What happened

Shares of Raytheon (NYSE:RTN) were set to trade higher on Monday after the defense company announced plans to combine with the aerospace arm of United Technologies (NYSE:UTX), a deal that would create an aerospace and defense giant with $74 billion in annual sales.

Shares of Raytheon traded up nearly 7% in the pre-market, while shares of United Technologies were up 3.4%.

So what

Raytheon has always been an outlier among defense contractors, focused on electronics and missiles but lacking massive equipment platforms like warships, fighter jets, or tanks. The combination with United Technologies, which includes Pratt & Whitney engines and Rockwell Collins electronics and components, would create a sprawling enterprise with diversified exposure to both the defense and commercial sides of the business.

Two planes crossing in midair

Image source: Getty Images.

Under the terms of the deal announced on Sunday, Raytheon shareholders will receive 2.3348 shares in the combined company for each Raytheon share. The companies expect the merger to result in more than $1 billion in cost synergies by the end of the fourth year.

The combination has little direct overlap, but with both Raytheon and Rockwell Collins focused on electronics, there are ample opportunities for collaboration. The larger company will also have more leverage when dealing with aircraft manufacturers Boeing and Airbus, who at times have tried to squeeze suppliers like United Technologies in order to better compete on price.

United Technologies under CEO Greg Hayes is in the middle of a three-way split, separating its Carrier HVAC and Otis elevators businesses from its aerospace assets. Hayes post-deal will run the combined Raytheon Technologies Corp., with current UTC holders owning about 57% of the combined business. Current Raytheon CEO Tom Kennedy will be named executive chairman of the combination.

Now what

The deal in theory should have a relatively painless antitrust review, since the companies have very few overlapping products, but investors should watch carefully whether the transaction gets caught up in the broader trade spat between the U.S. and China (although President Donald Trump did create some regulatory uncertainty around the deal in comments on CNBC Monday morning questioning whether the defense industry is too consolidated.) The companies are hoping to complete the transaction in the first half of 2020.

On paper this deal is a winner, with the new company expected to return between $18 billion and $20 billion in capital to shareholders in the first three years after completion. The combination will be better diversified and able to weather a slowdown in commercial orders or Pentagon budget troubles better than either could on their own.

Of course, there is a lot that can go wrong when two companies merge. Hayes has been a prolific dealmaker since taking over as CEO of UTC in 2016; however, this is his biggest integration challenge yet. But assuming all goes to plan, there's good reason for shareholders to be excited about this megamerger.