L3Harris - A Dividend Growth Star

Summary

• L3Harris reported strong 2Q21 earnings that, once again, underlined the company's capabilities when it comes to generating shareholder value.
• The company remains in a great spot to benefit from the modernization of NATO's defense forces and should be able to generate long-term EBITDA and FCF growth.
• LHX is a perfect dividend growth stock as investors will more than likely benefit from long-term dividend growth and significant buybacks.

bbevren/iStock via Getty Images

Introduction

Finally! I get to talk about one of my favorite stocks again. The defense giant L3Harris Technologies (NYSE:LHX) just released its 2Q21 earnings, which is a perfect opportunity to reiterate my bullish long-term call. The company beat both non-GAAP EPS and revenue expectations and updated its outlook. The company expects to generate higher earnings on lower sales (FY2021 outlook revisions). Even more important, the company remains incredibly well-positioned to deliver long-term shareholders. Based on current expectations, we're looking at a free cash flow ("FCF") yield of more than 6%, which means investors should be prepared for higher dividends and a lot of buybacks. Even when it comes to valuation, I remain bullish despite a stock price close to its all-time high. In this article, I will give you the details. So, bear with me!

Here's What Happened In 2Q21

Let's start by mentioning the numbers that hit the wires first after an earnings release. The company beat non-GAAP EPS expectations by $0.08. GAAP EPS came in $0.45 below expectations. In this case, the company's divestitures had a major impact on GAAP EPS, which is why there is no harm in ignoring GAAP EPS - even though it might sound I'm sugarcoating things already at the start of this article.

Source: Seeking Alpha

Anyway, sales came in 5.6% higher than expected. In this case, the $80 million are neglectable. Overall, I would even argue that sales growth isn't that important as new orders are far more important - as they determine if sales growth can grow in the future.

With that said, I will continue to talk about revenue a bit as LHX made a slide that clearly shows organic growth. Keep in mind that since the L3 and Harris merger, the company has been divesting parts of its business to create synergies between other segments. For example, the company agreed to sell its electron devices business to Arlington Capital Partners for $185 million. This will bring the total of announced divestitures since the 2019 merger to roughly $2.7 billion.

As a result, the company's organic sales growth was higher than reported sales. In 2Q21, organic sales growth was 6.2%. Non-GAAP EPS growth outperformed due to a significant boost in EBIT margins.

Source: L3Harris 2Q21 Earnings Presentation

In this case, and as aforementioned, non-GAAP EPS rose from $2.83 in the prior-year quarter to $3.26. This was caused by higher volumes and higher productivity ($0.08), synergies ($0.10), a lower share count ($0.18), and others, which includes a tailwind in both pension payments and taxes ($0.07).

Now, let's take a look under the head. In other words, how did the company's business segments perform? In 2Q21, the company reported 12% sales growth in its Integrated Mission Systems segment thanks to new NATO awards and new maritime-related orders. Operating income increased by 2.2% as the operating margin declined from 16.8% to 15.3%. Margins were lower due to the product mix and the ramp on growth programs. Additionally, the quarter some somewhat weak new orders as the book-to-bill fell to 0.81. This means that production outperforms new orders. However, on a half-year basis, the B/B ratio remains at 1.06. If anything, volatility in B/B should be expected as defense contract volumes tend to be volatile. Some quarters are simply better than others without any underlying reason that is worth discussing.

The slightly smaller Space & Airborne Systems segment reported 3.2% sales growth. This segment benefited from a ramp on missile defense and other responsive space programs, as well as classified growth in intel and cyber. Growth in these areas more than offset lower F-16 production volumes. Note that LHX produces Mission Avionics for this type of plane. Again, that's just production timing.

Moreover, the operating margin improved from 18.8% to 19.7% as a result of higher operating efficiencies. The book-to-bill ratio came in at 1.02.

Moving over to Communication Systems, we see a 3.2% increase in organic sales. This segment benefited from tactical communications, especially internationally. The Department of Defense modernization also caused growth in Integrated Vision Solutions, which is one of the company's core strengths. Thanks to higher volumes and operating efficiencies related to integration benefits caused an operating margin improvement from 23.8% to 25.5%. The company's book-to-bill ratio rose to 1.28, which indicates that sales growth will remain high.

Last but not least, the smallest Aviation Systems segment reported 4.7% higher organic sales. This segment benefited from double-digit growth in commercial aerospace from recovering training and avionics product sales and growth in defense aviation from a ramp in fuzing and ordnance systems as well as mission networks from higher FAA volume. This segment, too, benefited from higher operating efficiencies, which boosted the operating margin from 12.5% to 14.5%. The book-to-bill ratio came in at 0.90. On a year-to-date basis, the book-to-bill ratio remains at 0.87.

Here's What's Next

As aforementioned, quarterly earnings reports in defense markets are always a bit tricky as new orders tend to be volatile. That's why I mainly care about a company's position in the industry and its ability to generate long-term value. This information beats short-term book/bill ratios and sales growth/contraction.

In the case of L3Harris, I remain extremely confident that investors are betting on a company that has the ability to generate long-term value thanks to its position in an increasingly high-tech defense environment. As the company's new CEO Chris Kubasik (he's succeeding Bill Brown) mentioned, the company has the ability to "outgrow the budget" and to deliver sustainable long-term growth.

Our most significant opportunities remain for ISR aircraft missionization and other upgrades, land force modernization and enhanced Maritime Systems. All-in-all, as we consider the trajectory of our top line over the coming years, we remain confident in our ability to outgrow the budget and deliver sustainable growth through our domestic positioning, revenue synergies and international expansion to drive a large pipeline of opportunities underpinned by our leading R&D investments.

As I mentioned in my last article, the best way to think of L3Harris is as a company that is engaged in more or less all aspects of the modernization of the (NATO) defense forces.

The best way to think of L3Harris is a company that supports (roughly) all military operations of the United States and its allies. The company operates four segments: Integrated Mission Systems, Space & Airborne Systems, Communication Systems, and Aviation Systems.

I believe that a good way of summarizing all segments is by using the company's own words.

At L3Harris we anticipate and mitigate risk with end-to-end solutions that meet our customers' mission-critical needs across all domains.

For example, the company has ground-team support solutions like radio communication equipment, satellite systems, and electronic warfare solutions to support more or less all major military jets and support planes. The company also produces reconnaissance solutions, avionics, and so much more.

Before I go any further, it's important to discuss the company's guidance as they downgraded the top line and upgraded the bottom line, which might cause confusion. First of all, the company now sees FY revenues between $18.1-$18.5 billion. That's down from $18.5-$18.7 billion. However, EPS is now expected to come in between $12.80-$13.00, which means the company raised the lower bound of the range. This is due to higher EBIT margins. In this case, the company seems confident to reach the upper bound of its prior range of 18.00-18.00%.

Source: L3Harris 2Q21 Earnings Presentation

Free cash flow is expected to come in between $2.8-$2-9 billion. Next year, we can expect more than $3.0 billion in free cash flow.

Source: TIKR.com (Includes 2021/2022 expectations)

And speaking of FCF - finally - here's why $3.0 billion in potential FCF is so much.

Right now, LHX has a $47.8 billion market cap. This means that its FCF yield is 6.3%. To give you a better understanding of what this means, if the company were to spend all of its FCF on dividends, this is the yield we would get. This obviously isn't happening, but even if the company's FCF were to remain flat at $3.0 billion in the future, it means that the company has a lot of room to grow its dividends. Right now, it only takes $840 million to service its $4.08 per share annual dividend (1.8% yield). On top of that, 2022 expected net debt/EBITDA is close to 1.3, which means the company does not need to prioritize financial health.

In other words, I have little doubt that long-term dividend growth will remain high. In February of this year, the company hiked its dividend by 20%. The company also established a $6 billion share repurchase program back then, which equals 12.6% of the current market cap. That's wild and fully backed by the company's fundamentals(!).

Valuation

At the end of last month, I was working my way through my favorite long-term holdings. I noticed that both Raytheon Technologies (RTX) and L3Harris Technologies had the same year-to-date return and the same 12.3x 2022 EBITDA valuation. Both outperformed the defense ETF (ITA) by a wide margin.

Source: Twitter

The valuation hasn't changed a lot since then. Using a $47.8 billion market cap and $5.6 billion in expected net debt next year, we get an enterprise value of $53.4 billion. That's 12.7x 2022 EBITDA.

12.7x EBITDA is a great deal. It's not deep value - and I doubt it will ever fall that far - but it's a fair price given that we could be looking at more than 5% annual EBITDA growth and further rising FCF. Additionally, the company's dividend yield is well off its lows.

Data by YCharts

On top of that, the company's expected FCF yield of more than 6% is a good deal. It's well off the lows. I will increasingly use FCF yield as a valuation tool as getting a good price for (future) FCF is extremely important for dividend growth investors - and others. Unfortunately, the longer-term valuation range is useless as LHX is a young company since the 2019 L3-Harris merger.

Data by YCharts

Takeaway

L3Harris had a good quarter. The company reported strong sales and non-GAAP EPS and was able to raise full-year EPS guidance despite lowering its sales expectations. Going forward, I remain extremely confident that this company will deliver rising EBITDA and FCF for its investors, which makes it a perfect dividend growth stock as the company has a lot of room to grow its dividend even based on current FCF 'capabilities'.

Additionally, the valuation is very fair even though the stock broke its all-time highs after reporting strong earnings.

Right now, the stock has a 4.5% weighting in my portfolio, which I will increase over the next few weeks.

Source: FINVIZ

Long story short, if you're looking for long-term dividend growth, look no further because it doesn't get much better than this.

(Dis)agree? Let me know in the comments!

Analyst’s Disclosure: I/we have a beneficial long position in the shares of LHX, RTX either through stock ownership, options, or other derivatives. 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.

This article serves the sole purpose of adding value to the research process. Always take care of your own risk management and asset allocation.