The reinvention of United Technologies (NYSE: UTX) kicked into fifth gear with the company's announcement Sunday of a planned merger with Raytheon (NYSE: RTN). The deal, UTC's second major aerospace transaction in short order, creates a new powerhouse in the industry with broad exposure to both government and commercial contracts.
Terms of the deal call for Raytheon shareholders to receive 2.3348 shares of UTC for each share held. Post-deal, United Technologies holders would own about 57% of the combined business, called Raytheon Technologies, with UTC CEO Greg Hayes serving as CEO and Raytheon CEO Tom Kennedy to be named executive chairman.
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The deal is expected to be completed in 2020, with closing slated soon after completion of UTC's previously announced plan to split its aerospace, Carrier HVAC, and Otis elevators businesses into three publicly traded companies.
The combined company would have a pro forma market capitalization of about $120 billion and generate about $75 billion in annual sales, with exposure to a number of key aerospace and defense subsectors. It also marks a change of course for UTC back toward defense after selling helicopter maker Sikorsky to Lockheed Martin in 2015.
Here's a look at the new Raytheon Technologies and how investors should view the aerospace behemoth.
A more diversified portfolio
Raytheon is a defense specialist that's focused on missiles, radars, missile defense, and electronics. The company caters to some of the Pentagon's most pressing needs, but in years past has been vulnerable to slowdowns in Pentagon procurement. The stock languished in the early part of the decade due to partisan budget battles that led to sequestration.
United Technologies, meanwhile, is heavily exposed to commercial aerospace, which accounts for about three-fourths of total aero sales, and even after the company's $23 billion purchase of Rockwell Collins last year, it still faces pressure from aircraft manufacturers Boeing (NYSE: BA) and Airbus to bring down costs. It also owns Pratt & Whitney, maker of engines for both defense and commercial platforms.
The combined company would be much less exposed to the whims and cycles of either the government or commercial sector. About 55% of total revenue would come from defense, and less than 5% of combined sales are on projects that overlap. The new Raytheon Technologies would rank behind only Boeing and Airbus globally in terms of total aerospace sales, making the combination less reliant on any one piece of business and harder to push around in contract negotiations.
Although Raytheon and UTC don't often compete with each other, there are areas where they are complementary that could get a boost from the combination. Raytheon appears to lag Lockheed Martin in terms of hypersonic missiles, and UTC's Pratt & Whitney research and development team should be a boost to that effort. Similarly, Raytheon's large cybersecurity business should be of use as a resource to Rockwell Collins' defense electronics and avionics operations.
What's the downside?
Given there is so little overlap between the companies, the deal in theory should not face much antitrust scrutiny. But in comments made on CNBC Monday morning, President Donald Trump raised the specter of a prolonged review, lamenting the amount of consolidation that has already occurred in defense. The Pentagon supply chain has been under scrutiny recently from lawmakers, and this deal will offer Congress a chance to take a detailed look at the billing practices of UTC and Raytheon, similar to what TransDigm Group has endured this year.
The deal could also get caught up in geopolitical headwinds. UTC's purchase of Rockwell Collins was held up for months while regulators in China analyzed the transaction, and there have been some high-profile examples of both the United States and China playing hardball with corporations as part of the broader trade war between the two countries.
There are also only limited synergies to pull from the deal, putting the pressure on management to grow revenue and earnings without the crutch of massive cost-cutting. And because there is so little overlap, Raytheon and United Technologies will not enjoy the same cross-selling advantages that often come in a merger between two more similar corporations.
Deal integration could also be hindered by the broader shifts going on inside United Technologies. UTC announced its planned purchase of Rockwell Collins almost two years ago, and the aerospace organization has been in flux nonstop since. Hayes and his management team face the Herculean task of integrating Rockwell Collins, engineering a three-way split, and now planning the Raytheon integration all at the same time.
There's a chance a rival suitor could try to jump in and break the deal. Boeing has long been thought of as an ideal partner for Raytheon because it would combine the former's big project expertise with the latter's electronics and systems work. But given Boeing's commercial issues, management is unlikely to take on the distractions of a hostile bid at this moment, and it seems unlikely another bidder will emerge.
Great potential... eventually
United Technologies shares are up only 8% over the past five years, compared to a 92% gain for Raytheon and a 48% climb by the S&P 500. Part of that is industry-specific: It's been a strong few years for defense stocks. But UTC shares have largely been stuck in neutral due to uncertainty about deal-making and future corporate engineering plans.
With all the moving pieces surrounding this deal, investors should be ready for a similar performance from shares of UTC and Raytheon in the quarters to come. The stocks will likely trade in tandem, which also means that any weakness in UTC's soon-to-be-jettisoned elevator or HVAC units could weigh on Raytheon as well.
Over the long haul, the new Raytheon Technologies looks like a powerful combination with exposure to some of the higher-margin areas of both commercial and government aerospace and could well be a stock worth owning. But that promise is going to take some time to materialize.
Existing shareholders should buckle up and enjoy the ride, but there is no reason for new investors to climb aboard right now.
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