August 24, 2017

Opinion: Don't Dismiss UTC's Potential Acquisition Of Rockwell

Source: Aviation Week & Space Technology

On Aug. 4, a press report caused a Friday night stir when it reported that United Technologies Corp. (UTC) (covered by our colleague, Jeff Sprague) is “weighing an acquisition” of Rockwell Collins. The report cited “people familiar with the matter,” adding that there is no certainty the deliberations would lead to a transaction, and it is not clear if talks are even occurring. Although Rockwell Collins’s stock price spiked up the following Monday, neither company confirmed or denied the report, and business as usual has continued. Rockwell’s share price has subsequently faded a touch, as investors failed to see the anticipated bid from UTC.

The key attraction of this potential transaction would be the lack of product overlap. At UTC, Aerospace Systems and Pratt & Whitney do not have exposure to the avionics, radio, connectivity and cabin equipment and services in which Rockwell specializes. This has long been apparent, and when United Technologies was looking at Goodrich in 2011, it was often reported that Rockwell Collins was also being considered.

Although there is no product overlap, the pushback to such a deal could come from customers and competitors over scale: Airbus and Boeing can assist a struggling supplier such as Triumph, but to prop up a UTC/Rockwell behemoth would be tough. Perhaps more pertinent, it would also be more challenging to bully a UTC/Rockwell into more aggressive pricing agreements, whereas smaller suppliers are easier to push around. Competitors are also likely to be wary of pure scale and the theoretical risk of bundling products, which was the argument raised to block the GE/Honeywell deal in 2001.

The biggest issue, though, was likely to be the price. If UTC were to pay $155 per share for Rockwell Collins (+30% versus the undisturbed price), we calculate that this $32 billion equity and debt deal would value the company at 25 X the current-year-2018 GAAP P/E (generally accepted accounting principles price/earnings) ratio, or 13.8 X EV/Ebitda (enterprise value/earnings before interest, taxes, depreciation and amortization). A deal at this price would be dilutive for UTC’s earnings and have a poor return on capital.

However, this price issue could be addressed if UTC were to structure a transaction as a Reverse Morris Trust, splitting out its similarly-sized aerospace businesses and combining them with Rockwell Collins. This would create a pure play aerospace and defense supplier, with sufficient critical mass across the portfolio to offset the risk and cash-flow requirements that come with the Pratt & Whitney engine OEM business. 

In essence, this would be very similar to the structure that Safran has created and is looking to add to with the acquisition of Zodiac Aerospace. For UTC, it would also allow it to unlock the value in its non-aerospace divisions, as peers in the building systems sector trade at higher valuations. The conglomerate overhang on the company’s shares would thus effectively be removed.

We also think that customer concerns regarding scale could be assuaged by negotiation and the extension of current OEM pricing arrangements. Airbus, Boeing and others of their ilk would not want a combined UTC/Rockwell using its scale to obtain better pricing, so locking in the existing trajectory would probably see their objections waived. This would leave competitors looking to prove that the scale of the new business would lead to bundled purchasing, but to date the “nose-to-tail” model has not had a notable impact on supplier market shares. A broader portfolio gives a supplier more options on which to focus its R&D and pricing firepower, but we have yet to see OEMs favoring any suppliers just because of their scale. 

However,  while there has been no comment yet from either party, this does not necessarily mean a deal won’t happen. As we saw with the Goodrich transaction, negotiations for major deals can take many months before they are concluded to the satisfaction of both sides. In the meantime, just the possibility of a transaction is likely to support Rockwell Collins’s share price and valuation. 

Robert Stallard is a Global Aerospace and Defense analyst with Vertical Research Partners LLC (VRP). The views expressed are not necessarily those of Aviation Week.

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