Energy: United Technologies and Raytheon Look to Build an Aerospace Titan

The deal has some high-profile detractors, but it looks like a winner.

Lou Whiteman
Lou Whiteman
Jun 30, 2019 at 1:00AM
Energy, Materials, and Utilities

Earlier this month, Raytheon (NYSE:RTN) and United Technologies (NYSE:UTX) announced a "merger of equals," promising to create the world's second largest aerospace company by total revenue. At the same time, United Technologies has also been preparing for the spinoff of its Otis elevator and Carrier HVAC divisions. Motley Fool contributor Lou Whiteman joins the show to break down these deals and more on this week's episode of Industry Focus: Energy and Industrials.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.

This video was recorded on June 27, 2019.

Nick Sciple: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is Thursday, June 27, and we're talking about the merger talks between United Technologies and Raytheon. I'm your host, Nick Sciple, and today I'm joined by Motley Fool contributor Lou Whiteman via Skype. How are you doing, Lou? 

Lou Whiteman: I'm good! How are you? 

Sciple: I'm doing great! It's the middle of summer. Fourth of July is next week. Very excited to be here with you. You're about getting ready to go on a trip here pretty soon, the summer in full swing. What's going on with you, Lou?

Whiteman: We're going to test out, we're taking a 12-year-old to Ireland to see how that goes. See if she can enjoy Ireland as much as her parents will. I'll let you know! [laughs] 

Sciple: Yeah, I spent some time over there as well. I didn't realize before I went to Ireland how many sheep there are in that country. It's sheep as far as the eye can see. Green, rolling hills and sheep. I really hope you enjoy the trip. 

Today, we're here to talk about, as I said, United Technologies and Raytheon. On June 9, they announced a merger of equals that will create a combined company, I believe, at $120 billion. When you look at this deal, first off the top, what was your reaction when you saw the news come down?


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 Whiteman: It's a heck of a deal for a few reasons. For one, in the context of the defense side, Raytheon is more of a defense company and United Technologies, we're talking about only their aerospace assets. I'm sure we'll get into that. But they're in the process of splitting three ways. But United Technologies is primarily a commercial aerospace company. On the defense side, since the 1990s, we haven't seen any tier-one prime consolidation. This doesn't count, because it's not like Raytheon and Lockheed Martin are coming together. But there's been an open question for going on 20 years, the so-called Big Five or the big prime contractors, are they boxed in? What can they do? This is a pretty creative answer to that. So, wow, but also very interesting.

Sciple: You take a look, United Technologies is going to get about 57% of the combined company, but they're going to split the board about 50/50. United Technologies CEO becomes CEO of the combined company. Raytheon's CEO is going to be the chairman. But it looks like he's going to be heading out in a couple of years. What do you see in how these companies are coming together from a combination point of view in reaction to how things are getting split off and the leadership transition between the two companies?

Whiteman: I like Tom Kennedy, Raytheon's CEO. I'm not surprised that he's willing to step aside here. I think he was probably thinking succession plan anyway. Greg Hayes is relatively new on the job, but he's done a good job. He's been more decisive than some of his predecessors have been. Case in point, this. He's an aggressive guy. I think he's up for the challenge. But boy, he's loading up his plate.

Sciple: Yeah, and he's gotten a little bit of criticism leading up to this merger. Like I said, it's a merger of equals between these two businesses. One famous investor, Bill Ackman, came out in and has criticized this deal as maybe not fully realizing the value that is inherent in United Technologies. He said that there is a conglomerate discount on the shares, and by merging with Raytheon, they're basically exchanging undervalued shares and giving Raytheon the benefit of that conglomerate discount. When you look at some of those criticisms of this merger from a valuation point of view for United Technologies, do you think Ackman has a point here? Or do you think he's a little misguided with those criticisms?

Whiteman: Let's take a step back. Ackman's has been involved in the United Technologies for a while, including pushing for a three-way split. Maybe even more than a three-way split. It never really gained traction because of the M&A that United Technologies was doing. They just finished the Rockwell Collins deal, which substantially grew the aerospace side, but they needed to get that deal closed, and at least start to bring it in house before they considered this. Ackman was very big on splitting up the three parts. That is happening. He's always been more interested in the aerospace side than the other two parts. Yes, as you say, his basic feeling now is, with the aerospace side still suffering from the conglomerate discount, why are you pledging its shares now, when, in his mind, it's going to be much more powerful on its own? 

I don't necessarily buy his argument. For one, I think he's missing the fact that Raytheon isn't really getting a premium here, either. This deal is not designed to give either side a premium. The idea of the deal is that the sum of the parts will make them stronger. Raytheon is valued at something like 11X EBITDA in the deal. It's a little wishy-washy because it's stock, but that's about where they are now. There's a lot of benefits that Raytheon is bringing as well. Raytheon brings defense exposure, which is a different customer set. United Technologies, for all of its scale, they are still subject to Boeing and Airbus, and they still have to bow under pressure to Boeing and Airbus. Raytheon has a whole different customer in the U.S. government. That revenue diversity will help the company. 

Also, probably most important, and what Ackman seems to be conveniently missing out on or skipping over is, United Technologies, it's hard to say because the split's going on, but it looks like they're going to give the aerospace unit about $24 billion in debt. Raytheon, by comparison, has less than $3 billion in debt. Combining these two companies, you're going to have a much more pristine balance sheet. You are going to have the flexibility to return capital to shareholders. You're going to have the flexibility to invest in R&D. You're going to be able to do a lot more with this balance sheet by bringing the Raytheon side in. That's really, really to United Technologies' benefit. They were going to have, not liquidity issues, but they were going to have a substantial debt burden on their own as this split goes out.

Sciple: Right. Just having those stable revenues from the defense side of the business not being subject to as much cyclicality as you'll see in the commercial airlines space, it's a clear benefit for United Technologies. One program I've seen called out a few different places is the Pratt & Whitney geared turbofan engine, and what can mean for United Technologies moving forward. However, it's cost $10 billion or more to develop over time. There's clear opportunities for that part of the business to grow. However, it takes a lot of upfront investment for that to grow.

When you look at this deal in the context of what it will do for that geared turbofan next generation Pratt & Whitney engine, what opportunities it might have for United Technologies to more comfortably reinvest in that part of the business, what new opportunities does this Raytheon merger create there?

Whiteman: Well, for one thing, just to give you an idea of the size and the scale we're talking about, I saw a number -- 60,000 engineers are coming together here. There isn't a lot of overlap in the business. United Technologies doesn't make missiles. Raytheon is probably best known for the Patriot system, the anti-missile system. They do a lot of that work. There isn't a lot of direct overlap. But, for example, Pratt & Whitney is in a difficult development cycle right now. Raytheon does do work with engines of their own, missile engines. Hypersonics is one area where I think they can work together. There are more areas for potential collaboration than there are areas where there's going to be overlap and cut or combined. But the collaboration is important here. You're bringing together a lot of people from related fields. And, oh, by the way, Raytheon does have a $40 billion backlog that projects well out into the next decade as far as planning for leverage, planning for revenue, planning on keeping the balance sheet healthy. That's something that is maybe not unique to the defense industry, but with the government as a customer and the government making, by law, spending plans five, 10 years out, there's a lot of predictability there that you can use when you're making investment decisions, which I think is very much under-appreciated on the commercial side. But I think it will be to United Technologies' benefit. 

Sciple:  Yeah, when you have that flexibility to think long-term because you have more diversified revenues, always a good thing for a business, particularly one that can maybe suffer from some cyclicality as you go through the upgrade cycle in commercial airlines, things like that. 

Last thing on this merger, any final thoughts on this merger before we move on? What should investors be watching as this continues to play out and finalizes, if that's what ends up occurring?

Whiteman: The downside, and I think this is sort of what's driving Ackman's frustration, the Rockwell Collins deal took a lot longer to close than anticipated, mostly because of Chinese regulators, not U.S. regulators. The point being, this was dead money for United Technologies for a while because people were anticipating getting this deal closed, maybe we'd see a split, what will we see? The split already put the company in limbo. But now the extra complexity of a major deal, even if this is a good deal, it's hard to imagine this stock really running for another year, year and a half, maybe, at worst case scenario. You shouldn't have an antitrust issue here because the businesses don't overlap much. However, we have seen the President chime in, talking about fears about defense consolidation in general. We're sure to see Boeing chime in a little, because Boeing doesn't like its suppliers to have too much heft or too much muscle, and certainly, this company will be tougher to push around. Also, the wild card from Rockwell Collins was China. Given the current situation... just ask FedEx what it's like, dealing with China. I don't think it's a given that this deal will be rubber stamped anyway. Why potentially wouldn't China, if this continues, recurrent tensions, why wouldn't they step in and gum up the works? On the surface, it looks like a done deal. It looks like a pretty good deal. But there are a lot of things that are very much outside the company's control that investors at least need to watch and be mindful of it as this plays out. It's likely to be a long process that plays out, potentially with some twists that are hard to predict right now.

Sciple: Yeah, something we're going to continue to follow. Another thing with United Technologies that has continued to play out, and you have alluded to this, is spinning off both its Otis Elevator division, as well as the Carrier HVAC air conditioning division of the business. This was an announced back in November, that they were going to spin these businesses off. Now, the current timeline we have for when that will officially be done is looking like about the first half of 2020. 

When you look at these spin-offs, and we talked a while back about DowDuPont splitting into three companies, is this is a similar profile to what we saw with DowDuPont, creating different businesses with different profiles that maybe might fit different investor bases from how these businesses are being split off?

Whiteman: Yeah. It's important to say, too, that the Raytheon deal will not close until after the split is complete. Very much, this is important to the United Technologies story right now. 

They are different businesses. I think for the most part, United Technologies, the aerospace business stands out from the other two. But Otis and Carrier certainly aren't the same. Otis is the name in elevators. Two million elevators installed. Great reoccurring revenue on the services side. They have to maintain all those elevators. Growth has been an issue. More recently, that growth has come from China. In the last few years, we've seem Otis' margins fall, in part because of competition in China. That looks like an income play, a solid services revenue that isn't going to disappear, but you have to question where the growth will be. 

Carrier is sort of a hybrid between the two. Again, you have a huge installed base. I think it's 100 million air conditioners installed in the U.S. They're a $20 billion company. Their margins are a little better. There's growth potential there. But, again, it's largely a services business. Also, for Carrier, I don't think they are the top name in the industry in terms of reliability and service. They have taken their hits for quality. They have some work to do with that. 

Otis, it's hard to imagine Otis involved with M&A because Otis is too big to be bought, and they're too big, probably, to buy anyone of note. Carrier is in a business that has been consolidating. They'd be a big acquisition for someone. I don't know if that's reasonable. But as you can see them involved in deal-making more than Otis. Both of them probably lean toward income. Carrier with a little more growth potential, but probably a little more risk, because, as I say, it's a competitive market, and in recent years, I don't think they've been the best-regarded brand in the industry.

Sciple: Yeah, you look at Otis, the elevator business, there's a little bit of appeal there. From the servicing side, you get some steady revenue. As you mentioned, it can be an income play, because you have regulations that require you to get these things serviced and licensed over time. That creates some steady income. However, we're not throwing up multi-story buildings at the same rate of growth we're seeing in aerospace. Probably will be a slow grower, but an income opportunity there. 

Do you think this is going to be value-creating for shareholders as we spin these off? That, like Ackman has said, the sum of the parts is worth more than they're being valued at today? Would you consider buying shares today to realize the valuation expansion as these companies spin off? Or are you really only interested in the aerospace part of the business right now?

Whiteman: I do think there is a conglomerate discount. I'm old enough to have seen this go back and forth, and back and forth. It tends to be after extended up cycles that we see the talk of conglomerate discounts and talk to break up. If we had five, 10 years of weakness or another big recession, that's when you start seeing businesses talk about the value of coming together and having disparate revenue streams tied to different cycles. But, yes, United Technologies, if you look at the sum of the parts, it has been undervalued. Part of that, I think, is the conglomerate. Part of that is, they've been such an active dealmaker and there's been so many moving parts inside the company that it's just hard to get your arms around. 

I do like the long-term prospect of breaking these companies up. I like aerospace best, probably. But I do think there's value to be created. Because of how long this is going to take, because of the uncertainty, I wouldn't rush in and buy here. You probably can make a case that you'd do all right, but I'd be more interested in looking once it's done. But if I'm holding right here, I'm certainly not selling, and I'm probably going to do fine. 

Sciple: Certainly. Last question, as we see more of these companies breaking up, and the de-conglomeratization trend, as you said, that's something we tend to see toward the end of the cycle. Is that something that you're concerned about, as we see this wave of companies getting split up? Or is it just something you see from time to time?

Whiteman: I think that goes back to the core Fool philosophy is. You find good companies, and you stick with them. There are good companies being created here. There may be some less good companies that come out of some of these splits, or companies that appeal to other people. But for me, in DowDuPont, for me it'll be DuPont, it looks like an attractive company. I think Raytheon and United Technologies, once that comes together, that is a company -- to be honest, Raytheon to me was not a company in the defense base, I have nothing against it, but it wasn't top of my list to buy. I would be more inclined, I think, to buy this combination because of what it offers than I would have been to buy Raytheon on its own, or even United Technologies as a conglomerate on its own. 

I think, regardless of where we are in the cycle, you look at the businesses. If there's a quality business being created, The Motley Fool has proven over a long time that will work out just fine for you. I think that's the case here.

Sciple: Absolutely, Lou! Always great advice for our listeners. I always love having you on to discuss these businesses! Looking forward to having you on again soon! I'm sure there'll be more to see. Obviously, it'll be another full year before we see all these companies spun out. Maybe we'll get more revelations in the coming days. Thanks for coming on!

Whiteman: Thank you! Always a pleasure!

Sciple: As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against the stocks discussed, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for his work behind the glass. For Lou Whiteman, I'm Nick Sciple. Thanks for listening, and Fool on!