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An Analysis on the United Technologies-Raytheon Merger

PRESENTED TO:

Professor Keith Porter

PRESENTED BY:

Amrit Kabo (40055229) Thierry Matin (40045680)

Louis-Émile Gaudette (40085070) Jonathan Dybka (40045217)

John Molson School of Business

FINA 415 - Mergers & Acquisitions

Fall 2020 - Section BB

Friday, December 11th, 2020

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Contents

INTRODUCTION ......................................................................................................................................... 3

Case Overview ........................................................................................................................................... 3

Overview of Raytheon ............................................................................................................................... 3

United Technologies Overview ................................................................................................................. 4

INDUSTRY OVERVIEW ............................................................................................................................. 6

Aerospace and Defence Industry ............................................................................................................... 6

Commercial Aerospace Industry ............................................................................................................... 7

Industry Participants .................................................................................................................................. 8

MERGER TERMS & NEGOTIATIONS ...................................................................................................... 9

Deal Structure ............................................................................................................................................ 9

Strategic Rationale ................................................................................................................................... 10

Regulatory Process .................................................................................................................................. 15

Pro-Forma Entity ..................................................................................................................................... 16

Market Reaction & Investor Criticism .................................................................................................... 18

POST-MERGER INTEGRATION ............................................................................................................. 19

COVID-19 Impact ................................................................................................................................... 19

VALUATION .............................................................................................................................................. 21

Fairness Opinion ...................................................................................................................................... 21

CONCLUSION............................................................................................................................................ 24

REFERENCES ............................................................................................................................................ 26

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INTRODUCTION

Case Overview

In June of 2019, United Technologies Corp. (“UTC”) and the Raytheon Company

(“Raytheon” or “RTN”) agreed to an all-share merger that created a massive multinational

conglomerate and one of the largest aerospace and defence manufacturers. The deal was worth

roughly US$90B and was eventually completed in April 2020, with the merged entity being known

as Raytheon Technologies (NYSE: RTX, “RTX”). The transaction created the second largest U.S.

Aerospace & Defence company by revenue, trailing only Boeing, with exposure to both the

military and commercial markets. In this paper, we will analyze the key components of the merger.

Overview of Raytheon

Raytheon, founded in 1922, was a major defence contractor for the United States. In

combination with its subsidiaries, it was composed by the following business segments, as per

figure 1; Integrated Defence Systems (“IDS”), Intelligence, Information and Services (“IIS”),

Missile Systems (“MS”), Space and Airborne Systems (“SAS”). The IDS segment provided

integrated air and missile defence systems, notably the patriot-missile systems, to operators such

as the U.S. Army and Navy; the MS segment developed missile and combat systems for the U.S.

Forces and allied nations; the IIS segment specialized in items such as cybersecurity and data

analysis, which it provided to operators such as the U.S. Intelligence Community and finally, the

SAS segment provided sensor and communication systems for operators such as the U.S. Air Force

(RTN Form 10K 2019). In terms of end markets, the company was primarily focused on the

defence sector in the United States, with roughly 69% of total revenue being generated by military

defence contracts from the U.S. government with an additional 14% of revenue being generated

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by foreign military sales through the U.S. government. Although Raytheon was considered to be

the 4th largest defence contractor based on contracts won (Federal Procurement Data System,

2020), the heavy dependence on the defence sector exposed the company to risks such as changes

in regulations or requirements, contract termination and customer concentration. Given the

dependence on the U.S. government, winning said contracts and then delivering on them in both a

timely and effective manner were key for the Raytheon Company (RTN Form 10-K 2019).

Figure 1: RTN Revenue Mix

Source: RTN Form 10K 2019

United Technologies Overview

UTC was founded in 1934 as United Aircraft Corporation, however, as the firm focused

on growth by M&A and diversified into other industries, it rebranded itself as UTC in 1975. Via

its M&A strategy, UTC became a multinational conglomerate and prior to the merger, the

company operated through the following business subsidiaries, as per figure 2: Otis, Carrier, Pratt

& Whitney and Collins Aerospace Systems. The Otis segment provided elevator and escalator

manufacturing, installation and service company to commercial, residential and infrastructure

property sectors across the globe and accounted for ~17% of 2019 sales. The Carrier subsidiary

provided heating, ventilating, air conditioning, refrigeration, fire and security solutions for

residential, commercial and industrial applications and accounted for ~24% of sales. Following

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the acquisition of Rockwell Collins in 2018, UTC announced it would divide itself into three

businesses by spinning off its Otis and Carrier segments into independent companies owned by

shareholders. These spin offs were completed in Q2’2020 and were part of UTC at the time of the

merger; hence we have included them in the company description. The Pratt & Whitney subsidiary

manufactured aircraft engines, which it sold to commercial, military, business and general aviation

markets - notably supplying the engine for the F-35 Lightning II aircraft being produced by

Lockheed Martin. Finally, the Collins Aerospace Systems segment provided technologically

advanced aerospace products and aftermarket service solutions for aircraft manufacturers, airlines,

regional, business and general aviation markets, as well as military and space operations. In terms

of end market exposure, UTC served the commercial, industrial and military markets. Although it

wasn’t necessarily as concentrated as Raytheon was, UTC was still the 7th largest defence

contractor based on contracts won (Federal Procurement Data System, 2020). Henceforth, the

company was still exposed to the risk of changes and terminations in both U.S. government and

commercial contracts (UTC Form 10-K 2019).

Figure 2: UTC Revenue Mix

Source: UTC Form 10K 2019

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INDUSTRY OVERVIEW

Aerospace and Defence Industry

The end of the Cold War brought upon great changes to the overall defence industry;

defence spending shifted away from large arsenals of traditional weapons and instead emphasized

innovative weapon systems, rapid deployment and extreme precision. As a result of this shift, the

defence industry has been characterized by consolidation/M&A as scale and innovation have

become necessary for winning contracts. Notable M&A activity includes the $30B acquisition of

Rockwell Collins by UTC in 2017 and the $20B merger between L3 Technologies and Harris in

2018. These contracts, which governments will offer to companies in exchange for the

manufacture of key military goods and services, are a key driver of the defence industry, along

with geopolitics. Global military expenditure was estimated to have been ~$1.9T in 2019, with the

bulk of the spend coming from the United States ($705B) (Sipri, 2020). As the U.S. government

is a predominant force in the defence industry, and both companies are based in the U.S., we will

focus on the U.S. defence market. Following the end of the Iraq War, the Department of Defence’s

budget decreased as per figure 3, before being increased by President Trump’s administration in

2017. In terms of an outlook, the defence budget is certainly expected to stagnate. Even prior to

the pandemic, the defence budget for FY2021 was set at around $705.4B, compared to $704.6B in

FY2020 - a growth of just 0.1% (Department of Defence Budget, 2020). Due to the significance

of the pandemic and the corresponding exacerbation of the deficit ($3.1T in FY2020, the highest

percentage of GDP since 1945 as per Bipartisan Policy), spending on defence will likely decrease

going forward which will impact all contractors.

Figure 3: DoD Defence Budget

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Source: Macro Trends and Sipri.org

In terms of market share, the US market is not necessarily significantly concentrated in

terms of contracts won due to the regulations regarding contracts awards, however a select number

of companies, such as Lockheed Martin, Boeing, Northrop Grumman and RTN have historically

won the largest contracts. Following the merger, and based on 2019 figures, Raytheon

Technologies would have accounted ~3.7% of total U.S. defence budget spend, creating the third

largest defence contractor in the U.S. (Federal Procurement Data System, 2020), allowing the

merged entity to gain the necessary scale to become a more dominant player in the industry.

Figure 4: Top 10 Federal Defence Contractors (% as a total of DoD spend)

Source: Federal Procurement Data System

Commercial Aerospace Industry

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The commercial aerospace industry is composed of companies that manufacture aircraft

for commercial air travel and was estimated to have generated roughly $784B in 2019 (IBISWorld

2020). The manufacture of aircraft has been long dominated by the likes of Boeing and Airbus,

however companies such as Raytheon Technologies provide critical aspects such as engines and

cabin equipment. In terms of an outlook, the industry is likely to decrease in the near term as the

pandemic and its corresponding virus-curbing restrictions have significantly ravaged air travel,

with IBISWorld forecasting a ~24% contraction in sales. The restrictions have had obvious impacts

on the supply chain, given that airlines have deferred many deliveries in a struggle to preserve cash

and survive. These deferrals have crept up the supply chain and impacted not only the

manufacturers of passenger aircrafts such as Boeing and Airbus, but the providers of aircraft

equipment such as General Electric and Raytheon Technologies (Ferguson, 2020). Although short-

term expectations are low, as RTX’s CEO Greg Hayes himself stated in the company’s Q2 2020

earnings call that he does not expect commercial air travel to return to “normal” until 2023, the

industry should benefit from a recovering in air travel and the increasing backlog of orders in the

long-term.

Industry Participants

In figure 8, we have compiled the top companies in the aerospace & defence industry. As

outlined, not only is the merged entity, RTX, one of the largest companies in the industry, but it is

perhaps the most balanced across the commercial and defence markets. Diversification was one of

the key reasons behind the merger (it is further elaborated upon later in this report) and has become

especially necessary in light of the pandemic as the commercial industry has been effectively

halted due to virus-curbing restrictions.

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MERGER TERMS & NEGOTIATIONS

Deal Structure

The merger agreement was initially announced on June 10, 2019, with the agreement being

a merger of equals transaction combining UTC’s aerospace business, composed of Collins

Aerospace and Pratt & Whitney, with Raytheon, creating Raytheon Technologies Corporation.

Shareholders of each respective company approved the deal in October of 2019 and the deal finally

closed on April 3rd, 2020. In terms of the deal structure, it was an all-stock transaction where

Raytheon shareholders received 2.3348 shares in the new combined company for each existing

share they owned previously. The aggregated value of the new entity at the time of the

announcement was roughly $90B (implying a forward EV/EBITDA of ~13x and no premium due

to the structure of the deal). Raytheon shareholders received control of 47 percent of the merged

entity, with the remaining 53 percent going to UTC shareholders. Additionally, UTC CEO Greg

Hayes became the CEO of the combined company, while Raytheon’s CEO, Thomas Kennedy,

became chairman. In terms of the board of directors, UTC controlled eight of the 15 pro-forma

seats, with the remaining seven coming from Raytheon. (RTN FORM 8-K, 2019) In terms of

leverage, the new entity’s net debt stands at ~$26B, of which UTC contributed roughly ~$24B. At

these levels, the company’s credit profile qualifies as “A-rated”. Furthermore, both parties were

subject to termination fees; Raytheon would have to pay UTC ~$1.8B if Raytheon backed out of

the deal and UTC would have to pay Raytheon ~$2.4B if UTC backed out of the deal (RTN FORM

8-K, 2019).

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Strategic Rationale

Cost Synergies

As the A&D industry consolidates, there will be increased pressure exerted on players to

expand their R&D budget. R&D budgets are pegged to revenues, so as these companies continue

to scale operations, capital allocated to research will also rise, putting pressure on competitors to

follow suit. Raytheon was thus given the choice of increasing its R&D budget or scaling up the

business. They choose the latter, by accepting the merger proposal from United Technologies the

new entity will remain competitive within the industry (Liwag & Sharpe, 2020). Management is

expecting the combined company will achieve $1B in gross cost synergies by year four of

operations (RTX M&A Investor Presentation, 2020). These cost savings will be achieved by

consolidating various business segments. $350M will come from supply chain and procurement,

$325M from corporate consolidation, $175M in facilities consolidation, and $150M from IT and

SG&A savings (Investor Relations, 2020). RTX expects to realize these savings by the fourth year

of operations, which will give the new entity time to consolidate.

Based on these estimates, management is expecting to spread the overhead across the larger

organization. Considering the aerospace and defense industry is relatively low output, their

individual units have a higher unit cost. By consolidating segments, they will be able to eliminate

redundancy and drive down the unit costs of their output. Although this would be more effective

if RTN and UTC had identical products, which they do not. UTC’s Pratt & Whitney division does

not have much in common with RTN’s information services. These units will therefore remain

intact, and the synergies are limited. The main area in which RTX will benefit from cost synergies

will be in economies of scale. As we can see the biggest savings will be in the supply chain

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($350M) and IT($150M) segments. Both of these will see lower per-unit costs as operations scale

up (Gaughan, 2017).

As the industry consolidates, R&D expenses will continue to grow in absolute dollar size

while becoming smaller as a percent of revenues. Looking at Figure 5 we can see the justification

for the merger as Raytheon Technologies is able to field a competitive research expense.

Figure 5: A&D Industry Research Expense

Source: FactSet

Revenue Synergies

Revenue synergies are hardest to achieve and are often overstated by management of

merging firms. It is estimated that 70% of mergers failed to achieve topline synergy expectations.

This is often due to management's failure to consider the cost of the disruption which can lead to

a loss in customers (Christofferson & McNish, 2020).

RTX will benefit from a more diverse source of revenues. Raytheon’s defense business

will complement United Technologies’ aerospace revenues. Management believes that both

entities can leverage each other’s technologies to innovate product offerings and drive revenue

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growth in areas such hypersonic missile systems, directed energy weapons, intelligence,

surveillance and reconnaissance, cyber protection for aircraft, and artificial intelligence in aircraft

(Liwag & Sharpe, 2020).

For RTX, the source of its revenue synergies will most likely come from faster growth

markets and a combination of functional strengths. Looking at Figure 6, we can see UTC has faster

growing revenues which will contribute to the new company by giving it access to the faster

growing aerospace industry. RTN’s contribution is its stable defence segment which is more

dependent on defence spending rather than the state of the economy.

Figure 6: Revenue Growth

Source: CFRA

Diversification & Financial Synergies

As a larger, more diverse firm, RTX will be substantially less risky compared to the two

original firms. The new Raytheon Technologies will have exposure to RTN’s defence business as

well as UTC’s aerospace business. This means the company will have a more diversified source

of revenues. At the moment, the commercial aerospace sector has collapsed due to the COVID-19

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pandemic, while defence spending has remained consistent. Because the combined cash flows are

not perfectly correlated, RTX will benefit from financial synergies which will lower its chance of

bankruptcy. Looking at Figure 7, we can see RTX has a lower cost of capital at 8.8% compared to

its predecessors at 9.26% and 10.39% for UTC and RTN respectfully.

Figure 7: Cost of Capital

Source: CFRA

Technology & Scale

As mentioned, the merger created one of the largest global Aerospace and Defence

companies by revenue. The combined portfolio of Raytheon Technologies Corp. now spans across

a very large variety of business verticals, both in the Commercial Aerospace and the Defence

markets. The new management team expects numerous overlap opportunities in technological

competencies of both aforementioned teams. To name a few, the company suggests it can now

serve customers in the Hypersonic/Future Missile Systems area with enhanced solutions

combining UTC’s signature high-temperature materials, thermal management, and advanced

propulsion systems with Raytheon’s vehicle integration expertise, seekers and payloads, and

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advanced guidance and control technology. Such examples can be observed in numerous areas of

both the defence and the commercial aerospace areas. With a team of ~60,000 engineers, ~38,000

patents, 7 R&D centers around the globe, and a pro-forma R&D spend of ~$8B in 2019, it is not

hard to imagine how the post-merger RTX now has some end-to-end capabilities that are very

difficult to match by its peers.

In terms of scale, given how diversified and balanced the merged entity is, it now has the

ability to invest through the business cycle, regardless of where it stands at any point in time. This

is made possible due to the offsetting nature of the commercial and defence cycles. The company

is also less reliant on any individual programs or customers. Finally, the combined total

addressable market is significantly increased for the combined company.

Figure 8: Competitive Landscape

Source: RTX Investor Presentation

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Regulatory Process

All mergers and acquisitions transactions are subject to antitrust laws. Antitrust laws are

put into place to promote fair competition and protect consumers from predatory pricing or

excessive market power. In the case at hand, the Antitrust Commission of the Department of

Justice (“DOJ”) of the United States and the European Commission had to go over the proposed

transaction to ensure Raytheon Technologies would not gain excessive market power in any areas

of business. Although both regulatory agencies approved the transaction, they concluded Raytheon

needed to proceed with the divestiture of its military airborne radios and its big space-based optical

systems businesses. The reasoning behind such decisions is quite simple; The companies were

among the very few suppliers in this niche market, and therefore, without intervention, would

lessen competition in these markets. (Department of Justice - Office of Public Affairs, 2020) After

working closely with the DOJ, Raytheon proceeded to sell its aforementioned military airborne

radios business (including facilities in Indiana, Florida and Connecticut) to BAE Systems Inc. for

roughly ~$2.1B. ($1.9B for Collins Aerospace’s military Global Positioning System and $275M

for Raytheon’s Airborne Tactical Radios’ division) (Erwin, 2020)

Finally, after having made the required divestitures and proceeded with the scheduled spin-

offs of the Otis and Carrier brands, there are now 4 distinct groups under the Raytheon

Technologies name today: Collins Aerospace, Pratt & Whitney, Raytheon Intelligence & Space,

and Raytheon Missiles & Defense.

Figure 9: Pro-Forma Business Segments

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Source: Raytheon Technologies

Pro-Forma Entity

In terms of pro-forma entity, Raytheon Technologies’ geographical exposure is now

comprised of 55% domestically generated revenues (i.e., Revenues generated in the U.S.), with

the remaining 45% being international. The end market breakdown showcases the merged

company’s balanced profile, with the Commercial Aerospace segment and the Defence segment

accounting for roughly 46%, and 54% of revenues, respectively. (See Figure 10)

Figure 10: Pro-Forma Business Mix

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Source: Raytheon Technologies

With regard to capital structure, the merged entity is skewed towards a more equity heavy

structure. The company currently has a market capitalization of roughly ~$90B ($87.3B to be

exact) and roughly ~$34B in total debt (~$1.5B in short-term debt and ~$33B in long-term debt).

Figure 11: Pro-Forma Capital Structure

The company’s credit ratings have been updated by credit agencies following the execution

of the merger and have remained stable despite the ongoing global pandemic. Moody’s current

issuer rating is a respectable “Baa1”, while Standard & Poor’s hold a strong “A-” rating. In other

words, credit agencies classify RTX’s credit worthiness as having an “adequate” to “strong”

capacity to meet its financial commitments (Ferguson, 2020).

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Market Reaction & Investor Criticism

The merger had attracted criticism from activist investor Bill Ackman who voiced concerns

that it would lower the quality of United Technologies as a company. In his view, the company

was on track for success as it separated into three divisions and focused on its aerospace business.

Having spun off its Otis and Carrier businesses, Ackman believed UTC would trade at a higher

multiple as a smaller and leaner company potentially in the mid 20’s P/E multiple. He questioned

the logic UTC for using its (in his opinion) highly undervalued shares to buy inferior Raytheon

shares. UTC had an undervalued share price because of years of acquisitions, which increased

amortization and artificially reduced earnings. This contrasts with Raytheon, because they are a

pure play in the industry, their share price did not suffer from discounting like UTC (Ackman,

2019). Daniel Loeb of Third Point Management also criticized UTC for what he saw as a pivot

from their initial strategy of focus and accountability. In his letter to UTC shareholders, he pointed

out management’s timing of the purchase as Raytheon is trading at a historically high multiple of

13x 2019 EV/EBITDA (Loeb, 2019). Overall, we can see there is concern among UTC

shareholders that the company is turning into an unwieldy conglomerate which would reflect

negatively in its trading multiples. The combined company will however, only trade at a discount

if the market believes there to be a lack of synergies.

Despite these concerns, Raytheon Chief Financial Officer Toby O’Brien asserted the

combined entity would be more resilient as the aerospace and defense industries do not always

move in tandem. These markets can be considered complementary to each other as they have

similar capital requirements and margins (See Figure 12). Raytheon’s defence business is certainly

a source of stability as government contracts have not slowed as a result of the COVID-19

pandemic (Sutherland, 2020).

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Figure 12: Margin Comparison

Source: CFRA

POST-MERGER INTEGRATION

COVID-19 Impact

After the merger was completed in April of 2020, the new Raytheon Technologies had the

misfortune of beginning its tenure at the beginning of the Covid-19 pandemic. As a result, the

company has experienced revenue declines in all of its segments. This new challenging market

landscape will create difficulties for the new company as it consolidates. The pandemic had also

impacted valuation, as the merged entity became “more expensive” on a relative basis – perhaps

reflecting higher market expectations. Figure 13 demonstrates RTX is currently trading at a higher

multiple compared to April and also at a premium compared to the former UTC and RTN.

Raytheon Technologies, along with other aircraft manufacturers, such as Boeing and Airbus, will

likely see higher costs in 2021 as lower volume hurts economies of scale.

Figure 13: Relative Valuation

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Source: Bloomberg

Despite trading at a higher multiple, certain cost synergies have not materialized. RTN’s

research budget as a percent of revenue is higher than its predecessors at 4.7% of revenues. This

is the same case with COGS, at 87.4% of revenue which is substantially higher than that of the

previous RTN and UTC (See Figure 14). This may be as a result of a lack of economies of scale

and margin compression as a result of the pandemic. Of course, no definitive conclusions can be

made, as management expects the cost synergies to emerge after four years.

Figure 14: Margin Analysis

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Source: Company Filings

Note: 2020 numbers are as of Q2’2020

VALUATION

Fairness Opinion

Further, we decided to provide a fairness opinion through contrasting the terms of the actual

merger relative to our valuation of both Raytheon and United technologies. Indeed, we have valued

Raytheon close to the implied transaction price, at $223.59 and United Technologies at $111.36.

Our valuation accounted for divestitures, as well as synergies from the merger. Synergies were

forecasted according to management guidance and broken down into both cost and revenue

segments, with the integration costs netted from cost synergies.

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Figure 15: Quantified Synergies

Although Raytheon’s share price closed at $116.96 as at the merger date, United

Technologies’ exchange ratio of ~2.335x implies a share price of $223.08. That being said, we

believe Raytheon was adequately valued by United. However, we do not believe United

technologies, valued at $86.01 per share, was fairly priced, given our intrinsic valuation of

$111.36. If United had fairly priced themselves, they could have compressed their exchange ratio

to ~1.81x, providing decreased short-term dilution to EPS and overall increased value creation for

shareholders.

Relative to our scenario with a ~1.81x exchange ratio, we can see the difference in EPS

accretion/dilution vs the realized merger scenario. EBITDA improvement is constant regardless of

the transaction structure, with notable increases in the third year and a loss in the first year given

integration costs.

Figure 16: Accretion/Dilution Analysis

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This structure would have also provided United Technologies' shareholders with increased levels

of ownership in the pro forma entity.

Figure 17: Ownership Analysis

The merger did provide some notable benefits, namely increased balance sheet capacity

through improved Debt/EBITDA, given Raytheon’s low amount of leverage. This could allow the

newly formed Raytheon Technologies to increase leverage in line with United Technologies’

acquisition heavy growth strategy.

Figure 18: Leverage Analysis

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Overall, it does appear that the transaction was completed in Raytheon’s favour. The timing

and viability of the acquisition are also in question. Although the synergies are viable, their present

value when added to UTC’s stand alone share price only adds ~$2 per share, which questions the

attractiveness of the merger. For the timing, it seems like a strategic error to take on a large

acquisition of this type during a restructuring process (referring to United’s divestitures). This

might have overwhelmed management and led them to undervaluing UTC as at the closing of the

merger.

CONCLUSION

In summary, the strategic rationale underpinning the merger appeared sound, yet the timing

and pricing of the acquisition were questionable. The exposure to defense revenue streams that

United Technologies gained through acquiring Raytheon allowed the firm to diversify its top line,

limiting the effects that the pandemic had on the commercial aerospace industry. The pandemic

also minimized the effects of cost cutting synergies and the overall quantitative value add of the

synergies remains relatively modest. That being said, we believe United Technologies should have

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re-considered the timing of the merger given the restructuring they were going through. Despite

shareholder approval of the deal, UTC’s management shifted away from its strategy of becoming

a leaner, more efficient entity following the divestitures. Additionally, re-considering the timing

of the merger may have allowed them to value themselves more in line with their intrinsic value

and provided them with a better transaction structure, increasing total value to shareholders. In

short, although we believe UTC’s reasoning behind the merger did make sense, the company

would have been better off re-considering the timing of the merger.

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