Defense contracting giant Raytheon (NYSE:RTN) reported first-quarter earnings Thursday, regretting to inform shareholders that both sales and earnings had declined year over year. Investors reacted as you might expect -- bidding the shares down somewhat. But was that obvious call the right call?
Let's find out.
In first-quarter 2015, Raytheon reported:
- A 4% decline in sales versus first-quarter 2014, to $5.3 billion.
- Net profit down 8% to $554 million.
- Earnings per diluted share down 5% to $1.79.
Despite the declines, Raytheon appears to have given Wall Street analysts everything they asked for, and more. According to the Associated Press, Raytheon's revenue exceeded expectations by a slim margin, while earnings quite simply blew out da box. Whereas analysts were looking for $1.43 per share in profit, Raytheon produced 25% more.
With profits flowing nicely in the quarter, Raytheon then proceeded to increase its estimates for earnings for the rest of the year as well. Previously predicting at most $6.35 per share in earnings from continuing operations, management now projects that profits will range from $6.67 to $6.82 per share.
That's certainly an encouraging prediction. However, sales and earnings declines notwithstanding, the really big disappointment in Raytheon's quarterly results concerned cash flow, and more specifically free cash flow -- the cash profits the company earned for the quarter. Raytheon generated $620 million in positive free cash flow in the year-ago quarter, but it produced none in the latest quarter.
Precisely zero. As in, every last cent of $55 million in cash from operations was immediately consumed by capital spending.
Ouch, indeed. And yet, despite this disappointing result, Raytheon made a surprising second prediction last week. Rather than ratcheting down expectations for cash generation in response to a single cash-poor quarter, Raytheon raised its guidance (by $100 million) for how much cash it will produce this year.
Management dismissed concerns over first-quarter cash flow, saying the temporary dry spell was "primarily due to the timing of collections." Accordingly, Raytheon expects things to return to normal in short order, and said cash generated by operations is now expected to range from $2.4 billion to $2.7 billion. If we assume capital spending will be roughly the same as what Raytheon spent last year -- say, $300 million -- then free cash flow for 2015 should come in anywhere from $2.1 billion to $2.4 billion.
What it means to investors
Will that be good enough to make Raytheon a buy? (Or at least not a sell?) Again, let's look at the numbers.
At current pricing, Raytheon stock carries a $33.4 billion market cap. If we divide that by our most optimistic guess at 2015 cash profit ($2.4 billion), we end up with about a 14 times price-to-free cash flow ratio. That valuation seems a bit rich relative to analysts' expectation for 8% long-term earnings growth at Raytheon, even with the stock paying a tidy 2.5% dividend yield. But it's not so divorced from reality as to necessitate selling the stock today.
Long story short, although I own Raytheon stock myself, I'm not so enamored of the valuation that I'd encourage anyone else to go long Raytheon. But the stock's not so expensive that I'd recommend shorting it, either.
Long story short-er: Rate Raytheon a "meh." And keep your eyes open for better bargains.
Rich Smith owns shares of Raytheon today, but he's not sure how much longer that will remain true. You can find him on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 355 out of more than 75,000 rated members.
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