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Raytheon and United Technologies Merge to Create Undervalued Defense Behemoth

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On April 3, Raytheon (NYSE:RTN) and United Technologies (NYSE:UTX) successfully closed their merger after clearing the last regulatory hurdles the previous week. The merger will create a defense behemoth that generated $74 billion in revenues during 2019. The new company will be named Raytheon Technologies and will begin trading on April 3 under the stock symbol RTX.

Preceding the merger, United Technologies spun off its HVAC division Carrier (CARR) and its elevator division Otis (OTIS) into separate companies, both of which have been added to the S&P 500.

In order to clear the last holdup from the U.S. government, Raytheon agreed to divest its military airborne radio business, while United Technologies agreed to divest its GPS and space optical businesses. These other spinoffs "are all expected to be completed following the merger."

The merger and spinoffs result in multiple companies with strong financials and growth prospects. Let's take a closer look at each of them.

Raytheon Technologies

To complete the merger, each share of Raytheon was converted to 2.3348 shares of Raytheon Technologies, while each share of United Technologies was converted to one share of the combined company.

Raytheon is a major U.S. defense and industrial manufacturing company with its core operations in weapons and military and commercial electronics. After spinning of the necessary divisions, United Technologies brings its aerospace businesses to the combined company, including Collins Aerospace, one of the largest suppliers of aerospace and defense products in the world.

The new company will be led by United Technologies Chairman and CEO Greg Hayes and headquartered in Waltham, Massachusetts.

"Today, we introduce Raytheon Technologies as an innovation powerhouse that will deliver advanced technologies that push the boundaries of known science," Tom Kennedy, executive chairman of Raytheon Technologies, said. "Our platform-agnostic, diversified portfolio brings together the best of commercial and military technology, enabling the creation of new opportunities across aerospace and defense for decades to come."

United Technologies closed trading at $86.01 per share for a market cap of $74.50 billion, a price-earnings ratio of 13.42, an operating margin of 11.64% and a cash-debt ratio of 0.16, while Raytheon closed trading at $116.96 for a market cap of $116.96, a price-earnings ratio of 9.8, an operating margin of 16.36% and a cash-debt ratio of 0.79.

Over the first quarter of calendar 2020, Raytheon shares dropped 46%, while United Technologies shares were down 42%, resulting in the companies trading near or below their intrinsic value according to the discounted cash flow model and Peter Lynch earnings lines.


While the combined company will have the advantage of scale and complementary operations, which could help it gain more market share, there may not be much market share to gain in the immediate future. During times of economic crisis, governments typically cut spending on aerospace and defense contracts. Thus, declines in quarterly revenue may drive shares lower in the short term, despite the company's long-term value and current undervaluation.

Additionally, some analysts and investors hold that the low amount of cost-cutting synergies make the merger pointless from a shareholder perspective.

"Raytheon brings very little applicable technology to [United Technologies] aerospace offerings," Daniel Loeb (Trades, Portfolio) wrote in a letter to United Technologies' board in June of 2019. "The benefits of Raytheon's cyber and data analysis capabilities are not quantifiable and could be replicated through commercial collaboration or supply agreements."

In the letter, Loeb stated that Third Point planned to vote against the merger, though the firm only cut its holding in United Technologies by 13.22% and invested approximately $177 million in shares of Raytheon in the fourth quarter of 2019.


Carrier and Otis

Aside from the merger, the Carrier and Otis spinoffs, which are pure plays in their respective industries, also provide interesting opportunities. For each share of United Technologies stock, shareholders will receive one share of Carrier and half a share of Otis.

Carrier and Otis have little to do with United Technologies' main aerospace concentration, so it is likely that the company underinvested in these side businesses given their potential. After spinning off, the new companies will be able to focus on their niche specialties of HVAC and elevators, respectively.

Unlike the newly combined Raytheon Technologies, which operates in highly cyclical sectors, Carrier and Otis represent more stable areas of the market. Though installation of new HVAC and elevator units will likely fall as construction slows down, these products must also be maintained, serviced and replaced if broken.

Without enough focus on growth, Otis, which had the highest return on capital of United Technologies' businesses, lost market share to Kone (OHEL:KNEBV) in China. Some businesses are better off as a pure play, and this is likely to be the case with Otis. The strong intangible value of its brand, which has a 160-year history, is the number one name in elevator safety brakes, which will help drive its growth as an independent company.

Carrier is widely recognized as one of the largest and most reputable HVAC providers in the world, with a presence in the Americas, Europe, Asia Pacific and the Middle East and Africa regions. The market for HVAC is expected to grow to $130 billion by the end of 2020, primarily due to increasing demand in developing countries as well as developed European countries that have seen unprecedented heat waves in recent years.


With an economic downturn in progress in the U.S., most companies are seeing their share prices plummet. Raytheon and United Technologies, which merged on April 3, are no exception, especially as their operations are mainly in the aerospace and defense sectors, which follow the strength of the economy and largely depend on government spending.

However, the all-stock merger of equals was able to proceed, as were the spinoffs of Otis and Carrier into pure plays in their respective industries, allowing all three resulting companies to focus on their areas of expertise. Businesses all too often see their growth suffer because of unnecessary diversification, or "diworseification," as Peter Lynch calls it. The merger and spinoffs are the opposite of diworseification and show high potential to unlock value fore shareholders.

Disclosure: Author owns no shares in any of the stocks mentioned. The mention of stocks in this article does not at any point constitute an investment recommendation. Investors should always conduct their own careful research or consult registered investment advisors before taking action in the stock market.

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This article first appeared on GuruFocus.