Morningstar | Raytheon Fires Off a Nice EPS Beat in 3Q; 2019 Margins and Cashflow Not as Impressive
Wide-moat Raytheon reported a third-quarter beat on EPS consensus. However, the stock, along with much of the U.S. defense sector, is down. For Raytheon, we think the weakness in shares is related to investors focusing on continued margin pressure combined with unimpressive 2019 guidance for cash and margins. Our thesis that Raytheon's backlog positions it for industry-leading growth remains intact but the defense sector's coincident pullback with the broader market confirms our view that the industry was fully valued. However, the selloff is a bit overdone in our view, particularly given the increasing U.S. defense outlays we anticipate for 2019; we value Raytheon at $212 per share and the stock is trading in undervalued territory at a price/fair value of 0.83.EPS came in at $2.25 compared with $1.97 last year with lower taxes offsetting charges related to already announced pension plan restructuring. Revenue stood at $6.8 billion, up a solid 8.2% year over year. Consolidated and segment operating margins contracted by 60 basis points, falling to 17.4% and 12.4%, respectively. Management pulled down 2018 segment margin guidance to a 12.3%-12.4% from 12.5%-12.7% primarily because of weakness at Missile System. But management raised EPS guidance thanks to its outlook for faster revenue growth (midpoint of 7% versus 6% previously) and positive tailwinds from nonoperating items.
We got an initial look at 2019. Raytheon is forecasting 6%-8% growth for 2019, which came in ahead of consensus but right in line with our expectations of 7.2%. Raytheon also envisions a book/bill above 1.0 next year. Management believes it can hold the line on segment operating margins, noting the aforementioned 2018 margin downgrade. The midpoint for operating cash flow stands at $3.9 billion; we were looking for a larger increase versus 2018 given 2019 sales growth and recent pension changes but management maintained that cash taxes are eating up some cash flow next year.
Management confirmed that operating cash flow for 2019 plus 2020 should land at $8 billion-$9 billion, implying potential room for cash flow growth in 2020 or just conservative guidance for 2019. Although not part of formal guidance, management sees capital spending at around 3.5% of sales for 2019, basically the same as this year as a percentage of revenue. We're also looking for a higher level of share buyback activity during 2019 relative 2018 (a 1.5% decrease in shares outstanding is forecast for 2018) because of Raytheon's under-leveraged balance sheet and management's limited appetite for acquisitions because of a dearth of large defense hardware acquisition targets combined with the clean-up going on at its most recent acquisition, Forcepoint.
Like other defense contractors (for example, General Dynamics' ground vehicle business) Raytheon is exposed to Saudi Arabia with roughly 5% of the company’s year-to-date sales emanating from the Middle Eastern Kingdom per management’s comments. The company is also anticipating a large order next year from Saudi Arabia for its TPY-2 radar as part of Lockheed's THAAD antimissile defense system, which was approved by the U.S. State Department in October 2017. This order now looks to be in potential jeopardy given recent developments among the U.S., Saudi Arabia, and Turkey.
Raytheon, together with its subsidiaries, is a technology company, focused on defense and other government markets. The company has five segments: Integrated Defense Systems, which is engaged in integrated air and missile defense; large land- and sea-based radar solutions; command, control, communications, computers, cyber and intelligence solutions; Intelligence, Information and Services, which provides technical services to intelligence, defense, federal and commercial customers; Missile Systems, which produces missile and combat systems; Space and Airborne Systems, which develops integrated sensor and communication systems for missions; and Forcepoint, which develops cybersecurity products.
Morningstar, Inc. is a leading provider of independent investment research in North America, Europe, Australia, and Asia. The company offer an extensive line of products and services for individual investors, financial advisors, asset managers, and retirement plan providers and sponsors.
Morningstar provides data on approximately 530,000 investment offerings, including stocks, mutual funds, and similar vehicles, along with real-time global market data on more than 18 million equities, indexes, futures, options, commodities, and precious metals, in addition to foreign exchange and Treasury markets. Morningstar also offers investment management services through its investment advisory subsidiaries and had approximately $185 billion in assets under advisement and management as of June 30, 2016.
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