United Technologies (UTX - Get Report) and Raytheon (RTN - Get Report) investors aren't loving the idea of a merger of equals between the two manufacturing giants, and one analyst has explained what will need to happen for the deal to get done.
Both companies are down about 3% since news of the deal broke on June 10.
Shareholders of both companies will have to be convinced that both management teams' rationale for doing the deal is exactly what they say it is, says Stifel analyst Joseph DeNardi. Furthermore, they have to be convinced the rationale will create a combined company that can scale.
"It seems that investors continue to struggle with the strategic rationale for the transaction from both companies' perspectives with general skepticism regarding the validity of the rationale presented by UTC and Raytheon management teams (I.e. investors don't fully believe management)," DeNardi wrote in a note.
"It seems as though investors are skeptical that these are the true reasons for the transaction or that these reasons are insufficient to justify the transaction and/or the valuations in the transaction."
The rationale makes perfect sense to DeNardi.
For United Technologies, the idea is partly to "dampen cyclicality," DeNardi said. The Farmington, Conn., company produces large parts for airplanes and other machines. Fewer planes are made when the economy slows, as fewer people travel.
With the merger, United becomes part of Raytheon, which is traditionally defensive, as it produces weapons for the military, making the company not sensitive to the economic cycle.
In a combined UTX-RTN, the technologies would be synergistic, enabling more advanced builds of products, DeNardi outlined. Plus, the combined R&D spend would be hugely beneficial to building highly competitive products.
But there's something even more sensitive regarding this deal, for Raytheon.
The Waltham, Mass., company "has lost key hypersonics competitions to Lockheed as a result of a relative underinvestment vs. [Lockheed Martin] (LMT - Get Report) and now needs to ramp up R&D to catch up to Lockheed's technology," DeNardi noted.
Indeed, the global hypersonics market is expected to grow 7% annually between through 2022, according to Technavio Research. Raytheon certainly wants to cash in.
Meanwhile, Raytheon's 2019 free-cash-flow guidance for $2.85 billion, a 10% growth rate over 2018, is a deceleration from 2018's growth of 19%.
"Is it fair to say that RTN management looked at ... its need to ramp up R&D and got nervous about what valuation on a free-cash-flow basis could look like? Perhaps," DeNardi said.