3 Things You Need to Know if You Buy RTX Today
Shares in aerospace and defense company RTX (NYSE: RTX) have had a good year so far, with a 24% increase outpacing the S&P 500's gain of 11%. Still, can the run continue? Here's what you need to know before you buy the stock.
Three things to look out for with RTX
The new CEO, Chris Calio, has a clear handle on what investors want to hear from RTX in the coming years, and he outlined it in the recent earnings call. Addressing a key point for investors to look for from each of RTX's three segments, he noted:
For aerospace engine and aftermarket company Pratt & Whitney, it's "continuing to execute the [geared turbofan jet engine] fleet management plan."
For defense-focused Raytheon, it is "delivering the backlog and improved margins."
For aerospace original equipment manufacturer and aftermarket company Collins Aerospace, it's "generating strong incremental margins."
All three issues are crucial to the company's target of $7.5 billion in free cash flow (FCF) in 2025.
Pratt & Whitney and the geared turbofan engine
The geared turbofan, or GTF, isn't the company's only engine, but it is Pratt's most important growth driver. The engine is one of two options on the Airbus A320 neo family of aircraft. Unfortunately, it hit a high-profile issue last year when the company discovered a potential contamination in the powder coating used to manufacture discs in the engine.
As such, RTX was forced to remove 600 to 700 engines for inspection between 2023 and 2026, hurting operating earnings and FCF. For example, management lowered its 2025 FCF target to $7.5 billion from $9 billion due to these inspections.
The good news is that Pratt is progressing well with the inspections, and management confirmed that the "financial and operational impact remains consistent with prior guidance" on the earnings call. That's a significant plus and helps de-risk the stock.
And management had previously said it aimed to average 350 aircraft on the ground (AOGs) in 2024-2026 with a peak in the first half of 2024 -- something that Calio confirmed on the earnings call in late April by saying that "we are now essentially at our peak AOG level."
Raytheon's profit margins
The following chart shows how Raytheon's defense margins have declined recently. That said, if you look closely, you can see a slight increase in the first quarter of 2024 (9.5%) compared to the first quarter of 2023 (9.3%).
Data source: RTX, chart by author.
The margin situation is frustrating because Raytheon is growing sales and backlog at a healthy clip. For example, adjusted net sales increased by 4.7% in 2023, but the margin decline (9.9% to 9.2%) meant that its adjusted operating profit declined slightly from $2.45 billion to $2.38 billion.
The excellent news is that Raytheon's book-to-bill ratio of 1.23 in the first quarter ($8.1 billion in bookings and a backlog of $53 billion) supports future growth. Moreover, Calio discussed the recent $95 billion military aid package, saying Raytheon could address two-thirds of the $60 billion for Ukraine, 30% of the $25 billion for Israel, and 30% of the $10 billion for the U.S. Indo-Pacific Command.
There's little doubt Raytheon has revenue growth drivers, but growing margins to take advantage of it appears to be a problem.
Image source: Getty Images.
Collins Aerospace
The issue of margins at Raytheon also applies to Collins Aerospace. The segment's organic sales growth was 9% in the first quarter, and management expects organic sales growth to be in the mid to high single digits for the full year. As Calio said, management is looking to generate "strong incremental margins," meaning ramping up profit margins as revenue increases.
Collins Aerospace is doing an excellent job of it, with its adjusted operating profit margin rising to 15.7% in the first quarter compared to 14.8% in the same period last year.
But it would have been even higher at 18.3% if not for a $175 million charge related to securing alternative titanium sources. Chief Financial Officer Neil Mitchill said that since 2022, RTX has "been evaluating our global sourcing strategies to mitigate the potential impact of sanctions and other restrictions."
As such, it's an indication that the same global tensions creating demand for defense weapons are also creating cost headwinds for RTX's aerospace and defense businesses, and it's holding back margin expansion while revenue increases.
Image source: Getty Images.
What it means for RTX investors
Ultimately, investors need to monitor these three factors. Pratt & Whitney's news is good, and there's evidence of better margin performance at Raytheon. Still, if RTX is to hit its target of $7.5 billion in FCF in 2025, it will need to overcome productivity pressures from cost increases at Raytheon and Collins Aerospace -- and that's something investors should monitor.
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Lee Samaha has no position in any of the stocks mentioned. The Motley Fool recommends RTX. The Motley Fool has a disclosure policy.
