In a week when most of its aerospace peers reported Q2 earnings, aviation electronics specialist Rockwell Collins (which operates on a different calendar) reported earnings for its own fiscal third quarter. Rockwell Collins stock is down roughly 5% since the news came out Friday, so you can tell investors weren't entirely thrilled with the results.
But should they have been? Let's review:
The quarter in review
In its fiscal Q3 2015 earnings news, Rockwell Collins reported that:
- Sales increased 2% year over year in Q2 2015, rising to $1.29 billion.
- Earnings from continuing operations jumped 12%, to $1.33 per share.
- Free cash flow for the quarter reached $158 million. According to data from S&P Capital IQ, that's up more than 22% year over year.
None of which, I have to say, sounds particularly bad. Certainly not "subtract five percent from the market cap" bad -- which is what investors have done to Rockwell Collins stock in the days since the news came out. The fact is, Rockwell Collins' numbers appear to have actually exceeded analyst estimates for the quarter.
So, what exactly is it that investors are so upset about at Rockwell Collins?
Conceivably, investors could be reacting to earnings guidance for Rockwell Collins stock. But honestly, there wasn't anything particularly objectionable in there, either. Management basically reiterated the same guidance it had previously given:
- Full-year sales will range from $5.25 billion to $5.3 billion (slightly better than previous projections).
- Operating profit margins will average 21% (right in the middle of the previous range).
- This should generate per-share profits between $5.15 and $5.25 (higher than the low end of previous guidance, and lower than the high end, as Rockwell gets a better perspective on where the numbers are heading)...
- ...and a similarly narrowed range of guidance on cash from operations, which is now expected to range from $725 million to $775 million.
Minus capital spending of $200 million, that should yield free cash flow of perhaps $525 million to $575 million. What does all of this do to the stock's valuation?
Working from the midpoints of earnings guidance, Rockwell Collins shares that cost roughly $84 today are selling for 16.1 times current-year earnings. For a stock paying a 1.5% dividend and expected to grow profits at 10.7% annually over the next five years, 16 times earnings seems a bit high.
But the bigger problem is with the valuation calculated based on free cash flow: $550 million-ish FCF divided into Rockwell Collin's $11 billion market cap results in a P/FCF ratio of 20. Divided into the company's $13.5 billion enterprise value (the stock's market capitalization, plus its net debt) results in an even less attractive enterprise value-to-FCF ratio of 24.5.
And this, in a nutshell, is why I believe investors were right to sell Rockwell Collins stock last week -- not because the earnings report was "bad" per se, but because the stock quite simply costs more than its earnings and free cash flow justify.
Simply put, Rockwell Collins stock cost too much. That's why it went down -- and why it deserved to.
Rich Smith does not own shares of, nor is he short, any company named above. You can find him on Motley Fool CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 313 out of more than 75,000 rated members.
The Motley Fool has no position in any of the stocks mentioned. 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.