Raytheon's Got the Right Stuff

Pop-quiz hotshot (to steal a line from the movie Speed): Where do you go when you are looking for a turnaround story, you want to play the massive increase in U.S. defense spending, and you love the balance-sheet improvement thesis? There is only one place to go: Raytheon (RTN - commentary - Cramer's Take).

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For those of you who think investing begins with Cisco (CSCO - commentary - Cramer's Take) and ends with WorldCom (WCOM - commentary - Cramer's Take), let me give you a little history lesson: Raytheon went public in 1945. I like old companies. If a company sticks around for a long time, that means it's doing something right.

I'm fond of Raytheon, as it was my first big winner. I joined Goldman Sachs in 1990 just before the Gulf War. Raytheon's Patriot missiles played an important role in securing a quick victory for the U.S. forces. Saddam retreated, the troops came home and the stock went up. Happy ending for all (except Saddam, of course).

Fast-forward to the summer of 1999. The stock was trading at the lofty price of $70, but alas, all was not well with the company's financial statements. Boom! The stock got justifiably creamed. If you want to see a ski slope that would freak out Bode Miller, check out the graph (below left).

Raytheon's Olympic Downhill

The patient remained in intensive care until the events of Sept. 11. Thereafter, the stock sprinted from the $20s to the $30s on the broad rally in defense stocks. So where are we now?

Raytheon is very strongly positioned in the defense industry due to its focus on high-growth businesses such as defense electronics, missile systems and radar. Missile systems, Raytheon's prime area of expertise, are expected to be the biggest beneficiary of President Bush's increased defense expenditures. As a consequence, the company should be able to grow revenue faster than the defense budget over the next several years.

The Best Defense

Raytheon generates about 85% of its revenue from defense-related businesses and 15% of its revenue from its aircraft division. The aircraft division has been struggling from a poor macro environment, inefficient operations, historically aggressive financing tactics, a delay in getting new aircraft models to market and an aging product portfolio.

I don't expect this division to turn around quickly. Management is making tough decisions on cost, outsourcing and developments issues, and we will continue to monitor their progress. After management fixes this unit, I expect them to get rid of it.

The firm wisely sold its poorly performing engineers and construction unit to Washington Group International in March 2000. Unfortunately, this sale transaction proved to be too good a trade, and Washington Group subsequently filed bankruptcy. To make a long story short, the lawsuits between Raytheon and Washington Group were settled in November 2001. Raytheon should experience a final negative cash-flow impact of $425 million in 2002 for this unit. Thus, the overhang of this nightmare is almost over.

Raytheon's return on equity at 4.6% is the worst in the defense industry. This number compares quite unfavorably with General Dynamics' (GD - commentary - Cramer's Take) 21.9%, Lockheed Martin's (LMT - commentary - Cramer's Take) 10.2% and Northrop Grumman's (NOC - commentary - Cramer's Take) 7.5%. But here lies the opportunity. I believe that management "gets it," and is taking the right steps to cut costs and exit noncore businesses. In essence, the company is following the General Dynamics playbook. Raytheon is getting smaller, but it is getting better.

It has also meaningfully improved its balance sheet over the past year. The company has reduced debt from $9.1 billion in 2000 to approximately $6.2 billion following the second-quarter closing of the sale of its aircraft integration systems (AIS) business to L-3 Communications (LLL - commentary - Cramer's Take) for $1.1 billion. Debt reduction has been accomplished through asset sales and two large equity offerings in 2001 that raised a total of $2.2 billion.

Top Gun

Raytheon offers several opportunities for upside surprise: Defense spending is headed in only one direction, the aircraft industry seems to be slowly rebounding, the company has a few remaining noncore divisions to divest, management is committed to improving the balance sheet, and the industry is consolidating. Don't you think Raytheon's management noticed Northrop Grumman's hostile bid for TRW (TRW - commentary - Cramer's Take)?

Investment cycles always last longer than people expect. In my opinion, the bear market in technology is not in the ninth inning. It is not even in the eighth inning. Similarly, this defense spending cycle has just begun. I don't want to hear that Raytheon has moved already. It has not.

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Brett Messing is a managing director at Neuberger Berman LLC. The views expressed are Messing's and do not represent the views of Neuberger Berman LLC, its portfolio managers, employees or affiliates. At time of publication, Neuberger Berman or its clients were long Raytheon, although positions may change at any time. This material is not intended to be a formal research report or recommendation and should not be construed as an offer to sell or the solicitation of an offer to buy any security. Before acting on any advice or recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Messing appreciates your feedback and invites you to send it along.