Back on Raytheon Technologies' (RTX -0.65%) investor day presentation in May, CEO Greg Hayes outlined a target to generate more than $10 billion in free cash flow (FCF) in 2025. While many things can happen in the aerospace and defense market until then, the target does make Raytheon's current market cap of $131 billion looks like a good value. Fortunately, the recent third-quarter results demonstrate some excellent progress on that front. Here's how to think about the earnings and Raytheon's march to $10 billion.
Management's excellent execution
Raytheon's management has a history of exceeding expectations regarding wringing every bit of profit it can from generating cost synergies from mergers and acquisitions. That's a beneficial quality to have in the current environment.
The company is a result of an acquisition (the former United Technologies bought Rockwell Collins in 2018) and a merger (the aerospace business of United Technologies was merged with Raytheon in 2020). The excellent news is the total cost synergy of $600 million from Rockwell Collins will be achieved in 2021, a year earlier than management had initially anticipated.
Moreover, back in the second quarter, management raised its cost synergy expectation for the Raytheon deal to a total of $1.5 billion from $1.3 billion previously, with $600 million planned for in 2021. The excellent news from the third-quarter earnings call is that the target of $600 million is now $700 million. As such, don't be surprised if management raises the total cost synergy target in the future.
On track, but expect a bumpy journey
That said, investors will have to tolerate some lumpiness in Raytheon's progress to hit a target of $10 billion in FCF in 2025, not least because the commercial aerospace market is recovering in a highly uneven fashion.
For example, the narrowbody market is coming back much more quickly than the widebody market. Within the narrowbody market, the problems the Boeing 737 MAX has had in recent years mean the Airbus A320 Neo has a jump-start on its rival. That's a positive for Raytheon because its Pratt & Whitney segment sells engines on the Airbus A320 family but not on the Boeing 737 MAX. However, the production slowdown on the Boeing 787 widebody also hurts Raytheon because it sells parts on the airplane.
In addition, it hurts the profit margin when Pratt & Whitney, maker of aircraft engines, sells more geared turbofan engines (GTFs) on the Airbus A320 Neo family of aircraft because they come with a negative margin. The real money comes from aftermarket sales.
These dynamics played out in the company's third-quarter earnings and guidance. In a nutshell, Raytheon lowered its full-year sales guidance but increased its earnings and FCF guidance. As a result, organic sales growth is forecast to be just 1%, compared with a prior range of 1%-3%, but earnings per share (EPS) are forecast to be $4.10-$4.20, compared with a previous range of $3.85-$4.00. In addition, FCF is forecast to be $5 billion, compared with the prior range of $4.5 billion to $5 billion.
The following table shows the full-year details of the guidance changes, with some notes that reflect the dynamics we've discussed. In addition, it's worth noting that, according to Hayes on the earnings call, 40%-45% of Collins Aerospace's aftermarket sales go to the widebody market, and it has $10 million worth of original equipment sales on each Boeing 787 aircraft.
|Business Segment||Current Guidance, Adjusted Sales Growth||Previous Guidance, Adjusted Sales Growth||Current Guidance, Adjusted Operating Profit Increase||Previous Guidance, Adjusted Operating Profit Increase||Notes|
|Collins Aerospace Systems||Down mid-single digits||Down mid-to-low single digits||Up $250 million to $300 million||Up $100 million to up $275 million||Sales hit by widebody original equipment and aftermarket weakness; profitability benefiting from increased narrowbody aftermarket|
|Pratt & Whitney||Up mid-single digits||Up low to mid-single digits||Flat to up $50 million||Down $50 million to up $25 million||Sales guidance improved by GTF sales on the Airbus A320 Neo, but profitability held back by negative engine margin on GTF sales|
|Raytheon Intelligence & Space||Up low single digits||Up low to mid-single digits||Up $150 million to $175 million||Up $150 million to $175 million||Sales hit by supply chain issues, but profitability benefiting from productivity actions|
|Raytheon Missiles & Defense||Up low to mid-single digits||Up low to mid-single digits||Up $50 million to $75 million||Up $50 million to $75 million||On track|
The unevenness in the recovery is likely to persist for a few years yet, so investors can expect the fluctuating dynamics in Raytheon's commercial aerospace business revenue and earnings to do so as well. Nevertheless, the company remains on track.
It will take a while to get back to 2019 levels of profitability, let alone the 2025 target of $10 billion in FCF. As you can see, it won't be a straight-line performance. That said, internal execution is excellent, and the company remains on track in 2021 despite facing supply chain constraints, a Boeing 787 production slowdown, and a tepid recovery in widebody flight departures.
All told, Raytheon remains an excellent way to play an aerospace recovery.