RTX (RTX -0.29%) is one of the most fascinating investment propositions in the market. On the one hand, its end markets are in fine shape, and its valuation (based on its medium-term target) looks favorable. On the other hand, there's no shortage of risk, as hundreds of its Pratt & Whitney geared turbofan (GTF) engines will need to be removed and inspected over the next couple of years. Here are the bull and bear cases for the stock.
The bull case for RTX
There are five interconnected arguments supporting the bull case. First, RTX remains positioned in excellent end markets. The commercial aerospace market continues to recover as airline capacity builds due to consumers catching up on lost travel plans and business travelers returning. Meanwhile, the emphasis on global defense spending is increasing due to ongoing geopolitical tensions and the need to replenish equipment used by Ukraine.
Second, RTX's margins (notably in defense) have previously been under pressure due to supply chain problems and labor availability. As these problems lessen, there's an opportunity for RTX to expand profit margins.
Third, the company's backlog at the end of the second quarter stood at a record $185 billion, a substantive increase on the $175 billion and $156 billion backlogs at the end of 2022 and 2021 respectively. To put this figure into context, management estimates its full-year revenue in 2023 will be between $73 billion and $74 billion.
Fourth, with a substantive backlog in place and management having already adjusted its medium-term guidance to reflect the GTF issue, the key to unlocking shareholder value largely rests in the company's own hands.
Fifth, and in connection with the fourth argument, all RTX has to do is execute its plans, and the stock will be an excellent value. Having abandoned the target of $9 billion in free cash flow (FCF) in 2025 due to the headwinds created by the GTF inspections, management is now targeting $7.5 billion in FCF in 2025.
With the current market cap of around $105.7 billion, hitting the FCF target would put RTX on a price-to-FCF multiple of just over 14 times in 2025 -- an excellent value considering that a mature industrial stock is often seen as a fair value at 20 times FCF.
The bear case against RTX
The two most robust bear arguments involve risk in the economy and the ongoing GTF problems.
Image source: Getty Images.
For example, bears will point out that a large backlog doesn't mean much when a slowdown causes customers to cancel or postpone orders. That could happen in commercial aerospace, particularly with airlines (many of which still have weak balance sheets due to the pandemic). Moreover, if demand for commercial travel slows, flight departures will likely do so, too, leading to a slowing in demand for aftermarket parts.
Turning to the elephant in the room, the "GTF issue" is not over yet. Management's statements in July proved overly optimistic, and there's no guarantee that the estimated total $3 billion cash headwind between 2023 and 2025 will be the end of the story.
As a reminder, Pratt & Whitney plans to remove 600–700 GTF engines for shop visits between 2023 and 2026 due to potential contamination in the powder coating used to manufacture turbine discs in engines. The fleet inspection and management plan is expected to damage operating profit by $3 billion to $3.5 billion over the next few years, which has caused management to lower its FCF expectations for 2025 by $1.5 billion.
Given the uncertainty inherent in this plan, it's hard to conclude this will be the end of the matter. Indeed, management acknowledges that the full impact is subject to "data-driven assumptions that Pratt & Whitney continues to refine, including, among other items, shop visit quantity, work scope, turnaround time, and part availability."
Moreover, Pratt & Whitney is analyzing other engine models in its fleet with regard to the potential impact of the powder metal on them.
Image source: Getty Images.
Buy, sell, or hold?
RTX won't be a buy for most investors right now, but if its stock price dips from here, then it could become very interesting -- not least because, provided the economy avoids a recession, the actions necessary to unlock shareholder value are primarily in the company's hands. It's a stock to monitor to pick up on any market-led weakness.
In addition, RTX's management expects the "majority" of incremental engine removals to be complete in 2023 and early 2024. So cautious investors may want to hold off buying, awaiting updates as Pratt & Whitney gets more data on the engine updates.
