RTX - RTX: Long-Term Holders Should Take Advantage Of Its Valuation And A Yield Over 3%

2023-09-21 07:14:45 ET

Summary

• Raytheon has experienced significant issues with engines produced by its commercial aviation unit, Pratt & Whitney.
• The recent airplane engine problem is a major mistake that could potentially worsen, but it doesn't change secular tailwinds in the company's favor.
• Stock downgrades are reasonable for short-term investors, considering the current situation.
• However, for investors with a long-term time horizon, getting one of the leaders of the entrenched and stable US Defense complex is a golden opportunity for getting the benefits of compounding.

Raytheon, or RTX (RTX), has had a brutal couple of weeks after a major issue with engines produced by one of its commercial aviation units, Pratt & Whitney. It is one of my largest long-term holdings. Over time, I hope to accumulate a large position by re-investing dividends and consistent monthly purchases. Stocks with drivers enabling them to pay dividends through extreme economic cycles are good to own for the purpose of compounding. I think Raytheon has staying power and favorable secular drivers despite a huge engine issue recently resulting in a $3 billion charge.

This major engine issue provides a major lesson. First of all, let's all be thankful that we learned about this issue from a company announcement instead of flaming debris on a television screen. That is a victory in itself, given the high-profile stumbles of Boeing (BA) in the last few years. But the major lesson is that if you're a long-term stockholder looking to build wealth through compounding, then even massive $3 billion hits from a major engineering error are something to be excited about. Take your eyes off the CNBC, kids. There is a better way.

That's right. It's the power of stretching the time horizon. If you were swing trading this stock, you're in a world of pain. But this weakness is a gift for those who know Raytheon's strengths will ensure it continues earnings and supports the dividend well into the future. Here are some of the key reasons why I like the stock:

• Competitive Position: Raytheon is at the top of an effective triopoly in the US Aerospace & Defense sector. Even more important than this entrenched competitive advantage is that Raytheon's particular product lineup, which includes the world's most sophisticated air defense, is increasingly desirable.
• Competitive Products: As I mentioned when I covered Raytheon early this year, a generational defense spending boom is coming. Of course, the army moves slowly. Raytheon has an exciting mix of stalwart and increasingly necessary defense products like the PATRIOT Missile System and some exciting stuff like laser weapons.
• Defense Spending Will Be Systems Heavy: The modern Western approach to military spending is not personnel intensive. That could change if a hot war erupts involving the United States or its European or Asian allies. However, better equipment is the most efficient way to upgrade your military.
• US Defense Contractors Gaining at Russia's Expense: Many traditional Russian allies are having questions about being reliant on Russia for both arms and security guarantees. The poor performance of Russian equipment in Ukraine and the diminished capacity caused by cast equipment losses have made many traditional Russian arms customers start looking at Uncle Sam.
• Solid Management and Good Dividend Prospects: I still think the long-term plan this company has laid out is viable despite the disappointing GTF engine issue. Despite risks that the issue could expand, I still think the company's track record suggests recent price weakness is an opportunity for long-term investors.

I will be making a much larger purchase of Raytheon than my regular monthly purchases soon to take advantage of the price weakness on what I deem ultimately to be a short-term catalyst, given my time horizon, even though it does have the potential to get even worse. The way management is handling this is the harder but safer way. The charge is large and the problem inconvenient, but that doesn't change the great record of returning capital and the strong secular tailwinds for the company's defense and commercial aerospace segments.

Recent earnings strength has shown that the fundamental strength of the commercial aerospace plus the defense segment has an earnings effect. Of course, the engine mess-up is regrettable, but it is ultimately temporary. The time-tested way to beat the market is through compounding. Time is your friend. Set the earliest possible date for sale that is at least ten years into the future. One psychological trick I even do with myself is buying the stock directly from the company for my long-term positions when I can.

There is no doubt that the recent airplane engine SNAFU is a major screw-up. It also has the potential to get worse. I think the recent downgrades of the stock are largely sensible if you have a shorter time horizon. The hit will affect FCF in the following periods. However, I think the tailwinds in defense and the continued relatively higher growth of commercial aerospace will be a profitable and sustainable mix despite the headwinds from the engine issue. Ultimately, I think the company can outperform expectations because of a generational rise in defense spending.

I have recommended this company twice in the last year and stand by that recommendation. Indeed, if you have a long time horizon on Raytheon, I think the recent weakness is an opportunity to accumulate a lower-cost basis and lock in a higher yield on your investment. Raytheon is one of my biggest holdings. I plan not to sell the stock until 2033 at the absolute earliest.

Valuation and Dividend

Raytheon is incredibly cheap on an intrinsic basis at these levels, which is a rare circumstance with someone who is not only so competitively entrenched within their industry but also is an industry that Uncle Sam needs. This is one of the major reasons I feel comfortable purchasing the stock at these levels.

As you can see, there is a significant upside on all four methods of DCF and a limited upside for the Peter Lynch Fair Value model. So, the valuation is very advantageous for long-term investors. Despite the recent drawdown, RTX is still undervalued based on P/E multiples compared to peers as a group. However, I think their impeccable competitive position helps to justify this. It also suggests to me that further downside in the stock will be limited, given the strength in defense and the generational increase in defense spending caused by the Ukraine War.

Despite the prolific drop that has occurred in the months since the engine issue was announced in July, the analyst targets still mostly suggest an upside in the defense stalwart. The stock closed below $75, meaning that on a 10-year basis, the name is only up about 5.5%. So, the valuation picture is very advantageous here, but it's especially enticing when you think about the dividend. Right now, Raytheon's dividend yield is above the industry standard.

So, I think the low valuation and my trust in management will deliver and take care of the current negative catalysts in an appropriate way. The diversity of its business helps the dividend safety at Raytheon. The plan has always been that weakness in defense could be offset by strength in commercial aerospace and vice versa. This is a test of that strategy, but I am convinced the company will ultimately pass.

The payoff ratio is still manageable. While there are always problems achieving growth at such an established and mature industrial company, I am confident that the impressive R&D prowess the company is known for will continue to deliver a competitive advantage and support the dividend well into the future.

Risks and Where I Could Be Wrong

Of course, the most obvious risk is that the engine issue continues to deteriorate. In July, the company said that about 1,200 engines would be affected by the issue. In the recent announcement, the number has more than doubled to 3,000 engines. If there is a significant expansion of the issue, it could materially affect earnings to the downside. This is because there is a highly labor-intensive fix involved. If the issue takes longer, it could cause more and more reputational damage.

Of course, other risks could materialize as well. Raytheon's CEO has spoken of the risk deglobalization poses to his highly globally integrated firm. While I tend to think the risk of deglobalization is often overblown due to sensationalism and the use of foreign boogeymen for domestic political purposes, there is definitely a chance that I could be wrong. The firm is relatively insulated from recessionary risks, given its primary drivers. Still, because of the heavy reliance on commercial aerospace, a recession could more adversely affect Raytheon than Lockheed or Northrup .

Conclusion

Raytheon certainly has somewhat of a nightmare scenario on its hands, but if you have a long time horizon on the stock, I actually think it will make your financial dreams come true quicker if you buy the nightmare. The underlying risk could get worse, and it is highly inconvenient and expensive. Ultimately, though, the world is watching a vicious war unfold on Europe's eastern flank.

Raytheon's technology has been crucial to ensuring civilian casualties aren't a lot worse, and its technology has prevented mass carnage from indiscriminate Russian attacks. As world governments up their defense spending, these images will be fresh and central in their minds. Whatever the future of war holds, Raytheon's technology will almost certainly have a central place in it.

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