Is Rockwell Collins Making a Huge Mistake in Buying B/E Aerospace?

WhenRockwell Collins(NYSE: COL)announced earningslate last month, it was a good news-bad news kind of a report. On the one hand, the company's $5.51 in full-year fiscal 2016 earnings were its best ever, and up a respectable 6% over last year. On the other hand, Rockwell's sales of just $5.26 billion barely budged from 2015 levels. Luckily, management has a plan to fix this, and get those revenues growing again:

Rockwell Collins is buyingB/E Aerospace(NASDAQ: BEAV).

Rockwell Collins, already one of the biggest players in aircraft avionics, aims to acquire B/E Aerospace, one of the biggest names in aircraft interiors. Image source: Getty Images.

How the deal will go down

Most of the financial pressso far has focused on what this deal means to Rockwell and its effort to roll up the airplane parts business, becoming a bigger player and better able to negotiate good prices when outfitting airliners for major plane builders such as Boeing and Airbus. Here at the Fool, though, our focus is on the individual investor -- so here's whatthis news means to you.

Beginning with the basics, Rockwell has agreed to pay $62 a share for B/E Aerospace. B/E shareholders will receive $34.10 cash, and $27.90 worth of Rockwell Collins stock, for each share of B/E they own. Rockwell characterizes this price as a "22.5% premium" to what B/E stock was worth "on Friday, October 21, 2016."

Investors appear to view the price as fair, with other bidders unlikely to materialize, and expect the acquisition will likely succeed. As of today, B/E Aerospace stock is selling for $59 a share, and sits within just 5% of the expected purchase price.

What it means for Rockwell Collins

This is a big deal for Rockwell Collins. The company will be spending the equivalent of $6.4 billion for B/E Aerospace, and assuming $1.9 billion of B/E's debt as well. Combined, that values the deal at $8.3 billion -- and Rockwell has a market capitalization of only $10.6 billion itself.

Once the deal is finalized -- and a "spring of 2017" closing date is anticipated, so this could happen in as little as six months -- the two companies could enjoy a market capitalization of $16.8 billion. With debt factored in, the new and improved Rockwell Collins should sport an enterprise value of perhaps $20.5 billion.

Valuing the new company

Management says the transaction will also result in a company boasting $8.1 billion in annual revenues and $1.9 billion in earnings before interest, taxes, depreciation, and amortization (EBITDA). Rockwell Collins also argues that the merged company will generate "over $6 billion in free cash flow over the next five years with expected free cash flow conversion of greater than 100 percent."

That works out to annual free cash flow and earnings both averaging roughly $1.2 billion per year, and enables us to posit the following, very rough, valuations on the stock:

  • Price-to-sales ratio: 2.1
  • P/E: 14
  • Enterprise value to EBITDA: 10.8
  • Enterprise value-to-free cash flow: 17.1

The upshot for investors

Compare the numbers above to the ones currently reflected for Rockwell Collins on Yahoo! Finance, and what you'll find is that the combined Rockwell Collins-B/E Aerospace will bear P/S and P/E ratios little changed from Rockwell's own. The EV/EBITDA ratio will be a bit richer. Most importantly, though, Rockwell is promising a great big jump in the production of free cash flow -- a jump that will bring its current valuation of 20x FCF down by 15%.

What this implies is that the new and improved Rockwell Collins stock may well be cheaper than the company is in its current form. If that's the way things play out, then this acquisition -- which since it was announced has already produced 17% profits for owners of B/E Aerospace stock -- could do good things for owners of Rockwell Collins-B/E Aerospace stock as well.

Rather than cashing out on the news, B/E Aerospace owners might want to hang onto their new Rockwell Collins stock, stick around a while longer, and see how this thing plays out.

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Fool contributorRich Smithdoes not own shares of, nor is he short, any company named above. You can find him onMotley Fool CAPS, publicly pontificating under the handleTMFDitty, where he's currently ranked No. 333 out of more than 75,000 rated members.

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