Warren Buffett's famous advice about being fearful when others are greedy and greedy when others are fearful springs to my mind when I consider investing in Raytheon Technologies (RTX -0.08%). While the overall market may well be being greedy right now, there's a strong case to be made that investors are behaving fearfully when it comes to stocks with significant aerospace exposure. In a nutshell, that's why Raytheon stock is a buy.
To put it simply, two-thirds of Raytheon's current revenue is coming from its defense business, and the market is significantly undervaluing its commercial aerospace businesses. As such, on a risk/reward basis, Raytheon stock is worth buying.
Image source: Getty Images.
To flesh out this argument, let's start by looking at Wall Street analysts' consensus estimates for the company's performance, and then calculate two commonly used valuation metrics. In this case, I'd recommend considering two ratios: enterprise value (market cap plus net debt) to earnings before interest, taxation, depreciation, and amortization (EV/EBITDA); and then the price to free cash flow (P/FCF) ratio.
Based on the 2020 estimates, Raytheon is not a cheap stock. On the other hand, its valuation needs to be understood in the context of the growth potential of its commercial aviation businesses -- largely inherited from its United Technologies acquisition. I'll go into detail on this below.
|
Metric |
2020 (Estimate) |
2021 (Estimate) |
2022 (Estimate) |
|---|---|---|---|
|
EBITDA |
$9.3 billion |
$10.6 billion |
$12.5 billion |
|
EV/EBITDA |
13.5 |
11.9 |
10.1 |
|
Free cash Flow (FCF) |
$2.2 billion |
$4.7 billion |
$6 billion |
|
P/FCF |
48.5 |
22.4 |
17.4 |
Data source: marketscreener.com
Why Raytheon is an excellent value stock
As you can see above, Raytheon's EBITDA is expected to increase by a double-digit percentage rate in the next few years, largely as a consequence of an anticipated recovery in the commercial aerospace market. Of course, it's far from clear just how long it will take for commercial air traffic to return to 2019 levels, but many observers, including Raytheon CEO Greg Hayes, are cautiously predicting that will happen in 2023.
Given that there's generally a six- to nine-month lag between commercial air traffic and a pickup in commercial aftermarket demand, it's reasonable to think that it won't be until 2024 that Raytheon gets back to 2019 levels of profitability in its commercial aerospace operations.
But here's the thing. If you conduct a thought experiment and take a snapshot of what this company could look like at the end of 2021, then you would see an extremely favorably priced stock.
Let's start by assuming the commercial aviation market makes a slow and steady recovery in 2021 as widely available vaccines stem the spread of COVID-19, and people begin to book air travel again. In this case, at the end of 2021, the company would consist of a recovering aerospace business unit backed by a solid defense business with around $6 billion to $7 billion in EBITDA. With a forward price-to-FCF multiple of 17.4 and an outlook for double-digit percentage EBITDA growth until 2024, Raytheon stock at today's prices would look a bargain.
Long-term growth opportunities
Moreover, if the commercial aerospace market does recover to 2019 levels in 2023, it's unlikely to simply hold steady from there. For example, Raytheon's Pratt & Whitney's engines (including the geared turbofan on the Airbus A320 neo family) are set to provide the company with a multidecade earnings stream.
Furthermore, Raytheon's Collins Aerospace unit offers a comprehensive menu of components and systems for aircraft -- everything from aerostructures, cabins, and cargo systems to avionics, actuated systems, and flight-deck solutions. In other words, its exposure to commercial aviation is so broad-based that it will benefit from almost any upside move in the sector.
Image source: Getty Images.
Based on all of that, it's not hard to make an argument that Raytheon stock is a good value. However, it's still a stock that will require investors to have both patience and strong enough nerves to tolerate potentially negative news in the shorter term. It's abundantly clear that a recovery in commercial aviation will take time.
A stock to buy?
Ultimately, whether or not this is a stock for you comes down to your view on the aviation market. If you are worried that the pandemic will cause a structural decline in air travel, then Raytheon is definitely a stock to avoid.
On the other hand, if you believe that air travel will make a slow recovery once a large share of the population is vaccinated and the spread of COVID-19 is largely brought under control, then Raytheon is worth buying at the current price.
In the end, it's almost a philosophical question. Do you see the current weakness as creating a sector to be fearful of, or do you see a sector about to embark on a multiyear recovery? If you take the latter view, then Raytheon is a great stock to buy.
