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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 ) .
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.
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.
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.
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