While many investors are familiar with the large aerospace and defense contractors like Boeing Co. (BA, Financial) or Lockheed Martin Corp. (LMT, Financial), there are other names in the space that offer tremendous value.
One name in the sector that looks to be trading a significant discount to its intrinsic value is L3Harris Technologies Inc (LHX, Financial). We will explore the company's business model, most recent earnings report and valuation to see why L3Harris Technologies is an excellent investment opportunity.
Company background and earnings highlights
L3Harris Technologies came into existence following the completion of a merger between L3 Technologies and Harris Corp. on June 29, 2019. The combined company is now the sixth-largest defense contractor. The company is comprised of four reportable business segments: Integrated Mission Systems, Communications Systems, Aviation Systems and Space and Airborne Systems. The company has a current market capitalization of just under $39 billion and produced annual revenues in excess of $18 billion in the most recent year.
The company reported fourth-quarter and full-year earnings results on Jan. 29. For the quarter, revenue fell 3.5% to $4.66 billion, which was $230 million below Wall Street analysts' estimates. Organic growth was flat compared to the prior year as 3.7% growth in most U.S. and international businesses was offset by Covid-19-related weakness in Commercial Aviation and Public Safety. Adjusted earnings per share of $3.14 was a 10% improvement from the prior year and 4 cents higher than expected.
For 2020, revenue grew 42% to $18.2 billion due to mergers. On a pro forma basis, full-year revenue was higher by 0.5% and organic growth improved 2.9%. As with quarterly results, U.S. and international sales were solid, producing 5.6% organic growth. Again, Commercial Aviation and Public Safety businesses were challenged due to Covid-19. Adjusted earnings per share grew 13% to $11.60. Revenue for the year was $200 million below the company's estimates, but 5 cents better than prior guidance.
Integrated Mission Systems, the largest segment within L3Harris Technologies, had a revenue decline of 0.1% to $1.5 billion. The Maritime business benefited from a ramp up in manned and classified platforms. This gain was offset by project timing in certain programs. This business received several awards during the quarter, including a $668 million award to the Intelligence, Surveillance and Reconnaissance program for sustainment services for the U.S. Air Force C-130 aircraft. The funded book-to-bill for this segment was 1.04 for the quarter. Operating margins expanded 100 basis points to 14.3% and 230 basis points to 15.3%, respectively, for the quarter and full year. Pro forma revenue grew 3.3% to $5.5 billion for the year.
Revenue for the Space and Airborne Systems grew 4.3% to $1.26 billion. Organic sales were higher by 4.8%. Higher volumes for the F-35 program and recent awards for the Space business more than offset weakness stemming from project timing in the Intel & Cyber business. The funded book-to-bill ratio was 0.81, down from 1.05 in the third quarter of the year. Quarterly margins improved 150 basis points to 19.5%, while full-year margins were up 20 basis points to 18.8%. Pro forma revenue increased 5.5% to $4.9 billion for 2020.
Communications Systems revenue improved 2.1% to $1.1 billion with organic growth higher by 3.4%. Tactical Communications saw strength in customer demand from the U.S. Department of Defense, the Middle East and Central Asia. This segment also experienced headwinds related to project timing, especially in the Integrated Vision Solutions business. Public Safety experienced weaker demand due to Covid-19. Funded book-to-bill was 0.95, which was a slight improvement from the third quarter of the year. Quarterly operating margins contracted 60 basis points to 24.4%, but full-year margins expanded 200 basis points to 24.4%. Revenue grew 3.9% for the year on a pro forma basis.
Aviation was the weakest segment within L3Harris Technologies. Revenue declined 22% to $845 million, primarily due to the company's divestiture of its airport security and automation business in May of last year. Organic sales fell 11% as Covid-19 continues to greatly impact the company's Commercial Aviation business. Defense Aviation experienced an increase in volumes for combat propulsion systems as well as classified programs. The funded book-to-bill ratio fell to 0.89 from 1.08 sequentially. The operating margin was -15.5% compared to 14.9% in the previous quarter. Margins for the year expanded 100 basis points to 13.8%, while pro forma revenue was down 12% to $3.5 billion.
L3Harris Technologies has proven to be a very shareholder-friendly company. The company generated $2.7 billion of adjusted free cash flow last year and distributed $725 million of dividends while repurchasing $2.3 billion worth of stock.
The company also announced a 20% increase in the company's quarterly dividend, giving the stock a current yield of 2.2% using the new annualized dividend of $4.08. Including pre-merger history, this most recent increase marks 20 consecutive years of dividend growth for L3Harris Technologies. The company also announced a new $6 billion share repurchase authorization, which represents more than 15% of the company's current market capitalization.
L3Harris Technologies' balance sheet looks to be in good shape. The company ended 2020 with $37 billion of total assets, including $6.1 billion of current assets and $1.3 billion of cash and equivalents against total liabilities of $16.1 billion and current liabilities of $3.1 billion. L3Harris Technologies does have $7.7 billion of total debt, but just $10,000 of debt is due within the next year. And with adjusted free cash flow coming in at nearly three times 2018 results (the last full year prior to the merger), L3Harris Technologies is likely to have little issue growing its dividend, repurchasing shares and managing debt obligations in the future.
The company also provided guidance for 2021. It expects revenue of $18.5 billion to $18.9 billion for the year, which would be a 2.7% increase from the prior year at the midpoint, but was lower than consensus estimates of $19.2 billion. Adjusted earnings per share is projected to fall in a range of $12.60 to $13, 10.3% growth at the midpoint and nearly in line with estimates. The difference in top and bottom-line growth stems from synergies occurring from the merger at a faster than expected pace.
Valuation
Based on a current share price of $183 and the midpoint of company guidance, L3Harris Technologies has a forward price-earnings ratio of 14.3. This is in line with many peers in the aerospace and defense sector. What separates L3Harris Technologies from its peers is the price the stock trades at in comparison to its intrinsic value, as estimated by GuruFocus.
GuruFocus estimates L3Harris Technologies' GF Value to be $260 today. Using the current share price, the stock has a price-to-GF Value ratio of 0.70, which earns L3Harris Technologies a rating of modestly undervalued. Shareholders would experience a gain of 42% if the stock were to trade with its GF Value not including the dividend.
Final thoughts
L3Harris Technologies is performing well post-merger, with the defense businesses seeing organic growth. Certain segments and business, such as Aviation Systems in general and Commercial Aviation in particular, continue to be hurt by the Covid-19 pandemic. That said, margins for almost every other business improved both for the fourth quarter and the full year. Even with the headwind from Covid-19, organic growth still grew nearly 3% in 2020.
The company is not shy about returning capital to shareholders, both by way of double-digit dividend increases and massive share repurchases.
Just as important, the stock appears to trade at a steep discount to its intrinsic value and offers potential upside that other names in the aerospace and defense market don't.
Reaching this level is doable based on the performance of the company's defense businesses and share repurchases. An eventual recovery from the Covid-19 pandemic would go a long way in solidifying the Aviation Systems business as well. Investors willing to bet that this headwind will eventually subside could be well rewarded by purchasing L3Harris Technologies at the current price.
Author disclosure: the author maintains a long position in Lockheed Martin.
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