Back in May, I felt that shares of defense contractor L3 Harris Technologies, Inc. (LHX, Financial) offered investors the chance for at least low double-digit returns based on the stock’s valuation.
Shares are mostly unchanged since the last time I looked at the company, but I still believe that the name could provide solid returns going forward. In fact, I'm even more bullish on the stock after recent news. I think the market is steeply undervaluing this company due to temporary headwinds.
Earnings highlights
L3Harris reported third-quarter earnings results on Oct. 29. Revenue fell 5% year-over-year to $4.2 billion and missed Wall Street analysts’ estimates by $293 million. Adjusted earnings per share of $3.21 was a 37 cent, or 13%, increase from the prior year and was 3 cents ahead of expectations.
Much of the year-over-year decline in revenue can be attributed to divestitures. Also supply chain issues impacted results, L3 Harris saw an organic revenue decrease of just 1%, driven by the shortage of electronic components that is impacting a high number of industries.
Revenue for Integrated Mission Systems fell 3% to $1.34 billion The Maritime business is seeing a ramp up in certain platforms, but this was offset by the timing of an aircraft award and deliveries. Book-to-bill was 1.04 for the quarter.
Space and Airborne Systems improved 3% to $1.28 billion due to demand in missile defense and other response programs. Avionics work for the F-35 was lower than the prior year and the timing of programs in other businesses offset these gains. Book-to-bill was 0.98.
Communications was lower by 6% to $1.03 billion. This segment was the most impacted by supply chain constraints, which were mostly seen in the Tactical Communications business. Lower volume and contract roll-offs elsewhere also added to the year-over-year declines. Radio demand in Public Safety, however, was robust.
Aviation fell 21% to $625 million, but nearly all of this was due to L3Harris’ divestiture of its Military Training and Combat Propulsions systems in early July of this year. Organic growth was up 1% due to training and avionics sales in the commercial aerospace business. Book-to-bill was 1.10 for the quarter, a strong recovery from the first half of 2021.
Leadership provided updated guidance for the rest of the year. Sales are now foreseen to come close to $17.9 billion, down from prior guidance of $18.1 billion to $18.5 billion, with organic growth of ~2%, down from 3.0% to 5%. Adjusted earnings per share is now expected in a range of $12.85 to $13.00 compared to $12.80 to $13.00 previously.
Takeaways
L3Harris had a mixed quarter as earnings per share was above what was anticipated while revenue came in a bit weak. The good news is that the weakness seems to be more of an issue related to program timing and, more significantly, because of supply chain disruptions, especially in the Communication segment. Neither of these is a company specific issue, with supply chain constraints acting as a broader overhang on the aerospace and defense sector as well as other industries. On the other hand, commercial aerospace experienced a recovery and sales were up double-digits in the Aviation Systems segment.
Despite these pressures, organic growth was down marginally while earnings per share were up by a double-digit percentage. The net income margin expanded 170 basis points to 11.3%, as all segments showed gains during the quarter.
The U.S. government also continues to swoop in and save the day for defense contractors with an ever-expanding defense budget. The House of Representative passed a $778 billion defense policy bill last week that was $24 billion more than what the White House had initially requested and 5% above last fiscal year’s funding.
Defense spending may not have gone up as much as it did during some years in the past, but it is still robust. This should positively impact most of the names in the defense sector, including L3Harris.
It is not shocking then to see that L3Harris continues to see high demand for its products. The company received orders of $4.5 billion during the quarter, leading to a funded book-to-bill ratio of 1.07.
Some examples of key awards include a $400 million order for Integrated Mission Systems for advanced capabilities in several areas, such as reconnaissance, from the U.S. Air Force. This segment also received a $400 million contract for an underwater training program. The Space and Airborne segment received a nearly $1 billion, 10-year contract from the U.S. Air Force for engineering services and an upgraded countermeasure warfare systems for the B-52. More recently, L3Harris was a part of a group of defense contractors that received a modification award of $2.4 billion for the F-35 program.
L3Harris’ backlog remains solid and growing as the company took in more in new orders than it received in revenue during the third quarter.
Valuation analysis
Using the current share price of ~$218 and the midpoint of leadership’s guidance, shares of L3 Harris are trading at 16.7 times expected earnings for the year. This valuation is in line with most peers.
Shares do seem to have upside potential when looking at the GuruFocus Value chart:
With a GF Value of $236.71, L3 Harris has a price-to-GF-Value ratio of 0.92. Reaching the GF Value would reward investors with an 8.6% return. Add in the dividend yield of 1.9% and the stock could provide more than 10% in total returns for investors.
Final thoughts
L3Harris’ most recent quarter showed the company isn’t without challenges, with supply chain issues being the most impactful. The plus side is that most businesses saw revenue growth, the book-to-bill ratio was strong and the operating margin expanded. The company did lower its revenue and organic growth expectations for the year, but raised the low end of its adjusted earnings per share guidance.
At the same time, the stock is trading below its intrinsic value according to GuruFocus. L3Harris also offers a market beating dividend yield that, when combined with potential share price appreciation, could result in a double-digit total return. L3Harris could be a name to watch for those investors looking for a solid return from the aerospace and defense sector.
