The Best Is Yet to Come for Raytheon Technologies

Raytheon Technologies (RTX 0.69%) is doing well, but it's not crushing it. A glass-half-empty view sees the current challenges implied by that statement and concludes that the company isn't delivering as expected. However, a glass-half-full perspective sees the opportunity for significant revenue and margin expansion when Raytheon solves its issues. Here's what you need to know before buying the stock.

Raytheon remains on track but could do better

The challenges and opportunities in Raytheon's business can be seen in the table below. Note that profit declined in both defense-focused businesses in the first quarter. The overwhelming majority of profit growth is set to come from the commercial aerospace-focused segments in 2023, albeit with a slightly disappointing margin performance at Pratt & Whitney, which makes aircraft engines and after-market parts.

These facts might worry investors buying the stock with expectations of a ramp-up in defense spending and the upside potential coming from the recovery in commercial aerospace as air traffic rebounds. 

Data source: Raytheon Technologies' presentations. 

Raytheon's challenges

The issues at defense boil down to the supply chain challenges that hit the aerospace and defense industry over the past couple of years. So naturally, the topic came up on the earnings call, with Chief Operating Officer Chris Calio saying, "As you sort of look ahead to the RMD margin profile, the two principal drivers of that margin improvement are going to be material flow and flow in our factory." In other words, the defense businesses need more inventory in their warehouse to increase profitability when executing orders. But, of course, that will only happen when the supply chain bottlenecks ease. 

Meanwhile, Pratt & Whitney's profitability is being held back by "time on wing" problems with its geared turbofan (GTF) engine. The GTF is Pratt's newest engine and one of two options on the Airbus A320 neo family of aircraft, and "time on wing" refers to how long the engines can be flown without needing maintenance. Discussing the matter, Calio said, "We are not yet at the level we and our customers expect. This has put stress on the operations of the fleet."

Raytheon has plenty of opportunity to increase profit

The challenges are real, but so are the opportunities, and there are plenty of them for Raytheon, starting with the defense businesses. 

• The gradual easing of supply chain constraints will lead to increased profitability at RIS and RMD.
• Orders remain very strong at RIS and RMD, with their book-to-bill ratios at 1.34 and 1.43, respectively, and backlogs of $17 billion and $35 billion.

While Raytheon can't execute perfectly right now, conditions will improve, leading to greater profitability. It's underpinned by solid order growth as the U.S. looks to increase defense spending and NATO countries such as Poland plan to spend 4% of their gross domestic product on defense in 2023. Meanwhile, according to Chief Executive Officer Greg Hayes, "We've only seen about $2 billion of awards related to Ukraine munitions replenishment. We expect that we'll see more of that coming up later this year and into next year."

Image source: Getty Images.

Turning to the commercial aerospace-focused segments: 

• Pratt & Whitney is working hard to install upgrades to improve "time on wing."
• The ramp up in GTF production is holding back profit because each engine comes with about $1 million in negative engine margin, but the real money will be made when those engines are serviced in a few years.
• Parts used in wide-body aircraft tend to be higher margin and demand for them should increase as the recovery in air travel broadens to the wide-body aircraft typically used for long-distance international flights.

Putting these points together, it's reasonable to expect revenue growth and margin expansion at Collins Aerospace and Pratt & Whitney in the coming years. 

Is Raytheon Technologies a buy?

Raytheon's full earnings and cash flow potential aren't being delivered right now. Still, its end-market demand remains excellent in both commercial aerospace and defense, and management has a line of sight for improvements in the supply chain and the GTF. 

The company's best days are ahead of it. If you believe that defense spending will remain in growth mode and that the commercial aerospace recovery will continue, then the stock is an excellent option.