Daily Memo: When Do Mergers, Acquisitions And Divestitures Pay Off?
Dealmakers in mergers and acquisitions who focus on the aerospace and defense industries are expecting a healthy year ahead for what they do, which is facilitating the buying and selling of businesses.
They are likely to say that Jan. 31 during Aviation Week’s M&A conference in Beverly Hills, California, despite a widely acknowledged slowdown in deal flow in late 2022.
But is the end-result of what they do good for the companies involved and the industry as a whole?
That age-old question has been debated for generations, but new research is helping to elucidate when and how M&A is beneficial, and when it is not. The findings could be telling for some of the biggest names in aerospace and defense currently active in M&A or divestitures, including Aerojet Rocketdyne, General Electric (GE), L3Harris Technologies, Raytheon Technologies, and others.
Indeed, the question popped up recently after Raytheon Technologies said it will merge its two defense divisions this year under the Raytheon brand. It is a homecoming of sorts, as both defense divisions are remnants of erstwhile defense prime Raytheon Corp., which combined with Pratt & Whitney and Collins Aerospace—then part of United Technologies—in April 2020 to form the current Raytheon Technologies.
That deal created industry’s first genuine Super Tier 1 supplier, and simultaneously became an even larger defense prime, creating a company that rivaled its own airframer customers Airbus and Boeing in annual revenue, workforce and other metrics. Not surprisingly, there have been several restructurings and divestitures along the way.
Still, the latest move essentially puts back together much of the old Raytheon, and that somewhat puzzled veteran analyst Ron Epstein of Bank of America. “The reorganization begs the question, what real revenue synergies are available now that historical Raytheon could not find?” Epstein said. “The cost savings in the reorganization are apparent with respect to headcount reduction, but we believe the case for greater customer focus, and streamlining is difficult to flesh out.”
He notes that old Raytheon reported six business segments, then four, and now two, which may make it more difficult to determine what is driving the business. What is more, an old challenge remains: one of the divisions to be consolidated, Raytheon Intelligence & Space, has been more of a holding group for a collection of siloed businesses that saw lower operating margins due to the services nature of their businesses.
“We believe Raytheon Technologies should level-set with the investment community on how the new structure will benefit the company, shareholders and transparency in results,” Epstein said in a Jan. 25 report.
Observers expect more changes at Raytheon Technologies since Chris Calio was promoted to president with the explicit task of carrying out the latest restructuring. More divestitures could be one tool. Shedding lower-margin businesses and standing up so-called pureplay aerospace and defense businesses has been a popular move for years: witness GE’s ongoing break-up, with the conglomerate’s leadership choosing to remain with what they call GE Aerospace until sometime in 2024.
But such moves do not necessarily result in better positioned businesses, according to research by Bain and Co. consultants. For a December 2022 article in the Harvard Business Review, they analyzed more than 350 public spin-offs valued at greater than $1 billion between 2000 and 2020.
“The most unexpected thing we learned was that 50% of companies pursuing a separation fail to create any new shareholder value two years down the road, and 25% destroy a significant amount of shareholder value in the process,” the Bain group wrote. “This happens despite their stated intentions to create value through greater management focus, additional growth opportunities, targeted capital allocation, and investment profiles that match a more specific investor base.”
There are exceptions, including in aerospace and defense, and they cited the carve-out of Howmet Aerospace, which in April 2020 spun off from Arconic. Fifteen months on, the combined market cap of both companies had grown more than 150%. But otherwise the evidence from their study was overwhelming, the Bain group wrote. The average separation delivered as little as a 5% increase in combined market cap two years after spinning off.
Mergers have their own challenges, as well. Defense and government contractors generally cite two M&A strategies to grow: horizontal integration, or what the researchers called “customer penetration,” (i.e., acquiring a target with overlapping customers); and vertical integration, or “customer expansion,” (i.e., acquiring a target with customers new to the acquirer).
A December 2022 report from academic researchers at George Mason University’s Baroni Center for Government Contracting found that the performance of federal-government M&A was “unclear.” They dug into 400 federal deals over 17 years and made a couple of surprising conclusions.
“Our empirical findings show that investors react positively to customer expansion but not as favorable to customer penetration, as financial markets appear to prioritize access to new revenue sources over improving efficiencies,” the George Mason researchers said. In other words, it is better to find and add new government customers than to try to go deeper with current clients.
That may be playing out at Raytheon Technologies now. One vertical integration move cited by the researchers was United Technologies’s $30 billion takeover of Rockwell Collins in November 2018.
On the other hand, L3Harris’s proposed $4.7 billion takeover of Aerojet, announced in December, could be a good example of the seemingly preferred horizontal expansion. The former, an asset-light holding company of subtier suppliers and services providers, is far different from the latter, which is the last independent major provider of rocket engines and missile propulsion to the government and industry. They have little overlap but run in the same circles.
Of course, that may be little comfort to existing L3Harris shareholders, many of whom have become used to the spinoff story that dominated L3Harris since its own “merger of equals” in June 2019. Pledging billions of dollars to buy a very different kind of business does not naturally land well with shareholders who were eager to get that money in the form of returns, and financial analysts continue to say L3Harris must keep convincing them. But if recent research is any indication, at least they can reasonably expect value creation is in their future.