In August of this year, I wrote my first article discussing the long-term potential of L3Harris (LHX). Roughly 3 months later, I believe it’s time to cover the company again as more data has been released and more investors have gotten interested in the company. Needless to say, I’m still extremely bullish as L3Harris is doing very well in these challenging times. The company is not only a well-established provider of aerospace and defense products and services but uses its capabilities to generate cash and increase shareholder returns. Year-to-date the stock has been sluggish, but I have little doubt that investors will reap the rewards for many, many years to come. In this article, I will tell you why.
Note that the first part (company description) of this article was also used in my August article. As this part does not add additional value and is still up-to-date, I decided to use it again.
What’s L3Harris? (It’s A Tech Company)
Before I discuss the merger, let me say that right now, L3Harris is officially characterized as an industrial company focused on aerospace and defense. However, and this is why it’s such an interesting company, roughly 40% of its employees are scientists, engineers, or programmers. The CEO, Bill Brown, mentioned this in a June interview with CNBC’s Mad Money. In the same interview, he mentioned that commercial sales are only 5% of total sales. In other words, one is not buying into a predictable industry (based on economic expectations), but into a company that will survive and thrive by being a leader in its field – winning Government contracts, thanks to their superior technology.
With this in mind, let’s take a look at why the company is called L3Harris and what kind of products and services it sells.
Let’s start by mentioning that the Harris Automatic Press Company was founded in 1895 in Ohio. The company, which spent 60 years developing printing presses (among other products) merged with Radiation in 1967, a developer of antennas, integrated circuits, and modern technology used in the space race. This caused an HQ shift to Melbourne, FL in 1978. In 2015, Harris purchased Exelis Inc., which almost doubled the company.
L-3 Communications was founded in 1997 to acquire business units from Lockheed Martin (NYSE:LMT) that had previously been owned by the Loral Corporation. L-3 Communications, founded by Frank Lanza, Robert LaPenta in a partnership with Lehman Brothers changed its name to L3 Technologies in 2016 to better reflect the company’s wider focus since its founding in 1997.
Prior to the merger, and based on expected 2018 data, the companies were very similar. For example, while L3 Technologies generated $10.1 billion in revenue, which is significantly more than Harris’ $6.3 billion in sales, both companies generated close to $1.1 billion in EBITDA. Logically, based on the sales data, the Harris EBIT margin was higher. That said, they both generated roughly $1.0 billion in free cash flow, maintained a dividend payout of 28% (L3), and 33% (Harris) of free cash flow, and had 2.0x and 2.5x net leverage.
As a result, the merger was an all-stock ‘merger of equals’ with a combined equity value of $34 billion and an enterprise value of $41 billion. The company, now called L3 Harris Technologies moved its headquarters to Melbourne, Florida. Former L3 shareholders received 1.30 Harris shares in the new company. Harris shareholders own 54%, while L3 Shareholders own 46% of the company.
This merger made L3 Harris the 6th largest defense player in the United States with a customer base consisting of the US Air Force, the US Navy, the US Army, as well as other Department of Defense customers and international governments.
The company’s products include integrated mission systems, space and airborne systems, communication systems, and aviation systems. Looking at L3Harris as a whole, the company produces products for unmanned aircraft, solutions for electronic warfare, power distribution for Maritime end-users, sensors, radars, tactical communication systems, and space and cyber solutions. Looking at this list, it makes a lot of sense that roughly 40% of the company’s workforce caters to high-tech jobs.
The Shareholder Wins
One of the things that I consider to be very important when picking long-term investments is buying a company that is a leader in its business and has the capabilities to turn this success into shareholder distributions through either buybacks or dividends or preferably both. Railroad stocks are a great example. These companies have a very efficient way of doing business and turn revenue into free cash flow thanks to low costs. While economic cycles always cause mid-term stock price declines, these companies are always a way to ‘get money from the economy’ into one’s pocket. And that’s what this is all about as investors want to grow their own net worth and turn hard-earned cash into income-generating investments.
You probably know where this is going, but L3Harris does all of these things.
The only problem I have is that the company is very young (2019 merger). However, if 2020 year-to-date is any indication of the firm’s success, we are in for a long period of capital gains and dividend income.
I don’t have to tell anyone that 2020 has been a challenging year so far. We were hit by the quickest market sell-off in modern history, an unprecedented economic decline, and a fierce election cycle. Despite all of these challenges, the company hit it out of the park. Year-to-date, L3Harris grew its sales organically by 4.1% to $13.5 billion. Again, note that this is organic growth, which is adjusted for acquisitions and divestitures. EBIT margins rose from 16.6% to 17.9%, which made it possible to grow EPS by 14% to $8.47.
Before we dive into cash flow and debt, let me give you a quick overview of the company’s business segments.
The largest segment, Integrated Mission Systems, reported 4.6% organic sales growth to $4.1 billion year-to-date. The company saw strong growth in Maritime from a ramp on manned and classified platforms, which more than offset a modest decline in Electro-Optical due to program timing. The operating income margin in this segment rose from 12.9% to 15.7% as the company achieved operational excellence and integration benefits, which more than offset higher investments.
Space & Airborne Systems saw 6.1% organic sales growth to $3.7 billion as F-35 growth in Mission Avionics and classified growth in Intel & Cyber more than offset program timing in Space and Electronic Warfare. Unfortunately, the operating margin dropped by 20 basis points to 18.6% as the program mix more than offset integration benefits.
Communication Systems reported 4.7% organic growth to $3.3 billion as lower demand in Public Safety was unable to offset gains in Tactical Communications and Integrated Vision Systems. The demand came from the Middle East, Europe, and APAC countries. The operating margin rose from 22.1% to 23.9% as integration benefits and cost management showed promising results.
Last but not least, Aviation Systems reported flat organic growth as growth in Defense Aviation Products and Mission Networks offset weakness in commercial aviation. Nonetheless, the operating margin rose from 12.1% to 13.4% as integration benefits benefited this segment too.
With that said, these numbers tell us a few things. First of all, the company is doing extremely well in challenging times as its products are almost entirely independent from commercial aviation. However, this also means that analysts will have a harder time building model as defense intelligence is a key point when trying to understand how the company’s orders will be impacted in the mid-term. Outsiders will have to ‘trust’ the company. However, that’s why I went with L3Harris there is almost no way the company will not benefit from rising defense spending given its size and significance in the (global) defense industry. I would not say the same if this company were a small-cap player.
Now, let’s look at shareholder value – because that’s what this is all about. As you can see in the table below, the company generated $2.1 billion in operating cash flow in the first three quarters of this year. CapEx, as defined by net PP&E additions came in at $194 million. This is slightly above the prior-year value of $178 million. This means that free cash flow came in at $1.9 billion. The company used this cash to buy back stocks worth $1.9 billion and pay dividends worth $546 million. Both buybacks and dividends are up significantly as the company boosted dividends per share by roughly 13% this year.
With this in mind, let’s move over to the next table, which shows the company’s balance sheet. I’m only using this table to provide some backup, so don’t worry if you are not that familiar with balance sheets (the same goes for the cash flow statement). What the data below shows is that current assets cover 137% of current liabilities. This is mainly the case because the company has $1.3 billion in cash – enough to service all accounts payable if they wanted. Total liabilities are valued at just 42% of total assets. Additionally, the company’s LTM EBITDA is valued at just 1.06x net debt. This is based on $4.92 billion in net debt and LTB EBITDA of $4.66 billion.
You probably guessed it already, but the company’s $6.26 billion long-term debt is exposed to relatively low yields as the table below shows. The company’s largest bond ($1.9 billion expiring 2028) is yielding at ‘just’ 6.4%. Smaller bonds with a shorter maturity yield less than 4%.
This topic is tricky as there are countless ways to assess whether a stock is ‘cheap’ or ‘expensive’ – and even these definitions are hard to define. I believe the graph below paints a pretty clear picture. The dividend yield is 1.83%. This is one of the highest levels since the merger in 2019. While I prefer to buy dividend yields close to 3%, I make exceptions when companies are expected to accelerate dividends and buybacks on a long-term basis. In other words, you don’t have to give up strong (expected) capital gains to generate a high dividend yield in the future. The other ratio, EV/EBITDA, is at 15.9. This is down from 32.0x as the company’s stock price fell while fundamentals improved. Hence, I believe that the current valuation is fair.
Some reasons that explain why the stock is down are uncertainty in the entire aerospace/defense industry, suppliers at risk due to COVID-19, ETFs that drag down ‘everything’ during a sell-off, and investors that prefer FANG stocks in uncertain times (among others).
L3Harris offers everything I’m looking for in a dividend stock. The company is a leader in its business, does well during recessions (fundamentally), and is able to turn sales growth into high free cash flow and increasing shareholder distributions. While I cannot predict how the economy is going to develop over the next 5, 10, or 40 years, I have little doubt that this company will steadily increase its dividends and use excess cash to repurchase stocks.
The valuation is fair, and the fact that the stock has been sold-off in 2020 offers great buying opportunities. I have little doubt that the uptrend that started in 2012 will remain strong and lead us to new highs in 2021 or the first half of 2022 – depending on the economic trend.
Note that I did not once mention the presidential election in this article as there is no clear winner while I am writing this and because it doesn’t matter. I am sticking to all of my investments (all mentioned in my Seeking Alpha bio) regardless of who calls the White House his home. Simply because my investment horizon goes way beyond the next four years.
Thank you very much for reading. Please make sure to click the like button and subscribe if you don’t want to miss any updates. All long-term holdings are listed in my Seeking Alpha bio.
Disclosure: I am/we are long LHX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article serves the sole purpose of adding value to the research process. Always take care of your own risk management and asset allocation.