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A 20% Price Drop Isn’t Enough to Make This Defense Stock a Bargain

By Reuben Gregg Brewer – Updated Nov 22, 2018 at 8:31AM

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Raytheon stock is down materially from recent highs, here's what's going on and why the drop still isn't enough to make the stock a buy

Military contractors across the board have been hit hard since late September, with Raytheon Company (RTN) now down over 20% from early-year highs. After such a material drop, one that would put the stock in "bear market" territory, it makes sense for investors interested in the military contractor space to take a look at this industry-leading name. But value conscious investors shouldn't jump in just yet; here's what's going on and why Raytheon is still a pass.

Looking behind the drop

Raytheon really has one major customer, the U.S. government. Many of its contracts, meanwhile, span multiple years and can even last a decade or longer. There's not a huge question about whether or not the company will be paid, but there's always a little uncertainty about changes at the government level that might impact military contractors.

A military drone flying in the sky

Image source: Getty Images.

Usually the issue is budgeting-related, with the big concern being defense spending cuts. However, in late September there was a notable move toward changing the way in which defense contractors like Raytheon get paid. Although this is a simplification of a complex process, defense contractors are effectively on the hook to pay for a project until it is completed. Because contracts are often massive, in the multibillion-dollar range, it would be difficult for most companies to front that kind of cash. So the government provides reimbursements along the way, called performance- and progress-based payments.     

This is a pretty big deal, with some industry watchers suggesting that these payments could be cut from 80% to 50%. That would leave contractors like Raytheon to cover more of a project's costs until it was completed and the government would pay it in full. The added costs might require additional leverage and could eat into free cash flow. That, in turn, could make it harder for companies to pay dividends and, more generally, fund their ongoing businesses. The government and contractors are in talks to try to find a middle ground that makes both sides happy, but investors are clearly showing their dissatisfaction with the uncertainty caused by the plan to change the way in which contractors are paid.   

It's likely that a deal will be worked out and that, longer-term, the industry will adjust to whatever the new rules end up being. And there's not likely to be a material impact from whatever decision is made for a year or more. So the current drop is more about uncertainty than long-term viability. The United States will always need a military and the vital companies that support it.

RTN Chart

RTN data by YCharts

In fact, Raytheon is doing really well right now. Third quarter sales were up 8% year over year with earnings advancing 14%. The company even raised its full-year 2018 earnings guidance... for the third time this year. And it provided a first look at 2019, suggesting that sales will be up between 6% and 8%. This is not a company that's struggling and 2019 looks likely to be another good year.   

One of the key metrics here is the company's backlog of work it's contracted to perform but that has yet to be completed. At the end of the quarter Raytheon's backlog stood at $41.6 billion, up $5 billion year over year. That's a record high for the company. Helping that along was a book to build ratio of 1.28 in the quarter. A number over one indicates that a company was awarded more contracts than it worked off. For the year the company is expecting a book to build ratio of 1.1. With a growing backlog of work in the pipeline, management painted a bright picture during the conference call

Cheaper, but not cheap

Which is why investors shouldn't be too quick to jump on Raytheon's stock. To paraphrase Benjamin Graham, often considered the father of fundamental analysis, even a great company at too high a price can be a bad investment. And, despite the stock decline, Raytheon's strong outlook has left it looking pretty expensive today relative to peers.

RTN PE Ratio (TTM) Chart

RTN PE Ratio (TTM) data by YCharts

Pulling out some key metrics, Raytheon's price to earnings ratio of roughly 21 is above its five-year average of 19.6. The stock's P/E is even more out of line with the broader aerospace and defense industry, as benchmarked by iShare U.S. Aerospace & Defense ETF (ITA 0.88%), which has an average P/E of roughly 18.6.     

But it isn't just P/E that's suggesting Raytheon is expensive today. The trend is the same for price to sales, price to book value, and price to cash flow, as well. In each case, the company's current numbers are higher than the five-year average and the broader industry. Yes, Raytheon's shares are cheaper than they were a couple of months ago; however, they still aren't cheap.

Not the right time

Raytheon is a well-run company in a vitally important industry. With only one main customer, investors are rightly concerned about a potential change in the way military contractors get paid. However, Raytheon is doing very well right now and 2019 looks like it will be another good year. The upshot of these two facts is that, while the stock has fallen around 20% from recent highs, it still isn't cheap. This is a case of a great company that's not a great investment right now if you have a value bent.

Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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