Investors in RTX(NYSE: RTX) already have a good idea of where the aerospace and defense company might be in a year. Management has set a free cash flow (FCF) target of $7.5 billion in 2025 as it builds on the recovery in commercial aviation and executes on a growing backlog in defense.
But what will the company's outlook be after that, and will its valuation justify buying the stock? Here's the lowdown.
RTX's commercial aerospace growth prospects
In regular times, RTX tends to generate roughly half of its revenue from commercial aerospace and half from defense. Let's start with its commercial aerospace business, which has excellent long-term growth prospects.
The commercial market is split between original equipment manufacturers (OEMs) driven by new airplane production, and the aftermarket, which is driven by passenger traffic and aircraft use. For an approximation of the long-term growth rate of both markets, Boeing's long-term commercial market outlook calls for airplane fleets to grow at a 3.5% annual rate from 2023 to 2042 and passenger traffic to grow by 6.1%. RTX is well positioned in each market.
Pratt & Whitney, its engine and engine aftermarket business, serves both the commercial and defense aerospace markets. Its most exciting long-term growth opportunity comes from the aftermarket on its geared turbofan (GTF) engines used on the Airbus A320 neo family of aircraft and the Embraer E-Jets E2 airplanes. The GTF is one of two options on the Airbus A320 neo family. As Airbus ramps up production and aircraft are flown more, Pratt & Whitney will generate decades of lucrative aftermarket revenue.
Meanwhile, the other commercial aerospace-focused business, Collins Aerospace, benefits from both the OEM and aftermarket and is a leading provider of various components including avionics, structural components, electrical systems, cabins, power solutions, and interiors. Its size and scale mean it is highly likely to generate industry growth rates, at the least.
Image source: Getty Images.
RTX's prospects in defense
RTX's defense-focused segment, Raytheon, manufactures missiles and defense technologies (including the Patriot air and missile defense system), and space and intelligence systems. The U.S. government was responsible for 46% of its sales in 2023. As such, every defense budget is closely watched.
While global defense spending was at an all-time high of $2.4 trillion in 2023, and the U.S. defense budget is at a record $886 billion, it's important to note that this is a period of heightened geopolitical tension. Moreover, while $886 billion is vast, it's only a 3% increase on the previous year's budget.
Raytheon's medium-term revenue outlook is good, but the long-term growth rate might likely be closer to low single digits. In addition, defense companies -- like RTX, Lockheed Martin, and Boeing's defense segment -- have had issues with margins recently.
Lockheed Martin's CEO has discussed the possibility that the U.S. government was taking better advantage of its strong bargaining position. In addition, heightened geopolitical tensions make trade more challenging and pressure supply chains and material availability, mainly due to imposed sanctions -- a byproduct of the same forces driving increased defense demand.
Image source: Getty Images.
Where will RTX stock be in 3 years?
If RTX delivers on its free cash flow goal, the stock was trading at roughly 18.7 times that amount as of Tuesday. That would be a 7% discount to the rough valuation of 20 times free cash flow you might expect from a mature industrial company. By "mature," I mean that the company's earnings growth aligns with nominal gross domestic product (GDP) growth.
That might seem an easy hurdle to overcome, because economists and investors usually focus on real GDP growth (which excludes inflation) in the low single digits. However, it's a different story if we include inflation and look at nominal GDP. Year-over-year nominal GDP growth was 5.5% in March and entered the year at a 7.1% rate.
As noted above, RTX does look undervalued, even if you assume it only has nominal GDP growth prospects. Looking into the crystal ball, the commercial aerospace business has the kind of high-to-mid-single-digit growth drivers that investors want to see.
Still, the long-term defense outlook is more subject to debate, and it makes sense to pencil in low-single-digit growth until something changes on the margin performance front.
As such, RTX stock will likely be higher in a few years, but don't expect stellar returns.
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Lee Samaha has no position in any of the stocks mentioned. The Motley Fool recommends Lockheed Martin and RTX. The Motley Fool has a disclosure policy.
