Geopolitical tensions remain excessively strained, and they don't seem poised to ease anytime soon. Investors attuned to this situation, moreover, are taking a closer look at defense stocks such as RTX (RTX -0.29%).
But opinions regarding the advantages and disadvantages of picking up shares of RTX (formerly Raytheon Technologies) right now vary widely. To help make sense of the different viewpoints, two Fool.com contributors look at the bull and bear cases for buying RTX stock.
RTX faces operational challenges
Lee Samaha: RTX's recent earnings were well received, but the company faces challenges in its end markets. The company is known for having a fair exposure split between commercial aerospace and defense. The former is more cyclical, while the defense businesses are seen as low growth but solid cash generators. The two combined well during the worst of the pandemic, when the defense business supported the commercial aerospace side. Now that the economy is recovering from the lockdowns, the commercial aerospace side is carrying the earnings growth baton.
There are two problems at RTX. They both center on cash flow and, specifically, management's target of $7.5 billion in free cash flow in 2025.
First, RTX's Pratt & Whitney faces challenges due to the discovery of potential contamination in the powder coating used to manufacture engine turbine discs. Management estimated a $3 billion hit to free cash flow from 2023-2025. Still, since the hit was essentially zero in 2023, it now sees a $1.3 billion hit in 2024, $1.5 billion in 2025, and "the rest spilling into early 2026," according to CFO Neil Mitchill on the earnings call.
Second, RTX's defense business missed its earnings target for the second year. As investors in Lockheed Martin and Boeing already know, it's been difficult to grow margins in the defense business in recent years. As Lockheed Martin's CEO opined recently, "the government's credit in a way, they've been taking advantage of that monopsony power," and defense contractors have taken "tremendous risk on cost and pricing and tremendous cost on the ability to deliver" on fixed-price programs.
Indeed, RTX lowered its profit growth expectation to 2025 for its Raytheon defense business.
Together, RTX will only hit its target of $7.5 billion in free cash flow in 2025 because of a $700 million improvement in tax expectations, working capital, and pension outlays. As such, RTX is falling behind its 2025 operational expectations, and that's a cause for concern.
Near-term turbulence doesn't spell doom for RTX
Scott Levine: My colleague Lee makes some excellent points regarding RTX's future cash-flow concerns. It's important for potential RTX investors to recognize, however, that the company's trajectory doesn't end in 2025. RTX will continue to operate in 2026 and beyond. So while headwinds undeniably exist, they don't preclude the company from achieving growth in 2026 and the subsequent years.
One of the auspicious signs that speaks to the bull case for RTX is the company's strong backlog. Receiving the largest guided missile order of its type in Raytheon history -- a $2.8 billion order from NATO -- RTX raised its defense backlog to $78 billion. This contributed to the company ending 2023 with a record backlog of $196 billion. Addressing the robust backlog on the company's conference call, RTX CEO Greg Hayes stated that he and the rest of the management team are "confident that we'll continue to see strong organic sales and earnings growth, along with accelerated free cash flow generation over the coming years."
Another encouraging sign is the company's potential margin expansion. Achieving $295 million in cost synergies (now having recognized $1.7 billion in cost synergies since its merger with United Technologies), RTX has made steady progress toward its $2 billion post-merger cost synergies target. As RTX continues to recognize cost synergies, management expects margins to expand. On the conference call, for example, CFO Neil Mitchill stated that "2025 would not mark the peak of where we see Raytheon's margin potential."
Sure, the company's powdered metal issue may affect growth in the next two years, but there are many examples of businesses throughout history encountering challenges and overcoming them -- from the 1982 Tylenol crisis that Johnson and Johnson faced to Chipotle's E. coli outbreak in 2015. For contrarian investors who have the stomach to withstand some near-term volatility with RTX, today is a worthwhile time to pick up shares.
Does RTX belong in your portfolio?
There may be disagreement about how bright RTX's future may be, but it's fair to say that both camps are making legitimate cases. The company's challenges regarding the powdered metal situation represent a valid concern, so it's reasonable for investors to balk at buying shares. On the other hand, the company's strong backlog suggests that this leading defense company remains in high demand, and it can very well succeed over the long term.
