Raytheon's Recovery

Summary

• Raytheon only recently regained its pre-COVID 2020 high share price.
• The company beat earnings expectations for Q1, but also trimmed 2022 guidance.
• The Wall Street consensus outlook is bullish.
• The market-implied outlook (calculated from options prices) is slightly bullish.

Ryan Fletcher/iStock Editorial via Getty Images

Raytheon (NYSE:RTX) just reported earnings, beating expectations on earnings but missing slightly on revenue. The company also provided a reduced outlook for 2022 as a result of Russia trade sanctions which will cut $750 million in expected sales. Management also cites supply chain issues and the tight labor market as posing challenges in 2022, but also anticipates benefits from increased defense spending.

While the shares have dramatically outpaced the broader market over the past 12 months, with a total return of 26.2% vs. 5.1% for the aerospace and defense industry average (as defined by Morningstar) and 0.96% for broader U.S. equity market, RTX is currently trading only slightly above the pre-pandemic 2020 high. RTX total returns have lagged the iShares U.S. Aerospace & Defense ETF (ITA) over the past 3-, 5-, and 10-year periods.

5-Year price history and basic statistics for RTX (Seeking Alpha)

RTX is expensive relative to trailing earnings, with a TTM P/E of 38.9, far above the normal historical range of 10 to 21. The forward P/E, at 20.8, is on the high end of the normal range. The trailing P/E is so high because earnings are far below their pre-COVID levels.

Trailing and estimated future quarterly EPS for RTX. Green (red) values are amounts by which EPS beat (missed) the consensus expected value (Source: E-Trade)

While the Q1 results reported on April 26th beat expectations, this quarter and Q4 of 2021 exhibit a substantial slowing in earnings growth coming out of COVID. The outlook for earnings suggests that the recovery to post-COVID levels of earnings will take years. The consensus outlook for earnings growth is 15.1% per year over the next 3 to 5 years.

The relative attractiveness of RTX depends heavily on the outlook for earnings recovery, which depends on a host of hard-to-predict factors. In analyzing the stock, I rely on two forms of consensus outlooks. The first is the well-known Wall Street analyst consensus. The second is the market-implied outlook, which represents the consensus view among buyers and sellers of options.

Most readers will be familiar with the analyst consensus, but may not have encountered the market-implied outlook, so a brief explanation is needed. The price of an option on a stock reflects the market's consensus estimate of the probability that the stock price will rise above (call option) or fall below (put option) a specific level between now and when the option expires. By analyzing the prices of put and call options at a range of strike prices, all with the same expiration date, it is possible to calculate a probabilistic price forecast that reconciles the options prices. This is the market-implied outlook. For readers who would like a deeper discussion than provided in the previous link, I recommend this excellent monograph published by the CFA Institute.

Wall Street Consensus Outlook for RTX

E-Trade calculates the Wall Street consensus by aggregating the views of 6 ranked analysts who have published ratings and price targets over the past 3 months. The consensus rating is bullish and the consensus 12-month price target is 18.8% above the current share price. The small number of analysts included in the consensus calculation is unusual, especially for a large company.

Wall Street analyst consensus rating and 12-month price target for RTX (E-Trade)

Seeking Alpha calculates the Wall Street consensus using ratings and price targets from 21 analysts who have published views in the past 90 days. While the consensus rating is bullish, consistent with E-Trade, the consensus 12-month price target is somewhat lower, implying a 12-month price appreciation of 10.6%.

Wall Street consensus rating and 12-month price target for RTX (Seeking Alpha)

The consensus price target has been shown to have predictive value as long as the dispersion among the individual price targets is not too high. The dispersion is moderate for both the E-Trade and Seeking Alpha analyst cohorts.

The expected total return for RTX over the next year is 12.8% using the Seeking Alpha consensus price target and 21% using the E-Trade value. It is unusual to see such a large difference between consensus outlook calculations. This is almost certainly the result of the small number of ranked analysts in the E-Trade cohort. With such a small sample for the E-Trade consensus, I believe that the Seeking alpha result is more representative.

Market-Implied Outlook for RTX

I have calculated the market-implied outlook for RTX for the 8.8-month period from now until January 20, 2023 using the prices of call and put options that expire on this date. I selected this option expiration date to provide an outlook through the end of 2022 and these options were the closest match.

The standard presentation of the market-implied outlook is a probability distribution of price return, with probability on the vertical axis and return on the horizontal.

Market-implied price return probabilities for RTX for the 8.8-month period from now until January 20, 2023 (Source: Author’s calculations using options quotes from E-Trade)

The market-implied outlook is generally symmetric, with the maximum probability corresponding to a price return of -1.5%. The expected volatility calculated from this distribution is 29% (annualized), which is close to the 28% implied volatility calculated by E-Trade for the options expiring on January 20, 2023. This is a fairly level of volatility for large-cap U.S. stock, especially in the relatively volatile current market conditions.

To make it easier to directly compare the probabilities of positive and negative returns, I rotate the negative return side of the distribution about the vertical axis (see chart below).

Market-implied price return probabilities for RTX for the 8.8-month period from now until January 20, 2023. The negative return side of the distribution has been rotated about the vertical axis (Source: Author’s calculations using options quotes from E-Trade)

This view highlights how closely the probabilities of positive and negative returns match (the solid blue line and the dashed red line are close).

Theory suggests that the market-implied outlook is expected to have a negative bias because investors, in aggregate, are risk averse and thus tend to pay more than fair value for downside protection (put options). There is no way to directly measure whether this effect is present, but the expectation that there will be a negative bias means that a highly symmetric market-implied outlook, as we have here, should be interpreted as at least slightly bullish.

Summary

RTX has been hindered by the slow recovery of global aviation from the pandemic and, more recently, because of trade sanctions against Russia. The shares have only regained the pre-COVID 2020 highs since February. An earnings recovery to pre-COVID levels is expected to take years. The shares have rallied dramatically over the past 12 months, however. The Wall Street consensus rating is bullish, with a consensus 12-month price target implies a total return of 12.8% to 21%, although the higher value is based on E-Trade’s small sample consensus. As a rule of thumb for a buy rating, I want to see an expected 12-month total return that is at least ½ the expected annualized volatility (29%). RTX does not meet this criterion on the basis of the Seeking Alpha consensus price target, but can get there if we give some weight to the E-Trade value, which is based on ranked analysts (the average of the two consensus price targets results in 16.9% expected return). The market-implied outlook is slightly bullish. With RTX consistently beating expectations for earnings coming out of the pandemic and prospects for higher global defense spending, along with a bullish Wall Street consensus outlook and a slightly bullish market-implied outlook, I am assigning a buy rating for RTX.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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.