Over this past weekend, United Technologies Corporation (UTX) and Raytheon Company (RTN) announced that they were merging in an all-equity transaction subject to approvals. The combined company will be known as Raytheon Technologies Corporation. The merger creates an investment opportunity for those seeking both dividend growth and capital appreciation. United Technologies has a 25-year history of growing the dividend. In addition, United Technologies has a recent track record of successfully acquiring other large aerospace and defense companies. At the same time, United Technologies will divest large business subsidiaries through future spin-offs of Otis and Carrier. The future spin-offs should unlock value for these businesses. But, more importantly, it will allow the capital structure to be improved for the merged company. Furthermore, the newly merged company will have combined two companies with significant strength in aerospace and defense, positioning it for future growth in these markets that few other companies can match. For these reasons, the merged company gets my interest as a Dividend Growth Investor, and I view the merged company as a buy.
United Technologies and Raytheon Merger Details
Notably, the creation of Raytheon Technologies will attain pro forma revenue of ~$74B. This is more than Lockheed Martin Corp. (LMT) with ~$54B of revenue in 2018, the current largest defense contractor. But it is still behind Boeing Co. (BA) with ~$101B in revenue in 2018, the largest aerospace and defense company. The merged company will have capabilities in avionics, aircraft propulsion, ISR systems, PNT, and missile and missile defense systems, as seen in the chart below.
The current transaction is being billed as a merger of equals. Raytheon shareholders will own 43% of the merged company, and United Technologies shareholders will own 57% of the merged company. Raytheon shareholders will receive 2.3348 shares in the new company for each share of Raytheon that they own. The UTX Chairman and CEO will become the Executive Chairman for two years after the merger. The current Raytheon Chairman and CEO will assume the same positions in the new company. Notably, the deal is conditional on separation of the Otis and Carrier businesses from United Technologies.
Divesture Of Otis And Carrier Will Focus the Business And Improve The Capital Structure
United Technologies and thus Raytheon Technologies will be more focused and stronger financially after spinning out Otis and Carrier. Although the current merger is dependent on the separation of Otis and Carrier, this should not be a problem as these are essentially stand-alone businesses within the current conglomerate structure of United Technologies. The spinout of these businesses is supposed to take up to 24 months from the earlier announcement and cost $3B. But saying that, United Technologies was successful in selling its Sikorsky business to Lockheed Martin for $9B in cash. This provides some confidence that United Technologies should be able to complete the tax-free spinouts before closing the impending merger with Raytheon.
There are likely little existing synergies between the elevator, escalator, HVAC, refrigeration and building fire safety businesses with the commercial aerospace and defense businesses. The Otis and Carrier businesses are dependent on commercial construction and, to a lesser degree, on residential construction. By exiting these businesses, United Technologies will become a more focused organization before the merger with Raytheon. In turn, the merged company can focus forward on revenue and cost synergies in aerospace and defense rather than spinning out unrelated businesses.
The spinout will also permit United Technologies to realign its capital structure before the merger with Raytheon. Short-term debt was about $4,182M, and long-term debt was about $41B at end of Q1 2019 for United Technologies. The chart above indicates that Raytheon Technologies will have about $26B in long-term debt with an expected "A" credit rating. Of this total debt, about $24B will come from United Technologies and about $2B from Raytheon. This means that United Technologies will realign its current capital structure and assign about $20B to Otis and Carrier during the separation of these businesses and the remainder to Raytheon Technologies. This permits United Technologies to take advantage of Raytheon's balance sheet that carries little in the way of short-term debt at $800M and long-term debt at $1,361M. But this was offset with $2,093M in cash and cash equivalents. This is an advantage for Raytheon Technologies as it permits United Technologies to effectively reduce the large debt load from the relatively recent Rockwell Collins acquisition before the merger.
United Technologies Has A Recent History Of Successful Acquisitions
Since 2012, United Technologies has transformed itself from a diversified industrial conglomerate into a leader in aerospace and defense. This included buying Goodrich Corp. for ~$16.4B in 2012 expanding United Technologies' presence in commercial aviation. This was followed by the ~$30B acquisition of Rockwell Collins, forming Collins Aerospace expanding the avionics, defense and interior businesses.
In general, United Technologies has exceeded the announced cost synergies for its recent acquisitions. For the Goodrich acquisition, the expected cost synergies were $350M to $400M, but United Technologies realized over $600M in cost synergies as seen in the chart below. Similarly, for the Rockwell Collins acquisition, United Technologies expected cost synergies of $500M, but the revised estimate is now over $600M. The expected cost synergies for the impending merger is ~$1B, including $350M from supply chain and procurement, $325M+ from corporation and segment consolidation, $175M from facilities consolidation, and $150M from IT and other SG&A. But based on the recent track record, the merged company may exceed those expectations leading to higher cash flows. In turn, this would permit Raytheon Technologies to either reduce debt further or return more cash to shareholders through buybacks and dividends.
Expected Cost Synergies In The United Technologies and Raytheon Merger
The Merged Company Will Be Focused On Future Technologies
This merger is not really about improving balance sheets and improving cash flow, although these two items will likely happen. The important part is the direction of the merged company from the perspective of future technologies. United Technologies brings strengths in areas such as advanced propulsion, high temperature materials, thermal management, sensors and other areas. These areas will integrate with Raytheon's strengths in systems integration, energy weapons, advanced guidance and others. Combined together, Raytheon Technologies will have the ability to develop and engineer the next generation of defense technologies in missiles, hypersonics, directed energy weapons and persistent ISR as seen in the chart below.
Raytheon's Capabilities And Customer Focus In Defense
Source: United Technologies and Raytheon Merger Presentation
Similarly, the synergistic combination of capabilities in commercial aerospace permits Raytheon Technologies to provide next generation technologies in this market as seen in the chart below.
Raytheon's Capabilities and Customer Focus In Commercial Aerospace
Source: United Technologies and Raytheon Merger Presentation
Risks To Completion Of The Merger Between United Technologies And Raytheon
There are two main risks to completion of this impending merger. First, there could be regulatory resistance from different government agencies. There have been some concerns that the proposed transaction could reduce competition leading to antitrust concerns. Furthermore, there is some added risk in that President Trump has stated he is a "little concerned" about the proposed merger, questioning whether it could "take away more competition" or make it "less competitive". Saying that, there is little extant overlap in the current markets of United Technologies and Raytheon. The CEO of United Technologies has indicated that there is less than 1% overlap in current sales. But still, the proposed merger is more about synergistic capabilities and complementary technology offerings, which could raise antitrust concerns. In addition, since both companies are defense companies, the Department of Defense must approve the merger. The DoD has blocked mergers before, such as the blocked combination of Lockheed Martin (LMT) and Northrop Grumman (NOC) in the 1990s due to concerns over reduced competition. The DoD wants to ensure that there is sufficient competition to promote development of advanced technologies for weapons systems. However, the DoD and other government agencies did permit merger of L3 Technologies (LLL) and Harris Corporation (HRS) to move forward creating a top six defense contractor. In turn, this provides some confidence that the DoD would be OK with the United Technologies and Raytheon merger, especially since it is being promoted as a way to develop next generation defense technologies. Hence, I view the risks of DoD or other regulatory agencies blocking the deal as low at this point.
The second risk is resistance from shareholders who may not approve the deal. This is a real risk as several prominent activist investors have recently come out against the deal. Notably, Bill Ackman of Pershing Square Capital sent a letter to United Technologies CEO Gregory Hayes, prior to the announcement of the deal, essentially opposing the merger. He has stated that the merger would "significantly lower the business quality" of its aerospace business and that they "...will oppose it, publicly if necessary, as we expect will the substantial majority of the company's shareholders". But Ackman and Pershing Square control only < 1% of shares, suggesting that his opposition alone is not sufficient to stop the merger. But saying that, Dan Loeb of Third Point Management, who controls ~0.8% of shares, has also come out against the impending merger. If enough large shareholders oppose the merger, then it may not succeed in the current form. But currently, I view the risk of shareholders not approving the deal as low unless more large institutional investors come out against the transaction.
Estimated Valuation Of Raytheon Technologies
Let's now examine the pro forma valuation of Raytheon Technologies from the perspective of enterprise value. The current enterprise value-to-sales multiple for United Technologies is ~1.9X - 2.0X, while that of Raytheon is ~1.85X - 1.95X. Lockheed Martin has an enterprise value-to-sales multiple of ~1.9 - 1.95X, while that of Northrop Grumman is ~1.95X - 2.1X. Based on these multiples, a reasonable and conservative one to use for Raytheon Technologies, ~1.9X. The expected revenue in 2019 is ~$74B (pro forma), excluding Otis and Carrier, as seen in the chart below. Hence, the pro forma market capitalization is roughly ~$140B. If we use the ~$69B in aerospace and defense sales between the two companies in 2018, then the pro forma market capitalization is ~$131B.
From the perspective of pro forma earnings, Raytheon Technologies is expected to earn ~$9.3B in 2019. Using a reasonable and conservative P/E multiple of 15.0X gives a market capitalization of ~$140B, which is consistent with the above estimates. Note that the current market valuation of the two companies is ~$150B, which includes Otis and Carrier. But these two businesses had profits of roughly $2B and $3.1B in 2018, respectively. If we use a reasonable P/E multiple of 15.0X, then these two businesses are worth ~$30B and ~$45B by themselves after they are spun out. This suggests that the combination of United Technologies and Raytheon is currently being undervalued by the market most likely due to regulatory risk and also execution risk of the spin-offs followed by a merger in rapid succession. This suggests that there is considerable upside to the deal with the caveat that there exists some uncertainty in the valuations of Otis and Carrier.
Raytheon Technologies Pro Forma Financials In 2019
Over several years, United Technologies has repositioned itself from a diversified industrial conglomerate to an aerospace and defense giant. The spin-offs of Otis and Carrier followed by the merger with Raytheon in the next 12 to 18 months will rapidly complete this transformation. Raytheon Technologies will have a strong balance sheet. The merged company will also be diversified with ~46% commercial aviation sales and ~54% defense sale. The merged company should be able to return substantial cash to shareholders through dividends and buybacks. In fact, Raytheon Technologies plans on returning $18-20B in the three years after the merger completion. The market seems to be currently undervaluing the merged company. But if the merged company exceeds expectations, then the current valuation may be low. Hence, I view the merged company as a buy.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.