Harris Makes the Transition to Record-Breaking Free-Cash Flow

Any company that's reached its 118th birthday has something that's worked in the past. However, a history of success doesn't guarantee a bright future. In fact, to stay relevant, companies have to be able to adapt when the environment they operate in changes. Harris (LHX 0.34%), a communications and IT company, has recognized the change to its environment and is in the middle of a multi-year transition.

To see whether this transition will prove profitable, I interviewed Harris' CEO, Bill Brown. The following is the second segment in a four-part series that'll tell you what you need to know about Harris' transition, its future, and why it may merit your investing dollar.

Harris takes on the future
Harris is a technology company, but its core customer is the U.S. government. More pointedly, when I asked Brown about Harris' biggest challenge, he said: "The biggest challenge was that the external environment was rapidly changing. Our core U.S. government customers, who represent more than two-thirds of our revenue, were experiencing a highly uncertain and challenging fiscal environment."

In other words, because of sequestration and reduced government spending, Harris' environment has changed. Here's how it's adapting. 

First, because of the unprecedented nature of sequestration, Brown said Harris is focusing on what it can control -- namely, "our quality, cost, technology, and performance against customer expectations."

He continued: "We are focusing our portfolio, maximizing cash flow, returning more capital to investors through higher dividends, and increasing investment in R&D."  

Further, Brown's statement regarding the focus on the portfolio isn't just lip service. In fiscal 2011, Harris built a state-of-the-art off-site data center called the Harris Cyber Integration Center, which was supposed to be used for cloud computing. Harris had also expanded into broadcast communication services by offering hardware and software products. However, when Brown took over as CEO in November 2011, he examined Harris' business portfolio, and he came to a conclusion: "I first took a hard look at our portfolio of businesses and decided that our prospects for success in our broadcast and cyber integrated solutions businesses were low, and we divested them."

In short, Brown found that the broadcast communication services didn't align with Harris' overall strategy and portfolio, and the profits for off-site cloud computing weren't there -- so instead of pouring more money into these ventures to try and force them to work, Harris cut the fat. His decision resulted in a better-aligned company, and additional savings.

"By executing the restructuring actions announced in April faster than expected and expanding their scope somewhat, we generated additional savings in the quarter," Brown said. "These actions are now expected to generate annualized cost savings of $60 million, versus the $40 million to $50 million originally anticipated."  

Those changes aren't the only ways Harris is focusing on its business environment.

"The continuing U.S. government budget headwinds will certainly be challenging for Harris and virtually any company serving this market," Brown said. Consequently, Harris is moving to capitalize on overseas sales, which have become more important.

"From a change standpoint, one area that I am particularly interested in is our international presence," he said. "During the past five years, international revenue has grown from about 10% of total revenue to about 26% today, with the opportunity to grow to beyond 30% in the coming years." 

Moving forward
With a market cap of approximately $6.2 billion, Harris falls into the category of "smaller defense company," meaning reduced government spending could have a bigger impact on its bottom line -- for comparison, Boeing's market cap hovers around $81.4 billion, Lockheed Martin's is $39.4 billion, and Northrop Grumman's is $21.4 billion. Harris is aware of the gap and is making the necessary changes.

As a result, Q4 2013 revenue was down as expected -- $1.36 billion, compared with $1.44 billion in the prior year. GAAP income from continuing operations was $71 million, or $0.65 per diluted share, compared with $137 million, or $1.20 per diluted share in the prior year, and non-GAAP income from continuing operations was $154 million, or $1.41 per diluted share, compared with $162 million, or $1.42 per diluted share, in the prior year. 

However, Q4 free cash flow was better than expected at $273 million and resulted in a strong $655 million for fiscal 2013 -- up 6% versus the prior year and 119% of non-GAAP net income.

Orders came in at $1.43 billion, down from the prior year, but 105% of revenue. Orders further resulted in a funded backlog that's up 2% sequentially and 4% year over year. 

In addition, Brown said: "During fiscal 2013, we recorded record free cash flow, repurchased $400 million of stock and increased our dividend 12% on top of a 32% increase in fiscal 2012. On Aug. 26, entering our fiscal 2014, we announced a further increase of 13.5%, along with a new $1 billion share repurchase authorization." 

A Foolish wrap
Thanks to reduced government spending, Harris' business environment has changed. But Harris is embracing that change and has a good idea of what it needs to do to stay relevant and thrive in the future. That's good news for investors, as shares sit at $57.26 -- near their 52-week high of $58.56. Thus, while Harris still has a lot of challenges to overcome, it looks pretty good overall.

Check back soon for Part 3 of my exclusive interview with Bill Brown, where we'll delve further into sequestration, what Harris is doing to combat it, and Harris' competitive advantage.