L3 Technologies Inc (LLL: HRS) – Share price as of 02/11/2018 – $189,25

Harris Corp (NYSE: HRS) – Share price as of 02/11/2018 – $147,7

Introduction

On October 14, 2018, military communication providers Harris Corp and L3 Technologies Inc. announced that they had entered into a definitive agreement to complete an all-stock merger, thus creating the 6th largest contractor in the United States. The combined company, L3 Harris Technologies Inc., is valued at approximately $34.0bn and employs roughly 48.000 individuals. Furthermore, L3 Harris Technologies Inc. could now bid on larger projects, which have resulted from the increased military expenditure of the Republican administration.

L3 Technologies Inc. (LLL: HRS)

L3 Technologies, Inc., formerly L-3 Communications Holdings, Inc., headquartered in New York City, is a prime contractor in Intelligence, Surveillance and Reconnaissance (ISR) systems, aircraft sustainment, simulation and training, night vision and image intensification equipment, and security and detection systems. It develops advanced defense technologies and commercial solutions in pilot training, aviation security, night vision and EO/IR, weapons, maritime systems, and space.

The company is divided into three business segments:

  • Communications & Networked Systems, which offers solutions in connecting space, airborne, ground and sea-based platforms with secure, real-time data; the division’s expertise extends to complex encryption and data security for a variety of new aircraft programs and U.S. Army infrastructure initiatives;
  • Electronic Systems, which provides defense, commercial and international customers with innovative and diverse technologies and solutions;
  • ISR Systems, which offers a broad range of multi-domain intelligence, surveillance and reconnaissance mission solutions, including space avionics and payloads, soldier systems, airborne sensors and aircraft, mission command & control, intelligence solutions, modeling & simulation and life-cycle support.

Harris Corp. (NYSE: HRS)

Harris Corporation, headquartered in Melbourne, FL, is a leading technology innovator that supplies products, systems and services that have defense and civil government applications, as well as commercial applications. Innovation has been the cornerstone of Harris’ success since its founding nearly 125 years ago, when it entered the market by offering cutting-edge automatic presses, and it remains the driving force behind everything it does.

The company, like L3, operates in three business segments:

  • Communication Systems, which designs, engineers and manufactures a broad portfolio of networked communication solutions, night vision technologies and integrated systems for U.S. military, U.S. allied international forces, public safety and commercial applications;
  • Electronic Systems, which offers an extensive portfolio of solutions in electronic warfare, avionics, wireless technology, undersea systems, and air traffic management;
  • Space and Intelligence Systems, which delivers complete solutions for global situational awareness, space superiority, Earth insights and provides intelligence solutions from advanced sensors and payloads, as well as ground processing and information analytics.

Industry Overview

The global military communication industry is strongly influenced by the defense budgets and policies of individual governments. The industry can generally be divided into the following segments: shipborne, ground-based, underwater, air-ground and airborne communication. As numerous countries wish to develop innovative technologies that maximize security and efficiency as well as replace aging equipment, the industry is expected to grow steadily from $31.5bn in 2018 to $37.7bn in 2023 (CAGR of 3.6%). Moreover, experts believe that ground-based communication will be the most sought-after technology, while the demand for IP-centric gear, supporting both data and voice, will also rise. The costs and standards of developing these advanced technologies may nonetheless hamper the growth of the industry.

Over the upcoming years, the United States will continue to dominate the military communication industry. The following graph highlights the immense expenditure of the United States government on national defense, ranging from 2% to 10% of GDP between 1950 and 2016 and amounting to a total of $610bn in 2017. The second, third and fourth largest spenders in the field of national defense in the aforementioned year were China, Saudi Arabia and Russia with $228bn, $69bn and $66bn respectively.

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Screen%20Shot%202018-10-31%20at%2009.26.25.png However, researchers anticipate that several initiatives, favouring the development of cutting-edge communication systems, in various APAC countries, such as China and Japan, will progressively erode the large market share of the United States in the future. For example, according to China’s recent budget report, the nation plans to dedicate $175bn to military expenditure and thereby “modernize the army, promising to unveil a world-class armed force by 2035”. The following chart illustrates that military expenditure across the entire world is expected to grow steadily in the period 2019-2022:

Key market participants have recently been able to diversify their portfolios by establishing strategic alliances and by providing integrated products. The largest sellers include General Dynamics, Thales Group, Rockwell Collins and BAE Systems. Furthermore, M&A activity has been strong within the industry. Northrop Grumman purchased the defence and space contractor Orbital ATK for approximately $7.8bn in June 2018 and General Dynamics acquired the IT and cyber-security firm, CSRA, for $9.6bn at the beginning of 2018. The first transaction was motivated by the Air Force’s desire to order a new intercontinental ballistic missile. The deal would most likely help Northrop Grumman to outcompete Boeing for the contract. General Dynamics, the producer of Gulfstream jets, tanks and Navy ships, stated that the primary reason for the purchase were the severe hacks, which the company experienced in recent years.

Deal structure

L3 and Harris have agreed to combine in an all-stock merger of equals to create the 6th largest defence company in the U.S. and a top 10 defence company globally, focused on developing differentiated and mission critical solutions for customers around the world.

The merger agreement stipulates that L3 shareholders will receive a fixed exchange ratio of 1.30 shares of Harris common stock for each share of L3 common stock, consistent with the 60-trading day average exchange ratio of the two companies. Once the merger is complete, Harris shareholders will own approximately 54% and L3 shareholders will own approximately 46% of the combined company. The deal was unanimously approved by the boards of directors of both companies and it is still waiting for the shareholder approval. It is expected to close by mid 2019.

The joint corporation estimates $16bn net revenues, $2.4bn EBITDA and $1.9bn free cash flow for the calendar year 2018. Moreover, the parties have declared strong commitment to maintaining the current investment grade credit rating, and to sticking to their own current dividend payouts practices, even deploying excess cash towards shares repurchases

Deal Rationale

The total value of mergers globally in the industry, reached a record of $72bn last year, according to estimates by PwC. The explanation of this convergence can be found in two reasons:

  • the benefit from the US corporate tax rate cut, from 35% to 21%;
  • the President Donald Trump’s budget, where military expenses have been set to increase this year by $94bn (which is more than any country in Europe spends in a year) to $700bn.

As said, broadly speaking, it seems the agreement has been pushed by the current strong momentum, featuring the industry the two companies operate in. Indeed, as previously hinted at, the Trump’s administration has been raising the military spending regularly over time. And specifically, the dedicated budget is expected to still go up by 3% in 2019 against 2018 (already was up by 9-10% with respect to 2017). Combined with the extant corporate tax cuts, the current American defense policies awash companies in the sector with cash, in such a way so as to boost their growth and stimulate deals.

The second core driver of the merger at issue is to be found in its four main forecasted benefits for the two corporations involved.

First, thanks to the agreement, the two companies would finally meet a suitable size to exploit a proper economies of scale. Therefore, the “too large to be small, too small to be large” problem seems to have been overcome, allowing the two parties to bid on demanding projects. Consequently, their spectrum of activities might range from upgrading computer systems to space exploration, and their domains might get multiple, encompassing air, sea, land, space, and cyber.

Stemming from this first reason, the second benefit is the $500m cost-cutting that the merger would produce. Of that disclosed amount, the companies have promised to return about $300m to customers (such as the American Department of Defense), mainly in the form of prices reductions.

The third positive effect of the deal, according to Melius Research’s consultant Carter Copeland, is the creation of a true “Dream Team”. Indeed, the two technology-driven firms share a deep culture of innovation and sizable investments in R&D. Their combined workforce of more than 22,500 engineers and scientists, therefore, will end up leveraging L3’s expertise in sensors and Harris’ communication equipment. Someone already points at a potential future development of highly sophisticated mechanisms, aimed at sending data about enemies’ location to augmented-reality goggles worn by soldiers.

Fourth, the last benefit is probably the most meaningful one, concerning expectations of future expansions (or contractions) of the defense industry. As a matter of fact, the US government’s growing deficit and the prospected economic downturn cast some doubts on the feasibility of Trump’s budgets for military expenses. In Harris’ CEO, Mr. Brown’s words: “Don’t know when, but a downturn in military spending is inevitable”. Having this in mind, and acknowledging Harris Corporation is mostly defense-related, the rationale of the deal seems now clearer. Indeed, with the merger, Mr. Brown allows his company to count on L3’s non-military activities as well, such as training airline pilots. The resulting diversification, he hopes, will allow Harris Corporation to do well both in upturns and downturns of the defense industry.

Overall, the growing concern about the sustainability of the Trump’s administration budgetary commitment is casting some doubts on the prospected performance of the recently-born L3-Harris Corporation. Only the future can tell if diversification in scope will be enough to offset a cut in military expenditures.

Market reaction

In the aftermath of the announcement of the merger at issue, investors have shown great optimism. This latter sentiment brought L3’s stocks up by 8.5% by 11:37 am on Monday October 15th, after jumping as much as 11% (the biggest intraday gain the company has recorded in four years); as at October 26th, the price has reached an equilibrium at $204.25. The same occurred for Harris’ shares, which climbed by 7.4% in few hours that Monday, currently selling for $160.84.

Advisors

For Harris Corporation Morgan Stanley & co. LLC acted as financial advisor, whereas Sullivan & Cromwell LLP acted as principal legal counsel. Paul, Weiss, Rifkind, Wharton & Garrison LLP acted as special counsel to the company’s Board of Directors.

For L3 Technologies Inc. Goldman Sachs Group Inc acted as financial advisor, whereas Simpson Thacher & Bartlett LLP acted as legal counsel.

 


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