The Raytheon Companycurrent (NYSE: Price RTN $116.96)

Krause Fund Research Spring 2020

April 4, 2020 Aerospace and Defense The Raytheon CompanyCurrent (NYSE: Price RTN $116.96)

Recommendation: Buy April 4 , 20 April20 2, 2020

Analysts Current Price $116.92

Yichen (Ethan) Sun Target Price $195-$215 [email protected] William Braverman Investment Thesis [email protected] Glei Hoxhalli We recommend a buy rating for Raytheon because the current [email protected] stock price does not adequately reflect the outlook for the company. We believe the stock prices recent decline was due to Company Overview the adverse market conditions created by the Covid-19 virus. This decline fails to consider Raytheon’s ability to weather this storm Raytheon is one of the world’s largest defense contractors, due to the long-term nature of their contracts, and the extent of with five main business segments providing products and their backlog. services to domestic and international customers. Raytheon was founded in Delaware in 1922 and has seen continuous Drivers of Thesis: growth. The company focuses on developing missile • Raytheon’s current corporate strategy to automate its systems, surveillance and radar solutions, and advanced manufacturing process, and merge with United space technology. Raytheon has grown to be large enough Technology will decrease their costs and increase to service the U.S Armed Forces and many of its allied margins. nations. On April 2, 2020, the company merged with United • Increase in backlog order from 2018 will cushion the Technologies Corporation to form Raytheon Technologies effect of COVID-19 crisis. and is now listed on the NYSE as RTX. Risks of Thesis: • Recent plunge in oil price will lead to weaker demand Stock Performance Highlights from Middle Easter customers, which drives roughly 52 week High $233.48 half of Raytheon’s international sales. 52 week Low $103.00 • Increasing pressure to balance the current US budget Five Year Beta 1.20 deficit may cause the United states to lower their defense Average Daily Volume 3.57 m spending, which could in turn decrease future revenue outlooks for Raytheon. Share Highlights • Defense spending as a percentage of GDP is projected to Market Capitalization $32.57 b fall for the next ten years. Shares Outstanding 278 m One Year Stock Performance EPS (2019FY) $11.94 P/E TTM 9.81 240 3600 Est. Long Term Growth 4.8% 220 3400 Dividend Yield 3.2% 3200 Dividend Payout Ratio 32% 200 3000 180 Company Performance Highlights 2800 ROA 9.63% 160 2600 ROE 27.35% 140 Sales $29.18 b 2400 120 2200 Financial Ratios 100 2000 Current Ratio 1.34 4/2/2019 6/2/2019 8/2/2019 10/2/2019 12/2/2019 2/2/2020 4/2/2020 Debt to Equity 1.83 Raytheon S&P 500 Source: Yahoo Finance

Important disclosures appear on the last page of this report.

Executive summary Real GDP Growth can indicate increased production and revenues for the Industrial As of April 2nd, 2020, our analyst team is sector. Current forecasts have indicated that we recommending a “Buy” rating for Raytheon. are entering into a period of contraction due to We believe that Raytheon will experience the concerns with the Coronavirus. According growth despite contractions in the global to the International Monetary fund1, Real GDP economy. Furthermore, we think the merger for the United States is estimated to decrease in with United Technologies will create a Defense 2020 by 5.9%, and the consensus estimate for industry behemoth. More specifically the GDP growth of 2020 is at negative 3%. Our synergies that exist between Raytheon, and group’s projection of GDP growth is around UTC’s subsidiaries of Rockwell Collins and negative 4% for 2020. Although the short-term Pratt Whitney will allow them to decrease their projections of Real GDP are negative, we feel COGS expense. This will, in turn, allow them to that is mostly due to the lost production and have greater leverage during the bidding consumption caused by COVID-19. It is still process with their contracts. unclear when this pandemic is going to come to Our discounted cash flows and economic an end, and the total cost it will cause the US analysis yields an intrinsic value of $212.46 per economy, and the lasting effect it will have on share. In our dividend discount model, we had consumer spending behavior. Therefore, we an intrinsic value of $196.70. These two prices hold a slightly pessimistic view on the US GDP have influenced our target price range of $195- and expect an L shape recovery until the first $215. This range shows a rare growth quarter of 2023 to 2.1% opportunity of a 66.78% to 83.86% increase in the stock price of $116.92 as of April 2, 2020. COVID-Crash The COVID-19 pandemic has caused businesses and consumers to adapt to new Macroeconomic Outlook lifestyles. As of April 17, 2020, there are 705,112 cases2 throughout the United States and 2 Real GDP Growth a total of just over 2.2 million globally. The death rate currently stands at approximately Real GDP YOY Growth 6.8% globally2, with a toll of 153,177 deaths2. 6.00% Companies and consumers have started to shelter in place in order to stop the spread of the 4.00% virus. This has come with serious revisions in 2.00% estimated revenues because of lost production and sales. In addition, companies in industries

0.00%

05 09 13 03 04 06 07 08 10 11 12 14 15 16 17 18 19 02 that are more affected by the virus, such as retail -2.00% and restaurants, have had to lay off workers. Overall, watching the spread of the virus over -4.00% the next couple of months will be crucial in Real GDP YOY Growth determining the real impact of this virus on our -6.00% Figure 1: Real GDP YOY Growth1 economy. No one at this point really knows how

2 long it will take companies to recover and regain US and Iran relationship the ground they have lost.

We have predicted that the virus will start to become controlled within the next year in the hopes there will be a working vaccine. We believe this is the biggest threat to the short- term growth and outlook of the global economy.

US Military Defense Budget One of the most important macroeconomic factors regarding Raytheon is the US military defense budget. Approximately 68% of Figure 2: RTN Stock Price8

Raytheon’s revenue comes from the US In late December and early January of 2020, government which is why the two are closely tensions between Iran and the United States were correlated. According to the Congressional escalating rapidly. On Dec. 29th, 2019 the United Budget Office, the US defense budget3 is set to States killed 25 Iranian backed militiamen using grow to 705B, 728B, and 752B in 2020, 2021, drone strikes in Iraq4. In response, Pro-Iranian and 2022 respectively. In total over the next 10 supporters stormed and attacked the US embassy in years, the US military defense budget growing Baghdad on the 31st. This, in turn, led to further by 2.74% YoY. However, this growth is slightly retaliation when a US drone strike killed Qassem slower than its GDP Growth projection. This is Soleimani, a general in the Iranian military. Iran because they are also projecting a decrease in later shot missiles at 2 US military bases in the defense spending as a percentage of GDP. region injuring over 50 soldiers. During this time Defense spending as a percentage of GDP is period, it was clear Raytheon was seeing an increase expected to decrease from 3.1% in 2019 to 2.5% in its stock price because of the tensions between in 2029. In addition, the COVID-19 puts further the two countries. More specifically, because pressure on the defense spending budget. The Raytheon is one of the key drone vendors to the aforementioned forecasts were prior to the United States, it seems as though their stock price is COVID-19 outbreak therefore we do not positively correlated with increased tensions and believe they will hold true. We think that the skirmishes involving the US. decrease in GDP and the increase in government We do not believe that the United States will stimulus will cause the defense budget to have enter a war with Iran soon, however, Raytheon stagnant growth over the next three years. does stand to benefit from Middle Eastern instability.

Industrial Production Index Producer Price Index Industrial Production Index Producer Price Index

115 220 210 110 200 105 190 180 100 170 95 160 150 90 140

85 130 120 80 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 Figure 4: Producer Price Index6 Figure 3: Industrial Production Index5 The Producer Price Index shows the average The industrial production index is an important movement in selling prices of domestic economic indicator in the industrial sector production over time. It is one of the main tools because it is a measure monthly real output in used for adjusting prices in long-term purchase the manufacturing industry. IPI can also be used contracts. According to the Federal reserve bank to predict the growth of production that consists of St. Louis6, PPI has decreased the last two of output (physical units) and inputs (production months going from 199.4 in January to 196.5 in process raw materials). According to the February to ultimately 193.8 in March. We 5 Federal reserve bank of St. Louis , IPI has believe this trend will continue and that PPI will started to decrease, going from 109.58 in stabilize towards the end of summers at February to 103.66 March. This 5.4% decrease approximately 180. This metric shows that has more than likely been caused by factories some of Raytheon's revenues from their long- being shut down due to coronavirus concerns. term contracts could be in jeopardy and revised This, in turn, will create a cyclical effect as down in the near future depending on the producers will start to face further supply chain structure of the specific deal. issues when sourcing their direct materials. We believe that the IPI index will continue to Interest Rate Environment decrease as more and more factories face issues Interest rates are an important factor for all throughout their supply chain due to the businesses, but they are especially important for outbreak. We are expecting IPI to hit a low of capital intensive companies like Raytheon. The 95 in July and then gradually recover once the interest rate environment is highly influenced outbreak is contained. by the Federal Funds rate. The current target range for the Fed funds is between 0-25 basis points. According to the CME fed watch tool7, 100% of analysts estimate that this range will remain unchanged for at least a year. In this low interest rate environment, opportunities exist for Raytheon to increase capital expenditures and

4 their R&D funding without significantly outsourcing, and consulting. Service firms are also increasing their interest expense. This will allow threatened by budget cuts, more so than defense Raytheon the access to cheap capital, enabling manufacturers, because their short-term contracts them to explore new products and business are more likely to be canceled in times of economic segments in the defense industry. uncertainty. Concerns about IT and cybersecurity have arisen from recent security threats such as a Capital Market Outlook 2019 data breach from the Defense Information We are anticipating that the recent negative Systems Agency.11 This new economic trend will market conditions will continue throughout the most likely benefit these service companies who summer and into 2021 based on the outbreak of provide IT and support services, which could the coronavirus. After the virus is controlled, we include Raytheon’s subsidiary Forcepoint. believe that the market after a three-year period the market will continue its previous trajectory and that the Aerospace and Defense sector will continue to be one of the key industries driving US GDP growth.

Industry Analysis

Aerospace and Defense Overview The Aerospace and Defense industry engages in the design, development, and manufacturing of advanced aircraft, space systems, propulsion systems, and other missile and space vehicle parts. The industry serves both military and commercial markets. Major industry competitors to Raytheon Figure 5: Industry Market Share%8 include Lockheed Martin, Northrop Grumman, and The primary consumer of products of this industry Boeing. These are all considered manufacturing is the United States government. In 2019, out of the defense companies and tend to fare better during 31.5 billion in revenue in this industry, 57.6% was times of budget cuts as major R&D contracts and for the US military-industrial complex. Other equipment acquisitions are long term contracts that major buyers include Saudi Arabia, Israel, the are normally fixed for the specified horizon. United Arab Emirates, Japan, and South Korea. Another subsector within the defense industry International buyers have been steadily increasing consists of services, intelligence, and technology throughout the past ten years, and they usually firms such as Leidos, CACI, and Booz Allen provide a higher margin for the company as well.10 Hamilton. While these companies also derive the majority of their revenue from government Recent Developments and Trends contracts, their structures and the services they offer Raytheon, General Dynamics, Lockheed Martin, have key differences from their manufacturing and Northrop Grumman together control 68.3% of counterparts. Service companies tend to do more the defense primary industry. In addition, as you short-term deals, in areas such as IT, logistics, can see in the histogram below, all four of them

5 have more than 60% of their revenue stream $6 billion from its 2018 backlog of $42.4 coming from the United States government defense billion. spending, with Northrop coming in at the highest This backlog is especially important for percentage of 83%. This significant exposure Raytheon since they will likely depend on it for towards government spending creates uncertainties future revenue until the economy makes a full of their revenues over national election outcomes. recovery. As part of the new post-merger RTX If the government spending budget were to get cut, company, Raytheon’s backlog will be a steady these companies would face a risk of canceling base of sales which will bolster decreasing sales their programs that are not under contract. from the Collins and Pratt and Whitney business However, their contracts are mostly 5 to 10 years segments, which are both more closely tied to long. Hence, we do not see this as a risk in the short commercial aerospace and therefore affected by term.8 the economic downturn.

Figure 7: Backlog YoY Growth8 Figure 6: % Revenue from DOD Spending8 Industry P/E Comparison Record Backlog According to the P/E comparison graph below, Defense primary companies saw an increase in we saw a jump in the P/E value for the market their backlog orders in the fiscal year ending leaders in the defense industry. We believe that 2019, signaling an increase in demand. this is partly due to the presidential election Huntington Ingalls saw the highest increase at result of Trump taking office in 2016. Trump 27.5% due to several new large shipbuilding has been pushing for a higher fiscal policy since contracts. Increases in backlog orders are the start of his campaign to boost the economy, usually seen as a positive sign for the growth of this has also meant increased defense spending a company, since it makes their revenue streams as well. Trump has also pulled out of the Iran more stable, and their revenue projection more deal, which created further uncertainties and reliable and predictable. These firms have all created geopolitical risks. The graph below that guided high single digit growth rates for the shows the timeline of the Iran conflict over the year 2020, due to increased margins and last two months, we see a correlation between government spending. share price and geopolitical issues. We believe Raytheon’s total backlog as of Dec. 2019 is that the increase in the DOD budget and the $48.75 billion, which is an increase of roughly increasing uncertainties for geopolitical issues

6 have created the spike in P/E ratio that you see previous generation equipment which comes in the defense industry today. with the benefit of having higher margins.

Company Analysis

Overview and business description Raytheon is a large US defense manufacturer and contractor. Compared to its main competitors like Lockheed Martin and Northrop Grumman which make fighter jets, long range bombers, UAVs, and other military crafts, Raytheon’s primary line of business is guided missiles and air defense systems, like the Patriot missile defense system.8

Raytheon's business segments can be broken up into Figure 8: Historical P/E Ratio in the Aerospace Industry8 the 5 business segments: Missile Systems, Space &

Airborne Systems, Intelligence, Information & Catalysts for Growth or Disruption Services, Integrated Defense Systems, and In August of 2019, Trump signed a two-year Forcepoint. The Revenue decomposition for FY deal that lifted the spending cap for the federal 2019 is shown in the chart below: budget through July 2021. In contrast to the budget control act of 2011 signed by Obama, which was put in action to decrease the United States debt deficit by a trillion over ten years. The two-year deal Trump signed would help avoid another government shutdown but also increase the national debt. This bill will boost defense spending by roughly 3 percent per year. This is certainly good for the defense industry, but there is still uncertainty about what will Source: Factset8 happen after this deal expires. International markets provide an opportunity for Missile Systems: defense companies to grow, however, to win Headquartered in Tucson, Arizona, this segment over international clients the companies will develops, integrates, and produces missile and have to offer “offsets” to the foreign combat systems for the U.S. armed forces and its governments, which means manufacturing a allied nations. Missile systems are Raytheon’s portion of the weapons system in the buyer’s largest business segment making up 28% of 2019 country. The International markets are also sales and it includes products like the Patriot missile valuable for another reason. Defense defense system, which continues to be the primary contractors are not allowed to sell the latest surface to air missiles system used by the US and generation of weapons systems and technology allied militaries. to foreign governments, so instead, they sell

This segment has averaged 6.72% yearly growth for Forcepoint provides cybersecurity solutions such as the past 5 years. insider threat solutions, data loss prevention, firewall technology, cloud and email security, and Space and Airborne Systems: cross domain transfer. Based in McKinney, Texas this business segment designs and manufactures satellite sensors that are Forcepoint is Raytheon’s smallest business used for military, scientific, communication, and segment, bringing in only 2% of the company’s intelligence purposes. These sensors are also used sales. This segment has averaged 5.16% yearly for aerial and surveillance operations and electronic growth over the past 3 years. warfare systems. Competition This segment makes up 24% of sales and has Raytheon exists in a highly competitive market with averaged 4.23% yearly growth for the past 5 years. well-established competitors. The primary competitors of Raytheon that we identified include Intelligence, Information & Services: Lockheed Martin, Northrop Grumman, General Headquartered in Dulles, Virginia, IIS provides Dynamics and Boeing. technical and professional services to intelligence, defense, federal and commercial customers. The The Department of Defense awards contracts division also provides training, logistics, through competitive bidding, and this competitive engineering, and operational support services to bidding can hurt margins as competitors lower their homeland security, space, civil aviation, and prices in order to win the contracts counter-terrorism clients. There is a rising frequency in bid protests from Since 2008, almost every deploying US soldier has unsuccessful bidders. These bid protest will delay been trained by Raytheon’s Global Training the start of the contract and could even result in the Solutions. This segment makes up 23% of sales and award decision being overturned, requiring has averaged 3.76% yearly growth over the past 5 contractors to re-bid on the project. years. An example of this is the 3DELRR contract, a long- Integrated Defense Systems: range radar system project worth around $1 billion, Based in Shrewsbury MA, this division specializes that Raytheon won over their competitors in in naval and ship electronic systems. More October 2014. However, after they won the award, specifically it manufactures naval and land-based Lockheed Martin and Northrop Grumman filed radar and sonar equipment, torpedoes and naval protests which led to the contract being delayed mine countermeasures, and cyber and intelligence until 2017. Ultimately the contract was awarded solutions. back to Raytheon, but it was cancelled yet again in early 2020 due to technical and supply difficulties.9 This segment makes up 22% of sales and has averaged 3.04% yearly growth over the past 5 years.

Forcepoint:

Based in Austin Texas, Forcepoint is one of Raytheon’s newer business segments. Created in 2015 in a joint venture with Vista Equity Partners

Collins Aerospace Systems: which engages in the production and design of aerostructures, avionics, interiors, mechanical systems, and mission systems for commercial, regional.14and military use. This segment had approximately $26 billion in 2019 sales.

Pratt & Whitney: designs and manufactures aircraft engines and auxiliary power systems for commercial, military and business aircraft. The segment had $21 billion in 2019 net sales. 14

Figure 9: 2019 Contract Type Distribution12 Raytheon Intelligence & Space: This segment consists of Raytheon’s old Intelligence, Information Merger Analysis & Service combined with the Space and Airborne On April 3rd, 2020, Raytheon and United systems. The segment produces sensors, develops 14 Technology finally closed their merger after training programs, and cybersecurity solutions. clearing up all the regulatory requirements after 2019 sales were approximately $15 billion. almost a year after the announcement. This merger Raytheon Missiles & Defense: producing radar to has created an industry behemoth that together track and detect threats, and missiles.14Raytheon generated $74 billion in revenue, creating the 2nd Missiles & Defense: This is a combination of two largest aerospace and defense company in the of Raytheon’s old segments, integrated defense world. The new company will be named Raytheon systems and missile systems. This new segment Technology with the ticker symbol of RTX. Each produces Raytheon’s missile and missile defense share of Raytheon stock was converted to 2.3348 systems along with naval and land-based radar and shares of Raytheon Technology, while each share of sonar equipment. 2019 sales were approximately United Technology is converted to one share of $16 billion. Raytheon Technology. This merger will give the new company significant strategic synergies throughout the defense sector.13 SWOT Analysis

This merger comes with many complications. One Strength of them is that each company had to spin off parts Raytheon is well positioned compared to other of their divisions to clear all the regulatory companies to weather the Covid-19 storm. Due requirements. United Technologies had spun off its to the nature of its contracts, and the fact that HVAC division Carrier and its elevator division they are negotiated well into the future makes Otis into separate companies that are now listed on their sales uniquely immune to the recent the NYSE. They also divested their GPS and space downturn. optical businesses. Raytheon had to divest its Changes in military strategy also favor military airborne radio business.13 Raytheon, which primarily manufactures The post-merger company will consist of 4 business missiles and missile defense systems, because segments: (15) the military seeks to minimize troop

9 deployment in favor of using UAVs and missile Valuation strikes. Revenue decomposition Weakness In our revenue decomposition for Raytheon we The Aerospace and Defense industry is highly separated out their five core business segments; competitive, and the companies within this Missile systems, space & airborne systems, sector rely on technological advancements to Intelligence, information & services, Integrated secure contracts. Raytheon’s focus on missile defense systems, and force point out to forecast. systems has left them in a niche sector within The total revenue from these categories was the industry. As other segments start to grow, then grown as a function of GDP growth and the like cyber and biological warfare, Raytheon will percent of GDP going to government defense need to adapt to this new landscape to stay spending. We believe this to be accurate way to relevant. grow our revenues and sales accounts because of the strong correlation between Raytheon’s Opportunity sales growth and the US defense budget. The merger between UTC and Raytheon will create a unique opportunity for the two From our revenue decomposition we then companies. The synergies that exist between factored in Raytheon’s eliminations which were Collins Aerospace, Whitney Packard, and roughly 6.4% of their revenues historically. Raytheon will allow them to be more Once the eliminations had been deducted, our competitive in the contract bidding process. The revenues flow into our sales totals on the result will be one of the largest defense income statement. companies in the sector. Key assumptions Threat Our model is driven by our revenue One threat that Raytheon will always face due decomposition because Raytheon is a revenue to their line of business is changes to driven company. We expect that most accounts government defense spending. At some point will be consistent with its previous percentage the US government will have to try and balance of sales metric that we’ve analyzed over the past their budget, and when they do cuts to defense ten years. spending are almost certain because of its Expenses relative size of the overall budget. With 68% of its revenues coming from the US, it is hard to We have forecasted our COGS expense account see a scenario where government defense to have as a decreasing percentage of sales spending can decrease with Raytheon coming through our model. Over the past ten years out unscathed. historically Raytheon has decreased COGS as a percentage of sales by roughly 7% from 78.68% in 2010 to 71.36% in 2019. While we do believe this trend will continue, we think it will have a less drastic decrease over the next ten years even with the upcoming merger. Overall, we have

forecasted our COGS as percentage of sales going from 71.1% in 2020 to 69.21% in 2029.

For our depreciation and amortization expense We forecasted our dividend payout ratio in the we have used the begging balances of PPE, and year 2020 toward the lower end of the historical Intangible assets times the historical charge offs range that Raytheon paid in the past. Eventually, in these accounts. Which comes to roughly we see the dividend payout ratio increasing 12.14% off PPE flows through to depreciation toward the higher end of the range at the cv year. and 8.02% of the value in our intangible assets Our forecasted dividend growth rate, however, account flows to our amortization expense. starts toward the lower end of the historical range at roughly 8% and continues to decrease Lastly our general & administrative expenses to just over 5% growth in the steady-state year. we have forecasted as a constant percent of sales based on the previous 10 years of historically Property, Plant and equipment data. This in turn left us with 1.32% of sales For PPE we have increased our capital annually being expense out to this account. expenditures by an average of 9.06% per year. Our equation for capital expenditures is through Tax rate our sales, and because our sales growth is based The 2017 Tax Cut and Jobs Act significantly on GDP some years, we have decreasing reduced corporate taxes from around 35% to amounts in our capital expenditures cashflows. 21%. For Raytheon this provided a significant We believe this to be accurate because boost to the company, 2018 FCF increased by historically Raytheon’s capital expenditures 42% to $3.3 billion, and 2018 EBITA also rose have jumped around based on sales. roughly 34% to $4.62 billion. Going forward, we forecasted this tax rate to remain the same, Debt however this is subject to change depending on We are forecasting debt to increase as a future political leaders and legislation. percentage of sales during our forecasted model. We believe that due to the low interest rate Share outstanding and dividends environment Raytheon will be incentivized to Raytheon has historically netted treasury stock increase their short term and long-term debt in and additional paid-in their capital on their order to finance their operations. balance sheet. Because of this, a treasury stock account is not seen on its historical balance Beta, Risk Free Rate, Equity Risk sheet. For simplicity, we decided to not net Premium, and Cost of Debt these two together and report the treasury stock We decided to use the five-year monthly raw on our balance sheet. In our share change beta collected from the beta calculator from the worksheet, we forecasted Raytheon using part Damodaran website, which resulted in 1.20. of their free cash flows on share repurchases over the next ten years. These buybacks are For the risk-free rate, we decided to use the 10- based on the trends we have seen historically year treasury from April 2nd, 2020 because that with Raytheon’s management. In 2020-2021 we is the last day Raytheon was publicly traded, have Raytheon buying back roughly 1% of their and we believe a 10-year treasury captures a shares outstanding per year. This eventually long enough horizon. The 10-year treasury hit a levels off to approximately .5% of their share by record low during March of 2020 and is still in the cv year. the low range at 0.62%.

To off-set this low risk-free rate. We decided to Discounted Cash Flow and Economic use the revised version of the Damodaran equity Profit Models risk premium of 6.16%. Damodaran has revised Upon completion of our DCF and EP model, we his equity risk premium higher because of the ended up with an implied price as of today of extreme volatility of the market in the past two $212.46. This is 82% higher than what months. We believe by using a market risk Raytheon is trading at before the day of premium that factors in the additional risk will completion of their merger with UTC. The make our model more accurate. Our pretax cost reason why we have such a high target price is of debt is the YTM of the 2028 corporate bond that during that date of the merger, the market is at 2.96%. The reason we used the 2028 seeing unprecedented volatility, and we believe corporate bond is because that is the closest time that the market reaction of Raytheon might be to maturity compared to the 10-year treasury we overexaggerated and oversold. We believe that used. Raytheon is well-positioned to weather through this pandemic after modeling in the potential WACC effect of COVID-19 on both the revenue and Using the current market value of the firm of cost side of our model. 39.61 billion, we were able to calculate an 82.21% weight of the market value of common Dividend Discount Model equity, and 17.79% weight of the market value Using the DDM for our valuation we have come of debt. up with an intrinsic stock price of $196.70. This marks a 66.78% increase in the trading price of With all the necessary elements to calculate April 2, 2020. The DDM model uses forecasted WACC defined, we were able to calculate a cost dividends as discussed above. These dividends of equity of 8.01%, and the after-tax cost of debt were then discounted by Raytheon’s cost of of 2.34% by adjusting the 21% of the marginal equity which is 8.01%. Our terminal year tax rate from the pre-tax cost of debt. Finally, growth rate and ROE assumption were 4.81% we calculated WACC to be 7.00%. and 15.6% respectively. However, we do see the NOPLAT and EPS Growth Rates potential that our sales downturn might be more In our model, we have NOPLAT decrease the pessimistic than what could happen in the first two years due to poor GDP outlook. After future. For that reason, we have given more the third year, we expect NOPLAT to gradually weight to the DCF and EP models when increase before hitting its constant growth rate determining our price range. of 3.91% in the cv year. Relative Valuation Our EPS growth follows a similar trend to Implied Relative Value NOPLAT, however, due to share repurchases the two figures are not entirely the same. In P/E (EPS 2020) $ 152.57 2020 we are predicting a 7.96% decrease in EPS. After 2020 we do have the EPS growth P/E (EPS 2021) $ 151.90 rate increasing annually before hitting its PEG (EPS 2020) $ 167.72 terminal growth value of 4.81% in 2029. PEG (EPS 2021) $ 159.55

In the relative valuation we used seven peer The 0.7% yearly PPE growth rate is derived comparisons, all of which are companies in the from our forecasted Capex growth which is defense manufacturing sector. The four primary around that same percentage. pure plays consist of Lockheed Martin, Northrop Grumman, General Dynamics and The results show that a lower cost of debt and Boeing. Along with these companies we lower rate of PPE growth will result in the included L3 Harris Technologies which highest possible firm value, although this is competes with Raytheon in sensor equipment, mostly influenced by the pre-tax cost of debt intelligence, imaging, targeting systems and rather than the PPE growth rate. other related products. Additionally, we also Beta vs Equity Risk Premium included Huntington Ingalls Industries which is the country’s largest military shipbuilding company and competes with Raytheon in the fields of naval sensors and technology.

We chose not to include any defense service contractors like LDOS, BAH, and CACI, Both beta and equity risk premium are variables because even though these companies are influenced by market activities. We used 10- similar in that they derive most of their revenue year US treasury yields to calculate equity risk through government contracts, they way these premium, and this risk-free rate has reached companies are structures and operate is some of its lowest levels historically in recent fundamentally different from the manufacturing months. This is thought to be a result of the contractors. coronavirus induced recession which has caused

many investors to exit their equity positions and Sensitivity Analysis move to safer, more stable investments such as

PPE Growth Rate % vs Pre-Tax Cost of Debt government bonds.

Beta for the firm was calculated for a 5-year monthly period, using tools from Damodaran’s site.

The results show that both variables have large effects on firm value, with low beta and low equity risk resulting in the highest possible In the above chart, we examined the effects of value. the PPE Growth Rate and the pre-tax cost of debt on firm value, because they are both key variables that drive a lot of the operating and interest costs. Raytheon is a capital-intensive firm so small changes to costs of debt can have large impacts on the overall company.

CV Year COGS % of sales vs GDP Growth Defense Spending as % of GDP vs CV Year Rate ROIC

These two variables were tested because they These two variables were tested because they can both influence firm value in various ways. both affect the final value of the firm. The As we mentioned earlier Raytheon is a capital- defense spending as % of GDP rate is used intensive firm meaning its COGS will make up in our model to forecast revenue growth, so a large portion of sales, and we forecasted that it is one of the biggest variables affecting firm COGS will be roughly 70% of sales. Along with value. this, our revenue growth rate is based off GDP growth and defense spending as percentage of As we can see from the results, the defense GDP. spending percentage has a very significant effect on the company’s value, whereas the CV The results show that lower COGS and higher Year ROIC has a much smaller effect. GDP will result in the highest possible firm value, which makes sense logically.

WACC vs CV Growth of NOPLAT

These two variables were tested because they both significantly influence the final CV NOPLAT.

The results show that a higher growth rate along with a low cost of capital would result in the highest possible intrinsic value. Our growth rate forecast for NOPLAT was 2.50%, and we can see from the table that increases in this number raise our intrinsic value. The WACC shows the opposite effect, with increases lowering the intrinsic value. Both results make sense given the logic behind each variable.

14 Important Disclaimer

This report was created by students enrolled in the Security Analysis (6F:112) class at the University of Iowa. The report was originally created to offer an internal investment recommendation for the University of Iowa Krause Fund and its advisory board. The report also provides potential employers and other interested parties an example of the students’ skills, knowledge and abilities. Members of the Krause Fund are not registered investment advisors, brokers or officially licensed financial professionals. The investment advice contained in this report does not represent an offer or solicitation to buy or sell any of the securities mentioned. Unless otherwise noted, facts and figures included in this report are from publicly available sources. This report is not a complete compilation of data, and its accuracy is not guaranteed. From time to time, the University of Iowa, its faculty, staff, students, or the Krause Fund may hold a financial interest in the companies mentioned in this report.

References com.proxy.lib.uiowa.edu/us/en/industry/33641b/m ajor-companies. (1) { IMF Real GDP growth }. (n.d.). Retrieved (11) Bing, C. (2020, February 20). U.S. agency from that handles Trump's secure communication https://www.imf.org/external/datamapper/NGDP_ suffered data breach. Retrieved from RPCH@WEO/OEMDC/ADVEC/WEOWORLD/ https://uk.reuters.com/article/uk-usa-defense- USA breach/u-s-defence-agency-personal-data-may- (2) Coronavirus (COVID-19). (n.d.). Retrieved have-been-compromised-letter-idUKKBN20E270 from https://news.google.com/covid19/map?hl=en-

US&gl=US&ceid=US:en (3) Duffin, E. (2020, January 29). U.S. - defense (12) (n.d.). Retrieved from outlays and forecast 2030. Retrieved from https://www.sec.gov/ix?doc=/Archives/edgar/data/ https://www.statista.com/statistics/217577/outlays- 1047122/000104712220000009/rtn- for-defense-and-forecast-in-the-us 12312019x10k.htm (4) Simon, Darran. “Tensions between the US and (13) Raytheon and United Technologies Merge to Iran Reached New Heights over the Weekend. Create Undervalued Defense Behemoth. (2020, Here's How It Unfolded.” CNN, Cable News April 3). Retrieved from Network, 6 Jan. 2020, https://finance.yahoo.com/news/raytheon-united- www.cnn.com/2020/01/06/politics/iran-us- technologies-merge-create-221019169.html tensions-qasem-soleimani-trnd/index.html. (14) Cordell, C. (2020, April 3). Raytheon (5) Industrial Production Index. (2020, April 15). completes merger with United Technologies. Retrieved from Retrieved from https://fred.stlouisfed.org/series/INDPRO (6) Producer Price Index for All Commodities. https://www.bizjournals.com/washington/news/20 (2020, April 9). Retrieved from 20/04/03/raytheon-completes-merger-with-united- https://fred.stlouisfed.org/series/PPIACO technologies.html

(7) CME FedWatch Tool: Countdown to FOMC - (15) “United Technologies and Raytheon CME Group. (n.d.). Retrieved from Complete Merger of Equals Transaction.” News | https://www.cmegroup.com/trading/interest- United Technologies and Raytheon Complete rates/countdown-to-fomc.html Merger of Equals Transaction | Raytheon Technologies, (8) FactSet Research Systems. Raytheon. www.rtx.com/News/2020/04/03/United- Segments. Retrieved February 18, 2020, from Technologies-and-Raytheon-Complete-Merger-of- FactSet database. Equals-Transaction.

(9) Insinna, V. (2020, January 9). Air Force to end

Raytheon's troubled contract for ground-based radar and look for new options. Retrieved from https://www.defensenews.com/air/2020/01/08/air- force-to-end-raytheons-contract-for-the-3delrr- groundbased-radar-and-look-for-new-options/

(10) Spitzer, Dan. “The University of Iowa Libraries.” Off Campus Access - The University of Iowa Libraries, Sept. 2019, my-ibisworld-