Shares of defense contractor Textron (NYSE:TXT) are tearing it up, rising more than 2% in early Wednesday trading after reporting fiscal-second-quarter earnings that significantly exceeded analyst expectations.
Expected to earn just $0.46 per diluted share on $3.52 billion in revenues in Q2, Textron "beat by a nickel," reporting $3.5 billion in revenues, which roughly matched expectations, but $0.51 per share in profits -- 11% more than Wall Street expected, and 28% better than what the company earned in Q2 of 2013. Among the other facts and figures that management revealed this morning:
- Three of the firm's four main manufacturing divisions reported improved revenues in the quarter (the firm's weapons unit, Textron Systems, being the exception).
- Operating profit margins grew by 150 basis points companywide, rising to 8.5%.
- "Manufacturing cash flow before pension contributions" -- the company's term for what we call "free cash flow," and a number that often understates Textron's true cash profitability -- came in at $271 million, a seismic reversal of last year's $362 million Q2 cash-burn.
Honing in on that last point, S&P Capital IQ data is now clocking Textron at $1.2 billion in trailing free cash flow production, or nearly two-and-a-half times the company's reported $495 million in profits that the company was permitted to report under generally accepted accounting principles.
This suggests that despite Textron's seemingly high 22-times-earnings "P/E ratio," the stock is actually quite a bit cheaper than it looks. Indeed, valued on free cash flow, Textron is now selling for just over nine times FCF -- a huge bargain if analyst estimates of 20% long-term annualized profits growth prove to be anywhere near correct.
Caveats and provisos
Before you get too excited about the evident value in this stock, however, it's worth pointing out that Textron itself thinks the $1.2 billion FCF number may be a fluke. Guiding investors on what to expect over the remainder of this year, Textron reiterated guidance for per-share profits to range between $1.92 and $2.12 at year's end. That works out to about $563 million or so in net profit.
"Cash flow from continuing operations of the manufacturing group before pension contributions" is likely to approximate that figure as well. Textron estimates that its version of "free cash flow" will range anywhere from $510 million to $610 million after pension contributions are taken into account.
At the midpoint of these guidance ranges, we're probably looking at a stock selling for about 20 times both earnings and free cash flow at the end of 2014. On a 20% growth rate, that looks just about the right valuation to me. The wild card, and the one thing that could make this stock a better bargain than it appears?
I still think Textron's version of free cash flow lowballs the company's true cash profitability, as reflected by the standard formula of cash from operations, minus capital expenditures, equals free cash flow. By that metric, Textron remains a bargain -- and a buy.
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Rich Smith has no position in any stocks mentioned. The Motley Fool owns shares of Textron. Try any of our Foolish newsletter services free for 30 days. 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.