Business Context and Reporting Period
Harris Corporation’s unaudited Form 10-Q covers the quarter ended September 28, 2018, the first quarter of fiscal 2019. Continuing operations comprised Communication Systems, Electronic Systems, and Space and Intelligence Systems. IT Services and CapRock were reported as discontinued operations following fiscal 2017 divestitures.
Harris adopted ASC 606 revenue recognition and ASU 2017-07 pension-cost presentation effective June 30, 2018. Prior-period amounts were recast for comparability.
Key Financial Metrics
| Metric | Q1 FY2019 | Q1 FY2018 | Change |
|---|---|---|---|
| Revenue | $1.542 billion | $1.410 billion | 9% increase |
| Gross margin | $532 million | $491 million | 8% increase |
| Gross margin percentage | 35% | 35% | Flat as reported |
| Income from continuing operations | $216 million | $165 million | 31% increase |
| Diluted EPS from continuing operations | $1.78 | $1.36 | 31% increase |
| Net income | $213 million | $159 million | 34% increase |
| Effective tax rate | 16.0% | 27.6% | Lower by 11.6 points |
| Operating cash flow | $117 million | $95 million | 23% increase |
Revenue increased in all segments. Communication Systems revenue rose 16% to $469 million and segment operating income rose 22% to $140 million. Electronic Systems revenue rose 9% to $589 million and operating income rose 6% to $115 million. Space and Intelligence Systems revenue rose 5% to $488 million, while operating income declined 1% to $86 million.
The effective tax rate benefited from the Tax Cuts and Jobs Act, excess tax benefits related to equity compensation, and other tax-accounting differences. Discontinued operations reduced net income by $3 million in the current quarter and $6 million in the prior-year quarter.
Cash Flow, Liquidity, Debt and Capital Allocation
- Cash and cash equivalents were $305 million at September 28, 2018, compared with $288 million at June 29, 2018.
- Operating cash flow was $117 million. Capital expenditures were $31 million, producing reported free cash flow of approximately $86 million before other financing and investing items.
- Financing activities included $216 million of borrowings, $200 million of share repurchases, and $82 million of dividends.
- Short-term debt increased to $294 million from $78 million, primarily reflecting commercial paper borrowings. Long-term debt, including the current portion, was approximately $3.7 billion.
- Harris had a $1 billion senior unsecured revolving credit facility expiring in June 2023, with $710 million available after $290 million of commercial paper borrowings.
- The company stated that existing cash, operating cash flow, credit availability, and market access should support anticipated needs for at least the next 12 months, while noting risks from leverage, government budget uncertainty, and capital-market conditions.
- Fiscal 2019 capital expenditures were expected to be approximately $170 million. The company expected no U.S. qualified defined-benefit pension contributions during the remainder of fiscal 2019, aside from minor non-U.S. contributions.
- The quarterly dividend increased to $0.685 per share, or an annualized rate of $2.740. Harris repurchased 1,219,750 shares for $200 million and had approximately $501 million remaining under its authorization.
Material Changes Versus the Prior Comparable Period
- Higher revenue across all three segments and productivity savings increased gross margin, while Communication Systems mix partially offset margin expansion.
- Engineering, selling and administrative expenses increased 4%, but declined to 18% of revenue from 19%, reflecting cost containment.
- Communication Systems benefited from strong U.S. Department of Defense tactical-radio readiness demand, including $38 million of higher Tactical Communications revenue.
- Electronic Systems benefited from Avionics growth, including $32 million from increased F-35 production, and higher Electronic Warfare revenue from F/A-18 and CV-22 platforms.
- Space and Intelligence Systems benefited from $32 million of higher classified-program revenue but faced higher bid-and-proposal and innovation-related research and development costs.
- Net unfavorable estimate-at-completion adjustments reduced operating income by $3 million, compared with a $5 million favorable impact in the prior-year quarter.
- ASC 606 reduced fiscal 2018 revenue by $14 million and continuing-operations income by $19 million on a full-year basis; the standard also created separate contract-asset and contract-liability balance-sheet categories.
Guidance, Outlook, Risks and Unusual Items
Management did not provide explicit full-year revenue or earnings guidance in the filing. Backlog was $7.9 billion at September 28, 2018; approximately half was expected to convert to revenue within 12 months and the substantial majority within three years.
On October 12, 2018, Harris entered into an agreement to combine with L3 Technologies in an all-stock merger of equals. L3 shareholders were to receive 1.30 Harris shares per L3 share. Harris shareholders were expected to own approximately 54% of the combined company and L3 shareholders approximately 46%. Closing was expected in mid-calendar 2019, subject to shareholder, regulatory, and other customary conditions.
- Merger risks include failure or delay in closing, regulatory or shareholder opposition, integration costs, potential earnings or cash-flow dilution, increased indebtedness, litigation, employee retention challenges, and failure to realize anticipated synergies.
- The company depends significantly on U.S. Government funding and contracts that may be partially funded, audited, or terminated for convenience.
- Fixed-price contracts, estimate-at-completion changes, subcontractor performance, cybersecurity events, export restrictions, geopolitical conditions, and foreign-exchange movements could affect results.
- Defined-benefit obligations were $674 million on the balance sheet, and future pension contributions could become material depending on asset returns, interest rates, and statutory funding requirements.
- Potential litigation and environmental matters were not considered material based on management’s assessment, although unfavorable outcomes exceeding recorded accruals remain possible. The filing identifies potential environmental exposure related to the Lower Passaic River remediation matter, for which party allocations had not been determined.
- Tax accounting for the Tax Cuts and Jobs Act remained provisional, including evaluations of transition tax, GILTI, FDII, and related deferred-tax positions.
Most Important Facts for Investors to Verify
- Reconcile the strong 31% increase in continuing-operations EPS with the lower tax rate and share repurchases.
- Monitor conversion of the $7.9 billion backlog into revenue and cash, particularly the growth in contract assets to $870 million.
- Assess leverage, the $300 million floating-rate notes due February 27, 2019, commercial-paper usage, and post-merger debt levels.
- Evaluate whether Space and Intelligence Systems can improve margins as bid-and-proposal and innovation spending increases.
- Review the ASC 606 retrospective adjustments and the judgment involved in cost-to-cost revenue recognition and contract estimates.
- Track merger approvals, timing, transaction and integration costs, projected synergies, and the effect on ownership, earnings, cash flow, and credit ratings.
- Confirm future dividend and repurchase capacity given debt maturities, pension obligations, capital expenditures, and merger-related restrictions.