With the Department of Defense heading on course for a $487B budget cut over the next decade, many investors are hesitant about investing in aerospace. While industry multiples remain low as a result, free cash flow generation in and of itself is still concerning. In this article, I will run you through my DCF model on Boeing (BA) and then triangulate the result against a review of the fundamentals of Lockheed Martin (LMT) and Textron (TXT). I find that Boeing is not currently a value play.
First, let's begin with an assumption about the top-line. Boeing finished FY2011 with $68.7B in revenue, which represented a 6.9% gain off of the preceding year. I model 11% per annum growth over the next half decade or so.
Moving onto the cost-side of the equation, there are several items to consider: operating expenses, capital expenditures, and taxes. I model cost of goods sold as 81% of revenue versus 5% for SG&A, 7% for R&D, and 2% for capex. Taxes are estimated at 29% of adjusted EBIT (ie. excluding non-cash depreciation charges to keep this a pure operating model.)
Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 9% yields a fair value figure of $77.92, implying 7.4% upside. This is not too much of a discount, in my view, to make the company a value play right now.
All of this falls within the context of strong performance by Lockheed:
"I see the quarter as a strong start to 2012 and a continuation of the execution momentum we demonstrated last year. We grew sales by 6%, earnings from continuing operations by 20% and earnings per share by 29%. Solid program execution and effective risk reduction coupled with ongoing cost-reduction initiatives lifted segment operating margins to 11.9% in the quarter, up from 11% the prior year".
Lockheed is also cheaper than Boeing. It trades at just a respective 10.3x and 10x past and forward earnings versus 12.6x and 12.8x for Boeing. Consensus estimates forecast Lockheed's EPS growing by 0.4% to $7.88 in 2012 and then by 7% and 11.2% more in the following two years. Assuming a multiple of 13x and a conservative 2013 EPS of $8.39, the stock would hit $109.07 for 28.9% upside.
On the higher-end is Textron, which trades at a respective 21.6x and 10.2x past and forward earnings. Consensus estimates forecast its EPS growing by 49.6% and then by 17.9% and 17.3% in the following two years. Assuming a multiple of 13x and a conservative 2013 EPS of $2.26, the stock would hit $29.38 for 24.9% upside. According to NASDAQ, the Street rates the stock near a "buy". While the beta of 2.3 suggests that the stock will outperform during a recovery, the low dividend yield makes me concerned about management's confidence in free cash flow. Lockheed offers a 4.7% dividend yield, nearly double that of Boeing. In my view, Lockheed is thus the best way to play the aerospace market from a risk/reward standpoint.