RTX: “Powdered Metal” De-Risked Further & New $10bn Buyback

Company Update (RTX US) (Buy)

Highlights

• Analyses confirmed other engines will not see significant impact

• RTX will now buy back $10bn more shares this year

• Q3 was positive, with strong growth in commercial aerospace

• RTX’s market cap remains $27bn (19%) lower than on July 24

• With shares at $78.41, we see a 98% return (25.3% p.a.) by 2026

Introduction

RTX released Q3 2023 results on Tuesday (October 24); shares have risen 7.2% in the past two days, but remain 19% below what it was before July 25, when the “powdered metal” issue was first disclosed; its market capitalization is currently $27.1bn lower, disproportionate to the $3bn the issue is expected to cost (or any reasonable multiple thereof):

RTX Share Price (Last 1 Year)

Source: Google Finance (26-Oct-23).

The most important news was the completion of further analyses that confirmed the impact from “powdered metal” will be insignificant outside the plan on PW1100 engines announced last month. This gave RTX the confidence to launch a new $10bn accelerated buyback, funded by debt initially but to be offset by $3bn of disposal proceeds in 2024. Favourable recent IRS guidance is expected to benefit Free Cash Flow (“FCF”) by $0.5bn in 2023 and $1.7bn in the years up to 2026. Overall, management continues to expect FCF to reach $7.5bn by 2025.

Q3 2023 results were positive, with strong growth in Pratt & Whitney and Collins more than offsetting a margin decline (on moderately higher sales) in Raytheon. Full-year 2023 outlook was revised slightly, with an improvement overall.

At $78.41, RTX shares have a P/E of 15.6x and a FCF Yield of 4.2% relative to 2023 guidance; the Dividend Yield is 3.0%. Our forecasts indicate a total return of 98% (25.3% annualized) by 2026 year-end. Buy.

(For a recap of our RTX investment case before the “powdered metal” issue, see our Substack article in April.)

Further Analyses “Substantially Complete”

The most important news from Q3 results was the completion of further analyses on Pratt & Whitney’s (“P&W”) other engines, confirming that the impact from the “powdered metal” issue will be insignificant outside the PW1100.

As CEO Greg Hayes explained on the call:

“We've also made significant progress on the safety assessments for the other Pratt & Whitney powered fleets. That includes the PW1500, which powers the A220, the PW1900, which powers the Embraer E2, and the V2500, which powers the legacy A320. With the analyses substantially complete, we do not expect any significant incremental financial impact as a result of those fleet management plans.”

As with the PW1100, the key is that the actual inspection of the parts affected by “powdered metal” and their replacement are both relatively simple and cheap, and would cause minimal disruption if they could be fit within routine workshop visits that will be scheduled in any case. This means that, for the V2500, RTX expects to have only “100 or less” incremental engine removals (out of 6,000 flying) over the next 4 years; and, for the PW1500 and PW1900, the additional work “will largely fit inside the shop visit plans that are already in place for these fleets” (according to COO Chris Calio).

Work on the PW1100 engines so far also indicates that RTX’s outlook there “both financially and operationally remains consistent with our expectations”. As disclosed previously, of the $3bn expected cash cost associated with the PW1100 fleet management plan, 80% is expected to be “customer support” while 50% is expected to materialize only in 2025.

On F135 engines (for the F-35 fighter), RTX’s fleet management plan is still being reviewed by the joint program office, but management expects it to have “limited, if any” operational impact.

New $10bn Accelerated Buyback

The de-risking of other engines gave RTX the confidence to launch a new $10bn accelerated buyback.

CEO Greg Hayes was explicit about the reasons behind the new buyback:

“Simply put, we see a significant discount between the intrinsic value of RTX and our current stock price … What convinced the management team and the board that it was the right time is our confidence in the powdered metal resolution. And having bound the financial impact of that, we saw this as an opportune time to double down on the stock.”

The new $10bn share repurchase program will commence the day after Q3 results, and is expected to be completed by the end of the year. With shares at $78.41, it is equivalent to 8.8% of the current market capitalization. The new $10bn replaces all existing buyback programs. Given RTX has already repurchased $2.6bn of its shares year-to-date, this means buybacks are now expected to total $12.6bn in 2023.

The $10bn buybacks will initially be funded by debt. However, deleveraging is expected to begin in 2024, including with $3bn of proceeds in 2024 from agreed asset disposals (specifically the $1.8bn sale of Collins’ actuation business to Safran, and the $1.3bn sale of the Raytheon cyber security business, reportedly to Blackstone). RTX’s Net Debt of $29.8bn (as of September) is in any case moderate, implying an EV / LTM EBITDA of 2.7x (not adjusted for disposals), and management has reiterated RTX’s commitment to a “strong investment-grade credit rating”.

Higher FCF from New Tax Guidance

Favourable recent IRS guidance related to R&D capitalization is expected to benefit RTX’s Free Cash Flow (“FCF”). CFO Neil Mitchill explained this on the call:

“The IRS recently provided guidance on R&D capitalization with respect to customer funded R&D for certain cost plus contracts. This means a portion of our previously capitalized R&D costs for tax purposes will now be currently deductible. While this will result in a slightly higher effective tax rate going forward, it will reduce our cash tax payments.”

RTX estimates the FCF benefit to be by $0.5bn in 2023 and $1.7bn in the years up to 2026. As a result, 2023 FCF is now expected to be $4.8bn, from $4.3bn previously.

2025 $7.5bn FCF Target Unchanged

Notwithstanding the different moving parts, RTX reiterated their 2025 FCF target of $7.5bn, with the headwinds from asset disposals and higher interest expense essentially offset by the tailwind from lower cash tax payments.

As before, we believe this is achievable, given RTX generated about $6bn of FCF on a pro forma basis in 2019 (net of $1bn in upfront GTF engine losses), and still generated $4.88bn of FCF in 2022 despite a $1.6bn headwind from the implementation of new tax rules on R&D capitalization (which should dissipate over time):

RTX Free Cash Flow - Historic & Targets

Source: RTX company filings.

Similarly, given 2025 FCF is expected to be $9bn before $1.5bn of “powdered metal” costs, we continue to believe RTX can reach its original $10bn FCF target (at the time of the UTX-Raytheon merger) shortly after.

RTX Q3 2023 Results Headlines

RTX’s Q3 2023 results were positive, with strong growth in P&W and Collins more than offsetting a margin decline (on stable sales) in Raytheon, the newly-merged defense segment:

RTX Sales & EBIT by Segment (Q3 2023 vs. Prior Periods)

Source: RTX results releases.

Adjusted EBIT growth in Collins and Pratt & Whitney was driven by strong sales growth, which was in turn driven by 20-30% growth in Commercial Aftermarket and Commercial Original Equipment sales in each segment.

Adjusted EBIT margin in the Raytheon segment fell, despite sales growth of 2.6%, due to a mix shift to lower-margin programs and lower net program efficiencies, including additional headwinds on certain fixed-price development programs. Management expects margins to improve as Raytheon progresses through key milestones on the fixed-price development programs, but improvements will be weighted towards 2025. (Targets released at the June 2023 investor day include a 135 bps improvement by 2025, compared to 10.9% in 2020, which implies a 12.3% margin in 2025.)

Full-Year 2023 Outlook Raised

Full-year outlook was revised slightly, with expected 2023 Adjusted EBIT unchanged in Collins, increased in P&W and reduced in Raytheon, the net effect being a slight ($25m) increase in total segment Adjusted EBIT:

RTX 2023 Outlook (By Segment)

Source: RTX results presentation (Q3 2023).

Sales growth expectations were also increased for Collins and P&W, but kept unchanged for Raytheon.

For the group, this means slightly higher full-year expectations for both sales and Adjusted EPS:

RTX 2023 Outlook (Group)

Source: RTX results presentation (Q3 2023).

Expectations for FCF and buybacks have been raised more significantly for reasons explained above (tax and new buybacks respectively).

RTX Stock Valuation

At $78.41, on 2022 financials, RTX shares are at a 16.1x P/E and a 4.3% FCF Yield; on the mid-point of the 2023 outlook, RTX shares are at a 15.6x P/E and a 4.2% FCF Yield:

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

Source: RTX company filings.

RTX currently has 3.0% Dividend Yield, based on a quarterly dividend of $0.59 ($2.36 annualized), which was last raised by 7% in April.

RTX Stock Forecasts

We update our 2023 FCF and share count forecasts, but keep other assumptions unchanged:

• 2023 FCF of $4.8bn (was $4.3bn)

• 2024 FCF of $6.0bn (unchanged)

• 2025 FCF of $7.5bn (unchanged)

• 2026 FCF of $9.5bn (unchanged)

• 2023 share count to fall by 10% (was 1.5%)

• From 2024, share count to stay flat (was 1.5%)

• Payout Ratio to be 65% in 2024-26 (on FCF) (unchanged)

• FCF Yield at 5.0% at 2026 (unchanged)

Our 2026 FCF/Share forecast is $7.15, 7% higher than before ($6.67):

Illustrative RTX Return Forecasts

Source: Librarian Capital estimates.

With shares at $78.41, we expect an exit price of $143 and a total return of 98% (25.3% annualized) by 2026 year-end.

We reiterate our Buy rating on RTX.

Ends

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

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.