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Having reported Q2 earnings on July 26th, 2012, Raytheon (NYSE:RTN) shares are roughly flat despite a relatively large EPS beat of $1.41 vs. $1.24 expected, a 13.7% beat. Furthermore, the company raised guidance on margins while maintaining an outlook of $24.5 to $25 billion in sales for 2012.

What is preventing the stock price from appreciating is the top line: domestic revenues and the future of defense spending as a whole. The bottom line, however, shows improved margins, remaining aligned with customers core needs, and overall EPS - factors that should contribute to a rising share price.

Revenues and Sequestration: The Burden

Revenues for the quarter came in at $5.992 billion, a three percent decline from Q2 2011 and a miss from analyst expectations of $6.2 billion. The NCS segment experienced the largest decline (-15%), but management reaffirmed its guidance for the year on the segment and sees sales recovering through the back half of 2012.

International sales remain at 25%. International sales were down about 5% on the quarter. However, this was expected by the company as many of the international orders received in the second half of 2011 are only just beginning to ramp up. Domestically, sales were down about 2.5% on the quarter. This, in turn, has fueled a -3% sales revenue growth for the first half of the year. Bookings were down in Q2 2012 to $6.2 billion from $7.4 billion in Q2 2011, while backlog was drawn down from $35.3 billion ending 2011 to $33.9 billion in Q2; however, funded backlog increased by $600 million. A positive that management emphasized is a general book to bill ratio of 1 to 1.5 for the year indicates decent demand; more unit orders were received than shipped.

Clearly, for the Mideast, missile-defense is important whether you look at Saudi, UAE, Qatar, Oman, those are all areas for us that have interest in providing air defense for a number of reasons given the issues they have in that part of the world. You didn't mention the Pacific Rim, that's also very active for us when you look at the threats that they have and various countries either trying to disrupt navigation or control navigation on the seas there. Changes were (the US) pulling out of Iraq, Afghanistan. So the U.S. has had a big presence there for the last, what, 10 years. And if the U.S. is pulling out then various countries realize that they have to do more and I think they're thinking about that and taking action very seriously.

Moving forward, domestic sales are expected to be flat within a range of +/- 2%, while international sales should see sales growth of 8% to 12%. As evidenced by the quote above, as the US ramps down spending as the presence in the Middle East decreases and the fiscal cliff looms, international defense interests are expected to 'pick up the slack'. Raytheon is one of the best positioned companies to benefit from international sales in the face of drawn down US defense spending.

On the subject of US defense spending, management mentioned sequestration in the conference call, but there is still little to no guidance on the exact effects of sequestration. Sequestration continues to be a burden on all defense companies as it is an election year and the prospect of reaching a deal before elections, or even after elections without a 'voter mandate' in the form of a large win for either candidate, is bleak. Swanson mentioned that most likely sequestration, which is self-imposed, will be delayed 12 months; leadership in Washington does not want sequestration to happen but does not have a solution. In light of sequestration, Swanson emphasized being flexible, lean, and 'mean', referencing experienced gained during a similar era in the 90's. The company, in his view, must be flexible so that as spending cuts come to certain areas, any other factory or area of business can perform well.

Technology and innovation, along with our people, continue to be our cornerstone, and these are areas where we continue to make the right investments.

We continue to directly invest in R&D in such areas as multi-function wideband systems, pulse weapons, automatic target recognition, smaller and more precise missiles, resilient networks and cyber products, just by way of example.

Margins and EPS: The Good

Margins, on the other hand, continue to be a strong point for the company. One analyst describes the margins as "terrific" on the Q2 conference call.

The strength in our underlying margin in the quarter was due to our continued focus on execution. We benefited from labor overhead and material efficiencies across the companies, some of which were expected in the back half of this year.

From a business perspective, the opportunities are weighted toward our production and international programs over our cost and service type programs. So a way to think about this might be, if you look at Technical Services or IIS, these businesses have a higher mix of cost and service programs so they don't offer the same level of opportunities as some of the other businesses.

Margins have shown improvement, an important aspect in the face of declining revenues and a significant factor in the EPS beat. Thus, margins in the IDS (air and missile defense) and SAS (aerospace) are expected to increase margins for the total year to 12.5% to 12.7%, a .2% increase from previous guidance.

In light of this, EPS came in at $1.41 compared to analyst consensus of $1.24. Operational improvements (margins) and capital deployment actions (share buybacks) are the primary drivers of the EPS gains. Reduced share count can be attributed to $.10 of EPS gains.

We raised our full year 2012 EPS guidance by $0.15 to a range of between $5.15 and $5.30, and on an adjusted basis, to a range of between $5.70 and $5.85. About 2/3 of the increase is driven by the performance improvements in the business that I spoke about a moment ago, and a little less than 1/3 is due to the recently passed pension legislation.

Management mentioned in the analyst question section that 1/3 of EPS gains is indeed due to pension legislation; from a gross basis, contributions come down in 2012 by about $500 million and $400 million in 2013. After taxes, cash flow is improved by about $100 million in 2012 and $300 million in 2013.

My Outlook on the Stock

Raytheon's case can be looked at as the burden (domestic revenues and sequestration) vs. the positives (operational performance and international sales growth). The burden is outside its control, while strong operational performance, with a flexible, lean disposition positions the company well should the hazy veil of sequestration be lifted. There were not many surprises in the Q2 release, although some concerns were raised about the missed revenues going forward. The company currently trades at a P/E of 9.5, which, again, indicates the company is being weighed down by its revenue/ sequestration outlook. The company has been doing the 'right' things, and if the company is able to continue to do these things (grow international revenues, continually improve technology and remain aligned with customer interests, and retain operating performance), I believe a higher P/E would be warranted. By applying a P/E of 11 to its 2012 expected EPS, I reaffirm my previous target share price of $58.5, and would recommend current shareholders to hold the stock considering its annualized dividend yield of 3.67%.

Disclosure: I am long RTN.

Source: Top Vs. Bottom: Raytheon's Revenues Weigh While Margins Show Strength