L3Harris Technologies: Future Dividend Aristocrat With Annual Return Potential (NYSE:LHX)

Introduction

It’s time to do one of my favorite things: Discuss L3Harris Technologies, Inc. (NYSE:LHX).

It’s one of the four defense giants in my portfolio, which together hold roughly a fifth of my net worth. On top of that, I have given this high-conviction investment a Strong Buy rating as I believe it offers the perfect mix of growth and value.

My most recent article on the stock was written on February 11, when I went with the title “L3Harris Technologies: My Favorite Dividend Growth Stock Continues To Fire On All Cylinders.”

Since then, shares are up 2%, outperforming the S&P 500 by roughly 40 basis points.

In that article, I highlighted a few important aspects of the company including its fantastic diversification. As the overview below shows, the company has major exposure in all defense “domains,” making it one of the most important suppliers and contractors in the United States and the entire NATO sphere.

It also completed the acquisition of Aerojet last year, adding a new pillar to its growth story as it’s now a key supplier in missile and rocket propulsion, allowing it to address more than 50% of the content of every single missile program.

Currently, the company is in the phase of reducing debt, which has slowed down dividend growth and buybacks.

The good news is that LHX is now in a situation where tailwinds align:

• Defense demand is strong – boosted by international growth.
• Margins are improving.
• The company is quickly reducing net debt, paving the road for higher distributions in early 2025.

In this article, we’ll discuss all of this and more as I explain why LHX remains one of my all-time favorite dividend growth stocks and a core holding of all family portfolios.

So, let’s get to it!

Demand And Efficiency Tailwinds Are Aligning

I have been overweight defense companies since I started buying them after the pandemic. However, last year, I took things to the next level when various sell-off opportunities allowed me to throw a lot of cash at my favorite defense players.

The past few years have been tough for defense companies. They were consistently hit by a mix of headwinds, including supply chain headwinds, inflation, and budget uncertainty in Washington, D.C.

Now, things are improving. As I wrote in the introduction, tailwinds are aligning, allowing investors to bet on what will likely be a prolonged period of consistent growth and improving shareholder distributions.

During its latest earnings call, the company emphasized its favorable demand environment, which comes with a new $844 billion defense bill. L3Harris’ programs are well funded as it has the right programs to satisfy evolving defense requirements. This has resulted in a 1.06x book-to-bill ratio, which means it gets $1.06 in new orders for every $1.00 in finished work. It now has a $32 billion backlog.

This includes deals like a $150 million network security deal with Taiwan and an international pipeline worth more than $10 billion – on top of the fact that L3Harris is a key supplier to Ukraine.

Our products are being used in theater and exceeding expectations. The supplemental bill will provide our allies access to needed capabilities while at the same time support the U.S. defense industrial base, including small and midsized businesses. With the bill just recently passed, we will give you more information during the next earnings call on the incremental opportunities that provides. – LHX 1Q24 Earnings Call (emphasis added)

One of its peers and customers, Lockheed Martin Corporation (LMT), is also upbeat about the FY2025 Presidential Budget request:

We expect FY2025 Presidential Budget request and additive supplemental funding will provide a strong underpinning for future growth over the next several years for our company, giving us further confidence in our long range plan. – LMT 1Q24 Earnings Call

Its other peer, Northrop Grumman Corporation (NOC), which has alignments with L3Harris products as well, confirmed this as well:

In March, the administration released the 2025 defense budget, and future year’s defense program, or FIDGET [ph]. And these also were consistent with our expectations. We continue to see robust support for our program portfolio in areas that include nuclear modernization, microelectronics, advanced weapons, and space. – NOC 1Q24 Earnings Call

It also helps that strong demand comes with lower development risks as the company sees a significant decline in program development risks, which should add growth visibility and lower operating risks.

On top of that, the company is increasingly focused on operating efficiencies as it has started a comprehensive cost-saving initiative called the LHX NeXt program.

This initiative aims to achieve $1 billion in gross cost savings by 2026 through the strategic optimization of the workforce, infrastructure, and supply chain.

Successes also include a decline of 20% in late deliveries since the Aerojet acquisition and the fact that it could turn multiple programs back to “green” by improving deliveries of critical products for the Department of Defense.

Before I tell you what this means for shareholder distributions, let’s take a closer look at the company’s numbers.

Billions In New Businesses and Great News For Shareholders

Putting everything together, the company saw 17% higher revenue, with organic revenue of 5%, supported by three of four segments. Operating margins improved to 15.1%, allowing EPS to grow by 7%. On a pension-adjusted basis, first quarter EPS was up more than 10%.

As we can see in the overview above, revenue growth was fueled by the acquisition of Aerojet Rocketdyne and organic growth in the Space Systems (“SAS”) and Tactical Communications segments.

Moreover, operational improvements across all segments contributed to margin expansion, particularly in SAS, where margins increased by 100 basis points.

To add some color, the Space Systems segment benefited from the launch of five L3Harris missile-tracking satellites as part of the SDA tracking Tranche 0 and HBTSS programs.

The company was also selected as the primary propulsion provider of the Missile Defense Agency’s next-generation interceptor (“NGI”).

This is a big deal as the NGI program is designed to protect the U.S. against advanced missile threats.

The NGI program plans to replace the current Ground-Based Midcourse Defense interceptors, which are tailored to threats from ballistic missiles launched by actors such as North Korea or Iran. Lockheed is partnered with now-L3Harris subsidiary Aerojet Rocketdyne. – Breaking Defense

Without the Aerojet Rocketdyne deal, L3Harris would have missed exposure to this critical defense area.

In light of demand and margin tailwinds, LHX raised its guidance. Not by a lot, but even small adjustments show that improvements are on the horizon.

As we can see below, the company tightened its revenue guidance range to $20.8 billion to $21.3 billion and reaffirmed its commitment to achieving a free cash flow of $2.2 billion.

Moreover, total company margin guidance for the year was increased to greater than 15% (instead of roughly 15%) with expectations for the Space Systems segment margin raised to approximately 12%. That’s a 1-point improvement.

Earnings guidance was increased to the $12.70 to $13.05 per share range.

This is great for shareholders. Not just because higher guidance is never bad but also because it bodes well for distributions.

The company replaced variable-rate debt with fixed-rate debt, saving 150 basis points. It also hiked its dividend (2.2% yield) for the 23rd consecutive year, which means it’s two years away from potentially becoming a Dividend Aristocrat.

This dividend hike was announced on Feb. 23 when the company hiked by 1.8%.

The company also resumed buybacks and expects to receive roughly $1 billion in gross proceeds from divestitures.

These funds will mainly go toward debt reduction as the company aims for a sub-3x EBITDA leverage ratio, which could be achieved at the end of this year.

Analysts expect net leverage to drop to 2.7x at the end of this year.

Once the company achieves its target, it will return 100% of excess cash to shareholders, which brings me to the valuation.

Valuation

This year, the company expects to generate roughly $2.2 billion. That’s 5.5% of its $40 billion market cap. To put things in perspective, the company could return 5.5% of its cash flow to shareholders this year.

That’s an impressive number.

However, this is just the start.

Analysts expect free cash flow to gradually improve to $2.9 billion in 2026. That would be more than 7% of its current market cap. By then, it will (almost certainly) be in a spot to return all of it to shareholders.

This makes LHX extremely attractive as it could boost the total return, fueled by dividend growth and buybacks.

This alone is a reason for me to stick to a Strong Buy rating.

However, using earnings per share growth, we can make the same case.

Currently, LHX trades at a blended P/E ratio of 16.6x. This is slightly above its long-term normalized P/E ratio of 16.2x. However, as I wrote in my prior article, the company’s stronger growth profile warrants a higher multiple, which is why I gave it an 18x multiple.

As we can see in the chart below, EPS growth is expected to accelerate to 11% in both 2025 and 2026. When adding its 2.2% dividend yield, we get a total return outlook of 14% per year. Since 2003, LHX (the company was L3 before 2019) returned 14.7% per year.

All things considered, in a market with an overall lofty valuation, I continue to be a buyer of LHX on any corrections as I believe it will be one of my best performers for many years to come.

Takeaway

L3Harris continues to stand out as a top pick in my portfolio, backed by strong fundamentals and promising growth prospects.

In light of favorable demand and efficiency tailwinds, the company’s recent achievements and strategic initiatives signal strong potential for shareholder distributions.

With a strong growth trajectory in revenue, margin expansion, and improved guidance, LHX demonstrates resilience and adaptability in the defense sector.

Furthermore, its commitment to debt reduction and returning excess cash to shareholders underscores its shareholder-friendly approach.

Considering its attractive valuation and anticipated total return outlook, LHX remains a very compelling investment opportunity for long-term gains and income growth.

Pros and Cons

Pros:

• Strong Growth Potential: LHX offers a compelling mix of growth and value with a promising outlook fueled by favorable demand and efficiency tailwinds.
• Resilient Performance: The company has demonstrated resilience amidst challenging market conditions, supported by its diversified revenue streams and strategic initiatives.
• Shareholder-Friendly Practices: LHX’s commitment to debt reduction, dividend growth, and share buybacks reflects its dedication to enhancing shareholder value.
• Anti-cyclical demand: Because it’s a defense giant, almost all of its sales are anti-cyclical.

Cons:

• Debt Reduction Impact: Because LHX is focused on reducing debt, it has temporarily slowed down dividend growth and buybacks.
• Market Volatility: Like any investment, LHX is subject to market fluctuations, which could impact short-term performance.
• Competitive Landscape: LHX operates in a competitive industry, facing competition from other defense companies and potential regulatory challenges.