RTX (RTX -0.29%), formerly known as Raytheon Technologies, raised its full-year sales and earnings guidance when it issued its second-quarter report last week. In addition, the company reported that it received a whopping $25 billion in orders in the quarter, giving it a book-to-bill ratio of 1.34 in the quarter and a record backlog of $185 billion.
Still, all of that was somewhat far from RTX investors' minds as they digested a piece of disappointing news regarding an issue with the Pratt & Whitney's unit's geared turbofan (GTF) engine. An issue that will hit the company hard.
The geared turbofan issue and why it matters to investors
Pratt & Whitney's GTF is RTX's answer to General Electric's dominance of the narrowbody engine market. GE's joint venture with Safran, CFM International, makes the sole engine used on the Boeing 737 MAX, but Airbus A320neo customers have a choice between CFM engines or GTFs. Airplane engines are often sold at a loss. The real money comes from contracts to service the engines and spare parts sales, which provide long-term earnings and cash flow.
RTX does have an extensive array of other businesses, but there's no denying that the GTF, its flagship jet engine, is an integral part of Pratt & Whitney's future and, therefore, the investment case for the stock.
What happened
Following an incident involving another engine in 2020, Pratt & Whitney determined that it had an issue with contamination in a powdered metal manufactured by the company and used on turbine discs in the GTF. Management determined that the condition "was present in rare instances in powdered metal" produced from the fourth quarter of 2015 through the third quarter of 2021, Chief Operating Officer Chris Calio said during the recent Q2 earnings call.
As such, management decided to remove 200 engines for inspection by mid-September. Pratt & Whitney also "anticipates" a further 1,000 engines will need to be removed and inspected "within the next nine to 12 months," according to Calio.
The inspections will cost money. Indeed, RTX lowered its free cash flow (FCF) expectations for the year to $4.3 billion from a prior estimate of $4.8 billion, with the $500 million reduction primarily attributed to this issue. At this point, it's a good idea to take a step back and summarize what we and management do and don't know about the matter.
|
RTX |
What We Know |
What We Don't Know |
|---|---|---|
|
GTF inspections |
200 inspections will occur by mid-October, with a further 1,000 to be completed by the end of 2024. |
An update may come in mid-October regarding the severity of the issue's financial impact on the company after the first 200 engines are inspected. |
|
Anticipated FCF impact |
$500 million hit in 2023. |
No estimate yet for hit in 2024. |
Data source: RTX presentations, author's interpretation.
What it means to investors
The market responded by wiping $14 billion off RTX's market cap. That may seem harsh -- it is, after all, 28 times what this issue will cost the company in FCF this year -- but management was clear that it needed more time before it would be able to estimate what this problem will do to FCF in 2024.
CEO Greg Hayes said on the earnings call that the company's medium-term target of $9 billion in FCF in 2025 "really shouldn't be impacted" because "by the end of next year, this inspection program will be almost all complete."
Hayes' comments highlight the view that this problem's impact on FCF should be temporary, and therefore, that it won't impact the long-term FCF generation coming from the GTF engine. Of course, that scenario assumes that Pratt & Whitney doesn't significantly lose market share to the CFM engine on the A320neo. However, considering that the issue doesn't affect engines produced after Q3 2021 or the engines currently being produced, it's reasonable to assume it won't impact future engine orders.
Moreover, as management noted, some of the 1,200 total engines to be inspected were already scheduled for "shop visits" in the period.
Image source: Getty Images.
Is RTX stock a buy?
RTX's end markets are growing strongly, and it's now targeting 9% to 10% organic sales growth in 2023, as compared to its prior estimate of 7% to 9%. The company's $185 billion order backlog should give investors confidence about its future, as should the environment around long-term engine demand as airlines return to profitability and airplane manufacturers ramp production. Meanwhile, defense orders are being boosted by the increased emphasis on military spending in light of the war in Ukraine.
Moreover, the key to RTX's valuation is long-term FCF generation, and although seeing that shrink by at least $500 million in the next couple of years is no small matter, it's not a huge amount (less than 6% of expected 2025 FCF) when looking at the long-term picture. As such, the recent decline appears overly fearsome.
However, if you are the kind of investor who doesn't like holding onto a stock with some potentially bad news overhanging it, then it makes sense to sell RTX. Either way, in October, management should provide an update on how the powdered metal contamination issue will impact FCF. Cautious investors may want to wait for that update before buying in.
