L3Harris: Not Just About Defense Spending, But About Business (NYSE:LHX)

L3Harris Technologies (NYSE: LHX) is one of the top defense contractors that has benefited from increased militarization, as evidenced by the increase in stock following the wars in Eastern Europe and the Middle East, as shown below.

However, its actions did not react after the recent award of a $587.4 million contract by the US Navy to equip drones with communication systems that can jam enemy radars. Also, unlike in 2020, when the stock rose in the run-up to the US election, there was no such excitement this time, despite several conflicts breaking out.

Also, going forward, higher defense spending may not be enough to justify an advantage, especially after DoD (Department of Defense) concerns about isolating the DIB (Defense Industrial Base) from the broader economy . They are also new which you enter to face. At the same time, the way in which hostile nation-states have manufactured weapons suggests that the conventional approach of achieving supremacy through sophistication that costs billions of dollars may no longer be sufficient.

Against such a background, this thesis aims to build an investment case, showing how L3’s business model is positioned to adapt to the new paradigm, and to this end, I highlight how its partnership ecosystem enables access to emerging technologies without spending too much. a lot.

Defense isolates and the need for a commercial DIB

In May, the DoD released a report on DIB that expressed the need for more competition after years of consolidating the industry in the hands of relatively few players, which led to less competition. Equally important, defense contractors have become increasingly isolated from the wider commercial economy, which limits both investment in defense-related technologies and access to emerging technologies such as cyber security and artificial intelligence to only to name two.

Thus, this issue of “isolation” needs to be addressed quickly because it stifles innovation, and this can be done by involving the corporations in the commercial world, especially since the DoD is expected to spend $841.4 billion this year alone. In this regard, the department’s regulators tend to review M&A transactions not only for national security reasons, but also based on antitrust and innovation criteria. Therefore, 10% of the approximately 400 defense-related transactions were reviewed primarily based on the competitive risks they pose, while commercial companies are not subject to the same level of scrutiny as defense contractors, which therefore , have fewer growth options open to them.

Consequently, defense contractors must come to terms with the “commercial defense industrial base” paradigm, which may involve recalibrating the mindset from a peace environment to a war environment, such as gaining rapid access to know-how and delivering what DoD wants instead of planning. projects in a way that prioritizes profits. This means that L3 must adapt its approach to the evolving industry landscape, while ensuring that its competitive positioning does not suffer, and its partnership with Palantir ( PLTR ) through which it assumed a role as subcontractor in a defense project illustrates just this. .

Palantir Partnership and L3’s Commercial Orientation

The team is to support the Pentagon’s CJADC2 (Combined Joint All Domain Command and Control) capability, whereby data collected by L3-provided battlefield sensors will be processed by the IT company’s AI-driven SIP (Sensor Inference Platform) for analysis purposes .

Now, for clarification, L3 already has advanced IT capabilities to deploy cyber security, analytics and cloud solutions to support the defense, aerospace and commercial sectors. However, as part of the partnership with Palantir, the goal is to go a step further, using in particular the latter’s expertise to analyze large amounts of data to obtain useful insights to provide a real-time and intelligence-based defense solution. data.

Putting this partnership in the context of DIB, it can be thought of as a step to reduce isolation while making L3 military hardware smarter through the use of AI and commercial Palantir software. Additionally, by working in collaboration with Palantir, the entrepreneur not only gets access to cutting-edge technology to accelerate their research and development, but also generates sales without having to spend money to acquire the latest AI.

Looking at profits, commercial businesses, especially those in the IT software industry tend to generate higher margins due to their scalable platforms, while defense players are more constrained due to the very nature of contracts. Thus, with sales mostly limited to the military and research and development costs on the high side because they span a relatively longer period of time, the gross profit margins of the largest defense contractors tend to to be much lower, or 12% to 26%, compared to more than 75% for commercial software providers.

In this sense, L3’s partnership with Palantir not only allows it to stop a long cycle of development and additional investment, but also expands its place in the higher-margin commercial sector. Notably, 76% of revenue in fiscal 2023 came from US government customers, meaning the remaining 24% was generated from non-government sources, including commercials covering both domestic and international companies. It has also taken advantage of advances in communications, space systems and avionics to opportunistically serve a wider range of industries, which may also explain why its EBITDA margins are higher than in comparison, as shown below.

Thus, it deserves to be valued better, given that the EV-to-EBITDA of 14.16x is lower than the average of 15.36x by 8.4%. Raising its current share price of $227 accordingly yields a target of $246, assuming EV-to-EBITDA growth reverberates proportionately through the share price, but there are risks.

Competitive risks and rate-sensitive stocks

The problem is that the EV metric also includes debt, which for L3 was $13.2 billion, versus cash and equivalents of just $547 million at the end of Q2 2024.

In this case, despite the stable cash flows normally associated with long-dated federal contracts, there are risks associated with holding large amounts of debt, as illustrated by how its stock has been affected by the Fed’s aggressive rate hikes of the US in 2022, according to the introductory chart. That means if the market believes the Fed isn’t cutting rates quickly enough as expected later this month, stocks could suffer because of its rate sensitivity.

Now, some will argue that it boasts $4.4 billion in debt, again due to long-standing government contracts, but it needs to pay dividends and fund its politics to prop up its value through share buybacks.

To its credit, the company decided to suspend M&A activity last December to shore up its balance sheet and achieve leverage of less than 3.0x by the fourth quarter of 2024. This is good, but questions remain about how it can quickly gain access to expertise and technology inorganically when competing for heavyweight government contracts or new entrants. One of those is Anduril, which has partnered with Oracle ( ORCL ) for AI-based weapons systems that can provide geolocation services, jam devices like drones and facilitate communications.

Thus, L3 may be disadvantaged and even outbid when bidding on a contract, which in turn may affect growth and cash generation because it cannot partner with Palantir on all projects. Looking deeper, the hiatus in acquisitions has been offset by a strategy to invest in startups active in autonomy, AI and cybersecurity since March 2022, either directly through equity ownership or indirectly with venture capital firm Shield Capital.

Thus, by building on third-party capabilities, including partnering with disruptive innovators, it can further apply emerging technologies to rapidly respond to national security needs. This strategy also provides agility while spending relatively less capital, not to mention exposing it less to the risk of being under the scrutiny of DoD regulators, as is the case when they make acquisitions.

However, with more than 75% of its revenue coming from the US government, much depends on which political party is in power and how the country interacts with its allies.

Adequate capital allocation, more agile and an acquisition

However, to be realistic, there should be limited correlation between the defense budget and who runs the White House or Congress, because the threat environment around the world has become more dangerous when you look at events in the Red Sea, North Korea, and Iran . This requires a strong defense industrial base, augmented by the strength of the commercial sector, where most of the latest innovations, including AI and unmanned systems, come from.

Looking further afield, competition has also emerged from low-cost, mass-produced drones and missiles from China, Iran and North Korea. To be fair, they aren’t as technologically advanced, but they are cheap and tons of them can be launched to immediately hit a target that can overwhelm the enemy. Thus, at least nine Iranian ballistic missiles landed in Israel after most others were shot down in space by the country’s Arrow defense shield. This is just another example of the changing threat landscape, and that cutting-edge technologies that cost billions of dollars to develop may not be enough, a problem exacerbated by innovation suffering as contractors shy away from risky bids (where can sustain a loss), which leads to losses. competition and even late product delivery.

In this regard, L3’s capital allocation and partnering strategies to acquire the necessary expertise in the rapidly evolving defense industrial complex seem better suited to the new paradigm, as they make the entrepreneur more agile and connected to the commercial world. On the other hand, it will have to share revenue with its partner, but as seen in the peer comparison table, it is growing the fastest among peers while spending relatively less in terms of Capex per dollar of sales generated below.

In addition, the company shed non-core assets as a portfolio shaping strategy, which saw the completion of the antenna and related businesses forming part of the Space & Airborne Systems segment for $200 million in June. This, combined with debt reduction, further justifies this bullish stance targeting 8.4% growth, which is reasonable given the risks. Ending with caution, rather than an election-driven rally, stocks are more likely to be volatile as the main focus turns to the US Federal Reserve’s actions and how inflation is playing out.