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Morningstar | Textron's 3Q Disappoints Because the Arctic Cat Acquisition Came With Fleas

No-moat Textron reported third-quarter results that missed consensus expectations due primarily to challenges integrating the Arctic Cat acquisition. Management knocked 5 cents off the high end of its 2018 EPS guide, while adding 5 cents to the bottom end. The new EPS range stands at $3.20-$3.30; consensus was at $3.34 going into the call. But Textron stuck with midpoint cash flow guidance of $800 million. Despite shares falling 10%, we're only trimming our fair value by $1 per share (to $55) due to slightly lower 2018 profitability than we initially anticipated and weakness at Arctic Cat persisting through most of 2019.

Revenue fell about 8% year over year driven by the divestment of Tools & Test in the Industrial segment and lower military ground vehicle production volumes (TAPV program) in the Systems segment. Aviation saw revenue fall 1.8% year over year, as flat jet deliveries combined with lower turboprop deliveries weighed on the segment's top line. Encouragingly, backlog increased $200 million at Aviation and this plus the massive NetJets deal for 175 Longitude and 150 Hemisphere jets earlier this week  (not yet in backlog) indicates to us that a business jet recovery is gaining traction. Despite delivering more helicopters this quarter (43 versus 39 last year), Bell Helicopter revenues were down 5.2% due to fewer 412 and 429 models.

EPS skyrocketed to $2.26 thanks to a large gain on the Tools & Test divestment. Controlling for the divestment results in $0.66 cents of EPS, up 6 cents versus last year thanks to lower taxes and fewer shares. Operating margins at the segment level contracted to 7.7%, from 8.5% last year. The Arctic Cat acquisition drove this contraction due to pricing pressures related to discounting in certain channels, which led to industrial margins collapsing 470 basis points year over year. On the other hand, Bell and Aviation margins expanded, with the former putting in a nice quarter, achieving 160 basis points of expansion.

Management indicated that the Artic Cat problems in the Industrial segment will likely persist for the next 12 months and that most of the issues are on the dirt side of the business, which augurs well for the winter season. While we're not anticipating another quarter like this one where profits completely collapse, we do think getting handle on distribution channels for Arctic Cat products will continue to weigh on results going forward and we've incorporated this into our 2019 projections.

At the same time, Textron's Industrial segment has a new head, Scott Ernest, who had been leading the Aviation business, and he will have his hands full with Arctic Cat, but we think he's the right executive for the job. Although Ernest's GE pedigree is a little less impressive now, his track record at Aviation is excellent and he can point to successfully integrating Hawker Beechcraft when it was acquired in 2014, while also transforming the segment into a high-end jet manufacturer. As an aside, we think Ernest's move into the Industrial business means Textron won't be contemplating a divestment of its non-aerospace and defense business any time soon.