RTX's Dividend Growth Trajectory Unlikely to Be Impacted by Engine Issues

RTX in late July lowered its 2023 free cash flow guidance by around 10% after identifying an issue with some of its aircraft engines that will require them to be removed from service for inspection earlier than expected.

This is not due to some critical design flaw but rather a manufacturing process issue with powdered metal used to make RTX's turbine discs between 2015 and 2021. Some of this metal could have been contaminated, potentially shortening the useful life of these high-pressure discs.

RTX uncovered this issue in 2020 when a turbine disc failed on an airplane. The company corrected the shortcoming in its powdered metal process and conducted over 3,000 inspections, finding a need to replace less than 1% of its discs.

This gave management confidence that RTX's disc turbines would safely last long enough until their engines' regularly scheduled service dates. But recent data analysis raised some doubts about this, resulting in an accelerated plan to inspect 1,200 possibly impacted engines within the next year.

Management should be able to provide an estimated total cost in October, factoring in data from the first wave of inspections taking place over the next month and the hefty compensation airline customers will receive due to disruptions to their flight schedules.

While this upcoming estimate could surprise investors again, this issue doesn't strike us as a major risk to RTX's long-term outlook or dividend profile. If we held shares, we would feel comfortable maintaining or increasing our position.

The aerospace and defense giant's free cash flow this year is now projected to sit near $4.3 billion, which still covers the firm's $3.5 billion dividend with a payout ratio near 80%.

While 2024's free cash flow will be impacted as well (only 200 of the 1,200 flagged engines will be inspected this year), there shouldn't be a lingering impact beyond the next year or two unless additional manufacturing defects arise.

S&P Global Ratings, which assigns RTX a BBB+ credit rating, similarly views "the scale of the problem as relatively moderate, based on preliminary indications."

Assuming no additional surprises, management previously guided free cash flow to hit $9 billion in 2025 thanks to continued strength in commercial aerospace markets and healthy defense budgets.

Even if this free cash flow figure came down by $1 billion, RTX could grow its dividend by 7% in each of the next two years and maintain a reasonable payout ratio near 50% in 2025.

RTX's ability to generate strong cash flow growth despite this setback reflects the firm's large and diversified business.

This engine issue is isolated in RTX's Pratt & Whitney (P&W) segment, which accounted for around 20% of adjusted operating profit in 2022 and was not expected to be the firm's primary growth driver the next few years.

Approximately 85,000 P&W engines are in service today, and less than 1.5% of them need to be reviewed for contaminated metal. There is much more to RTX than this short-term business problem.

Even if costs topped a couple billion dollars, RTX holds over $5 billion of cash, has less than $2 billion of debt maturing through 2024, and maintains low leverage.

Coupled with a massive installed base that provides predictable parts and service revenue and a company-wide backlog totaling $185 billion, RTX should remain a reliable cash cow while it addresses these challenges.

P&W also operates in an effective duopoly and has built a reputation for reliability since its founding in 1925. Along with the long design cycles for new planes and engines, we would be surprised if this isolated issue resulted in future market share losses.

More likely, P&W's profitability will take a short-term hit for a few years to make things right with customers. And by then, this situation will hopefully be in the rearview mirror for investors.

We will continue monitoring RTX as its makes progress inspecting its engines, with another update expected in October. Based on what we know today, we remain comfortable with the company's Safe Dividend Safety Score.