By: Carter Copeland
A transaction no one expected. The pro forma numbers look good. We and others have been patiently awaiting a separation of UTX Aerospace from the current conglomerate structure. The addition of RTN to this equation comes as a total surprise, and while it only changes the earnings algorithm slightly, it brings with it the prospect for less macro-cyclicality, albeit with heightened integration risk and several unanswered questions. We’ve scrubbed the pro forma model through 2025 and it looks reasonably good. Revenue, EBITDA, EPS and FCF/share CAGRs from 2020-2025 of 4%, 6%, 13% and 14%, respectively, for the new Raytheon Technologies Corporation. This compares to our stand-alone revenue, EBITDA, EPS and FCF CAGR expectations of 5%, 3%, 9% and 9% for RTN and 4%, 6%, 13% and 14% for UTX Aerospace, respectively.
“Why?” is our predominant question. RTN owners own Defense for defensiveness and growth visibility. UTX owners own the accelerating growth in the aerospace portion of the portfolio together with margin expansion and FCF growth resulting from 1) aftermarket growth picking up and 2) investments made in R&D, working capital/capex, and new engine losses moving in the opposite direction. The pro forma spreadsheet certainly offers good enough numbers to overcome some of the “thesis creep” inherent in this proposed combination, but we find ourselves still asking questions around what this combination tells us about the limitations each management team saw in their stand-alone portfolios. For UTX, the ability to add the RTN portfolio of technology without paying a control premium is interesting, and it enables much higher short-term capital deployment, but it looks a lot like a “reconglomeration” that adds complexity to a story that was getting simpler. For RTN, we suspect that longer-term FCF growth headwinds from pension income reversals and the pursuit of a differentiated cost structure served as the impetus to combine without a large premium.
“What’s next?” and “What does it mean for everyone else?” are close behind. The read throughs from this proposed transaction are fascinating, primarily as they point to a changing competitive landscape in Defense. The “social contract” established by the Defense group in the downturn (pursue growth while aggressively protecting margin rates and returning essentially all cash to shareholders) increasingly stands in contrast with what companies may need to do to be competitive in the current Defense market. Aggressive bidding behaviors and potential market share shifts may warrant higher internal R&D and/or cross-subsidization where possible (like we’ve recently seen from BA). There could be much more to come on this front.
We’re raising our year-end 2020 UTX and RTN price targets to $159 and $217, respectively.
See inside for a more detailed summary of the new Raytheon Technologies Corporation.