I’ve been successfully investing for almost a decade now.

That might seem like a long time; however, it’s gone by in the blink of an eye.

In the grand scheme of things, 10 years isn’t very long.

Even in this short period of time, though, I’ve seen numerous changes across technology, industries, and regulations.

This is why it’s important to invest in companies/industries that are as close as possible to a “sure thing” over the long run.

This is one reason I buy high-quality dividend growth stocks.

A company has to regularly grow its profit in order to sustain the regularly growing dividends necessary to be listed on the Dividend Champions, Contenders, and Challengers list.

It’s not feasible to write checks that can’t be cashed.

And you certainly can’t write ever-larger checks, year after year, if you can’t back them up.

Thus, a company with a long-term track record of growing dividends tends to be a “sure thing” more often than not.

These are often world-class businesses.

And they’re providing the products/services the world demands.

Dividend growth investing has treated me well.

It allowed me to go from below broke at 27 years old to financially free at 33, as I explain in my Early Retirement Blueprint.

Indeed, I’ve built out my FIRE Fund using this strategy.

That’s my real-life and real-money dividend growth stock portfolio.

It generates the five-figure and growing passive dividend income I need to cover my essential expenses in life.

I made sure to bet on “sure things” as much as I could.

Jason Fieber's Dividend Growth PortfolioI also did my best to buy dividend growth stocks when their valuations were appealing.

An intelligent, long-term dividend growth investor should always aim to buy a stock when it’s undervalued.

While price is what something costs, value is what something is worth.

Separating price from value is what can separate successful investors from non-successful investors.

An undervalued dividend growth stock should offer a higher yield, greater long-term total return potential, and reduced risk. 

That’s all relative to what the same stock might otherwise offer if it were fairly valued or overvalued.

The higher yield comes about due to the inverse relationship between price and yield. All else equal, a lower price will result in a higher yield.

A higher yield goes on to positively affect total return, leading to greater long-term total return potential.

Total return is simply investment income and capital gain.

A higher yield boots the former right off the bat.

In addition, the latter is also given a possible assist.

That’s due to the “upside” that could be present between price and value.

If the stock market more accurately prices a stock, pushing the price up toward fair value, that’s capital gain.

And that comes on top of whatever organic capital gain is possible as a company increases its profit and becomes more valuable.

Of course, this should all reduce risk.

An investor introduces a margin of safety when price is well below intrinsic value.

This margin acts as a buffer, protecting the investor’s downside against known and unknown risks.

It’s obviously less risky to put less capital on the table for the same exact asset.

But a margin of safety also limits the chances of an investment ending up “upside down”, or worth less than the price paid.

These dynamics are obviously favorable.

Fortunately, it doesn’t require a degree in economics in order to estimate intrinsic value of just about any dividend growth stock out there.

In fact, fellow contributor Dave Van Knapp put together a fantastic template for valuation that can be applied to dividend growth stocks.

With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…

Raytheon Company (RTN)

Raytheon Company (RTN) is a major US defense contractor and technology company.

Founded in 1922, they now have approximately 64,000 employees worldwide.

Currently the fifth-largest military contractor, the company is a leading manufacturer of missiles, missile defense systems, radar, and defense electronics.

They operate across five different segments: Missile Systems, 31% of FY 2017 sales; Space and Airborne Systems, 25%; Intelligence, Information and Services, 24%; Integrated Defense Systems, 23%; and Forcepoint, 2%. Eliminations accounted for -6%.

So I spoke about “sure things” at the outset of this article.

Well, there are fewer “sure things” in life than defense contractors.

Regardless of one’s political views, defense is a necessity in this world. It’s just a matter of fact.

It might not be a nice thing, but defending sovereignty is necessary today, was necessary 1,000 years ago, and will be necessary 1,000 years from now.

Meanwhile, the US vastly outspends any other country in the world as it pertains to defense spending.

Not only that, the US continues to increase its military spending year after year in order to maintain its offensive and defensive capabilities.

Knowing that should give investors a lot of confidence about Raytheon’s ability to grow its profit… and its dividend.

To wit, the company has increased its dividend for 14 consecutive years.

The 10-year dividend growth rate sits at 12.0%, which is more than solid. That’s well in excess of the inflation rate, which means investors are seeing their purchasing power increase with every dividend raise.

With a payout ratio of 40.4%, there’s still plenty of room for more dividend growth.

The only drawback here regarding the dividend might be the yield.

At 2.02%, the yield isn’t particularly high.

However, it does slightly beat the broader market. And it comes with double-digit long-term dividend growth.

In order to estimate future dividend growth, though, we’ll first attempt to estimate future earnings growth.

Building that estimate will require us to look at what the company has done over the last 10 years, as well as what the near-term future likely holds in store.

So we’ll compare the company’s long-term track record for growth to a professional forward-looking forecast. Blending the known past and approximated future like this should give us a good idea as to where Raytheon might be going.

The company increased its revenue from 23.174 billion in FY 2008 to $25.348 billion in FY 2017. That’s a compound annual growth rate of 1.0%.

Not an excellent top-line growth rate; however, the last decade has been fraught with uncertainty.

There was the Great Recession at the beginning of this period. Then the US budget sequestration in 2013 led to significant cuts in federal spending.

But US and global military spending have sharply risen in recent years. And Raytheon’s revenue has thus grown rapidly since bottoming out in FY 2014.

Earnings per share advanced from $3.92 to $7.53 over this 10-year stretch, which is a CAGR of 7.52%.

I added $0.59 back into FY 2017 EPS due to the related one-time tax impact that isn’t material to long-term earnings power.

The bottom-line growth was aided by a combination of margin expansion and share buybacks.

Regarding the latter, the outstanding share count was reduced by almost 32% over the last decade. That’s quite substantial.

Raytheon continues to buy back shares at a prolific rate. They repurchased 0.6 million shares in Q3 2018, which brought the YTD total up to 4.5 million shares repurchased. For perspective, that’s against less than 300 million shares outstanding.

Moving forward, CFRA is predicting that Raytheon will compound its EPS at an annual rate of 8% over the next three years.

They cite a lower tax rate, continued buybacks, and strong global defense spending as rationale. For perspective on US defense spending, President Trump recently backed a $750 billion budget for the coming year. That would be a substantial increase over the ~$700 billion budget for 2018.

EPS compounding at 8% annually would be roughly in line with what’s transpired over the last decade. Basically, it’s status quo.

This kind of EPS growth would allow for at least matching dividend growth. With the payout ratio being so modest, there’s actually room for Raytheon to produce dividend growth that would slightly exceed EPS growth.

That said, we can see that the 10-year DGR has already exceeded the 10-year EPS growth rate (12% versus 7.52%), which has led to the payout ratio elevating a bit. But there’s no danger here. This could continue on for the foreseeable future, although some leveling out would have to occur down the line.

The company’s balance sheet leaves even more breathing room, as it’s in excellent shape.

Raytheon has a long-term debt/equity ratio of 0.48. Total cash comes out to almost 75% of long-term debt. Moreover, the interest coverage ratio is over 16.

Profitability is robust and competitive for the industry.

Over the last five years, the company has averaged annual net margin of 8.87% and annual return on equity of 21.20%.

This company is, overall, a high-quality business.

There are only a few major players after consolidation. This oligopoly leads to rational pricing power.

Furthermore, the company’s moat is bolstered by its scale and engineering experience.

There’s not only breadth and scale to consider, but there’s also the fact that new competition would be highly unlikely due to the type and size of the products being manufactured. It’s not like a new business can come out of nowhere to start producing missiles.

Raytheon’s heavy concentration and reliance on the US government’s spending is both a gift and a curse.

However, the company has recently diversified into cybersecurity and other services. Its Forcepoint business segment is largely due to the Websense acquisition that started in 2015.

In addition, Raytheon’s massive backlog now stands at $41.6 billion (at the end of Q3 2018). That’s a record high. The backlog has historically been funded almost completely by the US government. But international customers now account for 40% of that amount. International diversification helps smooth US budgetary constraints.

There are risks to consider, though.

Primarily, the US budget has its fair share of critics. Due to the sheer amount of money the US spends on military (~$700 billion annually), military spending could be a source of cuts down the road (although that’s highly unlikely for as long as President Trump is in office).

At the right price, this could be a great long-term investment.

Well, the valuation does appear to be fairly compelling right now…

The P/E ratio is 20.02.

That compares favorably to the broader market, but it is higher than the stock’s five-year average P/E ratio.

I wouldn’t necessarily hold that against the stock too much, however. That five-year period was heavily skewed by the aforementioned sequestration. This led to fantastic valuations and opportunities across defense stocks around 2013 and 2014.

Most basic valuation metrics are slightly elevated off of their respective recent historical averages. But these metrics have all been arguably “tainted” by that 2013-2014 time frame.

The business has recovered nicely, and the stock has shot up as a result.

It admittedly got ahead of itself, reaching a 52-week high of $229.75. But after a subsequent dramatic fall to ~$172/share, it’s now appealing.

If the stock is appealing, how appealing might it be? What would a reasonable look at intrinsic value look like? 

I valued shares using a dividend discount model analysis.

I factored in a 10% discount rate and a long-term dividend growth rate of 8%.

That DGR is on the high end of what I usually allow for.

But I think Raytheon’s stable cash flow, record backlog, strong US (and global) defense spending, moderate payout ratio, and long-term track record for EPS and dividend growth permit this assumption. The forward-looking EPS growth rate would imply a baseline dividend growth of this level.

Moreover, the company is due a dividend increase with its next dividend announcement. So that’s something to keep in mind.

Of course, the payout ratio has expanded recently. And any major disruption to defense spending (especially in the US) could dramatically affect Raytheon’s profitability and ability to raise its dividend.

The DDM analysis gives me a fair value of $187.38.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.

The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.

I find it to be a fairly accurate way to value dividend growth stocks.

So I wouldn’t argue the stock is an absolute steal here. I do think one could do a lot worse than to buy a world-class defense firm at this valuation, though.

But we’ll now compare that valuation with where two professional stock analysis firms have come out at.

This adds balance, depth, and perspective to our conclusion.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.

1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates RTN as a 4-star stock, with a fair value estimate of $212.00.

CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.

They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

CFRA rates RTN as a 4-star “BUY”, with a 12-month target price of $245.00.

I came in the lowest by far. But averaging out these three numbers gives us a final valuation of $214.79, which would indicate the stock is 25% undervalued right now.

Bottom line: Raytheon Company (RTN) is one of the world’s leading defense firms. It operates with scale, expertise, geopolitical relationships, and diversification inside of an oligopoly. With a massive new defense spending budget, excellent fundamentals, double-digit long-term dividend growth, and the potential that shares are 25% undervalued, this high-quality dividend growth stock could be just what you need to play defense in this market.

-Jason Fieber

Note from DTA: How safe is RTN’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 98. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, RTN’s dividend appears very safe with an extremely unlikely risk of being cut. Learn more about Dividend Safety Scores here.

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