In 1999, Harris spun off its Lanier office products division. It also sold its semiconductor division, which later became Intersil. Harris has strong market share positions in broadcast equipment, high-frequency and multi-band man-pack tactical radios, and ground-based military satellite communications terminals.
Some of its important products include transmission equipment for microwave, satellite, and wireless communication; digital network broadcasting and management systems network test and management equipment and software; mobile radio networks; and air traffic control systems.
Its four operating segments are classified as: Government Communications Systems (accounted for approximately 46.2% of third quarter of fiscal 2007 revenue), RF Communications (28.2%), Broadcast Communications (12.8%), and Haris Stratex Networks (12.8%).
The commercial units serve a diverse clientele, including radio and television broadcasters, utilities, construction companies, and oil producers. Geographically, approximately 80% of third quarter of fiscal 2007 sales were to U.S. customers with the remaining 20% coming from international sources.
Investment Thesis
Strong Market Position: Harris has a strong market position in the government communications sector, with a broad product line and an enviable win rate on government contracts (over 60% historically and over 80% in recent quarters). The two defense electronics divisions (Government Communications and RF Communications) have seen a noticeable pickup over the past couple years as overall defense spending has increased dramatically and a major effort to upgrade the military's communications infrastructure is underway.
Notable successes include the company's Falcon II & Falcon III radios, which are being widely used by U.S. Special Operations forces, the U.S. Army and various NATO and Partnership for Peace countries.
Solid RF Segment Growth: Because it is a supplier of nearly 250 separate defense contracts, none of which represents over 5% of sales, Harris is not overly dependent on a particular program. During the first half of 2007, Harris was awarded an order worth $180 million by the U.S. Army Communications & Electronics Command for Falcon II AN/PRC-150, Falcon II AN/PRC-117, and Falcon III AN/PRC-152 high frequency radios.
On May 3, Harris was awarded a contract with the potential value of $422 million to supply its Falcon high-frequency multi-band radio system to the U.S. defense department. Harris won a significant five-year $600 million contract from the U.S. Census Bureau for its Field Data Collection Automation Program. The company also remains hopeful of winning a major part of the large $1.2 billion extremely high-frequency, multi-band satellite terminal program contract for the U.S. Navy.
New Opportunity: The newly formed Harris Stratex Networks, in which Harris holds 56% share, is likely to increase its revenue growth moving forward. This company is a leading provider of wireless transmission network solutions globally. Telecom carriers are increasingly upgrading their networks with 3G technology.
In the broadcast segment, the acquisitions of Leitch Technologies, Optimal solutions, and Aastra Digital Video provide a significant augmentation of revenue sources, orders, and income. In the third quarter, strong demand was generated for the new high-definition broadcast products.
Furthermore, recent plans to acquire privately held Multimax Inc is expected to solidify Harris position in the Government-wide acquisition contract market. Multimax has long list of customers, including the U.S. Navy, Marine Corps, Air Force, Army, Department of Homeland Security, Department of State, Department of Veterans Affairs and the Federal Aviation Administration. Multimax has key positions on major contracts, such as the Navy Marine Corps Intranet [NMCI] program.
Promising Pipeline: Top-line growth for Harris commercial businesses is increasing as the demand for broadcast and defense solutions continue to outpace typical industry growth rates. The company has a strong pipeline in diversified business ares with an addressable market size of more than $6 billion. During the first three quarters of fiscal 2007, Harris significantly expanded its businesses in the international markets that include South Asia, Middle East, Eastern Europe, and Africa. The revenue is likely to increase further as Saudi Arabia, Pakistan, Iraq, and Mexico are likely to procure more than $1 billion of military products from the U.S. government.
Strong Finance: Our favorable opinion is further supported by Harris solid finances. The company's profit margins continue to improve, and because its business is not capital intensive, Harris has been generating excess cash which it can use to reduce debt, pay dividends, buy back shares or make acquisitions. Harris Corp. generated over $113.2 million of free cash flow (defined as cash flow from operations less capital expenditures) in the third quarter of fiscal 2007.
In addition, the company maintains an attractive dividend payout yield and continues to repurchase common equity shares. The Board of Directors of Harris has approved a new $600 million share repurchase program in order to increase share-holders wealth.
INDUSTRY OUTLOOK - Favorable
The 2007 outlook for the telecommunications industry has become more favorable. The fundamental downturn may have reached a bottom, as telecommunication companies reduced spending and improved operating performance over the past several quarters. In addition, telecommunications companies continue to be the largest group in terms of Mergers and Acquisitions.
Consolidation among the largest telecommunications services-focused companies has created an environment where equipment-focused companies now interact, on a relative basis, with less customers and reduced selling opportunities. This has incubated consolidation among equipment companies as well to enhance marketing value by broadening product offerings for converged wireless and wireline networks.
Nevertheless, the economic scale of consolidated telecom service companies is creating pricing pressure and margin erosion potential as equipment companies contend for contracts based on pricing and features. Long-term growth prospects for the sector are not nearly as favorable as in the early part of 2000, but are more attractive than in 2006, with continued consolidation expected. While telecom carriers plan to increase capital expenditures in 2007, they will be more selective on technology choices and identify cost savings synergies, such as streamlining purchasing arrangements and limiting the number of preferred vendors.
In addition, shareholders continue to foster an environment where executives are held accountable to focus more on balance sheet improvements, financial discipline and improving free cash flow. This promotes greater diligence in investment decisions for longterm growth initiatives. Unfortunately for the equipment vendors, the conservative nature of tightened capital outlay remains the method of choice for improving free cash flow.
In recognition of spending constraints by carriers, telecom equipment vendors have already prepared by slashing expenses also in response to the previous protracted industry downturn. Now that expenses are under control and productivity is at higher levels, profit margins, in general, are expected to respond rapidly even with a modest pickup in demand. Companies that offer the most opportunities are focused on third-generation (3G) wireless, broadband [DSL] and fiber-to-the-home/node networking. There are also a few market leaders that have proven able to survive the sometimes turbulent opportunity swings in the industry.
INDUSTRY POSITION
Many of Harris products have specialized and differentiated core offerings. As a result, the firm does not compete directly with many other companies in the telecom equipment group. In the Government Communications Systems segment, Harris acts as the prime contractor on certain government contracts.
In many instances it continues to remain a subcontractor to one of the large U.S. defense contractors including Boeing (BA), Lockheed Martin (LMT), General Dynamics (GD), and Northrop Grumman (NOC). In the RF Communications segment, Harris main competitors are Thales Communications, General Dynamics, ITT Aerospace and Communications, and Raytheon (RTN).
In Microwave Communications, Harris typically competes with Alcatel (ALA), Stratex Networks (STXN), Ericsson (ERIC), and NEC. Competitors for the Network Support business include Teradyne (TER), Fluke (a subsidiary of Danaher), TTI Telecom International, Spirent PLC, Tollgrade Communications (TLGD), and Textron (TXT).
RECENT NEWS
Third Quarter Fiscal 2007 Financial Highlights: On May 1, Harris Corp. announced third quarter fiscal 2007 earnings results. Total revenue in the third quarter was $1,072.4 million, up 22% year-over-year and up 5.5% over the previous quarter. This was primarily due to robust demand for the company's Government Communications and RF Communications products, partially offset by weaker than expected results of Broadcast Communications platforms and Harris Stratex Network offerings.
On a GAAP basis, net income in the reported quarter was $214.9 million or an income of $1.52 per diluted share, compared to a net income of $72.5 million or an income of $0.52 per diluted share in the prior year quarter. However, in the third quarter, the company incurred $49.6 million of restructuring charges and booked a one-time merger gain of $163.4 million related to Harris-Stratex Networks merger.
Non-GAAP adjusted income (excluding one time gains and charges) was $101.1 million or an income of $0.71 per diluted share. Segment wise, the Government Communications Systems accounted for $500.3 million of revenue in the third quarter, up 9.5% over the year-ago quarter. The RF Communications segment accounted for $304.4 million of revenue in the third quarter, up 42.1% over the same quarter last year. The Broadcast Communications segment generated $138.6 million of revenue in the reported quarter, down 3.1% over the prior year quarter. Harris Stratex Networks segment accounted for $139 million of revenue in the same quarter, up 88.6% year-over-year.
During the third quarter, Harris generated $141 million of cash from operation and free cash flow was $113.2 million. At the end of the third quarter of fiscal 2007, Harris had $522.6 million of cash & cash equivalent on its balance sheet and $730.3 million of debt outstanding. Management Outlook for Fiscal Year 2007 and 2008 Management provided guidance that non-GAAP diluted EPS for the full year 2007 is expected to be approximately $2.77. Diluted EPS, on a GAAP basis, is forecasted at approximately $3.39 for the same fiscal year.
For fiscal 2008, non-GAAP diluted EPS is expected to be within the range of $3.28 - $3.38.
Expansion of Share Buy-back Program: The Harris Board of Directors has approved a new $600 million share repurchase program. The company is expected to purchase $200 million of its own common outstanding share during the fourth quarter of fiscal 2007 and the remaining $400 million will be spent during the next couple of years. Share buy-back will be funded through the available cash with the company.
Proposed Acquisition: On May 31, Harris signed a definitive agreement to acquire privately held Multimax Inc, a leading provider of information technology and communications services to the U.S. government, for total consideration of $400 million in cash. For the past 20 years, Multimax has managed large-scale, mission- critical networks used by the U.S. government. This acquisition is expected to significantly increase the exposure of Harris in the Government-wide acquisition contracts markets as this business opportunity is aggressively pursued by Harris over the past couple of years. The deal is expected to close by the end of fiscal 2007 subject to the regulatory clearance and is likely to be accretive to Harris EPS by $0.08 in fiscal 2008.
VALUATION
Harris is currently trading at 18x our estimated earnings for fiscal year 2007, which represents a premium to the forward P/E for the S&P 500, but a significant discount to the telecom equipment peer group. On the basis of all other valuation metrics, the stock is trading mostly below the peer group average. Given the firm s strong market position in several niche communications equipment categories, its favorable near- to long-term outlook, and solid finances, we believe Harris deserves to trade at much higher multiple than its current valuation. Thus we maintain our $60 price target which is based on a P/E ratio of 21.6x to our fiscal year 2007 earning estimates, closer to the peer group average.
RISKS
Harris is dependent on U.S. government contracts for a major part of its revenue. Federal budgetary pressures may result in deeper than expected cuts in defense spending, which may significantly impact the company's business prospects. The company may not be able to expand its market outside U.S. as expected by the management. Additional risk may be related to large long-term fixed-priced contracts if costs escalate beyond contract pricing. A shift in the U.S. government policy in foreign relations may result in the termination of some international contracts. Market opportunities for the company's telecom products and services depend on several factors including competition, network coverage and requirements, and overall growth of economies within different geographical regions. There can be no assurance that the market for such offerings will continue to remain robust in each of there business areas.
INSIDER TRADING AND OWNERSHIP
According to SEC filings and information posted on NYSE, there were no inside buy transactions and 7 inside sell transactions for the last three months. For the last twelve months, there were 11 inside buy transactions and 40 inside sell transactions.
KEY POINTS
As a leading government electronics supplier, Harris is benefiting from the increase in U.S. defense expenditures as well as strong market conditions for microwave communications and broadcast Communications solutions. Harris continues it expansion in emerging markets of Asia and Africa. The newly formed Harris Stratex Networks, in which Harris holds 56% share, is likely to generate a considerable demand in as the developing countries are increasingly deploying 3G communications networks. During the third quarter of fiscal 2007, Harris received more than $150 million of contract from U.S. defense department. Increased demand for high-performance Falcon II and Falcon III radios throughout the world generated significant new opportunities for the company. Harris is developing a next generation Navy protected SATCOM terminals that offer multi-band communication capabilities in a single terminal. Recently, the company received a contract with a potential value of $422 million to supply high frequency Falcon multi-band radio system to the U.S. defense department. Harris successfully integrated the newly acquired Leitch Technology, Aastra Digital Video, and Optimal Solutions Inc into its conglomerate framework. All three acquisitions help the company to increase global operations and reach. Recent plan to acquire privately held Multimax Inc is expected to significantly increase the size of Harris technical services units with a broader customer base. The company has a strong back log of $4 billion and a promising pipeline of new offerings. Management's earnings guidance for fiscal 2008 is very encouraging. The Board of Directors of Harris has approved a new $600 million share repurchase program in order to increase shareholders wealth.
OUTLOOK
We maintain our Buy rating for Harris Corp (HRS), a leading government electronics supplier, following its revised earnings guidance for fourth quarter (ended June) of fiscal 2007 and full fiscal year 2008. Higher defense expenditures by the U.S. government coupled with new expansion drives in the Asian, European & African markets resulted in significant organic revenue growth. The Falcon II & Falcon III tactical radio products continue to receive zealous market acceptance generating a healthy back-log of $4billion. Harris has a strong pipeline with a differentiated product base addressing a market size of more than $6 billion.
Recent plans to acquire privately held Multimax Inc is likely to increase Harris exposure to Government-wide acquisition contracts. Moreover, the company approved $600 million of share repurchase program to improve shareholders wealth. We believe earnings momentum remains compelling for Harris over the long-run.
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