Investors in Raytheon Technologies(NYSE: RTX) likely already know that the aerospace and defense giant has a stated goal of hitting $10 billion in free cash flow (FCF) in 2025. They have likely already priced the stock accordingly. Whether those investors believe the company can reach that goal or not probably plays some role in the stock's movement from quarter to quarter.
Recent earnings results shed some fresh light on the matter, so let's look at them in the context of the investment case for the stock.
Raytheon's medium-term guidance
CEO Greg Hayes discussed the 2025 guidance on the earnings call, telling investors that $9 billion in FCF was a more realistic aspiration now. The downplaying of expectations isn't due to anything related to operational performance or end-market conditions. Defense spending and commercial aerospace are in growth mode right now, and Raytheon booked a whopping $86 billion in orders in 2022, leaving it with a $175 billion backlog.
Instead, the reduction is due to legislation that became effective in 2022 resulting in a pull-forward in tax payments because research & development spending must now be capitalized and amortized over a minimum period of five years for tax purposes -- spreading out deductions over many years instead of upfront.
According to Hayes on the earnings call, that drag will still be about $1 billion in 2025, hence the reduction in expectations. However, the drag will disappear over time as the deductions kick in.
If you are keeping score on the matter, Raytheon's FCF was $4.9 billion in 2022, and there was $1.6 billion in tax due to the legislation. And FCF guidance for 2023 is $4.8 billion, with chief financial officer Neil Mitchill planning for $1.4 billion in tax relating to the law.
In other words, Raytheon is on track operationally to meet its previous guidance, but FCF timing is affected.
What to look out for with Raytheon
In a previous article, I identified a red flag and three green flags on Raytheon's pathway to 2025. The red flag is the ongoing issue with raw material inflation, the supply chain, and labor costs.
The first green flag is the improvement in defense spending and commercial flight departures (positively benefiting its aftermarket sales at Collins and Pratt & Whitney).
The second is the company's excellent track record of generating synergies from mergers (including Goodrich and the 2020 merger that created Raytheon).
The third is the potential for an easing in the aerospace supply chain, improving its ability to deliver products (notably in defense) and to help customers like Boeing and Airbus ramp up airplane production.
Raytheon's progress on these matters
Chief operating officer Chris Calio said he expects $2 billion in "labor and material inflation in 2023," with $1.2 billion related to product inflation and the rest labor-cost inflation. Calio noted that despite an improvement in producing structural titanium castings (Russia is a significant player in titanium), "it's not where it needs to be."
There's still an issue with rocket motors at Raytheon Missiles & Defense, he said. And with microelectronics, "while the lead times have stabilized, they haven't come down and back to 2019 historical levels." So the red flag is still waving, albeit with slightly less vigor.
The three green flags are also still flying. Management expects aftermarket revenue growth of 20% in 2023, driven by a return to 2019 levels of global air traffic. The defense backlog is expected to keep growing, supported by defense budget increases in the U.S., E.U., and Japan.
Turning to the market for commercial original equipment, the supply chain remains challenging, as noted above. Still, Calio said he expects "commercial aircraft volumes will be up around 20% year over year" in 2023. And Hayes, the CEO, said he didn't "see anything in our supply chain today" that would preclude "delivering either at Boeing or Airbus to the rates that they need."
Lastly, on synergies, management surprised investors by announcing a realignment of its four segments into three: Collins Aerospace, Pratt & Whitney, and Raytheon. Again, it's early days, but investors can look forward to some potential cost synergies from the move.
A stock to buy?
On balance, Raytheon remains an attractive stock. It's slightly disappointing that cost inflation with raw materials and the supply chain remains so high, and management has work to do to hit its 2025 targets.
Still, its end markets remain in robust growth mode, and it's a question of when, not if, Raytheon can deliver on its backlog. As a result, it remains the best stock to buy in the aerospace and defense sector.
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Lee Samaha has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
