Defense contractor Raytheon (NYSE: RTN) reported fourth quarter and full-year earnings Thursday morning. Investors seem to have liked what they saw, with Raytheon shares ending the week 6.2% higher than they began it, and continuing their rise in the new week. But was that the right call? Is Raytheon 7% more valuable after earnings than it was before?
Let’s find out.
Tax reform dinged Raytheon’s earnings in 2017, but could boost them in 2018. Image source: Getty Images.
What Raytheon said
For fiscal Q4 2017, Raytheon reported 8% sales growth to $6.8 billion. Profits for the quarter, however, declined 28% due mostly to a $0.59 per share charge to earnings taken in Q4 to account for changes to U.S. tax law .
For full-year 2017, sales increased 5% to $25.3 billion. Profits declined 8% because of the charge noted above.
In the end, Raytheon earned only $1.35 per diluted share for the quarter, and $6.96 for the year.
Bad news turns good
So far, so bad, right? And yet, investors were pleased with the results, so there must be more to this story. Here it is: After taking an initial hit on 2017 profits, Raytheon expects to save beaucoup bucks from the big reduction in U.S. corporate income tax rates. Furthermore, the company dropped a heavy hint that its sales are growing, which should permit the company to fully capitalize on the fact that those sales will no longer be taxed as heavily as they once were.
We know this because in 2017, according to Raytheon, the company booked new orders for weapons totaling 1.09 times the amount of revenue it billed in the year. That’s a good result, foreshadowing strong sales growth as those orders transform into sales over time. What’s even better is that in Q4, Raytheon’s “book-to-bill” ratio jumped even higher, to 1.26. That’s a good indicator that sales growth is also accelerating.
What comes next
Such a surge in expected sales could hardly come at a better time for Raytheon now that we know its tax bill on those sales will be lightening in 2018 and beyond. How much better are things getting for Raytheon? In 2016, the company says it paid an “effective tax rate” of 28.3%. That spiked to 35.8% in 2017. But in 2018 (and presumably beyond), Raytheon says it expects to pay something closer to 19%.
Thanks in large part to these lower taxes, Raytheon is predicting it will grow cash from operations by more than 40% in 2018 to about $3.8 billion. Earnings should jump to between $9.55 and $9.75 per share (up 39% year over year) this year, even though sales will grow only about 5% or 6%, to somewhere between $26.4 billion and $26.9 billion.
The upshot for investors
The big jump in profits and cash flow anticipated in 2018 explains why investors were so eager to buy Raytheon stock post-earnings, even though those earnings declined in 2017. The fact that Raytheon’s book-to-bill looks so strong, implying at least the possibility that sales will grow even faster than Raytheon is promising, is another mark in the stock’s favor.
Still, I think it bears remembering that at a share price of $211 and change, Raytheon stock now sells for nearly 22 times what it expects to earn this year. That’s a high price to pay given that — for now at least — management is only forecasting single-digit sales growth, and the company’s profit margins are already at historically high levels and unlikely to expand much farther. Despite strong sales growth in 2017 and even stronger guidance for 2018, I remain cautious on this stock.
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Rich Smith has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy .
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