RBC Capital recently raised its price target on aerospace and defense giant RTX(NYSE: RTX) to $96 from $88 while maintaining a "sector perform" rating on the stock. With the stock trading around $101, the updated price target suggests a 5.3% price drop over the next 12 months. I would also argue that a "sector perform" rating is, de facto, a sell rating. You can buy the sector through an ETF, so there's no need to take on stock-specific risk by buying RTX.
Is the caution over RTX stock justified?
The RBC analyst is right to be cautious about the stock but for slightly different reasons. Delivery delays at Boeing will indeed pressure the original equipment market (OEM), especially RTX's Collins Aerospace business. Still, the key issues for RTX were identified by soon-to-be CEO Chris Calio on the fourth-quarter earnings call in January: "We have two matters we've been heavily focused on, Pratt's powdered metal situation, and Raytheon's margins."
Two issues at RTX
The Pratt issue refers to removing and inspecting airplane engines manufactured with potential contamination in a powder coating used to manufacture turbine discs on engines. Management has previously disclosed that the "majority of incremental engine removals will occur in 2023 and early 2024." As such, management will likely give a more definitive update on the likely final costs and cash flow hit during the first half of 2024.
Margin pressures in defense businesses are an industry-wide issue. Raytheon, Lockheed Martin, Boeing, and GE Aerospace have all been affected.
The question is whether it's a cyclical issue that will improve as supply chains heal and defense contractors work through problematic fixed-price development programs secured in less inflationary times. Alternatively, this could be a structural issue relating to the defense industry's key customer, the U.S. government, in the words of Lockheed CEO Jim Taiclet, increasingly "taking advantage of that monopsony power, if you will, over the industry."
Cautious investors may want to wait for a more definitive update on the inspection issue and some hard evidence of improvement in defense industry margins before buying into RTX.
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Lee Samaha has no position in any of the stocks mentioned. The Motley Fool recommends Lockheed Martin and RTX. The Motley Fool has a disclosure policy.
