Rising Star Buy: Textron

This article is part of our Rising Star Portfolios series.

The recession has been a major blow to many companies, but possibly none more so than those selling capital equipment to businesses. Companies of all sizes have held back from upgrading or expanding their equipment, waiting to make sure they won't need that cash for something more important -- like survival. Remember, that was the time of the credit crisis, when cash became king. As a result, there's now a record amount of cash sitting on company balance sheets, and management teams are beginning to feel comfortable enough with the economic recovery to start loosening the purse strings. One company that stands to gain heavily from this is Textron (NYSE: TXT  ) .

The opportunity
Textron operates in four major production divisions: Cessna (business jets), Bell (commercial and military helicopters), Textron Systems (military hardware), and Industrial (auto parts and specialized vehicles like golf carts and golf-course care). And the recession has hurt each of those, especially the Cessna division, as you can see in this chart showing trailing-12-month revenue broken out by division:

Three things have me excited about this company.

First, as seen in the figure above, three of the four divisions -- all but Cessna -- have begun to turn around with increasing sales.

Second, regarding that fourth division, CEO Scott Donnelly said in the last earnings conference call:

Many customers, as you talk to them, are reaching a point now where they're a year or two beyond when their normal replacement and upgrade cycle would be. So I think we have a fair number of customers that are genuinely looking at getting back into the market. And so while I'd say it's probably too early to conclude whether this really will be a turning point in the business jet order environment, we are encouraged by the level of customer interest.

Third, the market hasn't quite caught onto this yet. At last night's closing price of $24.92 per share, the market is expecting the company to never grow free cash flow from the trailing $1.03 billion level ever again (using my hurdle rate of 15% for discounting).

Now I don't know about you, but when a company has managed to grow FCF by an average of 12% a year for the past five years, even through the recession, I think that's a messed-up expectation. Textron is expecting further growth, for instance, in its industrial division, and as Donnelly noted above, it should soon see growth in its Cessna division. If this lets Textron manage just half of that historical FCF growth rate for the next five years before flat-lining, then the expected share price should be more than $31, which is 25% higher than where it is today.

I expect the company to be able to do at least that well, and when the market realizes its mistake, shareholders should do pretty well, too.

The risks
So what could go wrong? Of course, the economic recovery could stall, but Textron's customers are still way beyond when they would normally replace and upgrade, as Donnelly noted. That can only be pushed out so far before companies have to upgrade. And to sweeten the pot for Cessna, Textron has introduced a new jet -- the Citation Ten -- that's more fuel efficient, appealing to companies worried about costs.

Also, the new Congress could cut back on the Defense Department's budget. However, we're still in two theaters of conflict, and the stuff Textron sells (such as unmanned aircraft and surveillance systems) has to be replaced and upgraded as they're used in the harsh environments of Iraq and Afghanistan. That's one reason I bought shares of Oshkosh (NYSE: OSK  ) for the Messed-Up Expectations portfolio a few weeks ago. And, just like Oshkosh, Textron is not solely reliant on military spending.

Third, competition among Cessna, General Dynamics' (NYSE: GD  ) Gulfstream, Embraer (NYSE: ERJ  ) , and others remains fierce. Currently, Cessna has the leading global market share at about 38%. However, others are pushing. For instance, Embraer recently signed a deal with Berkshire Hathaway's NetJets to deliver 50 business jets, and Gulfstream has been increasing deliveries this year relative to last year. Textron's new Citation Ten and other new models in the works will help it keep its lead, as will further expansion in India and China.

The action
Given the turnaround in sales, the growing interest in business jets, and the market's messed-up expectations -- I haven't even talked about the opportunity tied to automakers or what it's done to cut costs; come to my discussion board for that -- I believe now is a good time to climb aboard Textron, before it takes off. Therefore, the Messed-Up Expectations portfolio will open a starting position of about $350 tomorrow, and I'll be looking to add more going forward.

This article is part of our Rising Star Portfolios series, where we give some of our most promising stock analysts cold, hard cash to manage on the Fool's behalf. We'd like you to track our performance and benefit from these real-money, real-time free stock picks. See all of our Rising Star analysts (and their portfolios).

Berkshire Hathaway is a Motley Fool Inside Value selection. Berkshire Hathaway and Embraer are Stock Advisor picks. The Fool owns shares of Berkshire, General Dynamics, and Oshkosh.

Fool analyst Jim Mueller owns shares of Berkshire, but not of any company mentioned. He works for the Stock Advisor newsletter service. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (7) | Recommend This Article (22)

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  • Report this Comment On January 13, 2011, at 4:17 PM, summitclark wrote:

    You spoke of military sales, but no mention of the Osprey which brings them a good deal of revenue in Bell division. This is an aircraft that nobody seems to like, and may be on the choping block as Gates tries to trim the defense budget.

    Thoughts?

    -andrew

  • Report this Comment On January 13, 2011, at 4:37 PM, jrusso9722 wrote:

    Hi Andrew,

    I just think that Osprey is not mentioned that much, because of it's sad development, killing so many troops. Over the horizon transport from 30 miles offshore is, and will be important in the future. Refinement is constant. I don't see how Sec.Defense Gates can trim Osprey. Marine Expeditionary Vehicle, reportedly is on the block. I don't see anything else to replace Osprey. Respect. Joe

  • Report this Comment On January 13, 2011, at 8:09 PM, temporary1 wrote:

    I agree Textron's future looks bright

    but dig deeper

    Textron Financial division revenue should be on your chart

    as well as a sum of it's liabilities

    then you will understand Textron's price better.

  • Report this Comment On January 13, 2011, at 10:45 PM, TMFGebinr wrote:

    Hi temporary1,

    Oh, I know the Financial division is there and has been hurting earnings thanks to credit loss provisions and so forth. It's my understanding, however, that the division is being shut down and the various assets sold, except for the financing arm for floating loans to customers who are purchasing the products (e.g. the Cessna aircraft).

    This division will be a drag, but not a permanent one.

    Thanks for reading.

    Cheers,

    Jim

  • Report this Comment On January 14, 2011, at 2:34 AM, TheStankometer wrote:

    Jim-

    Thanks for the article! I felt like I learned a lot. I appreciate your insight very much because you clearly know more about the industry and the company than I do.

    A few weeks ago I was analyzing Textron and it's fundamentals seemed concerning:

    Negative, unstable ROE%, ROA%, and Net Profit margins. Decreasing gross margin. A mediocre P/E and an inconsistent book value per share.

    An unstable debt to equity ratio and a weak dividend.

    There has also been negative insider trading recently. And over 8% short interest (as a percentage of float).

    They do have a great P/FCF and P/Sales. But I wonder if that could be partially because their long term debt is 2/3 the size of their total current assets. Doesn't long term debt play a factor in making those ratios deceptive?

    Again, I don't know much about this industry or the company... but I wonder if Textron's customers are really going to be purchasing enough Cessna's over the next few years (in a struggling world economy) to make up for their stinky fundamentals.

    For now... I'm keeping my downthumb on TXT. Jim, if you can convince me that the fundamentals tell a different story than the one I'm seeing, I'll end the downthumb and turn it green :)

    Thanks again,

    ~djshagggyd

    (official nose of the Stankometer)

  • Report this Comment On January 14, 2011, at 2:56 PM, TMFGebinr wrote:

    Hi summitclark (Andrew) & jrusso (Joe),

    Regarding the V-22 Osprey from Bell, at a recent conference, management had this to say in response to a question on what if the contract is not renewed beyond fiscal 2014:

    "We have no indication that there will not be further V-22 sales after this existing multiyear [contract].

    There has been kind of -- there's always some commentary anytime the V-22 is mentioned about legacy issues associated with the V-22 and the most recent kind of came up in the Bipartisan Budget Commission that just came out with its findings and there was some noise in that about kind of the V-22. The reality is the customers who are using the V-22 are thrilled with it.

    It is performing extremely well in theater, as I said before. We have consistently been on time or ahead of schedule with deliveries.

    We have enjoyed cost underruns on that program. And so the military customer has benefited from their participation in those cost underruns and our dialogue with them absolutely suggests that there are going to be more V-22s purchased after this existing multiyear [contract]."

    Cheers,

    Jim

  • Report this Comment On January 14, 2011, at 4:50 PM, firemachine69 wrote:

    My primary concern is the impeding slowdown. Would it not be wiser to hold out for it to drop another buck or two, before diving in? (Not to mention, perhaps a better grip on its finance?)

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