At first glance, Raytheon (NYSE:RTN) appears to be an obvious winner from the Pentagon's push toward high-tech surveillance, missile defense, and refreshing the military's stockpile of advanced weapons. But you'd never know it from the company's fourth-quarter results or from its disappointingly conservative 2019 guidance.
The company reported quarterly revenue of $7.36 billion, up 8% year over year but short of analyst expectations for $7.46 billion in sales. Raytheon earned $2.93 per share in the quarter, ahead of estimates, but the beat was attributable to a substantial benefit from a lower tax rate, which was able to offset below-expectation operating results.
Raytheon also said it expects to generate $11.40 to $11.60 per share in earnings in 2019, below analyst expectations for $11.78 per share, on revenue of between $28.6 billion and $29.1 billion. This is around what analysts expected.
Raytheon is unique among the prime defense contractors in that it lacks large flagship properties like bombers, tanks, or warships; focusing instead on electronics, sensors, precision weapons, missile defense, and cyber, among other areas. The portfolio of best-in-class products gives it exposure to a wide range of platforms made by other contractors, as well as a leading seat at the table as the government contemplates spending hundreds of billions to refresh its missile and missile-defense capabilities.
Though Raytheon shares reacted negatively after the quarterly numbers were released January 31, a closer read of the results and the projections for the future show that Raytheon holders have little to worry about.
Investing for the future
In the quarter, Raytheon experienced some revenue weakness in its cyber and missile businesses, while classified business helped both its space and integrated defense systems (ISS) produce higher-than-expected revenue.
Profitability was hit by margin pressure in key areas. ISS -- focused on missile defense, radar, electronic warfare, and the command and control systems that manage these programs -- generated margins about 150 basis points below expectations due to investments in radar research and development (R&D) and several mature programs that are in the process of winding down. Its missiles unit, with margins of 11.8% compared to expectations of 14%, was similarly hit by early-stage development work and some production reserves.
Many of those factors figured into the depressed guidance for 2019, but CFO Toby O'Brien, on a call with investors following the results, was quick to note that the margin-draining R&D work being done now should pay off in the future.
Over the long term, it's positive because it does generate those new franchises and margin expansion opportunities when programs move into production. So I think specifically for missiles, we do expect them to improve their margins versus '18 and '19, as I said, to a range of 12.1% to 12.3%. They clearly have been hit with the higher level of development classified programs.
Missile bookings, O'Brien notes, climbed nearly 50%, to $1.5 billion in 2018.
Raytheon also has a large Army training contract winding down in 2019 that will eat into full-year revenue growth, depressing estimates by upwards of 2%.
Outlook is still strong
Raytheon has been a highflier over the past five years with its shares up nearly 75% and easily outpacing the S&P 500's 51.6% gain. But the last year has not been so kind to Raytheon investors: The company's shares are down 20% -- and down 12.5% in December alone -- compared to the S&P's 4.3% decline in the last 12 months.
Despite concerns about political infighting and fears that lawmakers will struggle to agree to a fiscal 2020 budget, the bull case on Raytheon is intact. The headwinds that ate into fourth-quarter results and depressed guidance appear to be more of a speed bump than a cliff, and the government's appetite for Raytheon-made products should continue into the foreseeable future.
Raytheon generated operating cash flow from continuing operations of $3.4 billion in 2018, beating the midpoint of its guidance for the year by $600 million. That appears sustainable and not just quicker-than-expected payments pushing the 2018 number higher at the expense of future quarters, as Raytheon upped its estimates for 2019 by $100 million, even after accounting for expected additional tax payments.
That cash number is important for investors, as Raytheon intends to return 80% of free cash flow to shareholders via dividends and buybacks. Raytheon does have some pension funding requirements to navigate over the next few years. But the cash, along with Raytheon's sector-low leverage, also gives the company significant firepower to do an acquisition if management sees an opportunity to boost its technology portfolio or spark growth.
Raytheon is not cheap: Trading at 19.36 times trailing-12-month earnings, it commands a higher valuation than most of its defense peers. If you're an investor picking defense stocks right now, I still prefer Lockheed Martin for the diversity of its portfolio and General Dynamics for its potential to appreciate in value as a key operating unit gets back on track.
But Raytheon holders with long-term horizons shouldn't lose faith because of the company's latest results. This is an excellent company with its finger on the pulse of Pentagon priorities that should be set up for growth for years to come.