Harris Corporation handles complex military communications networks for battlefield management and in military aircraft. It is also known for a brand of Stingray cellphone trackers used by U.S. law enforcement, and it is also a leading provider of air traffic management services for the Federal Aviation Administration. The company took a leap forward in 2015 with its $4.75 billion merger with a defense firm called Exelis, and it has made inroads in the space industry thanks to a recent classified contract, executives said in a recent call with investors.<doc-sep>(Reuters) - Military communication equipment providers Harris Corp HRS.N and L3 Technologies Inc LLL.N announced on Sunday an all-stock merger that will create the United States' sixth-largest defense contractor with a market value of $34 billion. Increased defense spending under U.S. President Donald Trump and the Republican-led Congress is driving contractors to pursue mergers so they have more scale to bid on bigger projects, spanning everything from upgrading computer systems to space exploration. In August, Trump signed a defense policy bill that authorized $639 billion in military spending such as buying weapons, ships, aircraft and paying troops. “We are in an environment where the economy is pretty strong, we know defense spending is coming up, the 2019 (federal) budget is up 3 percent over 2018, 2018 was up 9 to 10 percent over the prior year,” Harris Chief Executive William Brown said in an interview. “I think there is an increasing need for more investment, more end-to-end solutions,” Brown added. The transaction values L3 at $15.7 billion, slightly above its market capitalization at the end of trading on Friday of $15.3 billion. Harris has a market capitalization of $18.2 billion. L3 shareholders will receive 1.3 shares of Harris common stock for each of their shares. As a result, Harris shareholders will own about 54 percent of the combined company, with the remainder owned by L3 shareholders. The combined company, L3 Harris Technologies Inc, will have about 48,000 employees and customers in over 100 countries, the companies said. The merger is expected to close in midyear 2019, they added. The new company’s board of directors will have 12 members, consisting of six directors from each company. Brown will serve as chairman and chief executive officer, and L3 CEO Christopher Kubasik will serve as vice chairman, president and chief operating officer for the first two years following the closing of the deal, the companies said. In the third year, Brown will transition to executive chairman and Kubasik will become CEO. After that year, Kubasik will be both chairman and CEO. “The aerospace and defense industry is continuing to see a lot of change over the last year or so, and many people have believed for a long time this combination made sense and we have worked hard to make that happen,” Kubasik said in an interview. A string of deals have taken place in the sector. In June, U.S. defense contractor Northrop Grumman Corp NOC.N acquired Orbital ATK Inc for about $7.8 billion, giving it greater access to lucrative government contracts and expanding its arsenal of missile defense systems and space rockets. In April, weapons maker General Dynamics Corp GD.N bought CSRA Inc for $9.7 billion to expand its government services business, after CACI International Inc CACI.N withdrew its offer for CSRA following a bidding war. Morgan Stanley MS.N is acting as financial adviser to Harris and Sullivan & Cromwell LLP is serving as principal legal counsel, with Paul, Weiss, Rifkind, Wharton & Garrison LLP acting as special counsel to the board of directors. Goldman Sachs Group Inc GS.N is acting as financial adviser to L3 and Simpson Thacher & Bartlett LLP is serving as legal counsel.<doc-sep>Text size Radio maker Harris and electronics supplier L3 Technologies agreed to merge in an all-stock deal that will create the sixth-largest defense company in America behind Lockheed Martin, Northrop Grumman, Boeing, Raytheon and General Dynamics. Defense has been a hot sector for deals this year with nine transactions announced by our count worth in excess of $40 billion. That list doesn’t include Boeing and Woodward, who were said to be in talks in February, or the rumored private equity deal for advanced materials provider Arconic. In fact, there has been as much deal activity in 2017 and 2018 as there was in the prior nine years combined. One reason for the flurry of deals has to be the end of budget sequestration that pressured U.S. Defense outlays from 2011 to 2015, a period that saw spending fall on an absolute basis for the first time since the “Pax Americana” reigned during the Clinton-Presidential years. During sequestration, defense contractors had to tighten their belts, and they laid off workers and got higher earnings per share by expanding margins. For example, Lockheed’s workforce declined by over 30% from its peak of 146,000 and its margins have improved about 4% over that time frame. Defense stocks have responded positively to the new revenue environment. The sector returned 40% in 2017 and is outperforming other industrial stocks year-to-date. It’s not just domestic revenue. Don’t forget the Trump administration has focused on trade deals that help domestic industries. It made a deal with Saudi Arabia for the latter to purchase $110 billion worth of arms from the U.S. The deal comes to mind because it was one of the first things discussed when President Trump was weighing consequences resulting from the disappearance of a Washington Post journalist last night on 60 Minutes. All this good news has pushed defense multiples up slightly. In prior years, the group essentially traded at parity with the S&P 500 and today defense contractors are awarded about a 17% premium on a PE basis. That premium is being earned, in part, with strategically sound deals. The Harris and L3 deal are creating an electronics giant. The combined entity makes all the little things that go into larger things like a jet fighter, a guided missile or a UAV—unmanned aerial vehicle. So the industrial logic seems sound and Carter Copeland at Melius Research writes that “the strategic rationale is compelling.” Copeland also writes about valuation, adding, “by the time the deal closes we suspect the combined value will be comfortably north of $40bn on its way to $50-$60bn a couple of years later.” It’s easy to see how Copeland arrives at that figure. Before the deal was announced, the combined value for Harris and L3 Technologies was $33.5 billion. The market has tacked on $3 billion today after the merger news. The $3 billion equates to only six times the $500 million in announced cost synergies and that’s only about half the multiple that defense companies trade at today on an EV to Ebitda basis. Newsletter Sign-up Review & Preview Every weekday evening we highlight the consequential market news of the day and explain what's likely to matter tomorrow. PREVIEW But when your customer is the U.S. government, you don’t get to keep all the savings, so maybe capitalizing cost synergies is a bit aggressive. Still, the value bump today looks low when you compare free cash flow yields in the marketplace to the $3B in free cash flow mentioned by management as their goal three years out from the deal closing. That means there could be room to run for the combined company before any strategic considerations, even though both stocks are up nearly 10% today. HRS and LLL aren’t the only stocks to look at. Surely, all small and medium sized defense companies should remain on notice given the deal-making environment. It’s difficult to predict combinations, but that doesn’t stop us from trying. Truck maker Oshkosh won the contract to replace the Hummer, so its defense division could attract interest from a larger prime contractor. Boeing has a stated goal of getting into parts and aftermarket more aggressively and that could lead the aircraft maker to take another run at engine parts supplier Woodward. Also, Aerojet Rocketdyne is a stand-alone space propulsion franchise, but its real estate arm makes it difficult to compare it with other companies. And perhaps composite material maker Hexel could go the way of Cytec and get bought by a global chemical firm. We could go on, but in the end portfolio allocations to the defense sector still feel like a safe bet. Write to Al Root at allen.root@dowjones.com<doc-sep>
L3 Communications Inc. and Harris Corp. have agreed to merge in an all-stock deal, the two companies announced this week, creating a $33.5-billion military technology company. The combined company would be called L3 Harris Technologies and based in Melbourne, Fla., the home of Harris. The deal is expected to close next year, pending a review by the Defense Department. “L3 Harris Technologies will possess a wealth of technologies and a talented and engaged workforce,” L3 Chief Executive Chris Kubasik said in a news release. “By unleashing this potential, we will strengthen our core franchises, expand into new and adjacent markets and enhance our global presence.” Both companies have built military communications empires focused on networking and surveillance capabilities that are built into larger defense systems. Harris handles complex military communications networks for battlefield management and in military aircraft. It is also known for a brand of Stingray cellphone trackers used by U.S. law enforcement. And it has made inroads in the space industry thanks to a recent classified contract win, executives said in a recent call with investors. New York-based L3 Communications’ most visible products are the 360-degree scanners that travelers encounter when they go through airport security, part of a $170-million line of business with the Department of Homeland Security. It also makes night-vision equipment and sensor systems used in military aircraft. Under the stewardship of Kubasik, a former Lockheed Martin chief operating officer who took the helm at L3 last year, the company has established new business units around next-generation military technologies such as undersea drones. Under a succession plan agreed to as part of the deal, Harris CEO William Brown would serve as chief executive of the combined company for two years after the close of the merger. Then, Kubasik is to become chief executive in the third year, according to an announcement from both companies. In Sunday’s announcement, Kubasik said the transaction is intended to create a sixth prime government contractor. The five largest defense contractors — Lockheed Martin, Boeing, Raytheon, Northrop Grumman and General Dynamics — have dominated the U.S. defense market for years, each of them taking in more than $10 billion a year from the federal government. L3 Technologies and Harris took in a combined $8.3 billion from the federal government last year, making the combined company the seventh-largest recipient of 2017 U.S. contract dollars behind the five major defense contractors and McKesson Corp., a drug company. At $16 billion in projected 2018 revenue and about 48,000 employees, the new L3 Harris Technologies would be able to boast that it is the sixth-largest U.S. defense company. It would be bigger than shipbuilder Huntington Ingalls and BAE Systems. The combination is the latest in a flurry of mergers and acquisitions among government contractors, which are taking advantage of a frothy stock market and favorable defense spending to pursue new opportunities. Last year, Northrop Grumman bought Orbital ATK, a contractor focused on the space industry, for $7.8 billion in cash. United Technologies Corp. bought aircraft parts manufacturer Rockwell Collins for $30 billion. Deal making accelerated at the beginning of 2018 after a 2019 defense budget facilitated a healthy jump in spending and Congress lifted the “sequestration” caps that have hobbled the industry since 2013. In February, a small government contractor called ECS Federal was bought for $775 million by On Assignment, a Calabasas recruiting firm, in a rare instance of a commercially oriented technology company entering the government market. In spring, General Dynamics bought a midsize information technology contractor called CSRA for $7.2 billion. The merger of L3 and Harris also represents a further step in hollowing out the middle of the U.S. defense market, as large and middle-tier government contractors are finding they can climb the ladder more quickly by joining forces. The Defense Department could block the merger of L3 and Harris depending on the results of its review, though it has taken a hands-off approach to recent mergers.