Raytheon: Travel Recovery Offsets Q4 Bad News In Defense And Tax (NYSE:RTX)

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Introduction

Raytheon Technologies Corporation (NYSE:RTX) reported Q4 2022 results on Tuesday (January 25) morning. RTX shares have since risen by 3.5%, and are up 10.3% in the past year:

Raytheon Share Price (Last 1 Year)

We initiated our Buy rating on Raytheon in May 2020, and RTX stock has since gained 62% (including dividends), including 45% from the end of 2020.

Q4 2022 results and the new 2023 outlook contain mixed headlines, but overall underlying growth trends are solid once one-offs are excluded. The aerospace segments continued their strong EBIT rebound, driven by the ongoing recovery in global air travel. The defense segments saw significant EBIT declines, due to both supply chain issues and some execution problems. RTX is now merging the two defense segments into one to improve operational performance. There is also a reduction of the 2025 FCF target from $10bn to $9bn, as tax rule changes on R&D cost amortization are now expected to stay. RTX shares trade at a reasonable 20.7x 2022 EPS and have a 2.2% Dividend Yield. Our reduced forecasts indicate a total return of 44% (13.7% annualized) by 2025 year-end. Buy.

Raytheon Buy Case Recap

Raytheon is roughly 50/50 split between aerospace and defense segments. Both segments are protected by high technological requirements, long product cycles and a consolidated competitive landscape. Profits in the aerospace segments are mostly driven by recurring aftermarket revenues, and traditionally grow at high-single-digits; profits in the defense segments are driven by large defense programs, and traditionally grow at mid-single-digits.

Raytheon’s aerospace segments were significantly impacted by COVID-19 as global air traffic volume was reduced drastically by travel restrictions, though its defense segments remained resilient.

Our investment case has been based on Raytheon’s Free Cash Flow (“FCF”) rebounding in the next few years, as passenger air travel recovers from the disruption by COVID-19, helped by structural growth in both its commercial and military businesses. (Synergies from the UTX-RTN merger in 2020 have now been realised in full.)

We had been expecting FCF to reach $10bn in 2025, in line with what was the low-end of management’s target and reasonable when compared with the $7bn pro forma FCF achieved in 2019 (excluding $1bn of upfront engine losses at Pratt & Whitney) and the $8bn pre-COVID 2021 FCF target. However, as we will explain below, the 2025 FCF target has been reduced to $9bn by changes in tax rules that have shifted Raytheon’s FCF further out.

Raytheon Free Cash Flow – Historic & Forecasted (Updated)

Raytheon’s original $10bn FCF target for 2025 was based on expectations of strong double-digit EBIT rebounds from 2020 in its aerospace segments, and mid-to-high single-digit EBIT CAGRs in its defense segments:

Raytheon Expected Sales & Adjusted EBIT CAGR (2020-25)

These are currently unchanged, though the defense segments have been struggling recently.

Raytheon also targets a return of $20bn+ of capital in dividends and buybacks to shareholders in the first 4 years of the UTX-RTN merger (compared with a pre-COVID target of returning $18-20bn in three years).

Raytheon Q4 2022 Results Headlines

RTX’s Q4 2022 results were strong on a group level. Net Sales grew 6.2% year-on-year, Adjusted EBIT grew 10.5%, Adjusted Net Income grew 13.7% (helped by a lower tax rate), and Adjusted EPS grew 17.6% (helped by buybacks):

Raytheon Adjusted P&L (Q4 2022 vs. Prior Year)

For full-year 2022, RTX’s Net Sales grew 4.2% year-on-year, Adjusted EBIT grew 7.7%, Adjusted Net Income grew 8.1%, and Adjusted EPS grew 11.8%, driven by similar dynamics as described for Q4:

Raytheon Adjusted P&L (2022 vs. Prior Year)

NB. 2022 EPS benefited $0.06 from a reorganization of legal entities.

However, despite the much higher Net Income, 2022 FCF of $4.88bn was lower than the 2021 figure of $5.01bn.

In addition, Q4 results were more mixed on a segment level, with Adjusted EBIT rebounding by strong double-digits in the aerospace segments (Collins and Pratt & Whitney, or “P&W”) but falling by double-digits in the defense segments (Intelligence & Space, “RIS”, and Missile & Defense, “RMD”):

Raytheon Sales & EBIT by Segment (Q4 2022 vs. Prior Periods)

The full-year picture is similarly mixed, with EBIT growing by low-teens year-on-year in each of the aerospace segments but falling by mid-single-digits in each of the defense segments.

The mixed headlines also continued into the new 2023 outlook that was released at Q4 results.

Raytheon 2023 Outlook

RTX new 2023 outlook includes an organic sales growth of 7-9%. However, Adjusted EPS is expected to be $4.90-5.05, implying year-on-year growth of only 2.6-5.7%, and FCF is expected to be slightly lower at around $4.8bn:

Raytheon 2023 Outlook (Group)

Fortunately, 2023 outlook actually represents solid growth on a group level once one-off factors are excluded.

One-Off Factors Affecting 2022-23 Growth

Several one-off factors have artificially lowered RTX’s Adjusted EPS and FCF growth in 2022-23.

A key one is the new tax rules around R&D costs, part of the Tax Cuts & Jobs (TCJA) Act of 2017 implemented in July 2022. The new rules means that R&D costs, instead of having the option to be expensed in full in the same year as incurred, are now to be capitalized and then amortized over time, over 5 years for R&D costs inside the U.S. and over 15 years for those outside the U.S. This means that the tax benefit from each year’s R&D costs is now spread across multiple years, with the negative impact being the largest in year 1 of the implementation and falling over time.

Even for companies whose R&D is 100% U.S.-based, TCJA will have a negative cash impact until year 5:

Illustrative R&D Amortization Example

Raytheon FCF – Actual vs. Operational (2020-23E) — Source: Librarian Capital estimates.

Moreover, because companies will always have some R&D costs that are not yet amortized, they will always have temporarily paid more taxes than they should for each given year – in effect providing a permanent interest-free loan to the U.S. government.

For RTX, this means an actual reduction in FCF of $1.6bn in 2022, as well as expected reductions of $1.4bn in 2023 and around $1bn in 2025 (the 2024 estimate is not disclosed).

Another key one-off was that, in December, RTX received “a couple of large international advances” worth $500m in total that were originally expected for 2023, in effect shifting that cashflow a year early.

Adjusted for the TCJA-related tax payments and the large international advances, RTX’s FCF would have been $6.0bn actual in 2022 and $6.7bn guided in 2023, implying double-digit year-on-year growth in both years:

Raytheon FCF – Actual vs. Operational (2020-23E)

Other one-offs expected to reduce 2023 FCF include higher pension payments (about $500m in cash, related to lower market asset prices), the non-repeat of one-off tax benefits in 2022 ($325m, based on a $0.22 EPS impact) and higher CapEx ($200m).

On an Adjusted EBIT level, RTX’s 2023 outlook actually includes a solid growth of $1.22-1.45bn (17-20% year-on-year), though again mostly driven by the aerospace segments, with growth in the defense segments representing only a partial recovery from their 2022 declines ($252m for RIS and $435m for RMD):

Raytheon 2023 Outlook (By Segment)

The outlook includes $2bn of material and labor cost inflation in 2023, which represents a relatively modest 3.4% on 2022 total cost base of $59.3bn; $800m of the expected inflation is in labor, where RTX assumes a 4% increase.

Both the aerospace and defense markets have strong long-term potential, but at present RTX’s aerospace segments are doing much better while the defense segments are experiencing execution issues.

RTX Aerospace & Defense Segments Diverging

The performances of RTX’s aerospace and defense segments have been diverging in recent quarters:

Raytheon Segment Adjusted EBIT by Quarter (Since Q4 2019)

NB. Figures not adjusted for divestitures, FAS/CAS accounting and corporate expenses.

The aerospace segments, which were severely impacted by COVID-19’s disruption of global air travel, have seen EBIT recover increasingly strongly as aftermarket sales picked up. However, as of Q4 2022, their total Adjusted EBIT was still approximately 30% lower than the level in Q4 2019, because passenger air traffic volume remained significantly below 2019 levels even at the end of 2022.

As of November 2022, global Revenue Passenger Kilometres (“RPK”) remained around 25% lower than in 2019, with four out of six regions being lower by double-digits. Asia Pacific was particularly behind, due to “zero-COVID” restrictions in China:

Global Passenger Air Traffic Volume By Region (November 2022)

NB. ASK = Available Seat Kilometres. PLF = Passenger Load Factor.

Recovery should continue in 2023, helped by China abandoning “zero-COVID” in early December.

The defense segments, which held up well during 2020-21 (with the EBIT declines shown for early 2020 partly due to accounting rules around contract completion estimates following the UTX-RTN merger), have seen EBIT continuing to decline in recent quarters. Part of the decline in RIS was due to the disposal of a training services business in December 2021, but there were also supply chain issues and some execution problems.

Solving Problems at Defense Segments By Merger

RTX’s defense segments are suffering from both supply chain issues and some execution problems.

The supply chain issues have been well-known in previous quarters. Issues include castings, rocket motors and microelectronics (titanium was an issue but has since been resolved), and have been the result of disruption from COVID-19 as well as Russia’s invasion of Ukraine. They have affected RTX more in defense than in aerospace because, according to management, procurement rules on government contracts make them much harder to manage there.

RTX is expecting these issues to ease only in H2 2023. On the earnings call, management stated “it’s going to be the end of 2023 before we see structural castings back to 2019 levels”, while microelectronics will see a “back half recovery”.

Q4 saw RTX acknowledging other execution problems, with RIS finishing the year with a book-to-bill ratio of just 0.96x. (RMD had a much better book-to-bill ratio of 1.37x.). RIS’ shortfall in new orders contrasted with a generally healthy defense market, with the U.S. Defense Authorization Bill and the Omnibus Appropriations Bill implying a 10% increase in the U.S. defense budget in 2023, and RTX products like the Stinger missile and Patriot missile system in demand in Ukraine. As COO and new President Chris Gallio said on the call:

“We have had customer feedback throughout the last couple of years about the need for us to figure out how to better integrate some of our solutions, providing mission solutions to the customers, coming in with a unified narrative and an investment story.”

RTX is now merging the two defense segments to improve their operational performance. This will be a major undertaking, as CEO Greg Hayes described on the call:

“As we look at this reorganization, this is not just about putting RIS and RMD together to recreate the old legacy Raytheon Company. We’re going to look to take the entire portfolio of RIS, Collins, RMD and move the pieces where they most appropriately align from a technology and a customer standpoint.”

Management expects to decide on what changes are needed over the next few months, “have a really good understanding” of what they will be by the end of Q1, and to have these changes become effective in H2.

We see some execution risks with the defense segments, but ultimately believe management will succeed, given their track record in integrating past acquisitions (such as Rockwell Collins and BE Aerospace) and the relatively benign competitive landscape in defense where most segments are dominated by a few large players.

2025 FCF Target Now $1bn Lower

For 2025, due to the impact from TCJA tax changes described above, management is reducing its FCF target from $10bn to $9bn, but maintaining all other targets. CEO Greg Hayes stated:

“We remain confident in our ability to achieve our 2025 targets … (However), as we go into the 2025 timeframe, that drag (from TCJA tax changes) will still be about $1bn, about $800m of that is actual net R&D deferral and there’s a couple of hundred million dollars of additional interest expense and financing our little loan to the government… We had always talked about a $10 billion free cash flow in 2025. Realistically, I think that number is going to be $9bn”

2025 represents year 4 under the new tax rules, and the expected $800m actual net R&D deferral figure is half of the cash impact in 2022. TCJA’s impact will clearly lessen over time, though the pace it lessens will depend on the percentage of R&D based outside the U.S. (which are amortized more slowly) and the rate of its R&D growth.

Raytheon Valuation

At $99.60, on 2022 financials, RTX shares are at a 20.7x P/E and a 3.3% FCF Yield; on the mid-point of the 2023 outlook, including the $1.4bn impact from TCJA, RTX shares are at a 20.1x P/E and 3.3% FCF Yield:

Raytheon Earnings, Cash flows & Valuation (2020-23E)

Cash conversion (FCF / Adjusted Net Income) will be unusually poor in the next few years due to the one-off impact from TCJA tax rule changes; working capital is also elevated as RTX mitigates supply chain issues with more inventories.

Raytheon pays a quarterly dividend of $0.55 ($2.20 annualized), which represents a Dividend Yield of 2.2%. The dividend was last raised in April 2022, by 8% (from $0.51). We expect a further increase this April.

RTX repurchased $2.8bn of shares in 2022, including $408m in Q4. Its 2023 outlook includes a further $3bn of buybacks, equivalent to 2% of the current market capitalization.

Net Debt was $25.1bn at 2022 year-end, implying Net Debt / EBITDA of 2.1x. In addition, there are $4.8bn of retirement-related liabilities and $1.6bn of long-term operating lease liabilities.

Raytheon Stock Forecasts

We reduce our 2023-25 FCF forecasts to reflect the headwind from TCJA, but increase the valuation assumption for our 2025 exit from a 5.5% FCF Yield (which implies an 18x multiple) to 4.8% (which implies a 20.7x multiple, in line with the present). We are making the latter change because the recovery in aerospace earnings is now much more certain and because we expect investors to look past at least some of the $1bn temporary headwind from TCJA in 2025.

Our key assumptions now include:

2023 FCF of $4.88bn (was $10bn)
2024 FCF of $7bn (was $9bn)
2025 FCF of $9bn (was $10bn)
From 2023, share count to fall by 1.5% each year (unchanged)
Payout Ratio to be 70%(on FCF) in 2023 and 65% in 2024-25 (was 65% in 2023)
FCF Yield at 4.8% at 2025 (was 5.5%)

Our new 2025 FCF/Share forecast of $6.38 is 10% lower than before ($7.07):

Illustrative Raytheon Return Forecasts

With shares at $99.60, we expect an exit price of $133 and a total return of 44% (13.7% annualized) by 2025 year-end.

Conclusion: Is Raytheon a Buy?

We reiterate our Buy rating on Raytheon.