If the stock market was a beauty contest, very few investors would be voting for stocks in the commercial aerospace sector right now. However, to paraphrase a well-worn maxim, investing is often about greedily buying stocks that other investors are fearful of. Aerospace and defense company Raytheon Technologies (RTX -0.90%) certainly won't win any beauty contests, but it might just make investors a lot of money in the coming years -- provided they can tolerate some risk.
The case for buying Raytheon Technologies stock
My investment thesis for Raytheon is based on the following points:
- The company's substantial defense industry exposure will contribute the earnings and free cash flow (FCF) necessary to cushion it as its commercial aerospace business goes through a multiyear recovery.
- Based on historical FCF and management's guidance, the stock is a very good value.
The company's defense businesses came to the rescue in 2020 as the COVID-19 pandemic wrought devastation on the commercial aerospace industry. For reference, the current Raytheon Technologies was created out of the merger of the aerospace businesses of the former United Technologies (Pratt & Whitney and Collins Aerospace) and Raytheon Company (Raytheon Intelligence and Space, or RIS, and Raytheon Missiles and Defense, or RMD).
Image source: Getty Images
Its Pratt & Whitney unit manufactures engines and engine aftermarket parts primarily for the commercial aviation industry, although it does have some military customers. Collins Aerospace manufactures a wide range of structures and systems for the commercial aviation sector, and has some military exposure too. RIS and RMD are overwhelmingly defense industry businesses.
The table below shows how reliant the company is on its defense-focused businesses right now. As a further illustration, consider that Collins and Pratt & Whitney generated a combined $1.5 billion in adjusted operating profit in the fourth quarter of 2019, but just $194 million in the fourth quarter of 2020.
|
Raytheon Technologies Segment |
Q4 2020 Adjusted Sales |
Q4 2020 Adjusted Operating Profit |
|---|---|---|
|
Collins Aerospace Systems |
$4.388 billion |
$89 million |
|
Pratt & Whitney |
$4.496 billion |
$105 million |
|
Raytheon Intelligence & Space |
$3.853 billion |
$355 million |
|
Raytheon Missiles & Defense |
$4.395 billion |
$586 million |
Data source: Raytheon Technologies presentations.
However, the good news is that management sees a recovery in progress in commercial aviation and ongoing growth from RIS and RMD. In order to express these dynamics, management has offered guidance for 2021 in terms of both the full year and the Q2-to-Q4 period. The reason being that the results for the first quarter of 2020 largely were locked in before the impact of the COVID-19 pandemic was being felt, so comparisons including that period will be somewhat misleading.
Focusing on the guidance for the Q2-to-Q4 period, it's clear that Collins and Pratt & Whitney are expected to start generating substantive year-over-year sales and earnings growth -- at least in comparison to the pandemic-hit period.
|
Raytheon Technologies Segment |
Q2-Q4 2021 Sales Guidance |
Q2-Q4 2020 Sales |
Q2-Q4 2021 Adjusted Operating Profit Guidance |
Q2-Q4 2020 Adjusted Operating Profit |
|---|---|---|---|---|
|
Collins Aerospace Systems |
Up by a mid-single-digit to low-double-digit percentage |
$12.964 billion |
$986 million to $1.19 billion
|
$186 million |
|
Pratt & Whitney |
Up by a low-teens to mid-teens percentage |
$11.893 billion |
$311 million to $436 million |
($89 million) |
|
Raytheon Intelligence & Space |
Up by a mid-single-digit percentage |
$11.283 billion |
$1.21 billion to $1.24 billion |
$1.04 billion |
|
Raytheon Missiles & Defense |
Up by a mid-single-digit percentage |
$11.603 billion |
$1.57 billion to $1.60 billion |
$1.42 billion |
Data source: Raytheon Technologies presentations.
What this means for investors
Turning to Raytheon's full-year guidance, management is expecting full-year organic sales growth of 0%-3% with FCF of $4.5 billion and adjusted EPS of $3.40 to $3.70. Frankly, these are attractive numbers for a business likely to engineer a multiyear recovery in earnings and FCF.
For example, FCF of $4.5 billion would put the stock on a price-to-FCF multiple of 22.4. That may seem superficially expensive -- broadly speaking, a price-to-FCF multiple of around 20 is seen as a reasonable valuation for an industrial conglomerate -- but recall that the company's commercial aviation segment is still at the beginning of a long recovery path. In addition, the $4.5 billion figure includes $500 million of one-time merger and synergy expenses.
Image source: Getty Images.
Finally, here's what CEO Greg Hayes said on the FCF matter during the recent earnings call: "Think about that $4.5 billion normalized. If you take out the investments, we have north of $5 billion. That's going to continue to grow over the next several years back to that $8 billion to $9 billion that we had forecast."
For reference, he's talking about the original FCF forecasts made at the time of the merger, and before the pandemic hit.
Is Raytheon stock a buy?
If you think that the commercial aviation industry will make a comeback, and you believe Hayes is right that Raytheon will get back to $8 billion to $9 billion in FCF "over the next several years," then this stock is a very attractive buy at today's levels. Those figures represent 8% to 9% of its current market cap. Throw in a dividend that currently yields 2.9% that you can collect while you wait, and the opportunity to earn excellent returns looks real.
