Raytheon Technologies, known now as RTX, will gamble a portion of its future on stock buybacks that will increase the stock price (and thereby compensation for senior executives with stock options.) Stock buybacks are good when funded from earnings and cash flow increases and when the company is flush with money. But RTX announced that it will use debt to fund its stock buybacks.
While leverage has its place, is using debt to buy back shares to increase the stock price logical? For RTX, a primary product of their largest division, the Geared Turbofan from Pratt & Whitney, still faces massive issues because of a production problem with powder metal for additively manufactured parts. While there is a plan to fix the problem by 2026, it will be high cost and take several years to execute fully. The critical question is, will this be the last problem with the engine? If the past is prologue, the answer is no.
The GTF engine suffers from high temperatures and durability issues in the hot section (e.g., compressor blades, combustor liners). It has been constantly plagued with reliability issues from the program’s inception. While this engine is exceptionally efficient, airlines find it difficult to keep these engines on the wing. The current problem will cost the company more than $5.4 billion to fix before all is said and done and will take several years, during which airlines will need to be compensated for aircraft downtime. Although some engines have been fixed in 35 days, with an expected average of 60 days per inspection of thousands of engines, this problem isn’t going away soon.
Investing more capital into the GTF engine is not guaranteed to solve the problems. Wouldn’t spending $10 billion on ensuring a solid future for the engine rather than buying back shares be a better use of those funds? But that use wouldn’t impact the share price nor contribute to executive compensation.
Return capital to investors
The arguments for and against share buybacks are well known. Typically, share buybacks provide a solid way to return capital to shareholders that allows the shareholders to decide on whether to sell or hold the stock. Returning money to shareholders via dividends impacts all shareholders irrespective of their investment outlook and doesn’t enable shareholder choice. Usually, share buybacks are conducted with excess cash and indicate that other profitable investment opportunities have been exhausted.
A Pratt & Whitney GTF in a test cell in Mirabel. (RTX)
In this case, the share buybacks are being funded with debt, which weakens the balance sheet. Fewer shares may help the per-share numbers look better, but at what cost? Management must know with substantial certainty that the company’s performance and value will enable it to repay that debt quickly once problems are solved. A share buyback is often viewed as a way for management to indicate confidence in the company. The problem for RTX is that Pratt & Whitney’s track record on GTF reliability is not great. This is an industry in which surprises can happen – just ask Boeing.
We’re headed into a future in which new propulsion technologies will likely replace today’s engines, whether with electric power or hydrogen-fueled using either direct burn or fuel cell technology. A transition away from conventional engines will be costly and likely result in a strategic advantage for first movers. Pratt & Whitney, a first mover on a large geared turbofan for commercial aircraft, is unlikely to be a first mover for an open rotor design, which its two major competitors are actively working on.
If that design is more efficient than a second-generation GTF, Pratt & Whitney could lose technology leadership and market advantage for the next generation of aircraft coming on board between the mid-2030s and 2040. Are there no technology investments with higher potential payoffs than the share buyback, or is management at RTX excessively risk-averse after the multiple problems in bringing a high-technology GTF engine to the market?
Before the MAX crisis crashed its share price, Boeing had an aggressive share-buyback program. Boeing spent $43 billion in “excess cash” on short-term improvement to shareholder value that, in the end, netted the company nothing. That spending on share price manipulation could have funded two new aircraft programs, something Boeing desperately needs to compete with Airbus effectively.
Poof, that potential funding disappeared into thin air with no lasting benefit for Boeing or its shareholders, whose shares are worth about half of what they once were. The Boeing lesson illustrates how to go from number 1 to number 2 rapidly by not investing in the future. Is RTX heading down the same path?
The Bottom Line
Share buybacks rank only behind excessive CEO compensation in the list of unpopular corporate actions. While there can be valid reasons for stock buybacks, three items are particularly onerous.
- First, the company cannot be sure that all future GTF problems have been solved, as the potential exists for new problems to emerge. With a 99.44 percent probability, can management state that the GTF is Ivory Soap pure and that all technical issues have been solved?
- Second, using debt to repurchase shares seems to be a strange way to take advantage of leverage, particularly if additional issues emerge that could require cash.
- Third, in an era when fundamental changes in propulsion are coming, one would think that investment in emerging technologies that could provide a first-mover advantage would be substantial. RTX share buyback indicates that those opportunities don’t exist, and that doesn’t pass our smell test.