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Morningstar | Raytheon's 2019 EPS Guidance Comes in Below Consensus but Cashflow Looks Solid; Shares Cheap

Wide-moat Raytheon reported fourth-quarter and full-year 2018 results that beat on EPS but came in below consensus for operating profit due to lower margins at the MS and IDS businesses. We’re maintaining our fair value estimate of $212 per share and view the name as undervalued, trading at a price to fair value ratio of about 0.80.

Raytheon managed to grow fourth-quarter revenue 8.5% year over year on the back of strong performance in the SAS and in the IIS units. For the full year, consolidated revenue grew 6.7%. We continue to think growth will accelerate at Raytheon, and a 2018 book-to-bill of 1.2 times confirms our view. Raytheon refined its 2019 guidance and revenue growth came in a touch lower than last year’s initial outlook with the high end of the revenue range ($29.1 billion), implying 7.4% growth. However, segment operating margin guidance of around 12.2% appears to be in line and maybe a bit better than what management was initially anticipating for 2019. The EPS midpoint for 2019 of $11.50 disappointed relative to consensus but matched our expectations of $11.53. Lastly, management moved up 2019 operating cashflow by $100 million to a new midpoint of $4 billion.

Apart from IIS, margins contracted in each business during the fourth quarter, helping to send full-year 2018 segment operating margins down 40 basis points. The IDS business expanded margins over the full year, but the unit’s operating margins contracted 120 basis points in the quarter due to higher research and development. The MS business also saw margin contraction in the fourth quarter and over the full year due to a higher mix of lower margin development work (about 30% of revenue in 2018 compared with 20% a few years ago). Although segment margins were down, 2018 consolidated operating margins expanded 10 basis points to 16.8%, and Raytheon generated $3.4 billion of operating cashflow in 2018, which was $300 million above our forecast and beat midpoint guidance by $600 million.

The $4.6 billion operating cashflow number Raytheon gave for 2020 aligns with the previous $8 billion-$9 billion range management had given out for 2019 and 2020 combined. The $600 million of growth in operating cashflow from 2019 to 2020 will be driven by higher profits at the business units, milestone payments on international contracts, and slightly lower cash taxes.

Raytheon has one of the cleanest balance sheets in the U.S. defense industry, and following its pension cleanup and discretionary contribution in 2018, we calculate that the company has around $15 billion of dry powder (based on 3 times 2019 EBITDA consensus less existing net debt of $1.4 billion). Given the challenges the company has faced with Forcepoint, a business it acquired in 2015, we don’t think management will hunt for large deals. The share count guide for 2019 implies about $1.3 billion for repurchases, and this combined with about $1 billion in dividends roughly equates to Raytheon’s targeted 80% free cash flow return to shareholders. However, given the company’s clean balance sheet and significant dry powder, we think there’s an outside shot that buyback activity comes in higher than the management guide for 2019.

Raytheon’s embattled Forcepoint business could potentially be turning a corner; it registered 10% growth year over year in the quarter (the highest rate achieved over the past two years) coupled with margin expansion. Although Forcepoint is less than 1% of consolidated operating profit, it’s been a thorn in the side of management. Raytheon spent roughly $2 billion on acquisitions to stand up the business (primarily via the 2015 Websense deal). At the beginning of 2018 Raytheon’s executives indicated that Forcepoint should begin tracking to double-digit operating margins and 10% plus year-over-year growth sometime in 2019. While operating margins remain well below the double-digit level, Raytheon’s growth target for the business was achieved this quarter.