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Which IT Firm Serving Defense Is Riding Tailwinds for Aerospace Electronics?

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Resurgent commercial demand combined with a politically resilient defense budget will propel this undervalued stock to the front ranks of the aerospace sector.

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As worldwide defense spending shows more strength than widely anticipated and the battered civilian aerospace market shakes off its slump, companies with long-time expertise in aircraft electronics will emerge as huge winners.

Harris Corp (NYSE:HRS), an international communications and information technology company, is well positioned to gain from these trends by virtue of its innovative products and client diversification.

Based in Melbourne, Florida, the company ($5.6 billion in market cap) is divided into three segments: Radio Frequency Communications, Integrated Network Solutions and Government Communications Systems.

What gives Harris long-term staying power is an approximate 50/50 split between commercial and government clients, which allows it to weather a slump in either sector. For the company's full fiscal year 2012 (ending in June), revenue reached $5.5 billion, roughly half from the commercial sector and the other half from government agencies including the Federal Aviation Administration (FAA) and the Pentagon. This dichotomy helped the company survive the brutal slowdown in commercial aviation, which is finally showing signs of easing.

Meanwhile, the military electronics market will be fueled over the next decade by expanding airlift operations worldwide and the corresponding need for new communication, navigation and surveillance technologies that allow military aircraft to share airspace with commercial aircraft.

These are the very technologies in which Harris excels. Harris' products include combat radios, fighter-jet cockpit communications and command-control systems for military planners.

Harris helps end-users contribute to product development by maintaining a transparent supply chain that fosters collaboration and integration. This "groupware" approach to its supply chain ensures that each of the vendors contributing to an avionics or communications system produces standardized modules that can be easily integrated. Hence the company's oft-repeated motto: "Right item, right supplier, the first time."

The US military covets the company's products and Uncle Sam is one of the most profitable and reliable clients a business can serve. The Department of Defense (DoD) budget for 2012 is roughly $525 billion, up 89% since 2001. And despite investor fears of draconian cutbacks, reports of military spending's demise are highly politicized and greatly exaggerated.

Between now and the end of 2012, Democrats and Republicans must put aside their rancorous differences and somehow forge a compromise to avoid the dreaded "fiscal cliff," the term for drastic spending cuts and tax increases passed last year by Congress to prevent a first-ever US government default.

If January arrives without a federal budget agreement, investors can anticipate a broad selloff of stocks. The typically sacred DoD would be a major casualty of the fiscal cliff, with a projected $55 billion in reductions from current levels of discretionary defense spending in 2013. That represents a minimum 10% cut to nearly every defense program and activity.

Military hawks are loudly protesting these potential military cuts and key committee chairmen on Capitol Hill are working overtime to rescue defense from the chopping block.

The smart bet, though, is that the military won't hold a bake sale anytime soon. Students of politics know that the Pentagon almost always gets its way.

Despite the increasingly nasty partisan rhetoric, there's a strong likelihood that reason will prevail and a political deal will be hammered out before the tax and fiscal package is automatically triggered on January 1, 2013.

Military spending is likely to grow, regardless of which party occupies the White House or controls Congress. Robust Pentagon outlays in turn boost high-margin military electronics, which is Harris' forte.

The secular trend for greater military aerospace spending is global. According to the Teal Group, aerospace consultants based in Fairfax, Virginia, the world's air forces are at various combat aircraft replacement and upgrade cycles, which is good news for the avionics and electronics market. Despite calls for austerity in troubled euro zone countries, the aerospace market remains a global arms bazaar.

With their coffers full of "petro-dollars" and tensions in the region rising, Middle Eastern sheikdoms have been in a mood to buy fighter jets and communications systems. At the same time, most NATO countries are in an active replacement phase for their 1970s designed aircraft, while emerging nations such as India will evaluate entirely new aircraft sources in the near future.

More than 5,000 combat aircraft will enter service globally over the next decade, with a peak of 524 deliveries in 2014. These aircraft require sophisticated electronics and communications systems-Harris' area of expertise and a market whereby it enjoys loyal, repeat clients.

On the Bargain Counter

Despite these long-term advantages, the company's stock now trades at a bargain because of a disappointing first-quarter performance. On Oct. 29, Harris reported a net loss of $85.8 million in its first quarter for fiscal 2013, compared to net income of $121.6 million during the same period last year. The company also reported a 5.9 percent drop in revenue to $1.26 billion compared to $1.34 billion in 2011.

However, most investors are overlooking the fact that these numbers represent a one-time setback. Management blamed the earnings misfire on large impairment charges in the first quarter from discontinued operations in broadcast communications and cloud-computing data services, as the company seeks to focus on its core aerospace operations-a wise move that will payoff over the long term.

Orders in Harris' pipeline point to continued strong growth in the second quarter, but with a trailing price-to-earnings (P/E) ratio of about 8, the company remains attractively valued compared to the peers. Defense stocks now sport a trailing P/E of 10, compared to the trailing market P/E of 11.

In a harbinger of future success, Harris on Oct. 30 received a new $50.5 million order from the US Army for next-generation satellite communications terminals. Harris is the prime contractor for the five-year contract, which has a ceiling of $600 million.

Also in late October, Harris was awarded a DoD contract worth $397 million to continue providing it with its Falcon III handheld tactical radio systems.

Harris generates strong free cash flow and on Oct. 26 increased its dividend by 12 percent, the second increase this calendar year. The company declared a quarterly dividend of $0.37 per share, or $1.48 annualized, for an annual yield on the dividend of 3.1 percent.

The company also plows a considerable amount of its resources into research and development, maintaining a staff of 7,000 engineers and scientists, out of a total workforce of 15,000.

Harris' investment in technology innovation will continue to pay off for the company and its investors, this year and beyond.

This article by John Persinos originally appeared on Investing Daily.

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No positions in stocks mentioned.
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