By Eddy Elfenbein

Last week, Raytheon (RTN) and United Technologies (UTX) shocked the financial world by announcing they’re merging.

In the defense/aerospace sector, this is a massive deal. The two companies said the deal is a “merger of equals.” Interestingly, the deal is all stock.

Let’s take a closer look at this merger deal.

The backstory is that United Technologies, which is a Dow component, is working to reinvent itself. The company recently bought Rockwell Collins. UTX also has plans to spin off two of its divisions; Otis Elevator and Carrier. The new firm with will called Raytheon Technologies and will be exclusively focused on defense. Raytheon shareholders will own 43% of the new company while UTX shareholders will own the other 57%.

Raytheon is a nice asset to have. In April, Raytheon released an outstanding earnings report. For Q1, the company made $2.77 per share which was 30 cents more than expectations. That compares last year’s Q1 when Raytheon made $2.20 per share,

The company is doing especially well with cyber-security and its intelligence and information unit. Despite the impressive earnings beat, Raytheon didn’t change its full-year earnings guidance of $11.40 to $11.60 per share and sales guidance of $28.6 billion to $29.1 billion.

This is a company that brings a lot to the table. Earlier this year, Raytheon hiked its dividend by 8.6%. That was its 15th annual dividend increase in a row. Another thing Raytheon has going for it is a rock-solid balance sheet. I’m sure UTX wants to get their hands on that.

President Trump said he was leery of the deal. Actually, the two the firms don’t compete directly against each other so there shouldn’t be much anti-trust worries, but the president has a point. The defense sector has undergone intense consolidation. In the 1980s, there were 60 major defense companies. Today there are just five.

This is a crucial moment from defense firms. At the Paris Airshow, Boeing said the global defense industry will grow by $8.7 trillion over the next 10 years.

The merger trend isn’t over. Look at it from basic economics. Operating margins are under attack. A company like Boeing (BA), [which makes huge amounts of money from commercial aviation, can afford to be a very competitive bidder on defense contracts.

That squeezes prices and it leads to rival firms merging. They’re getting together out of necessity to cut costs. Who will be snapped up next? That’s a good question and there are a few serious contenders.

At the top of the list is Lockheed Martin (LMT). In fact, the stock has rallied impressively this year, so folks know that it’s a merger target.

The Pentagon simply can’t run without Lockheed Martin. The U.S. government accounts for 70% of its revenue. DOD alone makes up 60%. Lockheed makes everything from combat aircraft to satellites and spacecraft. The F-35 fight accounts from one quarter of LMT’s revenue.

Lockheed and the Pentagon recently agreed to what will be the largest procurement deal in history. Lockheed was worked to get the price of a new F-35 down to “just” $81 million.

The lower price could get attention from shoppers outside the U.S. Lockheed is prominent and I think many companies would want to be associated with a marquee name.

Lockheed would be a very attractive merger candidate for one of the other defense contractors.

Another target is certainly Northrop Grumman (NOC). The company could be a nice fir for several competitors. NOC has three major business units; Aerospace, Missions Systems and Technology Services. The company ranks just behind Lockheed and Boeing as the world’s top defense contractor.

Business has been going very well for NOC. In April, Northrop’s first-quarter earnings report beat Wall Street’s estimate by more than 10%. The sales figure, however, came in a bit light.

I was especially pleased to see the company raise financial guidance for this year. Northrop Grumman sees sales for this year of $34 billion. They project free cash flow between $2.6 and $3.0 billion.

The company increased its EPS forecast to a range of $18.90 to $19.30. The previous range was $18.5 to $19 per share. I also like to see a company raise its guidance. There are a lot of big firms who wouldn’t mind being married to NOC.

Lastly, there’s General Dynamics(GD). Over the long haul, GD has probably been the most successful defense stock. The stock is up about 100-fold over the last 40 years, and that’s without including a generous dividend history.

This company is one of the mainstays of the defense industry. They’re involved in so many different areas from IT to tanks and ships. GD is also involved in the commercial sphere. The company makes Gulfstream business jets.

GD could be a takeover target simply because, despite its great long-term run, its share price hasn’t done much lately. The stock is still well below its high price from early 2018.

By market cap, General Dynamics costs less than Lockheed or Northrop. Based on the current price, General Dynamics is going for 13 times next year’s earnings.

Looking at the state of the defense/aerospace sector, it’s highly likely that we’re going to see another big-time merger within the next 12 months.

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