Monday, April 3, 2017

Raytheon (RTN): A High Dividend Growth Stock to Consider on Dips

Raytheon Company (RTN) develops technologically integrated products, services, and solutions worldwide. It operates through five segments: Integrated Defense Systems (IDS); Intelligence, Information and Services (IIS); Missile Systems (MS); Space and Airborne Systems (SAS); and Forcepoint.

The company is a dividend achiever, which has managed to grow dividends for 13 years in a row. Last week, Raytheon raised its quarterly dividend by 8.90% to 79.75 cents/share.

Over the past decade, the company has delivered an annualized total return of 12.50%/year.

This strong performance was driven by the low valuation a decade ago, consistent dividend growth, consistent share buybacks, and strong earnings per share growth.

Raytheon has managed to triple earnings per share over the past decade. Raytheon earned $2.46/share in 2006, and $7.44/share in 2016. At the same time, net income essentially doubled from $1,107 billion in 2006 to $2,210 billion in 2016. A large portion of those gains came from cost containment, as sales only rose 20% during the same time period.

Another driver behind those massive earnings per share gains were from stock buybacks. The number of shares outstanding decreased from 445 million in 2007 all the way down to 295 million in 2016. While I usually prefer dividends over buybacks, I have found that they work wonders when managers can retire shares at low valuations. Unfortunately, that is not usually the case in Corporate America. The reverse is usually true – companies tend to buy back shares at inflated valuations when they are flush with cash. However, when share prices are low, companies usually halt share buybacks. If valuations on Raytheon stock continue to be high, the effect of share buybacks would be more subdued over the next decade.

The company is expected to earn $7.40/share in 2017 and $8.32/share in 2018.

I believe that defense companies will likely do well in the long run. The US will always need to spend money on defense. However, it may be best to own all of them, in order to diversify sector risk. Unfortunately, we cannot reduce the risk of budget cuts at the largest customer – the US Government. This is where having some additional sources of revenue can be helpful for defense contractors. Unless a program is under a multi-year contract, it could get canceled and take a hit to sales. In addition, the nature of getting contracts involved competitive bidding. Changes to contract rules could affect companies’ profits. In the case of Raytheon, the US government accounts for 2/3rds of sales. However, the company also tries to grow by tapping the international arms market and making strategic acquisitions.

Over the past decade, Raytheon has managed to boost dividends per share at a rate of 11.80%/year. Using the rule of 72, an investor can expect their dividend income to double at an annual rate of 12%. Future growth in dividends would be dependent on earnings per share growth.

The dividend payout ratio has remained below 40% for the majority of the study period. It is great to see a dividend growth company which has managed to grow dividends per share at the same rate as earnings per share over the past decade, while maintaining a payout ratio is the same range.

While the company looks attractive, the valuation is a little bit high right now. Raytheon shares are overvalued at 20.60 times forward earnings. The stock yields 2.10%. The company may be worth a look under $148/share. It would be an even better idea on dips to 15 – 16 times earnings (equivalent to an entry price of $112 – $119/share).

Full Disclosure: Long RTN

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