RTX - Use Current Undervaluation To Buy RTX Corporation

2023-07-26 03:50:02 ET

Summary

• RTX, formerly Raytheon, is facing a 14% drop in pre-market trading due to a problem with jet engines in its Pratt & Whitney segment.
• The company is expected to benefit from increased defense spending by NATO countries, driven by geopolitical tensions and depleted weapon stockpiles.
• Despite lowered free cash flow guidance and manufacturing defects, the company's Q2 results were strong, and the current stock slump could present a buying opportunity.

Investment Thesis

RTX ( RTX ), formerly Raytheon, is currently losing 14% in pre-market trading due to a problem in the Pratt & Whitney segment with jet engines. However, the Q2 results were otherwise good, and the order backlog continues to rise. Given the general world political situation and the fact that the USA is challenged as a world power as never before, it seems that the West and the East will enter into a new arms race. This should give a long-term boost to the company's military division. In addition, the company is attractively valued, especially after the 14%.

Defense spending and NATO

RTX is a direct beneficiary of this year's record U.S. defense budget spending. This amounts to $817B, 4.6% more than last year, and is generally increasing for decades. However, the increase would not be so huge if inflation were factored out.

A big difference to the past years and even decades is that not only did the United States increase their military spending, but also the European allies, triggered by the Ukraine war. This significant increase in defense spending is even without alternatives since the European weapons stockpiles are almost empty , according to their statements.

The turnaround since Russia’s Feb. 24 invasion of Ukraine has been nothing less than stunning, to the point that six NATO members have now pledged defense increases of $133 billion so far; militarily neutral Sweden has also pledged an increase. The first to make a 180° turnaround was Germany. Just four days after Russia’s invasion began, Chancellor Olaf Scholz announced his government would ramp up its defense spending in 2022 alone by €100 billion ($112 billion) taking defense spending from 1.53% of GDP to above 2%.

Breaking Defense

The article linked above about empty European stockpiles is from December 2022. Meanwhile, several Western articles and also statements from President Biden suggest that even American stockpiles are nearly empty for at least some weapons systems. And we don't know how long the Ukraine conflict and the Western weapons support will last. The Western arms depots may remain empty for several years because everything newly produced might be sent directly to Eastern Europe. This is not a certainty, but it is a possibility, and, based on the way things are looking at the moment, it seems quite likely. But even if arms deliveries were stopped tomorrow, it would still take years to replenish the country's own stockpiles.

And then there is also a possible conflict in the Pacific. We should all hope there will be no direct war between China and the US, and preferably no proxy war where Taiwan becomes the new Ukraine. But it is a possibility, and currently both sides are preparing for a possible conflict. The mere possibility and that China is rapidly upgrading its military compels the U.S. to do the same. In an article about Lockheed Martin ( LMT ), I wrote.

Even if the Ukraine conflict ends, the USA will concentrate more on the Pacific because there lurks the biggest challenger of the US hegemony position. This is also a change from the past: for decades, there was a military challenger in the form of the Soviet Union but no economic one. That has changed, and at the moment, unfortunately, it looks like we are witnessing a new split between East and West, as well as a new arms race.

Lockheed Martin Is A Beneficiary Of Geopolitical Tensions

All in all, the world is once again splitting into different blocs , and the Russian-Chinese axis is the greatest challenge to Western hegemony that has ever existed. We should all hope that it remains peaceful, but at the moment, it looks strongly like a new arms race.

Financial Progress & Trends

First, a short overview over a longer period for revenues, expenses, and net income. Since the end of the pandemic, the numbers have been moving in a positive direction

In the chart above, you can see that the gap between sales and expenses is tending to widen, which means that recently the margins have been improving, as can also be seen below.

Interestingly, despite the war, empty arsenals, and rising defense spending, there has been relative underperformance since 2022, especially against Lockheed Martin, and already for over a year against the S&P 500. Over the past ten years, the stock has generated a return of 86% and the S&P 500 227%.

Q2 results

I am writing this article while pre-market trading is still ongoing; the stock is losing about 14%. The lowered free cash flow guidance from $4.8B to $4.3 is about 10% less, and that's just this year. If the stock loses 14%, it becomes cheaper from that perspective.

... after the aerospace and defense company said its Pratt & Whitney unit found a manufacturing defect in some jet engines. Management lowered its full-year guidance for free cash flow to $4.3 billion from approximately $4.8 billion.

SA News

This is also surprising as the Q2 results were otherwise excellent, with beats in both revenue and EPS. They also slightly raised their overall guidance for this year's sales. Here is a summary of the key results - all numbers you can see here .

In addition, there is a huge and further increasing order backlog.

Valuation & Outlook

The company is currently valued at an enterprise value of $152B. The market cap is $122B, and the net debt is about $31B. Regarding valuation on a forward P/E basis, today's roughly 14% plunge in the stock makes it the cheapest buying opportunity in a year.

And even before this drop, estimates for the next few years looked quite positive. The pre-market 14% drop is not yet reflected in the estimates below.

Risks

China is currently one of the reasons why the USA is both arming itself and exporting weapons to Taiwan, among others. However, this is also a risk on several levels. Firstly, after these arms sales to Taiwan, China has sanctioned the RTX CEO (although it is unknown exactly how). Secondly, the company's production facilities would possibly be among the first targets in an actual war. However, this is only a risk in the worst-case scenario: a hot war between China and the US. If it comes to that, probably every stock would massively lose, and we all would have significantly larger problems than our stock portfolio.

But there are other risks. Recently, the CEO said decoupling is impossible and that the company itself has "several thousand suppliers in China" and also needs China's rare earths. That means in a conflict over Taiwan, it would be likely that China could bring production to a near standstill with mere economic sanctions and would not have to attack U.S. soil.

Greg Hayes, Raytheon’s chief executive officer, said the company has “several thousand suppliers in China and decoupled…” . . is impossible”.

“We can mitigate risk, but we can’t decouple it,” Hayes said in an interview with the Financial Times.

“Think of the $500 billion trade that goes from China to the US every year. More than 95 percent of rare earth materials or metals come from or are processed in China. There is no alternative,” Hayes said.

ustoday.news

In the long run, I think this risk of dependency will become less and less. At the very least, it would be strategically wise for the U.S. and RTX to either bring suppliers back into their own country or distribute them to more countries.

Share dilution, insider trades & SBCs

For me, these three things are standard checks I make in every article, as excessive stock dilution and stock-based compensation can put us, shareholders, at a disadvantage. As for insider sales, there was only one for a small amount in March. Over the last 2.5 years, buybacks have made up 4% of outstanding shares, as shown in the chart below. SBCs are at a reasonable level; no comparison to the proportions at some tech companies.

Conclusion

Geopolitical opportunities offset the geopolitical risks; I believe the overall situation will lead to rising military spending by NATO countries, and overall I think a hot US-China war is still rather unlikely. The pre-market 14% slump also seems exaggerated, which could mean an attractive rebuy or entry opportunity.

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