Bobbie DeHerrera/Getty Images News Investing in beneficiaries of transformational trends that can stand up to economic uncertainty is one way to beat the market during uncertain times. Another way is to invest in companies with strong competitive moats. Raytheon (NYSE:RTX) is in the sweet spot of qualifying for both. Firstly, it is a defense manufacturer, and demand for its wares will likely significantly increase. More than that, though, the battlefield success of its weapons signifies a broader shift to a different type of warfare. Nation-states looking to revamp their defense will want the stuff that viciously mauled the world’s second-most powerful military force. Secondly, there’s no commercial moat like an oligopoly or monopoly. Raytheon Technologies is an increasingly important member of the US Defense and Aerospace oligopoly- its bargaining power with its primary customer has increased significantly. Despite some of the most profound headwinds in recent history, the company has continually exceeded Wall Street’s expectations. We expect the seasoned and battle-tested management to largely continue this trend. Thinkorswim, RTX actual earnings vs. expected Not only that, but its primary customer can also be a powerful benefactor when it wants to be. Uncle Sam will be taking great pains to help ensure Raytheon is humming to the benefit of the free world and concurrently to the firm’s shareholders. US Defense priorities depend on Raytheon having enough capital to effectively conduct the grueling, high-touch R&D the industry requires. There’s a lot of uncertainty in 2023. Still, one thing you can probably set your watch on is that, on a secular basis, as geopolitical risk and great-power confrontation increases, defense spending of the US and its allies will reach a higher proportion of GDP than in recent decades. Peter G. Peterson Foundation One of the reasons the defense industry can be considered defensive is that it is insulated from economic cyclicality since it is so dependent on government expenditures. Raytheon is less defensive than its peers because it has a larger share of the commercial aerospace business than any big guys besides Boeing. They are thus more exposed to general economic activity than their peers. IATA Raytheon (RTX) has gotten headlines for producing some of the most successful weapon systems that devastated the Russian military effectiveness, like the Stinger and the Javelin. The Russian Army has been running out of tanks since May, and the extensive sanctions have crippled their defense industry’s capacity to replace them and other vital systems. Nothing advertises a product like smashing success, as ghastly as this particular “advertisement” may be. The Conflict in Ukraine Likely Continues to Escalate in 2023 to the Benefit of Big Defense While any reasonable person should hope for an end to such a devastating conflict (200,000 military casualties in 11 months), the history of warfare suggests that the current war is likely to grind on and potentially even expand. For example, toward the beginning of the First World War (early 1915), people were shocked that half a million soldiers had been killed. However, this was less than 5% of those who would ultimately perish from 1915 to November 1918 in the Great War. Unfortunately, the current character of the war in Ukraine suggests those who have so far perished, and the destruction so far wrought is likely only a mere fraction of what is to come. Center for Strategic International Studies The fighting is costly, and gains are limited except for a few successes in Kherson and to the East of Kharkiv. Nonetheless, the arithmetic of force is hard to calculate and depends just as much on those operating the equipment as the equipment itself. One of the reasons that Western support keeps escalating is because the Ukrainians demonstrate they can do it effectively. Our Vietnamese, Iraqi, and Afghani allies did not do as much, and they received levels of support that pale in comparison to what’s been given to Ukrainians. Institute For the Study of War Let’s take, for instance, the Republic of South Vietnam. The United States gave that ill-fated nation military assistance, making what it has given Ukraine look like a drop in the bucket. It also, of course, directly engaged their communist adversaries in the North. It dropped more munitions on Vietnam and neighboring countries than all the munitions expended in World War II, and still, victory was not attained. The United States spent a cool trillion each in Afghanistan and Iraq trying to defeat Islamist insurgencies that often resembled organized crime syndicates more than organized armies and suffered defeat. We’ve given the Ukrainians $22 billion worth of primarily secondhand equipment, and they’ve destroyed the Russian regular army as an effective offensive force in less than a year. This is a primary reason the arms will keep flowing- they’re practical, and our allies need them to survive. While there are some loud political rumblings about Ukraine, most members of Congress are happy to see the Russians stopped in Ukraine and are wise to the growing threat of a rising China. However, those counting Russia out so early may be too hopeful. Remember that starting a war with stinging military defeats is pretty much par for the course of the Russians. Still, they have a historic endurance and ferocity that shouldn’t be underestimated. It’s also why escalation continues; as the Russians adapt by bringing precious assets out of range, the Ukrainians will need munitions that can go further, like the longer-ranged ATACMs missiles that can increase the range of the very successfully deployed HIMARS system. BBC Research There are growing rumblings in Western intelligence communities that Russia will be planning a large offensive. Recent humiliations make Russian disengagement less likely as well. Some fear it will repeat the push on the capital and be particularly brutal and indiscriminate. Russia’s despicable use of force on civilian infrastructure and war crimes have made escalatory support that seemed unthinkable earlier in the war essential. Sadly, I suspect this pattern will continue. While I pray peace comes hastily, I think this is unlikely. We’ve already gone from secondhand equipment to the US military’s most advanced anti-aircraft system, the Patriot missile battery. This piece of equipment is generally reserved for only close US allies and has symbolic and military value. Similarly, Ukraine likely has intentions to conduct what will likely be a costly and protracted effort to retake the Crimean Peninsula. Such an effort could lead to escalation by Russia, but it certainly doesn’t bode well for the conflict to end soon or for the insatiable need for resources to let up. If anything, it’s more likely that the deaths, resources being consumed, and weapons systems being provided will all increase more than we’d currently imagine in 2023. However, even in a best-case scenario, which would likely be a cessation of hostilities and some frozen conflict zone similar to the 38th parallel, national defense expenditures are still likely to rise significantly (maybe even more than if Russia is roundly defeated). Indeed, some Defense experts theorize that NATO defense spending would have been higher had Russia’s tanks rolled over Ukraine like Czechoslovakia in 1968. But regardless of that, the world is forever changed. The war genie is out of the bottle. Before Russia invaded Ukraine, it was trendy to say that conflicts between globalized states were unlikely because of economic interdependence, but not anymore. Once people are dying on the scale that they are in Ukraine, long-existing positions can change quickly. Likewise, as the situation on the battlefield evolves, the need of Ukraine for support from its vital ally will change. As Russia adapts to the latest weapons, new ones will be required to maintain momentum. The US Defense Industry is Consolidated and Highly Dependent on State Spending Department of Defense The US Defense industry has consolidated over the last decades. Whereas there used to be a lot more competition, now a few big players dominate the most lucrative and prodigious contracts from Uncle Sam. It’s rare to get three bids for large ticket items. Raytheon is one of few companies able to bid on the big-ticket items and has a particular overlap in its products with what has been most influential in stopping the Russian onslaught. It is also integrated into sacred cow projects, like the F-35, for which it builds the engine. Competition between defense giants is not like competition for typical companies. But Raytheon is a junkyard dog when competing with rivals. When Lockheed Martin wanted to buy a key supplier of rocket engines (one of the most significant current supply chain thorns for Raytheon), the team at RTX played a central role in getting antitrust regulators to scuttle the proposed tie-up. Raytheon is in an enviable position of having undergone one of the largest recent defense mergers right before antitrust scrutiny on the industry began to increase. It has the upside kicker of recovering commercial aerospace demand. The best-in-class (BIC) contracts the company specializes in are becoming more critical to the procurement process. US General Services Admin. The company has received new orders for its Stinger and Javelin platform after these weapons systems’ unmitigated success in Ukraine. This success has yet to contribute to significant commercial gains. Still, I think these are forthcoming in a big way over the next few years despite the extreme current difficulty caused by the supply-chain disruption. Raytheon is a global company with 13,000 suppliers; only about 3% are problematic. Uncle Sam has realized the problem and is sending in the cavalry to help. There is a lot of room to improve the process for foreign arms sales that will help Raytheon’s margins. I also think the much more expensive Patriot Missile system will likely prove its’ mettle in Ukraine and boost demand for the next-generation model Raytheon is developing. This could result in a significant and extended addition to an already healthy backlog. The price of this system means meaningful top-line growth. Raytheon Is a Good Investment for the Uncertain Environment of Early 2023; The Company Has Stuck to 2025 Targets 2023 is an uncertain year and aside from the many risks vexing markets in the shorter term, one major change that will make its impact known for years to come is the shattering of the international order that occurred when Russia invaded Ukraine. For years, the trend in warfare had been toward lower-intensity conflicts where ammunition expenditure was low and general needs were far less resource intensive than the high-intensity slugfest occurring in Ukraine where tens, or even hundreds, of thousands of shells, are fired every day. Company Reports Q322 Generally, there is a lot of risk facing markets going into the year. We think anchoring a position to the likely outcome of a once-in-a-generation rise in defense spending helps mitigate the impact of considerable risk facing the market in 2023. Defense and Aerospace is a critical area that should be insulated from the many risks to equities as the year begins. Raytheon is a leading Defense contractor and also has exposure to a better-than-expected economic outcome because of its significant civilian aircraft segment. Firstly, the Federal Reserve may require tougher action than markets anticipate. Secondly, economists and many businesses are anticipating a recession of varying severity that will naturally inhibit economic activity, most acutely in cyclical areas of the economy. Thirdly, geopolitical uncertainty is at the highest level in decades. Raytheon benefits directly from this third risk. Finally, since a significant portion of revenues is derived from the US government’s defense expenditures, and all indications are that these will rise toward higher levels in coming years, it is better insulated from the first two risks than many stocks. In a time of great uncertainty like we’re currently facing, it’s advantageous to chain your investing prospects to trends that can weather the environment in the event of positive or negative outcomes affecting key risks. The rising geopolitical risk in several regions worldwide and the unfortunate conflict in Ukraine means that there will almost certainly be a secular rise in defense spending regardless of what the Federal Reserve does and whether there’s a recession, severe or mild. The level of inflation will also significantly affect the path of future defense spending. It is estimated that the DoD could lose up to $110 billion in purchasing power from recent rises. National Defense Industrial Association, “HOW INFLATION HURTS AMERICA’S NATIONAL DEFENSE AND WHAT WE CAN DO ABOUT IT” The changing geopolitical environment means that the share of GDP the US and critical allies spend on defense is moving toward levels last seen in the 1980s when big-power competition last dominated defense spending. Already the level of military sales approved by the US government to NATO members has nearly doubled. Germany, who had long shunned military efforts, is increasingly sending advanced weapons and taking a more proactive role in NATO. Japan also maintained only a skeletal military force and announced plans to double its spending this month. I suspect this is only the beginning of a major ramp-up in global military spending. The Balance of Power Between the Government and Big Defense Has Shifted Favorably, US Arms Industry Likely Gains at Russia’s Expense “We spend a lot of money on some exquisite large systems, and we do not spend as much on the munitions necessary to support those.” Gregory J. Hayes, Raytheon CEO The demands of this conflict and the increasing imperative to confront military buildups by other major powers will strain the current defense industrial base. Raytheon has bent over backward to restart the Stinger production line, but it ensured the government knew it was a hassle. Generally, Raytheon’s bargaining position with the Feds is reaching a more robust level than it’s been since the Global War on Terror. For example, the Feds have budged on allowing more multi-year contracts to proceed, allowing contractors to plan better. Dealing with Uncle Sam as your primary customer can be pretty tough. Just ask a lot of doctors why they no longer accept Medicare. Building guns and missiles for Uncle Sam is subject to many of the same perverse incentives. However, the Defense Industry has gone from a recent position of being heavily scrutinized and cornered into contracts that it might have to eat the cost overruns of to Uncle Sam asking what they can do to make tasks easier and production higher. This hasn’t shown up yet in earnings, but it likely will in the coming quarters. Company Reports, Q322 While this strain needs to be dealt with and improved, all-and-all, this will primarily benefit the big defense contractors like Raytheon (RTX). Raytheon, in particular, will be able to rely on subsidization from the US Government to secure supply chains. Friend-shoring, on-shoring, and supply chain hardening will all have to take place. Still, given the generational premium on the products and services Raytheon sells, it’s not going to be one the suffering to accomplish the de-globalization and hardening of the US defense industrial base. Arms Transfers: U.S. and Russia’s Biggest Trading Partners (visualcapitalist.com) Another tailwind for Raytheon is that its weapon systems may be defending democracy, but they also directly undermine a commercial competitor: Russia’s increasingly imperiled arms industry. Russia supplies 20% of the world’s military equipment, but as we’ve discussed, it no longer has the equipment to spare. It has drained stores in Belarus and has been forced to get shells and weapons from its ne’er do well allies. Russia’s fourth largest arms client, Vietnam, has already begun talks with US arms manufacturers to make a politically difficult switch. India, Russia’s largest arms consumer, has been cozying up to the United States and can’t be thrilled at the picture of burnt-out T-72s and the downing of sophisticated Russian aircraft. Russia’s industry is in shambles and faces dire financial straits. It can’t supply its military with adequate equipment, and the dismal performance of many systems likely disheartens critical consumers. The US Defense Industry is smelling a big opportunity for growth. Foreign arms sales to existing and new former Russian clients are a crucial potential upside catalyst for Raytheon that I think the market under-appreciates. Risks to Raytheon and My Bullish Thesis Supply Chain: There is no question that Raytheon enjoys a bullish situation from the demand side. However, even if demand is good, if you can’t produce what is needed, you can’t satisfy demand. This has created persistent volatility in margins, deliveries, and costs/profits. This will continue to weigh on the company throughout 2023. Supply-chain issues have vexed defense contractors throughout COVID-19. Long gone are the days of a nationally centered defense industrial base. The US aerospace and defense footprint mimicked the trends in the global economy and itself globalized as the internationalization of commerce occurred on an unprecedented scale. DoD “We went through six years of Stingers in 10 months.” -Gregory J. Hayes, Raytheon CEO. The stocks of Javelins and Stingers were quickly exhausted by the tempo of this conflict. While the COVID supply chain issues are resolving, changing the supply chain and industrial base to support more munitions production is another side of this problematic coin. For example, the rocket engines needed for many of the company’s in-vogue products are a chokepoint that won’t be resolved in the immediate term. Uncle Sam will be more active in helping alleviate these supply-chain issues. The company has already taken admirable steps and has crisis teams at suppliers to help rectify this situation. Labor: Labor needs in the Defense and Aerospace Industry are not only complicated by the fact that security clearances are needed for many crucial positions but also that there’s just a shortage of necessary skills in many markets. Compensation is also a huge issue. Sleepy assembly lines on their way to buying the farm are suddenly of the utmost importance for the fate of the free world. Still, augmenting capacity is expensive and challenging because it’s increasingly difficult to find sufficient concentrations of highly skilled, qualified, and trusted labor necessary to meet the needs of a dramatically different global threat environment than that which existed a year ago. Government Accountability Office “The biggest inflationary impact comes in compensation. We’re seeing more pressure on compensation, given what’s going on in the marketplace today.” – Gregory J. Hayes, Raytheon CEO. Raytheon has enormous and quite specialized labor needs. For example, the company hired 27,000 people in the first nine months of 2022 and needs to hire 10,000 more. Another complication is that, given the sensitive nature of the work, much of the required labor also needs to be able to obtain security clearances. Inflation: People who closely watch markets have only recently become acquainted with how unfortunate and frustrating erroneous inflation expectations can be. The word “transitory” has fallen out of fashion in a big way. But the Defense Industrial Complex has constantly been dealing with the costs of inaccurate inflation projections. Center For Strategic Budgetary Assessments, HOW I LEARNED TO START WORRYING AND HATE REAL GROWTH Inflation can be particularly problematic for the Defense Industry. There are already many moving parts in the contracting process, and the prices agreed upon in contracts may not always reflect the economic reality contractors face. The extensive supply chains mean that components and material costs can add up quickly across such a prodigious and global value chain. So, the risks for inflation are apparent, but some hidden benefits might be underappreciated for the uncertainty surrounding inflation. Indeed, there’s also some possible upside if inflation drops faster than consensus expects, which is my base case for 2023. Center for Strategic Budgetary Assessment, HOW I LEARNED TO START WORRYING AND HATE REAL GROWTH The projected levels of the defense budget depend directly upon expected inflation. As you can see above, the risk to the budget is likely to the upside. However, given the rapidly evolving security needs and the soaring demand, inflation’s direct impact can likely be mitigated with cost cuts and passing costs on to customers. The effect of it on the Defense budget is likely to exceed any downsides from inflation directly. Given the dangerous nature of geopolitical affairs, it seems that policymakers would instead aim high rather than risk hollowing out the budget at such a perilous time. Political/Tax Risk: There are some tax issues and pension issues that could cause short-term headwinds, but I think the secular tailwinds will more than compensate for these over the next few years. Political risk is also heightened by the media cycle. Still, I don’t think a very vocal minority resting their arguments on largely dubious grounds will be able to turn back the smashing and unexpected success of Ukraine and Western strategic imperatives to aid it. Conclusion Raytheon benefits from durable secular tailwinds for its core revenue drivers and an entrenched position near the top of a powerful oligopoly. These are attractive characteristics given the uncertainty stalking markets in 2023. There are headwinds, but I see them as largely priced in, whereas the market has not fully appreciated the generational shift in demand for the firm’s products. The share of GDP spent on defense is sure to rise across much of the West and even former clients of the Russian arms industry. Raytheon has a strong management team that has navigated the pandemic admirably (sticking to post-merge targets despite a massive curveball). TD Ameritrade Raytheon’s earnings are expected to be about flat in the first quarter of 2023 compared to last year. However, expected earnings growth accelerates from the 2nd to 4th quarters. Importantly, this acceleration likely occurs as crucial supply chain chokepoints alleviate. This is central to my picking Raytheon as an excellent stock to own in 2023: the earnings momentum is expected to increase throughout the year, and the risks are clearly to the upside given the rising demand for the company’s core products and help from the US government across the value chain, including in the form of subsidization. Solid dividends and share buybacks have been positive and should continue to be, sweetening the pot. Roger Trinquier, a French Colonel who wrote an experience-informed manual on Counterinsurgency, famously said that a modern conventional army fighting an insurgency was like “trying to hit a fly with a jackhammer.” There are things that metaphorical jackhammers do well, though, which is what is now needed after a long hiatus. Russia’s belligerence has resulted in many proverbial sidewalks and rugged rocks to break. Raytheon will thrive in the coming years on the escalating conflict in Ukraine and increasing efforts to counter China’s military buildup. Amazingly, so far, minimal tangible benefit has come to the companies from their battlefield successes, but it is coming. Hurry up and wait.
