Raytheon Stock: Healthy Fundamentals But Fully Valued (NYSE:RTX)

Thesis

Raytheon Technologies (NYSE:RTX) reported strong Q1 2022 results on April 26, 2022. Both topline and bottom line reported healthy growth amid supply chain disruptions and ceasing of defense business with Russia. Sales came in at $15.7 billion, representing a 3 percent YoY growth and a 4 percent organic growth. GAAP EPS came in at $0.74, representing a 45 percent increase YoY, although note that $0.41 of EPS was due to acquisition accounting adjustments and net significant and/or non-recurring charges.

Looking forward, the business fundamentals remain strong as travel activities renormalize, and the global defense budgets continue their expansion, especially triggered by the Russian/Ukraine situation. Although there are some uncertainties ahead too. The company adjusted its sales guidance to $67.75 – $68.75 billion, down from its previous guidance of $68.5 – $69.5 billion by about 1% largely driven by the global sanctions on Russia. Other factors like supply chain issues, inflation, and labor cost will persist and add another layer of uncertainty to its operation.

In terms of valuation, the stock has reached its full valuation and thus there is little margin of safety at its current level.

Considering the above pluses and negatives, our final verdict is a hold rating under the current conditions.

Strong Business Fundamentals But Some Challenges Ahead

RTX Q1 2022 results are overall positive. The recovery of Collins Aerospace is a highlight and main contributor, with revenues increasing 10% to $4.8 billion. Growth in the commercial aftermarket was particularly significant, at 39 percent. As CFO Neil Mitchill commented (the emphases were added by me):

As Greg noted, we delivered adjusted earnings per share and free cash flow that exceeded our expectations for the quarter. Sales of $15.7 billion were in line with our expectations and up 4% organically versus the prior year. Our performance in the quarter was primarily driven by the continued recovery of domestic and short-haul international air travel that was partially offset by continued supply chain constraints across our businesses. Adjusted earnings per share of $1.15 was up 28% year-over-year and ahead of our expectations, primarily driven by commercial aftermarket at Collins, $0.04 of commercial OE timing at Pratt and other corporate items, including lower tax expense, which more than offset the supply chain constraints.

Note that the adjusted earnings per share growth of 28% YoY Mitchill mentioned were different from (and substantially lower than) the growth rate of 45% in GAAP EPS terms as mentioned above. And again, this is due to the $0.41 EPS adjustment due to accounting adjustments.

Looking forward, the conflict in Ukraine will keep impacting its near-term revenues. The ceasing of business activities with Russia has led to a lower full-year outlook by $750 million, to a range of $67.75 billion-$68.75 billion, compared to its previous guidance. And correspondingly, its organic growth rate guidance is also lowered to the 6 to 8% range, 1% below its previous guidance range of 7% to 9%. Although, I would consider a 6% organic growth rate (letting alone 8%) already very healthy for such a leading stock. And the free cash flow is projected to be at a healthy level of $6 billion too.

Broadening our horizon a bit, I am optimistic that its defense segments will enjoy secular support for the longer term as the Russian/Ukraine situation, unfortunately, has heightened the global awareness of national security and triggered another round of defense budget increases. For example, its Intelligence & Space Segment reported a book-to-bill ratio of 0.80 a and a total backlog of $17 billion. Its Missiles & Defense Segment enjoys an even large backlog of $29 billion and an even higher book-to-bill ratio of 1.18. Such backlog and long-term government support will provide earning stability and growth for years to come.

Contemporary issues like travel recovery, supply chain issues, inflation, and labor cost can add another layer of uncertainty to its operation in the near term. But I only see these issues as temporary. Particularly, for the issue of inflation, defense budgets have historically has risen faster than inflation in the long term. And leading defense contractors like RTX have demonstrated the ability to keep up with inflation with no problem. Also, travel may not recover as quickly as RTX hopes. But the company maintains that strong momentum in aftermarket parts and services is a more indicative signal.

Valuation And Projected Return

In terms of valuation, RTX has reached full valuation and I do not see a meaningful margin of safety here. As seen from the first chart, in terms of dividends, the valuation is currently about 5% above its historical average. In terms of price to cash ratio, it’s currently valued at 12.5x, about a 4% discount from its historical average of 13x. Overall, I see these levels of deviations to be easily within the margin of error.

When compared to its peers like Lockheed Martin (LMT) and General Dynamics (GD), it’s trading at a substantial premium, as you can see from the second chart. Its FY1 PE of 20.2x is more than 20% higher than LMT and almost 10% higher than GD. Topline metrics such as price to sales or EV/sales ratio also indicate a sizable valuation premium. Admittedly, it boasts more diversified revenue sources, consisting of both civilian and military segments. However, I view the defense segment itself to be stable enough already and the larger premium difficult to justify.

With the full valuation, projected returns in the next few years are limited. For the next 3~5 years, an upper single-digit annual growth rate is expected (about 6.5%). And the total return is projected to be in a range of 22% (the low-end projection) to about 34% (the high-end projection), translating into an annual return of 5%to 7.5%. Not the most spectacular returns, but still solid, especially when adjusted for its A+ financial strength and A earning consistency.

Final Thoughts And Risks

RTX reported a strong quarter with healthy top-line and bottom-line growth despite a variety of headwinds ranging from supplies shortage and weaker travel recovery. Looking forward, I see the issues as only temporary. And I am particularly optimistic about its defense business. Bookings suggest that operations are well poised for healthy and steady growth forward. Its flagship Missiles and Defense enjoys a healthy book-to-bill ratio of 1.18x. The President’s budgetary request for 2023 suggests further growth catalysts in the next few years.

However, there are a few risks. There are some valuation risks. The stock now reached its full valuation compared to its own history and trades at a sizable premium compared to its peers. Its current valuation is within about 4% to 5% of its historical average. Such deviations could easily be caused by the margin of error in financials and offer no meaningful margin of safety.

The conflict in Ukraine is another major risk. Besides the lower guidance caused by the sanction on Russia, the conflict could also create high-order effects in unpredictable ways and impact RTX. It could worsen supplies change issues, exacerbate raw materials shortage, and even trigger a global recession. Considering these risks, our final verdict is a hold rating under the current conditions.