L3Harris: My Favorite Dividend Growth Stock Continues To Fire On All Cylinders (NYSE:LHX)

Introduction

On December 20, I wrote an article titled “14% Annual Return Potential: L3Harris Is My Favorite Dividend Stock Going Into 2024.”

In that article, I took an extremely detailed look at the well-diversified defense contractor L3Harris Technologies (NYSE:LHX), which has become one of the most important pillars of NATO defense capabilities after a major merger in 2019 and a series of divestitures and M&A projects, including Aerojet Rocketdyne.

In addition to major exposure in multi-domain defense, semiconductors, space defense, and surveillance, I explained that the company now has products in more than 75% of all domestic missile programs, which underlines just how powerful LHX has become.

Here’s a part of the takeaway from that article (emphasis added):

From its anti-cyclical business model to a commitment to innovation, L3Harris ticks all the boxes.

The recent Aerojet Rocketdyne acquisition has not only broadened capabilities but also opened doors to lucrative opportunities in the space industry.

With a clear vision outlined in its 2023 Investor Day, including a robust roadmap and shareholder-friendly initiatives, L3Harris appears poised for sustained growth.

[…] Shareholders can anticipate not just dividends but substantial value as LHX navigates a path of sustained growth and profitability.

In this article, I’ll elaborate on all of this, as the company recently released its earnings, which confirmed a strong demand environment and the fact that we are getting very close to a situation where both dividends and buybacks will accelerate, as LHX is aiming to distribute every penny of free cash flow to shareholders in the future.

When adding its attractive valuation, I continue to believe that LHX is one of the best dividend stocks money can buy.

So, let’s get to it!

L3Harris Is Poised For Consistent Growth

In 2023, L3Harris marked the fourth full year since the merger between L3 Technologies and Harris Corporation, two companies with rich histories.

This merger aimed to create a stronger entity with enhanced capabilities in the defense, aerospace, and technology sectors.

Despite challenges posed by macroeconomic disruptions over the past few years, L3Harris managed to meet its financial commitments and return to a trajectory of growth, as we’ll discuss in this article.

According to the company, these achievements underscored the effectiveness of the merger and integration efforts in creating synergies and unlocking value for stakeholders.

Additionally, the sale of a noncore business further streamlined the company’s portfolio, aligning it more closely with its core competencies and strategic priorities.

As some readers may know, I have more than 25% defense exposure in my dividend portfolio. The reason why I like LHX is so much is it streamlined and diversified business.

It is not dependent on certain major high-value projects, but it supplies all major defense contractors, allowing it to spread risks and benefit from growth in very specific areas without having to take on elevated risks.

Financially speaking, L3Harris reported robust performance for the fiscal year 2023, with notable increases in all indicators that matter, including revenue, operating margin, and earnings per share.

Total revenue reached $19.4 billion, representing a 14% year-over-year increase, driven by strong demand for its products and solutions.

Meanwhile, the segment operating margin stood at 14.8%, reflecting the company’s ability to effectively manage costs and improve operational efficiency in an environment of sticky inflation.

We also see strength across the board.

• SAS reported revenue of $6.8 billion for the year, representing a 7% increase compared to the previous year. The segment’s strong growth was driven by robust performance in areas such as Space, Mission Networks, and Intel and Cyber programs.

However, despite revenue growth, the segment operating margin for SAS was 11.4%, down 30 basis points compared to the previous year. This margin decline was attributed to growth in early-phase space programs, with expectations of margin improvement as the segment transitions into the more mature production phase of these programs in 2024.

• IMS reported revenue of $6.6 billion for the year, roughly flat compared to the previous year. The segment’s performance was impacted by program challenges and a lower international mix.
• CS reported revenue of $5.1 billion for the year, representing a significant 20% year-over-year increase, including 12% organic growth. The segment’s revenue growth was driven by a higher volume of tactical communication equipment and the acquisition of Tactical Data Links (“TDL”).
• Aerojet Rocketdyne, which was acquired in 2023, reported revenue of over $1 billion for the post-acquisition period.

Even more important than revenue growth is future revenue growth, which is why strong orders matter so much.

In 2023, the company got roughly $23 billion in new orders, pushing its book-to-bill ratio to 1.18x. This means that for every $1.00 in finished work, the company gets $1.18 in new orders.

It now has a backlog worth $33 billion. When it merged, that number was $16 billion.

To give you a bit more details, the company witnessed strong demand, particularly in sectors aligned with national security priorities. Key awards included contracts for the U.S. Army’s manpack and leader radios, Compass Call missionized business jets, and rocket motors for the Army’s guided multiple-launch rocket system.

Internationally, orders also saw a notable uptick, with a 24% increase compared to the previous year. These orders encompassed tactical radios, VAMPIRE systems for Ukraine, and an international space award for advanced payloads.

Even better, momentum from 2023 continued into early 2024, with the recent award for 18 satellites from the Space Development Agency valued at more than $900 million.

The company is also making good progress with its LHX NeXt program to enhance margins.

As highlighted at our Investor Day, we are executing on our LHX NeXt initiative aimed at delivering $1 billion in gross cost savings over the next 3 years. These efficiencies will optimize our infrastructure and leverage our scale, which enables us to achieve margin expansion moving forward. We executed a number of projects, including exiting facility leases, to reduce cost and overall square footage. We continue with our ERP consolidation with 10 reporting units being consolidated into 1 reporting unit earlier this month. And at the program level, our continued focus on program excellence has helped drive better EAC performance. However, we have more work to do in this area. – LHX 4Q23 Earnings Call

Based on these developments, it’s fair to say that the company remains in a good spot for sustained growth, which is also reflected in its outlook.

A Strong Outlook & Shareholder Returns

Looking ahead to 2024, L3Harris provided guidance consistent with its strategic objectives, projecting revenue growth and margin expansion across all segments.

Anticipated headwinds, such as lower pension income and increased interest expense, were factored into the guidance, with a focus on mitigating their impact through operational improvements and cost-saving initiatives – like NeXt.

So far, so good.

What matters as well is the company’s efforts to reduce debt.

After all, after a number of acquisitions, including Aerojet Rocketdyne, the company has shifted its focus from shareholder distributions (dividends and buybacks) to debt reduction.

With regard to its dividends, L3Harris targets a payout ratio of 35% to 40% of free cash flow, striking a balance between returning capital to shareholders and retaining funds for reinvestment in the business.

In addition to dividends, L3Harris actively engages in share buybacks to return excess capital to shareholders and enhance shareholder value.

Over the past three years, the company has bought back 8% of its shares and hiked its dividend by 12%.

The company currently pays $1.14 in quarterly per-share dividends. This translates to a yield of 2.2%, backed by a 36% 2024E adjusted EPS payout ratio.

The most recent hike was on February 24, 2023, when it hiked by 1.8%.

That said, the good news is that LHX is very close to achieving its target leverage ratio.

Analysts expect the company to lower net debt to $11.3 billion at the end of 2024. This would translate to a net leverage ratio of 2.9x.

In other words, 2024 is likely the last year with subdued dividend growth and buybacks.

So, what does that mean for shareholders?

As the company expects to return 100% of its FCF to shareholders, there are many reasons to be upbeat about what may come in 2025.

Analysts expect the company to boost free cash flow from $2.0 billion in 2023 to $2.2 billion in 2024. This implies a 5.5% free cash flow yield, given its $40 billion market cap.

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35% to 40% of that is roughly $830 million (using the midpoint).

This number supports its current 2% dividend yield. In 2025, FCF is expected to rise by 14% to $2.5 billion, paving the road for a return to double-digit annual dividend growth on top of 3-5% annual buybacks.

Obviously, these numbers are subject to change. However, they indicate what LHX could be capable of after it reaches its target leverage ratio.

Valuation

The valuation fits the fundamental developments.

Using the data in the chart below:

• Analysts expect the company to grow EPS by 3% in 2024, followed by a steep acceleration to 10% growth in 2025 and 12% growth in 2026.
• The company is currently trading at a blended P/E ratio of 16.9x.
• The five-year normalized P/E ratio is 18.0x.
• Combining the company’s dividend with an 18.0x multiple and expected EPS growth, we get an annual total return outlook of 12.7%.
• Since 2003, LHX has returned 14.9% per year.

All things considered, I see my thesis confirmed and believe that I am betting on the right horse.

On top of that, the company’s fantastic position in an anti-cyclical industry and its ability to quickly reduce debt and return to potentially aggressive dividend hikes and buybacks make LHX my favorite dividend growth stock at the moment – especially at this valuation in a market that is rather lofty valued.

Takeaway

L3Harris Technologies stands out as a top dividend stock pick, boasting a robust portfolio and poised for sustained growth.

With a focus on innovation, strategic acquisitions, and efficient cost management, LHX demonstrates resilience in navigating challenges and delivering value to shareholders.

As the company progresses towards its target leverage ratio, investors can anticipate substantial returns through dividends and buybacks, supported by strong free cash flow projections.

Positioned in an anti-cyclical industry and trading at an attractive valuation, LHX remains my top choice for dividend growth potential in a competitive market landscape.

Pros & Cons

Pros:

• Diversified Portfolio: LHX’s presence in various critical defense sectors, including multi-domain defense, semiconductors, space defense, and surveillance, provides resilience diversification benefits.
• Acquisition Strategy: Strategic acquisitions like Aerojet Rocketdyne enhance LHX’s competitive edge and offer opportunities for growth, particularly in the rapidly evolving space industry.
• Shareholder-Friendly Initiatives: LHX’s commitment to returning every penny of free cash flow to shareholders through dividends and buybacks demonstrates a strong focus on maximizing shareholder value.
• Growth Potential: With a strong demand environment, evidenced by notable revenue increases and a robust order backlog, LHX is poised for sustained growth in the foreseeable future.

Cons:

• Dependency on Defense Spending: LHX’s revenue is heavily reliant on government defense budgets, exposing it to risks associated with fluctuations in spending priorities.
• Margin Challenges: Despite revenue growth, certain segments, such as SAS, face margin challenges, which may raise concerns about overall profitability.
• Debt Reduction Focus: While prudent, LHX’s focus on reducing debt may limit immediate returns to shareholders through dividends and buybacks, potentially delaying the realization of shareholder value.