Growth and Value: Esterline Technologies - a Leading Defense Contractor
Investing versus Speculating
With the amount of volatility seen in the equity markets today, many people seem to believe that the old proven practices of investing in solid businesses for the long run no longer apply. But it's important to remember that there is a significant distinction between true investing and speculating. And it's even more important to recognize that the level of risk taken by speculators is significantly greater than the amount of risk assumed by investors.
Although there are famous speculators, the average investor would not have the appetite for risk or the steely nerves that speculation requires. On the other hand, most of the great icons of sound and prudent investing practices offer insights and strategies that are as much common sense and prudent behavior, as they are genius. Therefore, the everyday investor is capable of applying their insights and lessons, and therefore achieving their own low risk investment success.
Famous investors like Warren Buffett, Philip Fisher, Peter Lynch, Bill Miller, John Neff, Sir John Templeton, Thomas Rowe Price and Bill Ruane are just a sampling of many great prudent investors who believe in investing in good businesses rather than speculating in the stock market. Then of course there is Ben Graham, who taught many of the above-mentioned investing greats and offered us one of my favorite quotes to share: "in the short run the market is a voting machine, but in the long run it's a weighing machine."
Speculators focus on stock price movement and attempt to guess the magnitude and direction where the price of the market or a company may go next. Speculators tend to be very active traders, and therefore, tend to ignore, or at least pay very little attention to the fundamentals of the business. Consequently, the trader/speculator, deals with the voting machine or short-run market that Mr. Graham spoke about. To me at least, this turns the stock market into a casino, and trading is closer to gambling than it is to prudent behavior.
In contrast, sound investors are interested in owning the business and therefore take a longer-term approach. Since they do not intend to sell the business they invest in for a long period of time, short-term market volatility concerns them very little. Consequently, investors are interested in the "weight" of the business, and therefore carefully scrutinize the fundamentals underpinning the companies they are interested in. To prudent investors, the stock market merely represents the store where they can find good businesses to buy and hold for the long run. Once they buy their business, the store they bought it in is no longer of any interest to them.
Esterline Technologies - Solid Fundamentals on Sale
As I was recently shopping in the stock market store, I came across a very interesting business in the aerospace/defense industry that I believe is currently on sale. This is a growth business with solid fundamentals and a compelling thesis for continued above-average growth. However, since it operates in the defense industry, many investors, mistakenly in my opinion, seem to believe that cuts in defense spending would curtail or eliminate this company's growth potential. Consequently, I believe this quality company is being mispriced by Mr. Market, and is currently significantly undervalued.
The following slides from their Investor and Analyst Day Conference presentation on September 15, 2011 summarizes their businesses and geographic exposure. In addition to offering a balanced business mix by end market, Esterline Technologies (ESL) is not just dependent on the U.S. market, as half their business is done outside the United States.
When reviewing this company based solely on fundamentals we discover that Esterline Technologies (ESL) has generated a 9.2% earnings growth rate over the past 15 years (since calendar year 1997). However, since numbers alone do not always tell the whole story, a quick glance at their earnings record illustrates a sharp acceleration in earnings growth since calendar year 2004.
Esterline Technologies' earnings growth rate has accelerated to over 18.6% per annum over the time period 2005 to 2011. Most importantly, this time period includes the great recession of 2008. It's also important to acknowledge modest cyclicality within their operating results where earnings have occasionally flattened and even modestly fell in fiscal year 2009. However, after falling slightly, earnings accelerated once again in 2010 and 2011. A little cyclicality does not bother me, because like Warren Buffett, I am interested in an above-average growth rate of 15% or better even if it's a little lumpy.
Nevertheless, the voting machine short-term market has found cause to price their shares at a significantly discounted PE ratio of only 10.7. A similar reaction by the market during the middle of 2008 to the spring of 2009 resulted in an excellent opportunity to buy this growing business on sale.
Esterline Technologies - Thesis for Growth
Nine analysts reporting to Capital IQ expect Esterline Technologies (ESL) to grow earnings at 15% per annum over the next five years. If they were to achieve those earnings results and the stock was awarded a PE ratio expansion to a PEG ratio PE of 15, then investors could expect to earn in excess of 20% per annum on their investment. The following estimated earnings and return calculator illustrates that potential.
We believe the consensus estimates of future earnings growth for Esterline Technologies (ESL) are both reasonable and achievable for several reasons. First of all, we expect strong organic growth based on the fact that Esterline's products are attractively positioned to meet the most critical needs of their key customers. This would include fuel-efficient consumer and business jets, modern high-speed rail lines and advanced surveillance systems. The following four slides from their Investor and Analyst Day Conference on September 11, 2011 highlight their opportunity.
The final thesis behind our confidence in Esterline's ability to achieve their earnings growth are their numerous potential acquisition opportunities. Over the past decade, Esterline has acquired over 30 strategic acquisitions, and their largest acquisition was completed in late July of 2011. They purchased France-based Souriau Group for over $700 million in cash and expect this acquisition to increase fiscal 2012 earnings by over $.40 a share.
The following, and final slide, from their investor and analyst day conference provides their guidance on high single-digit long-term acquisition growth rates. When you combine their guidance for high single-digit organic growth with their expected acquisition growth, the consensus estimated earnings growth rate of 15% becomes very plausible.
We believe that there are several attractive candidates in the aerospace/defense industry. Names would include General Dynamics (GD), Rockwell Collins (COL), Boeing (BA), Lockheed Martin (LMT), United Technologies (UTX), L-3 Communications Holdings (LLL) and many others. However, of this entire sector, it appears that Esterline Technologies (ESL) offers the largest opportunity for future earnings growth based on its well-positioned product line-up and geographically diverse base. In fact, many of the companies mentioned represent important customers of Esterline Technologies.
On the other hand, unlike most of the other major players in the aerospace defense industry, Esterline Technologies does not pay a dividend. Instead, the company appears more focused on strategic acquisitions to grow their business and reward shareholders through growth. Therefore, Esterline Technologies' shares are more appropriate for the investors interested in the potential for above-average growth at a reasonable price. Finally, Esterline Technologies is offered as an opportunity for the prudent investor to build a long-term position in a high-quality growing business, and therefore, is not offered as a trading vehicle. Esterline Technologies is presented as a high-quality growing business that is currently on sale.
Disclosure: Long UTX, LLL at the time of writing.