Self-Defense Force
A Japan Self-Defense Force solider stands by a PAC-3 Patriot missile unit made by Raytheon at the Defense Ministry in Tokyo in 2012. About 30% of Raytheon’s sales are overseas, tops among U.S. defense contractors. (AP Photo/Shizuo Kambayashi)ASSOCIATED PRESS

[Updated June 10, 8:45 a.m.]

United Technologies and Raytheon have agreed to merge, the companies said Sunday afternoon, crafting an all-stock deal that would create a giant evenly balanced between civil aerospace and defense that may be better positioned to handle cost pressures and uncertain prospects in both sectors.

The two New England-based industrial stalwarts billed it as a “merger of equals,” but United Technologies investors would control 57% of the company, which will be called Raytheon Technologies, they said in a statement.

The combined company would have almost $80 billion in annual sales in 2020, which should push it past Airbus to be the second-largest aerospace and defense player after Boeing. The aggressive move, which was first reported by the Wall Street JournalSaturday evening, comes as a surprise, industry watchers told Forbes, with United Technologies already in the midst of a transformation: In November it completed a $30 billion acquisition of the aviation components supplier Rockwell Collins, and it was preparing to spin off its Otis elevators and Carrier climate controls units to become an aerospace and defense pure play.

“Everybody knew [CEO] Greg Hayes was reorganizing United Technologies to focus on aerospace and defense, but nobody anticipated a combination of this scale,” says Loren Thompson, a defense analyst and industry consultant with the Lexington Institute.

If the merger is approved by shareholders, it is expected to close in the second half of 2020 after United Technologies completes the spinoffs, which it had said would leave behind an aerospace company with $50 billion in annual revenue, roughly 75% on the commercial side, where its products run the gamut from avionics and aircraft interiors to jet engines, and 25% from defense, where its Pratt & Whitney unit has a dominant military engine franchise, making the powerplant for the F-35.

The Farmington, Conn.-based company’s product line has little overlap with defense stalwart Raytheon, which booked $27 billion in sales last year. Raytheon is the largest producer of missiles in the world, as well as missile defense systems like the Patriot. It also makes radars; sensors for warplanes, submarines and satellites; and electronic warfare and cybersecurity systems.

U.S. defense contractors have mostly opted to be pure-play businesses, and while defense spending has climbed sharply over the past two years, and is set to rise again in the next budget, it’s still below the heights reached during the George W. Bush administration, adjusted for inflation. Meanwhile their diversified competitor Boeing has ridden a 5% annual expansion in commercial air travel over the past 20 years to become the world’s dominant aerospace company.

Some observers say it’s the fat profits Boeing’s earning in commercial aerospace that enabled it to bid aggressively on price to win a recent string of big Pentagon defense contracts: the Air Force T-X trainer, the MQ-25 drone and the MH-139 helicopter.  

The budget outlook is another reason why hedging on defense might be a good move for Raytheon. CEO Thomas Kennedy has expressed optimism that the new focus in U.S. defense strategy on countering the threats posed by China and Russia play to the Waltham, Mass.-based company’s strengths, but with federal debt continuing to rise in proportion to the overall economy, Democrats in control of the House and the automatic defense spending cuts known as sequestration looming, the prospects for continued increases in military spending are in doubt. And when belts tighten it’s the weapons procurement budget that gets cut first, not personnel costs.

On the commercial side, there are storm clouds that could explain United Technologies’ interest in gaining more defense exposure. Its acquisition of Rockwell Collins has been seen as a move to gain scale against the increasing dominance of the airliner makers Airbus and Boeing. The exit of Bombardier from commercial aerospace and Embraer’s acquisition by Boeing are the capstones to a multi-decade wave of consolidation of plane makers that has left the two giants with the leverage to extract deep cost reductions from suppliers.  

While air travel is projected to double worldwide over the next 20 years, there are worries that the airline industry has gotten ahead of itself during a time of low interest rates and easy financing and ordered more planes than it can make efficient use of in the medium term. With airline passenger growth easing amid U.S. trade conflicts with China and Europe, some analysts are predicting cancellations could cut into Airbus and Boeing’s fat order books, and in turn hurt suppliers like United Technologies.

The merger will create a company with “expanded R&D capabilities that will allow us to invest through business cycles,” Hayes said in a statement. Together the two companies spend about $8 billion a year on research and development, and in a conference call Monday morning, Kennedy sketched out how they see foresee pooling resources: in the high-priority field of hypersonic missiles, Raytheon can leverage United Technologies’ expertise in high temperature materials for jet engines; and in directed energy weapons, United Technologies has relevant power generation and management technology.

Hayes said the merger would be “integration lite,” with no combinations of operating units between the two companies. The companies expect to reap $1 billion in annual cost synergies by the fourth year after the merger is closed, mostly at the corporate level, Hayes said, through savings on procurement and administrative expenses.

On the defense side they emphasized that the savings would be passed on to their main customer: the Pentagon.

The combination promises to put pressure on other aerospace and defense suppliers to get leaner and bigger. On the defense side, contractors’ options are constrained: the U.S. government has made clear it won’t condone any further consolidation among the major contractors. On the commercial side, large deals are more likely, with Honeywell and General Electric prime suspects, says analyst Richard Aboulafia of the Teal Group.

For GE Aviation, the world’s largest maker of aircraft engines, a combination with France’s Safran might make sense. The two have a successful 50-50 joint venture, CFM International, that makes the LEAP engine line. But the French government could play a spoiler role.

Honeywell would also make a logical partner for GE Aviation, Aboulafia says.

With greater scale, Raytheon and United Technologies could gain more bargaining power with the Pentagon, and larger geographic reach would give it more sway with members of Congress, says William Hartung, director of the Arms and Security Project at the Center for International Policy.

UTC CEO Hayes will be chief executive of the combined company; Raytheon’s Kennedy will be executive chairman

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