Defense giant and airplane engines supplier Raytheon Technologies (RTX 0.92%) reported its Q4 and full-year 2022 earnings last week, and judging by the response, it was a success.
Investors bid up Raytheon stock by 4% in the two days after earnings came out, despite the fact that Raytheon seems to have missed analyst targets for Q4 revenue (collecting only $18.1 billion, where Wall Street had predicted $18.5 billion), and only barely beat on "adjusted" (i.e. non-GAAP) earnings -- $1.27 per share versus the expected $1.24.
Many commenters seem to be crediting Raytheon's defense business for the beat, but is that really the case?
Raytheon by the numbers
Raytheon had a great Q4, growing its sales 6% year over year, but more than doubling its net profit to $0.96 per share (as calculated according to generally accepted accounting principles, or GAAP -- the $1.27 per share profit was a non-GAAP number). But Q4 is a special quarter, as it's the end of the year. It comes but once a year, so let's take a step back and examine the bigger picture today and see how Raytheon performed in 2022 as a whole.
In 2022 Raytheon grew its sales 4% to $67.1 billion (so sales accelerated a bit in Q4). Free cash flow for the year declined slightly -- down 3% to $4.9 billion -- but GAAP profits were $3.51 per share, up 36%. When compared to the relatively small improvement in sales, you can tell right away that Raytheon must have enjoyed some significant widening of profit margins in the year.
In fact, both of Raytheon's two biggest divisions saw improved profit margins in 2022. Collins Aerospace, with $20.6 billion in 2022 sales, added 190 basis points to its operating profit margin, hitting 11.4%. Engine-maker Pratt & Whitney more than doubled its operating profit margin. Granted, that margin is now still just 5.2%, but clearly the revival of commercial air travel post-pandemic is having a beneficial effect upon this part of Raytheon's business.
Roughly 92% of Raytheon's improvement in profits last year came from just these two divisions.
In contrast, Raytheon's more obviously defense-focused divisions -- Intelligence & Space and Missiles & Defense -- both saw sales decline in 2022 (6% and 4%, respectively). Both divisions also experienced significant erosion in profit margins on their sales, with operating profit margins tumbling 270 basis points each.
And I suspect that this had something to do with Raytheon's sudden decision, announced in the earnings press release, to merge both of these defense businesses into a single defense business to be known simply as "Raytheon." Going forward, Raytheon Technologies' three primary verticals will be known as Collins Aerospace (currently in growth mode), Pratt & Whitney (likewise), and Raytheon (in turnaround).
What comes next for Raytheon
So does this mean defense -- i.e. "Raytheon" -- is actually Raytheon Technologies' Achilles' heel?
That hardly seems likely, with Raytheon being a key supplier to the defense of Ukraine and elsewhere this year. In its press release, Raytheon listed nearly a dozen defense contracts it won in 2022, at values ranging from $210 million (F117 airplane engines) to $415 million (Evolved Seasparrow anti-aircraft missiles) to $1 billion (classified).
And indeed, it would appear that Raytheon's defense sales will be looking up in 2023. Management noted that backlog in the defense business grew to $69 billion in 2022, a 9.5% increase that foreshadows a reversal in 2022's sales decline. Still, this was smaller than the 14% increase in backlog for commercial aerospace contracts, which topped $106 billion.
It's surprising that commercial sales outperformed defense sales even in the middle of a shooting war. But the numbers don't lie. Guiding investors on what to expect in 2023, management noted that revenue will grow about 8% to $72.5 billion, even as adjusted profits grow about half as fast -- up 4% to about $4.98 per share -- and free cash flow continues to decline -- down about 2% to $4.8 billion.
One can only presume that Raytheon is incurring additional costs as it ramps up defense production, which is holding profits in check. At the same time, when you consider how much better Collins and Pratt performed in 2022 -- on sales, and profit margins and backlog -- it's clear that Raytheon's commercial business will be the growth driver at Raytheon Technologies this year. If you believe that Raytheon stock is a "buy" at its current valuation of more than 28 times earnings, and more than 30x free cash flow (I personally do not believe this, but opinions may differ), then it's this civilian half of Raytheon Technologies you'll want to watch like a hawk.
In 2023, as in 2022, your best bet is to think of Raytheon Technologies as first and foremost a civilian company -- and only secondarily as a defense stock.
