Defense stocks were a relative safe haven during COVID-19, with the Pentagon scrambling to keep assembly lines running and payments flowing during the lows of the pandemic.

Still, these are uncertain times for the defense sector. After a half-decade of budget growth, the Defense Department was facing flat budgets even before the pandemic, and added government spending in response to the crisis could further crimp Pentagon outlays.

There are still good investment opportunities in defense, but we're at a point in the cycle where it pays to be careful. Here's why L3Harris Technologies (NYSE:LHX) is tops on my radar among defense stocks right now.

An aerial view of the Pentagon.

Image source: Getty Images.

The nation's new defense prime

L3Harris was formed out of the June 2019 merger between Harris Corp. and L3 Technologies, two mid-tier contractors who combined have the heft to take on some of the massive defense primes. The company specializes in defense electronics, space, and cyber, and is focused on winning an increasing share of business directly from the government instead of as a subcontractor to a larger partner.

The company is still working toward the goal of $300 million in post-merger cost-cuts, and was hit harder than some of its defense brethren by COVID-19 because of its airport security equipment business, a unit it is divesting. As a result, L3Harris reported mixed second-quarter results, beating analyst expectations for earnings but falling short on revenue, and the stock has underperformed both the broader markets and a number of top defense companies.

LMT Chart

Defense data by YCharts

L3Harris held full-year guidance steady when releasing second-quarter results, giving investors little to get excited about. But there appears to be room for upside. In the first half of 2020 the company grew its funded backlog by 5%, adjusted for divestitures, despite COVID-19-related disruptions. And though L3Harris kept its margin outlook at 17.5%, company officials on the post-earnings call said they now see 10 to 20 basis points of potential added margin compared to previous estimates.

The pipeline remains robust. In the last few weeks alone, L3Harris received a U.S. Navy award to integrate its tech onto a planned crewless surface ship, was selected by Airbus to build a space antenna, and won what it called a "multi-million-dollar contract" to build sonar systems for an unnamed NATO member.

Much of the company's growth is expected to come in areas including space and intelligence where guidance is difficult because of the classified nature of the work. On the call with investors, CEO Bill Brown said the company sees the "classified part of the space business growing quite well," saying he expects it to be "a driver getting into 2021."

Follow the cash

Longer term, the company is forecasting $3 billion in free cash flow by calendar 2022, which seems like a pretty low hurdle to clear given L3Harris has generated about $2.7 billion over the past 12 months. That's up 20% year over year on a per-share basis.

Part of the reason for the conservative guidance is L3Harris will lose more than $100 million in annual cash generation sources via divestitures. But the company is also planning to use $1 billion of divestiture proceeds on buybacks, which should help offset the per-share declines.

Even with the divestitures and buyback plans, L3Harris is going to have billions at its disposal in the next few years that is likely going to be earmarked for investors. Management has expressed little interest in mergers and acquisitions while it finishes combining the pieces already in place. But I expect a new, larger buyback to be announced in the months to come, and would not be surprised if the dividend currently yielding more than 1.75% gets a boost before next spring.

Overall, L3Harris is likely to have at least $4 billion at its disposal over the next two years, enough to make a dramatic difference in the post-merger share count and give individual investors a larger stake in the company.

This stock won't stay under the radar forever

L3 and Harris merged, in part, because the two companies were competing against the better-known defense titans and were finding it difficult to get noticed. A year later and L3Harris still seems to be flying under the radar, and a combination of potential defense budget cuts, ongoing merger integration, and a planned CEO transition in 2021 when Brown gives way to former L3 executive Chris Kubasik seems to be keeping investors away.

I believe the L3Harris portfolio will hold up well in a potential tight Pentagon budget environment because its space, electronics, and intelligence offerings are unlikely to be the target of cuts, and its more discretionary areas like radios and night vision equipment are in full production and purchases are unlikely to be halted mid replacement cycle. Kubasik, at one point the next in line at Lockheed Martin, is one of the industry's top up-and-coming leaders and should be a strong leader as CEO.

Even in a difficult growth environment, L3Harris' cash generation capability should allow it to improve per share performance, and investors get a decent dividend with the potential upside to wait for it all to come together. L3Harris is a company worth investor attention heading into the final months of the year.