Raytheon: An Overview

Jun.26.12 | About: Raytheon Company (RTN)

I've developed a screen for value-based stocks with a strong, growing dividend for income. Following this screen, I've decided to take a closer look at Raytheon, Co (NYSE:RTN). The screen itself consists of:

  1. Security Type: Common Stock - I am interested in investing in US-based companies.
  2. Market Capitalization: Greater than or equal to 740 Million - I am looking for middle-large cap companies who have established themselves in the marketplace. Raytheon: $18.21 Billion
  3. P/E (Intra-day/ TTM) - Less than or equal to 12 - I want a company with a lower than average P/E to give it some 'value' and room for the stock price to grow. Following the screen, I must compare this to the industry and historical average. Raytheon: 9.81
  4. Dividend Yield: Greater than or equal to 3.2% - I am looking for a yield above 3.2% to give myself a consistent stream of income above the current Treasury yield. Raytheon: Annualized Dividend Yield 3.66%
  5. Dividend Payout % Last Quarter: Less than or equal to 65% - while I would like a strong dividend, I want to ensure that the company is also investing some of its profits back into itself. Raytheon: Payout Ratio 30.88%
  6. Dividend Growth Rate (5 Year Average): Greater than or equal to 5% - I want a dividend that has, on average, been growing over the past five years. Following the screen, I must check the dividends declared to ensure consistency in the growth of the dividend. Raytheon: 14.42%

Dividend screens in general are meant to ensure that I am investing in a stock that has a stable but growing dividend that will increase my yield-on-cost as time goes on.

Company Overview

Raytheon specializes in defense, homeland security, and other government markets throughout the world. It focuses on five inter-connected domains of air, land, sea, space, and cyberspace. It primarily operates domestically through government defense contracts but also operates internationally. It operates in six business segments: Integrated Defense Systems (integrated air and missile defense), Intelligence and Information Systems (intelligence, surveillance, and reconnaissance), Missile Systems (developer and producer of missile systems for the US and allies), Network Centric Systems (net-centric enabled mission solutions, modernization and communication), Space and Airborne Systems (advanced missions such as unmanned aerial operations), and Technical Services (mission support). In 2011, US Government sales represented $18.4 billion in 2011, or 74% of its total sales. Its international operations have been a bright spot as of late, with 25 percent of first quarter 2012 sales from international customers.

Raytheon closed at $54.82 on Friday, June 22nd.

Upcoming Events

  1. Ex-Dividend: $.50 on 7/2/2012
  2. Q2 Earnings: 7/26/2012

Positives

Dividend Growth: Raytheon has grown its dividend since 2004, initially increasing it by 1 or 2 cents (about 4.5%) until 2009, when it increased it by $.065 (17.3%) and more since then. A payout ratio of 30.88% indicates, to me, that the company has been investing nearly 70% of its earnings back into itself while still giving the investor a strong dividend yield. On top of this, the dividend can be increased or defended in the future by increasing the payout ratio if unfavorable conditions arise.

Strong Operating Margins: Raytheon increased its operating margins between Q1 2011 and Q1 2012, increasing its total operating margin to 13.1% in 2012 vs. 12.5% in 2011 on an adjusted basis. In its Q1 2012 Presentation, the company increased its EPS guidance and indicated generally increasing operating margins through its business segments.

Analysts are bullish on the stock, a combined 9.2/10, via Fidelity.

P/E Comment

Raytheon's P/E is currently 9.81, well below the Aerospace and Defense industry average of 14.65 and below its 5-year average of 11.11, indicating that it may be underpriced at its current level. However, these comparisons may be inaccurate as the Aerospace and Defense industry average includes companies such as Boeing and Airbus which have generally carried higher P/E's.

Also, the 5-year average may be inflated due to the higher spending averages prior to 2008; in the prior period of decreasing government defense spending (~1984-1997) the P/E for Raytheon was:

  1. 1995: ~$41 stock price/ (3.25 EPS) = 12.67
  2. 1996: ~48 stock price/ (3.3 EPS) = 14.54
  3. 1997: ~49 stock price/ (3.55 EPS) = 13.8

From my findings, unfortunately, SEC data filings for Raytheon are not listed electronically prior to 1994. Unfortunately, this is right at the bottom of the defense spending during this period -> the P/E may be high due to prospects of increased growth due to increased government spending between 1999 and 2008.

Raytheon is trading at a near 2-year high and still has a low P/E, indicating its strong earnings recently.

Negatives

Defensive Competition and Government Contracting: The Defense industry is highly competitive and based on specialized engineering. Raytheon anticipates increasing competition in core markets as a result of consolidation within the industry. Furthermore, Raytheon is tied to Government spending, and that "Congress generally appropriates funds on a fiscal year basis even though a program may extend across several fiscal years". Therefore, Raytheon may experience sudden drops in revenue from its major customer. This is especially true given the upcoming fiscal cliff that politicians in Washington have not made progress on and may result in decreased Government spending, leading to decreased revenues for Raytheon. However, Raytheon views itself as aligned to the Department of Defense's priorities and key capabilities.

This should lead to declining sales. In fact, Raytheon has experienced declining sales (in part due to decreased government spending), specifically in its network-centric business unit. This unit experienced a -11% change between 2011 and 2012. The company has decreased guidance for this unit and has experienced lower sales from this unit. I expect this trend to continue in the coming years.

Defense Spending Trends: Government defense spending rose from 3.6 percent of GDP to 6 percent of GDP under Bush and is planned to be reduced under President Obama to 4.6 percent of GDP by 2015. The department of defense plans on requesting $525.4 billion for FY 2013, a reduction 5.2% YoY.

6-Month Chart

The six month indicates that the stock may be overbought (near the top Bollinger Band). Its 50-day moving average is well above its 200-day moving average, while the 20 day moving average appears like it will soon cross over the 50-day moving average (a bullish signal). A pullback to either of these moving averages, which can provide some support levels, may represent a buying opportunity.

Click to enlarge

Margins

Raytheon

2011

2010

Revenue Growth

-2.52%

2.48%

Gross Margin

22.88%

22.33%

Operating Margin

12.07%

11.77%

Click to enlarge

DCF

  1. WACC of 8.6%, in line with a WACC of 9% and defense industry average of 7.3%.
  2. Sales Revenue Growth - -2%, given declining defense budget.
  3. Perpetuity Growth - .5%, defense spending should increase…. Eventually.
  4. Target Share Price: 65.53
  5. DCF itself

Conclusion

On top of passing my screen, Raytheon's follow up provides sound financial data. It has grown dividends at more than 14% and looks poised to continue to do so with only a payout ratio of 30.88%. On top of this, its P/E is below both the industry and historical average. Importantly, Raytheon has been improving its margins as the US Government's spending is being ramped down, which is essential to protecting its bottom line. Furthermore, it is branching out internationally and deriving more of its sales from international customers (recently as much as 25%). The company also sports a 1.1 PEG, which is .2 above the industry average but .6 below lead competitor Lockheed Martin's 1.7. Some negatives, however, are the consolidating defense industry and declining government defense spending, which still consists of ¾ of Raytheon's incoming revenues.

Based on P/E alone, I estimate the stock will climb in P/E - perhaps not towards its recent 5-year historical average but should move higher. When applying a P/E of 10.5, the stock has a target price of 58.48.

An attractive entry point on a pullback would be near the 50-day and 20-day moving averages, a price of about $52 dollars per share. From the P/E perspective, this would allow a 12% gain; from the DCF, a target stock price of about $65 is implied, which would represent a nice 25% upside.

My Potential Trade: Enter 50% of your position now, with a market order for approximately $54. Save 25% of your position for a pullback at $52. Save the next 25% of your position to see the direction of the economy over the coming month and potentially wait for Q2 earnings in a month. If Raytheon falls farther below $52 (unlikely in my view), you may cost-average down the remaining 25% of the position depending on the economy and the defense spending outlook, or you may cap your position at 75% of your total intended position and look for opportunity elsewhere. If commissions are of concern to you (as they should be a consideration to all investors, in my opinion - costs are costs), enter 50% of your intended position now and save 50% for entry on a pullback.

For more information on Raytheon's strategic position, view its investor's page.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in RTN over the next 72 hours.