JHVEPhoto
We live in a world of tremendous uncertainty. Will the Federal Reserve push us into recession? Will Europe have enough gas for the winter? What will Russian President Vladimir Putin do in Ukraine? Will China make a move against Taiwan? With all of these questions (and others too!) weighing on investors’ mind, it’s understandable why stock markets have fallen well below their all-time highs. However, investing in the US defense sector can be a useful way to build some insurance into a well-diversified portfolio because it is not tied much to the economic cycle, and a more uncertain geopolitical environment likely boosts demand for defense spending. This makes L3Harris (NYSE:LHX) an attractive investment.
For fiscal 2022, congress authorized $742 billion in defense spending. Now, Congress is working on finalizing plans for fiscal 2023. There will need to be more spending simply to account for inflation. On top of this though, there will be the need to rebuild weapons inventories depleted to help Ukraine fight Russia as well as demands from some to increase defense spending to confront dangers in the world. As a result, the Pentagon requested a $31 billion increase to $773 billion.
However, both parties in Congress favor an even bigger increase. The House National Defense Authorization Act totaled $840 billion while the Senate Armed Services Committee is proposing $857 billion. Where Congress ultimately lands is unlikely to be known until after the midterm elections, but given where congressional negotiators are starting from, there is poised to be a substantial increase in our defense budget. And given the increased threats from Russia and China, this increase isn’t likely to be a one-off but a secular upswing in my view. LHX is a good way to profit from this trend.
L3Harris shares are down about 6% over the past year, not a bad performance relative to the S&P 500, though they are down about 23% from their highs in the immediate aftermath of Russia’s invasion of Ukraine. This decline has left LHX with a reasonable 15.5x P/E. Given its exposure to key Pentagon priorities, excellent free cash flow generation, and strong capital returns, this is an attractive valuation to build a position in the company.
This year, the company expects to generate at least $13.35 in EPS, up 3% from 2021. If we exclude divested businesses, earnings growth would be 6.7%, and this comes despite a $0.40 headwind from supply chain issues, which has depressed revenue as it takes LHX longer to deliver products to the Pentagon. As supply chains normalize, that should help expand margins and boost earnings power in the coming years. Investors should not lose sight of the long-term tailwinds for LHX’s business due to passing supply chain problems. It is safe to say that post-COVID supply chain recovery has been slower than expected, but it will happen eventually. At this level of earnings, L3Harris will generate about $2.2 billion in free cash flow, resulting in a 5.5% free cash flow yield at the current share price.
Importantly, aside even from the tailwind of supply chain normalization, earnings and free cash flow should improve as L3Harris benefits from a larger Pentagon budget. Importantly, the company has built its business around core franchises in space, electronic warfare, and tactical communications, all of which are key Pentagon priorities as it develops 21st century capabilities and modernizes its systems. This is demonstrated by the fact that company’s book-to-bill ratio was 1.14x in Q2 and 1.06x year to date. A book-to-bill ratio above 1.0x means orders are exceeding delivery, translating in a rising backlog that translates over time to revenue growth as these orders are filled. Given anticipated defense spending increases, this ratio should remain solidly about 1.0x over at least the next 18 months. The business’s tactical communications business remains the standout with a 1.5x book-to-bill last quarter, and the backlog is up $200 million this year to $1.5 billion.
In total, space communications and cyber account for about two-thirds of the company’s revenue while 1/3 comes from traditional air and space programs. Aside from the secular gains, the firm will see from an increased focus in space and electronics, LHX has international contracts with NATO allies for its traditional capabilities. With NATO members promising defense spending increases to meet their 2% commitment to deter Russian aggression, there could be some additional growth here.
Over the past year, the company has reduced its share count by 5.6% to 194 million shares with $421 million in repurchases so far this year. This has been a cornerstone of the company’s strategy to generate shareholder value with the share count down 15% since the start of 2020. There is an additional $1.8 billion on the buyback authorization. With net debt to EBITDA of just 1.9x, LHX’s strong balance sheet leaves it well equipped to direct free cash flow to buybacks and dividends (the stock has a 2.16% dividend yield currently). Management expects the reduced share count from its buyback to boost EPS by about $0.64 this year.
With defense spending poised to rise high-single-digits in 2023 and likely mid-single-digits thereafter as Congress tries to boost the Pentagon’s real purchasing power, L3Harris is positioned to generate steady earnings and revenue growth. Fading supply chain problems provide a further tailwind, but given LHX’s business mix and a book-to-bill above 1.0x, LHX should be able to grow even faster than the Pentagon’s budget.
That means the company should be able to steadily repurchase $1.5-2 billion in stock per year, leading to 3-4% annual reductions in the share count. That combination of underlying earnings growth with a falling share count should facilitate about 10% EPS growth over the next three years. That would translate to about $17.5-18 in earnings power. At a 17x P/E, given its solid growth profile, shares could be $300 in three years, providing a 13% annualized return on top of the 2% dividend.
With a mid-teens total return potential over the medium term, LHX is an attractive long-term investment. On the plus side, this business opportunity is not correlated with the overall economic environment, and the worse the geopolitical picture becomes, the more upside there is to defense spending. As a consequence, not only does LHX work well as a stand-alone investment, it works very well in a portfolio as it can perform best at times when headwinds may weigh on the overall market. Investors should look to build a position in L3Harris.
Be the first to comment