Analysis / Acquisition

What Comes after the ‘Last Supper’?

On June 10, 2019, Raytheon and United Technologies Corporation announced plans to merge into a new company, Raytheon Technologies, in the first half of 2020. While the past few years have seen significant industrial consolidation with the defense sector, the proposed Raytheon-UTC merger would be the largest defense merger in recent history.

Q1: Who are Raytheon and United Technologies?

A1: Both Raytheon and United Technologies are major U.S. companies that operate in the global aerospace and defense market. Neither manufactures a lot of the big airplanes and ships that are the focus of military purchasing debates, but they produce many of the subsystems, such as radars, missiles, and engines that make those platforms work. It’s worth noting that the companies have very different histories. Raytheon has long been a predominantly defense-focused, advanced engineering company specializing on a discrete set of closely related markets such as missiles, radars, and other electronic sensors. More recently, Raytheon has made a major push into cybersecurity, adding a significant new market sector, but one reasonably close to its traditional strengths.

On the other hand, United Technologies has long been a classic example of a corporate conglomerate composed of unrelated businesses. The company has produced products as varied as elevators (Otis), air conditioners (Carrier), aircraft and space systems (Collins Aerospace), and jet engines (Pratt & Whitney) through its largely independent subsidiaries, but it has recently decided to focus more on its aerospace and defense business and spin off Otis and Carrier. Overall, its commercial business far exceeds its defense business, so while United Technologies is one of the biggest companies in the United States, it hasn’t been in the top tier of U.S. defense contractors. In contrast, the smaller Raytheon has been solidly established as a top defense contractor for a long time.

Q2: What triggered the Raytheon-United Technologies merger?

A2: The merger offers several potential benefits to the newly combined company, Raytheon Technologies, by giving it: 1) the ability to balance its revenue between the defense and commercial sectors that can cushion market shocks; 2) a commanding market presence across military and commercial aerospace supply chains; and 3) a highly skilled engineering workforce and base of technology that has the potential to deliver significant returns for years to come. The U.S. defense part of the defense market has been highly volatile in recent years, declining precipitously from 2009 to 2015 as defense spending fell, then recovering rapidly from 2016 through 2018 as Congress relented and defense budgets increased. Raytheon has ridden the defense market roller coaster both down and up, while United Technologies has been cushioned from these shocks through its substantial commercial business.

Raytheon Technologies will be a defense powerhouse, ranking at least third among U.S. defense contractors with the potential to rival Boeing for second. It will also be a commercial aviation powerhouse with a presence throughout almost every aspect of the aerospace supply chain. Boeing had expressed initial concerns about the extent of United Technologies’ control of the aviation supply chain when it merged with Rockwell Collins last year.The merger with Raytheon may create similar concerns for both Boeing and Lockheed as the new company will have a substantial presence throughout their defense supply chains. Finally, both Raytheon and United Technologies are known for their cutting-edge engineering. Both have invested heavily in research and development in recent years, and the complementary nature of their corporate investment strategies seems to have made a merger of equals attractive to both.

Q3: What is the U.S. government policy on such mergers and acquisitions, and what is the prospect for approval of the merger?

A3: The U.S. government reviews mergers and acquisitions for antitrust concerns, and this merger is a large transaction that is sure to get close scrutiny from government officials. This is true irrespective of anything else, but the concerns about competition expressed by President Trump when asked about this merger are certainly indicative of the importance of the transaction. The Department of Justice’s Antitrust Division and the Federal Trade Commission lead the U.S. government’s antitrust reviews, but when defense industry is involved, the Department of Defense (DoD) plays a major role in the analysis. Since DoD will also be a major customer of the new company, it has another channel of influence because ultimately Raytheon Technologies will be negotiating with DoD on future contracts. This influence channel may somewhat counteract the fact that the U.S. government’s credibility in opposing mergers was weakened when it lost its effort to stop the merger of AT&T and Time Warner in court in 2018.

The stated policy of the current leadership in DoD is that they will review all defense industry mergers on a case-by-case basis. They have neither explicitly endorsed nor repudiated the previous administration’s policy—known informally as the “Cowen policy” as it was announced at the Cowen Investment Conference in 2011—opposing mergers among the Big Five defense firms. This transaction would fall just below the previous policy’s formal redline but gets about as close to that line as possible. In all likelihood, given that there is no clear policy prohibiting it, the transaction is likely to go through. However, it is almost inevitable that the new company will be required to divest some defense capabilities, and potentially some commercial ones, that overlap between Raytheon and United Technologies to preserve competition. It is here that companies like Boeing and Lockheed could play a major role if they register concerns about the extent of the new company’s control of the aerospace supply chain. Supply chain concerns are currently a major focus at the Pentagon, particularly since the administration’s 2018 industrial base review identified almost 300 vulnerabilities and single points of failure in defense supply chains. This is likely to be the focus of the government’s review.

Q4: What is the potential impact for U.S. taxpayers?

A4: The proposed Raytheon-United Technologies merger will not likely have short-term repercussions for U.S. taxpayers given the nature of the merger. The greatest concern for taxpayers in these types of defense-sector mergers and acquisitions is whether this activity would decrease competition and drive up costs for them. While the merger would shrink the pool of defense vendors, it would not necessarily lead to significant declines in competition for defense contracts given the nature of the two companies involved. Except for a few select areas, there is minimal overlap between Raytheon and United Technologies’ defense portfolios.

However, in the long term, the proposed merger could lead to further restructuring within the defense industry that might have repercussions for taxpayers. As mentioned, this merger would solidify Raytheon Technologies along with Boeing and Lockheed Martin as the three largest U.S. defense firms, more distantly followed by General Dynamics and Northrop Grumman. More broadly, this move might spur further consolidation within the defense sector as firms jockey to expand their offerings and retain existing market share. Such moves might have negative repercussions for taxpayers, as previous CSIS research has shown that consolidation within subsectors correlates with greater rates of contract termination.

Q5: What broader trends are reinforced by the merger?

A5: There have been a series of mergers and acquisition in defense industry in recent years (in the areas of services, space, and defense electronics) that have accumulated into a substantial degree of industry consolidation such as the combinations of General Dynamics and CSRA, Northrop Grumman and Orbital, and L-3 Technologies and Harris; and the Raytheon-United Technologies merger continues this consolidation trend specifically in the space and defense electronics sectors. Any ensuing moves by competitors that follow are likely to concentrate in these areas as well.

This consolidation reinforces a broader trend in defense electronics that is increasingly merging products such as radars, radios, electronic sensors, and electronic warfare systems together into multifunctional systems. As these products have become increasingly digitized and defined in software, the boundaries between the companies that build these products are eroded. Digitization has brought companies into competition with one another that never used to compete, and it has also created pressure for them to consolidate. Digitization could also undermine incentives for innovation. While defense electronics has traditionally been a profitable business that has attracted companies like Raytheon, as software development increasingly dominates in defense electronics, profitability is threatened because DoD has historically paid meager rates of profit for software development. DoD must address this disincentive to ensure its ability to obtain innovation in the fast-moving defense electronics sector.

Critical Questions is produced by the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s).

© 2019 by the Center for Strategic and International Studies. All rights reserved.

(Photo: Department of Defense)

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