Douglas Adams had it wrong. The answer isn't "42," but "83."
And the question: Why is Armor Holdings'
As with most things Adams, this one will need a bit of explaining, so let's get to it. As described in last week's Foolish Forecast, Wall Street expected Armor Holdings to report a whopping $646 million in sales for the third quarter -- 44% higher than the previous year's total -- thanks primarily to its purchase of Stewart & Stevenson Services (S&S). As it turned out, though, Armor booked only $563 million in sales -- a difference of more than $83 million.
Naturally, the sales shortfall yielded smaller-than-expected profits as well. Although investors were prepared for a 16% year-over-year decline, they were taken aback at the magnitude of the shortfall -- the $0.58 per share earned translated into a 22% decline.
So much for last quarter. Now that S&S is part of Armor (and CEO Robert Schiller confirmed that the integration of the new acquisition is "proceeding smoothly," "ahead of plan," and achieving "better-than-expected gross margins"), what does the future hold for the combined company? First off, "better-than-expected" or not, S&S is a lower-margin business than Armor proper; with S&S onboard, Armor posted a quarterly gross margin 360 basis points lower than in last year's Q3 (the operating margin dropped 230 basis points, and the net, 210). Expect to see similar year-over-year declines in the combined company's margins going forward, until it's survived a full year of post-merger announcements.
So should investors buy Armor Holdings because it's now pulling in so much more sales? Or avoid it because it's making less on each dollar of sales than before? My thinking goes like this:
Armor Holdings shares carry a trailing P/E of 14. Even factoring in the lower profitability of S&S's sales, the addition of S&S has analysts thinking (on average) that the combined firm will grow its profits 15% per year in the future. Almost by definition, the 0.9 P/E-to-growth multiple that results from dividing the former by the latter numbers suggests that Armor Holdings is reasonably priced. What's more, if the firm succeeds in its joint bid with Lockheed Martin
Finally, based on year-to-date free cash flow of $87 million, annualized to about $116 million for this fiscal year, I calculate that the firm's price-to-free cash flow-to growth ratio looks similar -- just more than 1.0. Under either calculation (and admitting that one tool does not a valuation make), I consider Armor Holdings at least fairly priced, and potentially underpriced if the firm gets even a piece of the Joint Light Tactical Vehicle contract.
The Joint-what-kind-of-vehicle? Don't be embarrassed if you haven't heard of it. I only learned of this initiative to build a 21st-century Humvee a few days ago myself. Read all about it in: "General Dynamics Outflanked?"
Fool contributor Rich Smith does not own shares of any company named above.