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Raytheon Company: Great Earnings Do Not a "Buy" Make

By Rich Smith – Feb 2, 2014 at 8:00PM

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Profits growth and improved free cash flow don't change the fact that this stock is overpriced.

One of my very favorite defense contractors reported earnings this past week: Raytheon (RTN). Its earnings "beat the Street." Investors cheered. But I'm still not buying the stock. And now I'll tell you why.

Reporting earnings for fiscal Q4 and full-year 2014 Thursday, Raytheon announced that:

  • Fiscal 2013 sales declined 3%, capped by a veritable collapse in Q4 sales -- down 9%, but operating profit margins actually gained about 20 basis points, rising to 12.4% for the year.
  • Net income climbed 6% as a result, and profits per diluted share grew 9% to $6.16, helped by a share-count reduction of 10 million.

So far, so good -- and it even gets better. Raytheon produced $2.4 billion in cash from operations in 2013, a 22% increase over 2012 operating cash flow. Combined with a modest reduction in cash outflows for capital investment, this translated into free cash flow of $2.1 billion, or a 30% improvement over 2012 FCF.

As a result, Raytheon's now generating about 5% more real, cash profit than it reports as net income under GAAP. Its true valuation is correspondingly cheaper. Rather than the 15.4 "P/E" ratio that you see as the stock's valuation on Yahoo! Finance, it may be better to think of the stock as selling for just 14.4 times free cash flow. Problem is -- that's still not cheap enough.

Valuation matters
With Raytheon trading at 14.4 times free cash flow today, you'd ordinarily want to see this stock growing its profits at about 12% annually to justify its stock price (taking into account Raytheon's 2.3% dividend yield). Heroic efforts to boost cash production, cut costs, and make up for a shrinking U.S. defense budget by selling more weapons systems abroad, however, were only sufficient to lift Raytheon up to 9% profit growth. (The free cash flow performance was better than that, but FCF is notoriously lumpy. Investors who are banking on seeing Raytheon continue to produce 30% cash profits growth year after year are bound to be disappointed.)

Given all this, it's hard to see how Raytheon achieves the 10.6% long-term growth in profits that Wall Street is expecting it to produce. And given that even if it does achieve 10.6% growth, the stock will still fall short of the level of growth necessary to justify its stock price, I can't recommend buying Raytheon stock at this point.

No matter how much I like it.

Rich Smith has no position in any stocks mentioned. The Motley Fool owns shares of Raytheon. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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