L3Harris (NYSE:LHX) is one of the key beneficiaries of the intense geopolitical environment, with wars breaking out in the Middle East and Eastern Europe, and concerns over a conflict surrounding Taiwan. There is hope for a diplomatic easing of tensions with the impending Trump administration. However, this is not the only factor contributing to international instability. Amid rising defense expenditures across NATO and other Western-alliance countries, militaries are also modernizing, creating robust demand for AI and autonomous weapons and vehicles. Based on this outlook, L3Harris is positioned for continued growth, but its CAGRs are still only likely to be moderate.
Operational and financial analysisL3Harris is one of the world's largest aerospace and defense technology companies, specializing in delivering space, air, land, sea, and cybersecurity solutions, including those for mission-critical operations. The business operates through three primary segmentsIntegrated Mission Systems, Space & Airborne Systems, and Communication Systems. The company has a strong collaboration with NATO, has partnered with entities like Al Taif in the UAE, and works with the Australian Defense Force, among other countries worldwide. Of course, its largest customer is the U.S. Department of Defense.
Recently, the company has been proactively expanding its autonomous defense offerings, supported by advancements in artificial intelligence (AI). It has partnered with Palantir (NASDAQ:PLTR), among other AI companies, to help establish itself as a resilient modern leader in defense in the coming decades. One of its key autonomous defense systems is an open-architecture command-and-control system for the U.S. Department of Defense under the Defense Innovation Unit, which enables the simultaneous operation of hundreds of thousands of autonomous drones, vehicles, and maritime systems.
The company is robust financially, but all indicators point to average return prospects given its track record of moderate growth (which is likely to slow down following particularly strong growth in late 2022 through mid-2024 due to the Ukraine war and outbreaks of war in the Middle East). The hope of many U.S. and Western alliance citizens is that war with China, the regional leader in the East, will not manifest. Figures like Trump consider this achievable through diplomacy and trade competition, remaining agile as the economic conditions of both the U.S. and China evolve. However, there are many hard negotiations to be had during Trump's presidency, including a peace deal to be outlined with Russia and Ukraine. Unfortunately, it appears that even in a period of lasting peace, the competition between Western and Eastern powers means U.S. defense spending will have to remain robust for a strong deterrent. L3Harris is also focusing on cost-saving initiatives like a $1 billion annual savings target under LHX NeXt, providing stability for long-term investors.
While the company may deliver upwards of 9.5% year-over-year revenue growth in Fiscal 2024, it is reasonable to forecast a more moderate 5% annual revenue growth rate over the next three years. This conservative outlook factors in reduced defense spending as a result of stronger diplomatic ties, though still showing growth due to the need for deterrence, as I outlined above. With the company's cost-saving initiatives, it will likely reward investors with robust normalized earnings growth. The company is likely to deliver 5.75% year-over-year normalized EPS growth in Fiscal 2024, but this could easily climb to 10% annually in the following two years given the LHX NeXt initiative.
Valuation analysisGiven that the global geopolitical condition is currently fragile, I am opting for a shorter-term valuation model to allow for a more predictable growth outlook. My five-year model estimates December 2029 revenue of $28.49 billion. Due to increasing profitability likely stemming from its cost-cutting initiatives, I am forecasting an EBITDA margin of 20% in five years. I believe this could also be supported by autonomy from AI within the organization. Therefore, my EBITDA estimate for L3Harris in December 2029 is $5.698 billion. The company has a five-year average TTM EV-to-EBITDA ratio of 14.57 and a five-year average forward TTM EV-to-EBITDA ratio of 13.56I will use the approximate midpoint of 14 for my terminal multiple. This is highly conservative (given the long-term uptrend in its EV-to-EBITDA ratios) but accounts for the LHX NeXt initiative and slower revenue growth in a time of potential diplomacy over aggression. The result is a December 2029 enterprise value estimate of $79.772 billion. The company's current enterprise value is $57.6 billion, implying a CAGR of 6.73% over five years.
L3Harris Technologies' weighted average cost of capital is 6.72%, with an equity weight of 76.8% and a debt weight of 23.2%. The cost of equity is 7.22%, and the after-tax cost of debt is 5.09%. When discounting the December 2029 enterprise value back to present-day value over five years using its weighted average cost of capital as the discount rate, the implied intrinsic value is $57.63 billion. The margin of safety for investment is therefore 0.046%the company is essentially fairly valued.
In a more bullish outcome, the company could achieve December 2029 revenue of $31.5 billion, and have an EBITDA margin of 22.5%. The result of this would likely be a higher EV-to-EBITDA ratio, for illustrative purposes, I will use 15.5. Therefore, L3Harris could have a December 2029 enterprise value of $109.86 billion, implying a 13.8% CAGR over five years. In addition, this also implies a margin of safety of 37.78%. This bull-case outcome heavily depends on increased defense spending to provide an effective deterrent against China's invasion of Taiwan and other international conflicts arising in the East.
CounteranalysisDefense contractors grow revenues the most during periods of geopolitical tension and defense spending. Moreover, demand for advanced defense technologies is also a critical catalyst for growth in leading defense contractors. These two dominant factors contributing to growth are currently present, and while I am hopeful for diplomatic relations between the West and East instigated by the Trump administration, it is not certain that these positive international relations will manifest. Indeed, the greatest concern for international diplomacy at this time appears to be who will succeed Trump in the White House after his four years have culminated. A return of the Democratic Party could lead to greater geopolitical instability if the line of communication and negotiation between NATO, Eastern European countries, the United States, Russia, and China is not maintained in good will.
However, prolonged conflicts can strain government budgets, and the Trump administration is not the only factor in maintaining strong international order. NATO's collective defense strategy and member nations' commitments to increase defense spending are independent of U.S. presidential changes. Moreover, diplomatic relations with Russia and China are shaped by broader geopolitical dynamics, such as trade policies, military alliances, regional conflicts, and economic competition. In addition, major hot wars, such as the one in Ukraine, cause supply chain disruptions that can have negative impacts on the growth and profitability of leading defense contractors. Evidently, in the case of a major international nuclear war, the negative impacts on global economics, including the valuations of defense companies, would likely be significantly depressed.
Yet, with the current AI landscape and trends in technology modernization, even under stable geopolitical conditions (which seem difficult to predict with certainty), growth for defense contractors is quite likely to remain robust. AI is being integrated into almost all modern defense technologies, other than nuclear weapons. Autonomous systems and cybersecurity are becoming critical priorities for governments around the world that L3Harris serves. Therefore, this is a period of accretion for L3Harris unless the international landscape turns into a global hot conflict, at which point many valuations in most industries, defense contractors included, will experience heavy volatility.
ConclusionAt this point in history, it appears paramount that both Western and Eastern powers find common ground to discuss reparations to the international order. A failure to do so could draw the world into a hemispheric conflictwhile this may sound like it would benefit L3Harris, in a worst-case scenario of a nuclear conflict, the valuations even of defense companies could become severely depressed. While developing a robust deterrent with AI is paramount, the West would be wise to approach its defense spending with balanced moderation. Overinvesting may be just as detrimental to international relations as underinvesting. The company is fairly valued in a conservative case, but it might achieve an enterprise value CAGR of close to 15% over the next five years with a stronger stance on international defense by the Trump presidency.
This content was originally published on Gurufocus.com
