Investors weren't initially impressed with Textron's (TXT -0.23%) Q2 earnings announcement. Although earnings per share soared 53% in the second quarter, Textron stock initially sold off by 2%. Fortunately for shareholders, investors soon had a change of heart: Textron shares rebounded, and by Tuesday's close of trading had recovered all their losses -- and even gained a bit more.
With Textron stock now selling for $67 a share, however, the question becomes: Which reaction was the right one? Were the investors who sold off Textron stock in the face of an earnings beat last week right to do so? Or did the investors who bought back Textron stock making the smarter move?
Textron gave investors a close-up view of its business last week. Image source: Getty Images.
What Textron said
For Q2 2018, Textron reported:
- Industrial sales (ATVs, snowmobiles, and auto parts) grew 10% year over year, but profits declined 2%.
- Sales climbed 9% at Textron Aviation (Cessna and Beechcraft), with profit nearly doubling to $104 million.
- Bell (helicopters and Osprey tiltrotors) saw a 1% uptick in sales and a small increase in profits, hitting $107 million.
- The only division reporting really bad news was Textron Systems (UAVs and armored vehicles). There sales fell 20% to $380 million. (The good news is that profits suffered a much more modest 5% decline.)
Overall, Textron's operating profit margin climbed 110 basis points to 9.3%. This helped to transform a rather modest 3% uptick in total sales into a monster 18% gain in profits year over year. What's more, Textron bought back a lot of stock, helping to boost income from continuing operations to $0.87 per share -- up 53% from last year's $0.57 earnings.
At the same time, cash from operations from the company's manufacturing group surged to $468 million, up 13% year over year and helping to offset last quarter's negative cash flow. Capital spending declined sufficiently to boost this to an 18% increase in quarterly free cash flow, which rose to $386 million. For the first half of the year Textron's H1 FCF is $256 million.
CEO Scott C. Donnelly credited "margin improvements at Aviation, Systems, and Bell," with the strong results, combined with "revenue growth resulting from improving commercial demand across many of our end markets." However, a close review of the numbers above shows that essentially all the improvements Textron enjoyed in Q2 earnings came from just one division: Textron Aviation.
Valuing Textron
Turning to guidance, Textron told investors it expects to earn between $3.15 and $3.35 per share this year, for a midpoint of $3.25. That works out to a modest-seeming 20.6 P/E ratio based on current-year expected earnings.
But here's the thing: Management further confided that it expects to produce manufacturing cash flow of between $750 million and $850 million by year-end. Assuming capital spending continues at its present, roughly $80 million-per-quarter pace, that implies free cash flow this year could be perhaps $480 million -- only about $100 million more than Textron generated in Q2 alone.
Now, Textron stock currently carries a market capitalization of $17.2 billion. Add $3.2 billion in net debt and we're looking at about a $20.4 billion enterprise value, and thus an EV/FCF ratio of about 42.5 by year-end.
If you ask me, that's rather a lot to pay for this stock. Even with Textron showing respectable sales growth and improved profit margins, the stock looks rather expensive. Yes, the improvements evident at Textron Aviation are impressive, but the business of selling business jets is notoriously volatile. I'm not sure I'd put a lot of faith in Textron's improved numbers until I see a more broad-based trend of earnings growth across more divisions.
For now, I would not buy Textron stock.
