LMT - L3Harris Technologies: Looking Solid Heading Into 2024

2023-12-06 08:03:26 ET

Summary

• L3Harris Technologies is rapidly becoming a major US defense contractor through aggressive dealmaking and delivering handsome returns for investors.
• The company's growth has been driven by mergers and acquisitions, with revenues increasing from $7.5 billion in 2015 to $17.8 billion in 2022.
• L3Harris has closed on a $4.7 billion deal to acquire Aerojet Rocketdyne, which is expected to bolster future growth prospects yet additional interest costs limit near-term earnings growth.

Late in 2022, I called shares of L3Harris Technologies ( LHX ) aggressive in defense. The company is rapidly turning itself into a major US defense contractor, as it has been very active in dealmaking, delivering on handsome returns for investors along the way.

2023 has been dominated by a big deal for Aerojet Rocketdyne, a deal bolstering future growth prospects, although higher interest expenses mean that the real benefits of the deal are likely only seen in 2024 and beyond as more expensive leverage comes down.

About Harris - Rapid Growth Through Dealmaking

Harris has seen rapid growth over the past decade, as a $4.75 billion deal for Exelis in 2015 grew the business some 50% to a revenue base of $7.5 billion. These revenues were, and still are, generated from activities such as communication systems, space & intelligence systems, critical networks and electric systems.

A mere $70 stock in 2015 broke the $100 mark in 2017, rallied to the $200 mark pre-pandemic, and hit a high of $280 in the spring of 2022 as the war between Russia and Ukraine triggered enthusiasm among defense stocks.

Fast forwarding from 2015, a pro forma revenue base of $7.5 billion rose to $17.8 billion in sales for 2021 (as released early in 2022). The major driver behind this growth was the merger between Harris and L3 in 2019, a transformative deal.

The company posted adjusted EBITDA margins of 19% on those sales in 2021, working down to earnings of nearly $13 per share (on an adjusted basis). Net debt was pretty manageable at $6.1 billion, with EBITDA seen at $3.8 billion.

The company guided for 2022 sales to come in flattish at $17.5 billion, with adjusted earnings seen around $13.50 per share. A $280 stock early in 2022 had come down to $205 per share, making that a 20 times adjusted earnings multiple narrowed to 15 times.

Despite a good external environment for the business, in terms of geographical unrest, the company has seen a softer first half of 2022. To ignite some enthusiasm, the company announced a $1.96 billion deal to acquire Viasat's (VSAT) Tactical Data Links business, adding $400 million in sales at a near 5 times sales multiple.

The company cut the sales guidance to $16.8 billion following the release of the third quarter earnings report, with earnings seen between $12.75 and $13.00 per share, as net debt of $6.5 billion worked down to a 1.8 times leverage ratio based on $3.5 billion in EBITDA.

This thesis changed overnight as L3Harris, which commanded a $45 billion enterprise valuation at the time, announced a $4.7 billion deal for Aerojet Rocketdyne late in 2022. This came after a previous acquisition attempt by Lockheed Martin ( LMT ) did not succeed due to regulatory and antitrust issues. Pegging earnings power close to $12-13 per share, the company traded at 16 times earnings, while the company operated with a 3 times leverage ratio pro forma for the Aerojet deal.

With an excellent dealmaking track record, albeit organic achievements were rather lackluster in recent times, I was gradually warming up to L3Harris, with an intention to buy significant dips from hereon.

Expectations Stagnate

A $220 stock at the start of the year has come down to a low of $160 in the fall, after which shares have seen a big rally in recent weeks to current levels of $195 per share.

The company started 2023 on a solid footing, with first quarter sales increasing rather impressively and the book-to-bill ratio exceeding 1.3 times. This made the company guide for 2023 sales of $17.4-$17.8 billion (vs. $17.1 billion in 2022), with earnings actually seen down a bit to $12.00-$12.50 per share (vs. $12.90 per share in 2022). This guidance was hiked alongside the second quarter earnings report and in July, the company closed on the purchase of Aerojet Rocketdyne.

In October, L3Harris reported third quarter sales of $4.92 billion, up 16% on the year before, but this included some $455 million in sales from Aerojet during the quarter. The company maintained the full year outlook on an organic basis, but updated the outlook to reflect for the acquisition of Aerojet, now seeing sales at a midpoint of $19.3 billion and earnings actually flat at $12.35 per share (plus or minus ten cents) as the profit contribution of the deal offset by additional interest expenses incurred.

Net debt was reported at $13 billion following the deal. Trailing EBITDA is posted at $3.5 billion, but based on the recent quarter it comes in at $3.8 billion per annum, for a 3.4 times leverage ratio, still somewhat high. The 190 million shares granted the business a $37 billion equity valuation at the current $195 share price, valuing the entire business at $50 billion here. This values the operations at around 2.5 times sales, as equity continues to trade around 15-16 times earnings.

Addressing Leverage

In November, L3Harris announced that it has reached an agreement to sell its Commercial Aviation Solutions business in an $800 million deal to TJC L.P.

The deal is comprised out of a $700 million cash component, with the remainder being an earn-out based on the 2023 and 2024 performance.

The company announced that the deal was valued at 15 times EBITDA, set to close in the first half of this year. The divested business employ nearly 1,500 people which offer pilot training, flight data analytics, avionics, among others. While the EBITDA multiple fetched looks nice, unfortunately, not much has been said about the financial performance of the business.

The deal will cut pro forma leverage ratio by around 0.2 times towards 3.2 times EBITDA.

A Final Word

Truth is that I like the business and its shares even as they are flat compared to last year, but I do not like a tactical entry point here given that shares have run quite a bit higher in recent weeks. Currently, shares support a 2.5% dividend yield, but the external environment has become better for L3Harris, driven by the continued conflict in Ukraine, and now the renewed unrest in the Middle East as well of course.

Moreover, the company is making a move to tackle the leverage incurred following the Aerojet deal, which is a first start, needed as interest rates and thereby costs are higher of course in this environment. The added leverage makes that earnings per share have been coming in flattish despite growing sales.

Given all these moving targets, I am still quite constructive on the share here, as further (earnings) growth is likely in 2024. Given all this, I am still very constructive on L3Harris, but require a better entry point, let's say around $170-$180 to start building up a position here.

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