Harris' Weak Results Vindicate Its Aggressive M&A Strategy

NEW YORK (The Deal) -- When Harris Corp. (HRS) in February announced a $4.75 billion deal for Exelis (XLS), Chairman and CEO William M. Brown described the transaction as "transformational."

The company's latest earnings report, which was released on Tuesday, gave a clear picture of what Harris is trying to transform itself away from.

Melbourne, Fla.-based Harris reported fiscal third-quarter net income of $125.7 million, topping analysts' estimates for adjusted earnings per share but falling short on revenue.

The weakness, which Harris had telegraphed in an earnings pre-release, was attributed largely to sales slowdowns in the communications equipment maker's public-safety and CapRock satellite-communications units. CapRock has been hurt by a slowdown in energy activity that has led to less demand for remote-communications capabilities.

Energy and foreign-exchange-rate concerns weigh on the current Harris portfolio. The company relies on foreign sales for 31% of revenue and a higher percentage of its total Ebit (earnings before interest and taxes). Middle Eastern countries account for more than half of its radio pipeline, meaning Harris could be disproportionately affected by oil-related Gulf military-spending cuts.

Shares of Harris have been trading down since the April 21 pre-announcement, losing more than 4% since the news.

Harris was able to counter that weakness by cutting costs, allowing the company to meet earnings expectations. But there is only so much streamlining that can be done.

Enter Exelis. The McLean, Va.-based company makes communications gear, sensors, surveillance equipment and other electronics for defense and civil agencies. Not only does the deal allow further cost-cutting opportunities -- Harris says to expect between $100 million and $120 million in annual synergies from the deal -- but it also pivots Harris toward domestic government business at a time when analysts believe the Pentagon spending cycle is trending off of recent lows.

The deal couples Exelis' consulting and services business with Harris' hardware to create a top 10 domestic federal contractor with the resources and scale to better compete for communications contracts.

The two companies have complementary businesses. For example, Exelis is part of the Federal Aviation Administration's effort to modernize air-traffic ground stations, and Harris provides much of the FAA's communication networks between facilities.

The companies' combined radio-encryption intellectual-property portfolio is so formidable the Department of Justice might make the companies forgo some IP ownership rights in exchange for clearing the merger, though Harris said the deal is expected to close on time in June.

As the defense and government business grows, Harris' reliance on its other operations diminishes. As CEO Brown said during an earnings call this week, CapRock is "not a big part of the company," noting that it will be "even smaller when we combine it with Exelis."

More deals could follow. Moody's Investors Service this month said Harris has adopted an aggressive mergers-and-acquisitions strategy, and predicted add-on purchases could follow as Harris tries to take advantage of an expected "defense spending trough" and gain additional scale in the years to come.

It's a far cry from the recent past, when companies were going to great lengths to avoid having to rely on government customers plagued by talk of sequestration and shutdowns. Harris is going all in on government spending. For investors, deals can't close soon enough.

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