Summary
- L3Harris is a leading defense technology company which offers a range of military weapon systems and communications products, currently being used in Ukraine.
- The company reported solid financial results in Q4,22 as it beat revenue growth estimates and scored a range of government contracts, despite missing on its earnings.
- L3Harris bought back $1.1 billion worth of shares in the full year of 2022 and $183 million Q4.
L3Harris ( LHX ) is a leading aerospace and defense contractor, which offers a variety of innovative technology across land, sea, air and even space. The company is poised to benefit from increased defense spending which has been forecast to reach close to $1 trillion by 2032. This has been recently driven by catalysts such as the Russia-Ukraine war and increased uncertainty around Taiwan/China. A four star U.S general who heads up the U.S. Air Mobility Command has even warned of a potential War between the U.S and China in 2025. Although this is not definite by any means, this type of media rhetoric is expected to further bolster defense budgets. L3Harris recently reported its financial results for Q4,22, the company beat its top line growth estimates but missed on earnings. The positive with the earnings miss is it was mainly a result of a series of "one off expenses" related to acquisitions and the company has a huge number of government contracts in the pipeline. In this post I'm going to break down the financials of the company, the defense spending tailwinds and its valuation, let's dive in.
Financial Review
L3Harris reported stable financial results for the fourth quarter of 2022. Revenue was $4.6 billion, which beat analyst estimates by $215.93 million and increased by 5% year over year. This was driven by solid growth in the Space & Airborne Systems [SAS] segment as well as in the Communication systems segment. Before I dive into each segment in detail, I will review the growth trends in defense spending, which act as a tailwind for L3Harris.
Defense Spending Tailwinds
The United States spends more on defense than the next 9 countries combined. Between the year 2000 and 2011, there was a sharp increase in spending from "just" $295 billion to $699.4 billion. This was driven primarily by wars in Iraq and Afghanistan over the period. There was a dip in defense spending to $590.2 billion in 2017, but since that point the trend as been sharply upwards. It should be noted that the below chart was originally created at the end of 2021 and forecast U.S defense spending of $722 billion in 2022 and it to grow to a staggering $998 million by 2032. Keep in mind this was before the Russia-Ukraine war and many heightening tensions between China-Taiwan and the U.S.
Revised data for 2022 indicates the budget was $742 billion and is expected to jump to a staggering $817 billion in 2023.
L3Harris is poised to benefit from this growth in defense spending with a plethora of its products directly benefiting. This includes satellites, Surveillance and Reconnaissance [ISR] aircraft, maritime systems and even cybersecurity products. You may recall that just before Russia invaded Ukraine, U.S satellites detected movement of troops close to the Ukraine border, which acted as an early indicator of an attack. Now although it is unknown whether L3Harris technology was used specifically for this, the company offers leading technology in this space. L3Harris also offers a series of advanced Radar style technology such as " Electro-Optical and Infrared (EO/IR)", which helps give the navy a 360-degree view of their environment.
The Russia-Ukraine war specifically resulted in a staggering $62 billion in funding related to defense spending and this figure is set to expand as the fighting continues.
L3Harris has strong connections with the Ukraine Ministry of Defense and received orders worth "several hundred million" dollars related to Ukraine activities. This includes the "VAMPIRE" (Vehicle-Agnostic Modular Palletized ISR Rocket Equipment). This is a portable kit that can be installed on the back of any flatbed truck and used to launch laser-guided missiles. This is a beautiful piece of technology for Ukraine, where on the ground purpose-built military vehicles have been limited. The system can be installed in less than two hours by an average person with standard tools, making it ideal for the rough and ready Ukraine war environment.
L3 Harris is also expected to benefit from a "plus ups" in a variety of its products from Compass Call to Enchanced Night Vision Goggles. On its earnings call management noted that its program budgets have increased by over 15%, as the U.S must replenish military products sent to the Ukraine.
Internationally L3 Harris generates 40% of its revenue from Europe, and a staggering 30% from the Asia-Pacific. Countries such as Japan have vowed to increase defense spending by a staggering 26% in 2023 with a bold goal to double funding to 2% of GDP by 2027. This is driven by global uncertainty regarding China-Taiwan and the strong military rhetoric by the country's leader. Chinese ruler Xi Jinping reportedly told troops at a Chinese military base to "prepare for war". Xi Jinping was pictured in full military gear which acted as a strong visual statement. Then of course we have North Korea, which despite being a small country reportedly has the fourth largest army in the world with 1.3 million personnel. This country has continued to build out its nuclear weapons program. Kim Jong Un's sister has recently slammed the U.S for sending tanks to Ukraine and believes western tanks will "burn" in the region. This signals a global divide in which Russia, North Korea, and potentially (but hopefully not) China could form an "Axis" of partners similar to the dynamic of World War 2. Now although I could go into depth about geopolitics, the simple fact is L3Harris will benefit from increasing defense spending globally.
Specifically, L3 Harris reported an expansion in its international revenue to $4.4 billon or 23% of its total in 2022. With its total backlog expanding by 5% year over year.
Integrated Mission Systems
Breaking down L3Harris's revenue by segment, for the full year its Integrated Mission Systems [IMS] reported $6.9 billion in revenue which declined by 2% year over year. This lower revenue was mainly driven by a $53 million decline for its Intelligence, Surveillance, and Reconnaissance [ISR] systems which was partially offset by a $38 million increase in Maritime spending related to Virginia class submarines. A snapshot of the revenue of L3Harris is arguably not the best way to measure its orders, I believe contracts won can be more valuable. For example, the company won a contract worth up to a staggering ~$380 million related to the U.S Navy and its Cooperative Engagement Capability [CEC]. In addition, the company won a $200 million incremental contract for its Electro-Optic / Infrared (SPEIR) system, designed to track anti-ship cruise missiles and drones. On Land, the company scored a $40 million contract for the aforementioned VAMPIRE missile systems used in Ukraine.
IMS revenue (Q4,22 report)
Aerojet Rocketdyne Acquisition
In December 2022, L3Harris announced plans to acquire Aerojet Rocketdyne for a staggering $4.7 billion. The idea of this acquisition is to provide access to new markets which include missiles such as hypersonics. Management is expecting cost synergies of $40 million to $50 million in 2023 and greater earnings visibility thanks to a solid backlog increase to ~$30 billion.
Space and Airborne Segments
For the fourth quarter, Space and Airborne systems revenue rose by 7% year over year to $1.61 billion. This was driven by an $80 million increase in Space revenue which is part of a larger $700 million contract related to tracking of missiles using satellites for the Space Development Agency [SDA]. In addition, the company reported $25 million related to "Intel & Cyber" classified programs. Its Space segment has a strong pipeline of $25 billion, and the company submitted proposals for a further $3 billion worth of contracts in Q4,22 alone. The large pipeline of orders gives a solid outlook into the consistency of its future revenue which is great for investors.
SAS revenue (Q4,22 report)
L3Harris also reported $450 million in contracts related to the U.S Air Force with over $200 million related to international F-16 customers.
Communication Systems
Communication Systems [CS] reported full year revenue of $4.2 billion which declined by 2% year over year. The positive news was that in Q4,22 revenue increased by a rapid 17% year over year due to a $170 million increase in sales for its Tactical Communications systems. In addition, the company scored a $300 million contract to supply encrypted radio equipment to the Australian Defense Force.
CS revenue (Q4,22 report)
In January 2023, L3Harris announced it had closed the acquisition of Viasat’s TDL product line for ~$2 billion. The idea of this is help improve the usage of broadband communications across land, sea, and air. As military equipment is getting more advanced and the world is becoming increasingly connected, I believe this is a solid acquisition (at a high level).
L3Harris has also continued to strengthen its cybersecurity systems, and recently won a contract from the U.S DoD and AI office to create a prototype system to move data from sensors across the battlefield. This would be part of the JADC2 (Join All-Domain Command and Control) setup which aims to connect all sensors and intelligence from every military unit (across land, sea, air and space) to give a unified view of the battlefield, enhanced by artificial intelligence.
I look at this as an application of the Internet of Things [IoT], an industry that is forecast to grow at a 16.7% compounded annual growth rate.
Profitability and Balance Sheet
In the fourth quarter of 2022, L3Harris reported EPS of $2.17 which declined by 17% on a GAPP Basis. This was driven primarily by negative $0.32 in acquisition related costs and negative $0.09 in operations related costs. A positive is I expect the acquisition integration costs to be one of expenses and thus will not be a material issue long term. On a non-GAAP base EPS was $3.27, which was close to flat year over year.
L3Harris has $880 million in cash and cash equivalents on its balance sheet. The company does have fairly high debt of ~$7.786 billion but the vast majority of this is "long term debt" equating to ~$6.2 billion, thus manageable given the strong adjusted free cash flow of $2 billion in 2022.
L3Harris has a 2.11% forward dividend yield and paid out $864 million in dividends for the full year of 2022. L3Harris has a 15.28% 5 year growth rate for its dividend and I forecast this to be consistent given the large backlog of secure government contracts.
Stable Guidance
L3Harris has forecast revenue of between $17.4 billion and $17.8 billion in 2023, which would represent a 4.7% growth rate at the top end of the range.
Non-GAAP EPS is forecast to be $12.25 at the midpoint, this would be down slightly from the $12.90. But it should be noted that there was a negative $0.71 related to Pensions in 2022. In addition, to a negative $0.10 related to higher input costs from the high inflation environment and the labor market. This is partially offset by price increases which is a positive sign as it shows the company does have "pricing power" to a certain extent. Governments which purchase military equipment tend to focus on the "best" as opposed to trying to scrimp on prices. There is also expected to be a negative $0.02 headwind related to the higher interest rate environment, partially offset by tax efficiency.
For extra information, you can also see a break down of the guidance by segment. Stable revenue expected in the IMS and SAS segments with substantial growth expected in the CS segment relative to 2022.
Advanced Valuation
In order to value L3Harris I have plugged its latest financials into my discounted cash flow valuation model. I have forecast 4.7% revenue growth for "next year" (2023) which is in-line with management's guidance. However, in years 2 to 5 I have forecast an acceleration in revenue growth to 8% per year. This is optimistic but given the tailwinds from increased defense spending and the large amount of government contracts it's not unbelievable. In addition, L3Harris grew its revenue at an 11% rate in 2019 (pre Russia-Ukraine) war so its possible to at least return to prior growth rates.
L3Harris stock valuation 1 (created by author Deep Tech Insights)
I have also forecast the company will grow its operating margin from 11.31% in 2022 to 18% over the next 6 years. This may seem optimistic again but between 2015 and 2019, the company had an average operating margin of between 18% and 19%. Inflation was lower during that period, but there was also a lower number of tailwinds geopolitically. In addition, the company is now at a larger scale which has been bolstered by its number of acquisitions.
L3Harris stock valuation 2 (created by author Deep Tech Insights)
Given these factors I get a fair value of $214/share the stock is currently trading at ~$212 per share at the time of writing. Therefore the stock is just over 1% undervalued or "fair value" in my eyes.
As an extra datapoint, L3Harris trades at a price to sales ratio = 2.38x which is 10.58% cheaper than its 5 year average. The company also trades at a forward non-GAAP P/E ratio = 17.24x, which is just over 4% cheaper than its 5 year average. Relative to other defense contractors L3Harris trades at a mid range valuation, cheaper than Raytheon Technologies ( RTX ), which trades at a PE ratio = 19.90x.
Risks
Recession/Inflation
Even though parts of eastern Europe are at war, we cannot forget that the U.S is still experiencing a wave of inflation and record high government debt ( over $31 trillion). Inflation is on a downward trend but it's still above the Feds 2% target. This increases the cost for materials for L3Harris and also squeezes the consumer which has a knock on effect, which could impact future defense spending especially if the Russia-Ukraine war decides to finish soon.
Final Thoughts
L3Harris is a leading technology company in the defense industry. The company is poised to benefit from increased defense spending and its technology such as the VAMPIRE missle system has now been "battle tested" in Ukraine which further bolsters its credentials. Space should also not be overlooked as really this is the next frontier where both governments and private businesses are moving into (SpaceX, Blue Origin, Virgin galactic etc). Thus any technical expertise in this "space" is a strong positive. Its stock is "fairly valued" in my eyes at the time of writing and thus it could be a great long term investment.
For further details see:
L3Harris: Revenue Beat With Defense Spending Tailwinds