The recent earnings presentations from Raytheon Technologies (NYSE:RTX) served to highlight the investment case for the stock. In a nutshell, its commercial aerospace operations are facing very significant headwinds in 2020 and it's not going to be a V-shaped bounce back. However, RTX's defense businesses are going to support the company through difficult times, and on a risk/reward basis the stock looks a good value now. Here's why.
It's a good idea to break out expectations for its defense business in 2020 and beyond and then look at what this means for the overall valuation.
The company is the result of a merger between the aerospace businesses (Pratt & Whitney and Collins Aerospace) of the former United Technologies and the former Raytheon Company. Pratt & Whitney (engines) and Collins Aerospace (aerospace systems, avionics) are largely commercial aerospace businesses active in the original equipment manufacturer (OEM) and aftermarket space. Meanwhile, Raytheon Company was largely a defense business (missiles, defense systems, intelligence, and space). For argument's sake, let's assume that Raytheon Company represents the defense business of RTX.
Raytheon Technologies' defense business
As such, RTX is a business with around 55% of its sales coming from the defense market. The good news from the recent earnings call is that management affirmed that the impact on the profitability of its defense businesses in 2020 is likely to be minimal.
For example, management started 2020 by predicting its defense business (Raytheon Intelligence & Space, or RIS, and Raytheon Missiles & Defense, or RMD) would generate $3.75 billion to $3.86 billion in segment profit. Fast forward to the first-quarter earnings report and management is predicting just a $25 million reduction in profit from COVID-19.
In other words, the defense side of RTX remains on track, and it's reasonable to assume it's still on track for around $3.6 billion in free cash flow (FCF) in 2020 -- a figure outlined in analyst projections in company's SEC filings.
Taking that figure and assigning the average price to the FCF multiple of three of its peers (18.5) gives RTX's defense business a value of $67 billion. Given that RTX's market capitalization is currently $82 billion, this suggests the market is valuing the commercial aerospace business at just $15 billion. Frankly, that looks too cheap. A similar conclusion is reached when looking at an earnings-based approach.
Commercial aerospace and free cash flow
The question on everyone's mind is: What kind of FCF can be expected from commercial aerospace businesses in 2020 and beyond? During the earnings call, Jefferies analyst Sheila Kahyaoglu threw out a figure of $4.5 billion for overall FCF in 2020 and RTX chief executive officer Greg Hayes told her that her figure was "optimistic."
Given that Hayes expects RTX's commercial aerospace aftermarket and OEM sales to both be down around 50% in 2020, it's hardly surprising that FCF is seen as taking a hit too.
Goldman Sachs analyst Noah Poponak looked at matters from a slightly longer-term perspective, suggesting that $6 billion to $6.5 billion could be an FCF "floor in 2021," but chief financial officer Toby O'Brien said it "was too early to tell." Later on, Hayes said that the aftermarket segment would come back before the OEM market, remarking: "I think it's going to be a full two years before we see a recovery close to what we saw in terms of 2019 levels of aftermarket. That could well be three years."
Ultimately, the earnings and FCF profile of RTX's commercial aerospace business is going to depend on the shape of the recovery in the aviation space, and that's extremely difficult to predict right now.
That said, it's highly likely that air travel will enjoy some sort of recovery over time, and everything points to the second quarter of 2020 as being the bottom. Air travel is an integral part of the global economy, and in the decade prior to the COVID-19 pandemic, it's also been a profitable one. It may take time to rebuild airline balance sheets and deal with the financial fallout, but history suggests capital will flow toward profitable businesses in the end.
A good value
All told, it's hard to know the shape of the recovery and how it will impact RTX's overall earnings and FCF. There's a lot of uncertainty ahead.
However, it's also hard not to think that $15 billion is way too low of a valuation for RTX's commercial aviation businesses. This applies even if it does take the commercial aerospace business three years to recover. As a reminder, Pratt & Whitney and Collins Aerospace generated $6.2 billion in segment operating profit in 2019.
As such, the upside potential probably justifies the risk, particularly as the defense businesses are likely to carry on growing earnings/FCF while Pratt & Whitney and Collins Aerospace are in recovery mode.