RTX's (RTX -0.29%) mix of commercial aerospace businesses makes it attractive for dividend investors. The defense business is known for its solidity thanks to its highly creditworthy customers. Meanwhile, its airplane engines (Pratt & Whitney) generate aftermarket earnings for decades, and its commercial aerospace component business (Collins Aerospace) is a critical player in servicing both original equipment and aftermarket demand. That all points to long-term earnings generation and dividend growth.
Still, is it the best dividend stock for investors?
RTX's growth prospects
A company needs earnings and cash flow growth to grow dividends. RTX has both, but I think there are some concerns about its growth prospects, specifically its 2025 free cash flow (FCF) target of $7.5 billion. I have three specific points to address.
- Part of the cash flow hit from the need to inspect Pratt & Whitney engines has been pushed out to 2026.
- Based on management commentary, RTX will only reach $7.6 billion in FCF in 2025 thanks to factors that won't necessarily repeat.
- The defense industry may be in an era of structural decline in profit margins, and spending is contingent on political decisions.
Before getting into details, I want to stress that investors often pencil in FCF targets and then use them as a base for cash flow projections. In this case, it would be $7.5 billion in 2025 as a base. I'm arguing that the approach might be flawed due to the following three arguments. This would impact dividend growth, because FCF is used to return capital to investors through buybacks and dividends.
Cash flow hit from powder-coating issue
As a reminder, RTX discovered a potential contamination in the powder coating used to manufacture turbine discs in Pratt & Whitney engines. The company manufactures the geared turbofan (GTF) engine used on the Airbus A320 neo family of aircraft and others. The engines must be removed and inspected at a significant cost and cash flow burden to RTX.
In September, management said it faced a $3 billion cash headwind between 2023 and 2025. That's fair enough, and the market no doubt baked that into its valuation of the stock. Fast forward to the fourth-quarter earnings report in January, and there's a subtle change to expectations.
First, on the earnings call CFO Neil Mitchill said the impact in 2023 was "essentially zero." He didn't say the estimate for a $3 billion cash flow hit had changed, but he did say it had been pushed to the right with a $1.3 billion hit in 2024, $1.5 billion in 2025, "and then we see the rest spilling into early 2026."
As such, if you start with a base assumption of $7.5 billion in FCF in 2025, you must now strip out some FCF from assumptions over 2026 due to the push-out of the cash flow hit.
Reliance on favorable issues
The inspection issue will hit profits, and management also lowered its expectations for operating profit growth at its defense business, Raytheon. Management now expects Raytheon to grow operating profit by 1%-2.5% from 2020-2025 compared to a previous estimate of 5.5%-7.5%. As such, there's apparent pressure on its FCF target for 2025.
Image source: Getty Images.
Mitchill acknowledged that RTX had "$1 billion net of tax lower operating profit baked into this long-term guide." However, this is being offset by "by about $700 million of improvement in taxes" and a couple of hundred million dollars based on expectations for lower-than-previously-expected pension outlays.
These aren't items investors can price in for future cash flow generation.
Defense industry challenges
RTX lowered its growth expectations for its Raytheon defense business, and Boeing continues to report losses in its defense business, with notable pressure on its fixed-price development programs; Lockheed Martin also continues to struggle with margins, and recently gave a mediocre outlook for margin growth over the next few years.
There's a pattern here, and when Lockheed's CEO James Taiclet says that the U.S. government has been "taking advantage of that monopsony power," and it has led to contractors taking "tremendous risk on cost and pricing and tremendous cost on the ability to technically deliver these capabilities," investors should listen.
This may be a long-term structural issue in the defense industry, a significant concern in an industry where decisions are always subject to political risk.
Image source: Getty Images.
Is RTX a stock to buy for its dividend?
All told, the argument that RTX will generate $7.5 billion in FCF in 2025 and then have blue skies after that isn't quite as strong as it was previously. By extension, assuming strong growth in the dividend in the coming years is also more questionable. As such, there are better ways for dividend investors to invest than buying RTX stock.
