RTX Stock: Buy, Sell, or Hold?

Investors got what they wanted to hear from RTX's (RTX -0.29%) management recently. The company, formerly known as Raytheon Technologies, reassured investors over the financial impact of dealing with a manufacturing quality issue on its (Pratt & Whitney) aircraft engines.

Consequently, the stock enjoyed a relief rally. But where is it headed now? 

RTX reports a mixed quarter

The headline numbers were solid enough, and management upgraded its full-year adjusted sales guidance to $74 billion from a previous range of $73 billion to $74 billion. There was also a narrowing of its full-year adjusted EPS guidance to a range of $4.98-$5.02 from a prior range of $4.95-$5.05. 

RTX's latest update

Still, the earnings guidance wasn't the big news from the quarter. Instead, investors focused on CEO Greg Hayes' disclosure regarding the powder coating issue. As a reminder, management has identified potential contamination in powder coating used in the manufacture of turbine discs on Pratt engines between the fourth quarter of 2015 and the third quarter of 2021.

The issue requires Pratt & Whitney to remove and inspect engines, with an incremental 600-700 "shop visits" (engines are overhauled and maintained) between 2023 and 2026. Back in September, RTX management told investors the engine removals would result in a cash headwind of $3 billion between 2023 and 2025 and reduce its long-established free cash flow (FCF) target of $9 billion in 2025 to just $7.5 billion.

Image source: Getty Images.

Naturally, investors were concerned that these headwinds could morph into something more significant as the inspections occur. As such, it was pleasing to hear Hayes say, "We have made significant progress on our assessment of the Pratt & Whitney powder metal manufacturing matter and expect the financial impact to be in line with the previously disclosed charge."

Hopefully, this will allow investors to ink in, rather than pencil in, the target of $7.5 billion on FCF in 2025 into their valuations. 

A disappointing defense update from RTX

While the headline numbers were solid enough, much is happening underneath the surface. A breakout of the full-year guidance by segment helps detail some of the dynamics in the quarter.

By way of explanation, Collins Aerospace and Pratt & Whitney are commercial aerospace-focused businesses, although both have substantive military sales. Meanwhile, Raytheon is a defense business whose solutions include missile defense, air-to-air missiles, fire control radar, and electro-optical/infrared (EO/IR) systems.

Continued strength in its commercial aerospace businesses (Collins and Pratt & Whitney) is offsetting a weaker outlook in its Raytheon business. 

Data source: RTX presentations.

Frankly, the reduced profit outlook in defense is a disappointment. It's been a difficult year for defense stocks, as ongoing supply chain and labor issues and persistently high inflation have put pressure on profit margins. These issues are pronounced in fixed-price programs signed in a more benign inflationary environment, and both Boeing and RTX are struggling to work through them in a tough cost environment.

Unfortunately, the cost headwinds have extended through the year. Despite hopes that they would turn into a tailwind (as supply chain issues ease), the reality is RTX cut its profit outlook for Raytheon. 

Where next for RTX?

Looking ahead, the company can't rely on its commercial aerospace businesses to offset its defense businesses forever, and the reality is that commercial aerospace growth will slow now that the market has played "catch-up" after the devastation wrought on it by the travel restrictions. 

On a more positive note, RTX's overall backlog broke a new record at $190 billion (up from $185 billion at the end of the previous quarter), with the defense backlog at $75 billion (up from $73 billion), and end demand remains strong, with an overall book-to-bill ratio of 1.19 in the third quarter.

Is RTX a stock to buy?

On balance, RTX looks more like a "buy" than a "sell" right now. The update on the engine inspection issue removes a lot of uncertainty. Although the margin issues in defense continue to disappoint, they will likely ease at some point, not least as RTX works through legacy contracts. 

FCF of $7.5 billion in 2025 would put RTX at slightly over 15 times FCF based on the current price, and that looks like a good value based on the risk/reward proposition here.