By The Valuentum Team
As with many of its aerospace supply chain peers, Rockwell Collins (NYSE:COL) has benefited from the multi-year commercial aerospace upswing. Though commercial airplane delivery growth has started to plateau a bit at the airframe makers, the backlog of unfulfilled deliveries at Boeing (NYSE:BA) and Airbus (OTCPK:EADSY) remain several times that of their commercial revenue, speaking to ongoing visibility and a nice cushion to the dividends in the supply chain, including Rockwell Collins'. For fiscal 2016, management is targeting cash flow from operations in the range of $750-850 million and capital expenditures of ~$200 million, translating into significant free cash flow generation far in excess of its ~$180 million annual dividend obligation. Check out Rockwell Collins' Dividend Cushion Cash Flow Bridge in the image below:
Image Source: Valuentum
There are a few risks to the Rockwell Collins' story, however. The commercial aerospace cycle has been on an upswing for the better part of a decade, and while backlogs at the airframe makers remain strong, Rockwell Collins' end market is cyclical, and eventually orders and deliveries will slow. Free cash flow offers sufficient coverage of the dividend, and we're not too worried about leverage levels; debt-to-EBITDA stands at ~2x. Research and development, while necessary, will total as much as ~$1 billion in fiscal 2016, hurting earnings, and free cash flow continues to go to share repurchases. Total short and long-term debt stood at ~$2.1 billion at the end of fiscal 2015, which weighs on the company's Dividend Cushion ratio.
We've witnessed some of our favorite aerospace suppliers get taken out during the past few years, perhaps Precision Castparts (NYSE:PCP) being the most high-profile one - Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) scooped up that fantastic company. However, Rockwell Collins offers investors ongoing exposure to an industry with tremendous visibility and resiliency: the commercial aircraft making business. The company has a nice, solid dividend to boot!
Rockwell Collins' Investment Considerations
• Rockwell Collins makes communications and aviation electronics for commercial and military customers worldwide. Its products include integrated avionics systems, integrated cabin electronics systems, and communication and navigation systems. The company was founded in 1933 and is headquartered in Cedar Rapids, Iowa.
• The firm is looking to take advantage of the growing global middle class by accelerating its commercial international growth through an increase in R&D spending. It is also aiming to increase the international share of its Government Systems revenue from 32% in 2014 to 35% in 2018.
• Rockwell Collins expects accelerated expansion in commercial services revenue. The firm forecasts the segment to grow at a high-single-digit pace in the near term and expand to a rate greater than 10% by the end of this decade. A burgeoning backlog of undelivered planes at the commercial OEMs supports this trajectory.
• In fiscal 2016, Rockwell Collins is expecting revenue to grow modestly to a range of $5.3-5.4 billion. Earnings per share growth is expected to outpace the top line advances, with guidance coming in a range of $5.45-5.65. Free cash flow is anticipated to be modestly higher in the year as well ($550-650 million).
• Though we like Rockwell Collins' commercial aerospace exposure, approximately 30% of its business comes from US government contracts. Defense funding may face significant pressure in coming years due to competing budget priorities.
Economic Profit Analysis
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. Rockwell Collins' three-year historical return on invested capital (without goodwill) is 23.1%, which is above the estimate of its cost of capital of 9.8%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of 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. Rockwell Collins' free cash flow margin has averaged about 10.2% during the past three years. As such, we think the firm's cash flow generation is relatively STRONG. 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 Rockwell Collins, cash flow from operations increased about 26% from levels registered two years ago while capital expenditures expanded about 74% over the same time period.
We think Rockwell Collins is worth $78 per share with a fair value range of $62.00-94.00.
The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which 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. 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 three-year historical compound annual growth rate of 3.5%. Our model reflects a five-year projected average operating margin of 20.7%, which is above Rockwell Collins' trailing three-year average.
Beyond Year 5, we assume free cash flow will grow at an annual rate of 3.8% for the next 15 years and 3% in perpetuity. For Rockwell Collins, we use a 9.8% 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 $78 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 Rockwell Collins. We think the firm is attractive below $62 per share (the green line), but quite expensive above $94 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 Rockwell Collins' fair value at this point in time to be about $78 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 Rockwell Collins' 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 $102 per share in Year 3 represents our existing fair value per share of $78 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.
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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.
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