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Morningstar | United Technologies and Raytheon Will Combine to Form Megasize Aerospace and Defense Firm

In a surprise move, wide-moat-rated firms United Technologies and Raytheon announced plans to merge to create what will become the second-largest aerospace and defense firm as measured by 2019 pro forma sales. The announcement confirms credible rumors that surfaced June 8, suggesting that the parties were close to agreement on a merger. The deal is expected to close in the first half of 2020, after the planned spin-offs of United Technologies segments Otis (elevators and escalators) and Carrier (HVAC, refrigeration, and fire and safety). At a 57/43 ownership split in favor of UTC shareholders, the merger is the largest industrial M&A transaction of the year. Raytheon shareholders will receive 2.3348 shares in the combined company for each Raytheon share. The combined company will take the name Raytheon Technologies. UTC CEO Greg Hayes will stay on as CEO of the new entity, while Raytheon CEO Tom Kennedy will remain as executive chairman for two years. We are leaving our fair value estimates of $149 for UTC and $213 for Raytheon intact until we can more fully evaluate details of the deal.

Because the merger is a merger of equals without a takeover premium assigned and both firms trade at similar discounts to our fair value estimates, we don’t believe that the combination comes at the cost of either company’s shareholders. We think the combined company will benefit from increased scale, complementary technology that plugs the gaps of each separate company’s portfolios, and a portfolio that can offset a slowdown in either end market’s spending growth. We also don’t expect any significant hurdles on the regulatory front, given that both firms have minimal overlap in terms of their underlying businesses. Hayes generally loathes M&A activity with little chance of regulatory approval.

For proof, we point to UTC rebuffing an acquisition offer from wide-moat-rated Honeywell in 2016. Hayes justified this decision by maintaining that the neither of the two major airframe manufacturers nor U.S. regulators would ever approve the deal. Most of UTC’s and Raytheon’s overlap deals with defense systems, but United UTC’s strength lies in its commercial aerospace business, while Raytheon caters to defense. The new company will now have a 54/46 revenue split in favor of defense. The firms expect to return $18 billion-$20 billion of capital to shareholders in the first three years following the merger.

The new company is expecting pretax cost synergies of $1 billion split among supply chain and procurement ($350 million), corporate and segment consolidation ($325 million), facilities consolidation ($175 million), and IT and other selling, general, and administrative expense ($150 million). Other deal points include an expectation that combined debt will total $26 billion, of which UTC will contribute $24 billion. The company is targeting an investment-grade rating of single A. United Technologies will nominate 8 of the future 15 board members, while old Raytheon will nominate 7 including the lead director.

We were surprised by the announcement, given Hayes’ comments at the Electrical Products Group Conference, when he said he didn’t want to put the planned spin-offs of Otis and Carrier with some potential M&A transaction (albeit the spin-offs will take before the merger, and he may have referred to Otis and Carrier exclusively). Our chief insight into the deal is that UTC has decided that the best defense is a good offense.

We believe Boeing’s joint venture with French firm Safran to enter the auxiliary power unit market was clearly a defensive move amid fears of supplier consolidation. Now we think this is UTC’s latest move in the dynamic game of aerospace and defense M&A chess. We also believe this puts more pressure on competitors like General Electric, which is effectively out of the M&A market, considering that it could burn up to $2 billion in free cash flow this year.