the Airbus A220.

In short, don't buy either stock if you a worried about the aviation market, although it should be noted that United Technologies has more diversity of income and therefore is less exposed to a downturn in aviation.

What is a sum-of-the-parts valuation?

In a nutshell, a SOTP analysis compares the valuation of each constituent part of a conglomerate to its peers. For example, United Technologies is splitting into three companies (a combined aerospace business, climate control business Carrier, and elevator company Otis). And if you look at the valuations of each business compared with a peer, it's clear that United Technologies trades at a discount to the competitors of Carrier (Ingersoll-Rand), Otis (KONE) and an aerospace company like TransDigm.

In this case, we'll use an enterprise value to EBITDA ratio to calculate a SOTP valuation.

Turning to GE, you could also use TransDigm's valuation to get an estimate for the EV of GE Aviation. Such an approach could yield an EV for GE Aviation of around $128 billion. After which you would need to add up EV approximations for the remaining GE businesses and its stakes in Baker Hughes, a GE Company and Wabtec, and then don't forget to strip out net debt of the total GE -- a highly significant figure of around $110 billion.

General Electric vs. United Technologies

Of course, calculating a SOTP valuation is an inexact science -- not least because it usually relies on peer-group comparisons and assumptions over underlying earnings. That said, it's not unusual to see analysts viewing UTX stock as currently trading at 20% to 30% below its SOTP valuation. For example, a Morgan Stanley analyst sees United Technologies as trading at around a 25% discount to its SOTP.

Turning to GE, the author's estimate for SOTP is around $12.60 -- a figure not far from what analysts are estimating. Indeed, it's worth noting that GE's recently appointed vice president for investor relations, Steve Winoker, was until recently an investment analyst at UBS with a $13 target on the stock.

All told, both stocks look like they have upside potential of around 25%.

Why United Technologies is a better buy

The difference between the two stocks is threefold. First, United Technologies is actually going to split up, and this could lead to an improvement in performance in each of the individual companies -- the key rationale for the breakup, and one the principal reasons why so many other industrial conglomerates are breaking up.

Second, as discussed above, United Technologies has more diversity of income, while if you buy GE right now you are buying a business that is really only firing on one cylinder.

Third, unlike GE, United doesn't have a problematic capital arm or a troubled and currently loss-making business like GE Power.

Of course, there's nothing wrong in buying both stocks, but in a direct comparison, UTX wins out. Simply put, if the upside potential is similar for both stocks, but the downside risk is greater with GE, than on a risk/reward basis, it makes sense to favor United Technologies over GE.

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Lee Samaha owns shares of Ingersoll-Rand. The Motley Fool owns shares of and recommends TransDigm Group and Westinghouse Air Brake Technologies. The Motley Fool owns shares of General Electric. The Motley Fool has a disclosure policy.