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I view the current headwinds as being short-term in nature and expect that business conditions in the commercial aerospace segment of RTX's business will improve in once COVID-19 vaccines have been developed.
Summary
- RTX’s is experiencing challenges in its commercial aerospace business.
- Although RTX recognized non-recurring and non-operational items in Q2 which contributed to a $3.18B goodwill impairment and a $3.835B Q2 loss, these charges did not impact free cash flow.
- At the end of Q2 (June 30th) RTX had an order backlog of $158.7B of which $85.6B was from commercial aerospace and $73.1B was from defense.
- RTX has ample liquidity and should be able to weather weak business conditions.
- The dividend appears to be safe and management expects modest share buybacks to occur in 2021 with an acceleration in 2022 and 2023 if business conditions improve.
Introduction
The last time I wrote about Raytheon Technologies Corporation (RTX) was in this June 10, 2019 article at which time United Technologies Corporation (UTX) and Raytheon Company (RTN) had recently announced a proposed merger of equals.
Fast forward to the present and the merger has been completed and Otis Worldwide Corporation (OTIS) and Carrier Global Corporation (CARR) have been spun off into separately publicly traded companies.
NOTE: The newly created RTX started trading April 3, 2020 and closed at $49.93 that day.
Business Overview
We are now looking at a very different company from that of June 2019. RTX is now a company which operates in five business segments:
- Integrated Defense Systems;
- Intelligence, Information and Services;
- Missile Systems;
- Space and Airborne Systems;
- Forcepoint.
Investors desiring to know more about these business segments are encouraged to review Part 1 Item 1 in RTX’s 10-K in which a discussion of some of the notable initiatives and achievements in FY2019, such as certain key contract awards and new product introductions, can be found. As with any other investment, I strongly suggest you also read Item 1A in which RTX discloses and discusses various Risk Factors.
Over the years RTX has morphed into what it is today through some major acquisitions and divestitures. Given this history, investors would not be faulted for wondering whether further transformational acquisitions or divestitures are in the cards.
On September 16th, RTX’s President and CEO presented at the Morgan Stanley Virtual 8th Annual Laguna Conference. In his presentation he indicated that RTX continues to be in the market for bolt-on M&A of small technology companies and that it looks for places where it has opportunities to buy technology versus inventing the technology internally. Those, however, are not big acquisitions and are likely to be well below $0.5B in total spend in the current year.
Furthermore, he indicated that M&A in the near term and in the medium term is going to be difficult and senior management has indicated that the portfolio that has been assembled means additional major acquisitions are not required to be successful or to leverage scale.
Q2 2020 and YTD Results
Results from the most recent quarter can be accessed here and here.
Looking at the Q2 results we see:
- An order backlog of $158.7B of which $85.6B was from commercial aerospace and $73.1B was from defense.
- The recognition of significant non-recurring and non-operational items which contributed to a $3.18B goodwill impairment and a $3.835B Q2 loss.
This goodwill impairment is related to the impact of the Covid-19 pandemic on RTX’s Collins Aerospace unit; the impairment has no impact on RTX’s free cash flow (FCF).
In Q2, Collins' revenue dropped 36.1% to ~$4.2B as its business was affected by domestic and global airlines reducing their orders during the quarter.
For the benefit of readers unfamiliar with ‘Goodwill’, this is an accounting term which arises when the value of a business exceeds its assets minus the liabilities and can arise when a company acquires another business; the amount of goodwill is the cost to purchase the business minus the fair market value of the tangible assets, the identifiable intangible assets, and the liabilities obtained in the purchase.
In the current challenging environment, RTX’s priorities are:
- The support of employees, customers and suppliers;
- Technology and product innovation;
- The execution of integration and deliver synergies;
- Disciplined capital deployment and maintaining strong liquidity;
- Maintaining financial flexibility;
- Structuring the business for long-term success.
We can see from the Q2 earnings release that RTX’s commercial aerospace related business is challenged. This is expected to persist as original equipment manufacturer (OEM) production levels and aftermarket activity remain low. As a result, senior management has taken the necessary actions to strengthen the business, including achieving previously announced cost and cash savings for the current fiscal year. In addition, ongoing progress continues to deliver cost synergies from the Rockwell Collins acquisition and the Raytheon merger.
At the Morgan Stanley Virtual 8th Annual Laguna Conference, RTX’s President and CEO indicated no guidance would be provided given the uncertainty regarding the recovery of commercial air traffic. He did, however, indicate that RTX is seeing a gradual return to flight across all of the commercial markets. A full return to 2019 levels is unlikely until somewhere around 2023 with the timing of an effective covid-19 vaccine being a determining factor as to when this recovery will occur in 2023.
He also indicated that as of the beginning of September, commercial air traffic was down ~45% globally versus a low of ~80% back in March. China is leading the recovery with commercial air traffic down ~5% domestically, but still down ~74% internationally. In addition, Europe is down ~43% versus a low of ~90% and North America is down ~39% versus a low of ~75%.
Q3 earnings should be more or less in line with Q2 earnings. Free cash flow, however, should be positive in Q3 which is slightly better than management’s breakeven thinking of a couple of months ago. In fact, for the year, FCF of ~$2B is anticipated.
On the FCF front, a metric I deem to be extremely important, RTX has reported ~$0.559B in FCF for the first half of the current fiscal year; management expects the 2nd half of the current fiscal year to generate ~$1.44B of FCF.
The commercial aerospace team is driving ~$2B in cost reduction and ~$4B in cash conservation actions in FY2020. This includes the elimination of more than 15,000 positions across the commercial aerospace and corporate organizations, a ~20% reduction in SG&A at Pratt and a ~12% reduction at Collins. These headcount reductions are nearly double the previous estimate of ~8,500 management provided in July; further ways to reduce structural costs in all businesses are also currently under review.
On the liquidity front, RTX closed Q2 with ~$7B of cash, ~$26B billion of net debt, and revolving credit facilities of up to $7B.
Credit Ratings
Following the completion of acquisitions, divestitures, and a merger of equals in recent years, RTX’s long-term debt rating assigned by Moody’s has dropped two tiers from A3 (lowest tier of the upper medium investment grade tier) last reported in September 2015 to Baa1 (top tier of the lower medium investment grade tier).
S&P Global rates RTX’s long-term debt A- which is the lowest tier of the upper medium investment grade tier and is similar to Moody’s A3 rating; the rating is under review with negative implications.
The ratings are satisfactory for my purposes and I envision that RTX should be able to improve its long-term debt credit ratings as business conditions improve.
In reviewing ‘Note 8: Borrowings and Lines of Credit’ in RTX’s Q2 10-Q which begins on page 33 of 115, I see nothing that alarms me. I am confident that RTX will be able to meet the terms and conditions of its attractively priced long-term debt.
Valuation
Determining RTX’s valuation must take into consideration the current challenging business environment. If one were to use Earnings per Share (EPS), which takes into account the significant non-cash related goodwill impairment charges incurred in Q2, we would not be able to calculate RTX’s P/E since there were no earnings.
Given this, I am using the mean adjusted EPS guidance for FY2020 of $2.87 from 18 analysts and $3.85 for FY2021 from 17 analysts. The range in estimates is quite wide with the FY2020 low and high being $2.12 and $3.62 and the low and high for FY2021 being $3.34 and $4.85. Clearly, even the analysts who closely follow RTX can’t agree on how the company will perform in the current environment.
If we err on the side of caution and use the low estimate of $2.87 for FY2020 and a current share price of $57.45 we get a forward adjusted PE of ~20. RTX has just recently completed the first 3 quarters of FY2020 so I am not averse to looking at RTX’s forward valuation for FY2021 using $3.34. On the basis of the current share price and $3.34 in adjusted EPS we get a forward adjusted PE of ~17.20.
Both the FY2020 and FY2021 forward adjusted PE levels seem reasonable to me and I acquired shares because I am of the opinion they have a reasonable probability of appreciating in value over the coming year.
RTX has changed dramatically in the past year, and therefore, investors would be wise not to compare RTX’s current quarterly dividend with the historical dividend levels of United Technologies and Raytheon (both which can be accessed from RTX’s current dividend history webpage).
At $0.475/share/quarter and a current share price of $57.45, the dividend yield is ~3.30%. Canadian investors holding RTX shares in a taxable account will incur a 15% withholding tax thus lowering the dividend yield to ~2.8%.
In this environment it is prudent to look at the probability a company may need to cut/freeze its dividend to conserve cash. This matter was addressed by RTX’s President and CEO at the recent Morgan Stanley Virtual 8th Annual Laguna Conference. A considerable degree of work has been done on this front by RTX’s CFO and his team which have looked at all the downside scenarios. The findings were presented to RTX’s Board in April and there was unanimous agreement that RTX has the financial flexibility to continue to pay the current dividend and to grow the dividend as earnings recover.
As a result of the United Technologies and Raytheon merger and Otis and Carrier divestitures, RTX’s share count has changed significantly. As at the end of Q2 2020 the Weighted Average Number of Shares Outstanding has increased to ~1,230 million (this includes the effect of the potential exercise of 4.9 million stock awards, including stock appreciation rights and stock options) from 862.3 million for the 6 months ending June 30, 2019.
RTX’s President and CEO has indicated that the company has the borrowing capacity if it wanted to commence share buybacks right away. In the current environment, however, where RTX’s airline customers and OEM customers are encountering difficulties, RTX has decided now is not the time to repurchase a lot of shares.
There are, however, some small divestitures in the works and once proceeds are received from these small divestitures, RTX’s President and CEO expects that some of the sale proceeds will be deployed toward share buybacks. Furthermore, as the company begins to get better clarity in 2021 about the shape of the recovery of business conditions it is likely that some modest share buybacks will occur with an acceleration in 2022 and 2023 if business conditions improve.
Final Thoughts
RTX is currently experiencing headwinds. I view its current challenges as an attractive buying opportunity and like that it is relatively evenly balanced between the ‘challenged’ commercial aerospace business and the ‘steady and reliable’ defense prime contracting business.
I like that RTX’s defense contracting segments are unlikely to be severely affected by the pandemic over the near-term. This line of business is not exposed to the business cycle as revenue is almost entirely funded by government spending. In fact, RTX’s missile and missile defense products are highly prioritized by the National Defense Strategy and modernization is expected to remain a priority.
The company has indicated it remains committed to the return of ~$18B - $20B of capital to shareowners over the next 4 years. This includes, at the very least, the maintenance of the quarterly dividend and the beginning of share buybacks in the foreseeable future.
Given my outlook on RTX, I have acquired an additional 300 shares @ ~USD $58/share for one of the accounts included within the FFJ Portfolio.
Stay safe. Stay focused.
I wish you much success on your journey to financial freedom!
Note: Thanks for reading this article. Please send any feedback, corrections, or questions to [email protected].
Disclaimer: I have no knowledge of your individual circumstances and am not providing individualized advice or recommendations. I encourage you not to make any investment decision without conducting your own research and due diligence. You should also consult your financial advisor about your specific situation.
Disclosure: I am long RTX.
I wrote this article myself and it expresses my own opinions. I am not receiving compensation for it and have no business relationship with any company whose stock is mentioned in this article.
