Although Honeywell’s campaign to purchase United Technologies faces major hurdles, a union of the aerospace and building materials rivals is generally garnering praise as a deal that would enrich both companies’ shareholders. Indeed, if the integration goes smoothly—and Honeywell CEO Dave Cote is a master of upgrading businesses once he buys them—a new Honeywell-UTC could indeed prove a winner.
Honeywell faces a tough fight to get the deal done. On Friday, United Technologies (UTX), once again, rejected Honeywell’s bid arguing that the transaction would either be blocked outright for anti-trust reasons, or require regulatory delays and divestitures that would make the deal bad for UTC shareholders.
Indeed, a close look at what Honeywell (HON) is offering to pay, and the improvement in earnings needed to create lots of value, reveals that Honeywell has little margin for error. This deal is all about “synergies.” But If a merger requires big divestitures, or if its long-delayed closing traps UTC in limbo, as UTC suggest it would, or if the expense of combining and closing plants, and slimming the workforce, proves a lot bigger than expected, shareholders of both companies could witness not a triumph, but a smash-up.
Cote presented its offer to Hayes in an 11-page proposal at a February 19 meeting. Honeywell published the presentation in a press release on Friday. The new offer of $108 is divided between $42.63 in cash and $65.37 in stock, at Honeywell’s current price. The timing looks shrewd. When Cote and UTC’s CEO Greg Hayes first discussed a tie-up in April, UTC’s stock stood near a record, and its market cap reached almost $100 billion, about $20 billion higher than Honeywell’s. But then, the two companies’ fortunes sharply diverged. Honeywell weathered the recent big downturn in the general market with no damage to its shares. By contrast, UTC’s stock fell 26% from April to September following disappointing earnings. That decline pushed its market value below Honeywell’s.
The fall in UTC shares, especially compared to the resilience of his own stock, probably encouraged Cote to make a formal offer in late September. When he returned in February, Honeywell had just hit an all-time high of $107, and UTC shares were languishing at $87, giving Honeywell a market cap of $83 billion versus $73 billion for its target. Hence, Honeywell could now purchase UTC’s depressed stock with far fewer of its own shares. Put simply, UTC has suddenly gotten “cheap,” and Cote pounced.
But is buying UTC really a great deal at these prices? Not necessarily. In late 2014, UTC sold its weakest business, helicopter-maker Sikorsky, to Lockheed Martin for $9 billion. Given that the oil price collapse has pummeled Sikorsky sales to oil majors, it was a terrific deal for UTC. But it lowered core earnings from $6.5 billion in 2014 to $5.4 billion in 2015. So at its bid of $108, or $90 billion, Honeywell would be paying a price-to-earnings ratio of just over 16 for UTC.
That’s a good deal for UTC shareholders. They’d be receiving a 22% premium in stock and cash at the closing, if nothing much changes before then. But according to the presentation, it gets a lot better. At closing, Honeywell’s equity value would be $135 billion, with the UTC camp owning 40% of the stock. Cote is predicting that Honeywell’s shares will soar from $106 to almost $150, creating $59 billion in new market value. Of that number, the UTC crowd would receive $39 billion, a total of the $16.5 billion premium, plus an additional gain of $22 billion on gains in the stock, for a total return of 43%.
It would be pretty rich for the Honeywell folks as well. Its shareholders would collect a 40% return, all in capital gains.
Sounds great. But are the improvements Cote promises really achievable? In the presentation, Honeywell totals the current earnings of both companies; that number is $10.6 billion. It then adds $3.5 billion in “synergies before tax.” After deducting interest and taxes—the synergies are worth about $2.6 billion after tax—Honeywell forecasts that the combined companies should post $12 billion in net income. Applying a reasonable 16 multiple, Honeywell forecasts a market value of roughly $194 billion.
If Honeywell gets there, then the two camps will receive their 43% and 40% gains. But let’s say the synergies don’t happen. Then the combination earns just $9.4 billion, and the market cap becomes $151 billion, not $194 billion. All but $16 billion of the projected capital gains evaporate, and that’s over several years. Returns fade from excellent to puny.
Keep in mind that UTC management, according to people familiar with the discussions, think its shares are worth around $140 right now. So Honeywell may be forced to pay more if it believes the deal is as great as its presentation claims. The anti-trust review period could last two years, and that waiting period would leave UTC in limbo, potentially damaging its core businesses. Cowen & Co, for example, forecasts that the combination would be forced by regulators to divest aerospace businesses accounting for 8% to 10% of its total sales. A lot can go wrong in a merger this size, and few are bigger or more complicated.
This is a battle for the ages between two of the most successful industrial icons on the planets. It may not happen, but few spectacles have been more fascinating to behold.