Textron Stock: Main Drivers Now Outside Control (NYSE:TXT)

Wall Street isn’t a sentimental place, but I can empathize if Textron (NYSE:TXT) management and investors are a little frustrated with the circumstances around this aviation company. Supply chain issues are preventing the company from producing Cessna bizjets at targeted rates, while the wait goes on for a major military award that will play a significant role in the future of the company’s helicopter business.

These shares have fallen almost 10% since my last update, underperforming the broader industrial space and other aerospace-leveraged names like General Dynamics (GD), Honeywell (HON), and Lockheed Martin (LMT), and only doing a little better than Boeing (BA). I do have some concerns that expectations for the bizjet cycle are getting too bullish, but I believe Textron can still generate long-term revenue growth in the neighborhood of 5% and the shares look more interesting on that basis, but there’s above-average risk here right now.

A Lower-Quality Beat In Q3

For some investors an earnings beat is an earnings beat, but I would argue that Textron’s third quarter EPS beat wasn’t much to get excited about. With both revenue and operating income coming in below expectation, it was down to taxes, a share buyback, and other non-core drivers to fuel the beat.

Revenue rose about 3%, missing by about 5% to 6% (depending on which third-party reporting services you prefer). Aviation was down about 1%, Bell and Systems were down 2%, and Industrial was up 16%. Textron now reports eAviation as a separate segment, but it’s currently a tiny part of the business ($5M in revenue out of $3.1B). Bell and Industrial did do a little better than expected, but weaker results in Aviation and Systems overshadowed those performances.

Core operating earnings rose 16%, while segment profits rose 7%, the former missing expectations by close to 7%. Reported operating margin improved almost a point to 9.3%, while segment profit margin improved 40bp to 9.7%.

By segment, Aviation profits were up 42%, with margin up 360bp to 11.9%; Bell profits were down 19% with margin down 240bp to 11.3%; Systems profits were down 18% with margin down 240bp to 12.7%; and Industrial profits were up 70% with margin up 140bp to 4.6%.

I don’t believe the quarterly Aerospace results from Honeywell are particularly relevant to Textron, though I would note that Honeywell commented on ongoing strength in bijzets. General Dynamics posted almost 14% revenue growth in its Aerospace business (19% profit growth), while Embraer (ERJ) announced that it had delivered two more executive jets in Q3’22 versus the prior year (23 vs 21). The comparability of Lockheed’s Rotary and Mission Systems and Textron’s Bell isn’t great, but Lockheed did report a 5% revenue decline and a 10% profit decline on weaker production volumes.

Aviation Still Waiting To Show All It Can Do

Bizjet demand is still very strong, as a “perfect storm” of drivers has come together to drive a major cycle. The fleet was already getting old prior to the pandemic, and since the pandemic there has been heightened interest in private jets due to concerns about safety and decreased service quality at major airports and airlines. While bizjet takeoffs and landings are now about 15% above pre-COVID levels, the percentage of the fleet available for sale is still low on an historical basis (around 4%).

All of that should be good for Textron, and indeed, the company continues to see strong orders, with a book to bill of 1.5x (following 1.6x in Q2’22, 1.96x, in Q1’22, and 1.44x in Q4’21) and 10% sequential backlog growth to $6.4B (or almost a year and a half of revenue at Q3’22 rates).

Unfortunately, delivering on those orders has proven to be more challenging than expected. Supply chain issues and component shortages have hit many companies in many industries, but Textron has had issues sourcing enough engines – something I believe is partly an industry-wide phenomenon and partly supplier-specific (Raytheon’s (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 their 200-jet delivery target to next year, and while management started this year targeting 200, it’s looking like 175-180 may be the more likely outcome.

I do expect 2023 and 2024 to be strong years for bizjets, but I’ve seen a lot of sell-side estimates that see growth out through 2026 and beyond, and that could be more of a stretch. It’s clearly going to take time to refresh the fleet and meet demand, but the sell-side has a habit of forgetting that cyclical businesses are, in fact, cyclical.

The FLRAA Decision Could Be Make-Or-Break

The Army has kicked the can down the road a couple of times with its final decision for the contract award for the Future Long-Range Assault Aircraft (or FLRAA) program, the rotorcraft meant to replace the Black Hawk, but a decision is now expected 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 $50B or more over the full life of the contract, including lucrative maintenance/aftermarket sales.

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

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

The Outlook

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

I’m still looking for over 5% revenue growth from Textron, and winning the FLRAA contract would offer significant long-term upside, as I currently use a risk-weighted approach to reflect it in my model. I’m also looking for free cash flow margins to migrate toward 8% over time, and while the FLRAA contract could drive higher long-term margins, it would come at the cost of weaker near-term margins.

With my free cash flow model, Textron shares appear priced for an annualized total return in the high single-digits now, and that’s pretty interesting. Winning the FLRAA bid, though, would add around $12 to my fair value and push the expected annualized return above 10%. Likewise, while a margin/return-driven EV/EBITDA approach today suggests respectable upside from here (an $83 fair value using an 11.25x multiple), there would be upside on winning the bid.

Where the company to lose out, my fair value would drop by around $7.50/share or so in the immediate, taking the long-term expected return down into the 7%s – not bad, but then I’d also expect the stock to “overcorrect” in the short term.

The Bottom Line

Despite a strong bizjet business that is currently hamstrung by component availability issues, the Textron investment story today rests on the FLRAA award, and I can’t really handicap that beyond noting that most analysts seem to believe Textron will prevail. I believe there’s more upside to a win than downside to a loss now, but sentiment is hard to predict and I could see the stock getting hit beyond what a model may suggest is “fair”.

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