Last decade of overseas conflicts have spurred the need for communication equipment (rise in number of boots on the ground)
Evolving battlefield requirements: prior to modern-day conflicts, Tactical Radios were more of shared resource than today when almost every soldier and vehicle carries some form of individual tactical communication equipment
JTRS program of record for advanced Tactical Radios still under development, Harris has essentially been the sole provider of advanced Tactical Radios
Leverage to Tactical Radios
Tactical Radio business sales and profitability have boomed over the last 8 years
Prior to FY03, the business represented c250m sales at c20% margins or c$50m EBIT
In FY10, Harris' Tactical Radio business represented almost $1.6bn of sales at c42% margins (mid-30%s boosted by higher c50% MRAP / M-ATV radios) or $660m of EBIT (represents over 70% of consolidated operating profits)
Thesis
There is significant downside risk to Harris' Tactical Radio business, and hence to overall profitability
Catalyst: market reaction to order intake, forward earnings and backlog guidance
Tactical Radio Orders / Sales
Normalized Market
Normalized market for Tactical Radios is admittedly difficult to estimate due to volatility of orders (e.g. due to surge, MRAP / M-ATVs, volatile international orders)
Research shows that is not unreasonable to estimate that close to half (or $1.7bn) of FY10/11E combined c$3.3bn Tactical Radio sales were directly related to conflict (incl. the surge in Afghanistan) including
c$1bn orders for MRAPs / M-ATVs
c$300m manpack orders
Other conflict related-DoD orders and international orders (incl. indirect DoD funded), some due to interoperability requirements (e.g. NATO)
MRAP / M-ATV Orders
MRAP / M-ATV order carry significantly higher margins c50% (vs. mid-30%s for other Tactical Radios)
While difficult to predict with certainty, management does not currently expect future orders going forward
Ending Conflicts
Surge prompted build out of Tactical Radio capacity, current orders more reliant on troop deployment levels
Progress made in conflicts and eventual planned withdrawals suggests declining go-forward need for new equipment (large new Tactical Radio orders) as troops have been equipped and troop levels are expected to drop
Austerity / International Markets
US / other Western government austerity suggests minimization of unnecessary capital spending
Sales to non-allied countries are more difficult or in some cases even prohibited (e.g. China)
International competition: while not denying the potential for market share grabs, international markets are more highly competitive (Thales and ITT having significant penetration)
Order / Product Cycle
Due to the product-nature of the business, Tactical Radio orders have historically converted to revenue in a relatively short timeframe c7months (Backlog / NTM Sales c1.7x)
Currently Tactical Radio backlog stands at $1,060 one would expect the majority of these orders to be filled by year-end
Multi-year shelf life, long outside of conflict due to less wear and tear
Orders / Backlog Target Risk
YE11 backlog target was recently guided down from c$1.25bn (previously expected flat book-to-bill in FY11) to c$950m (midrange $900k - $1bn guidance)
Assuming 2Q11 guided c10% growth in RF Communications and slightly lower growth in their Public Safety and Professional Communications partially offset by stronger than expected Tactical Communications revenue, the company would need c$800m 2H11 orders (~$400m per quarter) to meet its c$950m YE11 midrange backlog target
Pre-surge, in FY09 non-MRAP orders came in at ~$290m/Q (~$260m/Q in 1H09)
Last quarter (2Q11), Tactical Radio orders came in at $300m of which $100m was booked as part of a large multi-year International order
While not impossible to reach, it would seem that there is more risk to downside than upside in meeting the YE11 backlog target
Future Orders
While it is difficult to forecast future Tactical Radio sales with precision, it would not be unreasonable to expect Tactical Radio orders to decline significantly on a go-forward basis
Recent order tailwinds could accentuate the near-term drop-off
Downside Scenario
Leverage to Tactical Radios
Because Tactical Radios account for a substantial portion of profitability (higher margin), the Company's EBIT / EPS are highly levered to their sales
$100m sales ~$35m EBIT or ~18c EPS
Other Business Segments
More Difficult to Analyze Bottom-Up
Not intending to contradict management, we piece FY11 / FY14 guidance (and street estimates) to build non-RF Communication segment estimates
Public Safety and Professional Communications (Other RF Communications Business)
Lower (c10%% margin) business
Incumbent has dominant market share (Motorola >70% if not more)
Large portion of customers are state and local governments or authorities related to these, many facing budget constraints
Government Communication Systems
Government budget spend constraints to pressuring outlook
Increasingly indications of competitive environment highlighted by peers in recent earnings calls
Integrated Network Solutions (INS)
Segment is a blend of acquired businesses, recently realigned to highlight growth potential and diversify away from Tactical Radio exposure; paid healthy multiples for some of these growth businesses
Differentiating competitive advantages hard to identify for some of these businesses (e.g. Cyber Integrated Solutions: cloud hosting / services)
Broadcast: management has struggled to turn to profitability for years
Seems to imply little downside to current elevated Tactical Radio sales levels
Downside Scenario
Assuming $1.2bn-1.4bn Tactical Radio sales, FY12 consolidated EBITDA should be closer to $1bn (c20-25% below consensus), and EPS closer to $3.70 (c25-30% below consensus) assuming a flat share count
Larger reversal in the near term (vs. more normalized medium / long-term) would not be surprising due to recent large orders
Without strong opinions about the current relative valuation levels vs. peers, one would estimate c25%-30% downside from these levels if the thesis plays out as expected
Risks
JTRS
Potential delays / cancelation: substantial risk around the future support of the JTRS program given recurring delays, lack of technical progress, cost overruns vs. Harris' strong product offerings
Would leave room for future modernization spend on non-program of record radios, in particular on Harris' products which are cost-effective and proven on the battlefield
Some form of dual-procurement is still possible due to the success of Harris products
Strategic Takeout
Some scarcity of midcap assets to acquire though Harris might be a little large given risks
Though large contractors pressured as trying to manage through period of shrinking defense spending, focusing on shareholder value, M&A could be badly received by investors; risk on future orders
Leverage to conflict spend
JTRS program of record progress
Conflicts
Prolonged involvement in current conflicts
New conflicts spurring additional tactical communications demand (e.g. Libya, Pakistan)
Betting Against Management
Betting against management with less visibility then they have
No indications of severe operational problems or fraud that would lead one to believe that the company is in serious jeopardy
Valuation / Macro Sentiment on Defense Space
Defense valuations are generally depressed and recovering from cyclical lows due to expectations of declining defense spending
Positive developments - including those related to political influences over US defense budget - could lead to general re-ratings of the space
Timing
Difficult to time the drop-off in orders
High-margin Tactical Radio sales translate to significant cash generation
In past, Harris applied cash towards M&A (seemingly expensive), could turn into a headwind if excess cash is applied to more shareholder friendly actions
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