Raytheon (NYSE:RTN) is one of a select group of large and well-known military industrial companies that serve the United States and its allies. It has a diversified business, with a focus on key and emerging areas of the defense industry that should serve it and its shareholders well over the long term. But is that enough to make Raytheon a buy? There's more to know here before you jump in.
A good business
Raytheon has four main divisions: intelligence, information, and services (22% of sales), integrated defense systems (23%), space and airborne systems (23%), and missile systems (30%). The last two are really core specialties, and both relate to the changing face of warfare, in which air supremacy and the ability to attack from vast distances is vital to maintaining an edge. It also has a small but growing business in the cyberspace area, known as Forcepoint (2% of revenues), which is an increasingly important defense issue.
As one would expect, a huge portion of Raytheon's business is tied to the U.S. government (about 70% of sales). However, the company also works with U.S. allies, and roughly 30% of its top line comes from other countries spread across Europe, Asia, the Middle East, and Africa. While the company's foreign sales offer diversification, it's important to remember that because of the products Raytheon makes, it can't simply sell to anyone. So even here, there's a tie back to the U.S. government, which generally must give its approval for foreign sales.
Financially speaking, Raytheon is on solid footing. It has an investment-grade balance sheet. Financial debt to equity is a very low 0.12 times, well below the levels of its closest peers. And it covered its trailing 12-month interest expenses by an incredible 21 times, vastly more than any of its peers. This is a company built to survive an industry downturn. It also has a 14-year history of annual dividend increases under its belt. (The roughly 1.9% yield is about what you'd get from an S&P 500 Index fund.)
As for the company's recent financial performance, 2018 was a pretty good year. Revenues were up nearly 7%, earnings advanced 46%, and the company generated record levels of cash flow. And, perhaps equally important, the company's $42.2 billion backlog of work at year-end was also at a record high. That suggests that the good times are set to continue for this military contractor. It's added a number of additional contract wins through the first few months of 2019, as well.
From a fundamental perspective, Raytheon looks like a great company to consider adding to your portfolio. The problem here is valuation, where the picture is a little more mixed.
Check out the latest earnings call transcript for Raytheon.
Price is what you pay
To paraphrase investing legend Benjamin Graham, a man who helped train Warren Buffett, even a great company can be a bad investment if you pay too much for it. Graham's preference was to buy stocks when they were on sale, usually when they were deeply discounted. That is definitely not the case with Raytheon today.
For example, the company's price-to-sales and price-to-book ratios are above their five-year averages. These metrics are also higher than the average for the SPDR S&P Aerospace & Defense ETF, which is a rough proxy for the industry. That said, Raytheon's price-to-earnings and price-to-cash flow ratios are both around 10% or so below their five-year averages. The P/E and P/S ratios are also below those of the broader group. This is a decidedly mixed picture, which likely suggests a company that's fairly valued.
Where the ratio analysis gets a little more interesting is the price-to-earnings-to-growth ratio, which is also known as the PEG ratio. This metric compares valuation and growth potential. Raytheon's PEG ratio of 2.4 times is well below its five-year average of 3.75 times. This ratio is also at the low end of its largest and closest peers. This suggests that investors may not be giving Raytheon enough credit for its growth potential. So from this perspective, the military contractor looks interesting.
But the big picture here is that, when looking at Raytheon, investors really don't come away with a definitive answer on the valuation front.
Is Raytheon right for you?
Raytheon is a well-run company that looks well prepared for the future, even if that includes some lean times. A great company, however, isn't always a great investment. Although it appears that investors may be underestimating Raytheon's growth potential, it's hard to suggest that the current price is a bargain. If you are a growth-minded investor and don't mind paying full price, or at least close to full price, Raytheon might be of interest to you. However, if you have a value bent and prefer to build in a margin of safety by buying at a discount, then it's still best to keep this name on your wish list and not your buy list. In other words, most investors should still be passing on this great company.