Latest Mixed Earnings Made Rockwell Collins A Cheap Stock

| About: Rockwell Collins, (COL)

Summary

Strong outlook will provide opportunities for the future growth of the company.

The top performer of the industry in terms of profitability.

Several growth investments to maintain future growth above the industry average.

Rockwell Collins (NYSE:COL) is a leading supplier of communication and aviation systems, and information services to a broad range of customers around the world. On 4/20/2016, the stock was trading at $94, but after mixed quarterly results, the stock went down by 5% in one day to then stabilize near $90. Is that drop justified, or a temporary drop in the 21% rise that started on 02/11/2013 after the market selloff which created a good opportunity to buy?

Rockwell Collins' fundamentals are in the top range of its industry. The company is showing strong and improving margins over the years, with strong expectations over the next ten years, especially regarding the growth rate. While competitors are expected to grow at a rate of 3% over the next few years, COL is expected to grow between 3% and 5%. The very large portfolio of the company offers a great diversification of customers and risks, and gives the company more potential for growth in the long run. The outlook for the overall industry is better growth rates than the forecast global GDP growth rate, which is going to improve the top-line growth of the company.

On 4/21/2016, the company reported mixed quarterly results. Revenue missed estimates by 1.38%, net income beat by 0.77%, and EPS beat by 1.90%. The stock went down by 5%, which seems to me like an overreaction from investors who were having doubts about the growth forecast of the company, even though the CEO stated he left the full-year outlook unchanged. Based on its excellent fundamentals, plus its large portfolio and R&D investments, the company is still better prepared than competitors for future growth and better margins.

Based on the stock chart analysis, the company is also offering a positive alpha compared to the aerospace & defense industry. The 5% drop will soon be erased as it offers an opportunity to buy the stock at a cheap price, and may be able to pass the $100 barrier over the next months.

COL vs Industry since 2014 (source: Bloomberg) Click to enlarge

Shareholder return performance since 2010

PRODUCT PORTFOLIO

COL's business is divided into three segments and serves a worldwide customer base, including the US Department of Defense, US Coast Guard, civil agencies, civil airports, defense contractors, foreign ministries of defense, manufacturers of commercial air transport, business and regional aircraft, commercial airlines, business jet operators, the FAA (Federal Aviation Administration), critical infrastructure operators, and major passenger and freight railroads.

The first segment of COL is Commercial Systems. It accounted for 46.4% of FY2015 total sales. This segment supplies aviation electronic systems, products and services. This segment has the highest operating margin of the three segments at 22.8% in 2015.

The second most important segment is Government Systems. It accounted for 41.7% of FY2015 total sales. It provides a large range of electronic products, systems, and services to the US government, federal agencies, foreign ministries of defense, and defense contractors. It supplies defense-related products such as communication systems, navigation products and systems, avionics sub-systems, precision targeting, electronic warfare and range and training systems, simulation systems, and maintenance and repair services. The operating margin of the segment was 20.9% in 2015.

The last segment is Information Management Services. It accounted for 11.9% of FY2015 sales. It provides communication services, systems integration and security solutions across the aviation, airport, rail, transit and nuclear security markets. This segment was created in December 2013, following the acquisition of ARINC Inc., which was a leader in communications and information processing solutions for the commercial aviation industry. The operating income of that segment is the lowest at 15.2%, but is in line with the industry ratio of 15.9%. The Monte Carlo simulation of the pro-forma shows that the price is more sensitive to the revenue than to the operating costs, and that the segment is showing very strong growth rates, with a YoY growth rate at 32%.

Government Systems sales stayed flat over the last three years due to the defense budget restriction. The defense industry is now expected to return to a 3% growth in 2016 following several global challenges like the rise in defense expenditures from non-ally states, and the recent resurgence of global threats. Even if the next American president is not willing to boost the defense budget, he or she will not be able to reduce it. Even if that particular segment will not have strong growth rates in the near future, it guarantees a certain level of sales over the next years and cannot be impacted by recession or financial crisis.

Revenue breakdown since 2011 (source: Bloomberg) Click to enlarge

INDUSTRY OUTLOOK

The core activity of COL is dependent on the defense industry and the commercial airplanes industry. As explained earlier, the defense outlook is looking strong as it will provide safe sales over the long run, the US defense budget is likely to increase, and it is not vulnerable in case of an economic downturn.

According to Boeing (NYSE:BA), the long-term demand (2013-2033) for new airplanes comprises 36,770 aircraft valued at $5.2 trillion. Around 42% of the new airplanes will replace older and less efficient airplanes. The 3% forecasted global GDP growth will be a key contributor to the growth of the aviation industry, which is expected to grow at 5%, and the cargo traffic industry, which is expected to grow at 4.7%. The growing middle-class worldwide will also support that growth. Fast-growing, low-cost carriers will be in need to replace aging airplanes. The demand will also be strong in emerging countries, especially China where the company has offices.

Market Growth Rate

Forecast Fleet Breakdown

The defense and aviation industry is driven by technological improvements, and key developments will continue to be essential for growth. Security and communication are also extremely important and highly regulated. The company is one of the leaders in developing sophisticated electronic systems for aircraft and airports to improve communication, data management and safety. FY2015 Research & Development accounted for $850 million or 16.2% of total sales. 32% of R&D is company-funded, and total R&D went up by 10% YoY. Such expenses are keeping the company ahead of the competition in terms of technological improvements.

In the past one year, lots of small and large companies have announced they are working on new designs for commercial supersonic and military supersonic/hypersonic aircrafts, which will require brand new high-end electronic systems. This new market will create an opportunity for the company by securing key contracts with manufacturers.

FUNDAMENTALS AND COMPETITORS

In 2015, the company reached a record sales at $5.244 billion, which represents a 5% YoY growth. Commercial Systems sales grew by 6%, Information Management Services went up by 32%, and Government Systems went down by 1%, primarily due to a negative currency impact related to the strong USD. The operating costs-to-revenue ratio was 77.2%, which is in line with its historic ratio of 77.3%, and well above peers' at 84.9%. The operating costs-to-revenue ratio is expected to decline to 74% in 2019. The revenue is expected to reach $6.331 billion in 2020, which corresponds to a CAGR of 4% over five years. The EBITDA margin, currently at 24%, is expected to gradually improve to reach 25% in 2019. The profit margin is expected to gain 1% to 14% in 2019. Free cash flow is also expected to increase by 66.5% over the next five years.

Revenue and EBITDA margin since 2013 (Source: Bloomberg) Click to enlarge

When compared to the overall industry and to competitors, we can see COL is outperforming every competitor. The EBITDA margin is 8% higher than the industry average, and the profit margin is 5.4% higher at 12.5%. Sales per employee at $269k is above the industry average and among the best in the industry. The EV/EBITDA is lower than peers' at 10.06. The free cash flow margin is 2.5% higher than the industry. Capital expenditures are expected to stay around the 2015 level at $200 million.

OCF, CapEx, and FCF since 2013 (Source: Bloomberg) Click to enlarge

Competitors Analysis (Source: Bloomberg) Click to enlarge

GROWTH INVESTMENTS

The company has developed several new products and had been awarded several contracts that are going to bring important revenue streams in the future.

Boeing selected Rockwell Collins to provide avionics for the 777X, which makes the company the supplier of flight decks for Boeing's entire fleet of next-generation airplanes. The Pro Line Fusion integrated flight deck is a segment leader gaining lots of interest from defense contractors and airplane manufacturers like Airbus (OTCPK:EADSF), Textron (NYSE:TXT), Sikorsky, Embraer (NYSE:ERJ) and Dassault (OTCPK:DASTY).

The key partnership with Boeing is becoming more and more important. The development of the 787 Dreamliner made COL to develop the most advanced systems ever deployed. The company is a key supplier for the development of the 737MAX and the 777X that will enter service in 2017 and 2020, respectively. COL is anticipating significant revenue in the next decade from its partnership with Boeing.

In 2015, the company secured three important long-term contracts to provide advanced airborne software-defined radios to Naval Air Systems Command, avionics and mission equipment to Sikorsky, and oceanic data link services to the FAA.

The company introduced in 2015, TruNet, a brand new communication system for military customers ensuring secure connectivity between ground and airborne elements. This system gives armed forces complete control of communications across the battlefields. It also introduced FireStorm, which is an integrated targeting system with digital connectivity to the battle space.

The R&D expenses were close to $1 billion in FY2015 and are expected to be close to $1 billion in FY2016. The company employs around 6,100 engineers. Such investments are essential for the firm to stand out within the industry, to continue to develop the best products, systems and services for the defense and aviation industry, especially when precision, communication, and safety are more important than ever.

CONCLUSION

Rockwell Collins is a well-established company serving worldwide customers with reliable products and services. The company is not entirely dependent on defense contracts or on the American government to grow, and its very large and complete portfolio is opening lots of doors for further improvements in top- and bottom-line growth. Its focus on R&D is a competitive advantage compared to competitors, as the company is in good position to always develop the most advanced products. Based on fundamentals, the company succeeded to have much better margins, and better growth than competitors. It secured many contracts and key partnerships that will bring important revenues over the next years. Expectations in revenue growth, EBITDA, and free cash flow are better than competitors, and can even be better due to the industry outlook, and the R&D investments. Currently, the stock is not performing as well as its peers or as the market. The last mixed earnings call made investors to doubt the strong expectations of the company, and the stock dropped by 5%. Due to the market position of the company, and as its full-year outlook remained unchanged, I think investors overreacted, which created this temporary but good opportunity to buy the stock near $90. I am expecting to see the stock catch up with the industry and to pass the $100 barrier over the next three to nine months.

COL Pro-forma Click to enlarge

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.