United Technologies (UTX - Free Report) and Raytheon (RTN - Free Report) are merging businesses in the largest deal of the year thus far. United Technologies is pivoting its business proposition into a pure-play aerospace and defense company. UTX is in the midst of spinning off lower growth segments like Carrier building systems and Otis elevators, while at the same time acquiring Raytheon in an all-stock merger.
This complicated reorg will form the 2nd largest aerospace and defense firm in the world by revenue, behind the industries longtime frontrunner, Boeing (BA - Free Report) . After United Technologies’ spin-offs, the combined firm with Raytheon will be worth $100 billion. According to the companies report, “upon completion of the merger, United Technologies shareowners will own approximately 57 percent and Raytheon shareowners will own approximately 43 percent of the combined company on a fully diluted basis.” The merger is expected to be wholly in the first half of 2020 once United Technologies has completely separated from Otis and Carrier.
There are quite a few things to consider when reflecting on the cost and benefits of this merger. The primary driver of the merger is diversification within the aerospace and defense as well as cost-cutting synergies, leveraging size. United Technologies is estimating “more than $1 billion in gross annual run-rate cost synergies by year four post-close, with approximately $500 million in annual savings returned to customers.”
There are quite a few concerns that investors have with this proposed merger, including a lack of operational overlaps and synergies within business segments. Raytheon’s focus is primarily on missile and radar technology, while United Technologies principal driver is engines and engine parts.
A concern that I have with this deal is the significant defense budget risk associated with both an economic slowdown and the uncertainty involved in the next election. 68% of Raytheon’s revenue comes directly from U.S. government contracts with an additional 13% going to foreign military sales through the U.S. government, totaling 81% of Raytheon’s top-line being related to the US government. Government contracts drive around 20% of the remaining United Technology segments' sales. A change in US leadership from the 2020 election could have a substantial material effect on the combined business’s bottom line.
Top-line growth for United Technologies’ remaining segments has been strong, but costs have been outpacing revenues, and gross margins are diminishing. I believe this is one of the primary catalysts for this merger. A larger pure-play aerospace and defense firm is going to have more leverage in negotiations with both suppliers and clients.
UTX’s investors are not enthusiastic about the merger with the stock falling roughly 3% in trading today. RTN investors appear almost indifferent about the merger with today’s returns being more or less in line with the rest of the market. So far this year both UTX (green) and RTN (blue) have outperformed the market, each showing returns north of 20%.
As I mentioned, this merger is coming at the end of an economic cycle and the complexity of the deal could cause some materially negative impacts on the firms’ bottom-line as the added complications usually involves added expenses. United Technologies pivot to pure-play aerospace and defense lowers its operational diversification and significantly increases its political risk. This upcoming election could break this combined firm if a new U.S. President decides to put military spending on the back burner.
The size and cost synergies between the two may hold more weight than investors and I are able to perceive at the moment. I would keep an eye on the development of this merger and more details to be released.
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