By Ilya Korzinkin - Date: 13/07/2019
Overview of the deal
Acquirer: United Technologies Corporation (NYSE: UTX)
Target: Raytheon Company (NYSE: RTN)
Estimated value: $121bn
Announcement date: June 2019
Acquirer Advisors: Morgan Stanley, Goldman Sachs, Evercore
Target Advisors: Citigroup, RBC Capital Markets
United Technologies Corporation (UTX) is acquiring all outstanding shares of Raytheon Company (RTN) in an all-stock deal at an estimated transaction value of ~$121bn. Once the deal is completed, RTN shareholders will receive 2.3348 shares of the NewCo, that will trade on the New York Stock Exchange under the name ‘Raytheon Technologies’ (RTX), with UTX taking control of 57% of the company on a fully diluted basis, while RTN shareholders will control 43% of the company. Gregory Hayes of UTX will hold the CEO position, whereas Thomas Kennedy of RTN will become executive chairman, and ascend to both roles after ~3 years. The board will consist of 15 members, with 8 partners from UTX and 7 from RTN.
With Raytheon long-wondering of how to create value from their ‘under-utilized’ balance sheet, this perhaps ingenious solution to sell it to United Technologies was proposed and gladly accepted (unanimously) by the company’s board. With cyclical deceleration looming on the horizon due to defence budgets flattening worldwide, UTX, with their diverse portfolio of services looked like a perfect candidate to hedge Raytheon’s defence-sector exposure-related risks.
The NewCo thus is poised to become a multi-industry behemoth conglomerate, and second only to BA (Boeing) in Aerospace and Defence, offering a ‘highly complementary services portfolio aiming to pass on ~$500mm of savings on to customers within the first four years post-transaction’ according to management.
This mega-merger therefore reinforces the trend for scale-hunting and portfolio diversification in the aerospace and defence sector in the face of a potential industry downcycle, however with the market response being unfavourable to say the least, with Bill Ackman, Donald Trump and Daniel Loeb all voicing their concerns, one may wonder whether bigger is always better when it comes to highly specialized and cyclical markets.
“It is largely a diversification play to build an absolute behemoth aerospace and defence contractor” - Douglas Rothacker, aerospace & defence analyst, Bloomberg Intelligence
Acquirer Company Details (United Technologies Corporation, NYSE: UTX)
United Technologies Corporation provides technology products and services to building systems and aerospace industries worldwide. Its Otis segment manufactures passenger and freight elevators, and related products. The company’s Carrier segment provides fire, security, and building automation as well as climate control services and building automation products and related services. Its Pratt & Whitney segment supplies aircraft engines, and its Collins aerospace segment provides a range of security and aircraft maintenance systems and services.
- Founded in 1934, Headquartered in Farmington, Connecticut
- President & CEO: Gregory Hayes
- Number of Employees: 240,000
- Market Cap: $111.07bn - EV: $153.80bn
- LTM Revenue: $18.36bn - LTM EBITDA: $11.08bn
- EV/Revenue: 8.38x - EV/EBITDA: 13.88x
Target Company Details (Raytheon Company, NYSE: RTN)
Raytheon Company develops integrated defence products, services and solutions for defence and other government markets worldwide. The main five segments for Raytheon’s operations are: i) Integrated defence systems ii) Missile systems iii) Intelligence services iv) Space and Airborne systems v) Forcepoint (data security).
- Founded in 1922, Headquartered in Waltham, Massachusetts
- President & CEO: Thomas A. Kennedy
- Number of employees: 67,000
- Market Cap: $51.00bn - EV: $52.70bn
- LTM Revenue: $45.8bn - LTM EBITDA: $5.11bn
- EV/Revenue: 1.15x - EV/ EBITDA: 10.32x
Projections and Assumptions
Short term consequences
With appealing face-value financials, UTX could use RTN’s strong balance sheet to de-lever its high standing leverage, thus adding scale and stability to the combined firm. RTN in turn, apart from being at a lesser top-line risk from the defence downcycle, could use UTX to expand their R&D capabilities, while UTX would benefit from employing RTN’s AI expertise, using it to develop higher quality connected aircraft systems at Collins.
The NewCo is expected to benefit from numerous other synergies, like better cost management through corporate and supply chain consolidation, and with less than 1% of the two companies’ sales overlapping, concerns about rationalisation limits have been highly limited from the two companies’ management. Benefits would be also reaped from RTN’s net zero pension contribution, as with an outstanding $7bn pension balance of the government to Raytheon, pensions become a long term source of cash for the NewCo.
Financially speaking, the transaction looks to create value with UTX shareholders getting a $3bn dollar uplift from 57% of the NewCo amounting to $78bn due to lower leverage, and projected capital returns to shareholders of $18-20 expected to be 50% higher than they would have otherwise been driven by a stronger balance sheet. RTN shareholders are set to benefit from the transaction also, controlling 43% of the combined company in contrast to only a 40% EBITDA contribution estimate. RTX would be trading at attractive FCF and EBITDA multiples comparing to its peer group, trading at <10x of 2020 EBITDA comparing to NOC’s 12.5x for example. EV for the two companies separately would be $100bn in contrast with $160bn combined, with ~$9bn EBITDA separately comparing to ~$13.5bn together, trading at 12x EBITDA in comparison to 11.5x separately. Better leverage goes without saying, with NewCo’s leverage at <2x in comparison to 3x separately. Pro-forma capital structure looks to be $26bn net debt at the time of closing, of which UTX would contribute $24bn, with the NewCo receiving an ‘A’ credit rating.
Long term upsides
The NewCo, with over 50% of its operations in defence, will become the most diverse tiered player with more scale than any of its peers in the market at 2.5x the size of GE in the respective sector for example, defining the future of aerospace and defence (according to UTX's management), with the newfound scale looking to push against the framer duopoly and provide cover for earnings and cash in fiercely competitive engine development campaigns. GE for example struggles with cycle management with <15% of their portfolio: defence and heavily weighted to Boeing, whilst the NewCo would benefit from less risk due to a more diverse top-line, posing questions industry-wide about the potential value of a standalone engine manufacture-focused company vs. a more solutions-oriented approach.
Risks and Uncertainties
Analysing the Market Reaction and Transaction Uncertainty
So with the merger hailed by analysts and management, why has the market reacted the way that it did with RTN down ~7%, UTX down ~2% since the announcement, and Bill Ackman and Daniel Loeb (of ThirdPoint), with majority interest in both RTN and UTX calling on to pressure against the deal, and Mr. Trump being ‘very very worried?
With deals of the sort usually boosting market cap through more M&A anticipation, the converse may be explained by investors potentially reading into lower EBITDA(P) valuation for RTX lower and RTN trading below LMT (Lockheed Martin) and NOC (Northrop Grumman) as an indication that defence valuations have stretched, as well as an indicator that this potentially signals the peak of the defence industry growth as the space becomes more competitive, with RTN’s failure to generate cash flow through ForcePoint and some problems with contract execution not helping the case either. DoD also has since implied that contractors are investing more, however RTX potentially will see a flow of cash in another direction, focusing on more commercial aviation segments. This comes in conjunction with defence stocks becoming hiding spots from trade risks thus riding on a wave of over-buying perhaps not in conjunction with appropriate multiples.
Another reason for such a negative reaction to the transaction would be questions posed towards whether this deal signals some sort of problems at RTN that is trying to be covered by the deal. Some concerns were raised by covering analysts over RTN in effect giving away their balance sheet in exchange for no premiums for funding RTX’s capex intensive engine development, however not only are RTN shareholders compensated above their EBITDA contribution in stock, with RTN's backlog growing at a nice pace and with the company receiving numerous awards in Q2 2019, it is unlikely that any major issues with RTN are imminent. Recent execution issues in the missile segments also raise further questions, however it is highly unlikely that the transaction has been made with risks of the most well-known business segment of RTN imploding on its contracts.
With both Ackman and Loeb voicing concerns over ‘distracted management’ due to over-diversification, which until long ago did not exist, as UTX was focusing on spin-offs and not portfolio diversification strategy-wise. He also questioned whether the merger will actually bring any benefits to R&D on both sides, as ‘The benefits of Raytheon’s cyber and data analysis capabilities are not quantifiable and could be replicated through commercial collaboration or supply agreements’. This comes after more, enquiries were made by ThirdPoint analysts and portfolio managers on the matter of unneeded diversification, since individual drivers were argued by some to become less significant in the face of a very diverse conglomerate.
However it must be pointed out that this provides high quality risk diversification for both of the merged companies' product portfolios, with commercial aero aftermarket being arguably a swing factor for profits and UTX having both growth and defence characteristics.
Mr. Trump in turn said that he was worried about competition in the defence space and bidding for Pentagon contracts being skewed as a result of the deal, however there is very little stress being put on the defence industry in structural or cyclical terms by the transaction. Sales overlap only in Pratt & Whitney segments, however management has been quick to point out that integration will be seamless, and with the NewCo still much smaller than LMT, market impact is likely to be severely limited.
Therefore with the current market situation we may deduce that either the investors do not yet have enough confidence in the transaction, or not enough value is being put on the diversification of the conglomerate if the current valuation is used as a base for judgement, however it is much more likely that the announcement simply caused a dislocation, with investors still figuring out what to do after the shock of the transaction.
Long term risks
Still, some questions remain outstanding, and cannot yet be put to bed by the bulls and stressed by the bears.
Missile segment performance of RTN was being called into question (54% of sales in defense), as LMT seems to be winning a majority of contracts in the hypersonic space, as well as NOC coming into the market and slowly growing its presence. RTN further faces a re-complete of the patriot program, therefore some analysts have questioned whether the deal acts as a cushion for potential under-performance in the missile and defence sectors of RTN. No firm conclusions may be drawn now, however some issues may be raised at how a potential increase in allocation of tech resources towards the defence segment of the combined company will aid development through higher R&D investment.
RTX will have to prove in reality, that increased investment into tech will reap benefits. For example, management is prudent on their view that RTN cyber capabilities would help UTX secure more commercial connected aircraft contracts, however why not sell this capacity as a service to UTX? Why does a merger serve better than establishing a JV in the hypersonic space?
Perhaps only time will tell, however what is clear, is that defensive plays and portfolio diversification in face of global uncertainty within the aerospace and defence markets will not go away, with UTX acquiring Rockwell Collins for $23bn and Pratt & Whitney earlier for example. Within the wider market, more and more questions are thus likely to be poised about the strategic future of HON aero and GE aviation, and attention shifted with greater focus on potential future transactions in the industry.
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