Raytheon Technologies (RTX 1.76%) CEO Greg Hayes closed the third-quarter earnings call by reminding investors that two-thirds of the company's current revenue is defense related, and it would support the commercial aerospace-focused businesses through a difficult time. It's an observation investors should take note of, because it lays out the case for the stock being a very good value right now. Here's the how and why.
Raytheon Technologies' valuation
Industrial conglomerates can be valued in a number of different ways, and the price-to-free cash flow (FCF) metric is a commonly used one. Of course, Raytheon is an aerospace and defense play these days, so it arguably deserves a premium rating to reflect the stability of defense revenues and the long-term growth potential in commercial aviation.
Note the italics in the above paragraph, because aviation is about the long term, so investors shouldn't just be focusing on the obvious issues with the industry right now. For example, it typically takes 10 years and huge sums of money to develop an aircraft engine, which then generates aftermarket revenue for decades to come. In other words, Raytheon's aircraft engines and aerospace components should always be looked at in terms of their long-run potential, even if the next few years will be weak.
The COVID-19 pandemic is unlikely to be around forever, commercial aerospace will come back, and history suggests there's never been an issue with attracting investment capital to the airline industry.
That said, let's conservatively stick to using the price-to-FCF multiple to value Raytheon. The following chart shows the trailing multiple for Raytheon alongside a couple of its peers. As a rough rule of thumb, a multiple of 20 times could be seen as a fair value for a company growing cash flow ahead of inflation.
The bad news first
As you can see below, Raytheon does not look cheap on this basis -- and recall that these figures include the fourth quarter of 2019, which was not impacted by COVID-19. In actuality, CFO Toby O'Brien told investors that "we continue to expect full year pro forma 2020 free cash flow of roughly $2 billion. This includes an outflow of about $1.2 billion for merger costs, restructuring, and tax on dispositions."
Using the $2 billion figure puts Raytheon at a 2020 price-to-FCF multiple of 40.7 times. Even if you add back the one-time items mentioned by O'Brien to get $3.2 billion in FCF, the 2020 multiple is 25.4 times. Again, not cheap.
More bad news from the earnings call
In addition, many investors probably would have been unimpressed by the company lowering its sales guidance for its defense-focused business in 2020. Moreover, Hayes was quite candid on the issues facing the commercial aviation industry: "We don't expect commercial air traffic to return to 2019 levels until at least 2023 and that's, of course, depending upon the timing of a widely distributed vaccine."
Hayes went on to pour cold water on the idea of a quick recovery, saying, "I don't think anybody should be focused on 2021 to see a big uptick in the commercial aftermarket" and "So this is not a one quarter, two quarter problem. It's going to be here for a while."
Three reasons Raytheon Technologies is still a good value
All of that said, the stock still looks like a good value for investors willing to close their eyes and ears to potential bad news on commercial aviation in the near term. There are three reasons.
First, the reduction in the full-year 2020 outlook in the defense-focused segments, namely Raytheon Intelligence & Space (RIS) and Raytheon Missile Defense (RMD), was minimal. Having previously predicted the segments would earn $2.405 billion to $2.510 billion from the second quarter to the fourth, management now expects $2.435 billion to $2.495 billion. However, given that corporate eliminations are expected to be $100 million rather than $130 million to $135 million, it all contributes to a drop in combined RIS and RMD earnings (excluding eliminations) of around $25 million.
Second, Raytheon still faces FCF headwinds in 2021; O'Brien spoke of $500 million to $600 million in nonrecurring cash items (merger costs and tax), possibly $500 million in structural cost actions, and potentially $850 million in pension contributions. However, these costs are not recurring, so they should be taken off a fair assessment of ongoing FCF. Moreover, the structural cost actions are being made precisely to improve earnings/FCF down the line.
Third, management didn't back off previous estimates for the former Raytheon Company businesses (primarily defense) to deliver $3.6 billion to $4.5 billion in FCF over the next few years. That will provide significant support to Raytheon's valuation and its ability to invest in developing solutions for the aerospace market.
The long view
All told, if you assume, say, $4 billion a year in FCF from defense alone in the next few years, it justifies an $80 billion market cap based on a 20-times FCF multiple. In addition, Raytheon's commercial aviation business lines, Collins Aerospace and Pratt & Whitney, will surely turn FCF positive at some point in the future...even if it takes a few years to get anywhere near the $6.2 billion in adjusted operating profit generated by that segment in 2019.
Simply put, the market is too readily discounting an eventual recovery in commercial aviation, and that makes Raytheon a good value for long-term investors. The stock does not look cheap on current valuations, but 2020 is likely to mark a trough, and the potential for FCF improvement is significant.