Shares of defense contractor Textron (NYSE:TXT) are in a funk, down 8.5% as of 11:35 a.m. EDT -- and falling. This being earnings season, you can probably guess that an earnings report is the culprit, and you'd be right.
Textron reported pro forma profits of just $0.61 per share for the fiscal third quarter of 2018, $0.15 below consensus estimates, and sales of $3.2 billion likewise fell short of Wall Street expectations for $3.5 billion in sales.
But is this really bad news? Like, down 8% bad? I think it is -- but perhaps not for the reason you may think.
GAAP profits for the quarter were a healthy $2.26 per share, boosted by profits from the sale of Textron's "Tools & Test" division. And although sales were down for the quarter in all four of Textron's remaining divisions, operating profits increased in Textron's largest and third-largest businesses -- Textron Aviation and Bell Helicopter, respectively -- indicating that profit margins on what revenues Textron did make, increased.
In addition, apart from the cash influx from selling Tools & Test, Textron greatly increased cash production from its remaining divisions. Manufacturing cash flow quadrupled year over year to $319 million. And with capital spending requirements less demanding this year than last, free cash flow (FCF) turned positive, with $245 million in positive free cash flow generated in the quarter ($501 million generated year to date).
With the year's final quarter now under way, Textron issued updated guidance for the full year, saying it now expects to earn, per GAAP, between $4.81 and $4.91 per share, and to generate positive "manufacturing cash flow before pension contributions" of $750 million to $850 million. Assuming capital spending continues at current levels and CapEx for the full year comes in near $310 million, this implies full-year FCF of just under $500 million.
If you ask me, that's the real reason investors are right to sell Textron stock today. Taking today's guidance as a given, Textron's free cash flow will increase not at all this quarter, and at today's prices, Textron stock is selling for a valuation of roughly 30 times trailing free cash flow. That's an awfully high price to pay for a cyclical defense contractor -- and a good reason for investors to sell Textron stock today.