2023-07-27 13:52:48 ET
Summary
- L3Harris Technologies reported a stellar 2Q23 with higher-than-expected revenue and EPS, driven by strong demand and easing supply chain issues.
- L3Harris' rock-solid guidance forecasts increased revenue and EPS, driven by strong demand, easing supply chain issues, and acquisitions.
- LHX looks extremely undervalued, with a potential 30-40% upside, making it an excellent investment with promising shareholder returns and debt reduction plans.
Introduction
It's time to discuss what has become one of my all-time favorite dividend growth stocks: L3Harris Technologies ( LHX ) . In April, I wrote my most recent article, calling the company a ridiculously undervalued dividend stock . Since then, I have aggressively added to it and bought it for almost all dividend portfolios that I manage/advise - including portfolios of various family members.
Luckily, LHX shares have done well this summer before selling off 5% after the just-released earnings.
The interesting thing is that these earnings were great. Not only did LHX do very well in the second quarter, it is expected to perform even better than expected in the next few quarters, boosted by strong demand, easing supply chain issues, and a business transformation that just benefited from the approval of the Aerojet Rocketdyne ( AJRD ) acquisition.
In this article, we'll discuss all of this and more.
So, let's dive in!
2Q23 Was A Stellar Quarter For L3Harris
Let's start with the numbers that hit the wires first.
In the second quarter, LHX generated $4.69 billion in revenue, which is $320 million more than expected and 13.3% higher compared to the prior-year quarter.
This helped the Florida-based defense contractor to generate $2.97 in adjusted EPS, which beat consensus expectations by 2 pennies.
The best news is that the company saw strong revenue growth in every single segment. The bad news is that inflation and operating challenges offset some of these gains.
In its Integrated Mission Systems ("IMS") segment, the company saw 8% higher revenues, boosted by higher volumes in key programs like Commercial Aviation and Maritime. ISR sales also supported the top line in this segment. Similar developments were seen in the Space & Airborne Systems ("SAS") segment, which benefited from strong momentum in Space and Intel, including Mission Networks.
Unfortunately, operating income suffered in both segments as a result of asset impairment charges and pricing/productivity headwinds.
In the Communications Systems ("CS") segment, the company saw 21% adjusted revenue growth. Operating income soared by 37% thanks to a mix of higher volumes and a favorable mix.
With this in mind, it gets really interesting as we look into the future, as the company's guidance was the real takeaway of its earnings release.
Rock-Solid Guidance
L3Harris has revised its revenue guidance for 2023 based on a strong first-half performance driven by the aforementioned strength in demand and new program ramps, particularly in the space domain.
The company now expects revenue in the range of $18.0 to $18.3 billion, up from the previous guidance of $17.4 to $17.8 billion, which is a significant adjustment.
However, the segment operating income is expected to remain consistent with prior guidance, ranging from $2.7 to $2.8 billion.
Essentially, incremental income from higher revenue growth is being offset by operational challenges within the IMS segment.
Despite these challenges, the company anticipates maintaining best-in-class segment operating margins of around 15.0% throughout 2023.
The guidance also includes updates on non-operating aspects, with a lower non-GAAP tax rate of 13.0% to 13.5% and higher FAS/CAS pension income of approximately $20 million, offset by an increase in interest expense of the same amount.
As a result of these updates, the non-GAAP EPS guidance has been raised to a range of $12.15 to $12.55 per share, and adjusted free cash flow guidance remains unchanged at $2.0 billion or more, with improvements in working capital expected in the second half of 2023.
While struggles in the IMS segment caused operating income guidance to remain unchanged, it needs to be said that both SAS and CS are expected to generate higher operating income than previously expected this year.
- Higher SAS guidance reflects the strong first-half performance driven by new program ramps within the Space domain. The updated guidance now indicates SAS segment revenue to be in the range of $6.7 to $6.8 billion, up from the previous guidance of $6.4 to $6.5 billion.
- L3Harris has also increased its revenue guidance for the CS segment, attributing it to improvements in material availability and a more consistent supply chain, which are important developments, given the supply chain struggles in the industry since the pandemic. The revised guidance projects CS segment revenue to be in the range of $4.9 to $5.0 billion, up from the previous guidance of $4.8 to $4.9 billion.
Supply Chain Challenges And Light At The End Of The Tunnel
Regarding the aforementioned cost issues, the company also addressed operational challenges within the IMS segment and how to solve them, particularly in ISR and Maritime sectors.
LHX is implementing various measures, including new-hire training, programmatic process improvements, risk management enhancements, and scrutinizing future opportunities.
These actions are expected to provide greater financial stability going forward and lay the groundwork for future profitable growth.
But wait, there's more good news!
As anticipated, the company's supply chain disruptions have been improving, allowing L3Harris to focus resources on fewer challenges.
Unfortunately, labor attrition and inflation remain watch items that present certain program-related challenges.
That said, L3Harris expects both supply chain and labor situations to improve sequentially for the remainder of 2023, which is all I needed to hear. It's also in line with what I've heard from other companies.
Strong Demand Fueling Future Growth
L3Harris is in a tremendous spot to benefit from higher global defense spending - both at home and in allied nations.
In the domestic market, the President signed into law the Fiscal Responsibility Act ("FRA") of 2023, which suspended the federal debt limit and established new discretionary funding limits for defense and non-defense accounts.
For Government Fiscal Year ("GFY") 2024, national defense funding is capped at $842 billion for the Department of Defense. L3Harris expects to begin GFY 2024 under a Continuing Resolution, which is assumed in the guidance.
So, any hikes in spending will have an immediate positive impact on guidance.
Furthermore, in the international market, L3Harris continues to focus on expanding its footprint.
Year-to-date, the company has received international orders totaling $3 billion, including significant support for Ukraine and international space awards.
The company anticipates this trend to continue as NATO allies and other nations increase their defense expenditures to address global threats.
This brings me to my favorite part of this article.
In light of strong demand, the company saw 17% higher orders. This boosted its backlog by 25% to roughly $25 billion. The company is now sitting on a funded book-to-bill ratio of 1.18, which means that for every dollar in finished products, it receives $1.18 in new orders.
A ratio above 1x is indicative of higher future growth.
The company also was approved to buy Aerojet.
Aerojet Rocketdyne Approval And Transformation
After reporting its earnings, the news broke that LHX got FTC approval on the Aerojet Rocketdyne acquisition. Despite headwinds from various politicians, the company is now able to close the deal on July 28.
For what it's worth, as I wrote in prior articles, the deal makes sense, as LHX is a supplier itself. By buying AJRD, the company does not reduce competition, as it will continue to sell to the big guys in the industry.
For example, Lockheed Martin ( LMT ) was not approved to buy AJRD, as the company is a major buyer of AJRD products. It would have gained an unfair competitive advantage versus other buyers of rocket engines like RTX ( RTX ) or Northrop Grumman ( NOC ).
Having said that, the info on the deal is limited. In other words, I stick to what I wrote in my prior article. The company will now focus on reducing debt to fuel shareholder distribution growth in the future.
L3Harris aims to maintain a net-debt-to-adjusted EBITDA ratio of under 3.0x in the long run. If this target is exceeded, the company intends to prioritize debt repayment to ensure it maintains a solid investment-grade credit rating. This can be achieved through a reduction in share repurchases and by potentially selling non-core assets to generate proceeds for debt repayment.
Related to this acquisition and past M&A, the company launched an enterprise transformation program called LHX NeXt .
This multi-phase, multi-year initiative is designed to harmonize and accelerate business enhancements following the major integration activities from the L3 and Harris merger.
The goal is to increase agility, cost competitiveness, and customer capacity while driving increased shareholder value.
The initial focus has been on creating Centers of Excellence , optimizing third-party spending, and analyzing organizational hygiene.
The company is also identifying investments in key technologies and system enablers to support this transformation.
Shareholder Returns And Debt Reduction
In 2Q23, the company reiterated that it would prioritize debt reduction in the short term while focusing on capital returns in the long term.
However, the company is still distributing cash.
In the second quarter, the company returned $338 million to shareholders. The year-to-date amount is close to $1 billion. Roughly half of this consists of dividends.
- The company currently yields 2.4%.
Despite slower dividend growth related to M&A, the 5-year average annual dividend growth rate is 15.0%. I expect strong double-digit growth to return the moment LHX has reached its leverage target.
As of June 30, 2023, the company's net leverage ratio was 2.5x (EBITDA).
The company targets a leverage ratio of less than 3.0x net-debt-to-adjusted EBITDA . When above this target, L3Harris expects to prioritize debt repayment to maintain solid investment grade credit ratings and achieve this through a moderation in share repurchases and proceeds from potential non-core asset divestitures.
LHX Stock Valuation
After its earnings release, the stock dipped 5% (while I am writing this). I believe that investors were caught off guard when the company noted ongoing cost issues that prevented operating income guidance from being hiked.
While that annoyed me as well, I see no issues for long-term investors.
The company is benefiting from strong demand, slowly easing supply chains, a new enterprise initiative, and its ability to quickly deleverage its balance sheet after the AJRD merger.
Looking at the numbers below, we see that the company is expected to boost free cash flow to $2.8 billion in 2025, which would imply a 7.7% free cash flow yield. Using 2024 numbers, we are dealing with a potential 6.8% FCF yield.
As the dividend yield is at 2.4%, this indicates a lot of room to reduce cash and boost both dividends and buybacks once the post-merger debt load has been reduced.
It also means that LHX is trading at 14.8x 2024E free cash flow, which is way too low - in my opinion.
In my prior article, I made the case that LHX is at least 30% to 40% undervalued.
I'm narrowing that range and making the case that LHX shouldn't trade below $270.
The just-released earnings and comments were good. Also, higher certainty related to the AJRD deal will likely allow the company to generate synergies quicker than expected.
Given my view and the current price action, I'll remain a buyer, as I believe that LHX is one of the best industrial dividend stocks on the market with a ridiculous valuation.
Takeaway
L3Harris Technologies continues to impress as a top-notch dividend growth stock with a promising future. The company's second-quarter performance was stellar, and its guidance points to even greater prospects ahead. Despite some operational challenges and supply chain issues, LHX's ability to adapt and transform bodes well for its long-term growth.
The key takeaway here is that LHX is well-positioned to capitalize on strong global defense spending and expanding international markets. With a robust backlog, strategic acquisitions, and a commitment to reducing debt and rewarding shareholders, LHX remains an attractive investment.
As a long-term investor, I firmly believe that LHX's current dip in stock price presents a fantastic buying opportunity. This gem in the industrial dividend stocks sector is undoubtedly undervalued, and I stand firm on my conviction that LHX shouldn't trade below $270.
For further details see:
L3Harris Has Become A Strong Buy After Stellar Q2 Earnings