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Morningstar | L3 and Harris Order Dessert to Top Off the 'Last Supper' Consolidation Wave That Began 25 Years Ago

The highly consolidated U.S. defense industry traces its roots to a 1993 meeting between contractors and the Department of Defense, where the former were instructed to merge because of budget cuts; industry executives refer to this event as the "last supper." The denouement of this consolidation wave was unveiled Oct. 14 with the announcement that L3 Technologies and Harris will merge to create L3 Harris Technologies. This is an all-stock merger (1 Harris share to 1.3 L3 shares) and management anticipates closing mid-2019. Although we think there are some regulatory hurdles (perhaps regarding night vision and data links), our sense is that the U.S. government will ultimately approve the deal. The merger makes sense: U.S. defense budgets are growing, and there is limited product overlap but significant cultural, end-market, and core technology overlap between L3 and Harris.

From a valuation perspective, we think it's a positive for L3. The shares are up nearly 13% since the news and management anticipates $450 million of integration costs to achieve $300 million of annual savings net of sharing with customers. We are putting L3 under review to analyze our fair value estimate and also our narrow moat rating, with an eye to potentially upgrading it.

The combined entity has pro forma 2018 revenue of $16.4 billion with operating margins of 14.6% and free cash flow close to $2 billion. By the third year of operations, L3 Harris should be at approximately $19.5 billion in revenue (our estimate) with at least a 16.5% operating margin including cost synergies but excluding about $500 million of intangible amortization. Free cash flow should land at $3 billion per management.

Management touts L3 Harris Technologies as the creation of a sixth U.S. defense prime contractor. Per our analysis of U.S. defense contracts, L3 Harris should capture about 5% of the defense hardware market, vaulting past BAE's U.S. arm but still sitting 300 basis points below General Dynamics.

We've never understood why defense companies are so enamored with the prime contractor moniker, given the higher margins available to large mezzanine suppliers; these margins typically come with a bit less program control and more operating leverage. In any event, we think L3 Harris will continue to act as a supplier, and given the long lead times in the defense industry, a shift to prime contractor roles on programs will take several years. Culturally, the companies are a good fit, in our view, with L3 and Harris both pursuing hybrid commercial and defense business models that feature higher levels of research and development spending and more cross-company technology sharing and cooperation than many peers.

Per our calculations, seven contractors now control just over 80% of the U.S. defense hardware market. This translates to an Herfindahl-Hirschman Index hovering above 1,500, which the Department of Justice typically considers moderately concentrated. However, the DOD and DOJ are likely to assess the deal from a much more granular perspective, and we think there might be a few areas like electro-optical/infrared technologies (for example, night vision), data links, and potentially some electronic warfare equipment that could come under heightened regulatory scrutiny. That said, we believe the deal will pass regulator muster. Ellen Lord, the new undersecretary of defense for acquisition and sustainment, who will oversee much of the competition review, recently said, in the context of mergers, "We like market forces to play out; it's by exception that we would intervene."

Should there be forced divestments as part of a preclose settlement, we think other, larger defense peers with more limited equipment content would happily snatch up the assets. Given the existence of only a half dozen or so large defense hardware players and the DOD and DOJ happy with the level of concentration among the largest prime contractors, we don’t envision the L3-Harris tie-up spawning major industry consolidation. But speculation around a potential Boeing and Northrop tie-up would undoubtedly heat up, should the U.S. government wave the L3-Harris merger through without any objections.

The U.S. defense manpower services market continues to consolidate rapidly, but apart from General Dynamics, which snapped up CSRA earlier this year, the hardware players have largely exited the manpower services business. We do think this deal ramps up the pressure a bit on defense mezzanine supplier Rockwell Collins, which is now facing a much larger combined L3-Harris competitor with substantial R&D firepower. But fortuitously for Rockwell's management team, it will be folded into the much larger United Technologies later this year.

From a growth perspective, the pro forma L3 Harris Technologies should achieve organic revenue growth approaching 6% year over year in 2018, and per consensus, 2019 and 2020 should be close to this pace of growth as well. However, based on our detailed work on DOD outlays to industry outlined in our recent piece, "Investors Are Hungover on Defense Stocks but the Spending Party Hasn't Even Started Yet," we're above consensus growth for L3 in 2019.

The merger should generate an annual run rate of $300 million pretax cost synergies by year three of the combined entity; gross pretax synergies are pegged at $500 million, but defense companies typically share at least one third of their efficiency gains with U.S. government customers. Within the cost synergies, direct costs like shared services and segment consolidations will constitute about 20% of the total with indirect costs (suppliers and footprint rationalization) making up the remainder. To achieve these synergies, the new company will spend $450 million, with about 60% of this spent within the first 12 months of close. Although management didn't quantify any revenue synergies, it did point to ISR, secure communications, electronic warfare, and space systems as verticals that are ripe for enhanced sales campaigns. Based on management comments and excluding any potential revenue synergies, we think the company will reach break-even on its integration costs around the third or fourth quarter of 2020, a little over one year after the currently planned closing.

In terms of management structure, current Harris CEO William Brown will become chairman and CEO of the new L3 Harris Technologies. L3 CEO Chris Kubasik will serve as president and COO but should be named CEO of the company two years following the deal’s closing, which based on a mid-2019 close would be toward the end of 2021, and then become CEO and chairman near the end of 2022 or beginning of 2023.