Harris Corp. - Undervalued And Underrated

Oct. 9.12 | About: Harris Corporation (HRS)

When E.T. calls home, he probably relies on equipment made by the Harris Corporation (HRS). Harris specializes in advanced technology for capturing, aggregating, distributing and analyzing all types of communications and information, including voice, video, data, and imaging. It sells its products and services to government and commercial customers in 150 countries and operates in 52 countries around the world. Harris' products and services are sold to a diverse market comprised of defense, national intelligence, civilian government, public safety and public service, transportation, utilities, energy, maritime, broadcast and new media and healthcare entities.

Organizationally, Harris is composed of three (3) business segments: RF Communications, Integrated Network Solutions and Government Communications Systems. The company reports on a June fiscal year.

RF Communications

Full fiscal year 2012 revenues were $5,451.3 million. In fiscal year 2012, the RF Communications segment contributed $2,141 million in revenue. This segment includes business units identified as U.S. DoD and International Tactical Communications and the Public Safety and Professional Communications. This segment is a supplier of secure radio communications and embedded high-grade encryption solutions for military, government and commercial enterprises. They also supply secure communications systems and equipment to public safety, utility and transportation markets.

Integrated Network Solutions

This group contributed $1,571 million in revenue from the sale of integrated communications and information technology and services to government, energy and healthcare customers. Products include IT services, managed satellite and terrestrial communications and standards-based healthcare interoperability and image management. This group has three business units: IT Services, Harris CapRock Communications and Healthcare Solutions.

Government Communications Systems

This group has three units: Civil Programs, National Intelligence Programs and Defense Programs which contributed $1,834 million to overall FY2012 revenues. These units develop, produce, integrate and support advanced communications and information systems. Products services are sold to both military and civilian agencies of the U.S. government.

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Harris has had a nice run-up in share price. Over the last 13 weeks, the share price is up about 24% and it is up about 44% over the last 52 weeks.

Revenues

Total revenues for FY12 are $5,451.3 million. The RF Communications segment contributed $2,144 million or 39.3% of the total. Integrated Network Solutions contributed 28.8% or $1,571 million and Government Communications Systems added another $1,834 million or 33.6%. What we see here is that the company's revenue stream is fairly evenly spread among the three business segments. Though its true that a very significant part of Harris' business is derived from the U.S. government, it is not totally dependent on the DoD side of the business. Civilian agencies, including the intelligence agencies are important customers. State, local and foreign governments as well as several large industry segments are also big business for Harris. This diversification of customers can serve as a buffer when some customer segments cut-back.

Year-over-Year, revenues increased a nominal 0.6%. this is well below the five year average growth rate of 7.8%. Revenue for 4Q12 declined to $1,436.2 million, or 5.6% from $1,521.0 million in the prior year quarter. Analysts are forecasting FY2013 revenues in the range of $5,186.0 million to $5,494.0 million with an average estimate of $5,427.74 million. Analyst expectations for FY14 are murkier. The range is from a low of $5,081.0 million to a high estimate of $5,580.1 million. The average FY14 revenue estimate is $5,422.96 million.

The company's revenue guidance for FY13 is flat to 2.0% growth compared to FY12. Based on this guidance, Harris expects revenues in FY13 to be about $5.5 million. This estimate is above analyst estimates and, if proven correct, presents a nice surprise.

Earnings

The company surpassed analyst EPS expectations for both the quarter ending March 2012 with EPS actual at $1.39 per share versus the consensus estimate of $1.325 per share and for the June quarter. The company reported EPS for the quarter at $1.42 compared to the analyst consensus of $1.405. In 4Q12, EPS - diluted from continuing operations were $1.15 compared to $1.06 per diluted from continuing operations the prior year. Harris has approved a plan to divest Broadcast Communications, which is now reported as discontinued operations.

For the full fiscal year, Harris reported EPS - diluted from continuing operations of $4.75 compared to $4.69 for the prior fiscal year. The company estimates that F13 EPS will be in the $5.10 to $5.30 range. The consensus among the eleven analysts providing FY13 estimates to Thomson Reuters is $5.15. This is at the low end of company guidance. The analysts are much more pessimistic with expectations ranging from a low of $4.65 to a high of $5.30.

Margins

Even in the face of declining revenues, a well managed company can widen their profit margins. For Harris, the gross margin for FY12 was 34.5%. The gross margin reached a low point in 2006 when it was 31.3 %. It has risen, a bit erratically over the years and reached a seven year high in 2010 when it hit 35.4%. The seven year average gross margin is 33.129%.

Operating margins have been even more erratic. Its low point was in 2009 when it sunk to 10.6% and rose the following year to 20.1%. Over the last seven years, the operating margin averaged 15.386%. The operating margin for FY12 is 17.3%. Operating margin for the RF Communications segment was 33.5 percent compared with 30.4 percent in the prior year, improving as a result of lower manufacturing costs and operating expenses. The Government Communications Systems unit reported operating margins of 13.3 percent compared with 12.7 percent in the prior year.

Net margin tells us what falls to the bottom line. Harris has a seven year average net margin of about 7.557%. Harris wrote off $528.1 million from discontinued operations driving net income down to $30.6 million making the net margin 0.4%.

Balance Sheet

Harris closed FY12 with $356.0 million with cash and short term investments and $1,883.0 million in long term debt. Long term debt to capital is 49.3% and long term debt to equity is 97.1%. The company generated $619.1 million in free cash flow which implies that Harris could pay off its long term debt from free cash in about three years. Another way of looking at it is that long term debt is about1.5X working capital. These metrics suggests that Harris generates ample cash to service its long term debt.

Profitability

I like to use several different metrics to evaluate profitability as each looks at the issue differently. The first metric is Return on Equity. The ROE for FY12, as reported, is a depressed 1.0%. If we make adjustments for discontinued operations, ROE is more like 19.3%. The second metric I use is Return on Invested Capital. This metric has the advantage of telling us how well the company employs all of its capital and not just the equity portion. I estimate that ROIC is a very healthy 41.6%. Though we all generally focus on earnings based metrics, I consider cash based metrics to be more informative. At the end of the day, it takes cash to pay the bills and it is cash that is paid out in the form of dividends or share buybacks or available for investment. Harris has a Cash Flow to Invested Capital (CFROI) ratio of 16.2%. I think this is a good indicator of future performance and Harris meets my test.

Capital Allocation

As investors, we look to how well our investment does in relation to other opportunities. In FY12, Harris raised its quarterly dividend from $0.28 per share to $0.33 per share for a total annual payout of $1.22. Harris has announced another increase to the dividend, this time to $0.37 per share or $1.48 annualized. This is the eleventh consecutive annual dividend increase. At the recent share price, the dividend yield is about 2.8%. The seven year average dividend yield is 1.7% which is suggestive of undervaluation.

The company also has a share buyback program in place. In FY12, they purchased 12,242,843 shares at an average price of $38.12. This represents a reduction in shares of about 9.9%.

Valuation

When it comes to valuation, investors have a wide variety of tools at their disposal. One approach is to use relative value. As alluded to above, the current dividend yield for Harris is about 65% above the long term average. At about 11X trailing earnings and just 10X the forward PE, the shares are trading hands at a discount to the market.

We compare Harris' Price Sales ratio of 1.07X to the industry median of 0.92X. The company has a price Book ratio of 3.0 which is much higher than the industry median. Harris has a long term growth rate for both sales and earnings that exceeds that of its industry median suggesting that Harris should be selling at a premium to the industry median.

I happen to think that metrics based on Enterprise Value are more meaningful than those based on equity alone. The EV to Free Cash ratio is 12.13X whereas the industry median is -0.3X. This tells us that the industry median carries a negative free cash flow and that Harris is free cash positive. In my opinion, an EV/FCF ratio of 12X is not especially high though I would want to see something more like 8X. Enterprise Value to Sales is an insightful number. I like to see EV/Sales below 1X at the time I purchase shares. Harris has a current EV/Sales ratio of 1.38X whereas the industry median is 0.85X. Our last metric is enterprise Value to Earnings Before Interest, Taxes, Depreciation and amortization (EBITDA). Harris has a low EV/EBITDA ratio of 6.81X when the industry median is 10.92X.

Conclusion

The big overhang for Harris is the pending sequestration of federal funding. Harris went into the current fiscal year with a huge backlog of orders. Should the sequestration take place, I expect to see the effects in 2H13. The company will be announcing 1Q13 results on October 29th. We may get some indication then of what the future holds. I am optimistic that the sequestration will not have a very dramatic impact on Harris. I think the defense contractors with major weapons systems will be hit more. Harris' products are too critical to the national intelligence services and to the military to be put on the shelf for long. Analysts are very confident of their estimates for FY13 and have been surprised to the good.

I think at the current share price Harris is undervalued. I think their level of profitability, both earnings and cash based, justify a higher share price.

Disclosure: I am long HRS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.