Harris Looks Ripe for Profit-Taking

We continue to like the U.S. stock market here, even at its recent highs, and we believe equities will move higher over the next six and 12 months. As always, though, we believe it makes sense to review a portfolio's current holdings. If a stock has reached its target price, or if it has moved significantly higher while its outlook hasn't materially improved, investors should consider taking full or partial profits and redeploying the funds into more compelling opportunities.

One such example is Harris (HRS), a communication-equipment maker based in Melbourne, Fla. We have recommended the stock a number of times over the past year, and we continue to like the company, but we believe it makes sense to take profits in the stock now.

Harris reported its fiscal year-end (June 2013) earnings last week, which were surprisingly good, primarily on the back of strong international results in the tactical radio business. Adjusted earnings per share for the quarter were $1.41, compared with the $1.15 expected and flat compared with the year-ago period. Profit margin in the radio business was very strong, reflecting strong cost controls and a beneficial product mix. In its other two businesses, results were pretty much as expected.

The outlook for the fiscal year just beginning is for earnings to be in the range of $4.65 to $4.85 per share, which would be down slightly from the year just reported. After fiscal 2013's flat growth, the company guided its revenue to low negative single digits; operating margins are forecast to be down slightly in each segment. Although forward bookings are greater than deliveries and backlog is up modestly, growth prospects overall for Harris are tough, at least for next year.

We are concerned about the ultimate effects of sequestration and general budget pressure on defense and government spending. The winding down of overseas U.S. military operations is a nagging overhang, somewhat offset by Harris' advantageous role in modernizing communications and control systems for civil government and military projects in the U.S. and abroad.

Management, led by CEO Bill Brown, has done a fine job of maintaining the company's profit and cash generation in a difficult spending environment, even as its key businesses are in transition. There is potential upside from a number of important Defense Department contracts that are currently up for bid, but the timing keeps slipping, and the outcome is uncertain.

In the meantime, the stock has moved up 35% over the last 12 months, and it now trades at 12.2x fiscal 2014 EPS. Harris' dividend yield is now just 2.6%, though another increase is likely before year-end. Share repurchases will continue, at the typical rate of $200 million annually. Free cash flow will be strong but likely less than last year. And operating results will only be as good as forecast because of yet another restructuring, which is targeted to cut yearly operating costs by $60 million.

Taken as a whole, Harris seems to fit the characteristics of a stock that has benefited from a strong market, has had fundamentals somewhat better than feared and is now no longer cheap. However, its business environment is unclear, and enthusiasm for improved results should be tempered by uncertainty about contracts.

We'd suggest taking at least some profit here, which should be redeployed into higher-conviction ideas that have better risk/reward profiles. Conversely, if the stock were to retreat to a more attractive valuation, say below 10x earnings ($47.50 a share), then the superior management team and the company's key market positions would necessitate considering a new position in Harris.

No one ever went broke taking a profit. Declaring victory with Harris makes eminent good sense.

At the time of publication, Katz had no positions in HRS.