The world is changing at an unprecedented pace.
A century ago, most people were riding around on horses.
Now we have robots doing invasive surgery.
It’s pretty clear that society is going to be very different in the decades to come.
This should tell investors something.
Investors should carefully invest in companies that offer timeless products and/or services that transcend rapid change.
I love investing in major trends and changes as much as the next guy.
And sometimes a new competitor comes out of left field.
This is why a portfolio should have a foundation of “bedrock companies“.
A bedrock company offers an evergreen business model.
My FIRE Fund, which is my real-money stock portfolio, has quite a few of these bedrock companies in it.
This Fund generates five-figure and growing passive dividend income.
I live off of this dividend income.
In fact, I used this Fund to retire in my early 30s, as I lay out in my Early Retirement Blueprint.
If you’re going to live off of your investments, you want a certain assurance that they’re going to be around for a while.
A great litmus test for the timelessness of a business model is a lengthy track record of growing dividends.
That’s one reason why I’m a dividend growth investor.
Check out the Dividend Champions, Contenders, and Challengers list to see what I mean.
That list contains more than 800 US-listed stocks that have raised their dividends for at least the last five consecutive years.
That tells me a lot about just how timeless a business really is.
Now, timelessness is great.
But it’s not everything.
The valuation at the time of investment is also extremely important.
Price is what you pay, but value is what you get for your money.
An undervalued dividend growth stock should offer a higher yield, greater long-term total return potential, and reduced risk.
That’s relative to what the same stock might otherwise offer if it were fairly valued or overvalued.
All else equal, because price and yield are inversely correlated, a lower price results in a higher yield.
This higher yield leads to greater long-term total return potential.
Total return is, after all, the sum of investment income and capital gain.
Boosting yield gives you more potential investment income.
Capital gain gets a potential boost, too, via the “upside” between a lower price and higher intrinsic value.
These favorable dynamics also reduce risk.
Undervaluation introduces a margin of safety.
That’s a “buffer” that protects the investors downside against unforeseen issues.
An undervalued high-quality dividend growth stock can be a tremendous long-term investment.
Fortunately, spotting undervaluation isn’t as difficult as it might seem.
Fellow contributor Dave Van Knapp put together an excellent valuation tool for dividend growth stocks.
Check out Lesson 11: Valuation, which is part of an overarching series on dividend growth investing.
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 67,000 employees worldwide.
One of the largest defense contractors in the world, Raytheon is a leading manufacturer of missiles, missile defense systems, radar, and defense electronics.
They operate across five different segments: Missile Systems, 31% of FY 2018 net sales; Space and Airborne Systems, 25%; Intelligence, Information and Services, 25%; Integrated Defense Systems, 23%; and Forcepoint, 2%. Eliminations accounted for -6%.
70% of FY 2018 net sales were domestic; 30% were international.
I noted earlier how important it is to invest in “bedrock companies” that feature timeless business models.
Well, it doesn’t get much more timeless than a defense company.
There will never – I repeat, never – be a day in which countries won’t have to defend themselves.
This is, unfortunately, the world we live in. Countries need to protect their sovereignty and populations.
This truth obviously bodes well for defense companies.
It creates an enduring demand for their products and services.
Making this industry even more attractive for investors, there’s limited competition. There are only a handful of major defense contractors in the world that have the scale and technology necessary to compete.
Raytheon often enjoys a monopoly or a duopoly, depending on the product and project. Particularly with complex radar systems, they’ll often be the only company that can produce the needed systems.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Enduring demand creates fertile ground for enduring profit. That translates to enduring dividends.
With Raytheon, that actually means enduring growing dividends.
Music to a dividend growth investor’s ear.
Raytheon has increased its dividend for 15 consecutive years.
The 10-year dividend growth rate is sitting at 12.0%.
Even more recent dividend increases have been strong, coming in near the 10% mark.
That’s plenty of dividend growth.
It’s way ahead of inflation, meaning a shareholder’s purchasing purchasing power on that dividend income continues to grow year in and year out.
And with a payout ratio of just 34.7%, there’s still plenty of room for more big dividend raises for years to come.
Plus, the stock yields a healthy 2.06% right now.
That yield is better than what the broader market offers right now, to be sure.
Plus, you’re getting that double-digit dividend growth on top of it, backed by a time-tested business model.
Raytheon has done very well for its shareholders over the last decade or so.
Revenue and Earnings Growth
But we always invest in where a company is going, not where it’s been.
I’ll now build out a future business growth trajectory, which should tell us a lot about what kind of dividend growth to expect moving forward.
This trajectory will also help us to determine a reasonable estimate of the stock’s intrinsic value.
I’ll base this trajectory upon both long-term proven results and a future professional forecast of profit growth.
Combining what’s already happened with what seems likely to happen gives us plenty to work with.
Raytheon increased its revenue from $24.881 billion in FY 2009 to $27.058 billion in FY 2018.
That’s a compound annual growth rate of 0.94%.
Not impressive, to say the least.
However, this last decade has actually been pretty tough for defense contractors.
I say that because you had multiple headwinds working against them.
This period starts off with the Great Recession.
Then there was the US budget sequestration in 2013 that led to massive cuts in federal spending, which notably included defense spending.
But defense spending has come roaring back in more recent years.
After bottoming out below $23 billion in FY 2014, revenue is now at a record high.
Meanwhile, earnings per share grew from $4.89 to $10.15 over this period, which is a CAGR of 8.45%.
Now we see where that strong dividend growth came from.
The excess bottom-line growth, which is rather incredible for such a challenging time frame, came from a combination of share buybacks and margin expansion.
For perspective on the former, Raytheon’s outstanding share count is down by more than 27% over the last decade.
Not only that, most of the buybacks occurred during the earlier portion of this time period – back when the shares were much cheaper.
Looking forward, CFRA believes that Raytheon will compound its EPS at an annual rate of 8% over the next three years.
They’re basically anticipating a continuation of the status quo.
A healthy global defense spending environment, increased operational efficiency, and buybacks are all cited as tailwinds for EPS growth.
To add to optimism, Raytheon’s backlog stands at a record $43.3 billion. There’s plenty of work to go around.
But those tailwinds are offset by higher input costs, geopolitical tensions, and overall global economic uncertainty.
I think this is a pretty reasonable expectation from Raytheon.
The global economic picture is arguably about as unclear as it’s been since the end of the Great Recession.
But the company is also in about as good a position as it’s ever been.
One aspect of this stock that should definitely be on investor’s radar is the fact that Raytheon has already announced its intention to merge with United Technologies Corporation (UTX).
Raytheon shareholders would get 43% of the new company.
This is a situation that, in my view, is a win-win for shareholders.
If the merger doesn’t go through, Raytheon is an incredible stand-alone business.
But if the merger does go through, the combination stands to benefit from immense scale, diversification, technological know-how, experience, breadth, and enviable positioning in the hierarchy of defense.
The new company would have a fantastic suite of businesses across both aerospace and defense.
Either way, I think Raytheon makes a lot of sense as a long-term dividend growth investment.
And the forecast for 8% EPS growth sets investors up nicely for dividend growth to at least be in that range. The payout ratio is low enough for dividend growth to modestly outpace earnings growth for many years to come.
Moving over to the balance sheet, Raytheon has a rock-solid financial position.
The long-term debt/equity ratio is 0.41, while the interest coverage ratio is over 20.
These are excellent metrics. And both have improved since the last time I looked at them.
Profitability is robust for the industry.
Over the last five years, the firm has averaged annual net margin of 9.33% and annual return on equity of 22.44%.
These numbers are great as they sit. But they’re even more impressive when you consider that both have improved markedly over where they were at just five years ago.
Raytheon is, by all accounts, a high-quality company.
The fundamentals are excellent. And most numbers have even been improving over the last few years.
There’s also a game-changing merger that could happen here, providing even more to like over the long run.
Of course, there are risks to consider.
Regulation, competition, and litigation are omnipresent risks in every industry.
While Raytheon has plenty of exposure to international markets, the company is still heavily reliant on US defense spending. Any contraction in US DoD spending would directly affect Raytheon.
Also, the company is particularly sensitive to any geopolitical issues.
Even with those risks, this looks like a timeless business that is highly worthy of investment.
Stock Price Valuation
The stock appears to be particularly worthy of investment right now based on where the valuation is at…
The stock is trading hands for a P/E ratio of 16.89.
That’s substantially lower than where the broader market is at.
This earnings multiple is also materially lower than the stock’s own five-year average P/E ratio of 19.9.
And the yield, as noted earlier, is a market-beating yield that comes with double-digit long-term dividend growth.
So the stock does look cheap. But how cheap might it be? What would a reasonable estimate of 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 admittedly on the high end of what I ordinarily allow for.
However, I think Raytheon’s business model, low payout ratio, historical dividend growth, fundamental quality, and positioning warrant enthusiasm.
The merger adds a bit of near-term uncertainty regarding the dividend policy, but it’s worth remembering that United Technologies has a spectacular long-term dividend growth track record of its own.
The DDM analysis gives me a fair value of $203.58.
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.
This was a reasonable valuation analysis, yet the stock still looks like a bargain here.
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 $216.00.
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 $215.00.
We have a rough consensus here. Averaging out the three numbers gives us a final valuation of $211.53, which would indicate the stock is possibly 15% undervalued.
Bottom line: Raytheon Company (RTN) is a high-quality company with a timeless business model. Excellent fundamentals, a market-beating yield, double-digit long-term dividend growth, a very low payout ratio, a possible game-changing merger, and the potential that shares are 15% undervalued are all reasons why dividend growth investors should take a very serious look at this stock right now.
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 99. 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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