Better Buy: Raytheon vs. United Technologies

United Technologies and Raytheon Company are set to merge in the first half of 2020, and as always in these situations, there's a temptation to lazily assume their share prices will track each other closely. Taking this approach might be a mistake because, based on the terms of the deal and recent events, it looks like buying Raytheon stock is the better option if you want exposure to the future Raytheon Technologies. Here's why.

The deal is good news

There's no point considering buying either stock if you don't think the deal will be value-enhancing. However, the good news is there's plenty of evidence to suggest the deal makes sense.

Raython's missile defense systems will be added to United Technologies' arsenal. Image source: Raytheon Company website.

The management of both companies believes the merger will generate $1 billion in annual cost synergies within four years. However, the merger isn't really about cost synergies -- the $1 billion figure represents just 1.1% of the estimated revenue of Raytheon Technologies in 2023. Instead the deal is being touted as an opportunity for each company to benefit from the other's technology.

In a nutshell, UTC's commercial aviation heavy operations (the company is also a leading player in defense aircraft engines) will be a complementary fit with Raytheon's space, defense, and missile systems. In addition, the steady stream of cash flows from the less cyclical Raytheon will balance out UTC's cash flows and enable it to invest in long-cycle products that require huge initial investments, such as the geared turbofan. 

Avoiding United Technologies' nonaerospace businesses

There's evidence that United Technologies nonaerospace businesses Otis (elevators) and Carrier (heating, ventilation and air conditioning, fire safety and security products) are underperforming compared to its aerospace businesses, Pratt & Whitney and Collins Aerospace. That being the case, investors will get exposure to the underperforming businesses if they buy United Technologies stock, while Raytheon will ultimately merge only with the aerospace businesses of United Technologies.

Carrier is an interesting business in its own right, and its separation should enable it to participate in industry consolidation in the future, but the fact is that it's not firing on all cylinders right now -- management just cut Carrier's full-year 2019 sales and earnings forecast. Meanwhile, Otis' exposure to the all-important China elevator market is an ongoing concern.

All told, if you like United Technologies aerospace businesses, why not just wait until after the separation or buy Raytheon stock and wait for the merger?

Raytheon is getting the better side of the deal

Digging into the details suggests Raytheon investors are getting the better side of the deal. To see why take a look at the key point of the transaction structure: Raytheon shareholders will get 43% of the combined company and United Technologies will get 57%.

It would reasonable to assume that the terms would reflect the respective companies' earnings and cash flow generation. For now, let's focus on free cash flow (FCF).

At the time of the merger announcement, United Technologies management said Raytheon Technologies would generate $8 billion in pro forma FCF by 2021. However, as noted by Vertical Research analyst Jeff Sprague on the recent earnings call, United Technologies' SEC S-4 filing shows a significantly larger number for unlevered FCF in 2021.

United Technologies CEO Greg Hayes said the $8 billion figure reflected "our own conservatism in terms of what we put out to the Street versus how we actually value the business." Moreover, CFO Akhil Johri said there was a difference between "what you see in the S-4 and what was used for valuation purposes with our internal plans."

In other words, the 57%/43% split was agreed upon with United Technologies management using possibly more favorable internal assumptions for what its business was worth. That's fair enough, and if you look at the average cash flow split in the projections in the SEC filing and take the five-year average split of FCF, the figures correlate nicely to the 57%/43% split.

Data source: United Technologies SEC filings.

But here's the thing. United Technologies investors might feel they are entitled to a larger-than-57% share because of the long-term growth in cash flow from Pratt & Whitney's geared turbofan (GTF) engine.

In fact, according to figures in the S-4 filing, Pratt & Whitney's FCF will grow at a compound annual growth rate of 26% from 2020 to 2023, and by 2023 it will represent around 30% of total UTC FCF (in the table above).

The growth reflects increases in services revenue from the GTF as the installed base grows from a few hundred GTF-powered aircraft in service to around 4,600 in 2025. Indeed, by 2025 management forecasts Pratt & Whitney's total large engine installed base to be around 17,000, up from around 12,000 in 2020.

Buy Raytheon

All told, it looks like Raytheon investors are getting a good deal, particularly by gaining exposure to cash flow streams from the GTF. In addition, the valuation of United Technologies before the deal will be dictated by what Otis and Carrier report.

Meanwhile, for Raytheon, the market should be pricing in what United Technologies aerospace businesses are reporting because that's what current Raytheon shareholders will have a claim on in the future.