Raytheon: Customers Out Of Money, Company Selling Weapons For Wars Past

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Raytheon's stock price has underperformed compared to other defense industry peers, despite the war in Ukraine being seen as an opportunity for weapons manufacturers.Raytheon's signature weapons may ...

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Q1 2024 provides hope for short-term gains.Beyond the short term, NATO members face tough fiscal and economic choices, while an end to the war in Ukraine will likely flood the rest of the global weapons market with deeply discounted Russian weapons that are currently produced in high volumes.   VanderWolf-Images Investment thesis: The war in Ukraine has been heralded as a golden opportunity for Western weapons manufacturers. Raytheon's (NYSE:RTX) stock price does not seem to share in the spoils of war, given that it underperformed the S&P 500 in the past five years.   Raytheon It performed nowhere near as well as defense industry peers such as Rheinmetall (OTCPK:RNMBY), which is up over 400% for the past five years, as I write this.   Rheinmetall stock price and other metrics (Seeking Alpha) Raytheon is up only 18% for the same period.   Raytheon stock price & other metrics (Seeking Alpha) With a forward P/E that is less than half compared with Rheinmetall, and about 50% lower compared with the S&P500 P/E which is about 27 currently, one could argue that Raytheon is underpriced and it is likely to catch up. The continued ratcheting up of global tensions and the ongoing Ukraine war also help to contribute to a positive thesis for this stock. On the other hand, the end of the Ukraine war will lead to a flood of Russian weapons on the global market, while NATO, which is by far Raytheon's biggest market is likely to scale back defense spending due to underlying economic conditions. Taking these factors into consideration, Raytheon is currently not an enticing long-term investment opportunity, despite all the short-term positive factors. Raytheon's financial results show deterioration in 2023, with Q1, 2024 offering investors some hope. While 2022, the first year of the full-blown Ukraine war started in a promising manner in terms of Raytheon's financial performance, 2023 was less than impressive, especially within the context of re-arming being the new buzzword throughout the NATO alliance. The hundreds of billions of dollars' worth of military and non-military assistance provided to Ukraine should have also bolstered its results as Western militaries are looking to replenish their depleted arsenals.   Data source: Raytheon Revenue growth has been less than impressive as we can see, and yet, revenue growth was perhaps the highlight of the year in 2023. Net earnings growth in 2022 suggested that Raytheon will participate in the war profits bonanza. Last year's decline in net earnings left investors disappointed. The first quarter of this year suggests that there may be some hope of Raytheon being at least a late-comer to the defense industry rally. Revenues increased by 12% Y-O-Y, while adjusted earnings per share increased by 10%.   Raytheon The significant increase in interest costs last year was also a significant negative in terms of its financial performance. Net interest expenses amounted to just over $1.5 billion, on revenues of just under $69 billion. Interest costs made up just over 2% of total revenues. For FY 2024, net interest costs are set to rise to $2.05 billion, based on estimates reported in Q1. I tend to start worrying about the financial health of a company when it starts to hover around the 5% level, which is not the case here. Having said that, the interest on debt cost is an issue that should be monitored for the longer term, given the deterioration we saw in 2023. Total debt increased from $31.9 billion in 2022, to $43.8 billion in 2023. It should be noted that the combination of rising debt and rising interest rates has the potential to accelerate interest costs in the next few years, as Raytheon will go through the process of rolling over its existing debt. Perhaps the brightest spot in Raytheon's financial performance is the backlog of orders of $196 billion at the end of 2023, which rose to $202 billion in Q1. It is equivalent to about three years' worth of revenues. In 2023, it locked in contracts worth $95 billion, which was significantly higher than sales volumes, meaning that the backlog of orders increased significantly for the year. This year it may see a repeat of higher order inflows than sales. I doubt that the trend will continue into 2025. Headwinds beyond this year. The Ukraine war could end in Russia's favor, freeing up Russia's enhanced capacity to export weapons systems, while NATO members will be freed from having to continue sending weapons to Ukraine. While there is always a great deal of uncertainty when it comes to war and the outcome of conflicts, as of right now, it looks like Ukraine's military is set to struggle even with more aid. The $61 billion aid package for Ukraine, will increase demand for many of its products, including its famed Patriot systems. That money will probably run out at some point next year, however, and in the absence of yet more aid packages, the outcome will most likely be the same, just delayed by perhaps a year. I don't think a repeat of the current package being considered will materialize when the current one runs out. Russia will most likely go on the defensive again for a year or so to minimize losses while Ukraine burns through the aid and then it will go on the offensive again. When the war ends, Russia will be left with much defense industry overcapacity including in terms of air defense systems, such as the S-400, which is a direct competitor to the Patriot system. Raytheon is developing anti-drone technologies, which will come up against Russian systems that will be offered to the global market once they are not being poured into the Ukrainian conflict. There are several overlapping weapons systems that Raytheon produces and exports to non-NATO countries, where Russia now has a developed overcapacity, which it will be eager to dump onto the global market. One can argue that Russian systems do not compare in terms of quality and so on. The counter-argument to it is that after pouring massive volumes of Western weapons systems and other indirect capabilities, such as real-time satellite information into Ukraine, Russia is still looking more likely to emerge victorious, while it is almost solely dependent on its own weapons industry. Another reality that is emerging out of the Ukraine war, is the fact that many of the weapons systems are not adequate to current challenges. For instance, the economics of using a Patriot system, which uses $4 million missiles to shoot down emerging aerial threats, such as longer-range suicide drones that often only cost less than $100,000 to mass produce in massive volumes, makes no economic sense. There is also the issue of the survivability of the system, in the face of new threats like hypersonic missiles that will often target high-value items on the battlefield, like the Patriot. A video emerged a while ago where a Patriot system was seemingly hit after firing off its entire complement of 32 missiles at an incoming missile and missed. Several claims, emerged since then that the Patriot is making easy work of Russian hypersonic missiles. It is not entirely clear to what extent we can get a true sense of reality when looking at it through the fog of war, but it does not seem like the Patriot is playing as crucial a role as it did during the two Iraq wars for instance. It does provide certain capabilities at a relatively high cost, while it certainly seems far more vulnerable on the battlefield than it used to be. NATO alliance is economically constrained, and unlikely to boost defense spending, while some recent spending plans are likely to be rolled back  With the war in Ukraine still raging, the ME region looking increasingly unstable as well as tensions with China rising, one would think that the US defense spending budget would be growing by leaps & bounds.   U.S. Department of Defense The FY 2024 defense budget asks for $825 billion, which is not much of a leap compared with the FY 2023 budget in nominal terms. It also makes provisions for significant pay raises and other support measures for defense department employees, which takes away from hardware procurement. There seems to be very little appetite for a hike in military spending given the massive deficits in the $1.5-$2 Trillion range. As a new age of hard choices approaches on the fiscal front, defense spending is likely to be an easy target for cuts, especially if geopolitical tensions eventually start to cool down. The situation is not much better in Europe. EU member states have a much better handle on the deficits, but they are also faced with a second year in a row of near-zero economic growth. A lack of economic growth, even as needs, such as health care & pensions for the growing ranks of the elderly population are inevitably putting the squeeze on national budgets. Finland, the second-newest NATO member, for instance, is looking at a 9 billion euro budget hole for the 2025-2028 period, which it partly intends to plug by cutting pensions and raising taxes. France is facing serious budgetary problems as well, which will necessitate austerity measures. Germany is faced with deficit issues that have been thought to be a thing of the past. Europe's budgetary issues are coming within the context of severe public discontent over high energy, food, and housing prices, and problematic agricultural policies, such as not enough subsidies to make up for all the burdens put on farmers through EU and national policies. While all the talk is about Europe's rearming, I don't see a viable path forward for European governments to achieve that within the context of an ailing economy and growing public discontent. The current mood, at least at the political level may lead to some shorter-term initiatives in this regard, but clearly, most European governments are not in a position to fiscally sustain higher military spending for a prolonged period. Investment implications: Raytheon's main market is stagnant, even as global military spending is increasing at a robust pace  Record global military spending in 2023 of $2.44 Trillion, driven in large part by the Ukraine conflict, but also conflicts and tensions elsewhere may seem like a great market for a company like Raytheon, which gets most of its sales from the defense sector. Based on its 2023 report, Raytheon gets about 85% of its revenues from the US & European markets, with the US market in particular, which accounts for 65% of its sales not increasing defense spending by a lot. In 2023, US military spending rose by 2.3%, compared to a global increase of 6.8% globally. It is a great illustration of the challenge faced by Raytheon in seeking growth, even as its main customer is seeing a stagnation in military spending. Europe, its second-largest market looks more promising in the short term, but there too, are long-term fiscal challenges that make it unlikely to be a promising market beyond the next two years at most. Russia will likely flood the global weapons market once the Ukraine war ends. Given a lack of growth in Raytheon's domestic market, an effort to penetrate global markets outside of the NATO alliance would make sense. At the moment it looks all the more viable given Russia's retreat from the global arms market since it needs most of its hardware to be deployed in Ukraine. Once the Ukraine war ends, the reverse will most likely happen and Russia will flood the market with weapons systems, at discounted prices for many years, since it will not want to abruptly end its current wartime levels of production. Raytheon is not likely to score many major contracts outside of the NATO alliance. Many would-be customers will probably wait it out to get those deep discounts on Russian hardware, such as the S-400 air defense systems that are arguably comparable in capability to the Patriot. While many countries will face US government pressure not to buy Russian weapons, Raytheon is also faced with restrictions on its sales, given that the US government tends to be cautious in approving sales to many countries on national security grounds. Some of Raytheon's big-ticket items are not suited to the current battleground situation. One of the main revelations of the Ukraine conflict is that we are now back to high-intensity, high-volume warfare. Expensive, high-precision weapons still play a significant role. For instance, Ukraine wants Patriot air defense systems deployed along the frontline to target Russian planes that are launching glide bombs. The problem is that once it gets within a 40-50-mile range from the contact line, it can potentially be targeted by cheap longer-range drones such as the Lancet, as well as a multitude of other cheap systems at Russia's disposal. In other words, it can make a difference on the battlefield, but its survivability is not what it used to be, which is problematic given the high cost of the system. Furthermore, it increasingly has no practical, economical use as an air defense system in most cases, in the face of cheap long-range drones, when its missiles cost about $4 million each. Raytheon is working on new solutions for today's battlefield realities. For instance, it is currently producing laser beam interceptors to counter drones, missiles, and other threats. This could be a viable countermeasure to emerging battlefield realities. If it proves to be the right path it could potentially make up for Raytheon's future loss from declining Patriot sales as well as that of other systems that are increasingly meant to fight wars from decades ago, not current confrontations. Conclusions On the face of things, Raytheon could be the story of the neglected stock that should have participated in the arms manufacturers rally, the same as the likes of Rheinmetall, but it did not, thus it is a potential buying opportunity. The P/E ratio difference does suggest that relative to its peer, Raytheon is deeply undervalued. At the same time, we have to consider the probability that the entire NATO-based defense sector is overvalued on potentially deeply flawed assumptions and expectations, namely that a massive re-arming is about to take place. The reality is that neither the fiscal nor the economic realities on both sides of the Atlantic provide the adequate foundation to support such an undertaking. Assuming that geopolitical tensions around the world can be tempered, Western governments will most likely seek to reverse recent plans for higher defense spending to address the multitude of other pressing needs. Raytheon is not well-adapted to providing the market with the weapons of the future. Weapons like the Patriot will continue to maintain battlefield relevance in terms of meeting certain needs, but not to the same extent as they did in past conflicts. New products such as laser weapons may turn out to be a success story or perhaps not. It is far too early to tell. Between Raytheon being caught out, and not necessarily ready to provide arms buyers with the right solutions for emerging battleground realities, as well as poor economic prospects for its main markets, which may cause them to cut back on arms buying, it does not seem to have very bright sales growth prospects going forward. Furthermore, the cost of servicing its debt is rising at a fast pace, which will cut into its net earnings. Taking all these factors into consideration, I do not see Raytheon's stock as a long-term buying opportunity currently. It was a good prospect in early fall when it was trading at around $70/share, but not at $100/share.  Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. 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