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Morningstar | L3 Beats on EPS but Profits and Cash Flow Disappoint, Looking Ahead to Harris Merger

Narrow-moat L3 Technologies reported fourth-quarter and full-year 2018 results ahead of consensus EPS thanks to a lower than expected tax rate, but operating profit and cash flow disappointed primarily due to the company's traveling wave tube activities. Management provided 2019 guidance (excluding any impact from the Harris merger) that featured margin expansion and solid, if somewhat conservative, revenue growth. We're maintaining our $207 fair value; our model incorporates the merger with Harris and assumes the deal closes midyear 2019.

In fourth-quarter 2018, revenue increased 8% year over year (7% organically) to $2.8 billion due primarily to increasing U.S. government sales (up 8% in the quarter). Segment operating margins expanded 50 basis points thanks to lower restructuring costs at the C&NS business and good performance at electronic systems and ISRS. For full-year 2018, L3 grew sales 7% and orders increased 16%. We were looking for full-year 2018 segment operating margins of 11.2% but L3 landed at 10.8% with most of the shortfall emanating from the C&NS business where margins contracted 240 basis points. Lifting off the losses of the traveling wave tube, or TWT, activities at C&NS reveals operating margins of around 11.5% for 2018.

We think 2019 guidance calling for 5% year-over-year revenue growth is on the conservative side, and management has admitted as much. Despite research and development spend remaining constant as a percentage of sales in 2019, margins should expand. Management anticipates 120 basis points of expansion in operating margins thanks to an accrual of pension benefits freeze adding 40 basis points and operations adding another 40 basis points; we think TWT headwinds should also abate. Free cash flow is pegged at just over $1 billion in 2019 by management compared with $935 million in 2018 due to higher operating cash flow combined with flat capital expenditures. L3 didn't give EPS guidance due to its pending merger with Harris.

Management stressed how the merger with Harris will accelerate the integration of L3's disparate businesses and therefore unlock synergies. While in theory this makes sense, we're a bit concerned that Harris is merging with an L3 organization that is in the process of transforming itself. Indeed, L3 is starting 2019 with yet another reporting structure after collapsing its four segments into three during 2018. In short, it might prove difficult to execute a merger and transform L3's business simultaneously. As a reminder, under the new L3 Harris Technologies company, management anticipates $450 million of integration costs to achieve $300 million of annual savings net of sharing with customers.