Krause Fund Research Fall 2015 Hawkeye Pride Recommendation: BUY Research Analysts Andrew Namanny A[email protected]Connor Frischmeyer [email protected]Brandon Svac B[email protected]Coner Elliott [email protected]Company Overview Rockwell Collins Inc. (NYSE: COL) is an industry leading aircraft electronics company. Rockwell focuses on three primary business segments: government systems, commercial systems, and information management services. Some of Rockwell Collins’ most established product lines include navigation and guidance functions, cockpit displays for military jets and rotorcraft, and embedded navigation systems for guided missiles. In the most recent fiscal year, Rockwell Collins had total revenue of $4.79 billion and an earnings per share of $4.52. Stock Performance Highlights 52 week High $99.37 52 week Low $78.15 Beta Value 0.65 Average Daily Volume 604,300 Share Highlights Market Capitalization $11.49 b Shares Outstanding 131.77 m Book Value per share $14.11 EPS (2015 Q4) $5.13 P/E Ratio 17.00 Dividend Yield 1.56% Dividend Payout Ratio 24.21% Company Performance Highlights ROA 5.71% ROE 32.06% Sales $4.79 b Financial Ratios Current Ratio 1.46 Debt to Equity 2.74% Rockwell Collins Inc. (NYSE: COL) November 13, 2015 Current Price $84.11 Target Price $87-$100 COL Indicates Steady Growth A valuable acquisition – COL’s acquisition of ARINC will provide ample growth opportunities as aviation becomes more automated and systems-based. Investing in the future – COL spends roughly 4 times as much per dollar of revenue on R&D as the industry average. This investment in developing new products will create value in the high-tech avionics industry. Promising commercial market – Growth in demand for air travel in emerging markets, and the need to replace aging US and European commercial air fleets will buoy demand for avionics products in the near future. Government Systems Woes – While we remain optimistic on Rockwell Collins as a whole, potentially decreasing defense budgets and the effect of US Government sequestration will weigh on government services revenue growth in the short term. One Year Stock Performance Source: Yahoo! Finance
Company Overview Rockwell Collins Inc. (NYSE: COL) is an industry leading aircraft electronics company. Rockwell focuses on three primary business segments: government systems, commercial systems, and information management services. Some of Rockwell Collins’ most established product lines include navigation and guidance functions, cockpit displays for military jets and rotorcraft, and embedded navigation systems for guided missiles. In the most recent fiscal year, Rockwell Collins had total revenue of $4.79 billion and an earnings per share of $4.52. Stock Performance Highlights 52 week High $99.37 52 week Low $78.15 Beta Value 0.65 Average Daily Volume 604,300 Share Highlights Market Capitalization $11.49 b Shares Outstanding 131.77 m Book Value per share $14.11 EPS (2015 Q4) $5.13 P/E Ratio 17.00 Dividend Yield 1.56% Dividend Payout Ratio 24.21% Company Performance Highlights ROA 5.71% ROE 32.06% Sales $4.79 b Financial Ratios Current Ratio 1.46 Debt to Equity 2.74%
Rockwell Collins Inc. (NYSE: COL)
November 13, 2015
Current Price $84.11
Target Price $87-$100
COL Indicates Steady Growth
A valuable acquisition – COL’s acquisition of ARINC will provide ample growth opportunities as aviation becomes more automated and systems-based.
Investing in the future – COL spends roughly 4
times as much per dollar of revenue on R&D as the industry average. This investment in developing new products will create value in the high-tech avionics industry.
Promising commercial market – Growth in
demand for air travel in emerging markets, and the need to replace aging US and European commercial air fleets will buoy demand for avionics products in the near future.
Government Systems Woes – While we remain
optimistic on Rockwell Collins as a whole, potentially decreasing defense budgets and the effect of US Government sequestration will weigh on government services revenue growth in the short term.
One Year Stock Performance
Source: Yahoo! Finance
Important disclosures appear on the last page of this report. COL | 2
Executive Summary
After thorough research and valuation analysis, we have determined that Rockwell Collins’ stock is slightly undervalued, so we are issuing a BUY rating. This rating reflects our perception of COL’s growth prospects going forward as commercial systems and information management services revenues grow. Rockwell Collins has benefited, along with the rest of the commercial aerospace sector, as global economics improve following the “Great Recession”. We see further growth opportunities for COL’s commercial system unit as emerging market demand continues to grow and aging American and European air fleets are replaced with more fuel-efficient airplanes. Rockwell’s unusually large investment in research and development positions them to take advantage of these opportunities and steal market share from competitors. Although the effects of government budget sequestration and expected reductions in defense spending threaten government service revenues, we see potential growth stemming from increasing conflict with the Islamic State (ISIS). This conflict is not currently reflected in our growth rate, and may buoy demand for Rockwell’s products above current estimates.
Economic Analysis
United States Economic Analysis
Real Gross Domestic Product (GDP) Real GDP, which is the value of goods and services produced in the U.S., increased at an annual rate of 1.5 percent in the third quarter of 2015, following a 3.9 percent increase in the second quarter. Each quarter, three estimates are released; the most recent estimate (first of Q3), as of October 29th, signaled that the increase in the 3rd quarter is primarily due to a downturn in private inventory investment and decelerations in exports, in nonresidential fixed investment, in PCE, in state and local government spending, and in residential fixed investment that were partially offset by a deceleration in imports.1 The current-dollar GDP (market value of goods & services less the goods & services used in production) increased 2.7 percent to $18,034.8 billion (versus a 6.1 percent increase in Q2 2015).1 The slowing increase in GDP can be significantly attributed to the economic slowdown in China that is impacting U.S. exports and Chinese imports. As you can see below, Real GDP increased two percent Year-over-Year from 3rd Quarter 2015.2
We predict that Real GDP over the next quarter will increase approximately 2.7 percent, which we attribute to the strengthening U.S. Dollar in international markets, and we expect to see an increased demand in U.S. goods & services while China is in their slowdown. Year over year, we expect Real GDP to increase between 3-3.5 percent. The second estimate of Real GDP will be announced on November 24th, 2015. Commodities Prices Across the board, we are seeing a drop in commodities prices. With Copper Futures at their lowest trading price in six years at $2.17 spot per pound, Crude Oil down from September at $41.74/barrel, gold at its lowest in five years at $1083, and aluminum futures at $1494 per metric ton.3 Below, you can see the variation of individual commodity groups versus the total Commodity Price Index. Historically, Metals prices are equal or above the Commodity Price Index line, while Energy is more volatile to economic conditions. Currently, oil is trading near its six year lows, driving Energy below the Commodity Price Index, while Metals are still above the index line, but we are seeing a rapid decrease from their peak in 2011.4
Source: Index Mundi
Driven by China’s previous focus on investment spending, commodities were previously at a large demand, but due to the shift away from construction and heavy industry in China, demand for commodities have dropped, increasing surplus inventories, and driving prices down as well. These adjustments have heavily impacted companies like Alcoa, who is one of the leading exporters in aluminum. In order to combat the lower demand, companies like Alcoa have begun reducing their capacity in order to cut costs. We believe this will allow them to combat the declining demand, and will help drive prices for these commodities back up to regular levels in the next year. Consumer Confidence With light vehicle sales surging in recent months, reflecting the decline in gas prices, we are starting to see a return of consumer confidence with regards to purchasing. Housing has been slower to recover than vehicle sales, but with the continued tightening in the labor market should push housing up going forward.15 Since consumer sentiment increased to 93.1 in November, which beat market expectations, we are seeing that
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consumers are more optimistic over current and future conditions of the economy.5 Some speculation over general consumer confidence has been discussed, due to the U.S. drop in CCI by 5.0 pts in October from September, which had seen a moderate increase. Currently, the CCI stands at 97.6, which is based on 1985 being 100, and is down from 102.6 in September. Consumers’ optimism regarding short-term outlooks were less positive in October than September, with 18.1 percent of consumers expecting business conditions to improve over the next six months, while consumers who are expecting business conditions to worsen increased at a rate of 0.2 percent to 10.6 percent.6 We believe this is partially driven by the slowdown of the China’s economy, and the impact this has had on commodities prices. Additionally, with the announcement of the Energy and Materials sector damaging EPS growth in the 3rd quarter 2015 (GEPS: -17.0 percent, GEPS less Energy and Materials: 2.0 percent), there is a fear regarding corporate and business performance in 2015. These figures, however, are heavily influenced by the strengthening U.S. Dollar in comparison to international markets, which drove only 35 percent of companies to beat revenue estimates in the 3rd quarter.7 Exchange Rates (FX) Exchange rates are an economic indicator of strength of an individual currency in retrospect to another currency, and is useful because it illustrates the economic opportunities that consumers and investors would have by converting their wealth to another currency in comparison with their current opportunity. As you can see below, with the total value of world trade estimated to be $24.8 trillion this year, and a forecasted value of $28.7 by 2020, the strength of U.S. Currency versus Japan (122.54 Yen/USD), China (6.41 Yuan/USD) and the Euro (1.07 USD/Euro) will affect the U.S. economy.8
Source: IBISWorld
China The U.S. Dollar has strengthened significantly against the Chinese Yuan over the past 5 years, primarily driven recently by the slowdown of the Chinese economy. The increase value in USD has hurt U.S. businesses that export to China, since the buying power of the Chinese Yuan has decreased due to the slowdown.
Japan The Japanese Yen is also relatively weak compared to the USD currently, which is exchanging around 122 Yen/USD. The Yen’s strongest position against the USD in the last 5 years was in October 2011, and the current growth of the USD in FY15 could show a strengthening of the U.S. economy, and a positive sign for investors in the short-term.9 Euro The USD is predicted to continue to strengthen against the Euro due to deteriorating concerns regarding Greece and the decision not to remove them from the Eurozone. This has softened inflation partially due to the drop in global oil prices and weaker trends in commodity and food costs. Eurozone is predicted to effectively level with USD at a 1.00 exchange rate by the end of Q4 2016, according to ScotiaBank.10 Interest Rates Interest rates affect companies’ cost of capital by raising or lowering the cost of borrowing, and also influence Capital Expenditure and Mergers & Acquisitions activity, in turn affecting the profitability of the companies. Historically, higher interest rates tend to slow down the economy and decrease demand for industrial products, while lower interest rates stimulate the economy. Following the hawkish tone of the U.S. Federal Reserve’s meeting in October, we believe that they will increase both short-term and long-term Federal Funds rates in December 2015. Historically, the short-term yield rate is expected to increase more than the long-term yield rate, since the short-term rate is more driven by a country’s Central Bank, while the long-term rate is generally influenced by more international factors. This will level the projected yield curve, flattening the variance between short-term and long-term bond yields. As the following graph demonstrates, we are currently at a historically low Federal Funds Rate. The rate was lowered by the Federal Reserve in order to combat the recession and financial crisis of 2009, however we are starting to see economic improvement since 2009, leading the Federal Reserve to consider raising the rates.11
The largest concern with this adjustment is the current inflationary rate, since many analysts are concerned that we are underestimating the current rate of inflation, and the Federal Reserve will need to take that into account come December. Currently, inflation is assumed at a zero percent, suggesting no
Important disclosures appear on the last page of this report. COL | 4
change in inflation for one year from September 2014 to 2015.12 If inflation is higher than estimated, the Federal Reserve will have to take that into account in their new interest rate. According to Janet Yellen, the Federal Reserve would like to see inflation moving toward the annual two percent target before raising rates.13 If the Federal Reserve decides to increase interest rates in December, it will cause increased volatility in the equity markets, however after 2-3 months we believe the markets will return to current levels on an uphill slope. With the last three rate hike cycles, equity prices have fallen when the Federal Reserve increased rates, yet in following months equity prices move higher as the better economic data is processed by the markets.15 The Fixed Assets market will be more heavily influenced by the change, and have already began to reflect a higher yield demand for both short-term and long-term bonds. Historically, the Federal Reserve’s increase leads to higher short-term bond yield, due to investors selling them in anticipation of the Federal Reserve rate hike. Unemployment On a macroeconomic scale, U.S. unemployment numbers appear favorable in the short term. Unemployment has steadily decreased over the last nine quarters, and currently sits at 5.0 percent.14 This 5.0 percent compares favorably with the average over the past 15 years of 6.1 percent, which captures recessions beginning in 2001 and 2008.15 Over the last year, unemployment has remained relatively unchanged, with a decrease of only 0.7 percent from October 2014. For the time being, we do not predict any change in the unemployment rate in the United States, however there is the opportunity for unemployment to rise in the future. Traditionally, unemployment is a lagging indicator of the economy, so we can expect to see an increase in unemployment if we see the economy improving. The cyclicality of this issue is that if unemployment rises, more people will theoretically apply for unemployment benefits, raising tax rates to compensate for these individuals, and an increase in taxes leads to less disposable income, both of which draw money out of the economy. However, as aforementioned, we do not believe there will be an immediate change in unemployment, and the above concerns address a further outlook on the economy.
International Markets Economic Analysis China The current economic slowdown occurring in China has impacted the global economy. The transition from a manufacturing and industrial centered economy to a consumer-focused one has led to a decrease in imports of commodities and industrial materials. The decrease in commodities imports by China is effecting the various emerging markets around the world, including Brazil and Russia, who specialize in mining exports. The recent slowdown in China’s GDP growth has caught up with this industry, after several years of capacity growth in order to fill China’s historically growing demand for
commodities since 2000.23 In order to combat the lower demand for aluminum, China has imposed a 15 percent duty rate on exports of aluminum ingots, which they believe will help prevent economic turmoil in these emerging markets, and force more Chinese producers to keep their business within China, reducing supply to the rest of the markets from China.16 Additionally, the slowdown is effecting the emerging markets in Korea, Taiwan and Singapore, who are heavily technology focused and thrive off of Chinese manufacturing. Analysts at JP Morgan believe that the build-up is slowing down, which presents a positive outlook for the Chinese economy in upcoming years.17 With regards to the United States Equity market, China’s change will not likely effect the US economy as much as some would think, since the United States only accounts for about 1 percent of China’s imports. Likewise, the European markets only account for 1.5 percent of Chinese imports, so there will not be much of an effect on those markets by the slowdown as well. The Central Bank of China has yet to utilize monetary policy to soften the impact of their slowdown. They have yet to lower interest rates and bank reserve requirements, which would stimulate lending in China; however it does not seem likely that they will be using it given their recently announced 5-year plan to stabilize growth. Eurozone The Eurozone is finally seeing recovery from complications with Greece earlier this year. Demand for housing and commercial building loans have increased in recent months, signaling an increased consumer confidence. The Bank of England has taken a dovish approach to changing interest rates, which signals their belief that they have not completely recovered from economic turmoil. However, this will benefit the United States because the Federal Reserve typically will not increase interest rates if other countries are adjusting theirs as well.18
Capital Markets Outlook Based on the previously discussed economic factors, we believe that the aerospace & defense sector will continue to perform strongly in the short-term and long run, based on strong demand for commercial aircraft from emerging markets such as the Middle East and Asia-Pacific region. On the contrary, one thing that worries us in regards to the aerospace sector is the tightening of government spending. However, with the increase in violence produced by the Islamic State, we could soon see a change in the planned reduction of government spending. It is especially clear that U.S. companies will continue to dominate the A&D sector as nearly 60% of the sector is composed of American companies.47 The global commercial aerospace sector is expected to sustain its significant revenue and earnings growth, underlined by extended record-setting production levels both at the platform and in the supplier base.
Important disclosures appear on the last page of this report. COL | 5
Additionally, the markets are expected to see significant volatility following an increase in the Federal Funds Rate, which will exaggerate the short-term volatility of returns in this sector.
Industry Analysis Industry Description The New York Times defines the Aerospace and Defense Sector as consisting of companies engaged in the production of spacecraft’s and commercial, military and private aircrafts. The industry also includes manufacturers of military equipment, such as tanks and related vehicles, bombs, missiles, associated navigational and guidance systems, artillery, ammunition and other related weaponry.19 This industry is heavily contracts based, and it requires significant capital to develop and manufacture advanced avionics equipment which provides a barrier to entry for new competition. While over 50 percent of commercial aviation products are exported, licenses to supply products to governments are rarely issued to foreign firms and domestic firms need to demonstrate a high level of corporate governance to win contract agreements. Governments tend to favor contractors that have a long history of work, rarely awarding contracts to new comers.35 Major players in the industry include: Honeywell, Lockheed Martin, Northrop Grumman Corp, Raytheon, Rockwell Collins and others. Revenues in commercial aerospace tend to be driven by global economics, as more robust economies lead to increased travel demand. Defense, on the other hand, is driven by defense spending budgets and international military activity.
Industry Trends Government Budget Sequestration Government services will likely see a decrease in revenues reflecting US government budget battles and the effects of sequestration. A recently forged congressional budget agreement offsets $22 billion of the $52 billion of mandated FY 14 defense sequestration cuts, as well as $9 billion of FY 15 cuts, resulting in base defense budget spending levels around flat with FY 13 for the next several years. The FY 15 Dept. of Defense budget submission incorporating sequestration cuts should improve overall contractor visibility and could spark a return of M&A activity, although it also means specific program cuts will need to be digested.32 Momentum In 2012, the U.S. aerospace industry contributed $118.5 billion in export sales towards the U.S. economy. The positive trade balance of $70.5 billion is the largest trade surplus of any manufacturing industry and came from exporting 64.3 percent of all aerospace production.34 Aerospace exports employ more jobs than the export of any other commodity. On top of this, the US is the largest aerospace market in the world. It is estimated that there will be a 3.5 percent increase per year in the number of large commercial planes per year over the next 20 years, which comes to a total value of $4.5 trillion.
Major Players We will be focusing on Lockheed Martin ($64.22B MKT CP), Honeywell ($77.90B MKT CP), Raytheon ($36.66 MKT CP), Northrop Grumman Corp ($31.58B MKT CP), and Rockwell Collins ($11.15B MKT CP) as some of the biggest players in this industry. These companies compete on price as well as innovation and service on existing products. Research & Development Research and development is one of the key drivers of value in this industry as avionics products tend to be on the cutting edge of innovation, particularly in the government sector. When we compared our main contributors across research and development we found an industry average of less than 5 percent of revenues. Rockwell Collins stands out as a clear leader in investment in R&D at 16 percent of revenues.
Source: Bloomberg
EBITDA We also evaluated our peer companies EBITDA margins expecting similar margins due to pricing transparency and contract-based revenues. Industry average margins are around 15-18 percent, with Rockwell Collins standing out at 23.1 percent.
Source: Bloomberg
Capital Expenditures CapEx as a percent of revenue also provided us insight into reinvestment requirements across the industry. Capex on average represents 2.3 percent of revenues in the avionics industry.
0%
5%
10%
15%
20%
Honeywell RockwellCollins
LockheedMartin
Raytheon Northrop
R&D as % of Revenue
0
5
10
15
20
25
Honeywell RockwellCollins
LockheedMartin
Raytheon Northrop
EBITDA Margin
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Source: Bloomberg
Competitive Rivalry Competition in this industry is moderate, and drops significantly as you move into more sophisticated products. There are a handful of key competitors that hold most government contracts, and Boeing and Airbus tend to award contracts to a relatively small sub-unit of companies as well. Honeywell represents approximately 2 percent of both Boeing and Airbus costs, and most of the avionics expense for both companies. Threat of Substitution There is a low to moderate threat of substitution in the Aerospace and Defense industry as it represents an integral part of military actions globally, and a significant portion of civilian travel. Potential substitutes are slim on the government services side, while in commercial systems we see the automotive industry as a main threat. Threat of New Entry Threat of new entry in the aerospace and defense sector is low because of high levels of required capital, patents, and the extensive use of service contracts in this industry. There is a significant amount of R&D as well as manufacturing expenses required to develop and build avionics products. Also, most avionics products are supplied on a contracts basis, and contracts tend to be awarded to large companies with a history of successfully filling orders. There is a high level of contract rollover in this industry. Industry Demand The global commercial aerospace sector is expected to sustain its significant revenue and earnings growth in 2015, underlined by extended record-setting production levels both at the platform and in the supplier base.3 This growth is likely to be driven primarily by increased production rates due to the accelerated replacement cycle of obsolete aircraft with next generation fuel efficient aircraft, as well as the continued increases in passenger travel demand, especially in the Middle East and the Asia-Pacific region. 32 Passenger and freight air travel is increasing dramatically abroad. Passenger travel is expected to increase 5.0 percent for the next 20 years, resulting in a need for increase in aircraft production.32
Company Analysis
Company Overview Rockwell Collins, a $5 billion revenue global company, focuses on aircraft electronics (avionics). Its business is conducted through three different segments- commercial systems (CS), government systems (GS), and information management services (IMS). In 2014, Rockwell produced total sales of $4.97 billion, $4.52 earnings per share, and capital expenditures of $163 million.36 Although the company has performed strongly in the past year, COL has not outperformed the S&P 500 since the middle of 2010.
Source: AmigoBulls
Business Segments Commercial Systems is primarily responsible for producing flight deck electronic systems. CS also performs a wide range of repair and overhaul services. Commercial system accounts for 46 percent of all Rockwell Collins revenues37. Products within the CS segment include integrated avionics systems, integrated cabin electronics systems to create a more enjoyable flight, landing sensors, situational awareness and surveillance systems such as enhanced vision, training simulators and weather radar. Maintenance repair for Rockwell customers is also a large part of the CS department. Government systems, which accounts for 44 percent of revenues, is responsible for producing communication systems, navigation systems, avionics, and cockpit displays for military jets and rotorcraft. GS also produces navigation equipment that is embedded in guided missiles. This department combines flight operations with navigation and guidance functions, cockpit display systems, and helmet-mounted displays providing the pilot a 360-degree view of their perimeter to limit response time. Information management services, their third and final segment, accounts for 10 percent of all revenues. IMS is a provider of communication, engineering, and systems integration support.37
0%
1%
2%
3%
4%
Honeywell RockwellCollins
LockheedMartin
Raytheon Northrop
CapEx as % of Revenue
Important disclosures appear on the last page of this report. COL | 7
Source: Bloomberg
Establishing a Global Presence Rockwell Collins is established globally. Some of their biggest customers include the U.S. Department of Defense, U.S. Coast Guard, civil agencies, airports, defense contractors, foreign ministries of defense, manufacturers of commercial air transport, business and regional aircraft, commercial airlines, the FAA, critical infrastructure operators, and major passenger and freight railroads.38 Rockwell utilizes a worldwide dealer network to distribute products and international sales representatives to assist with international sales and marketing. It is important to note that international sales increased 20 percent in the most recent year, growing to 38 percent of COL’s total revenue. Expanding globally is a one of Rockwell’s most important goals.39 Acquisition On December 23, 2013, Rockwell Collins acquired ARINC for $1.39 billion, which was the largest acquisition in company history. The acquisition was funded through a combination of new long-term debt and short-term commercial paper borrowings. This deal positioned Rockwell to become a leader in the fast growing aviation information segment. In the three quarters that ARINC has been part of Rockwell Collins, the IMS business contributed $421 million in additional revenue to their top line. This represents a 946 percent increase from the previous year. Commercial systems represents over 85 percent of ARINC revenues32. With their recent acquisition, Rockwell has made a clear effort to put more time and resources into IMS and CS rather than GS. We believe that governmental systems revenue will decrease 2 percent in the near term. However, IMS will increase 14 percent as a direct result of Rockwell Collins’ most recent acquisition. Catalysts for Growth/Change As you can see in the chart below, fiscal year 2014 saw a revenue increase of 11 percent, bringing total revenue to $4.97 billion. COL saw a 6 percent increase in commercial systems sales, bringing the total for that department to $2.3 billion.
Source: COL 10-K
This change was driven by an increase in deliveries of air transport aircraft and higher customer-funded development in business and regional aviation. Government Systems sales experienced a 2 percent decline to $2.2 billion. GS is a major concern for Rockwell - especially with the 2016 presidential election approaching. Although the Department of Defense’s budget remains steady, Rockwell’s revenue obtained from governmental services continues to decrease year over year. We expect to growth of 0.5 percent in Rockwell Collins’ commercial systems unit. Trade association IATA estimates global passenger air traffic grew 5.9 percent in 2014 after growing 5.2 percent for 2013, and sees growth of 7.0 percent in 2015.40 This change comes from an increasing recovery in world markets and economies. We expect to see an increase in demand for commercial jets fueled by growth in three areas. The first factor is demand from emerging markets, such as Asia, the Middle East, Eastern Europe, and Latin America. Many airlines in these regions have remained profitable, and fleet sizes must rise to accommodate increased demand. It is estimated that global airlines will need 38,050 airplanes over the next 20 years, which comes in at a valuation of more than $5.6 trillion46. The second growth area is the need among airlines to replace aging and less fuel-efficient planes to address rising fuel prices. Although the price of oil is about 27 percent below its mid-2008 peak (and jet fuel is about 42 percent below its peak), prices remain persistently high, and many believe the supply-demand balance for petroleum favors a return to higher oil prices in the future. The two regions with the oldest (and largest) air fleets are the US and Western Europe40. Lastly, as technology continues to advance, airplanes will need to be updated with the latest systems.
Combined Boeing and Airbus orders set new records in 2014 and backlogs continue to grow, now containing around eight years of production. Both companies have announced continued production increases over the next several years and new model introduction40. The highest level of orders since 1970 was recorded in 2013, totaling 3,032 units. In 2014, orders dropped slightly by 0.9 percent to reach 3,006 units40. While large sums of money from both base and supplementary defense budgets are still benefiting contractors, it is important to note that shrinking wartime funding, pressure from a large U.S. federal budget deficit, and the impact of sequestration are squeezing profits in the government systems space. However, Rockwell Collins has made large cutbacks at their facilities, which should keep EPS even on the defense side.
S.W.O.T. Analysis Strengths Diversified Business Model Rockwell Collins sells across three separate platforms: Commercial Systems, Government Systems, and Information Management Services.41 Revenue from one area can help offset lackluster performance from another area of their business. Commercial Systems accounts for roughly 44 percent of Rockwell’s revenue, while Government Systems makes up about 46 percent.42 Information Management Services is a fairly new business that developed out of their acquisitions of
$2,299 , 46%$2,209 ,
44%
$471 , 10%
Revenue by Department 2014 (in millions)
CommercialSystems
GovernmentSystems
InformationManagementServices
Sales 2014 2013 2012
U.S. $ 2,993 $ 2,827 $ 2,994
Non-U.S. $ 1,986 $ 1,647 $ 1,537
Total $ 4,979 $ 4,474 $ 4,531
Important disclosures appear on the last page of this report. COL | 8
ARINC and Pacific Avionics and accounts for 10 percent of Rockwell’s business.43 Research and Development Rockwell Collins spent approximately $1 billion on R&D in Fiscal 2014.39 This came out to be 16 percent of total revenue. In comparison – Lockheed Martin, a direct competitor, spent 1.6 percent of total revenues on research and development in the same fiscal year. COL is truly committed to producing and obtaining some of the best professionals and research in the industry Weaknesses Concentrated Customer Base Rockwell Collins relies heavily on fixed government contracts. With defense spending scaling back in the coming years this may become a problem. The aerospace industry also has only two main companies in the commercial sector: Boeing and Airbus. Lack of Bargaining Power Rockwell’s customers possess a great deal of information pertaining to the costs of Rockwell’s products across the industry and can leverage this knowledge to negotiate prices down. Opportunities Backlog Rockwell has a growing backlog, which should provide steady revenue growth and shows substantial demand for its products. As of June 30th 2015, Rockwell had a backlog of 5 million.43 This is an increase from 3 million in June of 2014. Rockwell’s customers Boeing and Airbus also have large backlogs.44 Increased use of Unmanned Air Vehicles The Department of Defense projects that the percentage of unmanned vehicles will grow from 25 percent today to 70 percent of the DoD fleet by 2035.45 Additionally, with an increasing security threat from the Islamic State (ISIS), Rockwell may see an increasing demand for UAVs in the near term. President Obama indicated reluctance to put troops on the ground, and an inclination to attack remotely. Rockwell expects growth in its Airborne Solutions/Avionics division with the increased use of Unmanned Air Vehicles.45 Threats Fixed Contracts Rockwell’s customers have strong bargaining power, and if costs begin to mount on a project, Rockwell may find itself losing money. Small Market Share Several of Rockwell Collin’s main competitors are larger both in size and scale, making it difficult for Rockwell to win large contracts. Currently they hold 7.39 percent of market share in commercial systems and only 2.71 percent of market share in government systems.42 Supplier Restrictions Although Rockwell has a number of suppliers, it relies heavily on critical suppliers and subcontractors for specific products,
and it does not always have an alternate supply source immediately available. An issue on a supplier’s end could severely affect the operations of COL.44 Overall this is not a large concern as we found 41 suppliers with average cost per supplier around 0.5 percent indicating that Rockwell is not heavily reliant on any one supplier for most of its products.36
Valuation Analysis Valuation Summary We recommend a BUY rating for Rockwell Collins Inc. We arrived at our decision after completing multiple valuation techniques including a dividend discount model, enterprise DCF, economic profit valuation, and relative valuation. The DCF and EP models reflect a positive outlook for Rockwell Collins. These two models produced an intrinsic value of $91.50, which is roughly 9 percent higher than the current stock price. Revenue Decomposition Rockwell Collins generates revenue in three different segments – government systems, commercial systems, and information management services. As government spending continues to tighten, Rockwell may see declining revenues in that division. The DoD’s budget has been in the spotlight recently, and tax payers are demanding reduced spending. With this decrease in funding, we believe that Rockwell’s government systems segment will see a decrease in revenues of 2.28 percent in the next fiscal year. As demand for commercial planes continues to increase, we forecast growth of 4.32 percent in Rockwell’s commercial systems group. This assumption stems from an analysis of the demand for airplanes currently. In addition, as new technological advancements occur, aircraft carriers will seek to update their fleets with higher fuel efficiency and more accurate navigation and weather systems. The International Air Transport Association (IATA) estimates that global passenger air traffic grew 5.9 percent in 2014 and foresees growth of 7.0 percent in 2015. With their recent acquisition of ARINC for $1.39 billion, Rockwell’s information management services group will see a large increase in revenues going forward. This acquisition positioned COL to become a serious player in the IMS industry. In the three quarters of 2014 that ARINC was a part of Rockwell’s operations, they saw an increase $421 million in their top line. We expect Rockwell Collins will see an increase of 14 percent in their information services revenue next fiscal year. Income Statement Assumptions COGS We forecast cost of goods sold as a constant percentage of revenues similar to current COGS expense at 69.65 percent.
Important disclosures appear on the last page of this report. COL | 9
Interest Expense Rockwell’s recent acquisition of ARINC was financed entirely with debt, adding significantly to their interest expense from 0.63 percent of revenues in 2013 to a projected 2.04 percent of revenues in 2015. We project a decreasing interest expense as a percent of revenues after 2015 as COL returns to their normal capital structure. Balance Sheet Assumptions Capital Expenditures As Rockwell continues to introduce new methods to bring in revenue, especially with the decrease in government systems, we foresee an increase of 13 percent in the next fiscal year. By obtaining new investments, Rockwell will continue to position itself as an industry leader – especially in the newly established information management services department. Long-Term Debt Long term debt will increase at large percentage this year and then slowly decrease as Rockwell Collins continues to pay off their long term debt from acquiring ARINC. This deal was financed primarily from debt. LTD will increase by 3.4 percent in the upcoming year and then in the years after will increase at a decreasing rate. Common Stock Over the past five years, Rockwell has seen a steady increase of 1.3 percent in their common stock account. We project to see an annual increase of 1.25 percent in Rockwell Collins’ common stock account over the next five years. Weighted Average Cost of Capital (WACC) Cost of Equity To determine the cost of equity, we used the capital asset pricing model. We determined a raw beta of 0.65 by using the four year weekly historical average. We believed this was an accurate beta given Rockwell Collins’ current operations. Cost of Debt When determining the pre-tax cost of debt for Rockwell Collins, we used the 22-year bond yield of 4.80 percent. This resulted in an after-tax cost of debt of 3.12 percent. Target Capital Structure When determining the current book value of debt and current market value of equity, we kept the capital structure constant when forecasting out for the next few years. By doing so, we arrived at an 83.76 percent equity weighting and a 16.24 percent for debt. The weight of debt includes LT debt, ST debt, and the PV of operating leases. By using these calculations, we produced a weighted average cost of capital of 5.59 percent DCF & EP Valuation The discounted cash flows and economic profit valuation techniques produced an intrinsic value of $91.50 for Rockwell Collins. This price is roughly 9 percent higher than current price, indicating an opportunity for investment.
The stock price of $91.50 is a result of high avionics demand within the foreseeable future. Between the increase in commercial demand and recent efforts to focus on building up their information management services, we believe that this price correctly reflects the direction in which Rockwell Collins is headed. Dividend Discount Model (DDM) The dividend discount model provided an intrinsic value of $97.82 as of November 13, 2015. This model, which we believe to be an accurate representation of their stock price, provides further evidence that Rockwell Collins is a good opportunity for investment. Rockwell, while not required, has increased their dividend between 6 and 12 percent every two years. This dividend increase symbolizes Rockwell Collins’ commitment to shareowner maximization. With Rockwell’s consistent increase in dividend, we find the DDM to be a valuable consideration when evaluating the stock price of COL. Relative P/E Valuation By using Yahoo! Finance and Bloomberg we were able to identify companies whose operations are similar to Rockwell Collins’. The companies used in our relative P/E model were Raytheon Company, Lockheed Martin Corp., Harris Corporation, Northrop Grumman Corp., and Honeywell International Inc. The model generated an average P/E ratio of 17.5. When multiplied by our forecasted EPS for 2015 our model generated a value of $83.58. Using the forecasted EPS for 2016 our model generated a stock price of $81.55. The PEG ratio produced values of $49.98 per share based on our 2015 EPS estimates, and $47.70 per share based on 2016 EPS estimates. These low intrinsic values produced from the PEG ratio are due to the low EPS estimates compared to Rockwell Collins’ competitors. This could produce a concern for investors.
Sensitivity Analysis To ensure the accuracy of our model's intrinsic price calculation we conducted a sensitivity analysis on 8 key assumptions within our model. We tested the model's response to changes in beta, the risk-free rate, market risk premium, effective tax rate, cost of sales assumption, SG&A assumption, CV growth rate, and CV ROIC. Using the results of our sensitivity analysis, we have determined a target range for the stock price of Rockwell Collins. Beta We used COL’s 4-year weekly beta of 0.65 in relation to the S&P 500 Index. This calculation is important in our model as equity represents 83.76 percent of Rockwell Collin’s capital structure. Small changes in our beta result in large discrepancies in our DCF price. A .05 decrease in beta results in a 6.23 percent increase in our stock price, and a .05 increase results in a 5.66 percent decrease in stock price. However, we do not anticipate fluctuation in Rockwell’s beta because it is in a mature and contracts based industry. We are confident in the accuracy of our beta.
Important disclosures appear on the last page of this report. COL | 10
Risk-free Rate With an increase in the federal funds rate likely in the near future, we see a risk to our valuation based on changes in the risk-free rate. We chose 3.06 percent as our risk free rate as it represents the yield-to-maturity on outstanding 30-year treasury bonds according to Bloomberg. Our model is sensitive to the risk-free rate assumption, and a 0.25 percent increase in the rate results in a 6.55 percent decrease in our stock price. This is a significant concern in our valuation. We do not see a decrease in the risk-free rate as likely in the near term. Tax Rate We tested our model’s sensitivity to changes in the effective tax rate as it can fluctuate on an annual basis. Our model is not sensitive to changing tax rates, and an increase of 3 percent in the effective tax rate results in only a 0.76 percent decrease in our implied intrinsic price. Likewise, a decrease of 3 percent in the rate results in only a 0.75 percent increase in our stock price. We are not concerned with changes in Rockwell’s effective tax rate. Market Risk Premium Changing market risk premium poses a significant risk to our valuation. Similar to our concern with beta, MRP poses a threat to our valuation because of Rockwell’s large amount of equity in their capital structure. We used Damodaran’s 4.62 percent as our MRP as we believe it represents the average future risk premium in the market. An increase of 0.5 percent in the MRP results in a 7.83 percent decrease in our implied value, and a decrease of 0.5 percent in MRP, an 8.94 percent increase. Cost of Sales and SG&A Cost of Sales and SG&A as a percentage of revenue represented two of the largest expenses in our model. We tested the sensitivity of our valuation to each of these expenses and found that they had little effect on our implied equity price. On average, an increase of 0.25 percent in these expenses resulted in less than a 3 percent decrease in our stock price and vice versa. Rockwell’s operating expenses and COGS have remained fairly stable historically as a percentage of revenues, and we expect that trend to continue in the future. Therefore, we do not see COGS or SG&A expenses as significant risks to our valuation. CV Growth A key assumption in our model is a 2.0 percent annual growth rate in Rockwell’s NOPLAT. This reflects operation in a mature industry, anticipated decline in revenues for the government services division of Rockwell’s business, and an optimistic outlook for commercial systems following their acquisition of ARINC. A 0.25 percent increase in projected CV NOPLAT growth results in a 5.6 percent increase in implied stock price, while a 0.25 percent decrease shows a 4.9 percent decrease. CV ROIC
Rockwell operates in a capital intensive industry, and therefore we expect a 16.37 percent CV ROIC. Because The Company’s ROIC is relatively low, changes in ROIC have little effect on implied equity value. Even an increase of 1 percent to Rockwell’s CV ROIC results in only a 0.62 percent increase in implied stock price. We do not see CV ROIC as a risk to our valuation.
Important Disclaimer
This report was created by students enrolled in the Security Analysis (6F:112) class at the University of Iowa. The report was originally created to offer an internal investment recommendation for the University of Iowa Krause Fund and its advisory board. The report also provides potential employers and other interested parties an example of the students’ skills, knowledge and abilities. Members of the Krause Fund are not registered investment advisors, brokers or officially licensed financial professionals. The investment advice contained in this report does not represent an offer or solicitation to buy or sell any of the securities mentioned. Unless otherwise noted, facts and figures included in this report are from publicly available sources. This report is not a complete compilation of data, and its accuracy is not guaranteed. From time to time, the University of Iowa, its faculty, staff, students, or the Krause Fund may hold a financial interest in the companies mentioned in this report.
13 USA Today | http://www.usatoday.com/story/money/markets/2015/02/25/yellen-house-testimony/23962867/
14 Bureau of Labor Statistics | http://www.bls.gov/news.release/empsit.nr0.htm 15 Bureau of Labor Statistics | http://data.bls.gov/pdq/SurveyOutputServlet 16 Customs | http://service.customs.gov.cn/default.aspx?tabid=9409 17 Guide to the Markets. Dr. David Kelly. 4Q 2015. JP Morgan Asset
Management
18 The Fabricator | http://www.thefabricator.com/article/shopmanagement/2015-metal-fabrication-forecast-steady-as-she-grows-article
Fiscal Years Ending Sept. 30th 2012 2013 2014 Operating Activities Net Income 609 632 604
Income (loss) from discontinued operations, net of tax 20 2 ‐14 Income from continuing operations 589 630 618 Adjustments
Restructuring 65 0 9 Gain on sale of business 0 0 ‐10 Depreciation 116 124 141 Amortization of intangible assets 54 53 84 Stock‐based compensation expense 24 20 24 Compensation and benefits paid in common stock 69 53 50 Excess tax benefit from stock‐based compensation ‐9 ‐9 ‐6 Deferred income taxes 102 55 113 Pension plan contributions ‐126 ‐122 ‐75 Changes in assets and liabilities
Receivables ‐26 ‐97 67 Production inventory ‐70 ‐96 ‐84 Pre‐production engineering costs ‐141 ‐170 ‐198 Accounts Payable ‐27 14 23 Compensation and benefits ‐75 33 ‐60 Advance payments from customers 23 32 ‐11 Accrued customer incentives 46 10 18 Product warranty costs ‐21 ‐5 ‐14 Income taxes ‐63 70 ‐21 Other assets and liabilities ‐16 ‐2 ‐8
Cash Provided by Operating Activites 513 593 660 Investing Activities Property additions ‐138 ‐120 ‐163 Acqusitions of businesses, net of cash acquired 0 0 ‐1405 Proceeds from the disposition of property 17 3 0 Acqusition of intangible assets ‐4 ‐1 ‐1 Proceeds from business divestitures ‐3 0 24 Other investing activities ‐1 0 8
Cash Used for Investing Activities ‐129 ‐118 ‐1537 Financing Activities Purchases of treasury stock ‐714 ‐589 ‐211 Cash dividends ‐157 ‐164 ‐162 Repayment of short‐term borrowings 0 0 ‐200 Increase in short‐term commercial paper borrowings, net 0 235 269 Increase in long‐term borrowings 247 0 1089 Proceeds form the exercise of stock options 21 61 37 Excess tax benefit from stock‐based compensation 9 9 6 Other financing activities 0 0 ‐1
Cash Provided (Used for) Financing Activites ‐594 ‐448 827 Effect of exchange rate chagnes on cash and cash equivalents ‐6 5 ‐12 Cash provided by (used for) discontinued operations
Beginning Invested Capital 3857 3890 3929 3957 3990 4035
ROIC 23% 16% 16% 16% 16% 16%
WACC 5.59% 5.59% 5.59% 5.59% 5.59% 5.59%
Economic Profit 672 423 412 419 430 435
Continuing Value 12136
Number of Periods to Discount 1 2 3 4 5 5
Present Value 637 379 350 337 328 9248
PV of Economic Profit 11279
Plus: Beginning Invested Capital 3857 Value of Operations 15136 Add: Income Tax Assets 306 Add: Other Assets 370 Less: Short Term Debt 483 Less: PV of Operating Leases 734 Less: ESOPs 35 Less: Long Term Debt 1721 Less: Retirement Obligations 968 Less: Other Liabilities 182
Value of Equity 11690
Shares Outstanding, Millions 133 Instrinsic Value 87.96 ‐ Partial Year Adjustment 91.50
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COL | 21
Rockwell Collins Inc.
Dividend Discount Model (DDM) or Fundamental P/E Valuation Model
