7investing Lead Advisor Matt Cochrane's investing thesis for L3Harris as his top stock for February 2023.
February 1, 2023
Matt Cochrane 00:00
All right, L3Harris Technologies, we’re going to be adding a new company to the scoreboard. This company is in the defense industry, it’s an industrial. It’s risk level – I have it as moderate. I’m thinking about making it high. So, you know, I welcome feedback on that.
Matt Cochrane 00:21
Investment type is income. It pays a pretty nice dividend and they’re pretty committed to raising it. Company size: large. I’s a little under $40 billion market cap. So, L3Harris Technologies was created in a merger in 2019 between L3 Technologies and Harris Corporation. The company builds itself as a trusted disruptor within the defense industry. It provides advanced defense and commercial technologies in the space, air, land, sea and cyber domains. Serves customers in over 100 countries, with its largest customers being the US government and its prime contractors.
Matt Cochrane 01:03
And going back to that merger real quick – we’ll get to that at the end. But like it just, it makes everything like it’s hard to like wrap around like exactly what this combined company still does and what it doesn’t do. But it’s divided into three business segments, which again, after the merger, it was four business segments, and then just this year and went to three business segments, just kind of, it’s just hard. And that’s kind of why I’m contemplating making it a high risk.
Matt Cochrane 01:31
But right now, it’s three business segments, Integrated Mission Systems, which is the largest space and airborne systems, second largest and communication systems. The integrated Mission Systems, it accounts for about $5.1 billion of company sales through the first nine months of ’22. All these segments are made up of like further sub segments. So this is the three sub segments for integrated mission systems are ISR, which stands for intelligence, surveillance, and reconnaissance. Maritime, and Electro Optical. I
Matt Cochrane 02:08
don’t know how in the weeds, I want to get into all the sub segments. So if you have questions, or you want clarification, just ask. But again, between the three segments, there’s 12 sub segments. So just going through each of them might get tedious. But if you have any questions, ask and I’ll be happy to go into detail more.
Matt Cochrane 02:31
About 70% of this segments, sales are to the US government 28% to foreign governments. And so instead of just getting to all the sub segments, what I thought I would do, it might be better. It’s just like, give an example of what this does. So, ISR is the largest sub segment. And so what’s going on right now with the F-35. They’re going through technology refresh 3, which is shortened TR3. And so the US Air Force is configuring all the F-35s, which, as we know are made by Lockheed Martin, another one of my recommendations.
Matt Cochrane 03:10
They’re going through the third technology refresh, and they just launched the inaugural flight for the first TR3 configuration. It was 50 minutes long, took the jet about 35,000 feet at speeds just shy of the speed of sound. And so what the technology refresh 3 does. It provides the computational horsepower to support modernized block four capabilities for the F-35. So that includes new sensor suites, more long range precision weapons, improved electronic warfare features, more powerful data fusion, and increased cross platform interoperability. Those capabilities provide the warfighter a combat edge to identify, track, engage and survive against advanced air, ground and cyber threats. It updates the core processing power and memory capacity, which just allows the F-35 to run advanced software packed with like really state of the art warfighting capabilities.
Matt Cochrane 04:15
And l L3Harris Technologies is behind a lot of that. In fact, I want to say this kind of revenue, equipment and supplies and parts and components within F-35 is about 5% of L3Harris’s total revenue.
Matt Cochrane 04:37
The second segment is space and airborne systems. This is the second largest segment within the company. This generated $4.5 billion in sales through the first nine months of this year. That’s about 35% of the total. And again so this is comprised of four sub segments, space, intel and cyber, mission avionics and electronic warfare. So most of this, you can almost just kind of summarize it by saying it provides satellite sensors to global missile warning and detection systems. Though it also defines and builds systems for the National Oceanic and Atmospheric Administration. That’s NOAH for short, it runs a GPS modernization program for the US Air Force. So it does other things. But a lot of it is like if, if a country was to launch like, like, whether it’s hypersonic, or just ballistic missiles at the United States, like the sensors on the satellites, that like, oh, look, there’s a missile coming from the US, or for, you know, England or for any of its customers countries, like it detects and tracks those missiles, and gives us our first warning that a missile is incoming.
Matt Cochrane 05:50
So again, let me just instead of going through all four sub segments, I don’t want to be tedious, but again, ask me if you want more detail. So an example is this, the Space Development Agency just recently awarded, they’re trying to build a tranche one tracking layer. And so what that does, it’s like, there’s several companies bid for this contract. And what just happened was like, the Space Development Agency announced the two finalists, one of them being L3 Harris Technologies, the other one being Northrop Grumman. And, and so the contract for it to build a space segment, consisting of two planes with seven space vehicles per plane, that’s 14 satellites, from each performer for a total of 28 satellites and four planes to collect infrared data and provide network communications. Each agreement includes a launch services segment for launch preparation, and a ground segment for operations in sustainment. The prototypes will provide global and persistent indications, detection, warning tracking and identification of conventional and advanced missile threats, including hypersonic missile systems.
Matt Cochrane 07:03
And then finally, communication system. So this is the smallest segment, it realized a little over $3 billion in revenue for the first three quarters of ’22 – about 24% of the company’s total, divided into five sub segments, tactical communications, broadband communications, integrated vision systems, public safety and global communication systems. About 68% of sales were to the US government, and 29% of sales were to foreign entities from 2021. And these are really just radios and tactical communications for anything from on the ground, troops on the ground, they need communications, they have sales to law enforcement agencies and radios, things like that, but just all kinds of communications, all kinds of communication systems all over the world and throughout the military.
Matt Cochrane 08:01
So, look, it’s not like, you know, any of us, I think, need to be reminded of like, what’s going on in the world. I mean, you know, Ukraine was invaded by Russia last year. You have, you know, China, it continues to like rattle its sabers about invading Taiwan, you have a supply chain crunch, affecting the entire defense industry, which really affected L3Harris this past year. And I believe, as that alleviates will actually like – if you look, L3Harris was one of the the worst performing defense companies in 2022. And I believe a lot of that was because they were affected more by the supply chain crunch than almost any other defense company. I believe once that alleviates they’ll see the benefits more than any other defense company.
But, you know, there’s a lot of headlines, but nothing affects more L3Harris than the defense budget. And so a lot of this is like the same stuff that I talked about with Lockheed Martin. But like, you know, the most significant variable affecting L3Harris’s future. And look, admittedly, it’s out of the side, the company’s control, but it’s the US Department of Defense budget. You know, with a one congressional act, all future contracts could be sold. You know, there could be political movements that take hold that either, you know, that could be about just like withdrawing from world events, or that like, are about fiscal responsibility and cutting military spending, you know, sort of like, you know, political movements could come from the right or the left, that could affect the defense budget.
Matt Cochrane 09:41
Such things have happened before. So like, you know, just looking at this chart while it’s up and to the right, there’s like whole decades where it goes down or is basically flat. Like after the Berlin Wall fell in 1989, effectively marking the end of the Cold War. You know, US defense spending fell 10 percent over a decade. So a decade later, it was it was 10%, lower than it was. And it wasn’t until 9/11 that military spending ticked up again, you know, but that’s like the 1990s, you know, like you could conceivably go through another decade like this, where defense budgets continue to trend downward.
Matt Cochrane 10:20
So you have these things that really do affect the future of L3Harris. And, you know, a decade – you know, we’re long term buy and hold, but a decade is a long time.
Matt Cochrane 10:30
I just believe it enjoys many moats, and a lot of these are very similar to Lockheed Martin and other large defense companies. But it enjoys high switching costs that results in decade long contract wins; and several other unique intangible economic moats that are pretty unique to the defense industry. So, high switching costs, long contracts. But the products just require great technological complexity. But has limited buyers.
Matt Cochrane 11:00
So just think, they’re supplying and outfitting F-35s with modern up to date state of the art electronic warfare capabilities. Right? Like, there’s not too many other companies that can do that. And even other companies tried – to put that much money in research into trying to say no, actually, I know, L3Harris has been outfitting the F-35s, you know, with this equipment for a long time, but we want to come in and try to compete with them. Well, there’s only one buyer. And so it’s a daunting task for an outside company to try to do that. You also need a willing and skilled workforce with classified security clearances. And so it required a really highly skilled workforce. But they need employees who can pass a security clearance and are willing, they’re willing to work on equipment like this.
Matt Cochrane 12:09
So L3Harris, like I said, at the very beginning, they bill themselves as a trusted disrupter. And what does that mean? So they talked about here like this is a quote from the CFO recently. “The disrupter part is our differentiator. And this is what we’re bringing to the table in terms of driving value for all of our stakeholders. And so what does that mean? It means that at the foundation innovation is core to who we are as a defense company.” And they talked about how like they spend a lot on r&d, and but they’re also willing to partner with like companies like Palantir, or Anduril. Or these new disruptors in the industry, or even through like incubator funds, like they have a partnership with us the Shields Fund, which is like a venture capital firm that just invest in like defensive upstarts. And so L3Harris basically has a first crack at like, like working with some of these companies.
Matt Cochrane 12:09
Microsoft had HoloLens which was going to be used in the on by the army for training purposes. And a lot of Microsoft employees said we don’t want to take part of this, you know, and it’s hard to find willing, skilled employees that can also pass security clearances to work on this kind of stuff. So it’s just, I just think the defense industry industry enjoys unique moats.
Matt Cochrane 12:47
So again, rather than getting tedious and talking about all the different things, sometimes I think it’s just better to go with like an example. Like I want to talk about their their Skywarden for the armed overwatch effort. So basically, the US Special Operations Command, they’re like, you know, we need you know, sometimes like we’re tracking like a terrorist cell in Africa, or we have these very rural outposts that need air support, but we don’t want to send an F-35. One, we don’t want to station F-35s in these kinds of remote outposts because they need a lot of maintenance. You need a lot of maintenance crews there now. Becomes this whole big thing.
Matt Cochrane 14:19
And you don’t want to send them like from like an Air Force base like from Guam, you know, all the way to Africa, and things like that, but they want just like something that something just for simple reconnaissance, intelligence, and sometimes for armed air support. And so wL3Harris Technologies came in and said, Look, we’re going to outfit this plane that’s normally used for for fighting fires in Texas, an air tractor, and we’re gonna put it with all this electronic equipment. And it’s like, you know, the contract could go up to $3 billion, and that’s a contract that L3Harris just won last year late in 2022.
Matt Cochrane 14:36
So, they they outfitted it with like all kinds of radars and detection stuff and some armed stuff. But like it can be used for that when you’re not worried about any aircraft in opposition, like, you know, you can, this is just like a cheaper and much more effective and much more practical thing the US military can use in very remote places.
Matt Cochrane 15:34
And again, the same thing I talked about with Lockheed Martin, there’s an international catalyst right now. France is talking about boosting their military spending by over a third. You have NATO members who have been pushing and trying to get to 2% GDP dedicated to defense spending. But now there’s some NATO members saying that should be the floor, not the ceiling for what they spend.
Matt Cochrane 16:02
And even for just the European and NATO countries to get to 2%, you’re talking about a nice increase from here, you know, and L3Harris exposed to a lot of international sales. You know, on Twitter the other day, I posted something about the defense industry, and somebody’s like, well, you know, what’s your Russia in Ukraine conflict ends, like that, that’ll go away? I don’t think it does, you know, defense budgets. You know, one, the NATO countries decided to go to 2% of GDP to defense spending back in 2014, when there was the Russian Crimean conflict, you know, like, this is like longer term defense budgets are longer term stuff.
Matt Cochrane 16:52
And I think they’re now realizing, one, they can’t just rely on the US and they want their own defense, because you have bad actors around the world that they might want to protect themselves from, and not always have to rely on the US to do that. And I’m talking about NATO and Europe, but it’s like Japan too. Japan’s talking about increasing its military budget, Australia.
Matt Cochrane 16:52
So I think a lot of US – I’ll say, loosely, US allies around the world are looking to increase their defense spending. So L3Harris will be exposed to that. So the company pays a really nice dividend and increases every year, it’s buying back shares. I think both of those are tailwinds for investors. You know, I don’t think I need to go into too much detail like that, but management is, is pretty dedicated to that.
Matt Cochrane 17:49
Alright, so now, briefly I do want to talk about yes, L3Harris is exposed to the Department of Defense spending. And like, if defense spending does go down, I don’t think it will. But if it does, significantly, for a long time, that obviously hurts L3Harris.
Matt Cochrane 18:10
Compounding matters are just making it more difficult. So look, again, four years ago, or almost four years ago was the merger. So you had a lot of overlap between some of the divisions. So they’ve made a lot of divestitures in the last few years. And trying to like wrap my arms around exactly at what this company does. And like, oh, that division is no longer part of the company, they sold it. And they’re also making acquisitions, which are like, another one of the reasons the stock got hit. It’s trying to acquire Aerojet Rocketdyne, which is like a company that provides a lot of rocket propulsion that they can use on satellite and stuff like that. And GE and Textron and Lockheed Martin tried to buy it, you know, it had to pay up for it, there was a lot of bidders on it.
Matt Cochrane 19:05
I think it’s a really nice asset and thing to get, but the balance sheet is confusing right now, to just be honest with you with all the divisions and acquisitions, you know, in the merger just a few years ago, and then the corporate restructuring, it’s kind of more complicated than I wish it was. But that being said, I also think though, that’s one of the reasons why we’re getting the stock at a decent price.
Matt Cochrane 19:37
So that’s all L3Harris. Questions?
Luke Hallard 19:48
You might have answered it in your closing paragraph. You mentioned Northrop Grumman. Juat looking at the comparison of the financials L3Harris. Where Northrop seem to be more robust. L3Harris seem to have a much higher free cash flow position. Is that because of divestitures and maybe they generated income from other sources somehow.
Matt Cochrane 20:10
So I’ll say like, three Harris’s margins are pretty good for a defense company. So there’s pros and cons to it. So take a satellite, right? Like, they don’t make the whole satellite, they don’t make the satellite get to space, right, but they do a lot of the stuff. A lot of the payload for the satellite, like why we’re putting that satellite up there is because of like the L3Harris equipment is on the satellite. So like, the satellite is to detect incoming nuclear missiles, right. L3Harris doesn’t have much to do with a satellite, to get all that equipment into space, right. But that’s a lot of times, that’s the lower margin stuff. And the higher margin stuff, like the sensors and electronic equipment, that has to be sensitive and survive in space, and all this stuff, is the higher margin stuff. And that’s what L3Harris does. Talking about an F-35, like, right, so, it’s, um, it’s, you know, L3Harris does not make the jet. And that is what wins, like, the decades long contract from the US Department of Defense and other countries. You know, like, that’s a huge advantage for Lockheed Martin.
Matt Cochrane 21:39
But a lot of the stuff inside of it, while it doesn’t come with that guarantee of 30 years of dominating that platform. It’s higher margin, though, the stuff that’s inside of it. I don’t know if this is quite accurate, but like trying to understand what L3Harris does, and like their electronic jammers and, and tracking and radar and communication equipment, like, you know in Top Gun at the end of the new Top Gun, and they’re going in and they’re like, well, we can’t send them to stealth fighter because, like, there’s jammers or something like that, you know, they’re trying to make a scenario plausible, where you can’t send in the stealth fighters. And you have to send in like the older jets that Tom Cruise used to do in the old Top Gun, right.
Matt Cochrane 22:28
And the stuff that the Technology Refresh 3 stuff that L3Harris is putting into the self fighters. Like, I think would like override that stuff. Right? So where you could just send in, like, some stealths, and you know, Tom Cruise wouldn’t have to go in and, and be a cowboy. So, you know, it’s a less exciting movie. But I think its higher margin stuff, I guess, is my is what I would say, but it doesn’t come with those, like super long contracts. Right?
Matt Cochrane 22:56
But I do think a lot of their stuff is higher margin, like they’re talking about this specifically for the satellites is where we’re talking about like the stuff they put on a satellite. That’s the high margin stuff on the satellite, if you want to win, you know, and whoever carries the L3Harris equipment up, that’s much lower margin.
Matt Cochrane 22:56
It’s easier for another company to compete for that kind of equipment inside the Stealth. I think it’s still hard, than it is to compete for the Stealth. I mean, you know, there’s, there’s like, there’s literally like two or three companies on Earth, I think that could even try to make a Stealth, you know, and the communication stuff and the electronics stuff inside of it. There’s more companies than that. Again, I think it’s so hard, you know, but there’s pros and cons to it.
Steve Symington 23:40
Don’t really have a question, but a comment kind of on some of that. You guys might recall that Textron was my old stomping grounds. I was a sales engineer for them. And L3 and Harris were both customers of ours. Actually, L3 was one of my larger accounts when I worked with them and in traveled and visited them a couple of times. And I don’t think a lot of people realize how, like how far their feelers go, and how deeply ingrained they are in so many systems and governments, you know, we were just selling – it was like LIDAR software and satellite like even feature extraction modeling software to them. But yeah, their presence is significant and they’re an impressive company. And I agree that I think they’re they’re attractively valued right now. So I’ve kind of kept a side eye on them, but never quite bubbled up to the top. So I’m glad to get him on the scorecard at this point.
Simon Erickson 24:49
Yeah, Hey, Matt, you said that L3 had a tough year last year because of supply chain disruptions. I assume if they’re doing electronics and really sensitive stuff for the government, they probably got some tight restrictions on, you know, who they’re going to get those chips from or whatever the supply chain looks like. Why do you think it’s going to improve in 2023 if it was having issues in 2022?
Matt Cochrane 25:11
I think like, just in general, like a lot of the supply chain problems from COVID are beginning to ease. Their stock got hit for a couple reasons at the end of the year. So like, if you, if you look at it’s price chart just compared to other defense companies, for most of 2022 it was having a very good year. And then the last, I’d say last quarter or so like it’s really taken a hit, which is why I think it’s kind of a good opportunity now.
Matt Cochrane 25:40
Okay, but that being said, they they did seem to suffer more from supply chain crunch than other defense companies. So like, the radios that the Army uses, right? And there’s like, I forget how many parts they said was inside of this thing. But it’s like, a ridiculous, right, like 1000s or 1000s, of parts. And they said, Look, if you’re Lockheed Martin, and you’re missing a park, for your F-35, you can still deliver it and get paid for it. And you’re going to put in that one little part later. They said for this radio, we can’t, we can’t deliver and get paid for it until it’s a radio.
Matt Cochrane 26:22
You know, so it’s part of their contract. So like it just at the beginning, and they were talking about all year, like I mean, all industrials, I think were going through the supply chain problem. They just thought it was going to ease more at the end of last year, and it didn’t. So they missed their estimates. I mean, not by a lot, but they missed their estimates, they lowered guidance, you know, in the third quarter and that certainly did not help. But they’ve been doing stuff on their supply chain all year, they’re trying to find new sources, trying to find new vendors, trying to make it more robust. I think as like, a lot of companies since COVID. You know, and two, I think it just continues to get better from, you know, as the further we get away from COVID, the better it seems to get.
Simon Erickson 27:13
And even though you were calling it, I think you were saying kind of like moderate/higher risk, because its a little more concentrated than that a large company like Lockheed, it still feels like a good choice for maybe more of a risk averse investor, just because they’ve got you know, the backlog in place, you know, such as such stable contracts. I mean, do you have thoughts on that matter? What type what type of investor this would be good for?
Matt Cochrane 27:35
Oh, yeah, depending how risk averse you are, if you want an exposure to the defense industry, you wanted to be more conservative, I’d say go with Lockheed Martin, to be honest with you, I think that is more risk averse. I think this is more of, even though I still classify as income, and I think that’s correct, especially when compared to other companies on our scorecard. It is more like a growthy, more exciting company in the defense space that has more upside potential than Lockheed, but also probably more downside risk. So, but of course, it’s less aggressive than some of our other companies. Right. But I like having exposure to both, Lockheed and L3Harris, to be honest with you.
Matt Cochrane 28:31
I think both companies like the defense industry, I really like because it’s sheltered from a recession and a lot of macro, like things that go wrong in the world. It’s sheltered from a lot of that. And, you know, I think there’s like international catalysts at play right now. As I reviewed, like most a lot of countries are raising their defense budgets in response to some of the global threats we’ve seen in last year or two.
Matt Cochrane 28:59
And I think when you talk about space, and the new US Space Force, and the things they’re going to do with satellites, I think L3Harris is gonna be involved in a lot of that. So I think they’re exposed to a lot of like, higher margin high growth stuff. There’s no guarantee they win those contracts. Right. So that that’s the risk, but I think they have a really good chance at winning a lot of those contracts in the next decade. So a little more risky than Lockheed.
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