RTX - RTX Corporation: Well-Defined Value With Little Risk Of Becoming A Value Trap

2023-10-18 17:05:27 ET

Summary

• There are two stages involved in selecting a value stock: defining a stock selling below its fair value, and ensuring it is not a value trap.
• My favorite value stock is RTX Corporation, which I have owned for seven years.
• The article emphasizes the importance of thorough analysis and confidence in the chosen value stock.

There are two basic stages in selecting a value stock:

1. Use a number of criteria helpful in defining a stock selling below its fair value.
2. Go back over the numbers and the broad argument attempting to poke holes in your thesis until you are confident the stock is not a value trap.

My favorite value stock right now is one that I already own. In early 2016, the market underwent a 20% correction prompted by fear of Fed tightening and my response was to establish a position of some size in United Technologies ("UTC"). What I liked was its mix of civilian and military business and the fact that it was the leader in most of its businesses. It was familiar to me because I had looked at it from time to time over fifty years since it was United Aircraft.

In a convoluted series of moves beginning in 2018, UTC bought aerospace company Rockwell Collins and spun off its two major non-defense businesses, Carrier Global ( CARR ) and Otis Worldwide ( OTIS ), the leading producers of air conditioners and elevators. The goal for spinning off these businesses was to get rid of low growth businesses and improve the focus of United Technologies. In 2020 United Technologies agreed to merge with Raytheon, another defense company I had followed casually for many years. This cluster of actions was consistent with the general strategy of large defense companies to maintain or increase overall size while getting rid of non-defense business not compatible with defense businesses. Including its Pratt and Whitney engine manufacturing division the surviving company, formerly Raytheon and now called RTX Corporation ( RTX ), became the largest defense company by revenues, and excluding the non-defense of Pratt and Whitney the #2 defense business behind Lockheed Martin ( LMT ).

One result of the two spinoffs, one major acquisition, and the merger with Raytheon was that it became very difficult to measure longer-term trends in revenues, cash flow, or earnings. This is broadly obvious in the sharp drop in revenues with the departure of CARR and OTIS and their inexact replacement by the new Collins Aerospace division. Defense companies generally have moderate and lumpy but persistent growth in revenues, cash flow, and earnings. They pay solid and increasing dividends and regularly buy back shares. What they can provide in a portfolio is a diversifier with low correlation to all other positions.

Large defense stocks are low risk, with the major risk in making an unsuccessful bid and losing out on a major contract. This is a risk that is often mitigated by the fact that components are often outsourced. Wars do not necessarily boost defense stocks because of the long lead times required to ramp up production and acquire materials like rare earths. They are, alas, the beneficiaries of more or less constant demand from many countries which wish to improve their ability to attack or defend against their enemies.

How Did RTX Stumble Its Way Into Being A Value Stock?

Anyone who follows RTX even slightly knows that Pratt and Whitney Geared Turbofan - GTF - engines had a problem. The details have come out piecemeal and are open to a wide range of estimates of the ultimate cost, the best current number being something between $3.5 and $7 billion. The cause of the problem was the presence of a contaminant in the powdered metal used in the engines which will not cause the aircraft to crash but will produce earlier fatigue and more frequent maintenance. While engines currently being manufactured do not have the problem, estimates of the number of engines affected in the past has risen from 200 to 600-700.

Although earlier reports hinted at the problem, it was not addressed publicly until CEO Greg Hayes (who came to RTX from United Technologies) scheduled a specific conference call on September 11, thus getting the GTF engine problem out in front of the Q3 earnings report. That way it could be discussed briefly as something that happened in the past. As it turned out, the engine problem had existed from 2015 through 2021, meaning that it began before the merger with Raytheon and occurred very much on Hayes' watch at UTC.

It was not the first time United Technologies presented basic information after the fact and behind a bit of a smokescreen. Shareholders of Rockwell Collins complained that they had not been fully informed that with the upcoming United/Raytheon merger they were to receive in part shares of Carrier and Otis, which seemed much less attractive than the newly formed aerospace and defense company. Their protests evaporated, however, as the spinoffs outperformed the seemingly more desirable Raytheon Technologies, as spinoffs often do. Carrier tripled and Otis more than doubled. The former United management was left in the position of having told a fib (by omission) when the truth would have suited better.

Could the same thing be true of the way that RTX has fed out information on the engine problem? That may well be the case. As long as there are no major new developments to come to the fore, the problem with the GTFs is very unlikely to leave any lingering problem with RTX. What that leaves for the value investor is the need to assess how far below fair value RTX is trading specifically because of concerns about the engine problem.

Backing Into The Current Undervaluation

The basic premise of this article is that the GTF engine problem has reduced the stock price of RTX meaningfully but is likely to pass after a couple of years, leaving the future of RTX where it would have been if the GTF problem had never occurred. The major problem in determining this future value is the difficulty in factoring in future growth based on past growth. The combination of an acquisition, two spinoffs, and a merger makes the past five years a dubious basis for projection into the future.

Take revenues for example. Starting in 2018 from the low, the Revenue Growth number for the past five years produced by the Seeking Alpha Quant system is 14.59%, a number which evidently benefits from the low base in 2018. The One Year Forward Revenue Growth number using the same Quant system is a more plausible 4.5% as the low base of 2018 falls off. I could extend this phenomenon through other measures, but they would produce results equally unhelpful. The reality is that it's better to find a better method to assess the future of RTX, as it is likely to be on the far side of the GTF problem. The best approach is to compare RTX to a similar company in the same industry, in this case Lockheed Martin ((LMT)), which serves as a proxy for the Aerospace/Defense industry.

Despite being ranked #1 and #2 by revenue in the defense business Lockheed and RTX aren't exactly twins, mainly because RTX has the significant non-defense business of Pratt and Whitney. It is nevertheless a better comparison for RTX than Boeing ( BA ), where the non-defense business is much larger. RTX and Lockheed currently have market caps of $107 and $110 billion respectively, and Lockheed's 5-year Growth Rate (moved forward a year as I did with RTX) is 4.43%, almost exactly the same as that of RTX based on comparison of results in the SA Quant system. The companies are also entangled in many projects including the F-35 Joint Strike Fighter. The fact that RTX provides the more technically complex parts in that and several missile systems suggests anecdotally that it might have a higher growth rate in the future. Until the last two months, at least, the market apparently thought so.

The assumption should be that RTX and Lockheed should trade at roughly the same P/E ratio with roughly the same dividend yield. In fact, RTX trades at a P/E ratio of 14.7, about 10% lower than the 16.2 P/E ratio of Lockheed, while the decline in its stock price has resulted in a dividend yield of 3.19% to the 2.86% of Lockheed. The difference in both cases can be attributed to concerns about the GTF problem.

The chart below shows the one-year comparative performance of RTX and Lockheed. Note that longer charts do not produce a meaningful comparison because of - you may have guessed - acquisition, spinoffs, and mergers by RTX.

The above chart led me to look up and consider a few other numbers. Back to its days as United Technologies, RTX has grown faster than LMT in part because non-defense aviation generally grows faster (not of course in the recent years following Boeing's two crash catastrophes). As a result RTX has been priced as a "growthier" stock. As late as the end of June RTX had a 19 P/E, based on the promise of future growth while Lockheed was priced as a steady plodder with a 15 P/E. The GTF event has thus dragged the RTX P/E down by about 33%. Dividend yield on Lockheed was 2.7% in June, slightly higher than the present. RTX, however, had a 2.4% dividend yield, meaning that its stock drop increased the yield by 33%. The market cap of RTX in late June was $132 billion compared to $107 billion for LMT. Over that brief interval RTX thus lost almost 25% of its total market cap, far more than LMT (proxy for aviation/defense stocks).

All of the above numbers plus the above chart show the devastating effect the GTF problem has had on the market's valuation of RTX. The numbers on the chart may provide a best guess on RTX's undervaluation. After tracking very closely until August RTX fell about 24% more than LMT over roughly two months, meaning it would have to perform 33% better than LMT to get back to its place in A/D valuations.

According to the SA Quant system, LMT is now ranked #20 of the 69 stocks in the Aerospace and Defense Industry Group with RTX ranked #24. Both are ranked as Hold. The GTF problem ambushed the Quant system which had RTX ranked as STRONG BUY compared to LMT's HOLD. If it appears that the GTF problem will be resolved at a manageable cost with no lingering liabilities, RTX should begin closing the above gaps in valuation metrics in such a way as to warrant a return to its STRONG BUY status.

Conclusion

Many problems leading to lower valuation have long term impact, examples being a new competitor or loss of a suit with long term damages awarded to a large number of litigants. For defense companies mistakes tend to have a beginning and end. It was probably reasonable for CEO Hayes to speak of the engine problem as something that happened in the past and was being handled. There is no evidence that RTX will be stuck with the sort of problem which would make it a value trap. Unless there are more shoes to drop, a possibility which can never be ruled out completely, there is every likelihood that after some painful payments to airlines for time out of service RTX will eventually look back at the engine problem as a blip.

The strong potential for growth should not change. Before the problem with engines RTX was priced to outperform its peers. Within a couple of years, RTX Corporation should be priced that way again. Meanwhile, CEO Hayes assured on September 11 that capital return would not be affected, so that owners can expect a yield of more than 3% and continuing share buybacks while they wait. Looking at the above numbers, the best estimate is that over a period of years it should outperform its industry peers by at least 30-40%. RTX Corporation stock is a STRONG BUY and I may add to my position.

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