2023-04-04 16:27:21 ET
Summary
- L3Harris Technologies is one of America's largest defense suppliers, thanks to a well-diversified business model and a strategic merger in 2019.
- The only reason why dividend growth has come down is M&A-related deleveraging.
- Current M&A deals and divestitures are reshaping the company for improved long-term growth in key areas.
- LHX is a fantastic mix of growth and value. I believe the stock is undervalued and poised for long-term outperformance.
Introduction
One of the first defense stocks I bought for my dividend growth portfolio is L3Harris Technologies (LHX) , a company that has its roots in the 2019 merger between Harris and L3. The decision to buy L3Harris was based on a number of factors including, but not limited to, a decent dividend yield with a sustainable long-term growth rate, a wide-moat and well-diversified defense portfolio, anti-cyclical demand growth, and expected outperformance versus its industrial sector peers.
In this article, I will discuss all of this in light of new developments in the defense industry, the company's attractive valuation, and the pending acquisition of Aerojet Rocketdyne (AJRD).
So, let's get to it!
The Need For High-Tech Defense
Since Russia invaded Ukraine last year, one thing has become clear: NATO nations need to boost defense spending. It's part of the bull case that has been repeated in almost every single defense-focused article written since then.
At the end of last month, the Wall Street Journal published an op-ed highlighting some issues related to the budget.
The event that triggered this article was China's Xi Jinping's trip to Moscow to work on his anti-Western axis. China and Russia are increasingly working on expanding their global footprint when it comes to trade. This includes boosting defense capabilities.
It's one of the reasons why the Biden Administration is seeking an $842 billion defense budget in 2024.
While $842 billion might seem like a huge number, it's a real increase of less than 1% in real dollars. Assuming that inflation in certain areas (like aerospace) is higher, we can assume that the industry is right when it makes the case that this is an indirect budget cut. According to the WSJ:
To the extent the press is covering Mr. Biden's $842 billion Pentagon budget, it is to note the number is large. Yet defense spending at 3% of the economy is low by historical standards. The Pentagon says the proposal is a 0.8% real increase over fiscal 2023, but that is based on an inflation fantasy. This is a defense cut, and not from an epiphany of fiscal restraint. Mr. Biden is choosing to put welfare entitlements over national security.
The WSJ makes the case that accelerated investments are needed in key areas like the Air Force. While the Air Force is buying advanced fighters like the F-35 (as expected), a large number of fighters are being retired.
The Air Force deserves points for buying 72 fighters, which is the minimum needed to keep inventory stable. Meanwhile, the service asks to retire 310 aircraft, and some of this is inevitable. The F-15C/Ds leaving Okinawa with no permanent replacement are structurally exhausted; the A-10 is 40 years old and too rudimentary to operate against adversaries like China.
While the Air Force is trying to invest in smarter equipment like unmanned aircraft that can support manned jets like the F-35, we're decades away from this becoming a large-scale reality.
Moreover, as the graph below shows, defense spending has been in a steady decline (as a percentage of GDP).
Federal Reserve Bank of St. Louis
The current proposal would lower defense spending to just 3% of GDP, a multi-decade low. Also, note the shaded areas in the chart above. Historically speaking, recessions cause the ratio of defense spending to GDP to rise. This is based on lower GDP (it's a recession) and higher defense spending. After all, boosting defense spending is a very efficient way to support the US economy. The defense supply chain is complex, and it involves tens of thousands of companies. Boosting defense spending tends to create a very efficient trickle-down effect.
With this said, the discussion so far seems rather bearish. A defense budget that barely beats inflation in times of high demand is not something that fuels a massive defense rally. However, the need for targeted defense spending in high-tech areas is high. Lawmakers know that there's no way to avoid further defense hikes. This is bullish for defense contractors.
The L3Harris Dividend Experience
A Well-Diversified Defense Contractor
On June 29, 2019, L3 officially merged with Harris in a merger of equals. This merger created one of the most advanced and well-diversified defense suppliers in the world.
The company operates three business segments .
- Integrated Mission Systems
[...] including multi-mission intelligence, surveillance, and reconnaissance ("ISR") and communication systems; integrated electrical and electronic systems for maritime platforms; and advanced electro-optical and infrared ("EO/IR") solutions.
- Space & Airborne Systems
[...] including space payloads, sensors, and full-mission solutions; classified intelligence and cyber defense; avionics; and electronic warfare.
- Communication Systems
[...] including tactical communications; broadband communications; integrated vision solutions; and public safety radios; global communications solutions.
Since its merger, the company has reshaped its business through a number of divestitures, whose proceeds were predominantly used to repurchase shares.
Now, the company is acquiring businesses that complement its business and expand its capabilities in areas that make LHX even more competitive. For example, in my December article , I highlighted the $2 billion deal to acquire Viasat's Tactical Data Links product line, which allowed the company to directly compete with major defense contractors as its networking technologies cover platforms like the B-2, C-130, F-16, F-18, and a wide range of missile systems.
According to the company :
The acquisition aligns with L3Harris's Trusted Disruptor strategy to provide customers with innovative and alternative solutions. TDL technology will improve the company's JADC2 capability and provide immediate access to Link 16 waveform, platforms, prime contracts, and a path to Advanced Tactical Data Links (ATDL) for future, integrated solutions.
TDL will expand the company's commercial pricing portfolio focused on defense applications across all domains for DoD and U.S. allies as a prime contractor.
Moreover, the company is looking to buy rocket engine producer Aerojet Rocketdyne for $58 per share in a $4.7 billion enterprise-value deal. Back in December, I wrote that this deal, valued at 12x 2024E EBITDA, was very fair, especially considering that AJRD operates in a fast-growing industry.
Whether it is space exploration, advanced rocket technologies (like hypersonics), or spending on missiles (also related to Ukraine), missile technology is the place to be. Buying AJRD at 12x 2024E EBITDA is a great deal.
While AJRD shareholders approved the deal in March, LHX is still waiting for approval. The Federal Trade Commission had requested a second review of the deal, extending the waiting period imposed by the Hart-Scott-Rodino Act.
One of the opponents of the deal is Senator Warren. As reported by Seeking Alpha :
In late January Sen. Elizabeth Warren (D-MA) urged the FTC to block L3Harris's ( LHX ) planned acquisition of the rocket maker, arguing it would reduce competition in the defense industry.
"This deal between Aerojet and L3Harris would reduce competition in the shrinking defense industry to a new low, and I encourage the FTC to oppose this dangerous transaction," Warren wrote in a letter to FTC Chairwoman Lina Khan as well as two Democrats on the commission.
My opinion is that approval is very likely. The reason why Lockheed Martin ( LMT ) was prohibited from buying AJRD is the high competition risk. AJRD is a key supplier to LMT. If LMT had bought AJRD, it would not only reduce its own operating costs but also get significant leverage over its competitors. After all, they are also major buyers of AJRD supplies.
LHX is different. The company supplies all major contractors with a wide variety of products and services. That's also why I bought the stock, as it compliments my other defense holding so well. While this deal would make LHX more powerful, it doesn't create a situation where defense contractors are at a disadvantage.
So far, we also haven't heard any major complaints from contractors like Raytheon Technologies ( RTX ), which publicly fought the LMT takeover of AJRD.
So far, we have established that LHX is a well-diversified defense stock with growth opportunities, even if it fails to buy AJRD.
Now, let's dive into its dividend.
The LHX Dividend & Total Return
Excluding dividends, LHX is trading where it was when the merger between Harris and L3 was closed in 2019.
This is disappointing because defense stocks have entered a significant bull case with support from higher spending (related to the war in Ukraine) while supply chain problems are easing, and money is spent on buybacks to boost earnings per share.
Over the past three years, LHX has bought back 12% of its outstanding shares with a combination of organic free cash flow and post-merger divestiture proceeds.
The company is currently 25% below its 52-week high and down 5% on a year-to-date basis.
While this is mainly due to uncertainty regarding the AJRD deal and the defense budget, it increases the value for shareholders. We now get to buy with a much more attractive risk/reward. This includes a higher dividend yield.
As of February, LHX pays a $1.14 per share per quarter dividend. This translates to a 2.3% dividend yield.
Unfortunately, dividend growth has declined. Below, I listed all post-merger hikes.
- February 2023: +1.8%
- February 2022: +9.8%
- February 2021: +20.0%
- February 2020: +13.3%
The company's dividend is protected by a 35% payout ratio.
While I have little doubt that dividend growth will improve in the future, the company is preparing to reduce debt related to the Viasat and (potential) AJRD deals.
As of 4Q22, the company has a leverage ratio of 2.5x (net debt to EBITDA). On an adjusted basis, that number is 1.8x EBITDA. Needless to say, these numbers are pre-AJRD.
Until 2025, the company aims to stick to a capital deployment plan that includes share repurchases, acquisitions, dividends, and debt repayments.
While it's hard to say what the actual numbers will look like in the years ahead, we'll likely see subdued dividend growth and repurchases to absorb major M&A deals.
However, the company remains committed to using share repurchases to avoid share dilution and maintain steady dividend growth.
This is what CEO Chris Kubasik said in the 4Q22 earnings call :
[...] a nice pie chart (Author: the one above) that kind of lays out our capital deployment over a five-year period and it shows us a fair amount of balance. But I don't foresee us doing any acquisitions for a couple of years, as you would imagine.
We have some non-core assets that we're going to sell, and we're going to use those proceeds to bring down the debt over the next few years. We'll keep annual dividend increases and remain competitive, as you would imagine.
And then we'll repurchase shares probably at least $500 million a year to absorb any dilution and depending on cash flow and other dynamics, that number could increase as we go forward.
While I expect dividend growth to remain subdued, I am not considering selling LHX to buy a stock capable of growing its dividend at a faster pace. After all, I am a long-term investor, and I approach investments by putting myself in the shoes of the CEO. Dividend growth is only (expected to be) subdued because of strategic M&A deals. These deals will reshape LHX, making it a more powerful defense stock.
Once the post-merger debt load has been reduced, the company will be in an excellent spot to boost the dividend with support from major buyback programs.
To me, that's fantastic.
For example, excluding AJRD, LHX is on track to generate $2.0 billion in free cash flow this year. This translates to a free cash flow yield of 5.3%. That's a terrific deal. If LHX weren't aiming to buy AJRD, it could easily boost its dividend by 20% without stretching its capital budget.
This also shows that LHX shares are rather undervalued at current prices.
LHX Valuation
A part of the valuation is the aforementioned free cash flow yield. Excluding AJRD, we're dealing with an implied 5.3% FCF yield for 2023.
On top of that, LHX is now trading at 12.5x 2023E EBITDA, which is too cheap (in my opinion).
I believe that the stock should not trade below 15x EBITDA, which implies at least a 22% upside to fair value. Using 2024 estimates, that number increases to 33%.
In other words, my "fair" value price target is $240, which is slightly below the consensus estimate of $250. Over the next 12-24 months, my target is $260.
FINVIZ
However, please take these targets with a grain of salt. These are based on EBITDA estimates and the valuation. I only communicate these numbers and time frames to let readers know how I assess the fair value. I have no intention to sell if LHX reaches my targets. Also, these targets can be delayed due to unforeseen economic events or the company's inability to grow.
Takeaway
In this article, we discussed one of my favorite dividend growth stocks. LHX was one of the first defense stocks I added to my dividend portfolio thanks to its well-diversified business model, its fantastic management, and its ability to let shareholders benefit from its success through dividend growth and buybacks.
LHX is currently undervalued, as it is working on a number of major M&A projects that could reshape the company and allow it to accelerate growth in key areas.
While it remains to be seen whether LHX gets approval to buy AJRD, I like the current valuation and the long-term risk/reward. While dividend growth and buybacks could remain subdued in the next 1-2 years due to M&A deals, I have little doubt that LHX will outperform the market on a long-term basis and return to aggressive dividend growth once it has achieved its deleveraging targets.
If I didn't have 23% defense exposure already, I would be a buyer at these levels.
For further details see:
L3Harris Dividends - The Perfect Mix Between Growth And Value