Description

For longer time-horizon investors, Textron (NYSE-TXT) presents a compelling opportunity to own an inexpensive stock that is using its considerable cash flow to retire shares at a healthy clip. Meanwhile, as investors we wait for the market to better understand and discount the optionality and future growth around Textron Bell’s new V-280 aircraft. I believe this opportunity could be worth approximately $17.50 per share or 26% of the share price, before considering the large potential impact of future share repurchases. The V-280 is very well positioned to capitalize on the coming military helicopter replacement cycle for the U.S. and its allies, and will serve to turnaround TXT’s otherwise struggling Bell division.

Given those views, most of this write-up will focus on the long-term optionality associated with Bell Textron’s December 5th, 2022 announcement of a transformational win for the Army’s Black Hawk helicopter replacement program (FLRAA – Future Long-Range Assault Aircraft). Since the announcement, Textron shares have languished, -3.6% compared to the Aerospace & Defense ETF (ITA) -0.8%, the SPY -2%, and the XLI -3.6%. Shares remain very cheap on current earnings which include almost nothing from FLRAA (13.5x ’23 EPS guidance). Sell-side analysis regarding FLRAA has been limited, and fairly myopic. One could argue you are getting “something for nothing”; below I will make the argument that you are getting “something big for less than nothing”; that in fact you are being paid to wait for the benefits of the FLRAA win and also for the potential multiple expansion from becoming more of a pure-play Aerospace and Defense company over time. My key points with regard to Bell’s global opportunity are as follows:

1. Bell won for very good reason, so the contract protest from Lockheed Martin/Sikorsky has a lower chance of success than the typical protest (already very low).

2. The FLRAA contract is likely the first of a number of large contracts whereby the DoD is resurrecting Bell in recognition not only of its recent technological progress with tiltrotor technology, but also thinking strategically to strengthen the military industrial supply base as the geopolitical clouds loom ahead.  This idea includes my expectation that the US Navy, US Marine Corp, and our key allies in Europe, Asia, and Australia will likely follow the US Army’s lead here and leverage the considerable development expense.

3. The sell-side analyst who did the most comprehensive work on FLRAA (Jefferies) derived an estimate of $15/share for the NPV. Jefferies’ Bull case uses ~$100B of total procurement by 2050, consistent with the views of Textron management and the high-end of estimates out there in the public domain. This does not include Marines, Air Force, or Navy, and does not appear to include aftermarket revenues, the latter of which I believe could grow the overall profit pool by 20-40%. Further, share buybacks will end up making the dollar NPV be spread over far fewer shares.

4. My read of the current geopolitical climate tells me the procurement will be faster than Jefferies modeled, and more global, given these are the aircraft we need for a conflict in the Pacific.

5. Having secured Bell’s long-term health with the FLRAA win and thereby brought in considerable revenue to tilt the overall mix towards Aerospace & Defense, Textron may move further in that direction via acquisition or by spinning or divesting all or part of the Industrial division. The multiple arb is significant – General Dynamics (GD) being one example of the aspirational comp here given its large business jet exposure, trades at 11.8x ’24 EBITDA vs. TXT at 8.4x.

6. The biggest stretch, but worth considering, is that the newly developed tiltrotor technology could lead to a product in civilian and/or business aviation (with greater speed and efficiency vs. a helicopter and still no need for a runway, there could be a disruptive opportunity here). Similarly, Bell is marketing its electric aircraft “eVTOL” product, Nexus, which has some option value as well.

Business Background

Textron is a multi-industry company with 6 segments (w/ ’23 guided revenues):

• Aviation - $5.7B – mainly Cessna business jets, and parts/maintenance/service

• Industrial - $3.6B – Kautex fuel systems (German-based, mostly Automotive) and specialized vehicles (E-Z-GO golf carts, Arctic Cat ATV’s)

• Bell - $3.3B – military OEM (mainly V-22 Osprey tilt rotor, and the H-1 helicopter), and commercial helicopters OE, along with parts/repairs/maintenance/service/overhaul for 13,000 helicopter installed base

• Systems - $1.25B – unmanned systems, marine and land systems, and simulation and training solutions. Serves aerospace/aviation and defense markets

• eAviation - $45m, guided to lose $65m

• Finance - $45m – mainly offers financing for new and used Textron Aviation aircraft and Bell helicopters

Textron’s earnings have essentially gone nowhere since CY2014, and this underpins part of the skepticism built into the stock. 2015 EBITDA was ~$1.56B (adjusting out the EBITDA of an Industrial business that was divested in Q318), compared to $1.46B in 2022. Unlike most industrial companies, Textron has not been acquisitive in any significant way since Q1 of 2014 when they acquired Beechcraft for $1.4B, excepting the ~$300m Arctic Cat deal in March 2017. The table below depicts a comparison of EBIT by segment, 2022 vs. 2015.

So we have some reasonable progress in Aviation (business jets), especially considering the setback that came from the pandemic. Textron is a strong player here, and this segment is a solid anchor for the potential pure-play A&D down the road. 

Industrial has been weak over this period, though some of the drop in profit is related to a Q318 divestiture where they sold their Tools and Test business to Emerson for $807m. The March 2017 acquisition of Arctic Cat, which was losing money at the time, seems to also have dragged down margins. Meanwhile Kautex (fuel systems in automotive) has an uncertain future given the coming electrification of the global auto fleet. It is not hard to argue that these companies would be better off with other owners, while serving to minimize distractions to Textron investors.

Bell has suffered over this period, with its major military OE programs (V-22 Osprey and H-1 helicopter) and commercial deliveries both peaking in 2013 and declining sharply. Commercial is showing some life in ’21-‘23(e), with ~$600m in sales expected in ’23, but still down from $1.1B in 2013. Through this period and even before it, Bell was hard at work creating a solution for the Army as part of its Future Vertical Lift (FVL) initiative, which is the #3 modernization priority for the U.S. Armed Forces. Their announced win in December should serve as a much-needed shot in the arm, and then some, for Bell’s turnaround and for the path to pure-play A&D. More on all this below. 

Background – Future Long-Range Assault Aircraft (FLRAA)

Nearly 20 years ago, the U.S. Army began to think more seriously about what its future helicopter fleet would look like. In 2009, FVL was established by the Department of Defense (“DoD”). Through this time and continuing through the U.S. withdrawal from Afghanistan in 2021, there was considerable wear and tear on the fleet due to the harsh conditions and heavy use, while the fleet also suffered both combat and non-combat attrition. Morale has suffered, with the Black Hawk sometimes referred to as the “Crash Hawk”. These points taken together with current geopolitical threats, have added to the urgency of the issue and mean the FLRAA production is more likely to be pulled forward than pushed back.

A significant upgrade of capabilities is desired in the next generation of military aircraft. Most helicopters in the U.S. military fleet were designed many decades ago, including most notably the Black Hawk where Sikorsky made its first deliveries in the 1970’s. The Army is leading the charge to develop the Black Hawk replacement under the FLRAA banner and subsequently for a scout helicopter under the Future Attack Reconnaissance Aircraft (FARA) banner. Bell has won the larger FLRAA contract, and is still competing for FARA. The primary capability upgrade is what the Army refers to as “reach”, which is range combined with speed. The V-280 shines there, with a maximum speed of 320 mph, which compares to 183 mph for the Black Hawk and 285 for the DEFIANT X.

Key Thesis Points:

1. Bell won for very good reason, so the contract protest from Lockheed Martin/Sikorsky (expected to be resolved by the first week in April) has an even lower chance of success than the typical protest (already very low).

1. Bell’s design (the V-280 Valor) is not only better, it is importantly more familiar to the DoD. This is important both from the general comfort of the decision-makers regarding the performance of the aircraft, and also from the standpoint of greater certainty on maintenance costs. Sikorsky’s entry (DEFIANT X) has a novel design with twin rotor-blades stacked atop the helicopter (coaxial rotors). I believe there were concerns on the cost and difficulty of maintenance, to go along with generalized fear of the unknown. Bell, on the other hand, did a clever adaptation of their V-22 design that rectified several common complaints for that legacy aircraft, and gives the Army something more like a hybrid of a helicopter and a prop plane. On the V-280, the rotors tilt to convert from helicopter to prop plane, similar to the V-22, but the engine is stationary. This results in less mechanical wear and tear and lower maintenance costs. It also frees up the door-gunner who can defend the troops on approach or landing without being obstructed by a large engine on the tilted wing, an improvement relative to the V-22.

2. Video footage of the competing models in my opinion shows the V-280 to have greater maneuverability and agility, and a quicker vertical lift-off. In several videos, it demonstrates a side-to-side rocking or pendulum-type motion while hovering (something the Black Hawk lacks), giving future pilots a fighting chance if fired upon on the departure. After reviewing I believe every video that I could find of the SB-1 DEFIANT, I did not see any comparable capability in the hover mode of this competing prototype. The only operational capability that might be better on the DEFIANT is getting in and out of tighter spaces, either landing zones or something like a city street, which I think is well down the list of priorities.

In addition to the sweet dramatic music, the video below has a more extended look at the V-280's evasive maneuvers that appear to be a huge improvement in survivability with reduced vulnerability as compared to the Black Hawk

https://www.youtube.com/watch?v=T5a9Djp9gsg

Also watch this one, especially starting around 5:30. There appears to me to be a stark contrast in agility, maneuverability, and quickness in the hovering and landing tasks. Which one would you rather be in if the landing zone was under fire?

https://www.youtube.com/watch?v=_kp4xB8za5Q

3. The V-280 has already crossed the unmanned flight barrier, and can be piloted remotely for resupply missions into dangerous areas without risking the crew.

2. The FLRAA contract is likely the first of a number of large contracts. This includes my expectation that the US Navy, US Marine Corp, and our key allies in Europe, Asia, and Australia will likely follow the US Army’s lead here and leverage the considerable development expense.

It is important to note that while the Army played the lead role, the other branches have been involved in many aspects of FLRAA from the very beginning. The Navy, Air Force, and Coast Guard combined have something on the order of 650-700 Black Hawk variants compared to 2,135 for the Army. The Marine Corps would be something meaningfully incremental to the overall total of aircraft to be replaced as well, and they are the most familiar with tiltrotor and Bell given heavy use of the V-22 Osprey, which they use instead of Black Hawks as their assault aircraft. Despite not replacing Black Hawks per se, there seems to be strong interest to add the smaller, more nimble, lower maintenance profile, and more technologically advanced V-280 in some mission capacity.

Below is a 2019 article that is a good read for the general FLRAA topic and the potential for interest from other branches and even civilian applications.

https://www.thedrive.com/the-war-zone/21162/we-talk-v-280-valor-versus-v-22-osprey-with-bells-head-of-tiltrotor-systems

And below an interview with one of the Army Major Generals running the FVL program, that discusses other branches of the military being involved early.

https://www.youtube.com/watch?v=hQDKD3f2Ph4

There is also expected to be demand from our allies around the world. In awarding the contract to Bell, the Army sized it at $70 billion, including Foreign Military Sales (FMS). It makes sense that there is significant potential overseas, as Sikorsky says the global fleet of Black Hawks is more than 4,000 whereas we have only accounted above for ~2,800 or so within the US Armed Forces.

3. Jefferies did the most comprehensive work on FLRAA, deriving an estimate of $15/share for the NPV. Jefferies’ Bull case uses ~$100B of total procurement by 2050, consistent with the high-end of estimates out there in the public domain. This does not include Marines, Air Force, or Navy, and does not appear to include aftermarket revenues, the latter of which I believe could grow the overall profit pool by 20-40%. Further, share buybacks will end up making the dollar NPV be spread over far fewer shares.

Jefferies did good work back in October that is worth checking out. It sets out only to value the FLRAA contract, and does a good job of that except, arguably, the aftermarket piece and the lack of profit taxation. In scenarios laid out below, I have attempted to capture aftermarket as well as non-Army demand. At a high level, the Jefferies Bull case that results in $15 per share of value procures 1,269 V-280’s by 2050, replacing only a portion of the 2,135 Army Black Hawk fleet. For context on the global long-term opportunity, there are 4,000+ Black Hawks in the global fleet. 

My model supporting a $17.50 per share NPV is included below. Compared to Jefferies, my model includes aftermarket content on the V-280 and expected OE wins from other branches of the military, offset by adjusting for corporate taxation. I'd also note that the value will be much higher on a per share basis if Textron continues to repurchase shares at the high pace of recent years, which I exepct they will.

Note that there are some arguments that an aircraft that is 75% faster will be more efficient and therefore require fewer aircraft overall. This is likely to end up being a partial truth, however, this would not result in anything near the theoretical 40%+ reduction of the overall fleet requirement. For the important mission of moving troops and others around, the concept is likely mostly true, though complicated by maintenance intervals (which will not be 75% more efficient) and the need for some redundancy of assets. For a surveillance mission, a coordinated assault, a show of force, or all-out war, the speed of the V-280 would not necessarily result in a dramatically reduced need for fleet.

4. My read of the current geopolitical climate tells me the procurement will be faster than Jefferies modeled, and more global, given these are the aircraft we need for a conflict in the Pacific.

Tensions continue to rise between the U.S. and China with regard to Taiwan and other issues. Both sides are preparing for conflict, and some believe war is an eventuality. I can’t handicap any of that, but I can say that the V-280 Valor would be a tremendous asset and upgrade for U.S. forces there. The graphic below illustrates this, comparing the range of the V-280 with that of the UH-60 Black Hawk in the Pacific theater.

In the words of Boeing’s VP of Army Systems Tony Crutchfield “in the Pacific, it’s even more important because your lines of operation are going to be dispersed over a wide area; you’re going to have these small bases and supply lines that’ll be positioned either on ships or on islands…and build combat power faster than the enemy”

5. Having secured Bell’s long-term health with the FLRAA win and thereby brought in considerable revenue to tilt the overall mix towards Aerospace & Defense, Textron may move further in that direction via acquisition or by spinning or divesting all or part of the Industrial division. 

It is not lost on Textron management that pure-plays are awarded the highest multiples, all else being equal. Comparing to Aerospace & Defense companies, the multiple arb is significant – General Dynamics (GD) being one example of the aspirational comp here given its large business jet exposure, trades at 11.8x ’24 EBITDA vs. TXT at 8.4x.

To achieve the ‘pure-play’ status, Textron would have to separate or divest its Industrial segment, which is less than 14% of Segment EBIT. It would seem plausible to spin-off the entire division, or divest it in likely a two-step process. Kautex (auto fuel systems) is based in Germany and does not share any infrastructure – it appears to be a relatively easy carve-out situation. Finding the right home for it and getting value will be challenging but doable.  Investors are starting to ask more questions on this, and I think management is on top of it.

6. The biggest stretch, but worth considering, is that the newly developed tiltrotor technology could lead to a product in civilian and/or business aviation (at twice the speed of a helicopter and no need for a runway, there could be a disruptive opportunity here). Similarly, Bell is marketing its electric aircraft “eVTOL” product, Nexus, which has some option value as well.

This optionality is discussed in the video below. It's worth tracking and understanding over time, but hard to handicap at the moment.

https://www.youtube.com/watch?v=DxdSeLR7WI0

NPV of the V-280

At some risk of false precision, below I calculate a base case NPV of $17.50 per Textron share for the V-280 program, or ~26% of the current share price.  A few comments:

• I have included Navy and Marine Corps wins in here, though essentially in a probability-weighted way (delivering 348 vs. 800 total combined potential according to Textron). 

• Overall, I model 2,373 V-280 deliveries out to 2060, well short of replacing the 4k+ global Black Hawk fleet (not to mention replacing units that will inevitably be lost). If the geopolitical tensions globally continue to rise, and in particular if non-U.S. buyers feel compelled to grow military spend and bring their budgets to the table, deliveries could grow sooner than modeled and to ultimately higher levels than modeled. There are numerous examples around the globe of this sort of thinking. Japan, for example, plans to increase defense spending from 1% to 2% of GDP by 2027.

• In their analysis, Jefferies showed the total disbursements of the FLRAA contract of $112 billion to be ~39% of the Army’s Aircraft Procurement over the forecast period out to 2020. They argue that this level of expenditure would require a major shift in Army budgets. That may be the case, and the US Defense budget may indeed be the limiting factor that could bring down the NPV even if our Armed Forces and foreign military are clamoring for it. Certainly strange things can happen in military contracting, but this set-up, given the age of the fleet, a robust set of capability upgrades, clear support from Congress, and an enthusiastic Army leadership that has been working for 14 years on the program, I expect it will remain very high priority spending going forward.

Valuation and Return Expectations

As mentioned in the intro, I do believe investors in Textron are getting “something big for less than nothing”. By “less than nothing”, I mean that you are being paid via FCF generation and share repurchases. While collecting that, you wait for the benefits of the FLRAA win and also for the potential multiple expansion from becoming more of a pure-play Aerospace and Defense company over time.

In terms of FCF, Textron is guiding to $950m of manufacturing cash flow in 2023, down from $1,178m and $1,149m in ’22 and ’21 respectively. This year is a little lower due to expected customer deposit activity, but $1 billion is a reasonable normalized estimate. Also, Textron excludes pension funding from this number, which is reasonable especially with the pension currently overfunded to the tune of $1.1B.  Using the normalized $1B of manufacturing cash flow, Textron is trading at a 7% FCF yield. 

With shares trading well below intrinsic value and the company buying back shares aggressively, that 7% FCF yield is worth more than 7%. If you make the simplifying assumption that intrinsic value is equal to the current share price plus the estimated NPV of the V-280, then each dollar deployed in share buyback has a theoretical value of $1.26. This makes the 7% FCF yield equal to 8.8%. Add in some modest FCF growth, subtract ~1% for stock-based compensation dilution, and it is not hard to underwrite 10-11% IRR (with 1.8% of that in admittedly subjective 'return on share buybacks') before getting to any multiple expansion either from pure-play status or to discount future FLRAA earnings.

Risks

• One key risk that the market is grappling with is the impact of a recession on Textron Aviation. The GFC was not kind to the industry - revenue for delivered business jets by 2010 was down 28% from the 2008 peak, and did not regain prior peak levels until 2014. One mitigating factor for this period is the strong backlog coverage of the entire industry (generally around 2 years of backlog, including Textron). Part of the backlog strength is the fact that manufacturers have not been able to produce up to the level of demand due to supply chain issues. The large backlogs should serve to stabilize the competitive dynamic and allow for delivery schedules to be stretched out some should there be any order weakness, though a deeper recession will remain a meaningful risk.

A second mitigant could be that the industry is incrementally more of replacement market than it was in 2008, so natural retirements should be something of a stabilizing force. To illustrate, we looked at the delivery periods 15-25 years (prime retirement age) prior to ’08, and the same for 2023:

1. From 1983-1993, deliveries averaged 173 aircraft per year

2. From 1998-2008, deliveries averaged 575 aircraft per year

Said another way, the large number of deliveries in the business jet market in the years leading into 2009, are now retirement candidates. Relative to the 712 aircraft shipped in 2022 ($21.6B in revenue), the higher number of retirements is a tailwind acting against the economic weakness.

• The Defense budget could come under pressure as the U.S. government’s fiscal situation and national debt remains a big problem. A high-multiple pure-play Defense contractor could serve as some hedge on the short side.

Disclaimer: the author of this posting has a long position in the security discussed. The author reserves the right to transact in any way in the shares or to change his views without any obligation to inform anyone. Please do your own diligence and consult your financial, legal, and/or tax advisors before acting on any advice. While the author has tried to present facts it believes are accurate, the author makes no representation as to the accuracy or completeness of the analysis herein. Reader waives any cause of action against author related to the analysis above.

Catalyst

- Transaction to move towards Aerospace & Defense pure-play

- multiple expansion to discount the changed future at Bell and the large potential of the V-280 and related designs