Top Gun Raytheon Faces Collateral Damage

Problems in its nondefense divisions could eat away at any post-Sept. 11 windfall.
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If there's one hot sector in the market right now, it's defense. Air missile defense, command control intelligence, surveillance, reconnaissance. Since the Sept. 11 terrorist attacks, President Bush has been ratcheting up the defense budget, leading analysts to project a compounded annual growth of 10% in spending over the next few years -- a nice driver of top-line sales growth for all the defense stocks.

And one stock seems to have it all --

Raytheon

(RTN) - Get Report

. The company has a tremendous portfolio of missile and advanced electronics capabilities to take advantage of the sweet spot of that growth. It makes the Patriot and Tomahawk missiles, and supplies 50% of the Global Hawk unmanned aerial vehicle -- mainly the electronics for sensors used for intelligence-gathering and surveillance.

Many sell-side analysts, most of whom have been included in the company's banking deals, have been pushing the stock hard, particularly recently, just in time for Raytheon's second equity offering of this year, which closed Wednesday. And Raytheon has dutifully soared. Since Sept. 11, the stock has climbed 33%, outperforming even

Lockheed-Martin

(LMT) - Get Report

, which just won (over

Boeing

(BA) - Get Report

) potentially the biggest defense contract ever for the new Joint Strike Fighter.

But I'm not sure Raytheon deserves the praise. A close look at the company suggests that a jump in defense revenue simply gives Raytheon the cash to patch holes in its other businesses for at least this year and next.

There are big problems with Raytheon's nondefense businesses -- Engineering and Construction (E&C) and Raytheon Commercial Aircraft (RAC) -- which expose Raytheon to significant off-balance sheet liabilities. To reserve for expected losses at both of these divisions, Raytheon has taken almost $1.4 billion in charges this year.

Instead of generating substantial free cash flow in 2001, as the company had anticipated earlier in the year, Raytheon will be consuming cash, even with a big $500 million payment from Hughes Electronics that is a purchase price adjustment relating to Raytheon's merger with Hughes Defense in 1997.

Given the problems management acknowledges with free cash flow, it's hard to believe the company's going to be able to get everything else right. And at an enterprise value (market value of equity plus net debt, including off-balance sheet financing) to 2002 and an

EBITDA ratio of 9.7, this stock isn't cheap enough for me to look beyond these problems.

In July 2000, Raytheon sold its embattled E&C business to Washington Group International (WGI), formerly known as Morrison Knudsen. Then last March, WGI sued Raytheon in Idaho state court for alleged breach of contract and fraud in connection with the sale. WGI accused Raytheon of hiding the extent of E&C's business problems.

In May, WGI filed for bankruptcy. A court-appointed independent accountant will be conducting hearings on the pricing dispute through November. While the parties are reportedly trying to settle the dispute, there's no timetable for a resolution.

Raytheon has taken $633 million in charges to cover contracts for two power plants that it guaranteed would be finished, but which WGI has since walked away from. In other words, it is now Raytheon's responsibility to complete this project. Raytheon also took a $49 million charge in the second quarter for some 48 other projects that WGI also could abandon.

But Raytheon's exposure could be as much as $125 million for those projects. The charge assumes that Raytheon's estimates for the cost of completing these contracts are correct, although so far the costs are in line. But on the third-quarter conference call Oct. 19, Raytheon CFO Frank Caine left open the possibility that there could be more bad news at WGI, saying, "it's much too early to declare victory." In the third quarter, Raytheon recorded a loss of $23 million on its E&C business, which is classified as "discontinued operations."

In the meantime, Raytheon's commercial aircraft business, RAC, is entering a major downturn in the commuter jet cycle, slipping into the red in the third quarter. On the conference call, management said 2002 likely will be about breakeven for RAC, based on its current forecast that plane deliveries will drop 9.5% to 380 in 2002 from 420 this year.

Meanwhile, the business is consuming massive amounts of cash, largely from mounting inventories of used aircraft. RAC has about $1.6 billion in off-balance sheet receivables, mostly for its Beech 1900-D aircraft, a turboprop commuter plane. These are mainly loans and lease agreements covering planes that are likely to come back to the company at lower residual values than Raytheon reserved for. The company took a $745 million charge in the third quarter to address the biggest problems.

As a result of all of these problems, Raytheon expects to burn through more than $1.2 billion this year in its nondefense businesses. This will wipe out any of the $670 million it generates from the defense side, and won't be totally alleviated by the $500 million payment from Hughes.

Unfortunately, next year doesn't look much better. Raytheon expects a cash drain of about $400 million to $500 million from RAC, and $250 million from E&C, which will offset the $700 million expected to be generated by the defense side.

To me, that explains the recent $1 billion equity deal, which the company says is for general corporate purposes and to strengthen Raytheon's balance sheet by reducing debt. Some analysts speculated that Raytheon had to do this deal in order to avoid being downgraded to junk bond status.

Company spokesman David Polk does not dispute that. He says the deal "is consistent with our strategy to strengthen our balance sheet." It's interesting that the company is doing a second follow-on offering in the same year that it already raised $1.26 billion.

Although Raytheon seems to have taken adequate charges for off-balance sheet debt, "the problem is that this company won't generate cash for two more years, or until 2003," says Steve Binder, who follows defense contractors at Bear Stearns, and whose firm wasn't included on either of the company's equity deals this year.

That's despite a defense business that has tremendous products. People had high hopes for CEO Dan Burnham, myself included, when he jumped ship from Allied-Signal (now part of

Honeywell

(HON) - Get Report

) in 1998, after it became clear he wasn't going to succeed Allied's CEO Larry Bossidy. But even with Burnham at the helm, Raytheon's rash of disappointments and restructurings hasn't abated. The jury's still out on whether Burnham and his team have "the right stuff" to clean up Raytheon.

The prospectus for this last equity deal says it all: There have been restructuring charges and/or restatements every year since 1996 (as far back as the table went), including the early 2000 announcement that sales would be restated at RAC due to the aggressive way Raytheon was booking aircraft revenue. To comply with a new accounting rule, SAB 101, that the

SEC

had issued at the time, Raytheon had to restate its numbers from 1997 through 1999. The company said the way it was stating revenues prior to SAB 101 was consistent with the accounting rules at the time.

Does Raytheon have the right products in a hot sector? Undoubtedly. But you won't see much, if any, free cash flow for a while. Earnings are certainly at risk with the downturn in the commercial aircraft cycle; there could be more cash needed than anticipated at RAC and E&C, and accounting issues remain a concern.

At this point, I'm not willing to bet that this management team will be able to cope with the likely ramp-up in orders on the defense side. When one analyst on the conference call asked Burnham about the outlook for 2003, he replied: "We should have the wind at our backs."

If I had to own one stock in the defense sector right now, it wouldn't be Raytheon, it would be

General Dynamics

(GD) - Get Report

. It's not cheap, either, but at least you can sleep better at night.

Odette Galli writes daily for TheStreet.com. In keeping with TSC's editorial policy, she doesn't own or short individual stocks, although she owns stock in TheStreet.com. She also doesn't invest in hedge funds or other private investment partnerships. She invites you to send your feedback to

Odette Galli.