L3Harris Stock: Aggressive In Defense (NYSE:LHX)

It has been a long time since I had a look at L3Harris Technologies (NYSE:LHX). In fact, when I last looked at the shares in 2016, the company was still called Harris.

At the time the company was divesting some assets, needed to free up some capital after it bought Exelis in a $4.75 billion deal in 2015. That deal grew sales by some 50% to $7.5 billion, but more so created more diversification and potential synergies, even as the company remained relatively small compared to some of its larger defense counterparts.

A recap

Following the Exelis deal, Harris became strong in communication systems, space & intelligence systems, critical networks and electric systems. On an expected revenue base of $7.2 billion in 2016, the company was on track to post GAAP earnings at a midpoint of $5.63 per share, with shares trading at $92 per share at the time. The 6% earnings yield, or 16-17 times earnings multiple, looked reasonable, yet there were some leverage concerns as well.

Net debt came in at $4.2 billion, a number which rose to $6.4 billion if one includes pension liabilities as well. These were substantial numbers with EBITDA trending around $1.4 billion, for a 3 times regular debt ratio, or about 4.5 times if we factor in pension liabilities. Given the leverage I hoped to become a buyer around the $80 mark, but the shares have simply run higher, and kept doing so.

Shares broke through the $100 mark early in 2017, rallied to the $200 mark in 2019, and peaked at $280 in the spring of this year, with the Russia-Ukraine war triggering enthusiasm among defense stocks. Ever since shares have sold off quite a bit, now exchanging hands at $205 per share, numbers already seen back in 2019.

What Happened On The Fundamental Front?

In January of this year, L3Harris announced its 2021 results which revealed a 2% fall in sales to $17.8 billion, up more than $10 billion from 2016. This was largely driven by the merger of Harris with L3 in 2019, a huge deal which has truly been transformative for the business.

Adjusted EBIT margins rose 110 basis points to 19.1% of sales, and adjusted EBIT of $3.4 billion translates into adjusted earnings of $12.95 per share, with GAAP earnings coming in at $9.09 per share. By now the business is very well established, comprised out of almost equally large units which creates come diversification. Net debt is very manageable with $6.1 billion as I peg EBITDA around $3.8 billion, for a very manageable leverage ratio. The company guided for 2022 sales to come in flat (again) at around $17.5 billion, in part driven by some minor divestments, with non-GAAP earnings seen at a midpoint of $13.50 per share and GAAP earnings seen at $10.90 per share.

With shares trading at $280 at the start of the year, they have now come down to $205 per share, making that adjusted earnings multiples have contracted from 20 times to roughly 15 times earnings. After a soft set of first quarter results, the company maintained the guidance, even as the outside environment was looking better for L3 Harris. After another double-digit decline in second quarter sales, the company managed to maintain the guidance, yet warned that the results could come in at the lower end of the guidance.

In October, L3 Harris announced a $1.96 billion deal to acquire Viasat’s (VSAT) Tactical Data Links business, a deal set to add $400 million in sales. At a roughly 5 times sales multiple. This stands in sharp contrast to L3 Harris, which commands a roughly $45 billion enterprise valuation, with its own business is valued around 2.5 times sales.

After posting flattish third quarter results this fall, the company was still forced to cut the guidance, now seeing sales at $16.8 billion which is actually half a billion short from the lower end of the previously communicated guidance. Non-GAAP earnings are now seen between $12.75 and $13.00 per share, down quite a bit from the previous midpoint of the guidance at $13.50 per share, with GAAP earnings hurt by goodwill charges.

Net debt now comes in around $6.5 billion as the company posts a reasonable leverage ratio at 1.8 times based on $3.5 billion in EBITDA.

A Big Deal

With L3 Harris currently commanding a $45 billion enterprise valuation, the company announced the next deal. In December, the company announced a $4.7 billion, or $58 per share, deal for Aerojet Rocketdyne (AJRD) after a previous acquisition of the company by Lockheed Martin (LMT) did not proceed due to regulatory and antitrust issues. Pro forma net debt will increase to $11.2 billion, translating into a full leverage ratio of 3.0 times if we factor in $0.3 billion in adjusted EBITDA generated by Aerojet.

The deal is valued at 2 times sales of around $2.3 billion as the backlog stands at $7 billion, equal to 3 times annual revenues, while the backlog of L3Harris just exceeds the annual revenue base. Shares fell by about $6 per share, or 3% in response to the deal announcement. That makes that the valuation has come down by just over a billion, albeit that the deal was announced in a downbeat market, making the price action hard to read into.

And Now?

Accretion of the deal is fairly limited given incurred interest costs, yet with earnings power still trending at $12-$13 per share, the multiple has ticked up to 16 times earnings, albeit now accompanied by a 3 times leverage ratio, limiting the potential for more deals, buybacks or dividend hikes. While this looks reasonable, it is a rather aggressive acquisition strategy which creates quite a few moving targets.

The company has an excellent track record in creating value for investors in recent years, albeit that organic achievements have been lackluster in recent times. Nonetheless, I am cautiously upbeat here on the valuation and long-term ambitions, as the Aerojet deal looks quite solid.