Wall Street loves mergers and acquisitions. They feed the egos of CEOs by increasing their empires and garner big fees for the bankers that help put big deals together. They can also result in a big payday for investor of the firm that gets bought out. But, sadly, for these reasons, most mergers destroy shareholder value over the long haul.
For investors, the track record indicates that it can be more lucrative to bet on deals where firms break themselves apart. One such deal that became final less than two weeks ago found two giant defense and aerospace-focused firms merge, but also spin out two global titans into their own separate entities.
I just picked on mergers for being bad for shareholders, but last June’s merger between United Technologies and Raytheon was very unique in that it was a “merger of equals.” That means there wasn’t a large premium built into the deal to entice one set of shareholders to sell out. This sizeable premium is a key reason that mergers are bad over the long term.
The newly formed Raytheon Technologies creates one of the largest aerospace and defense firms in the world. And part of the deal called for two of United Tech’s divisions – Otis Elevator and Carrier Inc, to be spun out to their own independence. Independence can really motivate management teams and employees, which can be great for business, and shareholders
One other benefit of spinoffs is it can take investors and analysts awhile to get comfortable with the newly formed entities. It also takes a while for the financials to be released and understood. Therefore, those that study them carefully can gain an information advantage. On a related note, investors that see these new positions in their portfolio tend to sell them off because they aren’t that familiar and the position sizes can be pretty small. This puts near-term selling pressure on the shares.
Using TipRanks database, I was able to evaluate these 3 Buy-rated stocks to get a good feel for what the analyst community has to say as these firms get going on their own. Apparently, all three have appealing long-term upside potential. Let’s take a closer look.
Raytheon Technologies Corp (RTX)
The newly formed Raytheon is the crown jewel of this transaction. Raytheon and United Tech didn’t have a ton of overlapping businesses and therefore didn’t have a lot of regulatory obstacles to overcome in merging. Its four units consist of Pratt & Whitney military and civil aircraft divisions, Collins aerospace systems and components, intelligence and airborne systems, and defense and missile systems.
Breadth and scale are important when negotiating with national governments (the U.S. and its allies) and giant airlines. And while commercial airline demand is going to dip in the current recession, it will recover. Raytheon Tech is in a strong position because 54% of its business now comes from defense, which isn’t nearly as economically sensitive. And 45% of sales come from overseas, which provides diversification in any market environment and is important now that the U.S. has the highest number of covid-19 cases in the world.
Bank of America’s Ronald Epstein really likes Raytheon’s “steady defense cash” that will protect the aerospace business until it recovers, and expects $1 billion in cost synergies from the combination.
Epstein estimates $64.5 billion in sales this year and a substantial 12.5% jump to $72.6 billion in 2021. He sees another 11% increase to as much as $81 billion the following year. He estimates around $4 in EPS this year and next, with a boost to $5 in 2021. Better yet, “management projects double-digit cash flow growth…by 2021). Safety, cash flow, and growth are compelling characteristics for investors in any business cycle.
Epstein reiterated a Buy rating on Raytheon shares along with $95 price target. That is a very healthy premium of 47% above the current share price of $64.22. (To watch Epstein’s track record, click here)
We can see from TipRanks that Raytheon has regained its “Strong Buy” rating. In the last three months, the stock has received 11 “buy” ratings and only 3 “hold” ratings. Based on these ratings, the average $92 price target on RTX stock translates into upside of over 40% from the current share price. (See Raytheon stock analysis on TipRanks)
Otis Worldwide Corp (OTIS)
Otis Worldwide is one of the largest elevator firms in the world. Construction trends might slow for the foreseeable future, but elevators must always be maintained and kept safely running regardless of the economy.
Service is one of the key appeals of Otis as an investment. JPMorgan recently detailed that 57% of Otis’ sales (the rest are new equipment) stem from services, which tend to be stable along with higher margins. 82% of the service business stems from routine maintenance and repair, while the rest is from modernization.
16% of Otis sales come from China, which is already getting back to business as its coronavirus containment efforts appear to be working. The U.S. is only 27% of sales – the rest comes from the rest of the world. Like Raytheon, Otis is diversified across the world and among many customers.
JPMorgan analyst Stephen Tusa cited these strengths as a reason for his overweight rating and $53 price target. (To watch Tusa’s track record, click here)
One other reason spinoffs tend to do well over time is that the parent company may have neglected its smaller units. This appears to have happened at Otis – Tusa cited a compression in Otis’ profit margins over the past few years. This is reflected in the fact that rivals, including Kone and Schindler are more profitable. They are also trading at higher P/E multiples, which Otis management hopes to remedy.
Tusa concluded, “We are OW on Otis Worldwide Corp, as we see a strong franchise in a fundamentally attractive global elevator industry, poised to move beyond a decade-long margin reversion, for which earnings should hold up relatively well vs others through the downturn. Coming out the other side, we see potential for tailwinds around (1) China modernization, (2) a turn in the tide on investment/price/mix (3) with opportunities around tax rate and de-leveraging to set the company up well to accelerate its EPS/FCF growth.”
Overall, there is little action on the Street heading Otis’ way right now, with only one other analyst chiming in with a view on the elevator maker’s prospects. An additional Buy rating means Oti qualifies as a Moderate Buy. The average price target, though, is $53, and implies an upside potential of nearly 18%. (See Otis stock analysis on TipRanks)
Carrier Global Corporation (CARR)
United Tech’s last spinoff is Carrier Global Corp. Carrier has the highest risk/return of the bunch. It has some leading businesses, including air conditioning, HVAC and related products, refrigeration and shipping storage and transportation, fire, safety and security products, and building controls and automation. Its HVAC products are among the largest operators in both residential and commercial divisions.
The tradeoff is that these units are economically sensitive. Carrier was also saddled with a somewhat sizable debt position when United Tech spun it out. And, just like Otis, its margins have fallen as United Tech focused on its larger and more lucrative aerospace units.
These characteristics aren’t ideal, but is a key reason that Wolfe Research has initiated an outperform rating on Carrier shares with a $26 price target. That’s nearly double the current share price just below $14 per share. Lead analyst Nigel Coe advises investors to “keep calm and Carrier on” when it comes to the stock.
Coe sees risks in the current downturn in the HVAC and fire units. But these should be manageable, and the fire unit could be earmarked for sale, which would reduce the current debt load of about $11 billion by as much as $3 billion. Margins should improve with management’s renewed focus. But “these are quality franchises with scope for operational improvement. We see potential for significant appreciation, once the market is ready to accept more risk, with limited downside.”
What do other analysts say about the HVAC maker? TipRanks analytics shows out of 4 analysts, 1 is bullish on Carrier Global stock, while 3 are sidelined. That said, the consensus price target of $20.50 shows a potential upside of nearly 47%. (See Carrier Global stock analysis on TipRanks)
Disclosure: The author has a Long position in RTX, OTIS, CARR
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