Textron Looks Overvalued

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About: Textron Inc (TXT), Includes: COL, GD, HII, HRS, HXL, LLL, NOC, RTN
by: Abrar Hassan Saadi

Summary

Sales growth and margins are modest on a standalone basis, but lower in comparative terms.

A new contract with the DoD beginning in 2020 is worth of $2.2 billion.

Textron is going through a number of product developments.

Recent tax laws may have partially boosted aircraft sales.

My DCF model indicates that Textron is overvalued. Relative value shows mixed results.

Investment Thesis

Textron (TXT) is a renowned name in the aerospace and defense industry. It operates five segments: aviation, bell, systems, industrial and finance. The firm has a posted 4%+ average in sales growth for the last five years, along with good fundamentals. In its latest quarter, revenue was up in the aviation, bell and industrial segments which was partially offset by from lower revenues in systems segment.

Recently Textron and Boeing was awarded a $4.2 billion contract by DoD beginning in 2020 to deliver 58 units of V-22 aircraft, of which $2.2 billion is attributable to Textron. On the other hand, the firm has received approval in the quarter to provide 12 H-1 attack helicopters to Bahrain. Currently Textron has multiple products under development. Backlog in Aviation, Bell and Systems segment were $1.6 billion, $5.5 billion and $1.2 billion, respectively. Textron announced its expected full year EPS from continuing operations to a range of $3.15 to $3.35 a share, up $0.20 from its prior outlook. My DCF model indicates that Textron is currently overvalued, while relative value suggests mixed results. Combining all the factors, Textron is a hold.

Performance Profile

Textron scored an average of 7.79% in operating margin for the last five years, along with 4.6% average in profit margin and 3.91% average in FCF margin. While the stats are decent on a standalone basis, spreads derived from peer comparison show that Textron’s margins might be lower than the industry average. However, Textron scored 5th in terms of sales rank. The stats reveal that Textron’s gross margins are significantly lower than its peers, averaging roughly -9%. This implies that Textron’s have increased cost structure for production and consequently lower margins on a comparative basis. The peers include TransDigm (TDG), General Dynamics (GD), Hexcel (HXL), Harris (HRS), Raytheon (RTN), L3 Technologies (LLL), Rockwell (COL), Northrop (NOC) and Huntington (HII).

Textron minus Peer average

2013

2014

2015

2016

2017

2018

Average

Gross margin

-7%

-9%

-9%

-8%

-9%

-10%

-9%

EBITDA margin

-5%

-7%

-7%

-7%

-7%

-5%

-7%

EBIT margin

-5%

-8%

-8%

-8%

-7%

-6%

-7%

Profit margin

-3%

-4%

-4%

-5%

-2%

-5%

-4%

FCF margin

-6%

-6%

-4%

-5%

-6%

-3%

-5%

Source: data from Stockrow, data processed by the author.

Market dynamics

Textron’s aviation segment develops business jets, turboprop aircraft, piston engine aircraft, and military trainer and defense aircraft while Bell segment makes helicopters. These two segments accounted for more than 55% of Textron’s revenue followed by the industrial segment and the systems segment. textron growth and contribution by segment Source: data from 10-k, data processed by the author.

Fi-aeroweb (identifies itself as an aerospace & defense market intelligence website) reports that although aviation sales are posting modest growths, numbers in absolute terms have been down compared to 2007’s peak levels, a primary reason of which is the significant increase in aircraft price. The website reports that the price of business jets has soared more than twice during the 2007-2017 period which makes up the vast majority of U.S. and worldwide sales revenues, accounting for 85% and 89% of 2017 sales, respectively. On the other hand, besides strengthening market fundamentals, aviation sales might have picked up partially due to new tax plan that allows 100% bonus depreciation, allowing taxpayers immediate deduction of the cost of aircraft acquired and placed in service after Sept. 27, 2017 and before Jan. 1, 2027. Aerospace & defense does show momentum in last one year period. U.S. Textron's industrial segments develops automotive fuel Systems, functional components and tools and test equipment. Techsci projects global automotive fuel delivery systems to reach $73.88 billion by 2023.

Source: Fidelity

Ongoing developments

In its latest quarter the firm reported decent sales in jets and significant growth in turboprops. Textron is going through a number of developments, Citation Longitude (new super midsize aircraft) is going through the FAA certification process, AT-6 Wolverine (military aircraft) had a “positive flight performance” during the Air Force’s second phase of the light attack experiment program, 12 H-1 attack helicopters were given congressional approval to be delivered to Bahrain. Recently the firm has secured $2.2 billion worth of contracts with the DoD. Aviation sales was up 9% in the latest quarter. U.S.Government accounted for 22% for Textron's consolidated revenues in 2017.

“We continue to see improving order flow across our jet and commercial turboprop product lines with increasing strength coming from the international markets.” Chairman and CEO, Scott Donnelly

aircraft sales

Source: Fi-aeroweb

Revenue from industrial segment was up 10% in its latest quarter. Textron’s products under this segment are Fuel Systems and Functional Components, specialized vehicle and tools & test equipment. New introductions in industrial segment were Cushman Shuttle Personnel Carrier and the E-Z-Go Express personal transport vehicle. Revenue from systems segment were down due discontinuance of its Sensor Fuzed Weapon.

Valuation

Intrinsic value

My DCF model indicates that Textron’s intrinsic value is $59.93, implying an overvaluation of $10.07 per share (Textron trading at $70). The forecast inputs are held constant and revised slightly upwards from their long term averages. Growth rates in current assets and liabilities replicates historical changes in net working capital as percentage of sales very closely. Cost of equity and after-tax cost of debt have been taken from Damodaran’s estimates (aerospace/defense industry). I have assumed a perpetual growth rate of 3.5% which is applied to the terminal year unlevered FCF.

textron intrinsic value

Source: Financial statement data taken from Stockrow, forecast inputs are given at the notes section.

The impact of perpetual growth rate assumptions are shown on the following chart. As you can see, Ceteris Paribus, intrinsic value (implied shared price) reaches current market price when perpetual growth rate is assumed to be roughly 4% and begins to look undervalued at levels beyond 4%. Simply put, a 50 bps increase in my assumed perpetual growth rate would indicate the current market price to be its intrinsic value.

textron stock price sensitivity to perpetual growth rate

Relative Value

While P/E indicates that Textron is overvalued, P/B and EV/EBITDA suggests other-wise.

Ticker Company Name Market Cap PE Ratio Price/Book EV/EBITDA
TXT Textron Inc $17.79B 40 3.32 12.86
TDG TransDigm Group

$18.73B

25.72

-8.91

17.31

GD General Dynamics Corporation $61.01B 20.82 5.09 14.45
HXL Hexcel Corporation

$5.89B

21.26

4.21

14.57

HRS Harris Corporation

$19.66B

28.31

5.96

14.69

RTN Raytheon Company

$59B

24.93

5.56

13.1

LLL L3 Technologies $16.57B 25.86 3.04 13.51
COL Rockwell Collins, Inc. $23.17B 23.22 3.41 14.23
NOC Northrop Grumman Corporation $55.39B 24.79 6.74 17.62
HII Huntington Ingalls Industries, Inc. $11.2B 19.07 6.62 9.3
Average 25.40 3.50 14.16

Source: Seeking Alpha

Currently Textron is trading at peak high P/B levels, crossing the previous boundary set in the first half of 2015.
textron price to cash flow Source: Seeking Alpha

Conclusion

Textron does look like a solid firm, but I find it overvalued. Although stats are modest on a standalone basis, performance spreads indicate that it has higher cost structure and consequently lower margins. However, Textron is currently going through a number of developments which could give the firm a significant boost, besides the positive impact from tax benefits on aircraft sales. Combining all the factors, I would recommend a hold on Textron.

Textron forecast inputs and implied margins

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.