Premium #344 – Does United Technologies acquisition of Rockwell Collins really make sense?

The industry rumor has been confirmed. United Technologies acquisition of Rockwell Collins for $30 billion is moving forward. Both companies have a major presence in aerospace. UTC has two large units, Pratt & Whitney and United Technologies Aerospace Systems (incorporating the former Hamilton Standard, Sundstrand, and BFG Aerospace operations that included former Rohr, Coltec,TRW Aerospace, and Lucas Aerospace operations). Rockwell Collins acquired BE Aerospace to augment its traditional avionics business with a position in aircraft seating and interior components earlier this year. The merger provides virtually nose to tail components for commercial aircraft, including the flight deck instrumentation and controls, landing gear, engines and nacelles, electronic systems, and the capability to build most of the key components on an aircraft. Currently, UTC does not have an avionics nor an interiors unit, and there is little or no overlap between the proposed merger partner’s product lines. What does a full product line do? A complete nose to tail capability could provide leverage against OEMs, who are increasing negotiating better deals with their supply chain, who tend to be more profitable than those OEM airframe companies designing the aircraft. Both Boeing, with Partnering for Success, and Airbus with its Global Sourcing Network have begun to tighten their financial requirements for suppliers. By growing, UTC could gain a critical mass that Boeing or Airbus would find harder to push back against. United Technologies acquisition of Rockwell Collins provides that full product line. It is notable that UTAS, when they decided not to go along with Partnering for Success at Boeing, lost the 777-X landing gear even though they were incumbents on the 777. That type of switch is unusual, and sent UTC a message to “get on board” from Boeing. A merger with Rockwell Collins would make it more difficult for Boeing to exert its influence in the same manner, particularly if UTC begins to negotiate as a group, rather than its individual entities. It appears that much of the motivation for this comes from the potential to increase aftermarket business, which is where the supply chain earns most of its profitability. Boeing and Airbus earn little from this process, and are also seeking to improve their aftermarket positions, likely at the expense of the supply chain participants, who have a higher EBITDA than the airframe manufacturers. Will the merger really have an impact on Boeing or Airbus strategies? With Boeing’s announcement that it was going to build an avionics unit, the OEMs clearly want a larger piece of the aftermarket, which means designing some aspect of the parts with intellectual property to obtain a Boeing part number that they will control. With Boeing, and potentially Airbus, looking at big data as aftermarket revenue streams, they will want to ensure some aspect of their systems utilizes a proprietary Boeing algorithm or interface, which can be leveraged for aftermarket revenues. Clearly, Boeing and UTC are looking to battle for the same aftermarket revenue streams down the road, and something will have to give. Will a larger UTC necessarily influence Boeing’s positions? While it is a possibility, we don’t believe it will be substantially different than today. UTC was stung by the 777-X landing gear award to a smaller Canadian firm, Heroux-Devtek, and will likely not make that mistake twice, so an early victory went to Boeing. But when round two hits, UTC wants better negotiating power. Only time and negotiations will tell if it will make a difference. We don’t believe that Airbus or Boeing will be supportive of this merger, as they don’t want to be backed into a corner by larger and consolidated suppliers who could, effectively, supply nearly every key component for an aircraft. They would prefer, as Airbus has, thousands of smaller suppliers that can be more easily influenced and controlled. From an antitrust standpoint, the UTC approach to Honeywell last year would not likely have passed muster from an anti-trust standpoint. But a smaller Rockwell (roughly 1/5th of UTC) may be viewed differently than Honeywell, which is slightly larger than UTC in revenues. Is Rockwell Collins a bit too expensive today for this to make sense? The real crux of the matter is whether Rockwell Collins is overvalued, even prior to an acquisition premium. Rockwell Collins was trading at the high end of the aerospace scale in terms of an earnings multiple, perhaps anticipating synergies from their recently completed merger with BE Aerospace that closed in April. With a multiple of more than 16 times expected 2017 EBITDA, they are the second most expensive of US aerospace companies in terms of multiple. When one adds a 30% premium, that would be the equivalent of a multiple of 20.8 times EBITDA, which is very expensive. UTC is trading at a 10.8 multiple of expected 2017 EBITDA. Earnings performance, of course, influences valuation, and Rockwell Collins outperforms each of the UTC units, with a 2016 operating margin of 18.1. This compares to UTX at 15.4, UTAS at 15.9 and Pratt & Whitney at 10.4. What about synergies and cost savings? While one can often justify a merger based on cost savings and synergies, in this situation Rockwell Collins is run quite efficiently, and we don’t see a high potential for cost reduction given the different markets in which they operate from the other UTC aerospace units. We also don’t foresee immediate synergies between the business units, as they focus on very different areas and technologies. But over the longer term, Rockwell’s expertise in software and systems integration will flow into UTC controls and electronics businesses, perhaps making them “smart” devices. Will this generate value for UTC shareholders? UTC has traditionally tried not to “overpay” for acquisitions, and is just finishing a project to return $22 billion to its shareholders through dividends and share buybacks. The proposed acquisition of Rockwell appears to be a major change in direction from UTC’s traditional philosophy. The jury remains out as to how much value it will generate, as the $30 billion price tag is rather high. The Bottom Line Unless there is a hidden key to the aftermarket or tremendous synergies that we simply don’t see, this acquisition does not appear to make sense financially. While there are few immediate synergies, the acquisition is well run and cost-effective, and while it has a profitable market niche, it is also priced extremely high. Were I a Rockwell Collins shareholder, I’d jump at the chance to sell at nearly 21 times projected 2017 EBITDA. But I wouldn’t want to be on the buying side at that price point. From our viewpoint, United Technologies acquisition of Rockwell Collins provides potential synergies, but at too high a price.

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