Will L3Harris Repeat Lockheed Martin's Mistake?
In early 2021, Lockheed Martin bid too high for Aerojet Rocketdyne. Now, L3Harris is bidding even higher.
At long last, Aerojet Rocketdyne's (AJRD 0.09%) two-year-long attempt to sell itself may be drawing to a close. Last week, defense company L3Harris Technologies (LHX 0.70%) announced it will buy Aerojet and take the rocket-maker in-house. And the most amazing part of the news is this:
L3 is going to pay more to acquire Aerojet than Lockheed Martin (LMT 0.83%) wanted to pay early last year. Military history
Let's rewind a bit. Early in 2021, Lockheed Martin -- the world's biggest defense company -- announced its plans to get even bigger by buying Aerojet, which manufactures rocket engines for everything from spaceships to cruise missiles. In doing so, Lockheed would add new revenue streams to its defense business (which earns 10.5% operating profit margins, according to S&P Global Market Intelligence) and also give Lockheed a leg up in space (profit margin: 9.3%).
There was just one problem: The Federal Trade Commission decided that Lockheed Martin was already quite big enough all by itself (thank you very much), and nixed the deal in February 2022. And so, with Lockheed's $4.4 billion acquisition offer dead as a proverbial doornail, Aerojet Rocketdyne set about trying to find itself a new buyer.
This shouldn't have been an easy task. As I explained last month, Aerojet has a lot of problems that make it an unattractive target for acquisition (or indeed, stock investment). In addition to stagnant sales, declining profits, and negative free cash flow, one of the company's premier products of the last few years -- its AR1 rocket engine -- has no obvious market. Its most obvious potential customer, United Launch Alliance, decided to buy its rocket engines from another supplier.
On top of all that, Aerojet stock looks very expensive at a P/E ratio of 47. Let the bidding commence
Nevertheless, several potential bidders emerged for Aerojet, with Reuters reporting that companies ranging from private equity houses to defense companies like Textron to conglomerates like General Electric might all be interested in acquiring the company. Ultimately, though, L3Harris came out on top with a bid of $58 per share -- cash -- valuing Aerojet at $4.7 billion inclusive of net debt.
That bid, by the way, was $2 a share more than Lockheed had bid two years earlier. It's also a fair bit more than I suspect Aerojet Rocketdyne stock is worth.
How crazy is L3Harris?
To understand why this $2 difference matters, consider that in early 2021, the Federal Reserve's targeted interest rate was basically zero -- versus 4.5% today -- making it easy to borrow money for acquisitions at attractive rates. Today, however, interest rates are soaring, and cash is king.
Yet L3Harris is still spending like there's no tomorrow.
This is particularly important in light of the fact that, while L3Harris is promising to pay $4.7 billion for Aerojet, L3Harris doesn't actually have $4.7 billion. To the contrary, S&P Global data show that L3Harris has less than $530 million in the bank, versus $7.8 billion in debt. And so, as L3Harris admits, it will need to take on new debt in order to finance its purchase of Aerojet.
Result: Even if interest rates don't rise any higher (hint: interest rates are definitely going higher), this implies at least a 60% increase in interest expense for L3Harris going forward, as total debt approaches $12.5 billion. This implies annual interest costs of $435 million, eating up 17% of operating profit. And if you assume that lenders will charge more for loans to more heavily indebted companies, then interest expense will probably rise even more than that.
The upshot for investors
Granted, L3Harris may be happy to incur the extra expense, hoping as it will that booming demand for rocket motors for new weapons systems -- a hot commodity since the start of the Russia-Ukraine war -- will help to grow sales at Aerojet's defense business. If the new revenue from Aerojet is sufficiently profitable, it may end up offsetting much of the added interest expense for L3Harris.
Failing that, though, I'm afraid what we're looking at here is basically a stock (L3Harris) that costs an expensive 37 times trailing earnings, borrowing a lot of cash in order to buy a stock that costs an even more expensive 47 times earnings. That seems like a bad bargain to me.
Rich Smith has no position in any of the stocks mentioned. The Motley Fool recommends Lockheed Martin and Textron. The Motley Fool has a disclosure policy.