The aerospace and defense sector has been one of my favorite investment areas for some time, even though the Covid-19 pandemic has been a significant headwind to the commercial aerospace business. I continue to find the defense business attractive as it has several tailwinds that should be supportive of future growth, such as increases in defense spending and long dated contracts.
I have been particularly bullish on L3Harris Technologies Inc. (LHX, Financial) as the stock has traded below its intrinsic value at a time where most of the larger names in the sector now trade at or above their respective intrinsic values. L3Harris Technologies also has an impressive backlog and was awarded large contracts for future work in nearly every business during the most recent quarter.
Shares of the company are higher by almost 19% since I last discussed the stock, but I feel that it not too late to buy L3Harris Technologies as shares still offer tremendous upside.
Recent earnings highlights
L3Harris Technologies reported first-quarter earnings results on April 30. Revenue of $4.57 billion was 1.3% lower than the previous year, but $22 million above what Wall Street analysts had anticipated. Adjusted earnings per share of $3.18 was a 38-cent, or 13.6%, increase from the previous year and 24 cents ahead of estimates.
Adjusting for divested businesses, organic revenue improved 1.8%. A lower share count did add 16 cents to earnings per share, but gains in operational volumes and productivity and synergies made up the bulk of the gain.
Integrated Mission Systems posted organic growth of 5.9% year over year and 6% sequentially to $1.45 billion. An increase in manned platforms for the Maritime business was the driving force for growth, but Electro Optical also contributed to results. The operating margin expanded 180 basis points to 16.5% due to improvements in operations and cost management as well as integration benefits of L3 Technologies and Harris Corp.
Award activity remains robust for Integrated Mission Systems. This segment received $380 million in orders from the U.S. Air Force for advanced capabilities for a host of platforms. International orders totaled $450 million, including a new contract with a NATO customer to update a Gulfstream G550 aircraft. Maritime received a $827 million contract for engineering services from the U.S. Navy to modernize hull, mechanical and electrical systems for a variety of programs. Electro Optical received $127 million to provide avionics for rockets used in space launches. L3Harris Technologies also received smaller awards from international customers to provide imaging systems for submarines. As a result of this activity, the book-to-bill ratio for this segment was a strong 1.32.
Space and Airborne Systems remains steady as organic sales improved 4.1% to $1.24 billion. Strength in missile defense, space and F-35 programs led the way as volumes for each of these was higher year over year. Classified programs also remain in high demand. On the other hand, Electronic Warfare was weaker, though this was mostly due to program timing. The operating margin improved 90 basis points to 19.4%.
Book-to-bill was 1.15 for this segment as each business saw sizeable awards during the quarter. Space received $122 million to develop a satellite for the U.S. for use in the hypersonic and ballistic tracking space program as well as $100 million to update space domain awareness infrastructure. Elsewhere, L3Harris Technologies received $350 million in orders for the F-35, F/A-18 and F-16 programs. The company noted this contract has the potential to reach $1 billion in additional orders.
Revenue for the Communications segment was 2.9% higher at $1.11 billion. Tactical Communications benefited from the ramp up in modernization for the U.S. Department of Defense. Other communication business also performed well, though public safety remains challenged due to Covid-19-related impacts. Lower volumes on legacy unmanned programs also offset growth. The operating margin was up 240 basis points to 25.3%.
Tactical Communications received a smattering of orders, including $72 million for production of next-generation, multi-channel communication devices. Integrated Vision Solutions was awarded $65 million for advanced night vision and aiming devices for a Middle Eastern customer. Broadband Communication received $57 million for transceivers from the U.S. Army. The book-to-bill ratio was 0.92 as new orders weren't enough to overcome completed work.
Aviation Systems' revenue was down 8.3% to $814 million as Covid-19 pressured results in the commercial aviation business as expected. This decrease was close to what the company had guided toward previously. Mission Networks benefited from higher FAA volumes, while defense continues to be a tailwind to results. The operating margin was up 120 basis points to 15.7%. Despite a $125 million in orders for air traffic management contracts and a $25 million award for ordnance systems, this segment's book-to-bill ratio was 0.84 as demand in commercial aviation remains weak.
Overall, L3Harris Technologies had a book-to-bill ratio of 1.10 for the quarter. The company's backlog grew 6.4% to more than $21 billion, proving the company more than a year of work based on last year's revenue total.
L3Harris Technologies' balance sheet remains in good condition. The company ended the quarter with total assets of $36.6 billion, current assets of $7.5 billion and cash equivalents of $976 million. Total liabilities came to $16.1 billion, including current liabilities of $4.2 billion. Although the total debt that the company carries has nearly doubled to $7.8 billion over the past few years, just $14 million of obligations mature within the next 12 months.
Adjusted free cash flow improved 18% to $630 million. L3Harris Technologies also repurchased $700 million worth of stock. The company had previously announced its intention to repurchase $6 billion worth of stock, with slightly more than $2 billion earmarked for buybacks in 2021.
L3Harris Technologies updated guidance for 2021 as well. The company still expects revenue of $18.5 billion to $18.9 billion for the year, but now projects adjusted earnings per share of $12.70 to $13 compared to guidance of $12.60 to $13 previously. At the midpoint, this would represent a nearly 11% increase from 2020. For comparison purposes, L3Harris Technologies has an earnings per share compound annual growth rate of 9.7% for the 2011 to 2020 time period.
Valuation analysis
Using the current share price of $217 and the midpoint for earnings per share guidance, L3Harris Technologies trades with a price-earnings ratio of 16.9. This is a higher multiple than the last time I looked at the company, but the stock has enjoyed a rally since. Still, this multiple isn't too far off what peers are trading at.
Even after the gain in share price, L3Harris Technologies trades meaningfully below its intrinsic value as calculated by GuruFocus.
L3Harris Technologies has a GF Value of $248.98, resulting in a price-to-GF Value of 0.87. This earns the stock a rating of modestly undervalued. Reaching the GF Value would result in a 14.7% return from current levels, not including the 1.9% dividend that the stock offers today.
Final thoughts
L3Harris Technologies turned in another solid quarter that beat on both the top and bottom lines. The merger of L3 Technologies and Harris Corp. continues to pay off, with synergies providing lift to margins. The company also sports a massive backlog and saw a very good book-to-bill ratio in its largest segments. Covid-19 remains an issue, particularly in commercial aerospace, but the defense businesses remain in growth mode. L3Harris Technologies, with its massive repurchase authorization and 20% dividend increase earlier this year, is a very shareholder-friendly company.
Even after a double-digit gain since early February, L3Harris Technologies still has plenty of upside as it still trades below its intrinsic value. As such, I remain enthused regarding the company and stock's potential growth. I continue to view L3Harris Technologies as offering the best value in the aerospace and defense sector.
Disclosure: The author has no position in any stock mentioned in this article.
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