Shares of Raytheon (RTN +0.00%) have exploded higher this year, as instability in the Middle East and on the Korean Peninsula has focused investor attention on defense suppliers. Raytheon is up 27% year to date, more than doubling the S&P 500, and besting rivals Lockheed Martin, Northrop Grumman, and General Dynamics, as well.
The world's a dangerous place, so the long-term outlook for the defense sector remains strong. Here are three reasons to be particularly optimistic about Raytheon.
A global reach
Despite the U.S. government's seemingly endless hunger for new armaments, political gamesmanship, budget battles, and sequestration in recent years have all been reminders of the risk of being overly reliant on a single customer. Raytheon has done better than most of its peers at countering that risk.
Raytheon's missile expertise and, in particular, its Patriot missile-defense system, is popular among U.S. allies in the Middle East and across the globe. About 32% of second-quarter total sales and 35% of bookings were from international customers. In total, about 42% of the company's $36.2 billion backlog is comprised of international programs. Lockheed, by comparison, generated about 27% of sales internationally in 2016, while Northrop international sales totaled less than 15% of total revenue.
That diversification should benefit the company even after the initial order is complete. Raytheon is continuously updating its technologies. This year, for example, it developed a new radar for its Patriot system that allows it to detect potential threats earlier, and better track multiple targets simultaneously. As new advances are introduced, the company has a dozen potential customers with Patriot deployments around the world to which it can sell upgrades.
Right place, right time
Not all defense companies are created equal, and the Pentagon's shifting priorities tend to favor certain companies disproportionately. Raytheon is, perhaps, the most concentrated of all of the major defense contractors, but its core businesses are in the sweet spot of where the United States and its allies figure to spend much of their money in the years to come.
The Pentagon is dropping bombs in the Middle East faster than it can replenish them. Contained within the department's fiscal year 2018 budget is a request for $3.5 billion for preferred munitions, including Raytheon-built Tomahawk missiles and Small Diameter Bombs (SDBs). On Sept. 27, Raytheon was awarded $450 million from the Pentagon to continue design, development, and production of the SDB, and additional awards should follow.
A Raytheon Tomahawk missile is launched from the USS Sterett. Image source: U.S. Navy via Flickr.
Raytheon has particular expertise as a maker of advanced radar systems used for battlefield management and to track incoming threats. It's also a subcontractor on the Terminal High Altitude Area Defense missile system deployed in South Korea and on Guam to counter North Korean saber rattling. With global conflicts increasingly becoming a battle of competing technologies instead of just armies meeting on the battlefield, Raytheon figures to be a key supplier.
High-tech potential
Raytheon, in 2015, invested $1.57 billion for a controlling stake in Websense Inc., combining the commercial cybersecurity company with its in-house tech unit to offer military-grade cyber protections to civilian customers. So far, the combined unit, rebranded as Forcepoint, has failed to overwhelm. Its backlog is basically unchanged over the past two years, and a heavy investment in sales and marketing have led to operating margins of just 6.4% for the first half of 2016.
But Raytheon was thinking long term when it did the deal, and the company projects double-digit sales growth and margins for Forcepoint in the years to come. Private equity firm Vista Partners LLC still owns a 19.7% stake in the unit, and Raytheon will be required to eventually buy out its junior partner, or do an IPO. Should Forcepoint achieve the double-digit growth and margins Raytheon envisions, it would be a compelling addition to Raytheon's overall offering.
In June, Forcepoint CEO Matthew Moynahan told German business daily Boersenzeitung, "we think we could unleash enormous potential" via a public listing, though stressing it was too early to really contemplate such a move.
Raytheon's cyber unit has grown from about $100 million in annual sales prior to the Websense deal to $566 million in 2016. Apply the 4.71 multiple to sales the market currently assigns cybersecurity rival Symantec, and Forcepoint would be worth $2.6 billion today.
Raytheon targets returning about 80% of free cash to shareholders. Should the company continue to grow Forcepoint and eventually do an IPO, there could be a nice windfall awaiting shareholders in the years to come.
The bottom line
Raytheon's strong 2017 showing has the stock in uncharted territory, trading at above 2.2 times sales for the first time in at least 20 years. The company is going to have to make the most of all of these catalysts if it's to justify that sort of valuation.
Raytheon isn't there yet, and some of these opportunities, like Forcepoint, are going to take time to play out. Given the current premium valuation, there isn't a reason to rush in and buy the shares. But for investors with an ultra-long-term horizon or current holders of the stock, there's ample reason to believe the company's future is bright.
