EUR 850.00 For Business Accounts Only

Morningstar | Market Fully Valuing Merger of L-3 and Harris

L-3 Technologies and Harris Corporation have announced plans to merge and after modeling the merger, we're raising our L-3 fair value to $207 up from $204 per share. Our model values the newly formed company, L-3 Harris Technologies, by assuming it begins operations by mid-2019. As outlined in our Oct. 15 note, we think the deal makes strategic sense thanks to limited product portfolio overlap but highly complementary cultural, end-market, and core technology between the two companies. Our valuation indicates that the market is fully valuing the potential of a combined L-3 and Harris entity with L-3 shares currently trading at only a slight premium to our $207 fair value estimate for the merged company. In addition to our valuation changes, we reviewed our moat rating on L-3 and we're maintaining our narrow moat following the merger announcement.

Our valuation model assumes that management hits all of the targets it outlined as part of its merger announcement. Specifically, we think the annual cost synergies of $300 million pretax are achievable. And although our model doesn't embed any revenue synergies, we do forecast robust compound annual growth of 6.4% for the new entity based on 2018 pro forma revenue of $16.4 billion and our forecast of just under $30 billion of revenue by 2022. We peg operating margins at 15.4% in 2022, which are about 80 basis points higher than pro forma 2018 margins despite significant intangibles amortization linked to the merger. Our profitability projections include cost savings reaching an annual run rate of $305 million, which is just a touch above management guidance. Excluding the additional intangibles amortization related to the deal, we arrive at operating margins in 2022 of around 17.2%. These margins are well above the mid-16% level management has mentioned for the 2021 to 2022 timeframe. Free cash flow increases to $3.3 billion in 2022 up from 2018 pro forma of $1.9 billion.

Our narrow moat rating on L-3 in the wake of the planned merger is underpinned by the intangible asset and switching cost moat sources that both L-3 and Harris possess. The companies' intangible assets are built on highly engineered products that are often bespoke to the defense market. Switching costs rest on the fact that defense customers typically fund development of their new products and this plus a high cost of failure (weapon systems need to work practically 100% of the time) make them reluctant to try unproven products or services. While the increased scale of a merged L-3 and Harris could conceivably lead to market share gains, we don't generally view size as an intrinsic competitive advantage and therefore we've held off on a moat upgrade.