The deal makes sense both strategically, as it allows the combined company to capture a larger amount of the earnings created along the value chain and as it makes the combined company an even more dominant and important supplier.
On top of that, the deal also makes sense financially, as capturing synergies will create billions in value for shareholders, while a better negotiating position versus suppliers and customers could boost the margins of the combined company further.
Since this will be a stock-for-stock deal, debt is not a concern, and the combined company will have a very clean balance sheet and generate ample cash flows that will allow for strong shareholder returns going forward.
On Sunday, the two companies announced that they had agreed on an all-stock merger. It will be constructed as a merger of equals, where Raytheon's shareholders will receive 2.33 shares of the combined company for every share of Raytheon that they own before the merger.
This will result in Raytheon's owners owning 43% of the combined company, while United Technologies' owners will own 57% of the combined company.
Right now, the two companies have a combined market capitalization of $166 billion, with Raytheon being responsible for 32% of that, while United Technologies provides 68% of the current combined market capitalization. At first sight, it thus looks like Raytheon's owners will be the clear winner under the agreement, as Raytheon provides only 32% of the combined market cap right now, whereas Raytheon's shareholders will own 43% of the combined company following the merger.
This does not account for the spin-offs that United Technologies has planned for the first half of 2020, though, consisting of Otis and Carrier. These are United Technologies' elevator and cooling technologies segments that the company will separate and spin off to its shareholders before the merger with Raytheon is conducted. The value of these two businesses is included in United Technologies' current equity value but will not be brought into the combined company following the merger with Raytheon. It thus makes sense that Raytheon's shareholders will control a larger amount of the combined company relative to Raytheon's current portion of the combined equity value of the two companies.
When we look at the market's reaction to the merger announcement, we see that there are only modest moves in the share prices of Raytheon and United Technologies on Monday morning (RTN up 1%, UTX down 1%), thus, the market seems to agree that the merger details that executives of the two companies have agreed on are relatively fair to shareholders of both companies.
There are several benefits of such a merger in a strategic sense. Following the combination of the two companies, the newly created Raytheon Technologies will be an even larger and more important supplier to the aerospace industry. This will mean that customers such as Boeing (BA) and Airbus (OTCPK:EADSY) will be even more dependent on Raytheon Technologies in the future. This should lead to an improved negotiating position, and it should result in a larger market share.
As Raytheon Technologies will be a key supplier for several systems of aircraft manufacturers, it will be harder for these manufacturers to refuse Raytheon Technologies' attempts to sell additional systems or components. Raytheon Technologies will be such a large key supplier that Boeing and other customers could be pushed to buy all the goods that Raytheon Technologies offers, instead of shopping for individual suppliers for every system.
Raytheon Technologies will also have immense capabilities to develop new technologies and systems in-house, as the combination of the R&D departments of the two companies will result in a research powerhouse that will not be matched by competitors, which could improve Raytheon Technologies' technological edge versus competitors over time, which, in turn, should lead to a growing market share for the combined company.
One more reason why this merger makes sense strategically is that the combined company will be more diversified across business units. This will result in less cyclical results during downturns for certain markets, e.g. lower sales of Pratt & Whitney turbines during a potential downturn in the commercial aircraft industry would have a smaller impact on company-wide results following the merger.
Due to the fact that this will be a stock-for-stock deal, there are no financing costs or other huge additional expenses. The combined company will, however, be able to capture a meaningful amount of synergies once the merger is completed.
The two companies have announced that annual synergies should eventually cross $1 billion, which will positively impact the profitability of Raytheon Technologies. Combining overhead positions that are currently required at each of the two companies, and capturing other synergies across fields such as purchasing, warehousing, reporting, etc. will lead to a significant increase to Raytheon Technologies' profits.
Per the 10-Ks of the two companies, they have generated net earnings of $5.3 billion and $2.9 billion, respectively, during 2018. Combined, this results in $8.2 billion. The $1 billion in cost savings should result in ~$800 million of additional net earnings adjusted for additional tax expenses, which means that synergies alone will boost net earnings by ~10%.
Due to the fact that the two combined companies are worth $166 billion right now, per their combined market capitalization, and factoring in that synergies will lead to a ~10% boost to net earnings, one could state that the synergies related to the merger will create about $16.6 billion in value for shareholders, assuming the price to earnings multiple does not change going forward.
Raytheon had a net debt position of just $1.2 billion at the end of 2018 (10-K filing linked above), while United Technologies had a net debt position of $38 billion at the end of the most recent quarter (10-Q filing). Combined, this results in a net debt position of about $39 billion. This has to be adjusted for the debt that will be spun off via Otis and Carrier, though, and also for debt that the two companies will pay down during the coming four quarters. This is why the expected debt position at the time of closing is significantly smaller, at just $26 billion.
The two companies have generated a combined EBITDA of ~$16 billion during 2018. Even when we adjust this for the EBITDA decline due to the Carrier and Otis spin-offs, it is pretty clear that Raytheon Technologies will have a debt to EBITDA ratio of significantly less than 2 at the time of closing. Organic EBITDA growth and the capturing of synergies following the merger will make the leverage ratio decline even further, which signifies that Raytheon Technologies will be a company with a very healthy balance sheet.
This will allow Raytheon Technologies to pay out all of the company's free cash flows to the company's owners if the company wants to do that, as debt reduction is not necessary. $18 billion to $20 billion in shareholder returns during the three years following the merger have been announced, which equates to an annual shareholder yield of 4% - 5%, adjusted for the impact of the Otis and Carrier spin-offs. Investors can, therefore, count on ongoing dividend growth once the merger has been completed, I believe, while Raytheon Technologies should also be able to repurchase shares at the same time, which is welcome news for those investors that primarily seek share price appreciation.
The deal that has been announced by Raytheon and United Technologies looks good right now, as this will strengthen the company's position in the markets it is active in, while also enhancing R&D capabilities and improving the position versus suppliers and customers.
Capturing cost synergies will grow Raytheon Technologies' profits meaningfully, and last but not least, the combined company looks poised for a strong pace of shareholder returns following the merger.
The two companies have not looked like bad investments before the announcement, and they look like an even better investment right now, I believe.
The Power of Multiple Cash Flow Streams
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