LHX - L3Harris Technologies: Unlocking Value In The Defense Industry

2024-01-07 12:14:15 ET

Summary

• L3Harris Technologies is poised to benefit from rising global defense spending and geopolitical tensions.
• The company's Space and Airborne Systems segment is experiencing strong growth.
• L3Harris is actively reducing debt, targeting organic growth and free cash flow, and is undervalued compared to its peers.
• Despite risks like economic downturns and operational disruptions, LHX has upside potential from strong margins and international demand.

L3Harris Technologies (LHX) is well-positioned to benefit from increased global defense spending amid geopolitical tensions, shows strong growth in its Space and Airborne Systems segment, is reducing debt and targeting significant organic growth and free cash flow, and is undervalued compared to peers, offering an attractive investment opportunity.

A recent investor day for LHX emerged as a positive event for the company's stock. A key insight from this event is the management's commitment to expanding profit margins and boosting cash flow. There is a high level of confidence in the management's ability to achieve its sales and cash flow targets. While reaching the margin expansion goals might present challenges, they are deemed attainable, with expectations set for significant improvement.

Strategic Advantage in the Defense Sector

LHX stands as a prominent innovator in the aerospace and defense industry, specializing in designing, developing, and manufacturing radio communications products and systems, including sophisticated single-channel ground and airborne radio systems. The company's expertise extends across various domains such as air, land, sea, space, and cyber, providing cutting-edge defense and commercial technologies.

LHX is strategically positioned to capitalize on the growing defense arms race. The company's alignment with the growing sectors of the Future Year Defense Plan (FYDP) suggests that it is well-prepared to seize additional opportunities that arise. While the DoD base budget is projected to grow to $842 billion in 2024, the substantial supplemental request of $50 billion could represent a further 6% increase, signaling robust financial support for defense initiatives where LHX operates.

Heightened global tensions are driving a surge in defense demand across multiple regions, notably Europe, the Middle East, and the Asia Pacific. These geopolitical shifts translate into increased spending on defense, where LHX's diversified portfolio is likely to meet the expanding requirements. The company has notably increased its international exposure, with international revenues jumping from 10% at the end of 2021 to 20% by the third quarter of 2023-this strategic expansion into global markets positions LHX advantageously to capture the anticipated growth in international defense spending.

In essence, LHX's global reach, coupled with its alignment with current defense spending trends, renders it a formidable player ready to thrive amidst the escalating demand for defense and security technology.

Capturing Growth in Space & Airborne Systems

LHX is carving out a competitive edge within the space segment, distinguishing itself from peers with a portfolio deeply entrenched in national security and advanced technology. The Space & Airborne Systems (SAS) segment, pivotal to LHX's growth, saw a 6% sequential revenue increase in Q3 2023, primarily driven by escalating demands and the commencement of new programs in Space and Intelligence and Cyber sectors, despite a decline in legacy airborne platforms.

The SAS portfolio is comprehensive, encompassing space payloads, sensors, and full-mission solutions; classified intelligence and cyber operations; avionics; electronic warfare; and mission networks essential for air traffic management. LHX's proficiency in these areas is underscored by a record backlog, particularly in space, where it boasts contracts for over 50 satellites and has secured competitive prime awards worth more than $4 billion in the past two years.

Space operations, representing approximately 40% of the SAS segment's revenues, are anticipated to be the company's main growth driver. LHX's involvement ranges from conventional satellite production, mainly as a supplier, to more advanced projects like ground stations and smaller satellite systems. Notable among these is the Tracking Layer for the Space Development Agency ((SDA)), designed to provide global indications and targeting of advanced missile threats, including hypersonic missiles, and the Missile Defense Agency's Hypersonic and Ballistic Tracking Space Sensor (HBTSS).

While the Space segment is expanding robustly, its overall contribution to SAS profitability is still developing. With a diverse margin range across Space programs, the segment is expected to achieve a high single-digit margin, slightly below the broader SAS segment's margin of 12%. LHX's commitment to this segment is reflected in its strategic prioritization of profitability over sheer revenue growth.

As expressed in a recent earnings call, management is focused on improving margins by avoiding cost overruns on fixed-price contracts, such as those for missile tracking with the Missile Defense Agency (HBTSS) and the SDA's Tranche 0 for tracking. These projects, completed and awaiting launch, exemplify LHX's dedicated approach to enhancing profitability within the Space sector.

Shifting from Acquisitions to Growth, Profitability, and Operational Execution

LHX is shifting gears, placing a renewed emphasis on growth, profit margins, and execution following a substantial investment in acquisitions. The company has significantly expanded its capabilities by acquiring ViaSat's Link 16 business and Aerojet Rocketdyne, amounting to $6.6 billion in expenditures. This aggressive growth strategy has elevated its leverage ratio to approximately 3.7x.

LHX is implementing a comprehensive deleveraging plan to reduce debt by $3 billion to a leverage ratio of 3x. This will be accomplished through robust free cash flow generation and strategic asset sales, including the divestiture of its Commercial Aviation Solutions business for an estimated $600 million. Successful deleveraging is expected to set the stage for stock buybacks to resume between the second half of 2024 and the first half of 2025.

Looking forward, LHX has set ambitious financial targets, including a 4% rate in organic revenue growth, a margin expansion of 100-120 basis points, and a CAGR of 12% in free cash flow from 2024 to 2026. Furthermore, the company has doubled its gross cost savings projection for the LHX NeXt program, aiming for $1 billion in savings between 2024 and 2026. This initiative will target significant reductions in direct and indirect spending and labor costs.

If LHX successfully executes this stringent cost-saving plan, it will likely exceed its margin targets by 2026, heralding a period of increased financial efficiency and profitability. Such strategic financial management and operational execution are poised to enhance shareholder value and reinforce the company's competitive position in the defense technology sector.

Potential Downside Risks and Upside Opportunities

Downside Risks

Investors should be aware of several factors that could pose downside risks to LHX's stock price. A global economic downturn could lead to reductions in defense spending, impacting the company's bottom line. Government shutdowns and the unpredictability of election outcomes also present potential risks that could affect industry funding and policy decisions.

From a company-specific standpoint, there is the risk that LHX may not meet its margin targets, which is crucial for the stock's performance. The defense budget may be lower than anticipated, and any decrease in Operations & Maintenance (O&M) funding could impact the company's financials. The demand for tactical radios, a significant product for LHX, is also subject to fluctuations; a decline in this demand, both domestically and internationally, could negatively influence revenues.

Moreover, the company's Rochester, NY, radio manufacturing facility is critical to its operations due to the high margins of the radios produced there under commercial-type contracts. Any disruptions in this facility could pose substantial risks to the company's operational efficiency and profitability.

Upside Opportunities

On the flip side, some factors could contribute to an increase in LHX's stock price. Continued strength in profit margins and strong bookings would be positive indicators of the company's financial health and could lead to a revaluation of the stock price. Additionally, higher-than-expected demand from international markets could present upside potential, especially given the company's recent expansion in global exposure and international revenue streams.

The balance between these upside and downside risks will be crucial to LHX's stock performance. Investors should closely monitor these factors when considering the potential price trajectory of LHX shares.

Consensus Estimates & Guidance

The following table shows the consensus estimates for LHX from 2022 actuals forecasted through 2026, consistent with management's medium-term financial targets.

These figures portray a company managing to grow revenue and EPS over the forecast period, with a temporary contraction in margins projected to recover. The decreasing P/E ratio implies that analysts expect earnings to increase, presenting a more attractive valuation case.

For 2023, the company expects revenue between $19.2B and $19.4B, a segment operating margin of approximately 14.8%, and free cash flow of over $2 billion. Looking ahead to 2024, they anticipate revenues to increase to around $21B, with an improved segment operating margin of roughly 15.0% and free cash flow to grow to approximately $2.2B. By 2026, the company's financial framework projects a further increase in revenue to $23B, a segment operating margin of 16.0%, and a free cash flow of about $2.8B, indicating a growth trajectory and increasing profitability.

Valuation

Despite superior cash flow generation and margin opportunity, LHX trades at a discount compared to other defense prime contractors. This discrepancy is evident when analyzing LHX's valuation metrics compared to its peers. LHX has an enterprise value of approximately $53.2 billion, with a next twelve-month EBITDA of $3.9 billion. When we look at the EBITDA multiples, LHX stands at 13.58x, below the peer group median of 15.41x, despite boasting a higher LTM Gross Margin of 27% compared to the median of 19%.

This undervaluation is further highlighted when considering the implied share price derived from the peer median EBITDA multiple. If LHX were valued at the peer median of 15.41x, the implied enterprise value would be around $60.3 billion. After adjusting for cash and short-term investments and subtracting total debt, the implied equity value suggests a share price of $245.73. This figure starkly contrasts with the current share price of $204.42, indicating a discount of approximately 17%.

The current market price of LHX does not fully reflect the company's robust margin profile and the potential for cash flow generation. This could suggest an attractive opportunity for investors who believe in the company's long-term growth prospects and its ability to realize the margin and cash flow targets it has set. The discount also implies that there might be unrecognized potential in LHX's operational performance or market position that could if realized, lead to a reassessment of the company's stock value by the market.

Final Thoughts

L3Harris Technologies is a compelling investment due to its strategic alignment with increased defense spending, strong position in growth markets like space, and focused financial discipline aimed at margin improvement and cash flow generation. The company's discounted valuation relative to peers presents an attractive entry point for investors. Despite potential risks, LHX's clear strategic initiatives, robust backlog, and strong market position underpin its potential for long-term value creation, making it a worthy consideration for investors seeking to capitalize on the defense sector's expansion.

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