Harris Corp (HRS) Short: HRS has benefited from rushed radio procurement and the Army's tactical radio build out leading to exorbitant margins (50%+ EBIT for Dept. of Defense business) and huge volumes. This will change in FY12 as tailwinds turn to headwinds causing HRS to earn $3.30 compared to expectations of $4.65 (downside of 30% to 40% at 8x to 9x).
Thesis: Prior to 2003 HRS was primarily a communications company with radio sales making up less than a third of EBIT. When the war in the middle east broke out HRS was a primary beneficiary. According to the GAO,a 180 man Marine Corps which was equipped with 9 tactical radios prior to the Iraq war now has 225 tactical radios. This caused radio sales to go to 75% of EBIT from 20% with margins tripling to the mid 30%'s (once Public Safety and international are backed out the DoD is around 50%). This increase in radio sales has been the primary driver behind the increase in the HRS enterprise value from $2.1B in 2002 to $6.5B in 2010. Going forward volumes and margins are likely to be impaired for a number of reasons.
2002 - 2011 Tailwinds: Sole source integrated hardware / software manufacturer with underpenetrated / exploding TAM
Rapid procurement premiums: Significant reason EBIT margin from DoD increased from 34% in FY09 to 49% in FY10
Default option: Only advanced tactical radio, had default government contract. Caused margin to expand from 12% in 2000 to 49% in FY10.
Best Technology: Best tactical radio available
Increased Deployment: US military deployed overseas increased by 76% from 2000 to 2010.
Tactical radio build out: Number of tactical radio's per deployed soldier increased from 0.56 to 1.31.
Software sales: DoD used the HRS ANW2 waveform in the interim before SRW was ready resulting in very high margin software sales.
MRAP / Humvee program: HRS got $1.035B in MRAP radio orders at around 50% EBIT margins
2012 and on Headwinds: Hardware only / competitive market manufacturer with fully penetrated / shrinking TAM
Normal procurement process: DoD margins should fall to low 30% from current 50%
JTRS (General Dynamics manufactured) program of record becomes default: HRS goes from default program to a back up without built in funding
Lagging technology: New JTRS radios have better, next generation technology created with government R&D money
Build out finished / deployment flat to down: Research indicates tactical radio build out finished. Radio buys will be driven by deployment which is falling.
Move to SRW: Government moving to own waveform in 2012, taking away high margin software sales
MRAP done in FY11: Last of the high margin MRAP sales finish in FY11
Competition: DoD encouraging start up competitors with commercialization model
Bull Case:
Stock is at a 10% FCF yield
The trailing yield is based on buildout volumes that will not continue and margins that will compress.
HRS is stealing radio share from ITT and will continue to do so
The total addressable market will go from increasing to shrinking. Also, HRS has gained share because it had the best technology. Going forward JTRS will have the best technology, will be the default option and has built in funding in the budget.
HRS has the best radio technology
Military contacts have told us that the new JTRS radios have significantly better capability.
Defense budget cuts are aimed at redundancies and will free up money for procurement. Radios are essential and will continue to be bought
Military contacts have told us they have overbought radios and will slow procurement going forward.
International orders have been strong
Recent strength on international was at least partially due to order delays when HRS was at full capacity producing radios MRAPs. US and EU defense budgets are shrinking (US is 50% of global defense spending with the EU being another considerable chunk) and as a result international orders are unlikely to fill the hole.
Company could be an M&A target
This is the biggest risk to the short. Less of an issue given their divergent group of businesses
Valuation: FY12 DoD radio orders should be cut in half with a further decline in FY13 when JTRS radios are sold internationally. Margins should also revert back to low 30's which would cause HRS to miss FY12 and FY13 EPS by $1.30 and $1.60, respectively.
Risks:
New global conflict
JTRS delays (would mean downside is less but thesis would still likely work on lower radio demand and lower margins)
Irrational takeout
Other:
CEO Howard Lance recently entered into his first ever 10b4-1 plan
The Army recently completed a JTRS test at the White Sands missile range where the Vice Chief of Staff attended in person. The test reportedly went very well (for the HMS products that are competitors to the HRS products) and the Army is looking for ways to speed up procurement.
Catalyst
Release of FY12 budget in early Feb.
Margins falling in back half as rapid procurement premiums decrease
Transition to JTRS procurement in 2H11 (calendar, which is 1H12 for the military)
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