TXT - Textron: Improved Growth Visibility Warrants A Higher Multiple

2023-05-08 18:06:55 ET

Summary

• TXT operates in various industries, with Aviation and Bell being the most significant segments. Aviation's elevated backlog and Bell's recent FLRAA contract have resulted in high visibility for near-term growth.
• Aviation's profitability is expected to improve due to high incremental margins from increased volume and backlog. However, supply chain issues remain a constraint.
• The FLRAA contract has significantly improved Bell's growth runway visibility, which should drive sales and profitability in the future.

Summary

Textron ( TXT ) operates in various industries such as Aviation (~48% of segment profit), eAviation , Industrial (~13.5% of segment profit), Textron Systems (~12.4% of segment profit), and Bell (~26% of segment profit). These industries are also how the business is divided into segments. TXT 1Q23 results were relatively in-line with the business jet demand continuing to show its resiliency. In terms of growth outlook, the visibility seems high as well given that Aviation backlog is still significantly higher than pre-pandemic, but Cessna aircraft deliveries have yet to catch up (still below pre-pandemic levels). As for Bell, the award of Future Long Range Assault Aircraft [FLRAA] has further extended the growth runway visibility. Collectively, we now have about 75% of the business achieving high visibility of their growth in the near to med-term. With the stock now trading at 12x earnings, I believe it is not reflecting the earnings growth power of the company. It should at least trade at its historical average of 16x earnings. I am recommending a buy rating as TXT continues to deliver, and I believe the market will soon catch up on the strong visibility in earnings (thereby attaching a higher multiple).

1Q23 results

The Aviation segment saw a 1% increase in revenue to $1.15 billion due to price increases and increased volume, and an 11% increase in segment margin. Backlog increased by 2% sequentially vs last quarter to $6.5 billion, and by 27% year-over-year, implying a book-to-bill ratio of 1.1x. Bell's revenue dropped 26% to $621 million due to declining military revenue, and the segment margin fell 120bps to 9.7% due to declining volume and mix. In contrast to Aviation, Bell saw a decrease in backlog of 4% sequentially to $4.6bn, indicating a book to bill of 0.7X.

Aviation growth

As I mention earlier, the elevated backlog coupled with lower than pre-pandemic deliveries have resulted in a high visibility near-term growth for the Aviation segment as the backlog continues to support more than 1 year of deliveries/revenue. There is less revenue risk in the event of a recession because of the increased backlog compared to recent years, which gives insight into deliveries over the next few years. In addition, the continued low inventory levels (albeit slowly increasing) for used aircraft are supportive of the purchase of new jets. The issue concerning the growth here is the constraint by supply chain impacts. The segment continues to struggle on the supply side on select suppliers as well as inefficiencies from new hires (which has helped with labor situation after the hiring exercise in 2H22) as they gradually increase productivity. In terms of profitability, management has guided to 12-13% margins in 2023, which is a 100-200 bps improvement. I believe the guide is credible given the high visibility into the backlog, and volume which drives high incremental margin. There could also be a possibility for margins to be better than expected as the higher priced orders (higher margin) in the backlog flow into the P&L.

Bell margins

Unlike Aviation, the Bell segment was weaker as it got impacted by the absence of the FLRAA revenue during the protest period, in which it delivered 12% fewer Commercials, only 2 V-22s and no H-1s. As such, despite a 9.7% segment margin which was a 200bps improvement from last quarter, the absolute EBIT amount came in lower at $60 million. However, the good news is that Bell sales should continue to ramp up moving forward as it benefit from the $70 billion FLRAA contract awarded by the US army to replace the Black Hawk. I note that the $70 billion will last over decades, as such this milestone has really improved the growth runway visibility for the segment in my view. I expect the ramp up to be gradual, most likely weighted towards 2H as things get sorted out, and profitability should follow through consequently.

Valuation

With the improved growth visibility for both the Aviation and Bell segment, and the increased growth runway for Bell, I argue that the business deserves to start trading at a premium to its average. TXT trades at 12.5x forward earnings as of date of writing, which is 3.3x below its historical average. I believe this opportunity exists because the market has yet to fully digest the structural change from a cyclical business to one with strong visibility. As TXT grows as guided, I believe the valuation gap will close.

Conclusion

TXT 1Q23 results were relatively in line with business jet demand continuing to show its resiliency. The Aviation segment's elevated backlog, coupled with lower than pre-pandemic deliveries, resulted in high visibility for its near-term growth. Despite the Bell segment's weakness, the award of the FLRAA contract has improved its growth runway visibility. With about 75% of the business achieving high visibility of their growth in the near to medium-term, I believe that the stock is undervalued at its current trading multiple of 12.5x earnings. I recommend a buy rating on the stock as the market should soon catch up on the strong visibility in earnings, thereby attaching a higher multiple.

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