Thesis
L3Harris Technologies (NYSE:LHX) operates in the aerospace and defense technology industry across air, land, sea, space, and cyber domains. LHX 1Q23 results were largely in line with a modest beat on EPS, but the key thing to note is the valuation gap vs other industry peers, which has widened to near 2 multiple turns difference. While the difference could be attributed to the pending acquisition of Aerojet, I think the upcoming easing of supply chain, and strong demand as seen from bookings and backlog metrics should support the growth recovery narrative. I am recommending a buy rating as the valuation situation seems attractive today.
1Q23 results
LHX’s organic growth in revenue was 7% in 1Q23, which was 5% higher than the consensus estimate. Management blamed supply chain constraints and lower margin deliveries for the 170 basis point drop in segment EBIT margin to 14.3% during the quarter. For 1Q23, adjusted EPS was $2.86, which was slightly higher than the consensus estimate of $2.85, and FCF was $314 million. Management are sticking to their original forecast for FY23 and aim to close the deal on Aerojet by FY23.
Growth recovery
FY21 and FY22 had been tough years where LHX saw revenue decline due to the supply chain situation. A quarterly record of $5.8 billion in orders has pushed the book to bill ratio up to 1.31x, leading me to believe that things are beginning to turn around. The total backlog increased by 16% to $24.5 billion as a result of this momentum. Although the supply chain situation will have repercussions into FY23, I believe that things will eventually return to normal. Some progress is being made, which is promising. For example, the critical parts shortage is easing. Positively, management has stated that they anticipate further incremental improvements in supplier performance. In terms of growth outlook, I hold a positive view given the increasing attention to allocating more defense budget, in the wake of Russia/Ukraine war. The US Depart of Defense [DoD] has also increase their 2024 budget by over $26 billion over 2023 and $100 billion over 2022. I believe these budgets increase will have a direct flow through impact to LHX financials.
Margin concern
Segment margins have fallen sequentially by 170 basis points to 14.3%, which is below the full-year guidance of 15.2% to 15.7%. On one hand, management confidence in reiterating their guidance is good to know. On the other hand, it suggests margins need to accelerate for the rest of the year in order to hit guidance. It’s not out of the question, especially if one factor in the benefits of streamlined operations and tighter cost management, as well as the higher margin products that LHX will be able to ship as the supply chain relaxes. Internally, LHX has reported that it has successfully completed phase one of its integration of L3 and Harris, with savings of over $650 million over the course of three years, exceeding the original goal of $500 million. In the previous quarter, LHX launched phase two of an enterprise transformation program that aims to speed up business improvements by consolidating them under a single program office. My main concern is that it may be difficult to predict when the supply chain will begin to relax (FY23 or FY24). The supply chain problem will be resolved eventually, but if the main bulk of effect is only felt in FY24, LHX may not be able to meet guidance, which would be bad for the stock. What is giving my comfort is knowing that management has taken steps to ensure they can quickly get past this supply chain issue. The fact that they have redesigned over a thousand alternative parts and signed a strategic agreement with a major microelectronic chip-proving company that assures availability and raises them above the allocation process are very encouraging. In any case, I am placing my bet that management has further insights into the situation and should be able to meet guidance.
Aerojet acquisition
LHX signed a definitive agreement to acquire Aerojet Rocketdyne. From a strategic standpoint, this seems good as it provides LHX access to new markets. I believe the market concern regarding this deal is that it will push LHX leverage ratio much higher. In addition, I also think that the additional scrutiny from regulators extending the merger review process is not helpful from a stock perspective as investors might take a risk-off approach (sell the stock first and review later) given the heightened uncertainty.
Valuation
Historically, aside from the covid period, LHX use to trade in line with peer group with minimal difference. Today, LHX trades at 12.7x forward EBITDA which is lower than the peer group (Kratos (KTOS), Woodward (WWD), Raytheon (RTX), Lockheed (LMT), etc.) average of around 14.5x. I believe this ~2x difference is largely due to the leverage issue and pending acquisition, which means they are non-structural issues that should be resolved eventually when the deal closes and LHX work to reduce its debt level through earnings growth (supply chain easing, operational improvement, top-line growth from more defense budget, etc.).
Conclusion
1Q23 results were largely in line with a modest beat on EPS, with management reiterating their FY23 guidance and the pending Aerojet acquisition. The widening valuation gap compared to industry peers presents a buying opportunity, with the upcoming easing of supply chain constraints and strong demand from bookings and backlog metrics supporting a growth recovery narrative. Despite a margin concern, LHX has taken steps to mitigate the supply chain issue and streamline operations, providing confidence in management’s ability to meet guidance. While the Aerojet acquisition may increase leverage, it provides access to new markets, and the non-structural issues should be resolved through earnings growth. Overall, I recommend a buy rating as the valuation situation seems attractive today.
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