Raytheon-United Technologies Merger Proposal Spurs Controversy, Questions

Paul Dykewicz

The Raytheon-United Technologies merger proposal, aimed at amassing advanced technologies and products in defense and aerospace, is drawing controversy and questions.

The all-stock merger of equals is slated to produce annual cost synergies of more than $1 billion by the fourth year and new revenues from the technologies of the defense industry’s Raytheon Company (NYSE:RTN), of Waltham, Massachusetts, and the aerospace firm United Technologies Corporation (NYSE:UTX), of Farmington, Connecticut. The union would form Raytheon Technologies to create the world’s largest defense contractor and return a projected $18-$20 billion in capital to its shareholders during the first 36 months following the merger’s closing, but some prominent investors are verbally bashing the proposed deal.

Before the merger, United Technologies plans to sell its Otis elevator and Carrier systems-building business units separately in the first half of 2020, but still retain aerospace blue bloods Pratt & Whitney and the successor business to Rockwell Collins to join with Raytheon. Rockwell Collins, whose communications equipment serves astronauts in space, consolidated in November 2018 with UTC Aerospace Systems, which designed the space suits of America’s first astronauts, to form Collins Aerospace Systems.

After the three-way breakup of United Technologies is complete, its merger with Raytheon is expected to close by first-half 2020 and qualify as a tax-free reorganization for U.S. federal income tax purposes.

Raytheon-United Technologies Merger Would Create $74-Billion Giant

The merged company will have approximately $74 billion in pro forma 2019 sales. The leaders of Raytheon and United Technologies said the unified company would offer a strong balance sheet and robust cash generation, as well as give Raytheon enhanced resources and financial flexibility to support future research and development (R&D), along with capital investment through business and political cycles that affect funding for U.S. defense programs.

The merger agreement, which was approved unanimously by each company’s board of directors, calls for Raytheon shareholders to receive 2.3348 shares in the combined entity for each of their existing shares. Upon completion of the merger, United Technologies shareholders will own approximately 57 percent of the unified company, while Raytheon shareholders will own the other 43 percent.

The timing for the decoupling of Otis and Carrier is not expected to be affected by the proposed merger between United Technologies and Raytheon.

Raytheon-United Technologies Merger Proposal Gains Mixed Reviews

“We loved RTN as a stand-alone company, so seeing management settle for a slightly nebulous deal is a bit of a letdown,” said Hilary Kramer, a Wall Street money manager who leads the Value Authority, GameChangers, Turbo Trader, High Octane Trader and Inner Circle advisory services for individual investors.

Paul Dykewicz interviews money manager Hilary Kramer.

Third Point, a New-York-based hedge fund led by its founder and Chief Executive Officer Dan Loeb, is opposing the deal due to concerns it undervalues United Technologies. As a holder of 0.8% of United Technologies shares, according to the hedge fund’s most recent quarterly regulatory filing, Third Point seemed positioned to reap the benefits of billionaire Loeb’s May 2018 call for the aerospace company to sell the Otis and Carrier businesses to unlock an estimated $20 billion in value.

However, United Technologies announced its merger proposal with Raytheon unexpectedly and barely more than six months after receiving final regulatory approval in November 2018 for its $30-billion acquisition of Rockwell Collins. That purchase became one of the largest mergers in the history of the aerospace manufacturing industry, with United Technologies keeping Pratt & Whitney, a supplier of rocket propulsion systems and fuel-efficient, “geared turbofan” engines for commercial and military jet aircraft.

Pratt & Whitney, also a provider of powerful and fuel-conserving engines for regional and business jets, offers significant growth potential. For example, Pratt & Whitney’s F135 engine will be used in roughly 4,000 single-engine F-35 fighter jets that will be produced for three U.S. military services and at least a dozen allies to rank as the world’s largest military production program.

Plus, Pratt & Whitney will supply the U.S. Air Force with engines for its next-generation aerial-refueling tanker and for its future B-21 bomber. The Long Range Strike Bomber will be designed and built to give the Air Force the capability to launch from the continental United States to conduct airstrikes on any target in the world.

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Hedge Fund CEO Blasts Raytheon-United Technologies Merger Plan

Bill Ackman, founder and CEO of the New York-based Pershing Square Capital Management hedge fund company, also is objecting to the merger and he sent a sharply worded June 9 email with his reasoning to Greg Hayes, the chief executive officer of United Technologies. Ackman advocated finding enhanced value though the separation of the Otis and Carrier businesses to turn United Technologies into a pure play aerospace company, eliminating acquisition-related amortization that artificially reduced its earnings and market value.

We can see why strategic investors like Bill Ackman are less than overjoyed,” Kramer said. “After all, UTX has shuffled its side of the deck so much over the last two years that we just don’t know exactly what this offer is worth or what RTN shareholders are getting in exchange for giving up their independence. We’re getting 2.3 shares of UTX after Carrier and Otis spin out. Maybe that’s the equivalent of $200 to $230 for every RTN share today but there are simply too many moving parts involved to narrow that range any further.”

Kramer added that she had a “fairly high conviction” that Raytheon was on its way back to at least reaching $210 a share on its own, so much depends on United Technologies having the “dynamism” to hold up its end of the combined company better than the market currently expects.

Valuation Questioned in Raytheon-United Technologies Merger Plan

If Collins Aerospace is valued by factoring out the spin-off businesses, Pratt & Whitney brings roughly $30 billion in market capitalization, Kramer said.

“That’s not really enough to give us our $210 a share under the current terms,” Kramer said. “For that to happen, UTX would need to be trading above $220 a share on its own, which is possible but not a sure thing.

“Until management really lays the inner workings of what’s left behind after Carrier and Otis are gone, it looks like a great deal for UTX shareholders and a roll of the dice for RTN shareholders. Naturally, we prefer deals that go the other way. If there’s no premium in giving up our independence, scale isn’t a goal in itself. How much legacy debt will the new company take over from UTX and how much will be pushed to the spin-outs? How much growth will the new UTX contribute to its union with RTN? These are questions the press release should have answered.”

Another consideration is that the share price of United Technologies has significantly underperformed during the past five years, Kramer said. Shareholders are impatient and want something done, and this merger could add value through “financial engineering,” such as cutting costs while maintaining revenues, she added.

Raytheon-United Technologies Merger Plan Interests Technical Traders

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“Both Raytheon Co. and United Technologies are at technical levels where the securities will typically fall into corrective mode, swinging more widely on the daily and weekly charts, but without much incentive for longer-term bulls or bears either way,” said Toni Hansen, president and head trader at Trading from Main Street, a market analytics and trading education firm. “It looks to stabilize heading into 2020, so opportunities based on the anticipated merger are likely to offer short-term plays but drive investors batty by failing to easily commit to a larger bias.”

Chart Courtesy of www.TradeStation.com

A “bull trap” can ensnare investors with a false signal when a stock’s declining trend reverses and temporarily rallies to breach a prior support level. Such a situation could be occurring now, especially in Raytheon, and may draw increased buyers in the short term, Hansen said. But such buyers will want to pay “very close attention” to the stock’s momentum, she added.

Chart Courtesy of www.TradeStation.com

“Even though it may seem decent compared to the rally in the first quarter, any correction lasting longer than those that took place within that rally will be viewed with disappointment and make it easier for a larger bull trap to develop, such as the one I’ve hypothesized on the daily chart [shown below],” Hansen said.

Chart Courtesy of www.TradeStation.com

“The proposed merger is another example of consolidation in sectors, especially those that involve a lot of investment in technology,” said Bob Carlson, who heads the Retirement Watch investment advisory service. “It’s not clear what the benefits of the merger will be to shareholders. The two companies have little overlap in their products and defense contracts. Yet, executives say the merger will create cost savings through economies of scale. That’s a rationale for mergers that often isn’t fulfilled. It’s a tough promise to deliver on when the two companies have limited overlap.”

The companies also face a long road ahead to have the merger approved, Carlson cautioned. Defense Department officials are concerned about too much consolidation among its contractors and some large rivals, such as Boeing, might object to the merger of two competitors, he added.

Even President Trump told CNBC that he would be concerned about the possibility of reduced competition for federal defense contracts.

Chart courtesy of www.stockcharts.com

Chart courtesy of www.stockcharts.com

A Raytheon-United Technologies Merger Could Prove Beneficial

I think this news is good for UTX, especially if the feds allow it to happen, which I think they will,” said Jim Woods, who heads the Intelligence Report and Successful Investing advisory services. “The new company adds more defense business to UTX, so combined the company will be a mighty force in the field. I am watching this one closely to see what transpires further, but I like what I see so far.”

The leaders of Raytheon and United Technologies said the combination would create long-term value for shareholders that could not be matched if the companies stayed independent. They touted the merit of forming a balanced and diversified aerospace and defense organization to establish a broad and complementary portfolio of high-growth business segments, while reducing risk by becoming less concentrated than if they remained separate.

The combined operation would pump $8 billion annually into research and development spending, support seven technology Centers of Excellence and employ more than 60,000 engineers to develop new, critical technologies faster and more efficiently than in the past, leaders of the merger partners announced. They said areas of joint advancement would include “hypersonics” and future missile systems; energy weapons; intelligence, surveillance and reconnaissance (ISR) in contested environments; cyber protection for connected aircraft; next-generation connected airspace; and advanced analytics and artificial intelligence for commercial aviation.

Financial Gains Promised with Raytheon-United Technologies Merger

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Raytheon plans to consolidate its four businesses into two that will be named Intelligence, Space & Airborne Systems and Integrated Defense & Missile Systems. The new businesses will join Collins Aerospace and Pratt & Whitney as the four key segments of the unified company.

Net debt for the combined company at the time of closing is expected to be approximately $26 billion, with United Technologies likely to contribute roughly $24 billion. The unified company will seek an A credit rating at the time of the deal’s closing.

The board of directors of Raytheon Technologies will be comprised of 15 members, consisting of eight representatives from United Technologies and seven from Raytheon. The lead director would come from Raytheon.

Tom Kennedy, Raytheon’s CEO, would be appointed executive chairman. Hayes, who leads United Technologies, will be named CEO of Raytheon Technologies. Two years after the transaction’s closing, Hayes also will become the company’s chairman.

Raytheon Technologies will be headquartered in the Boston metropolitan area and will retain a corporate presence in its existing locations. The timing of the deal’s closing will depend on receipt of required regulatory approvals and the support of Raytheon and United Technologies shareholders, along with completion of the spin-off of the Otis and Carrier businesses by United Technologies.

Aside from its defense business, Raytheon serves the civil government and cybersecurity markets, as well as gives sensing and mission support for customers in more than 80 countries. It is possible that United Technologies’ management sees untapped potential in Raytheon and its cybersecurity business that hedge fund leaders Loeb and Ackman are missing, but nonetheless, investors should not feel rushed to buy either RTN or UTX amid continuing criticism and questions about their planned merger.

Paul Dykewicz, www.pauldykewicz.com, is an accomplished, award-winning journalist who has written for Dow Jones, the Wall Street JournalInvestor’s Business DailyUSA Today, the Journal of Commerce, Seeking Alpha, GuruFocus and other publications and websites. Paul is the editor of StockInvestor.com and DividendInvestor.com, a writer for both websites and a columnist. He further is the editorial director of Eagle Financial Publications in Washington, D.C., where he edits monthly investment newsletters, time-sensitive trading alerts, free e-letters and other investment reports. Paul previously served as business editor of Baltimore’s Daily Record newspaper. Paul also is the author of an inspirational book, “Holy Smokes! Golden Guidance from Notre Dame’s Championship Chaplain,” with a foreword by former national championship-winning football coach Lou Holtz. Follow Paul on Twitter @PaulDykewicz.

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