How Raytheon's Aiming for a $10 Billion Goal

Back on Raytheon Technologies' (RTX 0.35%) investor day presentation in May, CEO Greg Hayes outlined a target for more than $10 billion in free cash flow (FCF) in 2025. While many things can happen in the aerospace and defense market until then, the target does make Raytheon's current market cap of $131 billion look like a good value. However, the recent third-quarter results demonstrate some excellent progress on that front. Here's how to think about the earnings and Raytheon's march to $10 billion.

Management's excellent execution

Raytheon's management has a history of exceeding expectations regarding wringing every bit of profit it can from generating cost synergies from mergers and acquisitions. That's a beneficial quality to have in the current environment.

Image source: Getty Images.

The company is a result of an acquisition (the former United Technologies bought Rockwell Collins in 2018) and a merger (the aerospace business of United Technologies was merged with Raytheon in 2020). The good news is the total cost synergy of $600 million from Rockwell Collins will be achieved in 2021, a year earlier than management had initially anticipated.

Moreover, back in the second quarter, management raised its cost synergy expectation for the Raytheon deal to a total of $1.5 billion from $1.3 billion previously, with $600 million planned for in 2021. The excellent news from the third-quarter earnings call is that the target of $600 million is now $700 million. As such, don't be surprised if management raises the total cost synergy target in the future.

On track, but expect a bumpy journey

That said, investors will have to tolerate some lumpiness in Raytheon's progress to $10 billion in FCF, not least because the commercial aerospace market is recovering in a highly uneven fashion.

For example, the narrowbody market is coming back much more quickly than the widebody market. Within the narrowbody market, the problems the Boeing 737 MAX has had in recent years mean the Airbus A320 Neo has a jumpstart on its rival. Meanwhile, the production slowdown on the Boeing 787 widebody also hurts Raytheon.

Image source: Getty Images.

In addition, it hurts the profit margin when Pratt & Whitney, maker of aircraft engines, sells more geared turbofan engines (GTFs) on the Airbus A320 Neo family of aircraft, because they come with a negative margin. The real money comes from aftermarket sales.

These dynamics played out in the company's third-quarter earnings and guidance. In a nutshell, Raytheon lowered its full-year sales guidance but increased its earnings and FCF guidance. As a result, organic sales growth is forecast to be just 1%, compared with a prior range of 1%-3%, but earnings per share (EPS) are forecast to be $4.10-$4.20, compared with a previous range of $3.85-$4.00. In addition, FCF is forecast to be $5 billion, compared with the prior range of $4.5 billion to $5 billion.

The following table shows the full-year details of the guidance changes, with some notes that reflect the dynamics we've discussed. In addition, it's worth noting that, according to Hayes on the earnings call, 40%-45% of Collins Aerospace's aftermarket sales go to the widebody market, and it has $10 million worth of original equipment sales on each Boeing 787 aircraft.

Data sources: Raytheon Technologies, author's analysis.

The unevenness in the recovery is likely to persist for a few years yet, so investors can expect the fluctuating dynamics in Raytheon's commercial aerospace business revenue and earnings to do so as well. Nevertheless, the company remains on track.

Looking ahead

It will take a while to get back to 2019 levels of profitability, let alone the 2025 target of $10 billion in FCF. As you can see, it won't be a straight-line performance. That said, internal execution is excellent, and the company remains on track in 2021 despite facing supply chain constraints, a Boeing 787 production slowdown, and a tepid recovery in widebody flight departures.

All told, Raytheon remains an excellent way to play an aerospace recovery.