It's remarkable how events can change the narrative around a stock. Just a couple of short months ago Raytheon (NYSE:RTN) investors were looking forward to an exciting future with merger partner United Technologies (NYSE:RTX), or specifically, the aerospace business of UTX, Pratt & Whitney and Collins Aerospace.

The deal made perfect sense and the valuation looked attractive -- even using management's conservative looking guidance. However, with the advent of the COVID-19 pandemic, the whole investment outlook may have changed. Here's why, plus what you need to know before buying Raytheon stock.

A commercial airplane in flight.

Raytheon needs the commercial aerospace market to be strong. Image source: Getty Images.

Why Raytheon has underperformed 

The following chart goes a long way in explaining what's going on. As you can see below, Raytheon's defense peers Lockheed Martin and Northrop Grumman have outperformed the S&P 500 index in 2020, but Raytheon and its merger partner UTX have notably underperformed. The reason is that the measures taken to contain the novel coronavirus pandemic have hit the commercial aviation industry very hard.

As such, Raytheon investors must have felt as if the stock is already being treated like the company it will become: Raytheon Technologies, and that includes UTX's aerospace businesses too.RTN Chart

RTN data by YCharts

Raytheon looks like a good value, caveat emptor

Based on the information in UTX's SEC filings regarding the merger, the stock looked like a good value at the time, and it looks an even better value now.

Raytheon shareholders will get 43% of the new company. Based on Raytheon's current market cap of $40.5 billion, the market cap of the future Raytheon Technologies is valued by the market at around $94 billion. Add in the $26 billion in net debt and you get an enterprise value (market cap plus net debt), or EV, of $120 billion.

Using the approximation for EV and the figures for earnings before interest, taxation, depreciation, and amortization (EBITDA) and earnings before interest and taxation (EBIT) shows that the new company looks a great value based on the forecasts discussed above.

Metric

2020

2021

2022

2023

EBITDA

$15 billion

$16.3 billion

$17.1 billion

$17.9 billion

EV/EBITDA multiple

8

7.4

7

6.7

EBIT

$11.4 billion 

$12.6 billion 

$13.3 billion

$14 billion

EV/EBIT multiple

10.5

9.5

9

8.6

Data sources: United Technologies SEC filings, author's analysis.

The problem

Unfortunately, the earnings assumptions above are coming under severe threat from the slump in passenger traffic created by the COVID-19 pandemic. As the coronavirus has spread from its origin in China, the potential losses in revenue to airlines have mounted

Of course, if airplanes aren't being flown, there will be no aftermarket demand for Collins Aerospace and Pratt & Whitney aircraft engines. Moreover, if airlines are going bust, there will be cancellations of aircraft orders -- not good for Collins Aerospace, and disastrous for Pratt & Whitney's goal to generate a long-term income stream from servicing its airplane engines.

The jewel in UTX's crown is Pratt & Whitney's geared turbofan (GTF) engine, which competes with CFM International's (a joint venture between General Electric and Safran) LEAP engine on the Airbus A320 NEO. UTX currently has a 40% share, but has won 50% of the orders in the last year according to UTX CEO Greg Hayes. The question is, what happens to the assumptions around long-term cash flows from the GTF if airplane orders start to get cancelled? 

All told, nearly all of UTX's commercial aerospace revenue streams are under threat from ongoing weakness in the industry. 

Should you buy Raytheon stock?

Ultimately, this decision comes down to a personal view on the medium-term future of the commercial aviation market and the COVID-19 pandemic. You could split up the range of outcomes as follows, starting with the most bullish first:

  • The containment measures work as they did in China and there is a relatively quick global recovery; commercial air traffic normalizes in line with how it did after the SARS outbreak in 2002-2003.
  • Containment measures work over time and damage the aviation industry; commercial air traffic normalizes as outlined above.
  • Containment measures work over time; commercial air traffic enters a protracted period of lower growth as consumers are reluctant to travel.
  • Containment measures work, but only over an extended period; commercial air traffic recovery is delayed and a new normal of lower growth is ushered in due to ongoing hesitancy.

The likely outcome

It's impossible to know which one of these outcomes, if any, will occur. However, if it's the first, or something in between the first and second, then it's reasonable to expect a financial outcome along the lines of what's outlined in the table above but with a delay. In other words, Raytheon stock could be a very good value.

However, the third scenario requires a significant reappraisal of the new company's earnings prospects, and the fourth probably means you should avoid buying stocks altogether.