April 4, 2020 Aerospace and Defense The Raytheon Company ...

Important disclosures appear on the last page of this report.

Krause Fund Research

Spring 2020

Aerospace and Defense Recommendation: Buy

Analysts

Yichen (Ethan) Sun

[email protected] William Braverman

[email protected] Glei Hoxhalli

[email protected]

Company Overview

Raytheon is one of the world’s largest defense contractors,

with five main business segments providing products and

services to domestic and international customers. Raytheon

was founded in Delaware in 1922 and has seen continuous

growth. The company focuses on developing missile

systems, surveillance and radar solutions, and advanced

space technology. Raytheon has grown to be large enough to service the U.S Armed Forces and many of its allied

nations. On April 2, 2020, the company merged with United

Technologies Corporation to form Raytheon Technologies

and is now listed on the NYSE as RTX.

Stock Performance Highlights 52 week High $233.48 52 week Low $103.00

Five Year Beta 1.20

Average Daily Volume 3.57 m

Share Highlights Market Capitalization $32.57 b

Shares Outstanding 278 m EPS (2019FY) $11.94

P/E TTM 9.81

Est. Long Term Growth 4.8%

Dividend Yield 3.2%

Dividend Payout Ratio 32%

Company Performance Highlights ROA 9.63%

ROE 27.35%

Sales $29.18 b

Financial Ratios Current Ratio 1.34 Debt to Equity 1.83

Current Price $116.96

April 2, 2020

Current Price $116.92

Target Price $195-$215

Investment Thesis We recommend a buy rating for Raytheon because the current

stock price does not adequately reflect the outlook for the company. We believe the stock prices recent decline was due to

the adverse market conditions created by the Covid-19 virus. This

decline fails to consider Raytheon’s ability to weather this storm

due to the long-term nature of their contracts, and the extent of

their backlog.

Drivers of Thesis:

• Raytheon’s current corporate strategy to automate its

manufacturing process, and merge with United

Technology will decrease their costs and increase

margins.

• Increase in backlog order from 2018 will cushion the effect of COVID-19 crisis.

Risks of Thesis:

• Recent plunge in oil price will lead to weaker demand

from Middle Easter customers, which drives roughly

half of Raytheon’s international sales.

• Increasing pressure to balance the current US budget

deficit may cause the United states to lower their defense

spending, which could in turn decrease future revenue

outlooks for Raytheon.

• Defense spending as a percentage of GDP is projected to

fall for the next ten years.

One Year Stock Performance

Source: Yahoo Finance

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Raytheon S&P 500

The Raytheon Company (NYSE: RTN)

April 4, 2020

April 4, 2020

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As of April 2nd, 2020, our analyst team is

recommending a “Buy” rating for Raytheon.

We believe that Raytheon will experience

growth despite contractions in the global

economy. Furthermore, we think the merger

with United Technologies will create a Defense

industry behemoth. More specifically the

synergies that exist between Raytheon, and

UTC’s subsidiaries of Rockwell Collins and

Pratt Whitney will allow them to decrease their

COGS expense. This will, in turn, allow them to

have greater leverage during the bidding

process with their contracts.

Our discounted cash flows and economic

analysis yields an intrinsic value of $212.46 per

share. In our dividend discount model, we had

an intrinsic value of $196.70. These two prices

have influenced our target price range of $195-

$215. This range shows a rare growth

opportunity of a 66.78% to 83.86% increase in

the stock price of $116.92 as of April 2, 2020.

Real GDP Growth

Figure 1: Real GDP YOY Growth1

Real GDP Growth can indicate increased

production and revenues for the Industrial

sector. Current forecasts have indicated that we

are entering into a period of contraction due to

the concerns with the Coronavirus. According

to the International Monetary fund1, Real GDP

for the United States is estimated to decrease in

2020 by 5.9%, and the consensus estimate for

GDP growth of 2020 is at negative 3%. Our

group’s projection of GDP growth is around

negative 4% for 2020. Although the short-term

projections of Real GDP are negative, we feel

that is mostly due to the lost production and

consumption caused by COVID-19. It is still

unclear when this pandemic is going to come to

an end, and the total cost it will cause the US

economy, and the lasting effect it will have on

consumer spending behavior. Therefore, we

hold a slightly pessimistic view on the US GDP

and expect an L shape recovery until the first

quarter of 2023 to 2.1%

COVID-Crash

The COVID-19 pandemic has caused

businesses and consumers to adapt to new

lifestyles. As of April 17, 2020, there are

705,112 cases2 throughout the United States and

a total of just over 2.2 million2 globally. The

death rate currently stands at approximately

6.8% globally2, with a toll of 153,177 deaths2.

Companies and consumers have started to

shelter in place in order to stop the spread of the

virus. This has come with serious revisions in

estimated revenues because of lost production

and sales. In addition, companies in industries

that are more affected by the virus, such as retail

and restaurants, have had to lay off workers.

Overall, watching the spread of the virus over

the next couple of months will be crucial in

determining the real impact of this virus on our

economy. No one at this point really knows how -6.00%

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Executive summary

Macroeconomic Outlook

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long it will take companies to recover and regain

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

Raytheon’s revenue comes from the US

government which is why the two are closely

correlated. According to the Congressional

Budget Office, the US defense budget3 is set to

grow to 705B, 728B, and 752B in 2020, 2021,

and 2022 respectively. In total over the next 10

years, the US military defense budget growing

by 2.74% YoY. However, this growth is slightly

slower than its GDP Growth projection. This is

because they are also projecting a decrease in

defense spending as a percentage of GDP.

Defense spending as a percentage of GDP is

expected to decrease from 3.1% in 2019 to 2.5%

in 2029. In addition, the COVID-19 puts further

pressure on the defense spending budget. The

aforementioned forecasts were prior to the

COVID-19 outbreak therefore we do not

believe they will hold true. We think that the

decrease in GDP and the increase in government

stimulus will cause the defense budget to have

stagnant growth over the next three years.

US and Iran relationship

Figure 2: RTN Stock Price8

In late December and early January of 2020,

tensions between Iran and the United States were

escalating rapidly. On Dec. 29th, 2019 the United

States killed 25 Iranian backed militiamen using

drone strikes in Iraq4. In response, Pro-Iranian

supporters stormed and attacked the US embassy in

Baghdad on the 31st. This, in turn, led to further

retaliation when a US drone strike killed Qassem

Soleimani, a general in the Iranian military. Iran

later shot missiles at 2 US military bases in the

region injuring over 50 soldiers. During this time

period, it was clear Raytheon was seeing an increase

in its stock price because of the tensions between

the two countries. More specifically, because

Raytheon is one of the key drone vendors to the

United States, it seems as though their stock price is

positively correlated with increased tensions and

skirmishes involving the US.

We do not believe that the United States will

enter a war with Iran soon, however, Raytheon

does stand to benefit from Middle Eastern

instability.

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Industrial Production Index

Figure 3: Industrial Production Index5

The industrial production index is an important

economic indicator in the industrial sector

because it is a measure monthly real output in

the manufacturing industry. IPI can also be used

to predict the growth of production that consists

of output (physical units) and inputs (production

process raw materials). According to the

Federal reserve bank of St. Louis5, IPI has

started to decrease, going from 109.58 in

February to 103.66 March. This 5.4% decrease

has more than likely been caused by factories

being shut down due to coronavirus concerns.

This, in turn, will create a cyclical effect as

producers will start to face further supply chain

issues when sourcing their direct materials. We

believe that the IPI index will continue to

decrease as more and more factories face issues

throughout their supply chain due to the

outbreak. We are expecting IPI to hit a low of

95 in July and then gradually recover once the

outbreak is contained.

Producer Price Index

Figure 4: Producer Price Index6

The Producer Price Index shows the average

movement in selling prices of domestic

production over time. It is one of the main tools

used for adjusting prices in long-term purchase

contracts. According to the Federal reserve bank

of St. Louis6, PPI has decreased the last two

months going from 199.4 in January to 196.5 in

February to ultimately 193.8 in March. We

believe this trend will continue and that PPI will

stabilize towards the end of summers at

approximately 180. This metric shows that

some of Raytheon's revenues from their long-

term contracts could be in jeopardy and revised

down in the near future depending on the

structure of the specific deal.

Interest Rate Environment

Interest rates are an important factor for all

businesses, but they are especially important for

capital intensive companies like Raytheon. The

interest rate environment is highly influenced

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

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their R&D funding without significantly

increasing their interest expense. This will allow

Raytheon the access to cheap capital, enabling

them to explore new products and business

segments in the defense industry.

Capital Market Outlook

We are anticipating that the recent negative

market conditions will continue throughout the

summer and into 2021 based on the outbreak of

the coronavirus. After the virus is controlled, we

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.

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

include Lockheed Martin, Northrop Grumman, and

Boeing. These are all considered manufacturing

defense companies and tend to fare better during

times of budget cuts as major R&D contracts and

equipment acquisitions are long term contracts that

are normally fixed for the specified horizon.

Another subsector within the defense industry

consists of services, intelligence, and technology

firms such as Leidos, CACI, and Booz Allen

Hamilton. While these companies also derive the

majority of their revenue from government

contracts, their structures and the services they offer

have key differences from their manufacturing

counterparts. Service companies tend to do more

short-term deals, in areas such as IT, logistics,

outsourcing, and consulting. Service firms are also

threatened by budget cuts, more so than defense

manufacturers, because their short-term contracts

are more likely to be canceled in times of economic

uncertainty. Concerns about IT and cybersecurity

have arisen from recent security threats such as a

2019 data breach from the Defense Information

Systems Agency.11 This new economic trend will

most likely benefit these service companies who

provide IT and support services, which could

include Raytheon’s subsidiary Forcepoint.

Figure 5: Industry Market Share%8

The primary consumer of products of this industry

is the United States government. In 2019, out of the

31.5 billion in revenue in this industry, 57.6% was

for the US military-industrial complex. Other

major buyers include Saudi Arabia, Israel, the

United Arab Emirates, Japan, and South Korea.

International buyers have been steadily increasing

throughout the past ten years, and they usually

provide a higher margin for the company as well.10

Recent Developments and Trends

Raytheon, General Dynamics, Lockheed Martin,

and Northrop Grumman together control 68.3% of

the defense primary industry. In addition, as you

can see in the histogram below, all four of them

Industry Analysis

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have more than 60% of their revenue stream

coming from the United States government defense

spending, with Northrop coming in at the highest

percentage of 83%. This significant exposure

towards government spending creates uncertainties

of their revenues over national election outcomes.

If the government spending budget were to get cut,

these companies would face a risk of canceling

their programs that are not under contract.

However, their contracts are mostly 5 to 10 years

long. Hence, we do not see this as a risk in the short

term.8

Figure 6: % Revenue from DOD Spending8

Record Backlog

Defense primary companies saw an increase in

their backlog orders in the fiscal year ending

2019, signaling an increase in demand.

Huntington Ingalls saw the highest increase at

27.5% due to several new large shipbuilding

contracts. Increases in backlog orders are

usually seen as a positive sign for the growth of

a company, since it makes their revenue streams

more stable, and their revenue projection more

reliable and predictable. These firms have all

guided high single digit growth rates for the

year 2020, due to increased margins and

government spending.

Raytheon’s total backlog as of Dec. 2019 is

$48.75 billion, which is an increase of roughly

$6 billion from its 2018 backlog of $42.4

billion.

This backlog is especially important for

Raytheon since they will likely depend on it for

future revenue until the economy makes a full

recovery. As part of the new post-merger RTX

company, Raytheon’s backlog will be a steady

base of sales which will bolster decreasing sales

from the Collins and Pratt and Whitney business

segments, which are both more closely tied to

commercial aerospace and therefore affected by

the economic downturn.

Figure 7: Backlog YoY Growth8

Industry P/E Comparison

According to the P/E comparison graph below,

we saw a jump in the P/E value for the market

leaders in the defense industry. We believe that

this is partly due to the presidential election

result of Trump taking office in 2016. Trump

has been pushing for a higher fiscal policy since

the start of his campaign to boost the economy,

this has also meant increased defense spending

as well. Trump has also pulled out of the Iran

deal, which created further uncertainties and

created geopolitical risks. The graph below that

shows the timeline of the Iran conflict over the

last two months, we see a correlation between

share price and geopolitical issues. We believe

that the increase in the DOD budget and the

increasing uncertainties for geopolitical issues

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have created the spike in P/E ratio that you see

in the defense industry today.

Figure 8: Historical P/E Ratio in the Aerospace Industry8

Catalysts for Growth or Disruption

In August of 2019, Trump signed a two-year

deal that lifted the spending cap for the federal

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

happen after this deal expires.

International markets provide an opportunity for

defense companies to grow, however, to win

over international clients the companies will

have to offer “offsets” to the foreign

governments, which means manufacturing a

portion of the weapons system in the buyer’s

country. The International markets are also

valuable for another reason. Defense

contractors are not allowed to sell the latest

generation of weapons systems and technology

to foreign governments, so instead, they sell

previous generation equipment which comes

with the benefit of having higher margins.

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

the 5 business segments: Missile Systems, Space &

Airborne Systems, Intelligence, Information &

Services, Integrated Defense Systems, and

Forcepoint. The Revenue decomposition for FY

2019 is shown in the chart below:

Source: Factset8

Missile Systems:

Headquartered in Tucson, Arizona, this segment

develops, integrates, and produces missile and

combat systems for the U.S. armed forces and its

allied nations. Missile systems are Raytheon’s

largest business segment making up 28% of 2019

sales and it includes products like the Patriot missile

defense system, which continues to be the primary

surface to air missiles system used by the US and

allied militaries.

Company Analysis

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This segment has averaged 6.72% yearly growth for

the past 5 years.

Space and Airborne Systems:

Based in McKinney, Texas this business segment

designs and manufactures satellite sensors that are

used for military, scientific, communication, and

intelligence purposes. These sensors are also used

for aerial and surveillance operations and electronic

warfare systems.

This segment makes up 24% of sales and has

averaged 4.23% yearly growth for the past 5 years.

Intelligence, Information & Services:

Headquartered in Dulles, Virginia, IIS provides

technical and professional services to intelligence,

defense, federal and commercial customers. The

division also provides training, logistics,

engineering, and operational support services to

homeland security, space, civil aviation, and

counter-terrorism clients.

Since 2008, almost every deploying US soldier has

been trained by Raytheon’s Global Training

Solutions. This segment makes up 23% of sales and

has averaged 3.76% yearly growth over the past 5

years.

Integrated Defense Systems:

Based in Shrewsbury MA, this division specializes

in naval and ship electronic systems. More

specifically it manufactures naval and land-based

radar and sonar equipment, torpedoes and naval

mine countermeasures, and cyber and intelligence

solutions.

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

Forcepoint provides cybersecurity solutions such as

insider threat solutions, data loss prevention,

firewall technology, cloud and email security, and

cross domain transfer.

Forcepoint is Raytheon’s smallest business

segment, bringing in only 2% of the company’s

sales. This segment has averaged 5.16% yearly

growth over the past 3 years.

Competition

Raytheon exists in a highly competitive market with

well-established competitors. The primary

competitors of Raytheon that we identified include

Lockheed Martin, Northrop Grumman, General

Dynamics and Boeing.

The Department of Defense awards contracts

through competitive bidding, and this competitive

bidding can hurt margins as competitors lower their

prices in order to win the contracts

There is a rising frequency in bid protests from

unsuccessful bidders. These bid protest will delay

the start of the contract and could even result in the

award decision being overturned, requiring

contractors to re-bid on the project.

An example of this is the 3DELRR contract, a long-

range radar system project worth around $1 billion,

that Raytheon won over their competitors in

October 2014. However, after they won the award,

Lockheed Martin and Northrop Grumman filed

protests which led to the contract being delayed

until 2017. Ultimately the contract was awarded

back to Raytheon, but it was cancelled yet again in

early 2020 due to technical and supply difficulties.9

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Figure 9: 2019 Contract Type Distribution12

On April 3rd, 2020, Raytheon and United

Technology finally closed their merger after

clearing up all the regulatory requirements after

almost a year after the announcement. This merger

has created an industry behemoth that together

generated $74 billion in revenue, creating the 2nd

largest aerospace and defense company in the

world. The new company will be named Raytheon

Technology with the ticker symbol of RTX. Each

share of Raytheon stock was converted to 2.3348

shares of Raytheon Technology, while each share of

United Technology is converted to one share of

Raytheon Technology. This merger will give the

new company significant strategic synergies

throughout the defense sector.13

This merger comes with many complications. One

of them is that each company had to spin off parts

of their divisions to clear all the regulatory

requirements. United Technologies had spun off its

HVAC division Carrier and its elevator division

Otis into separate companies that are now listed on

the NYSE. They also divested their GPS and space

optical businesses. Raytheon had to divest its

military airborne radio business.13

The post-merger company will consist of 4 business

segments: (15)

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

Raytheon Intelligence & Space: This segment

consists of Raytheon’s old Intelligence, Information

& Service combined with the Space and Airborne

systems. The segment produces sensors, develops

training programs, and cybersecurity solutions.14

2019 sales were approximately $15 billion.

Raytheon Missiles & Defense: producing radar to

track and detect threats, and missiles.14Raytheon

Missiles & Defense: This is a combination of two

of Raytheon’s old segments, integrated defense

systems and missile systems. This new segment

produces Raytheon’s missile and missile defense

systems along with naval and land-based radar and

sonar equipment. 2019 sales were approximately

$16 billion.

Strength

Raytheon is well positioned compared to other

companies to weather the Covid-19 storm. Due

to the nature of its contracts, and the fact that

they are negotiated well into the future makes

their sales uniquely immune to the recent

downturn.

Changes in military strategy also favor

Raytheon, which primarily manufactures

missiles and missile defense systems, because

the military seeks to minimize troop

Merger Analysis

SWOT Analysis

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deployment in favor of using UAVs and missile

strikes.

Weakness

The Aerospace and Defense industry is highly

competitive, and the companies within this

sector rely on technological advancements to

secure contracts. Raytheon’s focus on missile

systems has left them in a niche sector within

the industry. As other segments start to grow,

like cyber and biological warfare, Raytheon will

need to adapt to this new landscape to stay

relevant.

Opportunity

The merger between UTC and Raytheon will

create a unique opportunity for the two

companies. The synergies that exist between

Collins Aerospace, Whitney Packard, and

Raytheon will allow them to be more

competitive in the contract bidding process. The

result will be one of the largest defense

companies in the sector.

Threat

One threat that Raytheon will always face due

to their line of business is changes to

government defense spending. At some point

the US government will have to try and balance

their budget, and when they do cuts to defense

spending are almost certain because of its

relative size of the overall budget. With 68% of

its revenues coming from the US, it is hard to

see a scenario where government defense

spending can decrease with Raytheon coming

out unscathed.

Revenue decomposition

In our revenue decomposition for Raytheon we

separated out their five core business segments;

Missile systems, space & airborne systems,

Intelligence, information & services, Integrated

defense systems, and force point out to forecast.

The total revenue from these categories was

then grown as a function of GDP growth and the

percent of GDP going to government defense

spending. We believe this to be accurate way to

grow our revenues and sales accounts because

of the strong correlation between Raytheon’s

sales growth and the US defense budget.

From our revenue decomposition we then

factored in Raytheon’s eliminations which were

roughly 6.4% of their revenues historically.

Once the eliminations had been deducted, our

revenues flow into our sales totals on the

income statement.

Key assumptions

Our model is driven by our revenue

decomposition because Raytheon is a revenue

driven company. We expect that most accounts

will be consistent with its previous percentage

of sales metric that we’ve analyzed over the past

ten years.

Expenses

We have forecasted our COGS expense account

to have as a decreasing percentage of sales

through our model. Over the past ten years

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.

Valuation

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For our depreciation and amortization expense

we have used the begging balances of PPE, and

Intangible assets times the historical charge offs

in these accounts. Which comes to roughly

12.14% off PPE flows through to depreciation

and 8.02% of the value in our intangible assets

account flows to our amortization expense.

Lastly our general & administrative expenses

we have forecasted as a constant percent of sales

based on the previous 10 years of historically

data. This in turn left us with 1.32% of sales

annually being expense out to this account.

Tax rate

The 2017 Tax Cut and Jobs Act significantly

reduced corporate taxes from around 35% to

21%. For Raytheon this provided a significant

boost to the company, 2018 FCF increased by

42% to $3.3 billion, and 2018 EBITA also rose

roughly 34% to $4.62 billion. Going forward,

we forecasted this tax rate to remain the same,

however this is subject to change depending on

future political leaders and legislation.

Share outstanding and dividends

Raytheon has historically netted treasury stock

and additional paid-in their capital on their

balance sheet. Because of this, a treasury stock

account is not seen on its historical balance

sheet. For simplicity, we decided to not net

these two together and report the treasury stock

on our balance sheet. In our share change

worksheet, we forecasted Raytheon using part

of their free cash flows on share repurchases

over the next ten years. These buybacks are

based on the trends we have seen historically

with Raytheon’s management. In 2020-2021 we

have Raytheon buying back roughly 1% of their

shares outstanding per year. This eventually

levels off to approximately .5% of their share by

the cv year.

We forecasted our dividend payout ratio in the

year 2020 toward the lower end of the historical

range that Raytheon paid in the past. Eventually,

we see the dividend payout ratio increasing

toward the higher end of the range at the cv year.

Our forecasted dividend growth rate, however,

starts toward the lower end of the historical

range at roughly 8% and continues to decrease

to just over 5% growth in the steady-state year.

Property, Plant and equipment

For PPE we have increased our capital

expenditures by an average of 9.06% per year.

Our equation for capital expenditures is through

our sales, and because our sales growth is based

on GDP some years, we have decreasing

amounts in our capital expenditures cashflows.

We believe this to be accurate because

historically Raytheon’s capital expenditures

have jumped around based on sales.

Debt

We are forecasting debt to increase as a

percentage of sales during our forecasted model.

We believe that due to the low interest rate

environment Raytheon will be incentivized to

increase their short term and long-term debt in

order to finance their operations.

Beta, Risk Free Rate, Equity Risk

Premium, and Cost of Debt

We decided to use the five-year monthly raw

beta collected from the beta calculator from the

Damodaran website, which resulted in 1.20.

For the risk-free rate, we decided to use the 10-

year treasury from April 2nd, 2020 because that

is the last day Raytheon was publicly traded,

and we believe a 10-year treasury captures a

long enough horizon. The 10-year treasury hit a

record low during March of 2020 and is still in

the low range at 0.62%.

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To off-set this low risk-free rate. We decided to

use the revised version of the Damodaran equity

risk premium of 6.16%. Damodaran has revised

his equity risk premium higher because of the

extreme volatility of the market in the past two

months. We believe by using a market risk

premium that factors in the additional risk will

make our model more accurate. Our pretax cost

of debt is the YTM of the 2028 corporate bond

at 2.96%. The reason we used the 2028

corporate bond is because that is the closest time

to maturity compared to the 10-year treasury we

used.

WACC

Using the current market value of the firm of

39.61 billion, we were able to calculate an

82.21% weight of the market value of common

equity, and 17.79% weight of the market value

of debt.

With all the necessary elements to calculate

WACC defined, we were able to calculate a cost

of equity of 8.01%, and the after-tax cost of debt

of 2.34% by adjusting the 21% of the marginal

tax rate from the pre-tax cost of debt. Finally,

we calculated WACC to be 7.00%.

NOPLAT and EPS Growth Rates

In our model, we have NOPLAT decrease the

first two years due to poor GDP outlook. After

the third year, we expect NOPLAT to gradually

increase before hitting its constant growth rate

of 3.91% in the cv year.

Our EPS growth follows a similar trend to

NOPLAT, however, due to share repurchases

the two figures are not entirely the same. In

2020 we are predicting a 7.96% decrease in

EPS. After 2020 we do have the EPS growth

rate increasing annually before hitting its

terminal growth value of 4.81% in 2029.

Discounted Cash Flow and Economic

Profit Models

Upon completion of our DCF and EP model, we

ended up with an implied price as of today of

$212.46. This is 82% higher than what

Raytheon is trading at before the day of

completion of their merger with UTC. The

reason why we have such a high target price is

that during that date of the merger, the market is

seeing unprecedented volatility, and we believe

that the market reaction of Raytheon might be

overexaggerated and oversold. We believe that

Raytheon is well-positioned to weather through

this pandemic after modeling in the potential

effect of COVID-19 on both the revenue and

cost side of our model.

Dividend Discount Model

Using the DDM for our valuation we have come

up with an intrinsic stock price of $196.70. This

marks a 66.78% increase in the trading price of

April 2, 2020. The DDM model uses forecasted

dividends as discussed above. These dividends

were then discounted by Raytheon’s cost of

equity which is 8.01%. Our terminal year

growth rate and ROE assumption were 4.81%

and 15.6% respectively. However, we do see the

potential that our sales downturn might be more

pessimistic than what could happen in the

future. For that reason, we have given more

weight to the DCF and EP models when

determining our price range.

Relative Valuation

Implied Relative Value

P/E (EPS 2020) $ 152.57

P/E (EPS 2021) $ 151.90

PEG (EPS 2020) $ 167.72

PEG (EPS 2021) $ 159.55

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In the relative valuation we used seven peer

comparisons, all of which are companies in the

defense manufacturing sector. The four primary

pure plays consist of Lockheed Martin,

Northrop Grumman, General Dynamics and

Boeing. Along with these companies we

included L3 Harris Technologies which

competes with Raytheon in sensor equipment,

intelligence, imaging, targeting systems and

other related products. Additionally, we also

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,

because even though these companies are

similar in that they derive most of their revenue

through government contracts, they way these

companies are structures and operate is

fundamentally different from the manufacturing

contractors.

PPE Growth Rate % vs Pre-Tax Cost of Debt

In the above chart, we examined the effects of

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.

The 0.7% yearly PPE growth rate is derived

from our forecasted Capex growth which is

around that same percentage.

The results show that a lower cost of debt and

lower rate of PPE growth will result in the

highest possible firm value, although this is

mostly influenced by the pre-tax cost of debt

rather than the PPE growth rate.

Beta vs Equity Risk Premium

Both beta and equity risk premium are variables

influenced by market activities. We used 10-

year US treasury yields to calculate equity risk

premium, and this risk-free rate has reached

some of its lowest levels historically in recent

months. This is thought to be a result of the

coronavirus induced recession which has caused

many investors to exit their equity positions and

move to safer, more stable investments such as

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

value.

Sensitivity Analysis

14

CV Year COGS % of sales vs GDP Growth

Rate

These two variables were tested because they

can both influence firm value in various ways.

As we mentioned earlier Raytheon is a capital-

intensive firm meaning its COGS will make up

a large portion of sales, and we forecasted that

COGS will be roughly 70% of sales. Along with

this, our revenue growth rate is based off GDP

growth and defense spending as percentage of

GDP.

The results show that lower COGS and higher

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.

Defense Spending as % of GDP vs CV Year

ROIC

These two variables were tested because they

both affect the final value of the firm. The

defense spending as % of GDP rate is used

in our model to forecast revenue growth, so

it is one of the biggest variables affecting firm

value.

As we can see from the results, the defense

spending percentage has a very significant

effect on the company’s value, whereas the CV

Year ROIC has a much smaller effect.

15

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.

16

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