Two industrial giants have had a very difficult 2020. The COVID-19 pandemic has hit the commercial aviation industry hard, and both have heavy exposure to the industry. In fact, they're fierce competitors, with rival engines on the Airbus A320neo. But investing is all about what's coming around the corner, so let's look at whether General Electric (GE +2.68%) or Raytheon Technologies (RTX +1.12%) are good values right now.
Before you buy either stock
There's no point ignoring the elephant in the room. To consider buying these stocks, you need to believe two things:
- The commercial aviation market will undergo a protracted recovery from the low point of the second quarter of 2020.
- Both stocks should be assessed for what they could become rather than what they are now.
If you aren't positive on the commercial air travel market, and in particular if you're sure there are likely to be concerns about the pace of the recovery, then read no further. That's something likely to be dictated by the ongoing attempt to contain the pandemic and the financial condition of the airlines. A widely available COVID-19 vaccine would certainly help matters, but even that might not allay passenger fears over travel. In addition, a second wave of the pandemic would definitely complicate matters.
Both companies need air travel to come back. Image source: Getty Images.
The second point is best explained when looking at each company's free cash flow (FCF) prospects. Excluding non-recurring items such as merger costs, restructuring, and taxes on dispositions; Raytheon expects to generate $3.2 billion to $3.4 billion in FCF in 2020. With a market cap of $95.9 billion, the stock trades at 28-30 times FCF for 2020.
It's even worse with General Electric, whereby management doesn't expect its industrial FCF to turn positive until 2021. Meanwhile, GE Capital's most valuable business is GECAS, an aircraft leasing business.
What General Electric could become
While the near-term outlook is very difficult, both stocks have a significant opportunity to generate billions in FCF in the future, amounts that would make their current valuations look very cheap.
The case for GE relies on the idea that air travel will return to 2019 levels sometime in 2023 or 2024 and take GE Aviation's FCF back up with it. In addition, management is in the process of engineering a turnaround in its power and renewable-energy businesses, while GE Healthcare can be relied on for an annual $1 billion to $1.5 billion in FCF over the next five years.
|
GE Segment |
2019 |
2022+ |
|---|---|---|
|
Power |
($1.5 billion) |
GE Power will get back to a high-single-digit earnings/FCF margin with a $1 billion in FCF and low-single-digit growth in the future. |
|
Aviation |
$4.4 billion |
GE Aviation will recover in line with commercial aviation recovery, and long-term FCF will be generated from aftermarket parts and services. |
|
Renewable energy |
($1 billion) |
Margin will get back on track for high single digits in line with its peers and the bet that offshore energy will start to pay off. |
|
Healthcare* |
$1.2 billion |
Steady low- to mid-single-digit growth in earnings/FCF. |
|
corporate and eliminations |
($2.1 billion) |
Cost cuts will lower outflows. |
|
Total GE industrial* |
$1 billion |
Wall Street has its analyst projections set for $4 billion. |
Data source: General Electric presentations. *Excludes the now divested biopharma business.
GE's market cap of just $55.2 billion means that if the company hits Wall Street's expectations for FCF in 2022, it would trade at 13.8 times 2022 FCF, a very attractive valuation.
What Raytheon could become
The case for Raytheon is based on the idea that FCF from its defense and space business, currently around 55% of revenue, will support the company as its commercial aerospace business embarks on a slow recovery. Before COVID-19, analysts were expecting the former Raytheon Company, which contributed nearly all the defense businesses of Raytheon Technologies, to generate an average of $4.1 billion in FCF until 2023. Given that there's been no adjustment to management's expectations for its defense business in 2020, it's reasonable to accept that those forecasts still stand.
Which stock is better on a risk-reward basis? Image source: Getty Images.
It's a different story for the commercial aerospace businesses, but provided Raytheon's Pratt & Whitney and Collins Aerospace can make a gradual recovery, then analysts' forecast for $6.8 billion in FCF in 2022 could materialize. Intriguingly, it's a forecast that would put Raytheon on a similar price-to-FCF multiple as GE in 2022.
General Electric or Raytheon Technologies?
Both stocks will be attractive for investors positive on commercial aviation. However, if I were forced to choose, I'd say Raytheon is arguably the better buy. Raytheon's non-commercial aerospace businesses are performing we'' right now, while the case for GE is based on the successful execution of a turnaround at power and renewable energy. So it's probably more likely for Raytheon to hit its earnings estimates.
Simply put, Raytheon looks like a better investment on a risk/reward basis, but don't count out GE as an investment option.
