With just a “fraction” of their respective businesses overlapping, the corporate chiefs behind the largest defense merger ever don’t expect any major regulatory hurdles in combining Harris Corp. [HRS] and L3 Technologies [LLL] into a $16 billion-plus sixth prime contractor on schedule in mid-2019.
“We do believe our businesses are complementary and we’ll go through a normal regulatory process,” said William Brown, chairman, president and CEO of Harris, adding, “I don’t expect any issue in consummating this transaction from any particular overlap.”
Harris and L3 on Sunday announced their proposed merger of equals, which will create the sixth largest defense contractor in the U.S. if the deal is cleared by government regulators in the U.S. and Europe. Christopher Kubasik, L3’s chairman, president and CEO, speaking Monday morning with Brown during a joint presentation to analysts, said, “Over the weekend, Bill and I reached out to customers and Congress and industry partners and everybody was appreciative of the heads up and seemed to be supportive so I think it’s going to be an exciting transformation deal and don’t expect any significant issues.”
Both executives stressed the complementary product and solution portfolios that both defense electronics companies bring to the table, with Brown saying they rarely compete head-to-head.
Areas where both companies offer similar and sometimes competing products are in night vision, particularly night vision goggles, data links and satellite communications. Brown said that for data links and satellite communications systems, the markets here are “very competitive” and that while Harris and L3 “have some positions there but they’re not necessarily completely competitive, a lot of it is complementary.”
Brown said he doesn’t want to get in front of the government’s assessment of the deal, “But again, we don’t see this as a significant concern in terms of overall scope and magnitude of the combined business.”
Byron Callan, an aerospace and defense analyst with the strategic advisory firm Capital Alpha Partners, said in a client note last Saturday after news of the potential deal was leaked to some media outlets, that he doesn’t expect the Pentagon to block the transaction given the minimal overlap between the companies and believes any anti-competitive concerns in areas such as night vision can be handled through consent decrees, which typically require the divestment of a product or business unit to maintain competition in the marketplace.
Nearly a year ago, Kubasik said L3’s vision is to become a non-traditional sixth prime contractor for its government customers, defined by increasing agility, innovation, affordability, speed to market, with more direct business with government customers while continuing to provide its industry customers with better solutions.
“This merger establishes us as the sixth prime with a well balanced portfolio of enduring missions and programs serving customers in every region of the world,” Kubasik said.
Sheila Kahyaoglu, an aerospace and defense analyst with the investment banking firm Jefferies, said in a client note on Monday she agreed that once the deal is complete L3 Harris Technologies should be the sixth largest U.S. defense prime contractor with “multiple opportunities to generate revenue and cost synergies.” In the near term, though, she expects the companies’ leaders to be focused on integration and closing the transaction.
Harris and L3 said that within three years of closing the merger they will achieve $500 million of cost savings synergies through reduced overhead, rationalizing their supply chain and real estate footprints, adopting common shared services, and consolidating the corporate and segment operations and administrations. Each company currently has three operating segments and Brown said he expects within a couple of years of closing the business is down to three or four segments.
In announcing the deal on Sunday, the companies said the increased scale that will be achieved through the combination will allow the new company to pursue opportunities it couldn’t as separate entities while also being more innovative, taking advantage of each other’s core capabilities to expand into new and adjacent markets, create new capabilities, and add content with existing customers.
One briefing chart used by Brown and Kubasik says that L3 Harris Technologies will spend 4 percent of its revenue on research and development, a level it says is above its peers.
The company will have 48,000 employees, including about 22,500 engineers, about 23,000 personnel with security clearances, and 1.5 million square feet of cleared workspace. Leveraging efficiencies and engineering talent will lead to more affordable solutions, the companies said.
Brown and Kubasik also said the merger offers the opportunity for upward of 2 percentage points of margin expansion.
Andrew Hunter, director of Defense-Industrial Initiatives at the Center for Strategic and International Studies, told Defense Daily in an email response for comment on the deal that he sees it as an opportunity to “capture growth, in this case in defense electronics.”
Hunter also said that changes in the capabilities of electronic systems may impact how companies in the defense electronics space view each other, particularly with respect to mergers and acquisitions.
Commenting on the pending merger, Hunter said, “I believe another driving factor is the increasing multi-functionality of electronic systems that is driving previous separate players in the electronics industry into competition with one another. While Harris and L3 have operated in largely separate markets before, the boundaries between sectors in the electronics market have been becoming increasingly fuzzy. This merger may be the first of several in the sector as historically separate electronics businesses look to combine.”
Brown and Kubasik believe their personal relationship combined with similar cultures and operating philosophies of the two companies will pave the way for a successful integration of the businesses. Brown said he has known Kubasik for several years and that they have a “great working relationship with strong personal rapport and mutual respect.”
For the first two years after the deal closes, Brown will be chairman and CEO and Kubasik vice chairman and chief operating officer. In year three, Brown will transition to executive chairman, “remaining focused on integration and other related activities,” he said, and Kubasik will become CEO.
The companies will announce the shakeout for other senior leadership positions at a later date, which will reflect “the best of the best from both companies,” Brown said.
If L3 Harris Technologies were operating today, its roughly $16.4 billion in expected sales in 2018 would put it behind U.S. leader Lockheed Martin [LMT], Northrop Grumman [NOC], Boeing’s [BA] defense business, Raytheon [RTN], and General Dynamics [GD]. The U.S.-based operations of Britain’s BAE Systems would be the seventh largest defense contractor in the U.S. followed by Huntington Ingalls Industries [HII].
Kubasik said that 85 percent of the company’s sales will be to U.S. and international government customers. One of the briefing slides used by Brown and Kubasik shows that 67 percent of sales will be as a prime contractor and that 72 percent of the work will be through fixed-price contracts.
The largest customer for L3 Harris would be the Air Force, generating 26 percent of sales, followed by international government customers with 17 percent, the Navy, other U.S. government customers, and commercial customers accounting for 13 percent each, the Army with 10 percent, and other Defense Department agencies making up 8 percent.