Textron Stock: Major Drivers Now Out of Control (NYSE:TXT)

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Wall Street is not a sentimental place, but I can empathize if textron (New York Stock Exchange:TXT) management and investors are a bit frustrated with the circumstances surrounding this aviation company. Supply chain problems prevent the company from producing Cessna bizjets in the target market. while the wait continues for a major military award that will play a significant role in the future of the company’s helicopter business.

These stocks are down nearly 10% since my last update, trailing the broader industrial space and other aerospace-driven names like general dynamics (GD), Honeywell (HON), and Lockheed Martin (LMT), and only doing slightly better than boeing (LICENSED IN LETTERS). I am concerned that expectations for the bizjet cycle are getting too bullish but I think Textron can still deliver near 5% long-term revenue growth and the stock looks more attractive on that basis but there is a higher risk than average. here right now.

A lower quality rhythm in the third trimester

To some investors, an earnings pace is an earnings pace, but I’d say Textron’s third-quarter earnings-per-share pace was nothing to get excited about. Since both revenue and operating income were below expectations, it was due to taxes, share buybacks and other secondary drivers to drive the pace.

Revenue increased approximately 3%, with a loss of between 5% and 6% (depending on the third-party reporting services you prefer). Aviation was down about 1%, Bell and Systems was down 2% and Industrial was up 16%. Textron now reports eAviation as a separate segment, but it is currently a small part of the business ($5M on revenue of $3.1B). Bell and Industrial did slightly better than expected, but weaker results in Aviation and Systems overshadowed those performances.

Core operating profit rose 16%, while segment profit rose 7%, the former missing expectations by nearly 7%. Reported operating margin improved nearly one point to 9.3%, while segment profit margin improved 40 bps to 9.7%.

By segment, aviation earnings increased 42%, with a margin of 360 bps to 11.9%; Bell’s earnings fell 19% with a spread of 240 bps to 11.3%; Systems profits fell 18% with a spread of 240 bps to 12.7%; and industrial profit rose 70% with a margin of 140 bps to 4.6%.

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I don’t think Honeywell’s quarterly aerospace results are particularly relevant to Textron, although I would note that Honeywell commented on continued strength in bijzets. General Dynamics posted nearly 14% revenue growth in its aerospace business (19% earnings growth), while clutch (ERJ) announced that it had delivered two more business jets in the third quarter of 2022 compared to the previous year (23 vs. 21). Comparability of Lockheed and Textron’s Bell rotary and mission systems isn’t great, but Lockheed reported a 5% revenue decline and a 10% profit decline on weaker production volumes.

Aviation is still waiting to show everything it can do

Bizjet demand remains very strong as a “perfect storm” of drivers has come together to power a major cycle. The fleet was already aging before the pandemic, and since the pandemic, interest in private jets has increased due to concerns about safety and declining quality of service at major airports and airlines. While bizjet takeoffs and landings are now 15% above pre-COVID levels, the percentage of the fleet available for sale remains historically low (around 4%).

All of that should be good for Textron and indeed the company continues to see strong orders, with book to bill at 1.5x (after 1.6x in 2Q’22, 1.96x in 1Q’22 and 1.44x in 4Q ’21) and 10% sequential order book growth to $6.4 billion (or nearly a year and a half of revenue at 3Q ’22 rates).

Unfortunately, fulfilling those requests has turned out to be more challenging than expected. Supply chain issues and component shortages have affected many companies in many industries, but Textron has struggled to get enough motors, something I believe is part industry-wide and part vendor-specific phenomenon. (Raytheon(RTX) Pratt & Whitney).

Given those challenges, deliveries were down in the quarter: 39 jets versus 49 last year and 48 last quarter. Management has now pushed its delivery target to 200 aircraft for next year, and although management started this year with a target of 200, it seems that 175-180 may be the most likely outcome.

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I expect 2023 and 2024 to be strong years for bizjets, but I’ve seen a lot of sell-side estimates that see growth through 2026 and beyond, and that might be more exaggerated. Clearly it’s going to take time to update the fleet and meet demand, but the vendor has a habit of forgetting that cyclical business is, in fact, cyclical.

FLRAA decision could be decisive

The Army has kicked the can down the road a couple of times with its final decision to award the contract for the Future Long-Range Assault Aircraft (or FLRAA) program, the helicopter intended to replace the Black Hawk, but now a decision is awaited. in November. It will take a few years for this program to ramp up, and margins in the early years are likely to be low, but this program could be worth $50 billion or more over the life of the contract, including lucrative maintenance sales. /Secondary market.

Textron’s Bell is competing with Lockheed Martin and Boeing for this award, and there are arguments as to why either side could win. The risk that I see is that it seems like the consensus view on The Street now is that Textron will win the award, and while that seems like a reasonable assumption given the arguments for and against that I’ve seen for both candidates, the reality is that it’s a binary result and no consolation price for Textron (aside, perhaps, from a much smaller FARA award in the future).

The risk of this event is amplified by Bell’s status without the FLRAA contract. Bell’s business is struggling as the H-1 program winds down, and there simply isn’t enough commercial demand for helicopters to sustain this business. I could see management repositioning some of the core technologies here toward urban aviation or other emerging helicopter applications, but that’s a “maybe” and any profit contribution would be years away (and could require significant M&A or R&D). D to achieve).

the perspective

Even without the FLRAA award, Textron is generating close to $1 billion in free cash flow and has a pretty clean balance sheet. That gives the company plenty of options for strategic mergers and acquisitions (possibly in defense, urban aviation, and/or space), as well as capital returns to shareholders. As it is, I don’t see the need for that much reinvestment in the aviation business, so there are plenty of options for that cash flow.

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I continue to look for more than 5% revenue growth from Textron, and winning the FLRAA contract would offer a significant long-term advantage, as I currently use a risk-weighted approach to reflect this in my model. I’m also looking at free cash flow margins to migrate towards 8% over time, and while the FLRAA contract could deliver higher margins in the long term, it would come at the cost of weaker margins in the short term.

With my free cash flow model, Textron stock looks like it’s trading for a high single-digit annualized total return now, and that’s pretty interesting. However, winning the FLRAA bid would add about $12 to my fair value and push the expected annualized return above 10%. Likewise, while a margin/return-driven EV/EBITDA approach today suggests a respectable upside from here ($83 fair value using a multiple of 11.25x), there would be an upside to winning the bid.

Should the company lose, my fair value would drop to around $7.50/share or so immediately, which would reduce the long-term expected return to 7%; not bad, but then I would also expect the stock to “overcorrect” in the short term.

The bottom line

Despite a strong bizjet business that is currently crippled by component availability issues, Textron’s investment story today is based on the FLRAA award, and I really can’t limit that beyond noting that most analysts seem believe that Textron will prevail. I think there is now more upside to a gain than downside to a loss, but sentiment is hard to predict and I could see stocks taking a hit beyond what a model might suggest is “fair”.

Textron’s qualities as an investment now really come down to its feelings about the FLRAA award and its willingness to buy ahead of that binary outcome. I think the risk/reward ratio is favorable, but that kind of short-term risk doesn’t appeal to all investors.

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