Is L3Harris Technologies Stock A Buy?

L3Harris Technologies Inc [NYSE: LHX] is an American aerospace, defense and information technology services company that provides products and technologies across air, land, sea, space and cyber domains.

It operates through the following segments:

• Integrated Mission Systems;
• Space and Airborne Systems;
• Communication Systems; and
• Aviation Systems.

The company provides products for the C6ISR market along with integrated electrical and electronic systems, airborne radio systems; sensors, wireless equipment, electronic warfare and cyber defense products; tactical radios, integrated vision solutions; avionics, security, detection, and other commercial aviation products; space and airborne systems, and night vision equipment for use in the government, defense, and commercial sectors.

L3Harris also provides commercial and military pilot training services.

L3Harris Technologies was formed from the merger of L3 Technologies (formerly L-3 Communications) and Harris Corporation in June 2019.

L3 has approximately $18 billion in annual revenue and 48,000 employees. The Melbourne, FL-based company is the sixth largest defense contractor in the U.S. and the 10th-largest worldwide, with customers in 130 countries.

The Bull Case for L3Harris Technologies

L3Harris makes battlefield communications systems, night-vision devices, sensors and satellite communications, laser range finding, modification, and image intensification equipment, among others.

The present company came into existence in 2019 with the merger of Harris Corporation and L3 Technologies. It was a prudent and well-executed merger as it allowed the two companies to bring together their respective expertise and resources to better compete in the US and global market.

Post-merger, the company focused on increasing the share of business directly from the government instead of as a subcontractor to a larger partner.

The merger also allowed L3Harris to realize cost savings of over $335mn since completion, with another $320-$350 mn expected to be saved next year alone.  All this has resulted in higher free cash flow, and has helped the company indulge in investor-friendly policies.

The pipeline remains robust.

The U.S. Air Force recently awarded L3Harris a 10-year, $85-million, IDIQ contract to produce up to 170 T7 robots to replace its existing 20-year-old Explosive Ordnance Disposal (EOD) system which mitigates explosive threats at bases. The contract includes robots, robotics support, maintenance and training, with initial deliveries scheduled in 2022.

It received $350 million in orders for advanced capabilities across incumbent platforms, including the Rivet Joint reconnaissance, National Command Authority and classified aircraft, further strengthening the company’s position as a partner of choice with the U.S. Air Force.

Among other noticeable contracts, U.S. Navy awarded L3Harris $100 million in awards for sensors and shipboard systems on the U.S. Navy’s Virginia and Columbia-class submarines.  Additionally, Airbus selected the company to build a space antenna. L3 Harris also won what it called a “multi-million-dollar contract” to build sonar systems for a NATO member whose name the company did not divulge.

L3Harris Technologies reported second quarter 2021 revenue of $4.7 billion, up 5.0% versus prior year. Net income was $413 million, up 49% versus prior year. EPS was $3.26, up 15% versus prior year.

In the second quarter of fiscal 2021, L3Harris generated $685 million in adjusted free cash flow and returned $1,057 million to shareholders through $850 million in share repurchases and $207 million in dividends.

L3Harris also completed the divestitures of the Military Training and Combat Propulsion Systems businesses, with total gross proceeds in the quarter of $1.45 billion.

In the long term, the company is forecasting $3 billion in free cash flow by 2022. Even with all the ambitious divestitures and buyback plans, L3Harris is going to have billions at its disposal in the next few years, which is excellent news for investors, given the fact that L3 Harris seems to be really keen on giving individual investors a larger stake in the company.

How Budgetary Constraints Impact L3Harris

Some argue that a downbeat U.S. defense spending is likely to impact the balance sheet and stock price of defense contractors such as L3Harris. On the face of it, the argument does not sound too outlandish as reliance on a single, dominant source of contracts – the US government—for your revenues ought to impact the bottom line. 

The U.S. government is responsible for 78% of L3Harris’ revenue, but don’t forget that L3Harris offers products centered around the command, control, communications, computers, intelligence, surveillance, and reconnaissance market, and considering that these are a top priority in the DoD’s modernization plan, L3Harris is unlikely to see any slide in obtaining new contracts, even if the overall defense spending is diminished.

Also, many experts believe that the fear of a cut in military spending is a bit exaggerated as defense spending held steady even during the Great Financial Crisis when the U.S. government was forced to borrow hundreds of billions of dollars.

As a harbinger of things to come, President Biden proposed a defense budget $38 billion higher than what the DoD requested. This excessive allocation for the military in the face of a forecast $3 trillion spending deficit in fiscal 2021 is indicative of how defense budgets remain immune from the state of the economy. 

LHX Stock Bull Case: The Bottom Line

The merger of L3 and Harris has allowed L3Harris to better compete against the more well-known defense titans. The same is reflected in the host of new contracts it has been receiving and its solid financial performance.

More importantly, L3Harris is a veritable cash machine, generating billions of dollars in free cash flow annually.

The defense contractor is projected to generate $3 billion in 2021. This is exceptional news from the investors’ point of view as the company has used the excessive cash at its disposal to reward shareholders, having generally refrained from other traditional uses of free cash flow, such as acquisitions and debt reduction.

All in all, L3Harris is an exceptionally well-positioned company with strong financial performance, stellar cash flow, a generous capital return program, and an attractive valuation.

Risks such as a slump in Pentagon’s spending does little to detract from the appeal of this investment because its space, electronics, and intelligence offerings are unlikely to be the target of cuts. 

The Bear Case for L3Harris Technologies

L3Harris, without an iota of doubt, is a really well-positioned company with sound operating fundamentals, but it is important to remember that every investment comes with risk, and L3Harris is no exception. It is, therefore, important for investors to keep a tab on LHX’s risk profile to ensure that the investment thesis remains intact.

As noted, L3Harris isn’t a major platform company, which means it is not in the business of building glamorous or newsworthy defense products such as fighter jets, tanks, missiles or warships considered vital to the nation’s defense.

For example, some of L3’s key products, items like night vision equipment and upgraded communications systems, are more discretionary than a new aircraft carrier and, as such, run the risk of being jettisoned in the face of budgetary pressures. 

There’s also some risk of possible budgetary curtailment impacting L3Harris’ short-term growth plans, but The Pentagon, keen on maintaining its military supremacy amidst drastically changing weapons technology, is certain to need the products and services of the company for communications upgrading. On top of that, L3Harris is also expanding its global footprint with a growing international customer list. 

Another significant risk for LHX is its reliance on a single client for the overwhelming bulk of its business. The company derived roughly 77% (or $14.2bn) of its total 2020 revenue from the U.S. government, which means the company needs to maintain a strong working relationship with the government and ensure that it fulfills its contracts with its largest client in a timely and cost competitive manner.

Also, L3Harris could face major headwinds in case there is a shift in the U.S. Government’s spending priorities, or for some reason or the other, the U.S. Government decides to terminate its relationship with the company. Such risks, however, are true of almost all defense companies.

L3Harris also needs to dedicate significant resources to prevent any type or form of security breach of its IT systems. The company deals with a lot of sensitive data and classified information and, as such, any cyber intrusion, apart from impacting the company’s operations, would also lead to an irreparable damage to its reputation.

L3Harris Technologies Stock Price Forecast

Twelve-month price forecast for L3Harris Technologies range from a high estimate of $292.00 to a low estimate of $238.00.

Overall, the average price target is $255.00, which represents around 13.5% change from the stock’s latest price.

Is L3Harris Technologies Stock a Buy?

L3Harris Technologies appears uniquely well-positioned to continue to grow, even if at some point of time there happens to be budgetary pressure from the Pentagon.

L3 Technologies + Harris Corp = Successful Merger

L3Harris came into existence through the merger of Harris Corp. and L3 Technologies in 2019. It was a really smart move as it gave the two mid-tier defense contractors the combined resources to explore new opportunities and expand globally.

One prime example of it is a Space Development Agency deal that combined Harris’ space payload expertise with L3’s onboard space electronics.

L3Harris’ forte lies in defense electronics and communications systems. Now that may not get as much headlines as building missiles or fighter jets, but in an increasingly digital world, where weapons technology has changed substantially over the past two decade, the technology provided by the company is crucial for the military.

About 20% of the company’s total revenue is on classified projects, many in space.

L3Harris Earnings Report

L3Harris delivered solid results for the quarter, building on what has been a strong year for the company. The business reported $3.26 EPS for the quarter against the consensus estimate of $3.18. This compares to earnings of $2.83 per share a year ago.

L3Harris posted revenues of $4.67 billion for the quarter ended June 2021. This compares to year-ago revenues of $4.45 billion. The business’ revenue for the quarter was up 5.0% compared to the same quarter last year.

L3Harris shares are up about 19.5% since the beginning of the year. And, as far as earning forecast is concerned, the current consensus EPS estimate is $3.22 on $4.66 billion in revenues for the coming quarter and $12.99 on $18.69 billion in revenues for the current fiscal year.    

The company said it expects “mid-single-digit” revenue growth in both, 2021 and 2022, which attests to its growing strength. In comparison, two of the largest defense contractors, Lockheed Martin (LMT) and Northrop Grumman (NOC), expect revenue augmentation of just 3% and 4%, respectively, in 2021.

Also, analysts forecast that L3Harris will grow its earnings by 13.6% annually over the next 5 years, just a notch above the 13.0% annual earnings growth it has been registering over the previous 5 years.

As such, an annual dividend growth rate of 8.5% over the long term can be reasonably expected by LHX investors.

Backlog increased 7% organically year-over-year to over $20 billion, with notable award activity across all domains.

Free cash flow was $685 million, and management expects to return 100% of free cash flow to shareholders, including divestiture proceeds.

Shareholder returns of over $1 billion were comprised of $850 million in share repurchases and $207 million in dividends.

The company now expects buybacks to be roughly $3.4 billion this year, against its previous guidance of $2.3 billion.

When combined with dividends, capital returns will be about $4.2 billion in 2021. Analysts expect LHX to generate $3 billion in annual free cash flow by 2022, thus allowing it plenty of room to keep repurchasing shares.

L3Harris Valuation

Despite an expensive valuation, L3Harris presents a strong case for investment with sales growth that should exceed that of most in the industry. 

LHX delivered strong performance in the quarter with solid revenue and book-to-bill growth, as it continues to execute on its strategic priorities and offer fresh and creative solutions.

The company expects its business to accelerate in the second half, driven by space, tactical communications, integrated vision solutions and classified growth as it begins to better tap international markets.

That, along with a potential dividend boost, makes it an investment of choice for someone looking to invest in defense hardware business.

L3Harris Technologies Investment Thesis Conclusion

L3Harris is well-positioned to generate long-term shareholder value. Global military expenditure has never stopped rising since 2001.

In 2020, total spending was close to $2 trillion, almost double the 2001 spend. The Pentagon, by far LHX’s single largest customer, is engaged in counter-terrorism operations in more than 80 countries, which means new contracts and orders will keep rolling in for the company.

Also, the U.S. withdrawal from Afghanistan is most likely to have wide-ranging implications for the defense sector. Stocks of companies like L3Harris should be a direct beneficiary of the declining stability of the region, as it is likely to spur demand for intelligence, surveillance, and reconnaissance missions.

For example, the company has ground-team support solutions like radio communication equipment, satellite systems, and electronic warfare solutions to support more or less all major military jets and support planes. L3Harris also produces reconnaissance solutions, avionics, and so much more.

The company expects its U.S. government businesses to accelerate in the back half, driven by space, tactical communications, integrated vision solutions and classified growth within Intel & Cyber and Defense Aviation.

LHX’s organic growth came in very strong, which allowed the company to upgrade its full-year guidance and continue massive shareholder value distributions through dividends and high buybacks.

Total revenue came in at $4.7 billion, up 5.0% versus prior year with solid growth across key end-markets as well as growth in all four segments. At the segment level, organic revenue was driven by Integrated Mission Systems and Aviation Systems, up 12% and 4.7%, respectively, and 3.2% growth in both, Communication Systems and Space and Airborne Systems. Funded book-to-bill was 1.00 for the quarter and 1.05 for the first half.

A rising EBIT margin is also a tailwind to the financial picture, having risen 200 basis points since the merger, and management is forecasting continued growth in the medium term to around 18.5%. On top of that, L3Harris generates billions of dollars in free cash flow annually. In 2020, free cash flow sat at $2.7billion, and is projected to rise to $3billion in 2021.

If we look at last year’s earnings growth, the company posted a solid increase of 20%. Also, it has grown its EPS by 22% in total over the last three years.

Moving forward, analysts expect the company to generate growth of 28% per annum over the next three years, while the overall market is forecast to only expand by 12% each year. This perhaps could be the reason L3Harris Technologies is trading at such a high P/E compared to the market.

Is L3Technologies Stock A Buy? Conclusion

L3Harris is a cash machine and the management has been handsomely rewarding the shareholders by returning excess cash.

The company has also been also using excess free cash flow for paying dividend which has grown at a CAGR of 18.5% in the past three years. L3Harris pays an annual dividend of $4.08 per share and currently has a dividend yield of 1.80%.

Importantly, the yield is well funded with a payout ratio of only 35.17%. Based on earnings estimates, L3Harris is expected to have a dividend payout ratio of 28.47% next year, which indicates the possibility of LHX increasing its dividend.

L3Harris isn’t a cheap stock, but it has the fundamentals to justify its premium valuation.  The company, with terrific financials, good dividend yield, low debt levels, rising margins, a large backlog, and billions of dollars in free cash flow is an excellent stock for investors to put their money on a long-term basis.

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