L3Harris: As This Narrow Moat Contractor Takes on Rockets, Shares 18% Below Our $227 Fair Value

We are initiating coverage of L3Harris LHX with a narrow moat rating and $227 per share fair value estimate. Our valuation implies the shares are about 18% undervalued. The firm has completed the acquisition of ViaSat’s data link networking business, as well as the more transformative Aerojet Rocketdyne, which supplies rocket motors and munitions to the defense and aerospace industry. The company’s proprietary research and development and a stated pause in sizable acquisitions present the opportunity for it to achieve industry-leading operating margins, as it ingests those deals over time.

We will observe with interest how L3Harris’ strategic acquisitions unfold and to what degree they fulfill the company’s ambition to position itself as the “sixth prime” defense contractor to the U.S. military. Our tally of the portion of the U.S. defense budget comprising the bulk of the Defense Department’s development and procurement (and some of the operations and maintenance) line items serves as the primary market in which L3Harris and other defense contractors operate and compete. Revenue of the top two, Lockheed Martin and RTX, have hovered around 21% of this budget for years, with leaner General Dynamics and Northrop’s around 13%, and Boeing’s somewhere in between. The defense budget has been growing of late, but all of the top five contractors’ share has gradually decreased over the past three years, by an average of three quarters of a percentage point. In this backdrop, the combined L3 and Harris achieved just over 6% of the available budget in 2020, but had also seen its share steadily drop. Thus, we see a valid rationale in L3Harris’ pursuit of Aerojet, one of two U.S. suppliers of critical components and motors for missiles, rockets, and munitions, and one that the U.S. Defense Department would want to have viable and well funded as it replenishes and expands its stockpiles.