Raytheon Price Contained At $90 Ahead Of Earnings? (NYSE:RTX)

Over the course of 2022, we traded Raytheon (NYSE:RTX) stock, and found ourselves questioning after hitting the sidelines earlier in the year, given the lack of upside to our position… Why didn’t Raytheon break $100, and what’s keeping the stock price contained at $90-$100?

We value the stock at $95 based on 21x FY ’25 non-GAAP EPS. We expect very limited upside to the stock based on the guidance that’s embedded into the stock, and the underlying assumptions of margins/growth embedded into our model. We feel confident that Raytheon will eventually get some of its weapon programs back on track as we progress through 2023.

Q4 ’22 earnings results set to be released Tuesday morning on January 24th may defy some of our expectations assuming RMD (Raytheon Missile and Defense) segment surprises on better than expected deliveries as opposed to order backlog growth. If the numbers mostly disappoint we doubt the stock will drop by much, as investors seem patient enough to wait on bad quarters, but could load up on any surprises. Even so, the business is so fairly valued according to our model that there’s absolutely no way we can recommend buying the stock, or selling short the stock, so we start out with a neutral rating on RTX… and find ourselves trading a tight range as opposed to hoping for a break-out above the key $100 level anytime soon.

Lawmakers and US defense spending holding up the stock price?

The Ukrainian War got priced-into the stock relatively early with Republican members of Congress and some Democratic lawmakers opting to buy aerospace and defense stocks. While it’s noteworthy that lawmakers have some Aerospace stock, we doubt it primarily influences their decision making much. There’s a lot of lawmakers that don’t own aerospace shares, so to gauge the interest in increasing war spending we look to some political sources.

Lawmakers are communicating like a confused Football team in the middle of OT as to how much defense spending to allocate this upcoming year. The sheer confusion among lawmakers and the amount to appropriate towards defense amid budgetary concerns, and government spending has caused the defense stocks to lag throughout the course of the year.

According to Politico correspondent Connor O’ Brien:

If Republicans’ fiscal hard line doesn’t result in reduced spending, the gridlock will likely force Congress to put spending on autopilot. Funding programs through temporary continuing resolutions. Defense hawks are eyeing another real increase this year of up to 5 percent to meet threats posed by Russia and China and to mitigate high inflation. And supporters of increased defense spending are now warning up front that they outnumber the budget hardliners in the GOP conference.

Yes, we have reached a point where Washington dysfunction can cause a spending cut to defense this year in the absolute worst case scenario. Though, we find it unlikely that the mixed Congress will be unable to pass an increase to defense spending, we note that there’s potential downside risks if the spending debate gets dragged out, but based on the current spate of debate and argument among lawmakers in Congress it may take a while longer to get a spending bill on defense finalized.

Analysts at Wells Fargo Securities also recently cited that major risks to defense stocks could come in the form of spending reductions, which has caused the defense names to lag a little in recent weeks. Matthew Akers from Wells Fargo Securities mentions, “A key issue will be whether Republican lawmakers will press for a rollback in fiscal 2024 spending to 2022 levels. Such a reduction would reduce defense spending by about 10%.” However, Connor O’ Brien back at Politico mentions, “Gutting the domestic funding for this fiscal year that House Democrats enacted on their way out of power will almost certainly be rejected by the Senate, which remains in Democratic hands, and President Joe Biden.”

Matthew Akers from Wells Fargo Securities goes onto mention the various downside scenarios in his report:

“A discretionary cut of this magnitude still seems unlikely to us given that many in Congress still want spending to move higher, including for defense,” according to Wells Fargo. “However, we are taking a closer look at the potential impact if this cut does come through.” Cutting 2024 defense spending to the 2022 level would trigger a 35% to 40% decline for defense stocks, the bank estimated. Capping it at the recently approved 2023 level could spur a 15% decline.

In other words, approving at the same levels could cause aerospace stocks to decline by 15%. Expectations of spending growth are already embedded into the expectations of US aerospace stocks.

International demand for Aerospace & Defense keeps bulls from panicking however

We find that across the board spending increases on defense related spending in both the European Union and Asia have already commenced with Japan committing to double its military spending to a 2% threshold, and enlist a larger active military force to match the Government’s spending objectives of reaching $324 billion in military spending over 5-years versus the prior $215 billion in military spending.

We anticipate that Japan will make various purchases of Patriot missile systems and missile ammunition from Raytheon Technologies. We also anticipate purchases of Tomahawk cruise missiles, and perhaps even pursue development of subsonic missile systems to keep pace with Chinese, North Korean and Russian missile programs. It’s also worth noting that Japan has started development of a 6th-generation stealth aircraft with the help of the United Kingdom and Italy, according to a news report.

This may put somewhat of a limit on the amount of demand for the F-35 stealth fighter from 2030 onward from other G-7 member countries excluding the United States. Lockheed Martin (LMT) and Raytheon will have to work diligently to reassure foreign allies that the existing 5th generational stealth fighter aircraft should be purchased in larger numbers.

This also impacts Raytheon, as it’s the primary supplier of the propulsion system for the F-35 and was awarded a recent $4.5 billion contract to retrofit the existing F-35 inventory, which could go onto become a sustainment contract valued at $9 billion for batches 15 and 16 for the Joint Strike Fighter.

Poland is also a noteworthy spender that’s been increasing its military spending, which makes sense as it borders with Russia directly, and is the primary EU-partner that supplies the Ukrainian military with weapons. However, much of Poland’s military contracts seem tied up with South Korean defense companies, including ground to ground missile systems from South Korea as well. However, we find that Raytheon’s ability to sell a wide variety of ammunition inclusive of Javelin rockets to be instrumental in the Ukrainian effort on the front-lines.

Delays in the procurement of F135 engines has put some added pressure on RTX

It’s also worth noting that Raytheon still has exposure to Poland primarily in the form of F-35 fighters that are a part of the batches 15 and 16 and potentially 17. The Raytheon engines are part of the 145 F-35 orders from Poland, Belgium and Finland. Lockheed Martin and the US Pentagon finalized the $30 billion lot agreement on December 30, 2022, which has diminished some concerns. But then again, the aerospace industry is notorious for delays, as the next lot of fighter jets went through you guessed it… more delays. The Pentagon temporarily stopped accepting orders for the Pratt and Whitney Engine for the F-35, because of a mid-December 2022 crash, which is delaying orders for the Pratt and Whitney F135.

Defense News goes on to elaborate:

“A source familiar with the program told Defense News the investigation into the Dec. 15 mishap found that a tube used to transfer high-pressure fuel in the fighter’s F135 engine, made by Pratt & Whitney, had failed. This discovery prompted the JPO to update its safety risk assessments, which affected jets with fewer than 40 hours of flying.”

Given the on-going delays with the F135 engine, and the recent failure in a test flight at a Texas facility, we anticipate that the order backlog will increase. Furthermore, this happened just days after completing the $30 billion lot agreement with the Pentagon, which further highlights the recency of losses that RTX has suffered in recent weeks. It’s not just the confusing political environment, but also the recent delay in the F-35 production and procurement that has put a lid on RTX’s stock price recently.

Next generation missile programs and keys for the upcoming quarter

Keep in mind, despite the gridlock in Congress we find that Raytheon’s next-generational missile program, or hypersonic missile program valued at $1 billion was awarded by the Pentagon this past September. Though, it’s not a massive contract by any means, we anticipate that next-generational development of the weapons program will yield an immense return in the form of follow-on contracts for a completed and functional hypersonic missile. It’s also reassuring that Raytheon was able to beat out its two primary competitors for the contract, Lockheed Martin and Boeing (BA).

Raytheon will be reporting earnings results on January 24th, 2023 on Tuesday morning. Analysts expect the company to report sales and earnings of $18.15 billion, and GAAP EPS of $1.02.

Expectations are mostly muted on growth as consensus expects the firm to report mostly in-line or slightly below prior guidance. Furthermore, with the spate of bad news tied to the Pratt & Whitney division, and negative growth comps for missile and rockets owed to shortages and an expanding backlog, expectations on earnings results isn’t all that high, and for the most part we think analysts and investors will hope to get better clarity on long-term growth trends and whether Raytheon can stick to its longer-term guidance of sustained revenue growth into FY’25.

Seth M. Seifman from J.P. Morgan summarizes Raytheon’s Laguna Conference from September of 2022:

RTX sees mid- to high-single-digit Defense growth through 2025. If we grow the midpoint of this year’s RIS (Raytheon Intelligence and Space Segment) and RMD (Raytheon Missile & Defense) sales guidance by 7% annually for three years we get $37b in 2025. This compares to the nearly $36b target from May 2021. (Expected growth for 2023-25 is stronger now but 2021-22 were light.) It is plausible that demand will support this growth but whether it will be evenly distributed through the period depends largely on the execution, where mgmt highlighted that near-term challenges remain.

It’s worth noting that Raytheon’s Missile and Defense reported a 6% y/y decline in Q3’22. We’re hoping that there’s some strength in results from Q4 ’22 earnings call and a return to some growth or sequential gains in the segment. We’re not expecting much in the way of space development until after the U.S. government passes a new budget. That being said, we’re still optimistic on the company long-term, as we anticipate that we’re still in the early-innings of the Ukrainian War, and that the cost of the war, and sustainment of resources to the front lines will likely keep RTX relevant in the minds of investors.

The main reason for slower RMD (Raytheon Missile and Defense) sales has more to do with production shortages driven by component shortages. We’re not certain if these supply issues have alleviated themselves on the missile munitions side of the business, though we’re well aware of the difficulties with the F-35 stealth fighter jet program in Q1’23.

We’re hoping for management to provide some colorful or optimistic commentary tied to the recent grounding of the F-35 jet, and its F-135 engine. For the most part, assuming management can deliver above expectations on just the RMD segment investors might reward the stock. Any news tied to the F-35 program that’s positive such as a resumption of orders following a technical fix would do even more to help the stock in 2023.

Valuation and the amount of upside we see in the stock

We value the business on FY’25 revenue and earnings, and apply a discount to our valuation to arrive at a fair value on RTX. We take the midpoint of the 2025 financial guidance and estimate revenue of $36.5 Billion for the RMD segment, and add the revenue contribution from the remaining segments $44.5 Billion to arrive at FY ’25 revenue of $81 billion. We anticipate that the company will grow revenue from FY ’22 $67.15 billion (consensus) to $81 billion (6.45% average sales growth) by FY ’25. Assuming the company is able to narrow some of its backlog and work on component constraints and shortages, RTX should sustain 6-7% revenue growth, but even that could prove too aggressive in this environment.

We apply an 11% non-GAAP profit margin to arrive at our non-GAAP net income, and non-GAAP dil. EPS figure. We estimate FY ’25 non-GAAP net income of $8.91 billion and non-GAAP dil. EPS of $6.14 on 1.45 billion shares outstanding (consensus conforming estimate). We then value the company at 21x non-GAAP net income or $187 billion and apply a 8.15% firm discount based on the WACC (weighted average cost of capital) to arrive at a valuation of $137.25 billion or $94.65 per share (we basically have a $95 price target).

Based on our valuation approach the stock trades awfully close at $94.36 per share. As a consequence, we see the stock being perfectly priced currently. So we cannot even lift our value estimate absent any material news tied to an improvement in jet engine orders, or better than expected deliveries from the missile segment for us to raise expectations on the stock.

So why are we stuck below $100?

Based on the long-term guidance, and the way analysts and investors value companies we arrive at the conclusion that the company is fairly valued and it would take an act of Congress to lift expectations on sales/earnings over the next 3-year period. Furthermore, we find that the recent grounding of the F-35 program alarming.

Until the engine issue gets solved and the missile deliveries improve, the stock might not break past $100 this year either. Based on just the growth inputs and long-term outlook it’s fair to assume that investors are either on the sidelines, or looking to hedge war themed risk, as opposed to hoping for a major break above $100.

We also hit the sidelines on our RTX stock positions earlier in May of 2022, as it hovered between $90 to $100. News suggested the stock could have much more upside, but the underlying business fundamentals haven’t improved by much in FY ’22.

Hype sent the stock higher, and the outlook and guidance embedded into the stock already reflects a fair valuation. Our 12-month price target implies that the stock will yet again trade range bound between $90 to $100 as opposed to the stock reaching the consensus price target of $107.24 implying 12%+ upside from current levels.

For these reasons we rate RTX a neutral or hold. Certainly some potential to trade the stock in a tight range given the wedge of bad/good news, but there’s hardly a compelling momentum thesis until the company delivers on production or wins a major aerospace and defense contract in foreign markets.