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Company, Industry, and Competition Rockwell Collins, Incorporated operates in Cedar Rapids, Iowa where it is a leader in the aerospace and defense industry. The company provides the design, production, and support of communication and aviation electronics to government and commercial customers. Though much of the company’s focus is on aviation systems, it also develops systems for ground and shipboard applications. For its governmental business branch, Rockwell Collins supplies defense communication and defense electronic solutions for the U.S. Department of Defense, as well as other foreign nations and manufacturers of military equipment. The commercial systems business supplies aviation electronics systems and products to commercial airlines, regional airlines, jet operators and manufacturers of commercial airlines. Rockwell has expanded its operations into more than 60 locations in 27 nations. A large portion of the company’s business is from international customers, including South Africa, Europe, Australia, Asia and Brazil. In order to expand its operations, Rockwell focuses on acquiring new businesses. Several key acquisitions within the past ten years, include Evans & Sutherland’s simulation business, TELDIX, NLX and Kaiser Aerospace and Electronics Corporation. The Aerospace and Defense industry is continually growing due to the need of updated aviation electronics and support systems. The industry focuses on catering to military and commercial electronics systems. According to the February 26th issue of the Wall Street Journal, over the past five years of returns the industry ranks 13th out of 75 rated industries, with a return of 16.3%. This makes the Aerospace and Defense Industry a superior industry when compared to the majority. Also noted in this issue, out of all companies in their respective industry Rockwell Collins rates second in five-year average returns with a return of 28.2%. Some of the largest competitors within the industry, based on market capitalization, include: Lockheed Martin Corporation, Honeywell International, General Dynamics, and Precision Castparts Corp. Rockwell holds the eighth-highest market capitalization within an industry consisting of 70 companies. The industry has a lower five-year sales growth rate than the S&P 500, with rates of 10.58% and 13.30%, respectively. Though the current operating margin trails the S&P (8.98 compared to 19.74), the aerospace industry is surpassing the index in terms of return on equity (22.68 to 20.34). The aerospace and defense industry is positively correlated with the S&P 500, following the trends of the index very closely. Within the week of March 26, 2007, the index has outperformed the industry by only 0.5%, with
the value of the industry being 740.78 as of March 30 (finance.yahoo.com). Below is a chart of the industry’s performance compared to the S&P 500 that week.
Shareholder Letter Evaluation Rockwell Collins’ 2006 shareholder letter, written by their CEO Clayton M. Jones was adequate but fairly vague. The overall tone of the letter was relatively personal, but we get the impression the relationship will be a short one due to the focus on the past and looking only to the immediate future with its goals. Analyzing the past, many positive figures are provided over the past year of the company’s successes and the reasons for them. The problem was no negatives were presented, which makes it harder to predict future difficulties without knowing the ones encountered in the past. Looking towards the future, this is the area which was lacking the most. Goals were set out for the coming year but with no specifics provided as to how they would be accomplished. However, the one positive we took away was the preciseness of the goals for the coming year. Otherwise, much of the letter was simply full of clichés such as, “Critical to our future success is our ability to attract and retain talented and motivated people.” After reading the letter, it was hard to come away with any idea of where future cash flow growth would come from. Overall, we give Rockwell Collins’ shareholder letter a grade of C due to its aforementioned shortcomings.
DuPont Analysis DuPont analysis is a technique used by many analysts to break down the different components (operating margin, tax burden, asset turnover, interest burden, and financial leverage) which make up a particular firm’s implied return on equity. It is beneficial because of its ability to pinpoint components of concern in relation to the industry as well as the S&P 500 index. All of our DuPont data was extrapolated from Reuters.com. As found on our calculations spreadsheet at the end of this document, in the DuPont analysis, Rockwell Collins greatly outperformed the industry and the S&P 500 with its current implied ROE of 44.46% compared to 22.5% and 19.5% respectively. Better performance was found in four of the five areas, except for financial leverage. The most encouraging margin over the industry we saw was that of Rockwell’s operating profit margin. This was double that of the industry. Operating profit margins are essential because they directly fuel companies’ returns on investment. The second most important element of the DuPont analysis is a company’s asset turnover, which is a measure of how quickly they can convert assets into cash. A company with a low asset turnover has trouble surviving in a competitive industry, especially if coupled with a low profit margin. Fortunately for Rockwell Collins, they excel in both areas with an asset turnover of 1.22, which doubles the S&P 500, and is about 20% higher than the industry. Some of these results can be attributed to the nature of Rockwell’s products. Most of the products are extremely customized and ordered before produced, resulting in high margins and no excess inventories. The next two components we looked at in our analysis are the tax burden and interest burden. These are basically negligible, due to how closely in line with the industry they are. It is worth noting that there is no interest paid by Rockwell Collins and very little by the industry, this signals efficiency in their payment of debt. The final component left to analyze is the financial leverage of Rockwell. Although the company’s leverage of 2.80 is lower than that of the industry (3.37), this can also be seen as a good attribute. High leverage can be a way to greatly increase profits, but only as long as the return on new investments turns out to be higher than the required debt payments. However, high leverage also adds more risk to the security. More risk to a security can result in a higher discount rate used to value a stock, which produces a lower intrinsic value. Rockwell’s low leverage with respect to the industry tells us that the company produces enough cash flow to fund new investment opportunities without using a significant amount of debt.
One Dollar Premise One financial tenet to be addressed is the one-dollar premise. This is a measurement of how many dollars of market value can be generated by one dollar of retained earnings and is a very good indication of whether management is making the right decision to be retaining the earnings or not. The “premise” is that for every one dollar of retained earnings, at least one dollar of market value should be generated. If this is not the case, then the earnings should be paid back to the shareholders in the form of dividends or buybacks, rather than be reinvested. This figure is found by dividing the five-year change in market value by the five-year accumulated retained earnings. The five year values are for 2002 – 2006. The change in market value was found by using the closing share prices on the last trading day of September for each of the two years, respectively, because the financial statements are dated September 31. The one-dollar premise was calculated to be an impressive $7.22. This means that for every $1.00 of retained earnings over the last five years, $7.22 was generated. This is an outstanding indicator not only of management’s ability to find profitable new investments, but also their decision making prowess in the allocation of cash to these projects.
Value or Glamour? When using a Contrarian investment strategy, it is important to determine whether a stock is a glamour stock or a value stock. A value stock is one that would be considered currently out of favor and at an attractive price, while a glamour stock would be one that has been returning well, making it somewhat in favor, but probably overpriced. To earn above average returns, our goal as an investor would be to find undervalued value stocks to invest in, creating a margin of safety for ourselves. The following is a table using the four ratios used to test for glamour or value in Rockwell Collins.
Earnings Yield Institutional Ownership Five-Year Sales Growth Price/Book
Rockwell Collins 4.37% 69.72% 6.50% 8.63
S&P 500 4.91% 70.63% 13.30% 3.93
Glamour/Value Glamour Value Value Glamour
According to the table, two of the four measures of glamour/value tell us that Rockwell Collins could be either, but we would lean more towards value. This is because we would place more emphasis on earnings yield and sales growth as the best indicators of the four to derive a conclusion. Rockwell’s earnings yield is relatively comparable to the market and the sales growth rate is significantly lower. So, if Rockwell is truly a value stock, then it should be currently undervalued, giving us potentially above-average returns in the future, as the market price returns to its intrinsic value.
Stock Price Riskiness and Volatility Both systematic risk and total risk were measured for this stock. The measure of systematic risk used was beta, and it is currently 0.56. The beta of the market is one, so what this means, is that changes in the market will be reflected in changes in Rockwell’s stock by approximately 56% of the value of the market changes. A total risk measure was calculated by using the past ten years of monthly returns (found using adjusted closes from yahoo.com), finding the standard deviation of them, and then annualizing by multiplying by time or in this case the square root of 12. The total risk from March 1997 – March 2007 was 28.42%, which is low compared to the market and other stocks we have analyzed, which indicate this stock is quite volatile, but the beta lower than one is contradictory to this. Past stock performance over the last five years has seen a fairly consistent upward trend, so consistent with very few variations that it isn’t surprising how low our standard deviation is. Over the last five years it has had about a 150% increase overall in stock price. Although the company has been in operations since 1933, it did not release its IPO until June 15, 2001. Therefore, the company meets our standards of being a publicly traded company for at least five years. Another measure of stock riskiness and volatility is a company’s consistency of ROE. This was determined by dividing the average ROE over time by the standard deviation over the same amount of time. For the analysis, we were asked to use ten years of data for this measurement, however, we were only able to obtain the past eight years of data for ROE. The consistency we found was 3.02, which means that the average ROE was three times higher than the standard deviation, which is a good indication of low volatility compared to other stocks we’ve analyzed thus far.
Quality of Owner’s Earnings Owner’s earnings is a measurement which Warren Buffett is a big advocate of examining as a measure of a company’s cash flow. He defines it as subtracting a company’s capital expenditures for the year from their total cash from operations for the year. This number is then divided by the number of shares outstanding to give us a pershare value. The five year average owner’s earnings is for the years 2002-2006 and comes to $2.16 per-share and the current owner’s earnings is for the year 2006 comes to $2.70 per-share. To compare numbers from year to year, we calculated two owner’s earnings growth rates, a five year average and a current growth rate, respectively. The five year average number we came up with was 7.05%, which was found by taking an average of the four year-to-year growth rates spanning 2002 to 2006. Three of the four rates calculated actually produced negative values. The current growth rate from 2005 to 2006 was -1.1%. It is somewhat alarming to see a negative growth rate over the years, but with further analysis, both total cash from operations along with capital expenditures have both increased nearly every year. The problem is that the capital expenditures have slightly outpaced the total cash from operations in their growth over a few of the years. The high capital expenditures can be attributed to recent construction of two new buildings at their Cedar Rapids locations. These buildings are just finishing up with no new short-term big projects in the making, hopefully causing the capital expenditure number to go down in the near future. Another comforting detail to note is that, despite the increase in their capital expenditures over the past five years, it hasn’t been accompanied by an increase in debt. Therefore, they are able to afford these expenditures with their current cash flows.
Intrinsic Value/Margin of Safety Intrinsic Value is a measure Buffett stresses very much. He won’t purchase a stock unless he has a “margin of safety”, that is, his intrinsic value is significantly more than the current market value. Essentially, he buys stocks at a discount. Therefore, if the stock does do poorly, theoretically, over time the stock will gravitate to its intrinsic value. Even though the firm does relatively poorly, the investor will have a safety net, still generating an acceptable rate of return.
To calculate our intrinsic value, we used Rockwell’s current owner’s earnings per-share of $2.70 as the cash flow number for time zero rather than the five-year average owner’s earnings. The discount rate was found using the Capital Asset Pricing Model equation with a risk-free rate of 5% (the current yield of a 3-month treasury bill), a market premium of 7%, and a beta of .56. This creates a required rate of return of 8.92%, which is less than our 10% minimum. A normal growth rate of 6% was used, and for the first five to ten years, a supernormal growth rate of 7% was used. The supernormal rate was found by multiplying our five year average ROE by one minus the five year payout ratio. We decided to use this rate because of its reflection of the firm’s buybacks and dividends. Over the past five years, Rockwell has paid out a fairly consistent dividend of around $.43 per-share and at the same time has consistent repurchased more and more shares every year. These are both encouraging things to see.
Recommendation It is our recommendation to the class that we purchase 160 shares of Rockwell Collins common stock, which totals to a dollar value of about $10,700. This would be paid for out of $37,833 of available funds. We are recommending this buy decision for a number of reasons, the first of which is the financial stability of the company. This is evidenced by its extremely impressive DuPont analysis, beating the market and industry in nearly every category except for leverage. We are especially pleased with its operating profit margin, asset turnover, and low leverage compared to that of its industry. It is clearly one of the top companies among its competitors. Secondly, we are also impressed with Rockwell’s ability to manage and produce cash flows effectively in the past as well as assuredly into the future. Its past can be measured by its tremendous one dollar premise value of $7.22 and a solid owner’s earnings per share of $2.70. Therefore, it is obvious the cash management is reinvesting is being put to good use. Although the future is difficult to predict, we have found three optimistic opportunities for future cash flow growth. First, an optimistic outlook for the commercial division of Rockwell can be seen by recent growth in the volume and profit margin of products supplied to Boeing, their number one commercial customer. Boeing, over the past few years has steadily increased the amount of planes they produce, mostly for airline growth in India and China. Along with this, the airline industry as a whole in America is beginning to rebound from their recent downturn.
Secondly, we predict an optimistic outlook for the defensive division of Rockwell. We believe there will be a steady demand for defensive products and services well into the future as a result of continued political and economic instability in the Middle East. Rockwell is also seen as an innovator in its industry, and whether at war or not, the government will always be in need of new technologies. Lastly, it is optimistic to note that Rockwell has recently finished construction of two new production facilities at their Cedar Rapids, IA location. The planned use for these is to not only to increase volume of current product lines but also be used for production of new product lines. Reversal Criteria In order for us to recommend a sell proposition for this stock in the future, two of the following three events would need to occur. The first is closely related to one of the goals laid out for the 2007 year, in the most recent shareholder letter. Rockwell’s shareholder letter states an overall 10% sales growth rate for 2007, compared to a 2006 sales growth rate of 6.5%. Therefore, if we saw no increase in the annual sales growth rate, this would be one indication that a sell decision would be in order. Another indication for selling would be if the intrinsic value fell 50% below the stock price. We currently have such a small positive margin of safety that we would need to see a significant difference between the intrinsic value and the stock price for us to make a decisive conclusion. Finally, if the implied ROE fell below that of the industry, it would be a good time to reevaluate our decision.
http://moneycentral.msn.com/investor/invsub/results/compare.asp www.reuters.com www.wsj.com http://www.rockwellcollins.com/ http://finance.yahoo.com/ www.morningstar.com
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