L3Harris Technologies, Inc.

Moat: 3/5

Understandability: 3/5

Balance Sheet Health: 4/5

L3Harris Technologies is a defense technology company that provides mission-critical solutions and products for the aerospace, defense, and communication sectors, primarily serving the U.S. government and its allies.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

L3Harris operates in the defense and aerospace industry, which is characterized by strong government influence and a high level of regulation. While this can present certain barriers to entry, it also means contracts are often influenced by the political climate and government policy.

The company’s most recent earnings report, which was for the quarter ended September 27, 2024, reveals a mixed performance. While total revenue increased compared to the same period last year, some segments have seen revenue reductions, including the Space & Airborne Systems segment.

The primary factors driving revenue appear to be continued government spending on defense, specifically the U.S. government budget.

Moat Analysis: 3 / 5

L3Harris’s competitive advantage is a mix of factors, placing it in a “narrow moat” category, rather than a wide or nonexistent one:

Barriers to Entry: The defense industry is notoriously hard to break into due to the complex regulatory framework, technical expertise required, high cost for development and manufacturing, and the extensive history and knowledge that major players in the market possess. This creates a significant barrier to entry.
Customer Relationships: The company is heavily reliant on government contracts, which often include long-term relationships and repeat business. As a result of these long-term contracts, revenue visibility tends to be very high, providing a predictable stream of income.
Technical expertise: Given the company’s mission of providing cutting edge technologies for the defense and aerospace sector, it needs to have a strong focus on research and development and this could act as a source of moat as its research expertise is difficult to replicate.
Proprietary products and services: The company produces a diversified range of products with specific capabilities that few other companies can offer. The high technical capabilities for their specific product segments act as a barrier to entry for many potential competitors.

However, these moats aren’t as strong as they might initially appear:

High Dependence on Government Contracts: A significant part of LHX’s revenues come from the U.S. Government. However, this is a double-edged sword. It provides a very stable stream of revenue, but it also makes the company vulnerable to changes in government spending patterns and political decisions.
Pricing power and contract stability: Although the company does have some pricing power due to its specialized technologies and solutions, it doesn’t have a full autonomy on its pricing, because its contracts are usually dictated by government agencies. These contracts are often fixed price and do not take into account changing market conditions and the company cannot raise its prices to reflect increasing costs.
Competitive Pressures: Many of LHX’s technologies and products can be replicated or improved by other defense companies, as well as government agencies themselves, which means that it has to consistently invest in R&D in order to maintain its competitive edge.

Risks to the Moat and Business Resilience

Despite possessing a notable moat, the company faces several risks that could erode its competitive advantage and affect its business resilience:

Dependence on government spending: As discussed, L3Harris is heavily reliant on government contracts, particularly in the U.S.. Budget cuts or changes in defense priorities, political factors, or budgetary changes could significantly impact the company’s revenues and profitability.
Cost inflation and supply chain issues: In recent years, the company has faced supply-chain disruptions and labor shortages which could raise production costs. Also, the company’s reliance on global supply chains exposes it to many other variables and supply chain risks, which can be difficult to control. The combination of these two factors can decrease margins and profitability.
Technological Disruption: Rapid advancements in technology could render some of the company’s products obsolete and can be taken up by competitors who are more flexible and willing to adapt to new innovations. This requires an ongoing effort into R&D for the company.
Integration Risks: Large acquisitions like the one they made this past year can be challenging to integrate, and often lead to unexpected costs and potential declines in productivity and profitability. It is vital that management properly oversee and complete the integration process, otherwise, they can create major problems for the company.
Macroeconomic uncertainty: The current macroeconomic conditions, including high inflation, high interest rates, and the possibility of a recession could affect consumer spending and government budgets, which in turn could indirectly impact the company’s profitability.
Geopolitical Risks: The instability around certain parts of the world could lead to changes in government spending priorities, or restrictions and sanctions, impacting the company’s financial performance. Also, the ongoing conflict in Ukraine could increase demand for defense products, but it could also result in uncertainty surrounding supply chains and costs.

L3Harris does possess qualities that increase its business resilience, but it still has its limitations:

Long-term contracts: Provide a stable and predictable stream of revenue which is a positive for business resilience.
Specialized products and services: Provides certain stability in revenues and profits as other companies cannot easily make products or solutions similar to the company’s.
High recurring revenue from after sales service and maintenance: Can act as a buffer against unexpected fluctuations.
Experienced management with a solid track record: In an industry like this one, having strong relationships, industry knowledge and strong leadership is essential for its success. However, if there is any significant change in personnel or leadership, it may impact the company negatively.
Diversified customer base: Helps the company balance its risk. The company works for various government agencies and not just a few, also, operates in various segments and diverse regions worldwide, helping it to better withstand economic conditions and changes in industry dynamics. However, it still is largely tied to the U.S. government.

Detailed Explanation of the Business

L3Harris is organized into four main segments:

Integrated Mission Systems (IMS): This segment provides integrated mission systems and communications solutions for air, land, sea, and space, including avionics, electronic warfare, and intelligence and reconnaissance solutions. It typically accounts for the largest portion of the company’s revenues.

Revenue in this segment has grown over the recent quarters thanks to higher volumes in its electronic warfare business and its integrated mission systems. The profit margin in this segment has varied and was affected by the mix of programs that the company was undergoing in recent times.

Space and Airborne Systems (SAS): This segment provides advanced space payloads, sensors and mission solutions, and communications capabilities for commercial and military clients. It also includes satellite products.
Communication Systems (CS): The segment provides secure communications, including tactical radios, satellite terminals, and networking gear.
Aviation Systems (AR): Offers mission systems and advanced avionics that provide safety and security for manned and unmanned platforms. Also provides training and logistics services to customers.

The company is heavily reliant on government contracts and the majority of their revenues are from U.S. Federal government, this means that, despite a global outreach, it is heavily influenced by changes in US government spending priorities and their economic conditions.

The industry L3Harris operates in is characterized by:

High barriers to entry: Requires significant capital investments, proprietary technology, government approvals, and strong relationships with customers.
Technological advancements: Competition is driven by innovation and technology, requiring companies to continually invest in R&D.
Long product life cycles: Due to the nature of government contracts, the life cycles of products and services are usually longer than other industries, providing predictability in revenues.
Geopolitical influences: Operations are often influenced by government regulations, trade policies, sanctions, and the political climate.

Financial Analysis

Let’s take a deeper look at L3Harris’s financials:

Revenue Growth: As mentioned earlier, revenue growth has seen an upward trend, primarily driven by the Integrated Mission Systems and Space & Airborne Systems segments. However, revenue can vary from quarter to quarter depending on contract progress and completion timelines. The company has cited a decrease in overall company revenue due to lower volumes in the Communication Systems segment.
Margins: The operating margins are somewhat consistent across segments, hovering around 16 to 17%, and they have been impacted by project mix, cost inflation, and the impact of acquired goodwill and intangibles. Their operating margin has seen a slight increase due to cost reductions in the SAS segment and increased margins in the IMS segment.
Free Cash Flow (FCF): L3Harris has generated a positive FCF in recent quarters. This positive cash flow makes the company able to return capital to shareholders via dividends, stock buybacks and acquisitions.
Debt: The company’s debt level is considered to be moderate to high, with the level fluctuating in line with acquisitions and capital expenditures. They have a history of managing and paying down their debt effectively. However, their level of debt is also the reason for their limited ability to reinvest in growth and R&D.
Share Repurchases: LHX has also recently increased their share buyback program by an additional $1 billion dollars, which will increase the returns to investors.
Dividends: The company offers a very good and solid dividend with the annual yield around 2.5% which has consistently increased each year for several years.
Capital Expenditure: The company has recently been increasing their capital expenditure, which has been directed toward improving its production and output capabilities. This indicates the commitment of the company toward long term growth and profitability.

Understandability: 3 / 5

The company’s operations are moderately complex. While they operate in a relatively straightforward defense and aerospace industry, the inner workings of the technologies involved can be intricate, requiring specialized knowledge to fully understand their business model. Their accounting is also a little more difficult to understand than other companies because of the long-term contracts and different revenue recognition policies.
The heavy reliance on government contracts makes the business model more reliant on non-market factors than pure market forces.
The business is complex due to acquisitions, requiring the investor to have an understanding of various financial metrics and industry standards.

Balance Sheet Health: 4 / 5

While the level of debt is moderately high, it does not appear to be crippling as the company has a steady stream of revenues to cover the debt. However, management should focus on paying down some of their debt.
The company has a solid cash position and a stable cash-flow, which helps them to meet their short term obligations.
The company has consistently generated a positive ROIC, which demonstrates that management is effectively deploying shareholder capital and maximizing returns.
The company’s equity is increasing, indicating that the company is generating returns for its shareholders.
Overall, the company has a reasonably healthy balance sheet.

Recent Concerns and Management’s Response

Acquisition of Aerojet Rocketdyne Holdings: The company recently acquired Aerojet Rocketdyne Holdings and completed the deal in July 2023. This acquisition has brought several challenges for the company, mainly integration risks and additional debt that was required to finance the acquisition. The management responded by stating that they are carefully focusing on the integration aspect of the merger and have established a proper management structure, in order to capture the synergies that will be generated from this acquisition.
Decreasing backlog and cancellations of contracts: The company has noted a decrease in their total backlog and have also had to deal with some contracts being canceled or discontinued in certain projects. The management have noted that they are focusing on building a more robust and diverse product portfolio and are trying to win new contracts in other areas to mitigate the effects.
Cybersecurity risks: A major issue has been the constant threat of cyber security attacks. Management have reiterated that they have implemented measures and safeguards to prevent and defend against cyber attacks but also highlighted the continued threat.

The management seem to be aware of the various risks and challenges ahead of them, but are putting a lot of effort and time to ensure long term profitability and stability. They are following strategies such as improving operating efficiency, cost controls, and diversifying revenue streams to address some of these challenges. However, the effects of those strategies are yet to show up in the financials.

Conclusion

L3Harris Technologies is a company with a narrow-to-moderate moat, which is based on various factors, including long term contracts, specialized product offerings, technological expertise, and some switching costs, all of which are not totally impregnable or defensible. The company is operating in a complex sector and is heavily reliant on government spending and the political climate, which makes it a difficult to value. Despite possessing good management and having a stable balance sheet, the company faces several risks and challenges going forward, which include increasing competition, high debt levels, and the risk of cost inflation.