Curtiss Wright: Slowing Growth Leads Market To Rethink Valuation

Curtiss Wright (NYSE:CW) shares were down sharply Friday after the company issued sales and earnings guidance that investors found disappointing. Let’s parse the press release:

Sales growth in the fourth quarter and full year was driven by organic growth across most of our base businesses and contributions from our 2006 acquisitions. Organic sales growth was 16% and 11% in the fourth quarter and full year ended December 31, 2006, respectively, compared to the prior year periods. Organic sales growth in the fourth quarter 2006 was due to the strength of all three of our operating segments, with Flow Control at 24%, Motion Control at 11%, and Metal Treatment at 8%, as compared to the prior year period. Our 2006 acquisitions contributed $9.9 million and $27.6 million in incremental sales for the fourth quarter and full year 2006, respectively, over the comparable periods in 2005.

Organic sales growth of 11% for the year doesn’t sound too shabby at all. And given the rising prices for industrial valves, which show no signs of letting up, it could continue.

industrial valve

Operating income in 2006 increased 2% for both the fourth quarter and full year over the comparable 2005 periods. In the fourth quarter of 2006, we established a reserve in the amount of $6.5 million to reflect potential liabilities arising from a jury verdict returned this afternoon against us in a lawsuit filed by a former employee. We will be appealing the verdict.

The jury verdict strikes us as an example of a legitimate one-time expense. While it does affect the company’s value (by $6.5 million, in fact) it is not something that we would expect to happen frequently. The company’s normalized operating margin is closer to 11.5% than to the 11.0% reported for 2006.

Operating margins were negatively impacted in 2006 by the above mentioned legal judgment, $4.9 million of costs associated with the adoption of FAS 123R, and higher pension expense of $4.2 million from the Curtiss-Wright pension plans.

While we think it is appropriate to exclude the jury verdict, we consider the pension and option (FAS 123R) expenses to be normal operating expenses. It is worth noting that the comparison to 2005 margins is unfavorable due to the adoption of FAS 123R, but since all future years will include the expense estimates ought to include them as well.

Net cash provided by operating activities for the full year 2006 was $143.9 million, an increase of 37% from $105.2 million in 2005. Our 2006 Free Cash Flow, defined as cash flow from operations less capital expenditures, was very strong at $103.7 million, a 65% increase from $62.7 million in 2005. All three operating segments experienced strong results. Overall cash conversion, defined as Free Cash Flow divided by net earnings, reached 129% in 2006 as compared to 83% in 2005. The strong cash flow resulted from higher cash collections, reduced inventories due to higher fourth quarter sales, as well as higher payables and advance payments.

Given that the business received some benefit from acquisitions, we believe the acquisition prices paid should be deducted from free cash flow. However, it still paints an impressive picture and there are signs it can continue. New orders received in 2006 were $1,333.0 million, up 6% compared to 2005. Backlog increased 9% to $875.5 million at December 31, 2006 from $805.6 million at December 31, 2005.

For the full year 2007, management expects to achieve total revenues to be in the range of $1.37 billion and $1.40 billion. We anticipate operating income in the range of $166 million to $173 million, including $6 million of Curtiss-Wright pension plan expense, and fully diluted earnings per share (NYSEARCA:EPS) to be in the range of $2.00 and $2.10. Our EPS guidance assumes an average of 45.5 million shares outstanding. In addition, we are expecting free cash flow, defined as cash flow from operations less capital expenditures, to be between $70 million and $75 million in 2007. The 2007 guidance does not include any potential impact resulting from the recently announced selection of the AP-1000 design to be used in power plants by China.

It is the indication that growth is slowing from 11% in 2006 to management’s guidance of 7-9% growth in 2007 that appears to be hurting the stock. In effect the market is saying that type of growth only deserves a P/E multiple of 17.5x rather than the 19.0x the stock appeared to merit before trading opened Friday.

CW 1-yr chart:

CW 1-yr chart