Not all parties are a good time -- 
It's OK to skip them sometimes...
May 13th, 2014

I received a request from Tom who wanted to know my perspective on Raytheon symbol RTN. I have written about this company in the past and most of the fundamentals look good. Had someone ignored that the company has more goodwill than equity, they would be sitting on a very good return. But investors have to realize that sometimes not going to the party is the right thing to do, even though everyone else there had a good time.

Sooner or later, that type of a party will be a bust and you’ll wish you hadn’t gone. Same thing with investing. While perhaps the investment worked out this time by ignoring some weak fundamentals, a practice of this sort of behavior eventually will lead to losses -- and some of those losses will wipe out huge gains.

Now that Raytheon has run up to the high 90s, is it a buy? Have the fundamentals improved? Or should investors take their money and run and be happy they didn’t stay at the party too long?

Most of the valuations look good with the exception of the price to tangible book value, which is blank because of high goodwill. The company has goodwill of $12.7 billion and equity of only $11.4 billion. This always scares me because if some of the businesses that are part of the goodwill aren’t performing, then the company has to reduce the value of goodwill. This not only reduces earnings for that amount but also reduces the equity.

The company has $4.7 billion in debt. When numbers start changing because of write-downs, this can trigger creditors to call in their loans based on certain requirements placed on those loans. If the loans are called in and can’t be paid, the creditor can force the company into bankruptcy to collect the money owed. If this happens, the stock would drop dramatically and shareholders would receive what is left after the IRS, employees and creditors were paid in full.

So while it is not likely this will happen, why take the risk if you don’t have to?

If that risk doesn’t bother you and you want to proceed, then the company doesn’t look too bad. It has a PE of 15.2 below the industry average of 19.41. Price to sales looks OK at 1.29 when the industry trades at 1.34. Price to cash flow also favors the company at 12.1 versus the industry at 13.3.

Company pays a reasonable dividend of 2.52 percent using only 35 percent of earnings to pay that dividend.

Looking at the growth rates of sales and earnings, I wasn’t all that impressed. While the industry as a whole saw a 0.27 percent increase in its sales, Raytheon experienced a 4.2 percent drop. On earnings-per-share growth -- perhaps through cost-cutting or bad earnings for the previous 12 months -- Raytheon did see an 8.9 percent increase but was still outdone by the industry earnings-per-share growth of 45.5 percent.

The balance sheet looks good for the company, showing a current ratio of 1.8 and beating the industry current ratio of 1.5. Debt to equity also favors Raytheon at 41.8 percent compared with the industry average of 59.3 percent. I will again point out the excessive goodwill, which could be written down anytime. This would reduce the equity, which would then increase the debt-to-equity percentage, perhaps to levels that could be uncomfortable for creditors.

Return on equity looks positive for the company and the industry, with the industry having a slight edge at 20.8 percent compared with Raytheon’s 20.6 percent. Net profit margin looks better, with Raytheon coming in at 8.8 percent -- about 25 percent better than the industry net profit margin of 7.0 percent.

Receivable turnover could be a problem for Raytheon at 4.7 when compared with the industry average at 7.2 times over the trailing 12 months.

Inventory turnover looks far better at Raytheon, turning over 45 times over the last 12 months compared with the industry 3.4 times.

The numbers are so wide it would be worth checking the inventory numbers to sales just to verify that there is nothing strange in the trailing 12-month numbers.

Looking forward, the mean earnings-per-share estimate is $7.76 for the year ending December 2015, which is up 12 percent from the December 2014 EPS of $6.93. Using a forward PE multiple of 16.5 would yield a target sell price of $128.04, roughly a 30 percent gain.

With the stock trading at a forward PE of 12.6 and all that goodwill, I will have to pass on this company. The intangible risk is just too high for me to feel comfortable with.


Do you have a question or a company you'd like me to take a look at? Email me at brent@wilseyassetmanagement.com!

Wilsey is president of Wilsey Asset Management and can be heard at 8 a.m. every Saturday on KFMB AM760. Information is provided by Reuters.

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