Saturday, December 8, 2012

Textron Research Analysis

Textron (NYSE: TXT) delivered a mixed quarter, but increased guidance. The market focused on the former and sent the stock down, but there has been a bit of a recovery since. In summary, Textron remains a play on North American spending and while the media attention usually focuses on its Cessna business, it’s actually the Bell helicopters segment that traditionally produces the bulk of profits. In addition, there are a lot of moving parts to Textron’s prospects, and investors need to be aware of them.

Introducing Textron

It’s easy to get trapped into thinking that Textron is really all about Cessna business plus a bit of military spending. On closer analysis, there is a lot more going on.  For example, here are the segmental profits on the manufacturing side.

See what I mean about Bell’s importance?

Interestingly, with the exception of Industrial, all the segments have over 70% of their sales in the US. This surprised me as Bell helicopter is a commercial and military supplier while Cessna claims to be the world’s leading general aviation company (unit sales) and has global recognition.  One company worth looking out for in this regard is Ametek (NYSE: AME) which has Textron as a major customer within its aviation sales. Interestingly, Ametek is seeing business and regional jet sales to be up low double digits on an organic basis and its outlook appears to match that of Textron's with regard to business jets.

Textron Systems is largely a manufacturer of defense and aviation mission support systems and is largely a play on defense spending in things like unmanned aircraft, weapons, and sensors. If you are looking for a company to compare this segments results with, I would suggest something like Teledyne (NYSE: TDY), which is also heavily exposed to trends in defense spending. In general, the bias is positive-the US does want to focus more on intelligent systems- but cutbacks are cutbacks and demand is also dependent on conflict. A winding down of military operations is not helping much either. Teledyne's weapons and sensors are a key part of the shift towards “smart” warfare rather than a reliance on pure hardware or military manpower.

The Industrial segment is a rather odd fit that manufactures fuel systems, golf/turf care equipment, and powered tools. It also tends to have a high percentage of sales coming from Europe.

In addition, Textron has a Finance arm which cannot be divorced from its overall operations. Essentially, it is a commercial business which provides financing for the purchase of Textron’s equipment. In order to demonstrate its importance, I have compared it to the industrial section for the last few years.

See what I mean about a lot of moving parts? Improving credit quality and an ongoing asset liquidation plan have improved performance here, so that the segment is now a net contributor instead of being a drag.

Textron Q3 Results

Textron outlined some execution difficulties within Systems and they recorded a $14m charge in the quarter. It had over-estimated the potential to transfer existing operating expertise on a DoD contract and ended up having to throw more resources than expected towards it. A hiccup? Perhaps, but these things tend to happen when end market demand is getting weaker.

There was some negative news with Cessna. Business jet orders were weaker in the quarter but management implied that things got better in September and gave a positive outlook for Q4. Cancellations are dropping which will obviously improve the net position, but it needs to increase gross orders. One idea is that 2012 will tend to follow the tendency of 2010 & 2011 in seeing a pick-up in orders in Q4. I’m not comfortable with this idea because in both those periods growth and business sentiment seemed to pick up at the end of the year. That is not the case this year as GDP growth forecasts are being downgraded at the moment.  The long term dream for Cessna was that the concept of the “air taxi” would take off in a big way.  The idea was popular around 2008, but the recession saw the concept fade and it has never really come back since.

Industrial also saw tougher times predicted. As mentioned above, this segment has a high exposure to Europe and the region was forecast to weaken, but there was also weakness emanating from the fallout of a political dust up between China and Japan. It seems that Chinese consumers are holding back on purchases of Japanese goods in response and this is having a knock on effect on Textron’s industrial sales.

The real star in the quarter was Bell where revenues increased 20% to over $1bn. Commercial deliveries were particularly strong at 46 units versus 26 last year. In addition, even the military side was stronger, although overall Bell’s backlog fell on a year-on-year basis by $434m to $6.3bn. Again, this is somewhat puzzling because a company like Honeywell (NYSE: HON) recently downplayed expectations for the defense and aviation markets. Perhaps the reason for the discrepancy is that Honeywell has more international exposure while Bell typically generates over 75% of its revenues from the US? Honeywell is far more aligned towards international sales than Textron is and it is much harder for a company of its size to focus on niche areas of defense with which it can profit while overall spending is declining.

Where Next?

With this stock, it is the direction of its earnings that are more important than quibbling over its value range. Metrics like earnings and cash flow will move around violently here.  I confess I’m not all that positive. The assumption of order growth in Cessna is baking in some optimism, which may not be delivered. In addition, continued performance at Bell seems a bit incongruent with the rest of the industry. Textron is telling you that times are getting tougher in industrial and systems. I think investors should listen and take a cautionary approach here.

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