As a follow-up to previous Harris write-ups, I am recommending a long position with up to 50% upside at which point the stock would be priced at an 8% free cash flow yield.

                     FY2010    FY2011    FY2012

Revenue      $ 5,206     $5,925     $6,416

EBITDA         $1,099     $1,229     $1,258

EBIT             $933         $1,017     $1,121

Net Income  $562         $587        $698

FCF              $640         $620        $749

 EV/Rev        1.2x          1.1x         1.0x

EV/EBITDA    6.1x         5.5x         5.1x

EV/EBITDA   6.9x          6.2x        5.7x

P/E             9.3x          8.2x          7.5x

P/FCF          8.2x          7.4x        7.0x

ROTC          35%         31%          34%  

Overview

Based in Melbourne, FL, Harris Corporation (HRS) is a diversified communications equipment company providing systems and services to defense/government and commercial customers. HRS provides products and services for two primary end markets: government and commercial communications. The company reports revenue in three segments: Government Communications, RF Communications, and Broadcast Communications. The Government business is comprised of information technology services, electronics systems, and communications equipment for the Department of Defense and other agencies within the U.S. government. The company's Commercial markets include broadcast transmission equipment for radio and TV and cable stations (Broadcast Communications) and other media networking solutions.

JTRS – OPPORTUNITY / NEW DEFENSE ACQUISITION PARADIGM

Joint Tactical Radio Systems is a Joint Program Executive Office created to get new radios for all of the armed forces. The military is doing this procurement differently from before. The JTRS PEO, which has Boeing as lead contractor, is focused on developing: a) waveforms (spectrums and policies), which are available for any contractor to use, b) radio types (required capabilities) which are developed in conjunction with a lead contractor but which any contractor can sell to the various armed forces if they choose to expend their own R&D c) enterprise level rules that determine how all the devices and waveforms interact with each other.

The two radio types that HRS is most interested in are Handheld, Manpack, Small Form Fit (HMS) and Ground Mobile Radios (GMR). HMS is either a walkie talkie shape, or a ruck sack portable radio or a hockey puck sized radio that fits on a small UAV / SUGV. GMR is a more complex radio designed to fit in vehicles. The primary wave forms are Soldier Radio Waveform (SRW) and Wideband Networking Waveform (WNW). SRW is pretty simple. WRW is more robust and complex. Both are designed with an emphasis on adhoc networking so that any and all other radios in the area can act as a node / relay point. The result is a network radio that can reach 30 to 50KM.

Falcon III

The Falcon III has been immensely popular with troops in the field. New capabilities are [allegedly] driving significant demand. The new radio allows live feed from UAV’s and is networked. It meets the requirements of the JITRS program but because it was commercially created has way better margins. HRS has been selling this radio for years. The company was able to use the criteria for HMS & GMR, which was available to all contractors to develop their own version and sell to the military.

Competition

General Dynamics has the program of record and have been developing the “official“ version of the HMS. Approved manufacturers of the HMS radio are BAE, GD, Rockwell Collins and Thales. Boeing has GMR. In a recent GAO report the procurement cost of the GMR program was valued at $14.2 billion over 11 years ($1.4 billion per year), and the HMS program was valued at $3.9 billion over 9 years ($450 million per year).

The JTRS Ground Mobile Radios (GMR) program is working at an accelerated pace to stay in lock-step with the Army’s PEO Integration, which is targeting 2011 to deliver Increment 1 capability to nine Infantry Brigade Combat Teams.

Given a successful LUT, the GMR program will work toward a Milestone C decision also in 2011 so Low Rate Initial Production can begin for the initial systems earmarked for the Infantry Brigade Combat Teams. Longer term, the program will undergo Multi-Service Operational Test & Evaluation (MOT&E) to include Soldiers and Marines in late 2012. More than 100 GMR radios are scheduled to participate in MOT&E. After that, assuming the program receives a good report and rating, it will receive a full rate production decision from the Office of the Secretary of Defense.

ASSESSMENT

Investment thesis boils down to, what happens to RF. If growth drops off because tactical radio market is saturated in US and abroad and margins come in from 34% to lower 30’s then the stock takes a battering. If growth continues from acquisitions and or tactical radios then the stock is worth ~50% more. As long as growth is coming from radios, investors are always going to be wondering when the music stops. Decent dividend yield (2% and growing) will serve to keep many shorts away.

In May 2008 Harris received an offer to purchase the company for ~$70 per share. Management rejected the offer at the time claiming that the offer undervalued the company. Since then HRS has grown its earnings per share by over 45%. Harris’ CEO recently announced an interest in transitioning out of his role. In many instances this is a signal to potential acquirers that a company is open to a sale. Harris’s strong cash flow generation and proprietary technology would make it attractive to a private equity buyer and with many large defense primes seeking exposure to expanding areas of the defense budget Harris could also be attractive to a strategic buyer.