Shares of defense contractor Harris Corporation (NYSE:HRS) shot up more than 10% earlier this month, after the military electronics specialist announced it is buying rival Exelis (UNKNOWN:XLS.DL) for $23.75 in cash and stock. Harris hasn't looked back since.
At last report, shares of Harris were trading for more than $78 apiece, a good 12% above their pre-announcement price. Exelis shares have fared even better, up 37% since February 5, and recently trading within two bits of the proposed acquisition price. Clearly, this is a deal that investors like -- a lot.
But are they right to like it? Let's find out.
In its February 6 merger announcement, Harris promised to buy Exelis for $23.75 a share -- assigning the target an enterprise value of "approximately $4.75 billion." Exelis shareholders will be paid $16.625 per share in cash, and receive 0.1025 shares of Harris for each share of Exelis they own besides. (Which so far is looking like a nice bonus, since contrary to usual practice, Harris shares went up after the announcement, instead of down).
Harris says that when all's said and done, the merged company will boast annual revenues in excess of $8 billion, employ 23,000 souls globally, and yield "a competitively stronger company with significantly greater scale." After cutting "$100 million to $120 million" in annual operating costs through "synergies," Harris avers that the deal will be "slightly accretive to Harris in the first full year and a significant contributor thereafter."
At current valuation, which is just a rounding error away from Harris's offered price, shares of Exelis are selling for just 1.0 times annual sales -- precisely what I've argued in the past is the right price for a profitable, growing, largely free-of-debt defense contractor. There are caveats to that general rule of thumb, however -- and especially so in this present case.
Traditional valuation metrics suggest that Harris is overpaying for Exelis. At its current valuation, the target company's shares sell for 19.5 times trailing earnings -- which seems high, given that analysts polled by S&P Capital IQ anticipate no more than 4% annual earnings growth out of Exelis.
Granted, from Harris's perspective, "4%" probably seems plenty fast. After all, these same analysts foresee only 2% annualized growth rates at Harris. But across the defense industry, most analysts expect 12% annualized growth will be more the form. While Harris will boost its growth rate with this inorganic acquisition, though -- and perhaps boost it even more if the promised "synergies" prove out -- the overall growth rate of the entity that emerges from this merger still looks anemic.
Another objection to Harris's move can be found on the company's respective cash flow statements. Harris, with annualized free cash flow of $589 million, is generating about 10% more "cash profit" than its income statement reflects. In contrast, Exelis generated only $205 million in FCF last year -- 16% less than its reported $244 million in net income.
What it all means to investors
Its attractive price-to-sales ratio notwithstanding, I actually think that Harris is overpaying for Exelis. The target company's anemic growth rate and low ratio of FCF-to-net income tell me the stock's simply not as attractive as its P/S ratio makes it seem. (Incidentally, at a P/S ratio of 1.6 itself, Harris's own stock looks even less attractive).
That said, in a world where defense contractors view "1x sales" as the "right" price to pay for another defense contractor, you can see why Harris was tempted to pull the trigger on this acquisition. And this may hold a hint for us, as investors wondering "who's next" after Exelis. Who's the next defense contractor to be snatched up?
Throwing a quick screen across the defense industry, in search of other potential targets selling for less than one-times-sales, I came up with two more potential targets for mergers and acquisitions in the defense industry. Namely, both Huntington Ingalls (NYSE:HII), and L-3 Communications (NYSE:LLL), currently sell for P/S ratios not much more than 0.9x sales. One single number doesn't necessarily make these stocks "buys," of course. But if you're looking for a place to do further digging, and find out who Big Defense might be looking to buy next -- I suspect these are two good prospects with which to start your search.