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3 Things You Need to Know If You Buy RTX Today

Motley Fool - Mon Nov 6, 2023

RTX(NYSE: RTX) is one of the most compelling investment options in the aerospace and defense sector, and the stock's current dividend yield of 2.9% doesn't hurt either. That said, the stock's 18.6% decline this year tells you it hasn't been a vintage period for the company, and anyone thinking of buying the stock needs to assess the puts and takes before taking the plunge or even dipping in their toes. Here's what you need to know about RTX.

The market is looking at $7.5 billion

Rightly or wrongly, investors tend to key off of targets that management sets in stone. For RTX, that target is $7.5 billion in free cash flow (FCF) by 2025. Based on the current market cap of $118.1 billion, if RTX hits it, it will trade at 15.7 times FCF in 2025. Given that a price-to-FCF multiple of around 20 times FCF is often seen as fair value for a mature industrial company, it implies a 27% upside to the current price or 12.6% per annum over two years. Add the dividend in, and its annual total return is 15.5%.

That's attractive enough, but investors need to consider the risk of the target being hit. Given that the company was forced to lower the target by $1.5 billion as a result of cash headwinds coming from the need to remove and inspect turbine discs potentially manufactured with contaminated powder metal, it's a genuine concern.

As such, the discussion around the stock will center on the potential pluses and minuses of the $7.5 billion figure. Let's put it this way: Say the market previously priced in the $9 billion target RTX had, then the target market cap might be $9 x 20 = $180 billion, so the reduction in the target to $7.5 billion implies a new target market cap of $7.5 x 20 = $150 billion, which is 17% less than the previous figure. That's not far off the decline in the stock price this year.

So, management's target matters.

Engine inspections will take time; color on them less so

Zeroing in on the commercial aerospace business, and specifically the GTF engine inspections issue, it's worth noting that increasing the sample size tends to lower the variance to the true mean of outcomes. In other words, the more engine inspections RTX's Pratt & Whitney does, the more accurate its forecasting of the final financial impact of the inspections will be. For example, when the issue was first disclosed back in July, CEO Greg Hayes told investors, "The 2025 outlook really shouldn't be impacted," and "In terms of the cash, really probably not a big difference as you get out to 2025."

Fast-forward to mid-September, and after about 200 engine inspections, Hayes told investors there would be a $3 billion cash headwind in 2023 through 2025, and he set the $7.5 billion in 2025 target as discussed here. Fast-forward further to the recent third-quarter earnings call in late October, he cheered the market by saying, "We do not expect any significant incremental financial impact as a result of those fleet management plans."

An airplane landing.

Image source: Getty Images.

With 600 to 700 engines still needing removal between 2023 and 2026, it's easy to cast doubt on the finality of that assessment. However, the reality is that management also said, "A majority of the incremental engine removals required by the fleet management plan will occur in 2023 and early 2024."

As such, RTX will get much more data on the removals within a few months, something that should give confidence in its forecasting.

Supply chain issues still exist in its defense business

As previously discussed, RTX lowered its full-year 2023 earnings guidance for its defense-focused business, Raytheon. It comes down to "productivity and mix challenges" coming from ongoing supply chain issues causing higher production costs, notably on fixed-price development programs signed in a less-inflationary period. RTX is not alone, as Lockheed Martin and Boeing have both reported very similar issues.

In fact, RTX's defense-focused businesses (previously run separately as Raytheon Intelligence & Space and Raytheon Missiles & Defense) also missed their initial sales and earnings guidance in 2022 due to supply chain issues impacting their ability to deliver products and stop margins declining.

An investor thinking.

Image source: Getty Images.

A stock to buy

On balance, I think the answer is "yes". Still, risk-averse investors might want to wait for more color on the engine inspections over the next few months and also some more positive news on the lingering supply chain issues in the defense industry. As disappointing as it is to write this, the supply chain issues continue to impact industrial companies negatively and surprise on the downside, and there's no point denying it.

That said, they will clear up at some point, and companies like Lockheed Martin, Boeing, and RTX will work through these legacy fixed-price programs; it will just take time, and investors need to be patient.

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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.

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