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Raytheon To Acquire Hughes Aircraft’s Defense Business

News

On January 16, 1997 Raytheon Co. announced that it has won a bidding war for General Motors' Hughes Aircraft defense business for $9.5 billion.

Analysis

The Deal
The complicated Raytheon transaction involves two simultaneous deals: GM spins off Hughes Aircraft to the holders of two classes of GM shares, and immediately Hughes Aircraft and Raytheon will merge in a stock swap. Raytheon shareholders gain control of 70 percent of the emerging company and GM shareholders get the remaining 30 percent through $5.1 billion in the form of newly issued stock.

Raytheon will also assume $4.4 billion of Hughes' debt.

Note that in general, the value of firm or a division is equal to sum of the value of equity and debt, i.e., not just equity. In the case at hand, the $9.5 billion value of the acquired division is the value of the division’s equity ($5.1 billion) and its debt ($4.4 billion).

Sources of Value Creation
Value is determined by the amount and timing of the cash flows as well as the risk of cash flows as measured by the cost of capital (= opportunity cost = discount rate). Moreover, for the deal to be viable to shareholders, it has to create additional value over the cost of the deal, i.e., it has to have a positive Net Present Value (NPV).

By combining the operation of Hughes, Texas Instruments, and Raytheon, the new company will be able to reduce its work force by 10% in the next 2 1/2 years. With 83,000 defense workers in the combined company, that could mean 8,000 job cuts. However, one should be careful not to take these estimates at face value since layoffs are politically sensitive everywhere, especially in Massachusetts, which has recently awarded significant tax breaks to its local defense giant to help it cope with the consolidation brought on by the vast reduction of the federal military procurement budget.

Another source of cost savings--an increase in operation cash flow--is from combining overlapping manufacturing facilities.

Although not directly related to the acquisition, Raytheon is expected to sell one or more of its commercial operations. The Amana division, which manufactures ovens, refrigerators and other appliances, is the leading candidate for the sales block, but some think the Raytheon Engineers & Constructors division could also be sold. So how would this crate value? If another company is willing to pay more for these divisions than they are worth to Raytheon, this would be a source of value creation. However, analysts expect Raytheon to create value through another source, namely to use the proceeds from the sale to reduce its debt, and thus, its cost of capital. Hence, a lower cost of capital implies higher value.

The Combined Company
The new Raytheon will be the world's third-largest defense contractor, trailing only Boeing Co. and Lockheed Martin Corp. Pending its $3-billion agreement earlier this month to buy the military electronics operations of Texas Instruments, it would derive nearly two-thirds of its $21 billion in annual sales and an even higher share of profits from defense.

The new company will produce such weapons as air-to-air missiles, antitank weapons, ground and air radar, communications systems, and sonar and mine-hunting equipment.

Raytheon will be rivaled only by Lockheed Martin Corp. of Bethesda, Md., with its $23 billion in annual sales. Los Angeles-based Northrop Grumman Corp. which lost out to Raytheon in the Hughes bidding, ends up a distant third in defense electronics, with 1995 sales of about $7 billion.

Besides defense, Raytheon operates a large construction company and produces Amana refrigerators and Speed Queen laundry equipment.

What Can Stop the Deal?
The deal requires approvals from the antitrust division of the Justice Department and the Pentagon, but most experts expect that the takeover will go through as proposed. The transaction should be completed about the middle of this year.

Why is GM Selling the Unit?
As noted above, because of potential synergies from combining divisions or companies, a division would be worth more to a company that can take advantage of synergies as additional value to the acquiring company shareholders gets created.

For General Motors it will avoid paying what might have been hundreds of millions of dollars in taxes. Thus, it is creating value to its shareholders through the reduction in corporate taxes, albeit at the expense of the U.S. Treasury.

Market Reaction
Raytheon is paying a relatively high price for Hughes. The price, about 1.5 times Hughes' annual sales, is much higher than the typical price-to-sales multiples in the industry. Despite that, investors thought that the deal was sound as evidenced by a stock price gain of $1.50 on the day of the announcement. The stock closed at $48.50--the same price they closed at Feb. 1, 1996.

General Motors' stock rose 50 cents, to $60.625. The General Motors H shares, which track the value of the Hughes Electronics businesses, were unchanged at $62.625.

Other Places of Interest on the Web

Hughes Electronics
General Motors
Raytheon

Sources: Los Angeles Times, New York Times: (January 17, 1997)