RTX: Is the Market Too Optimistic?

The market loved the latest report from RTX (RTX -0.29%) -- formerly called Raytheon Technologies -- and rightly so. The latest update from this giant aerospace and defense company contained many positives, including a good outlook for 2024 and 2025.

Still, when digging into the details, a couple of points of interest arise that will need to be monitored by investors. Here's the lowdown on an earnings report and outlook with many moving parts.

RTX's outlook

RTX showed good momentum in 2023 as organic sales rose 11%, and the company is forecasting a further 7%-8% increase in 2024. In addition, its order book and backlog continue to grow impressively with contributions from both its commercial aerospace and defense businesses.

In fact, $95 billion in new bookings in 2023 helped RTX increase its backlog by 12% over the year, and it now stands at a record $196 billion. Its book-to-bill ratio -- that's the ratio of orders received to the amount billed -- stands at a solid 1.28.

Recovery of the commercial aerospace business continues as flight departures have risen past 2019 levels. Meanwhile, defense spending is growing as a result of heightened geopolitical tensions. For reference, RTX's defense backlog increased 13% to $78 billion over the year.

Turning to the company's formal guidance for the year ahead, the headline numbers look positive:

• Organic sales growth of 7%-8% in 2024.
• Adjusted earnings per share (EPS) of $5.25-$5.40, giving RTX a forward price-to-earnings ratio of less than 17.
• FCF of $5.5 billion in 2023 followed by $5.7 billion in 2024, giving RTX a forward price-to-FCF multiple of 22.6.
• Management maintained its expectation for $7.5 billion in FCF in 2025, putting it on a price-to-FCF multiple of 17.3 in 2025.

Image source: Getty Images.

Two concerns from RTX's earnings and outlook

While the numbers look excellent and RTX remains a good option for investors, some issues are worth watching. COO Chris Calio, who will become RTX's CEO in May, hit them on the head during the earnings call: "We have two matters we've been heavily focused on, Pratt's powdered metal situation and Raytheon's margins."

RTX's powder metal problem

Last year, RTX discovered potential contamination in the powder coating used to manufacture turbine discs in engines. This issue created the need to remove engines for inspection. Management previously forecast a $500 million hit to FCF in 2023, resulting in a $3 billion cash headwind from 2023 to 2025, including a $1.5 billion headwind in 2025. As a result, RTX lowered its original target of $9 billion in FCF in 2025 to $7.5 billion.

However, the exact figures appear to be bouncing around. For example, CFO Neil Mitchill told investors that the FCF hit in 2023 "was essentially zero," with half of the expected $500 million hit moved into 2024, resulting in a $1.3 billion hit in 2024, a further $1.5 billion in 2025, "and then we see the rest spilling into early 2026."

However, he didn't explicitly confirm that the cumulative cash flow hit would be $3 billion. So there's potentially a question about what the hit might be in 2026.

Raytheon's margins

RTX's adjusted operating profit increase in 2023 and its guidance for 2024 clearly show that the commercial aerospace businesses are carrying the load.

Data source: RTX presentations.

Raytheon's adjusted operating margin fell from 9.9% in 2022 to 9.2% in 2023, with the defense businesses continuing to be hit with cost headwinds on fixed-price development programs and material cost increases and "supplier delinquencies," according to Calio.

These issues are ongoing, and while Mitchill maintained RTX's 2020-2025 sales and operating profit growth targets "discussed last year at our Investor Day," he lowered Raytheon's expected operating profit annual growth rate during the 2020-2025 period to 1%-2.5% from 5.5%-7.5%.

As a result, the $7.5 billion FCF target will be hit due only to a $700 million improvement in taxes, "as well as a couple of hundred million dollars" due to more favorable assumptions around pension outlay and working capital improvements, according to Mitchill. These factors are not likely to repeat and can't be relied on.

Image source: Getty Images.

A stock to buy?

These two issues are watch items. After two years of missing its defense business guidance, it's time for RTX to at least meet expectations this year. In addition, some further clarity on the engine inspection issue would likely be welcomed by most investors.

RTX continues to look like a good value, but the latest update wasn't as bullish as the market reaction to it indicates. The mid-term defense business guidance has been lowered, the $7.5bn FCF target in 2035 will only be hit due to non-operating earnings factors, and there are still some questions around the cash flow hit from the engine inspections.