Raytheon Has Become Too Cheap to Ignore

Along with the rest of the aerospace and defense sector, Raytheon has taken a beating over the past several weeks. Still, there is a lot to like about the sector

Mar 22, 2020

The past several years has seen some impressive returns for the Aerospace & Defense ETF (ITA, Financial). Last year alone saw the sector exchange-traded fund return nearly 32%, topping the return for the S&P 500. How quickly things have changed as the recent decline in markets has taken no prisoners. The ETF is down more the 46% for 2020, a stark reminder that even market darlings can be crushed during a panic. The S&P 500 has performed much better, “only” losing 29% year to date.

One aerospace and defense name that I have long liked is Raytheon Co. (RTN, Financial). I have purchased shares twice so far this year and have a loss of about 45% to date. Still, I find that there is a lot to like about the sector in general and Raytheon in particular. Shares of this company have become too cheap to ignore.

Why I continue to like the defense sector

Defense spending remains robust as the U.S. military will be provided with $738 billion in spending in fiscal 2020. This was a 4.6% increase from the previous year. Even with the uncertainty regarding the coronavirus and the economy in a presidential election year, I don’t anticipate that defense spending will decrease by that much even if there is a change in who holds the White House in November.

That is because the defense contractors often contribute to both major parties in the U.S. While Donald Trump has overseen aggressive spending increases on defense, Raytheon actually contributed $0 to his campaign in 2016. It should be noted that individuals from the company did give more than $35,000 to Trump that year. Individuals from the company, however, gave nearly three times that amount to his opponent, Hillary Clinton.

In 2018, Raytheon contributed more to the Democratic Congressional Campaign Committee than any other organization or individual. So far in 2020, the candidate who has received the most from individual associated with Raytheon is Bernie Sanders, someone not necessarily seen as the most vocal supporter of defense spending.

Additionally, aerospace and defense contractors often have operations throughout the country. A decrease in military budgets would result in the loss of jobs that are often high-paying, something no person in Congress wants, especially come election time. This helps insulate the sector from those wishing to reduce military spending.

The point is, regardless of which party controls the White House or Congress, defense spending isn’t likely to decline all that much going forward.

Another factor favoring defense names is that many of the contracts signed take years to reach fulfillment. For example, Raytheon received a $1.03 billion contract for anti-air and anti-surface missile defense from the U.S. Navy at the end of 2019. This contract is scheduled to run from 2019 through 2023, but there is language in the agreement that pushes the completion date back to 2026.

Since payments for these projects are paid as they meet certain end points, it is highly unlikely that the customer, usually the U.S. government, will decide to cancel the project after they have already made an investment in it.

In was announced yesterday that the Pentagon will increase progress payments to defense companies as the coronavirus deals a blow to the economy. Progress payments will increase from 80% to 90% to large defense contractors. Smaller companies will see their progress payments increase from 90% to 95%. This will allow big and small companies in this sector to pass along payments down the supply chain with the goal of keeping all components of the sector healthy enough to ride out whatever downturn Covid-19 inflicts on the economy.

Raytheon is likely to perform quite well regardless of economic conditions due to these factors, even if the coronavirus causes a recession. The company has a habit of doing quite well in poor economic conditions. During the last recession, while much of the business world saw steep declines, Raytheon grew earnings per share 48% from 2007 to 2009. While the company did retire 43 million shares over this period, net income grew 32%, showing the resiliency of its business during a difficult time.

In addition to these factors working in Raytheon’s favor, the company’s recent results have been excellent.

Recent earnings results

Raytheon reported fourth-quarter and full-year earnings results on Jan. 30.

The company earned $3.16 per share, 5 cents above estimates and a 7.8% increase from the previous year. Revenue grew 6.6% to $7.8 billion. For the year, earnings of $11.92 per share were more than 17% higher, while revenue improved nearly 8% to $29.2 billion.

Raytheon also said that future growth looks solid as is has bookings of more than $12 billion for the quarter and $36 billion for the year. As a result, the company’s backlog increased 15% to $48.8 billion, a new company record.

Individual segments also performed well. The Integrated Defense Systems segment had sales growth of 18% for the quarter and 12% for the year as demand for air and missile defense systems from international customers improved.

Sales for Intelligence, Information and Services inched up 2% for the quarter, but 6% for the year due to gains made in classified programs in both cyber and space.

Missile Systems grew 1% and 5% for the quarter and year, respectively, as net sales for classified programs was higher year over year.

Space and Airborne Systems saw sales grow 7% for the fourth quarter and 10% for 2019. Classified program sales were a main driver of growth as was Raytheon’s latest space-based global missile warning system. Sales for tactical communications was also strong.

Sales for Forcepoint were up 3% for the quarter and 4% for the year due to higher demand for products.

There are currently 17 analysts that cover Raytheon and they have an average earnings estimate of $12.65 per share for 2020. This would be a 6% increase from earnings results for 2019.

Raytheon and United Technologies (UTX) are expected to close their merger of equals sometime during the second quarter of 2020. As stated in the merger announcement, Raytheon shareholders will own 43%, while United Technologies shareholders will own 57% of the newly combined company. The new company will be called Raytheon Technologies and will be the second-largest defense contractor by sales.

Overall, another strong quarter and year for Raytheon. All divisions saw growth and the merger of equals with United Technologies remains on track to close very soon. Because of this, Raytheon is poised to do very well in the coming years.

Dividend and valuation analysis

Following the rapid decline in the value of the stock over the past several weeks, shares of Raytheon now yield 3.1% as of Friday’s close. The stock hasn’t averaged a yield this high for an entire year since 2013, according to Value Line. For additional context, the current yield is 100 basis points above the stock’s five-year average yield.

Raytheon normally announces a dividend increase around this time of year, so it is possible that shareholders will know the size of their raise for the May payment by the time you read this. As of now, the company has 15 consecutive years of dividend growth. Raytheon has raised its dividend by:

An average of 8.8% per year over the past three years.
An average of 9.3% per year over the past five years.
An average of 11.8% per year over the past 10 years.

Last year’s boost was for 8.7%, in line with the three-year average increase. More important than previous growth is the prospect for future growth. Considering the company’s payout ratios, Raytheon should have no issue there.

The company distributed $3.70 in dividends per share in 2019 while generating earnings of $11.92 per share for a payout ratio of 31%. The payout ratio has averaged 36% over the past decade. Using the current annualized dividend of $3.77 and expected earnings of $12.65 per share, the forward payout ratio is 30%. Remember that total dividends for 2020 are likely to be higher due to the expected upcoming increase.

Raytheon paid out $1 billion in dividends in 2019, while producing free cash flow of $3.5 billion for a payout ratio of 29%. This compares quite favorably to the three years prior, when the payout ratio was 39%.

By either earnings per share or free cash flow, Raytheon has a very conservative payout ratio, which should allow the company to continue paying and raising a dividend through the likely difficult economic backdrop in the near term.

The drop in share price has an added benefit beyond just a higher yield. Shares of Raytheon now look much more attractively valued than they have in quite some time. Using the most recent closing price of $124.14, earnings results for 2019 and expected earnings for 2020, shares of the company have a trailing price-earnings ratio of 10.4 and a forward price-earnings ratio of 9.8. The price-earnings ratios haven’t been this low since 2012. For context, Raytheon has a five-year average price-earnings ratio of 18.7 and a 10-year average of 14.8.

It is extremely likely that the coronavirus will have an impact on the global economy. The sheer number of people and countries impacted by the virus means previous earnings estimates are likely too lofty for most companies to achieve. There is a good chance the virus will cause a recession given the economic slowdown that is sure to happen due to the number of countries that are under quarantine or lockdown.

Regardless, defense contractors, especially Raytheon, have some positive forces working in their favor that should help to blunt the impact of a recession. The company was able to grow at a high rate during the last recession.

For the sake of argument, let’s assume the coronavirus and the likely recession that it causes results in a 20% decline in Raytheon’s projected earnings for 2020. This would give the company a projected earnings per share of $10.12 for the year and a forward price-earnings ratio of 12.3. This is still below the five and 10-year average valuations for the stock.

Using this reduced earnings total and the five and 10-year average price-earnings ratios, shares of Raytheon are likely worth $150 to $189. This is a 21% to 52% return from the current prices. And that’s if the company’s earnings results are below expectations. If Raytheon comes close to its estimates, then shares would be worth considerably more. And that’s before you add in the high dividend yield.

Final thoughts

The aerospace and defense sector has been hit especially hard since the coronavirus began spreading in the U.S. Raytheon hasn’t been spared, but this sector is very resilient. Contracts are often very long term, with customers motivated to complete projects. Spending on defense isn’t likely to decrease even with a potential change in control of the White House as the defense companies often contribute to members of both parties.

Raytheon’s most recent earnings report showed that all segments of the company are showing growth. And the merger with United Technologies will be transformative as the new entity will become the second-largest defense contractor in the world.

Finally, the recent drop in price has made Raytheon’s yield much more generous while also significantly lowering the stock’s valuation. This selloff has made shares of Raytheon too cheap, even when lowering expected earnings per share for the year by 20%. Investors looking for a good entry point into the name have received it over the past few weeks.

There is no guarantee that shares can’t trade lower from here, but Raytheon has too much going for it to warrant the current low valuation. Because of this, I rate shares of Raytheon as a strong buy despite the uncertainty in the global economy.

Disclosure: The author is long Raytheon.