L3Harris Technologies

L3Harris replaced its board chair and CEO Chris Kubasik with independent director Lewis Hay and Sam Mehta, respectively, following an investigation into Kubasik and the firm's code of conduct. The company in turn promoted new heads of the space and communications units formerly led by Mehta.

Why it matters: Kubasik led the combined L3Harris as CEO since 2021 through remarkable corporate transformation, growth, and industry turbulence. His sudden departure following a code of conduct investigation highlights the importance of coherent succession planning among executive leadership, and L3Harris obviously has activated its plan. We don't expect this series of executive turnover to alter the firm's strategy or prospects, and we view the new management team as seasoned and well placed to lead the company forward. The board mentioned in its announcement of the changes that Kubasik's conduct under investigation did not relate to "financial reporting, controls, customer relationships, or operational performance," which we surmise leaves something more personal or personnel-related, or both, in scope.

The bottom line: We haven't altered our $340 fair value estimate for narrow-moat L3Harris' shares, which now trade at around a 17% discount.

Our $340 fair value estimate implies an enterprise value to 2026 EBITDA multiple of 17.5 and 29 times our 2026 estimated earnings. The firm has its work cut out, but we think it can continue to improve margins through operating leverage and cost-cutting across its combined businesses.

We anticipate L3Harris' top line will grow at a 5.8% compound annual rate over our forecast period excluding the eventual divestiture of its commercial space propulsion business. We believe that despite increased US fiscal leverage, defense spending will continue growing faster than GDP for a few years because of heightened global geopolitical tensions.

We anticipate margin expansion over our forecast period, driven by synergies from L3Harris' series of mergers. We think the firm can improve GAAP operating margins from an average of 8.7% between 2023 and 2025 to about 13.5% by 2030. The firm achieves some of the best operating margins in the defense contracting business by developing its products primarily through internal research and development, which enables it to command premium pricing with customers.

We don't anticipate material changes in the firm's reinvestment from its mergers. We project capital expenditures to reach 2.5% of sales in a normalized setting, slightly below the defense industry average, as the firm produces smaller, less capital-intensive products. We forecast a spike in capital expenditures related to its missiles business, with most of the funds coming from the US government's investment in that venture. We expect L3Harris to allocate about 4% of sales to internal R&D, which is higher than peers and should provide the firm with a high-margin growth runway.

We use a 7.7% weighted average cost of capital, which is on par with the larger pure-play defense contractors we cover.

We assign L3Harris a Narrow Morningstar Economic Moat Rating due to its intangible assets and customer switching costs.

Economic moats are prevalent in the defense industry. We believe significant intangible assets imparted by extreme product complexity thwart new entrants. The switching costs that a risk-averse customer faces emerge from the mission-critical nature of the products, often decadeslong product lifecycles, and prohibitive time and cost to switch suppliers. We think that L3Harris benefits more from the switching costs related to the programs it deploys with customers than the inherent complexity of the development of very long-cycle systems, which the firm provides integrations with but does not primarily design and manufacture like its larger competitors. The firm tends to earn returns on invested capital in the low teens, exceeding our 7.7% estimate of its cost of capital, and we forecast it to continue to do so for at least a decade.

We believe incumbent firms are most eligible to service the military’s need to purchase arms (broadly defined). Arms production requires specialized expertise and usually lacks commercial viability outside of defense (aside from commercial aerospace), so new entrants would likely need to develop know-how from the ground up. We observe only a few capable incumbents in each major category of defense systems development. The SIPRI arms industry ranking shows limited competition: Lockheed Martin, Boeing, BAE Systems, RTX, Northrop Grumman, Airbus, and General Dynamics have remained the top six or seven global arms producers for the past 15 years. L3Harris ranked 10th in 2024.

L3Harris has built or acquired an enviable portfolio of communication, intelligence gathering, and avionics products, and we anticipate that it is more likely than not to continue earning economic profits. Product development can take years, and if the military is dissatisfied with a product, it is much faster and easier to work with the existing contractor to fix it than to fund an alternative. We view the products with the longest procurement cycles, like aircraft, ships, and strategic missiles, as the moatiest because they provide extraordinarily long-term revenue and profit visibility. We view short-cycle products such as defense IT contracting less favorably. Further, the military’s ability to succeed while protecting soldiers’ and civilians’ lives is contingent on these products working as intended, which we think protects proven suppliers from competition.

In space and mission systems, totaling about half of company sales, the firm produces and maintains a diverse set of sensors and control systems for satellites and other military vehicles as well as uncrewed underwater vehicles. These sensors are used for missile defense, surveillance, targeting, and interfleet communication. We think L3Harris benefits from barriers to entry from the extensive expertise required to produce these high-end sensors and UUVs. We see switching costs in the form of integration on longer-cycle and more-complex products, for example, by maintaining communication systems for attack submarines and ships that have decadeslong useful lives and are unlikely to change their communication systems to save on sensor maintenance.

In its communication and spectrum segment, the firm produces military-grade encrypted radios and broadband communication equipment and has product placement on a variety of aircraft, ships, and other vehicles. We see modest complexity-based intangible assets embodied in the company’s radio franchise. While plenty of firms create radios, sensors, and broadband networks, far fewer can provide them with sufficient speed, encryption, and durability to operate properly despite an adversary’s attempts to jam and disrupt them. While most of the time, complex manufacturing processes mean that firms do not compete much once a product is integrated onto a platform, there are some instances of recompetes. F-35’s Block 4 purchase included a dramatic upgrade to the cockpit and computers powering the aircraft. L3Harris won additional content on the F-35 from this upgrade, but we view the fact that the components were recompeted in the first place as indicative of less favorable business dynamics in comparison with the wide-moat defense contractors we cover.

The missile solutions business is one of the moatiest parts of L3Harris and accounts for about 18% of company sales. Solid rocket engines are a critical and notoriously difficult-to-produce component for medium- and long-range missiles. There are only two producers in the US, with a third being a partnership between Lockheed Martin and General Dynamics. L3Harris acquired this business as Aerojet Rocketdyne in 2023. The other incumbent in this area, Orbital ATK, was acquired by Northrop Grumman in 2018. Industry demand has outstripped supply for some time, and we do not see the third entrant as deteriorating this subindustry's attractiveness, in which the producers of solid rocket motors act as suppliers to firms they otherwise compete with on other programs.

Risk to L3Harris’ economic moat exists in the possibility, however remote, of a significant lapse or error in its government contracting or production processes causing its exclusion from delivering key defense systems. More broadly, if a malfunction, breach, or vulnerability of one of the company’s systems jeopardized military readiness, security, or capability or caused casualties, it would represent a key product governance failure on the part of the company and could be seen as a breach of the moat if it led to exclusion from a major program family or suspension from federal contracting. No single program represents more than 10% of our forecast returns, so we see the company as diversified enough and the risk remote enough not to model it in our forecast.

L3Harris' strategy to position itself as the "sixth prime" US defense contractor could offer growth potential if it is able to bid for programs it could not take on as a smaller and more specialized contractor.

L3Harris is at the base of a global replacement cycle for tactical radios, which we think will drive substantial growth.

Defense contractors operate in an acyclical business, which could offer some protection if the US enters a recession.

L3Harris depends on US military funding, which is an inherently political and thus uncertain process.

We expect that, for better or worse, L3Harris’ top line will be more reactive to changes in defense spending than longer-cycle peers.

Recent and future acquisitions may distract management and have at times attracted regulatory scrutiny.