RTX: One-Off “Powdered Metal” $3bn Hit Wipes $14bn Off Market Value

Company Update (RTX US) (Buy)

Highlights

• RTX has lost 24% ($34bn) of its market value since July 25

• The updated plan likely represents the maximum work scope

• Total cost of the new plan is $3bn, spread over 2023-25

• RTX stock is cheap even if this cost escalates significantly

• With shares at $74, we see a 96% return (23.6% p.a.) by 2026. Buy

Introduction

RTX provided an investor update on the “powdered metal” issue before markets opened on Monday (September 11). Shares finished the day down 7.8%, and are down a further 4% on Tuesday as we write this (at 10:45 U.S. EST). RTX shares have now fallen by 24% since the issue was first disclosed on July 25 are back to levels last seen in early 2021:

RTX Share Price (Last 5 Years)

Source: Google Finance (12-Sep-23).

We have had a Buy rating on RTX since May 2020, and had a modest holding in the stock before July 25. We have been adding to our position in recent weeks, with significant additional purchases in the past two days.

RTX has massively expanded the scope of its efforts to fix the “powdered metal” issue, and will replace parts on “as many as possible” of its whole 3,000+ GTF PW1100 fleet over the next few years. This likely represents the maximum of what needs to be done. The estimated cash cost to RTX is $3bn, consistent with the pro rata amount from the $0.5bn guided for the first 200 engines and a “suspect” population of 1,200 in July. Key to this is much of the work will be fit into routine shop visits, 80% of the costs will be “customer support” (including compensation), with modest labour and material costs as the other 20%. We believe the new figure are realistic.

More importantly, the costs involved are one-off, will only materialize over time and manageable even if they escalate. Dividend and capital return targets have been reiterated. The $34bn decline in RTX’s market capitalization since July 25 thus represents a significant over-reaction in our view. 2025 Free Cash Flow (“FCF”) will now be $7.5bn instead of $9bn, but we still see RTX achieving its original $10bn FCF target soon after 2025. With shares at $74, and the market capitalization at $109bn, our updated forecasts imply a total return of 96% (23.6% annualized) by 2026 year-end. The FCF Yield is 3.9% and the Dividend Yield is 3.2% at present. Buy.

Much Bigger New Plan Will Likely Be Maximum

The new fleet management plan RTX announced on Monday represents a massive expansion in the scope of its efforts to fix the “powdered metal” issue, going from inspecting 1,200 “suspect” engines and replacing one part (the High Pressure Turbine, or HPT, disc) as needed, to inspecting all 3,000+ PW1100 engines and replacing two parts (the HPT disc as well as the compressor disc) as much as possible over the next few years.  

It appears the results of the first 137 inspections carried out so far has led RTX to believe that more regular inspections are needed on the affected part and, to avoid repeated inspections and maximise engine lifespans, RTX has decided to pre-emptively the part across the fleet. COO Chris Calio explained how RTX’s thinking has evolved on the call:

“At the time of this (July) assessment, we were really focused on accelerating the inspections of engines that had not yet had the enhanced ‘angle scan” inspection. That’s the 1,200 engines in 2023 and early 2024 that we spoke about previously, and that remains consistent.

Pratt then continued to analyse the inspection protocol, and ultimately determined that repetitive inspections, combined with a part-life limitation on certain HPT (High Pressure Turbine) and compressor discs, would need to ensure that we have more opportunities to detect a crack after the initial inspection … This means that, even if an engine previously had an ‘angle scan’ inspection, we want to look at it again in that 2,800-3,800 cycle range, and so that now touches almost all of the (3,000+) PW1100 engines.

That being said, our goal is to eliminate the need for repetitive inspections, and so Pratt now plans to replace as many HPT discs as possible during these shop visits, with discs that have full certified life. This would have the effect of avoiding another removal in that cycle range I talked about, that 2,800-3,800, for the repetitive inspection. In addition, to ensure that the engine achieves the maximum time-on-wing interval when it leaves the shop, it makes sense actually to replace the compressor disc at the same time.”

As the new plan involves all current PW1100 engines, it likely represents the maximum of what needs to be done.

Other Pratt & Whitney (“P&W”) engines also contain the suspect “powdered metal”, but management has reiterated its expectation that they will be “far less impacted”. As we explained previously, the issue originated from a microscopic contaminant present in some “powdered metal” produced during Q4 2015 to Q3 2021, has been known since 2020, and the other engines have already undergone extensive inspections since then. In particular, “roughly half” of the V2500 has already been inspected with the enhanced “angle scan” in recent years. These other engines all have their own fleet management plans, but these mostly fit around their scheduled shop visits. Management has stated that further analyses for both the V2500 and PW1500-1900 engines will be completed by the end of this month (September).

$3bn Total Cash Impact in 2023-25

The new plan’s total cash impact to RTX is estimated to be $3bn in 2023-25, with $0.5bn in 2023 as already guided, $1.5bn in 2025, and an implied $1.0bn in 2024. The figure represents RTX’s 51% share of the program, with a similar amount to be shouldered by the program’s equity partners such as MTU Aero (with an 18% share).

RTX PW1100 Fleet Management Plan Headlines

Source: RTX investor update presentation (11-Sep-23).

The $3bn figure is consistent with the pro rata amount from the $0.5bn guided for the first 200 engines and a “suspect” population of 1,200 in July, even though all 3,000+ PW1100 engines will now be involved.

However, we believe the new figures is realistic. The key is much of the work will be fit into routine shop visits, and the inspections and replacements cost are modest on their own. 80% of the costs will be in “customer support” (including compensation) to offset disruption to airlines, with only the other 20% in labour and material costs. We believe this means most of the costs are related to the first 1,200 engines which will be dealt with more urgently and will cause more disruption, and relatively little incremental costs will be required to cover the remaining PW1100 engines over time.

Comments and datapoints provided by management support this view, with the “majority” of incremental engine removals (i.e. unscheduled disruption) to be in “2023 and early 2024” and Aircraft-On-Ground (“AOG”) to peak at 600-650 in H1 2024 (compared to an average AOG of 350 expected across 2024-26), implying much less disruption once the first 1,200 engines have been dealt with. Similarly, half of the total cash costs ($1.5bn out of $3.0bn) is expected to be in 2025 because they are “principally related to the timing of customer payments”.

Long-Term Impact Should Be Modest

RTX expects limited financial impact from the “powdered metal” issue beyond the 2023-25 figures above. As CFO Neil Mitchill explained on the call:

“We talked about the $3bn of cashflow between now and 2025. I think that’s preponderant of the cashflow that we are talking about in terms of the headwind ... We don’t see a long-term negative cash impact dragging on past the completion of these accelerated inspections. So, as you get past 2025, we remain confident in the cashflow-generating capability of the program.”

We also expect only limited indirect impact from the issue. While the issue is negative to RTX’s reputation, it is clearly making a huge effort to fix it and will be compensating customers. Engines have extremely long lifecycles, and a sizeable customer base is already locked in for the coming decades within the existing fleet and backlog. The aerospace industry is heavily consolidated, with only 2-3 providers for each major engine type. We also note that CFM International (a GE-Safran joint venture), the main competitor to P&W, is currently dealing with its own quality issue involving bonus parts from a U.K. supplier (AOG Technics) that have gone into many of its engines. RTX was unlucky, not bad.

Limited Visibility on Short-Term Costs

While the scope of the new plan likely represents the maximum of what needs to be done, the estimated costs associated with the new scope are much more uncertain.

“Customer support” costs, by far the biggest component (80% of the total), will ultimately depend on both how much RTX’s plan will disrupt airlines and how much the airlines will need to be compensated. RTX seeks to mitigate the disruption by expanding its production rate and workshop capacity, but investors’ visibility on both is limited. Our visibility over RTX’s contractual obligations towards airlines and local laws around compensation in each jurisdiction is even lower. The ability (and willingness) of RTX’s program partners to shoulder their share of the costs adds further uncertainty. The final outcomes on customer compensation may not be known for years. These uncertainties likely explain the collapse in RTX’s share price in recent days.

Confidence in Long-Term Outcome

What is more certain is that the costs are one-off in nature, will only materialize over time and are manageable even if they were to escalate,

RTX currently generates about $5bn of FCF each year excluding the “powdered metal” issue, and the $3bn total cost will only come due over several years. Even if it were to double to $6bn, or triple to $9bn, etc., the long-term viability of RTX is not at stake (though it may have to suspend its dividend in an extreme scenario), and its FCF would still eventually grow to the $9bn figure it targeted for 2025 as recently as July.

With this in mind, whether the one-off cost is $3bn, $6bn or even $9bn, the nearly $34bn decline in RTX’s market capitalization (from $143bn to $109bn) since July 25 represents a significant over-reaction in our view. It is simply wrong that the discounted present value of an $3bn one-off cost should imply a $34bn reduction in RTX’s intrinsic value.

This logic implicitly assumes that the market valuation on July 24 was no more than fair. However, even if we do not believe this, RTX shares are cheap relative to the $10bn of FCF we believe it will generate soon after 2025.

Achieving $10bn FCF After 2025

We still see RTX achieving its original $10bn FCF target soon after 2025, as it is a realistic figure compared to its track record and previous company targets, before they were impacted by one-off events.

Before COVID-19, RTX had generated a pro forma FCF of about $6bn, or $7bn excluding $1bn of upfront GTF engine losses, and management had targeted a FCF of $8bn in 2021 at the time of the UTX-Raytheon merger:

RTX Free Cash Flow - Historic & Targets

Source: RTX company filings.

COVID-19 was a significant negative for RTX as its commercial aerospace revenues fell with sharply reduced air travel, and high inflation also reduced earnings at the defense segments. However, RTX still generated FCF of $5.01bn in 2021 and $4.88bn in 2022. Prior to January 2023, RTX had targeted a 2025 FCF of $10bn, before new U.S. tax rules around R&D cost amortization shifted FCF outwards and led management to reduce the 2025 FCF target to $10bn. The latest 2025 FCF target is $7.5bn, after $1.5bn of expected headwind from the “powdered metal” issue.

We consider the original $10bn target, which implies a CAGR of just 6% from pro forma 2019 (excluding upfront GTF engine losses) as realistic. RTX is a leading player in an oligopolistic industry that enjoys the twin growth engines of growing passenger air travel and rising defense spending, and the demand for military products has risen significantly with the Russian invasion of Ukraine and rising geopolitical tensions in the Asia-Pacific.

Limited P&L Impact, Spread Over Time

We have focused on the cash impact of the program because we believe this to be the most meaningful.

The P&L impact will be spread over time, partly for accounting reasons. RTX will be taking non-recurring charges of ~$5.5bn in sales and ~$3.0bn in EBIT in Q3 2023, which represent “most” of the costs. However, these will not impact Adjusted Sales or Adjusted EPS, and the 2023 outlook for both remain unchanged:

RTX Updated 2023 Outlook

Source: RTX investor update presentation (11-Sep-23).

The rest of the costs are expected to be spread across 3-4 years, with some out to as much as 15 years.

As we explained previously, aftermarket revenues and costs for P&W engines under long-term contracts are reported under “percentage-of-completion” accounting, with the costs of repairs amortized over time. Management confirmed on the call they “don’t see it being a significant impact to GTF margins” over time, let alone P&W or RTX margins.

2025 P&L Targets Reaffirmed

Similarly, management has reaffirmed RTX’s 2020-25 “commitments” for sales growth (a 6-7% CAGR) and segment margin expansion (total expansion of 550-650 bps), as well as to return $33-35bn of capital to shareholders by 2025:

RTX 2025 Commitments

NB. 2025 FCF target of $9bn has been amended and is not shown. Source: RTX investor day presentation (19-Jun-23).

The one 2025 target that will not be met is FCF. RTX now expects to generate $7.5bn of FCF in 2025, down from $9bn.

Specifically, for 2023, management expects to pay its current dividend and complete its announced buyback program. (These are expected to cost roughly $3bn each this year.) For 2024, while not giving cashflow guidance for now, CEO Greg Hayes’s comments on the call imply both dividends and buybacks will continue. Much more definitively, he also committed RTX to maintaining its investment grade credit rating.

We believe RTX can certainly continue its dividends and investment grade credit rating, though buybacks may have to be reduced temporarily. RTX’s FCF was $4.89bn in 2022 (after an $1.6bn impact from new tax rules on the amortization of R&D costs) and originally expected to be $4.8bn in 2023 (after an $1.4bn impact from the same new tax rules) before a $0.5bn impact from the “powdered metal” issue. Net Debt was $30.0bn at the end of Q2 2023 (excluding leases, pensions and minority interests), equivalent to 2.5x 2022 EBITDA.

RTX Current Valuation

With shares at $74, relative to its updated 2023 FCF outlook of $4.3bn, RTX has a FCF Yield of 3.9%:

RTX Earnings, Cash flows & Valuation (2020-23E)

Source: RTX company filings.

RTX pays a quarterly dividend of $0.59 ($2.36 annualized), raised by 7% year-on-year in April, which represents a Dividend Yield of 3.1%.

RTX has an ongoing $3bn share repurchase program for 2023. As of Q2 2023, there had been $1.16bn of buybacks year-to-date; the remaining $1.84bn is equivalent to 1.6% of the current market capitalization.

RTX Stock Forecasts

We reduce our FCF assumptions in 2023-25 to reflect the new “powdered metal” costs, and also reduce our near-term buyback assumptions. We also extend our forecasts to 2026, when we assume RTX will generate a FCF of $9.5bn. Our new assumptions are:

• 2023 FCF of $4.3bn (was $4.8bn)

• 2024 FCF of $6.0bn (was $7.0bn)

• 2025 FCF of $7.5bn (was $9.0bn)

• 2023 share count to fall by 1.5% (unchanged)

• Share count to be flat in 2024 and fall by 0.5% in 2025 (was down 1.5% each year)

• 2026 share count to fall by 1.5% (unchanged)

• Payout Ratio to be 65% in 2024-25 (on FCF) (unchanged)

• FCF Yield at 5.0% at 2026 (implying a 20x multiple)

Our new 2025 FCF/Share forecast is $5.18, 19% lower than before ($6.38); our 2026 FCF/Share forecast is $6.67:

Illustrative RTX Return Forecasts

Source: Librarian Capital estimates.

With shares at $74, we expect an exit price of $133 and a total return of 96% (23.6% annualized) by 2026 year-end.

We reiterate our Buy rating.

Ends

Stocks mentioned: RTX 0.00%↑ . We are long.

Disclaimer: This article consists of personal opinions, based on information believed to be correct at the time of writing, but not guaranteed. We undertake no responsibility in updating content in this article. Nothing published here should be taken as financial advice.