Morningstar | The Byzantine World of Raytheon's 2Q: Classified Programs and Pensions
Despite Raytheon’s second-quarter beat, a combination of concerns tied to pension contributions hitting cash flow, growth slightly below peers, and an increasing mix of lower-margin classified work pressuring margins drove shares lower. However, we think shares in this wide-moat name are a bit undervalued, trading at a 10% discount to our $209 fair value estimate.Revenue increased 5.5% year over year in the second quarter, which is slightly below the 7% growth we’ve seen from other defense contractors. Management highlighted 6.5% growth in domestic revenue, and based on this we estimate that international sales increased a rather lackluster 3.3%. However, the book/bill stood at 1.3 during the quarter thanks primarily to classified orders. Management, furthermore, raised its full-year bookings guide by $1 billion. This augurs accelerating growth and confirms our view that defense budget authority is only now being translated into outlays. Raytheon’s EPS rose $0.89 to $2.78 this quarter; 80% of this increase was tax-related. Management upgraded full-year EPS guidance $0.07 to a new range of $9.77-$9.97. Operations (domestic orders translating into revenue) only drove $0.05 of the upgrade.
Due to a planned $1 billion post-tax pension contribution, management now forecasts a 2018 operating cash flow midpoint of $2.8 billion versus $3.8 billion previously. Separately, some pension plans purchased an annuity this quarter, transferring $1 billion of pension obligations off the balance sheet. The bottom line is that cash flows will fall this year, but future pension contributions should be lower and, all else equal, FAS expense should also come down. We'll be looking for Raytheon to move up its operating cash flow outlook for next year and beyond. Management was previously discussing $3.5 billion to $4 billion of operating cash flow for both 2019 and 2020, but comparing this midpoint to 2018 excluding pension contributions implies no cash flow growth.
On a pretax basis pension contributions will be $1.25 billion during the third quarter of 2018. Under accounting rules, however, tax benefits already accrued when Raytheon decided to make the contribution, resulting in a $95 million tax benefit this quarter. Turning back to the annuity, it will create an unfavorable aftertax, noncash settlement charge of $228 million next quarter. But the annuity purchase also brings tax benefits and when combined with the pension contribution and what management refers to as ongoing "tax improvements" that don't seem to be related to the pension plan, Raytheon's effective tax rate should land at around 10.5% for 2018, down from our previous forecast of 18%.
Given its high profile this quarter, we decided to take a stab at estimating some aspects of Raytheon's classified business. Based on management comments, we estimate that classified revenue this quarter stood at $1.33 billion, exhibiting 21% year-over-year growth. Furthermore, we believe the percentage of classified work, which stands at 20% of total revenue, will increase due to a 169% increase in classified bookings this quarter. Since classified work is often early stage cost-plus development contracts, margins are generally lower than other activities. Using typical cost-plus margins, we estimate that classified work represented 12% to 17% of total segment operating profit this quarter.
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.
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