The proposed merger of United Technologies Corp. (UTX) and Raytheon Co. (RTN) may spark a flurry of takeovers of companies totaling more than $100 billion in market value. As warfare becomes increasingly complex and expensive, the Defense Department is pushing defense contractors to supplement their research and development investments. This could prompt buyers including Honeywell International (HON), Boeing (BA) and General Dynamics (GD) to pursue deals with companies like Northrop Grumman (NOC), L3Harris Technologies (LHX) and Huntington Ingalls Industries (HII), according to a recent story in Barron's.

Rising Warfare Costs Could Prompt Defense Industry Mergers

  • The Defense Department is pushing contractors to invest more in R&D
  • Mergers help companies cut costs and divide development spending
  • Honeywell International, Boeing and General Dynamics may look to buy

Source: Barron's

A Defense Industry Merger Wave May Be Approaching

Although investors have been skeptical of the United Technologies and Raytheon merger, this could be the first of many such deals in the defense industry. With the Defense Department looking to pass along development and production risk to contractors, these companies face increasing costs and dwindling profit margins. Per Barron's, Seaport global analyst Josh Sullivan sees mergers as an important step toward diversification and cost-cutting and calls the United/Raytheon deal "ahead of the curve." Other companies in a position to buy could include Honeywell International, Boeing and General Dynamics; they may pursue deals with smaller defense businesses including submarine manufacturer Huntington Ingalls Industries ($10 billion in market value), electronics maker L3Harris Technologies ($42 billion) and bomber builder Northrop Grumman ($54 billion). All told, these deals would be valued at more than $100 billion.

What It Means

Part of the surge in merger interest comes from a shift from the Pentagon, according to a recent report by The Wall Street Journal. Contractors are anticipating a slowdown in Pentagon spending and a shift in focus toward hypersonic missiles, space systems and other technologies. Already, U.S. military spending cuts drove about 17,000 U.S. firms out of the industry between 2001 and 2015, per the report. For companies facing the increasing pressure to develop and perform, a merger could allow for crucial diversification and redistribution of costs. Indeed, aside from the United Technologies and Raytheon deal, there have been other mergers in recent months as well: Barron's reported in October that radio manufacturer Harris would merge with electronics company L3 Technologies to form L3Harris Technologies. Now, the newly-formed company could find itself part of another merger.

What's Next

The United Technologies and Raytheon deal is still in process, and no official plans for other mergers involving the companies listed above have been announced as of yet. Nonetheless, the changes in the defense industry have already been noticeable. Upcoming defense-to-defense mergers will face a challenge in the form of government oversight, however, because of the small number of prime defense contractors. Barron's suggests that one of the reasons the United Technologies and Raytheon merger has succeeded so far is because it represents an aerospace-to-defense deal. Defense mergers may be more likely if they involve smaller players or those focused on tangential industries.