UTX United Technologies Corporation

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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