The recent developments surrounding the aerospace and defence titan may have dismayed some investors, yet its robust underpinning growth remains intact. RTX (NYSE: RTX), formerly known as Raytheon Technologies, revised its annual sales and earnings projections upward with its Q2 report issued last week. Furthermore, the firm declared a substantial $25 billion in orders for the quarter, leading to a book-to-bill ratio of 1.34 and a record backlog of $185 billion.
However, an unfavourable update relating to an issue with Pratt & Whitney’s unit’s geared turbofan (GTF) engine clouded this positive news for RTX investors. This problem could severely impact the company.
The GTF issue’s relevance to investors
Pratt & Whitney’s GTF is RTX’s countermeasure against General Electric’s control over the narrowbody engine market. While Boeing 737 MAX exclusively uses engines produced by GE’s joint venture with Safran, CFM International, and Airbus A320neo, customers can choose between CFM engines or GTFs. Even though aircraft engines often sell at a loss, substantial profits derive from service contracts and spare parts sales, offering enduring earnings and cash flow.
Although RTX boasts a diverse portfolio of businesses, it’s indisputable that the GTF, its flagship jet engine, is crucial for Pratt & Whitney’s future and, subsequently, the investment proposition for the stock.
The Incident
An engine-related incident in 2020 led Pratt & Whitney to detect a contamination issue in a powdered metal they manufacture and use on GTF turbine discs. Management traced the problem to rare instances in powdered metal production from Q4 2015 to Q3 2021, according to Chief Operating Officer Chris Calio’s recent Q2 earnings call statement.
Management resolved to remove 200 engines for inspection by mid-September. Calio also stated that Pratt & Whitney expects to inspect another 1,000 machines “within the next nine to 12 months.”
The inspections will incur costs, leading RTX to revise its free cash flow (FCF) forecast for the year to $4.3 billion from an earlier estimate of $4.8 billion, with the $500 million decrease primarily due to this issue. At this juncture, it’s wise to summarize what we and management know and don’t know about the situation.
Impact on investors
The market’s response to the news was a $14 billion drop in RTX’s market cap. While this reaction may seem severe, as it’s 28 times the FCF costs the company is facing this year, management has communicated that it needs more time to ascertain the problem’s impact on 2024’s FCF.
CEO Greg Hayes stated during the earnings call that this inspection program’s influence on FCF should be short-lived and won’t affect the long-term FCF generated by the GTF engine. This scenario assumes that Pratt & Whitney doesn’t lose significant market share to CFM’s engine on the A320neo. Given that the issue doesn’t pertain to engines produced post-Q3 2021 or those currently being made, it’s reasonable to assume that future engine orders won’t be affected.
On top of that, some of the 1,200 engines slated for inspection were already due for “shop visits.”
Should one invest in RTX stock?
With RTX’s end markets demonstrating robust growth and an anticipated organic sales growth of 9% to 10% in 2023, it shows promise compared to its previous estimate of 7% to 9%. The company’s $185 billion order backlog and the rebound of airline profitability and aircraft production should give investors confidence in its prospects. Additionally, defence orders are gaining traction due to the increased focus on military spending amidst the Ukraine conflict.
Moreover, RTX’s valuation hinges on long-term FCF generation. While a minimum of $500 million shrinkage in the next few years is significant, it’s less than 6% of the anticipated 2025 FCF, hinting at the situation being excessively dramatized.
Nonetheless, if potential bad news affecting a stock unnerves you as an investor, it might be wise to offload RTX. In October, management is set to update on how the powdered metal contamination issue will influence FCF. It may be prudent for cautious investors to await this update before making an investment decision.
RTX’s recent difficulties with the GTF engine are significant but transient. The long-term prospects of the company, bolstered by robust growth in end markets and a hefty order backlog, remain compelling. The real impact of the current issue will be more apparent after the upcoming management update in October. Until then, cautious investors might consider adopting a wait-and-see approach. However, the recent dip in RTX’s stock price might present a lucrative entry point for those with higher risk tolerance and a long-term investment horizon.
