Harris: Leverage Keeps Me On The Sidelines

| About: Harris Corporation (HRS)
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Harris is a solid defense play, focused on electronics.

The company made a successful deal with the purchase of Exelis, although that deal involved quite some leverage.

While earnings multiples are not that high, leverage is high amidst constrained topline sales growth.

Even as I like the business, I see few potential triggers to create a lot of value in the short term.

Harris (HRS) is a medium-sized defense company holding strong market positions in many areas related to electronics. The company has long been following the strategy of its peers involving bolt-on dealmaking and buying back shares.

With defense budgets having been constrained in recent years, Harris made a flight forward by purchasing Exelis, growing the business by 50% in one transaction. This deal seems to have gone well as it improved diversification and projected synergies are being achieved, yet it left the balance sheet quite leveraged.

While forward price-earnings multiples are not even that high with shares trading at all time highs, Harris is constrained by sluggish topline sales developments. Given the leveraged state of the balance sheet as well as premium multiples at which the business is valued if you include debt, I see few opportunities to create imminent value.

The Business

Harris has been in existence for over 120 years, operating in at least as many countries as a leading technology innovator. While the company claims to be a technology innovator, it is in essence a major defense contractor being active in four major areas: communication systems, space & intelligence systems, critical networks and electronic systems. While it is true that these segments cater commercial customers as well, two thirds of sales are derived from catering US defense related agencies alone.

The company posted revenues of $5 billion in recent years, with sales being pretty stagnant. This was the result of declining defense budgets amidst pressure on the US fiscal budget. With the purchase of Exelis, Harris has gained further scale and has grown to a $7.5 billion revenue base. Exelis is active in similar markets as Harris but has a presence in some other attractive markets as well including air traffic management and weather systems.

While the $4.75 billion deal boosted the revenue base by 50% and has delivered upon $120 million in run rate synergies already, Harris continues to see benefits increasing towards $150 million per annum this year. The acquisition to acquire Exelis was a major move, but Harris remains a small player versus the likes of Lockheed Martin, General Dynamics, Northrop Grumman and Raytheon, among others.

The company does aim to outperform its peers on some metrics, as R&D spending at 4-5% of sales is relatively high. This acts as a defense against the fat margins and should over time result in organic growth outperformance versus the wider industry if those dollars are well spent.

The Current Performance

A lot of integration work has been done following the purchase of Exelis, as Harris has just ended its fiscal year of 2016. The company reported revenues of $7.47 billion for the year, as year over year growth numbers are heavily influenced by the deal. Each of the 4 segments contribute pretty evenly to the topline with revenues of each unit coming in between $1.5 and $2.2 billion on an annual basis.

The earnings picture has been highly distorted by impairment charges and integration costs, in part of offset by lower pension related liabilities. I believe that the adjustments made by Harris to non-GAAP earnings metrics are fair, as they do not include real costs such as stock-based compensation. For that reason the GAAP earnings of $345 million, or $2.75 are not that representative.

If we follow the logic to exclude the charges discussed above, earnings came in at $715 million, equivalent to $5.70 per share.

The Balance Sheet

Following the purchase of Exelis, the balance sheet has gotten quite leveraged. Not only does this reflect the purchase price, Harris "acquired" quite some pension related liabilities as well.

The company has cash balances of nearly half a billion as total debt stands at $4.5 billion. That $4.0 billion net debt level does exclude pension related liabilities of some $2.3 billion. If we factor those in, total net debt stands at $6.3 billion. The company still plans with a 7.75% return assumption for those pensions, resulting in potential negative surprises down the road.

The estimated EBITDA calculation is highly complicated. Let's start with net earnings of $324 million. If we add back $115 million in integration expenses, $183 million interest expenses and $266 million in taxes, we end up with adjusted EBIT of nearly $900 million. If we add back roughly $360 million in depreciation, amortization and goodwill impairment charges, EBITDA comes in at around $1.25 billion. That still results a 5 times leverage ratio, including pension related liabilities.

With pension related liabilities having long durations and Harris having many long term contracts in place, leverage is not really a concern but it surely limits the flexibility of the business.

Another Challenging Year

While revenues hit a high of $7.47 billion in 2016 following the Exelis transaction, and Harris continues to guide for long term growth, short term defense budget cuts are the dominant factor. Revenues for 2017 are seen at $7.11 to $7.33 billion, suggesting a 3-4% fall on an annual basis.

The good thing is that non-GAAP earnings are seen at $5.70 to $5.90 per share, being up marginally from the $5.70 reported for 2016 amidst falling sales. The other good news is that GAAP earnings are seen just $0.17 per share lower, as the integration of Exelis is nearing completion. With shares trading at $88, the 15-16 earnings multiple might look appealing. Note however that topline sales are falling given the budget headwinds as leverage remains high as a result of the pension liabilities.

If we assume $700 million net earnings, $300 million in taxes on those earnings, interest charges of $150-$200 million and $250 million in depreciation charges, EBITDA might improve to $1.35-$1.40 billion going forwards. That still results in leverage multiples of around 4.5 times.

What About JANA?

Alongside the fourth quarter earnings results release, Harris announced that it has reached an agreement with JANA Partners. The activist investor is one of Harris's largest shareholders and both parties agreed to the nomination of two new independent board members, as JANA will remain silent until the summer of 2017.

JANA's Barry Rosenstein believes that the strong position of the company in its core business results in more potential to unlock shareholder value. I wonder where Mr. Rosenstein, which firm holds a near 2% stake in Harris, really sees this value. The valuation multiples are pretty steep including debt, margins are solid as there are few immediate triggers to create value with shares trading at an all time high.

While Harris could always sell off some divisions, the overall valuation of the business is quite steep. Harris trades at roughly 12-13 times adjusted EBITDA if we take into account net debt as well as pension related obligations. That is certainly not a cheap multiple for a business, which although is very well positioned for the long term, is expected to shrink in the coming year. For that reason I see little potential value created from divestments, as the balance sheet is still highly leveraged, limiting the potential for substantial M&A and share buybacks.

Holding Off

I must say that I like the business of Harris, as the company has over time grown revenues, bought back shares and reported very stable margins. This dominant positioning and am ere 15-16 times multiple for the earnings look appealing. While 2017 continues to be a difficult year, executives plan for growth in the fiscal year of 2018.

There are some caveats however. Continued budget headwinds, pressure on topline sales and a highly leveraged business sheet limit the potential triggers for value creation. The balance sheet does not allow for major buybacks or dealmaking, while the high multiples make it difficult to create value by selling assets at good prices.

As a result, I see few triggers to sent shares higher although solid cash flow generation does leave potential to de-leverage the balance sheet. To create appeal, I would like to see revenue stabilization and preferably some lower multiples. With shares now trading at the high end of the trading range of $70-$90 over the past year, I would place my buying orders near the low end of the range.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.