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 -6.00% determining the real impact of this virus on our 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. 3 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).