Strong Signals for Harris Corp.

S&P likes the earnings outlook of the communications-equipment outfit and says the shares are "materially" undervalued

We view Harris Corp. (HRS; recent price, $52.58) as an attractive communications-equipment solution provider with a compelling valuation. We think the combination of high market-growth potential in tactical radios, radio frequency (RF) equipment for 3G wireless networks, and high-definition solutions for broadcasting and radio networks should spur revenue growth and lead to positive earnings gains and cash flow generation in fiscal 2007 and fiscal 2008.

We think the strong earnings outlook that we foresee for Harris supports a higher share price compared to its defense and communications equipment peers. At the same time, the company is driving its cost structure lower to match the downward pricing trends evident for these markets. We also believe that Harris will be able to gain market share over its competitors in select areas of U.S. government and defense communications markets.

We believe that Harris shares are materially undervalued, making the stock a compelling investment opportunity. The stock carries Standard & Poor's highest investment recommendation of 5 STARS (strong buy). Harris is structured primarily around the markets where its businesses operate—government communications systems, RF communications, microwave communications, and broadcast communications.

Everybody Counts

The government communications systems segment (47% of estimated total sales in fiscal 2007, ending June) conducts advanced research, develops prototypes and designs, and develops and produces state-of-the-art airborne, space-borne, and terrestrial communications and information processing systems for the U.S. Defense Dept., the Federal Aviation Administration (FAA), and other governmental agencies, as well as for large aerospace and defense companies that serve the defense industry.

The government segment currently has a diverse portfolio of more than 300 programs. The $2.2 billion FAA Telecommunications Infrastructure program materially contributed to the company's December-quarter sales.

Other important programs include the five-year, $600 million Field Data Collection Automation (FDCA) program for the U.S. Census Bureau, for which Harris demonstrated a wireless handheld device that will be used by 500,000 census takers during the 2010 Census; the $66 million CDL Hawklink program for the U.S. Navy; and several new programs for national intelligence customers and several commercial satellite antenna programs.

High-Performance Falcons

The RF communications segment (28%) supplies secure wireless voice and data communications products, systems, and networks to the U.S. Defense Dept. and other federal and state agencies, as well as to foreign governments' defense agencies. The segment offers a line of secure radio products and systems for person-transportable, mobile, strategic fixed-site, and shipboard applications. Orders were higher than sales in the fiscal 2007 first quarter. In the RF communications segment, we believe strength in both U.S. and international markets continues to drive higher orders and an improved sales outlook.

This segment is benefiting, in our view, from worldwide demand and customer preference for Harris' high-performance, feature-rich Falcon II and Falcon III tactical radios. The company received significant orders from the U.S. Marine Corps, U.S. Navy, and U.S. Army in fiscal 2007's second quarter, and international orders nearly doubled in the second quarter of fiscal 2007 compared to the prior-year quarter, with significant orders received from Romania, the Netherlands, Kenya, and Tajikistan.

The broadcast communications segment (15%) serves the digital and analog TV and radio infrastructure markets, providing transmission, automation, studio and network management systems. Through tactical acquisitions, Harris has broadened the product and services platform for this business to the radio and TV broadcasting markets. Component shortages hurt fiscal 2007 first-quarter results.

We believe a turnaround in sales performance and wider margins are needed from this segment to drive higher corporate EPS results.

Microwave Communications

We believe double-digit sales increases in the video distribution infrastructure and digital media solutions business areas should continue as Harris' customers upgrade to digital and high-definition broadcast operations. Radio transmission systems revenue should be higher, in our view, led by shipments of HD radio systems in North America, which offset TV transmission systems and software systems' potential revenue decline.

The microwave communications segment (10%) designs, manufactures, sells, and services microwave radio products, primarily for cellular network providers and private network operators. Harris closed on an agreement in January, 2006, to separate its microwave communications segment and combine it with Stratex Networks. The new company is named Harris Stratex Networks (HSTX). The company is the majority shareholder of the new company with a 56% ownership interest. Harris Corp. will consolidate the results of Harris Stratex Networks and reflect the minority interest for the 44% it does not own beginning in fiscal 2007's third quarter.

For Harris Stratex, we see orders outpacing sales for the company's international customer base. Driven by the deployment of 3G services and network expansions, we expect the Europe, Middle East, and Africa region to continue to dominate orders compared to the microwave segment's other regions. The combined company will be able to reduce operating costs and drive wider operating margins, in our opinion.

Last Year's Awards Pay Off

Following a 16% increase in fiscal 2006, we expect company-wide sales to advance at a mid-teens rate for fiscal 2007 and fiscal 2008. This reflects our view of strong government-related product demand from increased spending to support the war on terrorism, as well as improved demand for the RF communications unit. We believe these markets will remain a key driver of growth, along with the growing broadcasting communications business.

We think sales growth will benefit from the impact of major governmental contract and service provider awards from last year and upcoming proposed contracts. In our view, the January, 2007, combination of the microwave unit with Stratex Networks will benefit Harris as a majority owner.

We look for gross margins to be flat to up 100 basis points in fiscal 2007 and fiscal 2008 from fiscal 2006's 32.7%, with positive trends in the sales mix and higher-margin follow-on sales with key customers. We estimate operating EPS of $2.80 in fiscal 2007 and $3.20 in fiscal 2008.

Positive Fundamental Outlook

Based on our Standard & Poor's Core Earnings methodology, we believe that the quality of Harris' earnings is in line with its peers. Employee stock option expenses are included in our fiscal 2007 and fiscal 2008 operating EPS estimates. We are assuming 6 cents per share of stock option expense in both of these years.

Based on our estimates for fiscal 2008, Harris trades at a price-to-earnings (p-e) multiple of about 16.4 times and an enterprise value/EBITDA multiple of 10.3 times, slightly below the average for our communications-equipment peer group. With our view of Harris' positive fundamental outlook vs. its rivals, we believe the shares should trade at a premium to defense and communications-equipment peers.

Using this methodology and based on our projected 12% to 15% EPS growth over the next two to three years, and an enterprise value of 11.7 times our fiscal 2008 EBITDA estimate, we arrive at a 12-month target price of $59.

Some Execution Risks

We believe that Harris' corporate governance practices are in line relative to other communications-equipment providers we follow. Among the characteristics we view favorably are that the board of directors is controlled by a super-majority of independent directors greater than two-thirds, committees address governance issues, and the company does not have a poison pill in place or a dual-class capital structure.

One concern we have is that the chairman and chief executive officer positions are held by the same person, which may lead to conflicts.

Risks to our recommendation and target price, in our view, include reduced funding for U.S. governmental contracts, lower capital spending by service operators, and delays or missed contract orders. We believe there are execution risks in the broadcasting segment booking orders from its larger product platform and in the integration of Harris Stratex.

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