The Valuation Conundrum in the United Tech-Raytheon Merger -- Heard on the Street
June 20 2019 - 5:43AM
Dow Jones News
By Jon Sindreu
Who is getting the raw end of the merger deal between United
Technologies and Raytheon? The answer isn't as clear-cut as some
investors have argued. Much depends on how you value UTC's many
moving parts, including its flagship engine program.
Activist UTC shareholder William Ackman has said the deal favors
Raytheon shareholders, based on a bullish estimate of what UTC's
core aerospace business should be worth. Valuation metrics suggest
he has a point, as does Raytheon's slightly better stock
performance in the days since the transaction was announced.
But cold numbers may understate the long-term risks Raytheon
investors will have to shoulder once they own UTC's jet-engine
business Pratt & Whitney.
In this "merger of equals," 57% of the new shares will end up
with UTC's shareholders and 43% with Raytheon's. The companies say
the split is based on the value of discounted cash flows -- a
notoriously flexible measure. How it squares with the market value
of both companies is unclear, given that UTC is due to spin off its
air conditioning and elevator divisions before the merger.
The terms of the deal at the point they were announced implied a
theoretical stock price for UTC's aerospace business after spinoffs
of $80. Most valuation methods suggest this is low, but different
assumptions provide wildly different results. For example, Heard on
the Street's discounted cash-flow model -- using Barclays's
forecasts -- suggests a stock price of $103, whereas comparing it
with peers' valuations gives a range from $72 to $92 a share.
Valuing companies as the sum of their parts is a tricky
business. An added source of ambiguity in this case is UTC's geared
turbofan or GTF program, which powers the popular Airbus A320
jet.
Engines are a massive drag on earnings and cash during the
design and ramp-up stages -- they are normally sold at a loss --
but become a cash cow later as operators need repairs. These future
revenues are subject to risk: GTF is expected to break even in
about five years, but since 2018 it has grappled with a raft of
issues that have left many planes grounded.
Investors have had concrete experience of this risk in recent
history. Shares in Pratt & Whitney's U.K. rival Rolls-Royce
collapsed in 2015 when shareholders lost faith in the way its
complex accounting brought forward anticipated profits from future
service revenue.
This makes discounted cash flows an optimistic measure of value.
Investors don't seem to use them to value General Electric's
competing engine program, the LEAP, which is in a similar ramp-up
stage. On top of the execution risks associated with specific
high-stakes projects, there is the possibility that the jet market
cools in the mid-2020s after years of growth.
"It's not a given that the [UTC aerospace stand-alone] stock
would have traded on discounted cash flows," says Barclays
aerospace analyst Julian Mitchell.
The transaction also raises uncomfortable questions for the
combined entity, which explains why both stocks have fallen since
it was announced. The merger entails few efficiency gains, and the
new UTC-Raytheon giant may start a price war with Boeing for
defense contracts, compressing margins.
This may not be the kind of investment that the defense sector's
conservative, income-seeking shareholders were hoping for. On
paper, marrying UTC seems to come with a dowry for Raytheon. In the
risky real world, it isn't so simple.
Write to Jon Sindreu at jon.sindreu@wsj.com
(END) Dow Jones Newswires
June 20, 2019 05:28 ET (09:28 GMT)
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