United Technologies Corporation (NYSE: UTX) is a more than $110 billion conglomerate, while Raytheon Company (NYSE: RTN) is a more than $50 billion U.S. defense contractor. The companies just announced that they were merging in a merger of equals, with Raytheon shareholders getting 43% of the company and United Technologies Corporation getting 57% of the company. The new company will be called Raytheon Technologies. The purpose of this article is to discuss this merger in detail and why it is a strong investment opportunity.
Let’s start with the meat of the deal, or the transaction and the details around it.
United Technologies as a company has three main operating groups. This is the core company, which contains the Pratt & Whitney division and the Collins Aerospace divisions. The other is the Otis division, which manufactures elevators, escalators, and so on. This is the largest such company in the world with more than 2 million such devices on service contracts, and many others being built.
The last division is the Carrier division. This division is a global provider of HVAC, refrigeration, building automation, fire safety, and so on. As part of the deal, United Technologies will continue its previously announced plan to separate Otis and Carrier into two separate companies. Going forward, the new company, “Raytheon Technologies Corporation,” will be made of the leftover parts of United Technologies.
Another financial aspect for the deal is the net debt of the company will be $26 billion. Out of this, $24 billion will be contributed by United Technologies. Still the combined company will be much stronger financially given its enormous size.
Going forward, the company expects $6 billion in combined cash flow for the year, which it expects to grow to $8 billion by 2021. Given it will be valued in the neighborhood of $150 billion enterprise value, this is a fairly respectable FCF ratio, especially in the defense industry, which tends to trade at a premium due to its steadier income.
More so, the strong balance sheet of the combined company and its earnings power are expected to result in significant benefits for shareholders. More details have yet to come out, but the two companies individually pay a dividend just above 2%. Given the combined market cap (without debt) should be roughly $120 billion, that means dividends should cost roughly $2.5 billion annually.
The company expects its strong financial position will enable it to reduce $18-20 billion to shareholders over the first three years. Given that dividends should use up $7.5 billion of this, it should allow the company to repurchase approximately 10% of its outstanding shares. This significant share repurchase should reward shareholders incredibly well.
The company expects the transaction will close in the 1H 2020, after the closure of the Otis and Carrier spin-offs.
Another major benefit of the deal are the synergies. United Technologies expects $1 billion per year in synergies from the combined company. That is effectively a double-digit cash flow growth from the synergies. United Technologies has shown a strong ability to achieve synergies - it achieved 20% more synergies than originally anticipated from the $30 billion Rockwell Collins acquisition.
Combined Company Portfolio
Now that we’ve discussed the details of the transactions and how it will work, it’s important to discuss the assets and income of the combined company portfolio.
(Revenue By Segment - Combined Company Investor Presentation)
The combined Raytheon Technologies group will be composed of 4 divisions, each one bringing $16-22 billion in revenue. These are 4 divisions essential to the functioning of the rapidly growing and modern aerospace division. The aerospace industry is on a long-term growth technology that is expected to continue going forward, which should help these divisions out.
More so, the combined company will be split well across the commercial aerospace and defense segments, with half of its revenue coming from each. The commercial segment will be able to take advantage of the rapid growth in the aerospace sector worldwide. The defense sector will help support revenues and cash flow, even in the event of a market downturn.
More so, the combined company will be massive. It’ll have $69 billion in annual revenue. For reference, other major competitors such as Lockheed Martin (LMT) have a $54 billion revenue, while General Dynamics (GD) has a $38 billion revenue. The only larger companies are Airbus (OTCPK:EADSF) and Boeing (BA), which have a revenue of $74 billion and $101 billion respectively.
Being a larger company will enable the combined company, as a supplier to the aerospace industry, to increase revenue and not be pushed around as a supplier.
Overall, this shows the strong portfolio of the combined company.
United Technologies Acquisition Spree
United Technologies has been on an acquisition spree since 2008. Since the crash, the company bought Goodrich for $18 billion, Rockwell Collins for $30 billion, and now this merger. For both of these previous acquisitions, the company’s synergies were significantly above the anticipated synergies. Its anticipated $1 billion of synergies could be beat significantly.
(Synergy History - Combined Company Investor Presentation)
However, there’s also something to pay attention too with the acquisition spree. As the legendary investor Warren Buffett has said, being in a position of leadership, it’s much more fun and entertaining to make exciting massive deals than it is to just sit there and run a business effectively. United Technologies has a strong track record, but this isn’t necessarily the best sign for management.
It’s also important to note that from this deal, United Technologies might become too big to make significant additional acquisitions - as can be seen from the fact that its revenue will be close to that of Boeing and Airbus. That means the company will have to switch to organic growth. Especially of concern here is increasing global trade protectionism of their own industries, which could hurt the combined company.
Still, the acquisition spree, along with small add-ons, should bring strong rewards to shareholders.
Combined Company Shareholder Rewards
At the end of the day, what’s important to pay attention to in any deal is the ability to reward shareholders.
(Combined Financials - Combined Company Investor Presentation)
The combined company’s sales should have annual operating profit of $9.3 billion in 2019, along with EBITDA of $13.5 billion. This will involve 12.6% operating margins. With this amount of earnings power, the combined company’s debt of $26 billion is incredibly manageable. The company expects a combined credit rating of approximately an "A".
That means that its debt load should be incredibly manageable, costing the company less than $1.5 billion in interest annually.
Overall, this $6 billion in annual FCF is incredibly impressive. By 2021, this should grow to $8 billion as a result of growth plus synergies, which is exciting to see. At the same time, the combined company plans to invest $8 billion in annual R&D expenditures, which should help the company to increase its revenue going forward and increase synergies.
This $8 billion in FCF will go with $2.5 towards dividends and trade with a P/E ratio that’s significantly lower. That leaves $5.5 billion, minus dividend growth, that the company will be able to use for share buybacks. That will enable it to repurchase roughly a mid-single digit portion of its company annually, which will significantly reduce outstanding shares.
This reduction in outstanding shares will reward long-term investors well. More so, it will generate a high-single digit return for shareholders going forward. In fact, minus the acquisitions of United Technologies, both companies have a long history of decreasing share count. (Raytheon outstanding shares, United Technologies outstanding shares)
How investors invest in this deal is up to them given the anticipated merger of equals. However, I believe this is a conglomerate worth investing in for the long run given three things:
- Management’s track record of successful large deals and the extraction of synergies.
- The combined earnings potential of the combined company, which will allow the dividend to continue along with an increasing share buyback.
- The technology portfolio, scale, and R&D investment of the combined company that will enable it to be a dominating market force in a growing industry going forward.
I personally already own shares of both companies but plan to significantly increase my investment in United Technologies. I believe that the market is undervaluing the value from the Otis and Carrier spin-offs, which are both incredibly strong companies in their own regard, and industrial companies have had a tough time recently.
More so, even in a late economic cycle, I believe the combined company will be incredibly value for the reasons discussed above. Timing the market is hard, but should prices drop even more, I plan to opportunistically add to my position in United Technologies until the completion of the merger.
I look forward to hearing what you guys think in the comments below.
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Disclosure: I am/we are long RTN, UTX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.