Bet On Recovery With Raytheon, Defend Portfolio With Lockheed

F-35 fighter jets flying over clouds

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Introduction

Most of the stock market has performed miserably since the beginning of 2022. Rising interest rates, a general shift from growth to value, fears of recession, significant inflation, and a war in Eastern Europe are the main reasons for this bear market. However, mainly due to the conflict in Ukraine and the increased emphasis on defense spending in Western countries, major U.S. government defense contractors such as Lockheed Martin (NYSE:LMT), but also to some extent Raytheon Technologies (NYSE:RTX), have largely defied the bear market.

I covered Lockheed Martin back in October 2021 and concluded that it was an excellent pick if one wanted to get exposure to the industry, but in a virtually non-cyclical way. Of course, such companies are sensitive to the government’s defense budget, but history has shown us that military budgets are rarely cut. Raytheon Technologies, which was only formed in 2020 by the merger of Raytheon Company (RTN) and United Technologies (UTX), is another highly interesting company in my opinion, as it combines the reliability of defense spending-related cash flows with the potentially faster growing commercial aviation market. RTX took an unsurprising beating during the pandemic, as most air traffic was shut down, but the industry is now looking at a very strong backlog and is poised to grow strongly. This of course assumes that the largely expected recession will be mild and short-lived.

In this article, I will outline why I believe both stocks deserve a place in a diversified, income-oriented portfolio. Raytheon, in particular, is becoming more interesting, in my opinion, as investors have begun to price a recession into the stock in recent months. As of October 3, 2022, the stock is down 22% from its 52-week high. Lockheed has understandably held up quite well, but is now also 17% below its 52-week high.

Overview Of The Two Companies

Lockheed Martin

In essence, Lockheed Martin is a play on the U.S. defense budget (and probably most of the Western world), as the company derives most of its revenue from government contracts. In 2021, the company generated more than two-thirds of its revenue from U.S. government contracts. The majority of its equipment sales and services go to the Department of Defense, but also to the Department of Energy and the National Aeronautics and Space Administration (NASA). Approximately 28% of equipment sales and services were to international customers, such as overseas governments (p. 3, 2021 10-K).

LMT is probably best known for its F-35 combat aircraft, which also represents a major growth opportunity, both through aircraft sales and service-related revenue. In March 2022, for example, Germany agreed to buy 35 jets from Lockheed amid the war in Ukraine. The F-35 program will continue through 2070, providing cash flow through regular maintenance, upgrades and, most importantly, regulated margins. In 2021, the F-35 program accounted for approximately 27% of Lockheed’s consolidated net sales (p. 85, 2021 10-K).

In addition to the fighter jet program, which is included in Lockheed’s Aeronautics segment, the company also manufactures radar systems, underwater systems and helicopters, which are reported in the Rotary and Mission Systems (RMS) segment, Lockheed’s second largest segment in terms of net sales. Missiles and Fire Control (MFC) represents sales related to air-to-air missile systems, precision fires, close combat, strike systems and energy storage facilities. Finally, the Space segment includes human and robotic exploration, hypersonic strike and directed energy technologies. Figure 1 shows Lockheed’s net sales in 2021. The MFC segment was Lockheed’s most profitable segment in 2021, with an operating margin of 14%, while the other three segments had operating margins of about 10% to 11%. Earnings volatility was most pronounced in the RMS segment (12% relative standard deviation between 2019 and 2021), but this was also the segment with the strongest growth in terms of operating profit (2019-2021 compound annual growth rate – CAGR – of 12%). At the corporate level, operating profit grew at a compound annual growth rate (CAGR) of 6% during 2019-2021.

Lockheed Martin 2021 net segment sales

Figure 1: 2021 net segment sales of Lockheed Martin (own work, based on p. 42 of LMT’s 2021 10-K)

Lockheed’s aircraft, helicopters (Sikorsky), missile systems and space technologies are all based on highly complex and largely proprietary technology. The company enjoys a very solid and long-standing relationship with the U.S. government, and its proven track record makes it difficult to imagine Lockheed’s products being replaced by those of cheaper competitors. Barriers to entry are extremely high, as defense projects are typically capital intensive, lengthy, and classified. It is therefore hardly surprising that the investor service Morningstar has assigned Lockheed a wide economic moat rating with a stable trend.

Raytheon Technologies

Raytheon Technologies was formed in 2020 through the merger of Raytheon Company, a leading defense contractor, and United Technologies’ aerospace business (Otis Worldwide (OTIS) and Carrier Global (CARR) were spun off as separate publicly traded companies). As a result, the company’s sales are very well balanced among the four reporting segments (Figure 2), in contrast to most other companies in the sector:

  • Collins Aerospace Systems (CAS) is one of the largest commercial component suppliers to aircraft manufacturers, airlines and defense contractors. Through this segment, Raytheon Technologies produces and sells, for example, landing gears, sensors, and flight control equipment. Components are deeply integrated into aircraft, giving CAS significant bargaining power, although its two main customers are Airbus (OTCPK:EADSF, OTCPK:EADSY) and Boeing (BA), which together account for 18% of the segment’s total sales in 2021. Last year’s sales were down 9% from 2019, underscoring the industry’s ongoing recovery from the pandemic.
  • Pratt & Whitney (P&W) is one of the world’s leading manufacturers of aircraft engines supplied to commercial, military and business jet customers. For example, P&W manufactures the engine powering Lockheed’s F-35 fighter jet. Last year, the first flight of the GTF Advantage engine was successfully completed – it has a market share of more than 40% in current orders for the Airbus A320neo commercial aircraft.
  • Raytheon Intelligence & Space (RIS) is a prime contractor to the U.S. government and develops and markets space, communications and sensor systems (e.g. radars and jammers), as well as offensive and defensive cyber and software solutions.
  • Raytheon Missiles & Defense (RMD) supplies, for example, the Standard Missile family (surface-to-air) to the U.S. Navy, as well as the Patriot defense system and its lower tier air and missile defense sensor.

A breakdown of RTX segment sales for 2021 is shown in Figure 2. RIS and RMD are Raytheon’s most profitable segments, with operating margins of 12% or more in 2021, while CAS and P&W have struggled since 2020. P&W’s $1.8 billion operating profit in 2019, for example, swung to a $564 million loss in 2020. Although the segment posted an operating profit of $454 million last year, its operating margin of just 2.5% still leaves a lot to be desired. Jet engine manufacturing may not sound like a lucrative business, especially in light of a depressed industry that is still in recovery mode and the capital-intensive nature of the business. However, investors should understand that Raytheon often sells jet engines at a loss to benefit from the “foot in the door” tactic – a large installation base is a guarantee for high-margin recurring revenues due to mandatory maintenance and service work.

Raytheon Technologies 2021 net segment sales

Figure 2: 2021 net segment sales of Raytheon Technologies, excluding intersegment eliminations (own work, based on p. 116 of RTX’s 2021 10-K)

In short, Raytheon Technologies is a supplier of aircraft engines and components that has significantly diversified its involvement in commercial aviation through its merger with Raytheon Company in 2020. While the commercial aerospace industry is still recovering from pandemic-related setbacks, the company’s defense-focused segments continue to perform very well. While Raytheon should benefit from a recovery in the commercial aerospace sector (which would, of course, be interrupted by a recession), Lockheed Martin should be viewed as a lower-risk approach to the aerospace and defense sectors. The main risk to the latter company is its much greater dependence on the defense budgets of Western world governments. At least in the short term, however, this relationship should be seen more as a tailwind, as defense budgets are unlikely to be cut in light of the ongoing conflict and the likely permanent deterioration of relations with Russia.

Raytheon Vs. Lockheed: Growth And Profitability

Lockheed Martin has grown its top-line and operating profit at a CAGR of 3.8% and 4.5%, respectively, since 2008. Over the same period, after normalizing for working capital movements and stock-based compensation expenses, free cash flow grew at a CAGR of 5.3% (Figure 3). Of note, the significantly reduced cash flows in 2012 and 2018 are attributable to decreases in post-retirement benefit plan liabilities.

Obviously, LMT is not a particularly fast-growing company, but considering that the majority of its revenue is generated from government contracts, this type of growth rate seems reasonable. It should be noted that LMT shares fell sharply in October 2021 after management lowered its 2022 revenue forecast and indicated that the company was reconsidering its five-year business plan. Given that geopolitical tensions have increased significantly since early 2022, and the strength of the company’s F-35 franchise, it seems reasonable to expect that Lockheed can indeed continue to grow at rate of 3% to 4% per year.

LMT normalized free cash flow

Figure 3: LMT’s normalized free cash flow since 2008 (own work, based on the company’s 2010 to 2021 10-Ks)

From a profitability perspective, Lockheed has historically delivered very solid and stable results, especially for an industrial company with major government exposure. LMT’s return on invested capital has averaged 34% over the past decade and has been fairly consistent with a standard deviation of 8%. Because of the strong free cash flow conversion, Lockheed’s cash return on invested capital is also high, and both compare very favorably to the weighted average cost of capital and cost of equity, which I estimate at 8.0% and 7.6%, respectively.

Lockheed’s operating margin has trended well over the past decade and has stabilized at about 13% in recent years. Working capital management is also very solid – the company was able to maintain its inventory days and days payables outstanding while days sales outstanding declined significantly. This is particularly surprising for a prime contractor, but of course a welcome development.

Since Raytheon Technologies was not formed until 2020, only a very limited overview of its past performance is available. Comparing RTX’s performance to that of its predecessors seems futile, as United Technologies, for example, has intentionally underinvested in its elevator segment Otis due to necessary capital investments in the P&W and CAS segments (see my May 2022 article). Similarly, it makes little sense to discuss the working capital management of RTX and its predecessors, as supply chains have certainly changed significantly. However, it does not seem unreasonable to expect moderate margin expansion due to supply chain synergies.

As noted above, RTX is still recovering from the pandemic, and thus it is hardly surprising that its return on invested capital (negative in 2020, 4.7% in 2021, and 5.7% in the most recent trailing-twelve-month period) was below the weighted average cost of capital. A higher cost of equity for RTX appears reasonable (e.g., 9%), because of the company’s involvement in the cyclical commercial aviation sector and its ongoing recovery from the pandemic and the associated uncertainties. This in turn leads to a higher weighted average cost of capital, which I estimate at 7.9%.

Raytheon Technologies’ operating margin is still significantly impacted by the pandemic, but has recovered from the 2020 low of 2.3% to nearly 8% in the latest trailing-twelve-month period. The components business has traditionally been a relatively high-margin business (up to 20%), and the realization of synergies from the merger and the expected increase in high-margin service revenue in the P&W segment should lead to a normalization of RTX’s operating margin to levels similar to LMT. Of course, this assumes that the recovery of the P&W and CAS segments continues, which is also a prerequisite for RTX to grow at a similar rate as Lockheed. However, in my opinion, RTX has more room for margin expansion than LMT. In the longer term, the increasing emphasis on service revenue (e.g., related to the GTF Advance engine) could lead RTX to overtake LMT in terms of growth.

Since the merger, RTX benefits from relatively stable cash flows due to government contracts, but is of course much more vulnerable to defense budget cuts than its successor United Technologies, which was much more diversified. I think the exchange of OTIS and CARR with Raytheon Company can be seen as an equal replacement from a recurring cash flow perspective. However, given the expected strong growth in A320neo engine service-related cash flows, I see RTX as an even stronger cash flow compounder. Boeing’s 777 and 777X and Airbus’ A380 have shown, in my opinion, that the future lies in fuel-efficient narrow-body aircraft like the A320neo. I particularly like the economic moat underlying the P&W segment, which reminds me of my passion for elevator companies. Of course, aircraft engines are much more capital intensive, but I suspect that the moat around this business is even stronger than that of elevator companies, as an engine failure would most likely be devastating for the aircraft manufacturer’s reputation. Consequently, I cannot imagine aircraft manufacturers like Boeing, Airbus and, of course, Lockheed Martin switching to a potentially cheaper competitor, ignoring the good track record and reputation of the existing supplier.

Balance Sheet Quality And Dividend Safety

From a debt-to-equity perspective, both companies are similarly leveraged (RTX 1.2, LMT 1.4), but given RTX’s still relatively weak free cash flow, its notional debt repayment is still much longer than LMT’s. Assuming Lockheed suspends its dividend and buybacks, the company would need less than two years to pay off its financial debt, while Raytheon would need nearly six years. Lockheed’s interest coverage ratio of 13 to 15 times normalized free cash flow before interest is also much more robust than Raytheon’s, which is currently only six times. However, Altman’s Z-score (weighted by the coefficients suggested by P. J. Waites in 2014) does not indicate a problem at either company, but of course Lockheed’s balance sheet looks better from this perspective as well.

Figure 4 shows the upcoming debt maturities of LMT and RTX as indicated in the two companies’ 10-K for 2021. Both look fairly well spread out, but Raytheon could see some increase in interest costs if interest rates continue to rise and remain at high levels over the next few years, as nearly 50% of the company’s debt matures within the next decade, compared to 37% for Lockheed Martin.

Upcoming debt maturities for Lockheed Martin and Raytheon Technologies

Figure 4: Upcoming debt maturities for Lockheed Martin and Raytheon Technologies (based on each company’s 2021 10-K)

If there is one thing that is potentially problematic on Lockheed’s balance sheet, it is its pension liabilities. I have already pointed out that the company has offloaded significant pension liabilities in the past and continues to do so. As a result (but also, of course, because of changes in valuation assumptions), Lockheed’s pension liabilities have declined as a percentage of total assets over the past decade, but not so much in absolute terms. At the end of 2021, however, accrued pension liabilities were $8.3 billion, down from $12.9 billion a year earlier. Table 1 compares various pension obligation-, debt- and goodwill-related metrics for Raytheon, Lockheed, and their competitors General Dynamics (GD), Northrop Grumman (NOC), and Boeing.

Selected pension obligation-, debt- and goodwill-related for GD, NOC, BA, RTX and LMT

Table 1: Selected pension obligation-, debt- and goodwill-related for GD, NOC, BA, RTX and LMT (own work, based on each company’s 2021 10-K and data from Moody’s)

Obviously, LMT has the largest pension liabilities at 16% of total assets, while RTX and GD had the smallest relative amounts on their balance sheets at the end of 2021. NOC and BA reported slightly higher amounts, and they are also the most leveraged of the five companies, as indicated by the percentage of net debt to total assets. The ratio of enterprise value (EV, taking into account net debt and operating leases) to market capitalization (MC) can also be considered as a measure of leverage, but is skewed in the case of NOC due to its significant overvaluation (see below). All five companies have investment grade ratings, which is hardly surprising given that they are all more or less significant government contractors and operate in oligopolies. It is also not surprising that Boeing’s long-term debt rating has a negative outlook, considering that the company is underperforming Airbus in several areas, doesn’t have a particularly solid balance sheet, and of course, because of the 737 Max debacle.

In terms of dividends, both Lockheed Martin and Raytheon are solid dividend payers in my opinion. Lockheed has announced a 7% increase last week, similar to Raytheon’s latest annual increase of almost 8% in April 2022. Lockheed’s latest increase marks the company’s 20th annual dividend increase and brings the dividend yield to 3.0% as of October 3, 2022. Raytheon shares currently yield 2.6%.

Given Lockheed’s stable free cash flow, the dividend is very well covered, and the payout ratio of less than 50% of normalized free cash flow signals plenty of room for growth. Unsurprisingly, RTX did not cover its dividend in 2020, but given the recovery path and expected strong growth in service-related cash flows, investors can expect annual increases in the high single digits going forward. Of course, a recession or a re-emergence of virus-related travel restrictions will most likely extend the company’s recovery path, but I would still consider the dividend safe from a balance sheet perspective.

Risks

The main risks, of course, include a recession or a resurgence of virus-related travel restrictions, which would hit RTX much harder than LMT. However, I believe the company is now less vulnerable to economic cycles, in part due to the diversification of Raytheon Company’s businesses following the merger. Of course, given that the United States and most other countries around the world took on very large amounts of debt during the pandemic, it seems plausible that governments are contemplating austerity programs. However, given elevated geopolitical tensions and increased demand for defense equipment in European countries, it is reasonable to assume that defense spending will at least remain stable in the future.

Raytheon is also more exposed to foreign exchange risks, as 38% of 2021 net sales were to international customers (p. 7, 2021 10-K). Lockheed’s international sales were only 28% of total net sales in 2021.

As an investor who owns stock in both companies, I also think it is important to note that the two companies are closely linked, as Raytheon manufactures the F-35’s engine. Fatal accidents resulting from a defective engine would certainly hurt both companies, and therefore shareholder returns.

The elephant in the room in connection with companies involved in the aviation business is, of course, the risk of design errors leading to the cancellation of orders and posing a significant risk to the reputation of the company concerned. Personally, I see this risk as even more pronounced in the context of commercial aviation, as demonstrated, for example, by Boeing’s 737 Max debacle. Therefore, I also consider Raytheon to be a somewhat riskier choice in this context. At the same time, however, the economic moat surrounding mission-critical equipment such as aircraft engines is exactly what long-term cash-flow-oriented investors should be looking for.

Finally, both companies have significant debt on their balance sheets. Lockheed, while lower leveraged, carries relatively higher pension-related obligations on its balance sheet. Both companies are likely to see interest expense rise over the next few years, but Lockheed is in a more comfortable position due to its very stable free cash flow and more balanced maturity profile.

RTX Vs. LMT: Valuation

Largely due to the ongoing conflict in Ukraine, Lockheed Martin and, to a lesser extent, Raytheon Technologies have largely withstood the bear market of 2022. However, compared to 52-week highs, shares of the two companies are down 17% and 22%, respectively. The steeper decline in RTX is understandable given the company’s dependence on commercial aviation and the ongoing recovery from the pandemic.

Also from a valuation perspective (Table 2), Raytheon is slightly cheaper than Lockheed and also other competitors such as Northrop Grumman and General Dynamics. This is largely due to the tailwind in military spending, which disproportionately benefits GD, NOC, but to a large extent LMT as well. Boeing is a stock I would call a “deep value pick” of sorts. The company suffers from a deteriorating corporate culture, the strength of its main competitor Airbus, and its balance sheet is not particularly strong either. An investment in Boeing would require extensive due diligence, as the company could easily become, or already is, a value trap in an impending economic downturn.

According to my discounted cash flow models for LMT and RTX, the former is cheaper than the latter. Based on the aforementioned cost of capital, investors expect free cash flow growth of 1.7% and 4.8% CAGR, respectively. This discrepancy should not be misunderstood as irrational exuberance in the case of RTX, but simply a consequence of the expected recovery from the pandemic somewhere between 2023 and 2025, the growing service-related cash flow, and the increasing emphasis on high-margin components. It is clear that Raytheon’s free cash flow is still significantly impaired.

Selected moat- and valuation-related metrics for GD, NOC, BA, RTX and LMT

Table 1: Selected moat- and valuation-related metrics for GD, NOC, BA, RTX and LMT (own work, based on data from Morningstar, Seeking Alpha and each stock’s closing price on October 3, 2022)

Conclusion

The two companies discussed in this article are generally well-managed blue chips.

Lockheed Martin should be seen as a pure play in the defense sector, but is in a very strong position due to its F-35 platform, which will be maintained through 2070. Concerns voiced at the end of 2021 about LMT’s weak growth expectations have subsided due to the ongoing conflict in Ukraine and the related increased interest in defense spending, not only from the U.S. but especially from European countries.

RTX is much more diversified and less dependent on defense spending due to its Collins Aerospace and Pratt & Whitney segments, which generate significant revenues in the commercial aviation sector. The exposure to commercial aviation is, of course, a double-edged sword as it increases sensitivity to economic cycles. This is particularly underscored by the still ongoing recovery from the pandemic. In this context, the less cyclical defense segments provide a cash flow cushion in difficult economic times. However, as the company ramps up production of its GTF Advantage engine, cash flows are expected to grow strongly and become increasingly stable thanks to long-term service contracts.

Both companies have a wide moat around their business. Military and commercial aircraft are very capital intensive and require a special focus on safety and reliability. Therefore, and given the consequences of fatal accidents, it seems very unlikely that Lockheed or Raytheon customers would sacrifice safety and reliability for cost advantages. In addition, switching costs are typically very high because many components supplied by the two companies are deeply integrated into the aircraft and are difficult to replace.

I view RTX as a bet on the next economic expansion, with the added benefit of reliable cash flow from government contracts and a growing number of service and maintenance contracts. LMT is more of an anchor position, as it is less sensitive to economic cycles, but of course much more dependent on government defense budgets.

I own both stocks in my portfolio, but have only recently started buying shares in RTX. At a price in the low $80 range, I think RTX is a reasonably good buy, but am somewhat cautious because of the company’s relatively higher cyclicality and still impaired free cash flow. I have been an occasional buyer of LMT stock in 2021 and plan to add to my position if the stock price continues to decline. I consider the company an acceptable buy in the high $300 range.

Thank you very much for taking the time to read my article. In case of any questions or comments, I am very happy to hear from you in the comments section below.

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