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
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
2000
2200
2400
2600
2800
3000
3200
3400
3600
100
120
140
160
180
200
220
240
4/2/2019 6/2/2019 8/2/2019 10/2/2019 12/2/2019 2/2/2020 4/2/2020
Raytheon S&P 500
The Raytheon Company (NYSE: RTN)
April 4, 2020
April 4, 2020
2
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%
-4.00%
-2.00%
0.00%
2.00%
4.00%
6.00%0
2
03
04
05 06
07
08
09 10
11
12
13 14
15
16
17
18
19
Real GDP YOY Growth
Real GDP YOY Growth
Executive summary
Macroeconomic Outlook
3
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.
4
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
80
85
90
95
100
105
110
115
01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20
Industrial Production Index
120
130
140
150
160
170
180
190
200
210
220
01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20
Producer Price Index
5
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
6
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
7
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
8
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
9
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
10
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
11
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%.
12
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
13
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
References
(1) { IMF Real GDP growth }. (n.d.). Retrieved
from
https://www.imf.org/external/datamapper/NGDP_
RPCH@WEO/OEMDC/ADVEC/WEOWORLD/
USA
(2) Coronavirus (COVID-19). (n.d.). Retrieved
from https://news.google.com/covid19/map?hl=en-
US&gl=US&ceid=US:en
(3) Duffin, E. (2020, January 29). U.S. - defense
outlays and forecast 2030. Retrieved from
https://www.statista.com/statistics/217577/outlays-
for-defense-and-forecast-in-the-us
(4) Simon, Darran. “Tensions between the US and
Iran Reached New Heights over the Weekend.
Here's How It Unfolded.” CNN, Cable News
Network, 6 Jan. 2020,
www.cnn.com/2020/01/06/politics/iran-us-
tensions-qasem-soleimani-trnd/index.html.
(5) Industrial Production Index. (2020, April 15).
Retrieved from
https://fred.stlouisfed.org/series/INDPRO
(6) Producer Price Index for All Commodities.
(2020, April 9). Retrieved from
https://fred.stlouisfed.org/series/PPIACO
(7) CME FedWatch Tool: Countdown to FOMC -
CME Group. (n.d.). Retrieved from
https://www.cmegroup.com/trading/interest-
rates/countdown-to-fomc.html
(8) FactSet Research Systems. Raytheon.
Segments. Retrieved February 18, 2020, from
FactSet database.
(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-
com.proxy.lib.uiowa.edu/us/en/industry/33641b/m
ajor-companies.
(11) Bing, C. (2020, February 20). U.S. agency
that handles Trump's secure communication
suffered data breach. Retrieved from
https://uk.reuters.com/article/uk-usa-defense-
breach/u-s-defence-agency-personal-data-may-
have-been-compromised-letter-idUKKBN20E270
(12) (n.d.). Retrieved from
https://www.sec.gov/ix?doc=/Archives/edgar/data/
1047122/000104712220000009/rtn-
12312019x10k.htm
(13) Raytheon and United Technologies Merge to
Create Undervalued Defense Behemoth. (2020,
April 3). Retrieved from
https://finance.yahoo.com/news/raytheon-united-
technologies-merge-create-221019169.html
(14) Cordell, C. (2020, April 3). Raytheon
completes merger with United Technologies.
Retrieved from
https://www.bizjournals.com/washington/news/20
20/04/03/raytheon-completes-merger-with-united-
technologies.html
(15) “United Technologies and Raytheon
Complete Merger of Equals Transaction.” News |
United Technologies and Raytheon Complete
Merger of Equals Transaction | Raytheon
Technologies,
www.rtx.com/News/2020/04/03/United-
Technologies-and-Raytheon-Complete-Merger-of-
Equals-Transaction.
17
18
19
20
21
22
23
24
25
26
27
28
29