My Top Defense Stock to Buy in October

Raytheon Technologies (RTX 0.51%) remains the pick of the aerospace and defense sector. Still, the key takeaway from its latest presentation to investors is that anyone buying in now will need to be patient. It's going to take some time before the company's current earnings potential comes to full fruition.

Two key reasons to buy the stock

The case for buying Raytheon stock rests on the following combination of medium-term earnings drivers:

• The commercial aviation market is still in recovery mode from the period of pandemic-related travel restrictions.
• Geopolitical conflicts are pushing governments toward more spending on defense, and Raytheon's defense systems are attracting interest and orders. 

The company's two primary end markets have strong earnings drivers over the medium term. However, those benefits will not flow immediately down to Raytheon's bottom line. 

Unpacking Raytheon Technologies' third-quarter results

The recently delivered third-quarter report served to highlight this argument. Let's start with the headline guidance:

• Management lowered its full-year sales outlook to a range of $67 billion to $67.3 billion from a prior range of $67.75 billion to $68.75 billion.
• Full-year organic sales growth is now forecast to be 5% to 6%, compared to its prior guidance for 6% to 8% growth.
• Full-year adjusted earnings per share are now forecast to be $4.70 to $4.80, compared to prior guidance of $4.60 to $4.80.

Sales guidance is down, and earnings guidance is slightly up. Those are the headlines -- but the devil, as always, is in the details.

Guidance changes through 2022

Breaking out the evolution of management's adjusted operating profit guidance through the year tells a more nuanced story. Raytheon gives segment earnings guidance in terms of the change in adjusted operating profit from the previous year, so don't be alarmed at the figures in the chart below: The negative figures for Raytheon Intelligence & Space (RIS) and Raytheon Missiles & Defense (RMD) don't mean those segments will lose money. They mean that their profits will decline from 2021 levels. 

Management started 2022 expecting profits to grow for its two defense-focused businesses -- RIS and RMD -- but shifted to a negative outlook as the year progressed. However, it was a different story with the commercial aerospace-focused businesses, where management increased its segment earnings guidance as the year went on. 

The reasons come down to supply chain pressures and labor market challenges. CEO Greg Hayes discussed those issues on the recent earnings call, stating that there were problems with 400 of its 13,000 suppliers, and noting that even after it hired 27,000 new employees in 2022, Raytheon still needed 10,000 more. Moreover, Hayes conceded that growth in its defense businesses in 2023 "won't be as robust as we would like" due to the supply chain problems and the tight labor market.

In addition, CFO Neil Mitchill said the defense business's productivity was negatively impacted by delays in receiving materials and product upgrades. Typically, margins increase over time as manufacturers learn how to improve productivity with new products. 

Data source: Raytheon Technologies presentations. AOPG: Adjusted operating profit guidance. All change figures are for full-year 2022, relative to full-year 2021.

The long-term view

The supply chain and labor issues are frustrating, but they are likely to prove temporary. Meanwhile, the medium- and long-term potential for Raytheon is improving. It received $22 billion worth of orders in the third quarter alone, giving it a total book-to-bill ratio (orders divided by revenue) of 1.32. RMD's book-to-bill ratio stands at 1.5 times. Meanwhile, Raytheon has a whopping $168 billion backlog, representing around 2.5 years of revenue. 

All told, Raytheon's revenue, margin, and profits are all set for improvement in the coming years as it works through its supply chain and labor issues, and that's reason enough to be positive on the stock.