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Summary

  • The budget debates of 2012 and 2013 had defense companies on edge with future spending in jeopardy, but the storm seems to have passed.
  • Defense contractors can move into 2014 with a clear picture for revenue and earnings going forward.
  • Raytheon is poised to outperform its competitors, with a strong earnings picture and new technologies that show growing demand both domestically and abroad.

For anyone familiar with the Congressional budget debates that took hold of the political news during the last few years, it was very clear that defense spending in the United States had an uncertain future. After the events of the "fiscal cliff" and other budgetary obstacles ran their course, many military contractors saw a decline in business as allotted funds dried up. However, it seems that - at least for now - the storm has passed for what cuts the government is willing to stomach. With this in mind, defense companies can plan for 2014 with a much clearer picture of what the business landscape will look like. Now that investors can take macro headwinds off the table, company specific factors are all that remain when choosing a stock in this sector.

When looking forward into 2014 and beyond, many financial metrics and future catalysts point to Raytheon (NYSE:RTN) as an outperforming name in the defense industry. Raytheon is a lean and highly-profitable company with a focus on diversifying its international customers and growing demand for its defense systems. As global tensions around the world remain dynamic, Raytheon is in the best position to capitalize on current demand and solidify its position as a global provider of the best military systems offered today.

As mentioned above, Raytheon Company is a global provider of command, control, communications and intelligence (C3I) equipment as well as solutions for cyber and information security. Raytheon's clients include North American and international governments as well as commercial clients in need of security solutions. The more governments and organizations are in need of security and defense capabilities, the more business Raytheon generates.

When the company reported first-quarter earnings on April 24, management gave investors a look into the progress Raytheon was making as well as their goals for the immediate future. The main way Raytheon adds to its top and bottom lines is through securing contracts to increase its future bookings. This was a core focus during the conference call, where management unveiled a number of key developments that are showing growing demand for its products. One of these products, the Patriot fire unit, was booked by Kuwait in a $515 million deal during the quarter. The Patriot missile system continues to be a highly sought after defense unit, which is verified by recent deals such as this, as well as potential for future deals in South Korea and Qatar. Other deals that were secured during the quarter include a $195 million cyber security deal with the international market and a contract obtained to maintain NORAD's 47 Arctic radar sites. These deals, as well as others secured during Q1, are examples of the aggressive attitude Raytheon takes when competing for business against other defense contractors. The quality of RTN's product portfolio as well as their proactive approach to winning business should garner them a higher share of the domestic and international market.

Another positive development that surfaced during the first quarter was Raytheon's slow but steady shift towards a more diversified customer base. In the United States, a problem many defense contractors face when selling their products is their major dependence on the Department of Defense as a customer. If the DoD were to have less money to dish out to these defense companies, as was seen last year, revenues and earnings are more likely to be adversely affected. In order to shelter themselves from this over-dependence on U.S. business, Raytheon is aiming to diversify its bookings across more international markets. As of the end of 2013, international bookings had risen to a total of 30% of future sales, which should comfort investors who are looking for a more stable stream of income for the company.

Hosting the Q1 conference call and filling investors in on RTN's recent activities was Dr. Thomas Kennedy, who took the helm as Raytheon's CEO in early 2014. Kennedy, a 30-year veteran of the company, previously held positions as COO and executive VP, where he oversaw the consolidation of Raytheon's business segments from six divisions to four.

This experience, as well as a PhD in engineering from UCLA, gives Kennedy unique insight into how Raytheon operates, and should give the company an advantage with a familiar and tested CEO leading efforts going forward. What's more, Kennedy currently owns over 100,000 shares of Raytheon, which further validates his commitment to the company's success. Investors can buy into RTN and know that any events that drive the stock also affect the company's executives, which aligns the interests of shareholders and management to bring out value. Kennedy's stake in RTN amounts to almost $10 million of his own money; if this isn't a vote of confidence in the future of the stock, I don't know what is.

Raytheon's first quarter also saw a 10% increase to the company's dividend, which marks the 10th consecutive yearly raise of their payout. RTN's yield comes in at 2.5% at current prices, matching that of a 10-year Treasury bond. When deciding between the two, wouldn't investors want the asset that not only promises yield, but the potential for price appreciation and future dividend raises? Raytheon's financial situation would certainly support this.

The company currently pays out around 37% of their earnings in the form of dividends. This means that, even with zero earnings growth in the future, Raytheon could double its current distribution and still have money left over to grow its business. At a yield of 5%, dividend investors would be buying RTN hand over fist given its strong growth prospects and financial stability in addition to this juicy yield the company could support. I expect more dividend raises in the future as Raytheon grows its earnings and strengthens its balance sheet further down the road.

Looking forward into the rest of 2014, Raytheon has a number of catalysts that could spark a jump in earnings and ignite shares to the upside. One main development that concerns Raytheon's business is the situation between Russia and Ukraine. As the situation in Ukraine began to unfold, neighboring countries, mainly Poland, are trying to bolster their defenses and ease tensions in the region.

One way Poland is seeking to protect itself is through ballistic missile defenses, and is currently looking for viable options to add to its current arsenal. Enter Raytheon's Patriot missile system. Of the contenders for Poland's business, Raytheon's Patriot missile is cost effective, tested, and able to be fielded rapidly to Poland's aid, which is important given the current European situation. If Raytheon were to win this business, it would be a significant gain to the company's earnings, and give it a heightened reputation for providing the necessary aid in a tense diplomatic situation.

Another exciting development in Raytheon's product portfolio is a new micro thermal chip used in night vision technology. This chip is currently used in military equipment to aid combat personnel, but can be used in any situation requiring advanced vision and detection. Raytheon says that its manufacturing process for the new chip is so cost effective that applications are "endless" when selling it to military or law enforcement personnel, according to Raytheon's engineers.

The technology applies to civilian industries as well, from automobile sensors to safety testing to entertainment. If Raytheon continues to improve the quality of their thermal chip, new markets could be opened up to handle the unexpected and widespread application of this new product, which is exciting from a scientific and a business perspective.

As budgetary concerns in the United States dissipate, defense contractors can breathe a sigh of relief and bring focus back to expanding their military and commercial services for their customers. Raytheon has the financial position and the technology to beat its competitors and win new business, both domestically and internationally. With a new CEO at the helm, a growing portfolio of products, and global demand for its services, Raytheon is a company that is set to take the next few years by storm, and please shareholders with both dividend growth and earnings growth over the medium to long term.

Disclosure: I am long RTN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Raytheon - Expect A Strong 2014