Earnings hindsight: RTX

RTX, the artist formerly known as Raytheon Technologies, wasn’t in my plans for this series. But news happens, and I got a lot of questions about that news. So here goes. Again, consider this a notepad of thoughts coming out of earnings. Please understand these are only my thoughts, and not me telling you to buy, sell, hold, or do anything else with this stock.

RTX 2Q 2023

My bias: RTX is a combination of Raytheon’s old defense business and United Technologies’ (mostly commercial) aerospace business, including Pratt & Whitney engines and Collins electronics and interiors. I don’t personally own this stock, and heading into earnings I would have rated it a “meh.” Somewhere in the middle of the aerospace and defense pecking order for me, neither a bad company/stock nor one I personally own.

• EPS: $1.29 vs. $1.18 estimate

• Revenue: $18.32B vs $17.68B

• Backlog of $185B

• Commercial: Collins revenue was up 29% YoY, Pratt & Whitney up 26%

• Defense was ok. Strong sales (missiles division up 13% thanks to Ukraine) but book-to-bill (a measure of future business vs. current) was just 0.92x

All good, right? Yet the stock was down 10% plus. Because of this…

• Free cash flow fell to $193M, vs. $807M last year

• Cut FY free cash flow guidance by $500M

Pratt & Whitney has discovered a condition in powder metal used to manufacture certain engine parts that will require fleet inspections. For a large number of planes. The engine in question is the PW1100G-JM engine fleet, which powers the very-popular Airbus A320neo. This is a crown jewel of the P&W family under threat. It is also a huge task: Think about 1,200 engines to be inspected, with each one needing to be disassembled to check.

Key quote: “So I would say, look, we're on top of it. We've got this. It's going to be expensive. We're going to make the airlines whole as a result of the disruption we're going to cause them. And I think we're going to work ourselves through it. It's not an existential threat to RTX. It's not even an existential threat to Pratt. It is a problem, and we have them every day, and we'll solve it.” — CEO Greg Hayes, from the conference call.

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It is good to hear Hayes say it is not an existential threat. That said, you never want a CEO of one of your investments to even have to debate whether or not something is an existential threat. The fact that you are having the conversation is bad news. Period.

From what we know, it appears it is a manufacturing issue, as in how the powders are blended and the parts are produced, and not an engineering issue. That is the best-case scenario, and Hayes believing it is the case is good news. But as he said this is clearly P&W’s fault, and they will have to make the airlines whole and reimburse whatever disruptions occur. And that, in Hayes own words, will be expensive.

The thing to worry about here is the cockroach theory. Turn the kitchen light on and if you see one cockroach, there are pretty good odds you have a lot more than one cockroach out of sight. We only have to look as far as General Electric or Boeing to see cases where bad news reproduces faster than rabbits. It’s a real worry, and not something we can’t confirm or rule out based on what is known today.

On the other hand, this is how engineering is supposed to work. Try, test, confirm, and continue to test as the product goes through its life cycle. The cockroach theory is possible. It is also possible this will be a one-off, very expensive in the near-term, but a nothingburger over a long enough period of time. And given demand for engines is huge and the lead time is long, customers don’t have an easy choice even if they wanted to swap out future orders to a GE alternative.

If a cockroach, the stock didn’t fall enough. If a one-off, the drop was a buying opportunity. So, what’s an investor to do?

How to think: I personally won’t be buying here. Not because I think it is a cockroach. I actually, if I had to guess, would say this will likely end up as a very good entry point. I also don’t think the stock is likely to bounce back quickly: Even in the best-case scenario, this is likely to take time to play out and information will continue to drip out from here.

If we assume this won’t be worst case, RTX at these levels is set up well to beat the market over the next few years. RTX has exposure to two strong trends in aerospace. The need for munition replacement following Ukraine, and the swollen commercial jet order book.

It also has a (at times) meh bunch of assets that have been chopped up and mixed more often than a tossed salad in recent years, with a tinkerer at the helm in Hayes.

All in, I’m intrigued by the drop and might start watching carefully to see what comes next. But I long ago decided I prefer other aerospace names for my set-it-and-forget-it style, and I don’t think the drop is enough to make me change course.

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