What the United Technologies merger with Raytheon means for defense

  • By Al Root,
  • Barron's
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United Technologies (UTX) said Sunday that it struck a deal to merge with Raytheon , an all-stock transaction that would create an aerospace and defense giant rivaling Boeing (BA).

The deal could put pressure on peers to keep up with the pair, making other small-capitalization defense companies look all the more attractive as targets for acquisition. Together, United Technologies and Raytheon (RTN) would have about $72 billion in aerospace and defense revenues, more than other so-called defense prime contractors like General Dynamics (GD), Northrop Grumman (NOC), and Lockheed Martin (LMT). Boeing commercial aerospace and defense revenues top $100 billion a year.

Investors will likely approve of the deal, and Raytheon stock should move higher. What’s next for United Technologies stock may be more complicated. The company is in the midst of a massive transformation, spinning off its Otis elevator Carrier air conditioning divisions. Those transactions, announced late last year, are expected to be completed in the first half of 2020. United Technologies also just finished its $30 billion acquisition of avionics maker Rockwell Collins in December. Investors looking to own the combined aerospace businesses of Raytheon and United Technologies, through ownership of United Technologies stock, will have to wait at least a year to hold the stand-alone company’s shares.

Raytheon, for its part, makes missiles such as the Tomahawk and Patriot, but it also provides state-of-the-art electronics that investors may not be as familiar with. Raytheon electronics end up in high-profile products like Lockheed’s F-35 Joint Strike Fighter or Northrop’s stealth bomber.

Barclays analyst Julian Mitchell believes the deal could spark more M&A activity with industrial companies like Honeywell (HON) looking to acquire more defense businesses.

The biggest market beneficiary from this deal is likely the defense electronics sector. This isn’t the only recent deal in the space. Raytheon competes withh L3 Technologies (LLL) which is being purchased by Harris (HRS) in an all-stock deal announced in October. Harris and L3 will have more than $17 billion in annual sales once the deal is completed.

Investors love that combination. The stocks of Harris and L3 are up 14% and 16%, respectively, since the deal was announced, far better than the 4.5% return of the S&P 500 (.SPX) and the 1.7% return of the aerospace and defense components of the S&P 500 over the same span.

Mercury Systems (MRCY) is another small-capitalization, stand-alone defense electronic company, with less than $700 million in annual sales. The stock is up 44% year to date, and trades for a premium multiple, 34 times estimated 2020 earnings. Developments like United Technologies-Raytheon merger will provide some support to the stock valuation. Wall Street likes Mercury Systems stock: Despite the high price-to-earnings multiple, 78% of the analysts covering the stock rate it a Buy, about 20 percentage points better than the average buy-rating ratio for stocks in the Dow Jones Industrial Average (.DJI).

After Mercury, it gets harder to find small-capitalization defense electronics companies. Esterline was bought by TransDigm (TDG) earlier in 2019, Other small-cap defense names have been snapped up, too. Orbital was purchased by Northrop in 2018, and Boeing purchased distributor KLX to bolster and diversify its commercial aerospace business. Boeing also began and ended talks with aerospace engine component manufacturer Woodward (WWD) in early 2018.

It’s impossible to predict if and when more defense deals will take place, but small-cap aerospace and defense assets are definitely getting a lot more attention than in the past. It could be because the defense business is looking up after the end of U.S. budget “sequestration” in 2015 that pressured sales growth at defense companies. Or it could be because larger defense mergers wouldn’t be approved by the Pentagon.

Whatever the reason, the emerging trend means investors should keep an eye on small-cap aerospace and defense firms.

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