2023-06-09 13:15:31 ET
Summary
- L3Harris Technologies reported good Q1 2023 results despite ongoing challenges, with a solid demand environment and a high book-to-bill ratio. Nevertheless, a closer look is warranted.
- LHX stock remains undervalued due to the prevailing uncertainties discussed in the article, but the growth prospects are solid. The likely successful acquisition of Aerojet Rocketdyne will provide a significant tailwind.
- LHX is a compelling investment opportunity that continues to fly under the radar due to the lack of narrative tailwinds and weak Wall Street coverage.
Introduction
The stock market in general, but particularly defense stocks such as L3Harris Technologies, Inc. (LHX), were rocked by recent uncertainties surrounding the U.S. debt ceiling. This was compounded by a lawsuit and later a request for a more detailed review by the Federal Trade Commission in relation to LHX's planned acquisition of Aerojet Rocketdyne Holdings, Inc. (AJRD). As a result, the stock has lost significant ground and is down nearly 20% after its post- Q4 2022 earnings beat.
While the closing of the AJRD transaction remains somewhat uncertain, the debt ceiling drama has ended with President Biden signing the bill that includes a cap in the defense budget at $886 million for fiscal 2024, a 3.3% increase. LHX stock reacted positively, gaining nearly 10% after having hit a fresh 52-week low in late May.
I have covered the stock twice in the past.
In the first article, from late November 2022 , I compared L3Harris to The Boeing Company ( BA ) and concluded that LHX is " the better investment because the company is more agile, less dependent on long-term fixed-price contracts, and less capital-intensive than Boeing, which is currently fighting windmills. "
In my second article , published in January 2023, I became more optimistic based on the much improved valuation, calling LHX a "silent beneficiary" in a world increasingly focused on defense, largely due to the weak Wall Street coverage and lack of direct exposure to news-relevant warfighting equipment (e.g., Lockheed Martin F-35). I also highlighted LHX's management, which I believe is open and honest, best evidenced in its quarterly investor letters .
In this update, I take a look at the company's Q1 results and provide an updated valuation assessment. I also share my own position and strategy.
How Did LHX Perform In Q1 Of 2023?
For the first quarter of 2023, L3Harris Technologies reported strong revenue growth of 9% (7% organic) to $4.5 billion ($4.4 billion), and backlog reached $24.5 billion, up 16% year-over-year. The funded book-to-bill ratio increased sharply compared to Q4 2022 - from 1.0x to 1.3x. I compared quarter-over-quarter numbers in this context due to LHX's known issues related to supply chain disruptions, having put a lot of pressure on production in recent quarters. While the company continued to see increased demand in the first quarter, and the demand environment is indeed very solid (p. 7, Q1 2023 Investor Letter ), the increase in the book-to-bill ratio is due in part to the company's inability to fill orders - after all, revenues were down 2.3% quarter-over-quarter.
While management expects the supply chain to remain dynamic, it noted that the level of disruptions continues to decline. The company has reduced shortages of critical parts from about 65 to 35 over the past four quarters, while increasing the number of alternative parts from about 900 to 1,300. Overall, there are clear signs of improvement, and management reiterated its full-year guidance given the continued improvement in electronic parts availability and supplier performance. Still, I would hesitate to open a bottle of champagne in light of the results, also due to still high inflation and a tight labor market.
For the sake of completeness - my regular readers know that I don't put much, if any, emphasis on whether quarterly earnings per share ((EPS)) beat or fell short - the company slightly missed analysts' EPS estimates, delivering $2.86 per share. GAAP earnings were 38% lower, and the deviation was largely due to the amortization of acquisition-related intangible assets and transaction and integration costs. These are largely due to the merger of L3 Technologies and Harris Corporation in 2019, the acquisition of the Tactical Data Links (TDL) product line from Viasat, Inc. (VSAT) in 2022, and the pending acquisition of AJRD.
Operating and free cash flow increased significantly year-over-year, primarily due to improvements in working capital accounts. For the first quarter, LHX reported a $48 million decrease in accounts receivable (an increase by $239 million in Q1 2022) and a $90 million increase in accounts payable (a decrease by $43 million in Q1 2022). Inventories increased by $86 million, which is similar to Q1 2022 ($108 million), but definitely not a concern. Operating cash flow improved year-over-year from $39 million to $350 million. Quarterly free cash flow was $279 million (negative $16 million in Q1 2022), well below the expected $500 million (LHX expects >$2.0 billion in 2023). Working capital improvements are expected to occur primarily in the second half of the year. Overall, the company expects free cash flow to be about 65% focused on the second half of the year (p. 6, Q1 2023 Investor Letter). It should also be remembered that the free cash flow guidance of more than $2.0 billion includes $400M to $500M in expected R&D-related tax payments. Adjusting Q1 free cash flow for these payments, the number would have been $35 million higher.
All in all, I think the company delivered a solid performance despite ongoing challenges, which I think are manageable. LHX is still working to unlock efficiencies from the merger and is in the process of integrating Viasat's Tactical Data Links business, but I think it's appropriate to give management the benefit of the doubt due to the complex manufacturing processes and secondary effects from the pandemic. In retrospect, the merger of L3 Technologies and Harris Corporation came at a rather inopportune time.
In this context, the rather modest dividend increase of 1.8% - compared to the average growth rate of 14.6% over the last five years (excluding the 2023 increase) - should not be misinterpreted. A look at the past clearly confirms that management is shareholder-friendly. In addition to very generous dividend increases, the company spent more than $7 billion on share buybacks over the past three years and spent another $396 million in the first quarter of 2023.
I would argue that the decision to (temporarily) curb dividend growth is simply an act of financial discipline. LHX will have to take on significant debt to stem the acquisition of Aerojet Rocketdyne, and it should not be forgotten that L3Harris took out a $2.25 billion term loan in November 2022 to fund its acquisition of Viasat's Tactical Data Links business.
Moody's expects L3Harris' debt-to-EBITDA ratio (see my recent educational article on how to interpret leverage ratios) to exceed 4.0 times at the end of 2023, assuming the AJRD transaction closes successfully. The rating agency projects that the ratio could fall to 3.0 times by the end of 2025. This likely assumes that share buybacks are significantly reduced (or suspended altogether) and that the acquired businesses are properly integrated and supply chain challenges resolve. All in all, I can understand Moody's decision to change the outlook on LHX's long-term rating of Baa2 (BBB S&P equivalent) to negative from stable. The uncertainties are significant, and this is a key reason why the stock is 30% below its all-time high of $270 in March 2022.
How Much Is LHX Stock Worth Today?
Since the end of May, LHX stock has recovered quite nicely. The stock is still down following the run-up after the Q4 earnings beat, and is roughly unchanged since my last article. Let's take a look at an updated valuation of L3Harris stock.
According to FAST Graphs, the stock is now trading at fair value, or a blended price-to-earnings ratio (P/E) ratio of 15. Considering that L3Harris' growth averaged nearly 15% per year during the period shown in Figure 1, implying a price-to-earnings growth ((PEG)) ratio of 1.0, I think it's overly conservative to conclude that the stock is only fairly valued.
The assumption of a baseline free cash flow of around $2.0 billion (representing a free cash flow yield of a solid 7%) is probably also quite conservative, considering the company is still plagued by working capital issues and is still in the process of processing the merger. In addition, Aerojet Rocketdyne will also be a significant contributor to L3Harris' free cash flow, assuming the transaction closes successfully and the integration succeeds. AJRD's average free cash flow for 2020 to 2022 was only about $130 million annually, which is likely a conservative number given weak cash earnings in 2021 and especially 2022. I think it is also reasonable to expect that the acquisition of AJRD (and ViaSat's TDL assets) will strengthen LHX's position as a defense contractor, and the company will also likely benefit from synergies in the future.
Nevertheless, I used $2.0 billion as the basis for a discounted cash flow sensitivity analysis to remain conservative. Figure 2 shows that the stock is currently fairly valued, assuming a cost of equity of 8.5% and LHX's free cash flow to grow by slightly more than 3% over time. Given the past growth in free cash flow (an average of 11% per year since 2002), the current share price of around $190 seems cheap. Analyst estimates for free cash flow through 2025 are about 13% to 14% annualized, likely and largely due to the expected consolidation of AJRD, resolving of supply chain challenges, and efficiencies taking effect.
From these two perspectives, I reiterate my bullish stance and believe the stock is a solid buy. LHX stock also looks cheap from a dividend perspective, as its current yield of 2.4% is about 40% above its five-year average, according to Seeking Alpha's Premium Service . However, I would argue that the comparatively high yield is only partly attributable to the decline in the stock price. LHX stock has been treading water de facto since 2019, so much of the increase in yield can be attributed to generous dividend increases in recent years. Nevertheless, with the full expectation that management will return to more meaningful dividend growth in 2024 or 2025, I believe a starting yield of 2.4% is a solid base.
Conclusion
LHX has reported good results for the first quarter of 2023. The demand environment is solid, as evidenced by the strong order intake of $5.8 billion. The high book-to-bill ratio is also positive, but I would not over-interpret it due to ongoing supply chain challenges. After all, revenues are down 2% quarter-over-quarter. However, management has been open and transparent about the challenges.
In part, LHX's share price came under renewed pressure due to uncertainties surrounding the U.S. debt ceiling. The issues have resolved more or less as expected, and a 3% increase in defense spending is a positive outcome, in my view.
Another reason for LHX's poor performance is the ongoing uncertainties related to the pending acquisition of Aerojet Rocketdyne and the still ongoing merger integration. In the long run, however, I am confident that these issues can be resolved, and the market has priced in a de facto certain closing of the acquisition judging by AJRD's share price performance.
I would not conclude from the rather measly dividend increase that LHX has intractable operational problems. Once LHX has digested the acquisition and the efficiency measures take effect, profitability should increase, leading to significant free cash flow growth. This will enable the company to bring its leverage, which is expected to surpass 4.0 times debt-to-EBITDA after the AJRD acquisition, back in check.
Hence, the 1.8% dividend increase announced in February can be seen as confirmation of management's financial prudence. At the same time, the fact that management spent almost $400 million on share buybacks in the first quarter does not fit into this picture. However, I wouldn't go so far as to conclude that management bought back shares to prop up otherwise poor EPS. After all, the Q1 buybacks only contributed to a 0.47% increase in EPS when comparing the diluted weighted average shares outstanding in Q4 2022 and Q1 2023.
In summary, I remain very positive on L3Harris' growth prospects, but think the stock will likely remain range-bound due to prevailing uncertainties. I'm a big fan of the AJRD acquisition and also think ViaSat's Tactical Data Links business is a good addition to the portfolio. LHX continues to grow as a defense company, and the expanded portfolio will certainly enhance its position and negotiating power. Compared to other (larger) defense companies, L3Harris stock trades at a more compelling valuation, both from an earnings and free cash flow perspective. L3Harris does not benefit from the same "narrative tailwinds" as Lockheed Martin Corporation ( LMT ) or Northrop Grumman Corporation ( NOC ), which are directly linked to warfighting equipment covered in the news.
I reiterate my Buy rating and view LHX as a compelling opportunity that continues to "fly under the radar." I have bought shares in LHX on several occasions, but my position is still relatively small at about 0.7% of total portfolio value. I continue to buy shares and am not succumbing to market timing, as I think the stock is a good value at or below $200.
As always, please consider this article only as a first step in your own due diligence. Thank you for taking the time to read my latest article. Whether you agree or disagree with my conclusions, I always welcome your opinion and feedback in the comments below. And if there is anything I should improve or expand on in future articles, drop me a line as well.
For further details see:
L3Harris: The Missing Narrative Tailwind