By The Valuentum Team
Textron (NYSE:TXT) is a multi-industry company boasting a product portfolio that is nearly as balanced as it is diverse. The firm has displayed strong operating leverage in the recent economic upswing as income from continuing operations has jumped to nearly $700 million in 2015 from under $250 million in 2011. Textron had a solid year in 2015 as it recorded a segment profit of nearly $1.3 billion and a profit margin of 9.3%, both of which were improvements over 2014. 'Textron Aviation,' the company's largest segment in terms of revenue, was a key driver of overall segment profit growth from 2014 to 2015.
Though bottom-line performance has been solid at Textron, the company's revenue fell slightly in 2015 on a year-over-year basis. Its 'Bell' segment has suffered due to lower aftermarket demand and a reduction in aircraft delivered, helping push total revenue down by more than 3% in 2015. In addition to the cyclicality of its commodity-driven end markets, the intense competitive nature of its industry provides risk to Textron's operations. Continual product development will be necessary to maintain the firm's competitive position.
Textron's strong free cash flow generating ability allows it to continue to invest in its business. Capital expenditures have outpaced depreciation in recent years and have hovered in the $420-$480 million range from 2011-2015, and the firm has also been quite acquisitive as of late. Notable recent acquisitions include Douglas Equipment, TUG Technologies, Beechcraft and Cessna, among others. The 'Textron Aviation' segment is aiming to use these acquisitions to expand its service footprint, which will provide it with a degree of recurring, anti-cyclical revenue. Though we remain vigilant of integration risks associated with such acquisitions, Textron does have a solid integration track record.
Investments in its business have helped the firm off to a solid start in 2016, as total revenue advanced more than 4% in the first quarter of the year from the year-ago period, despite weakness in its 'Finance' segment. The challenge for Textron now lies in sustaining such top-line performance as it continues to integrate its recent acquisitions, works to extract synergies and maintains its focus on innovation and cost productivity.
Textron's Investment Considerations
• Textron is a multi-industry company. It conducts its business through five operating segments: Textron Aviation, Bell, Textron Systems (weapons and sensors), Industrial (E-Z-Go, Jacobsen), and Finance. Textron Aviation is its largest segment accounting for more than a third of revenue. The company was founded in 1923 and is headquartered in Providence, Rhode Island.
• Textron's portfolio is nearly as balanced as it is diverse. Textron Aviation accounts for ~36%, while its Bell Helicopter brand and Industrial segment each make up ~26% of revenue. Textron Systems and Finance account for the balance.
• Textron continues to advance its product portfolio. In 2013/2014, the company rolled out six new products: New Citation Sovereign+, Citation M2, New Citation X+, Turbo Skylane J T-A, Cessna TT*, and Grand Caravan EX. It continues to invest for growth, and we point to its unmanned aircraft systems portfolio as a key source of future expansion.
• The firm plans to grow its Textron Aviation segment through broadening its product portfolio and increasing its service footprint, which currently accounts for nearly 30% of segment revenue. We like the focus on aftermarket revenue as it has the potential to establish the beginnings of a meaningful recurring revenue stream.
• Textron continues to diversify its revenue base. The company has grown international revenues to more than 35% of total revenue from less than 10% in 2008. Increased diversification provides ongoing opportunities.
Image Source: Textron 10-K
Economic Profit Analysis
In our view, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.
The gap or difference between ROIC and WACC is called the firm's economic profit spread. Textron's 3-year historical return on invested capital (without goodwill) is 16.7%, which is above the estimate of its cost of capital of 9.3%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.
The concept of an economic moat - or sustainable competitive advantages - focuses purely on the sustainability and the duration of the competitive advantages that a firm possesses. The concept of an economic moat does not consider the cumulative sum of a firm's potential future economic profit creation, but only that at some point in time in the future, a moaty company will continue to have an economic profit spread and a no-moat firm will not. Let's examine the problem that arises by focusing exclusively on companies that have economic moats, or sustainable and durable competitive advantages.
Image Source: Valuentum
In the chart below, we show the probable path of Textron's ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Textron's free cash flow margin has averaged about 4.5% during the past 3 years. As such, we think the firm's cash flow generation is relatively MEDIUM.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Textron, cash flow from operations increased about 40% from levels registered two years ago, while capital expenditures fell about 5% over the same time period.
In the first quarter of 2016, Textron reported cash used in operations of $150 million and capital expenditures of $88 million, resulting in free cash flow generation of -$238 million (negative $238 million). This compares unfavorably to free cash flow generation of -$100 million (negative $100 million) in the year-ago period.
This is the most important portion of our analysis. Below we outline our valuation assumptions and derive a fair value estimate for shares.
We think Textron is worth $42 per share with a fair value range of $32-$52. Shares are currently trading at ~$38, in the lower half of our fair value range. This indicates that we feel there is more upside potential than downside risk associated with shares at this moment.
The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance.
Both our top and bottom-line forecasts for Textron in 2016 and 2017 mirror consensus estimates. We are expecting mid-single-digit revenue growth in coming years as new product development and acquisitions should continue to drive similar performance as we saw in the first quarter of 2016. We anticipate earnings per share growth outpacing revenue advances in the near term due to ongoing cost productivity initiatives at the firm, and our projections for capital expenditures involve the company continuing to plow a healthy amount of cash back into its business, slightly above recent levels.
Our model reflects a compound annual revenue growth rate of 4.2% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 3.1%. Our model reflects a 5-year projected average operating margin of 8.7%, which is above Textron's trailing 3-year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 3.1% for the next 15 years and 3% in perpetuity. For Textron, we use a 9.3% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $42 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Textron. We think the firm is attractive below $32 per share (the green line), but quite expensive above $52 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Textron's fair value at this point in time to be about $42 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Textron's expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $57 per share in Year 3 represents our existing fair value per share of $42 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.