We Reply : L-3 is another bonafide play on the defense spending boom, which began after 9/11 spurred our government to push aggressively into better systems and technologies to protect citizenry. While Boeing (NYSE:BA) is our favorite in the group [because it hedges any slowdown in military spending with growth in its commercial airline category], we really like L-3 because it focuses on several attractive defense niches, including surveillance + reconnaissance systems. The firm is in modest shape and carries roughly $1.50 in cash per share. At 17 x current EPS, 2 x book value, and .89 x sales (all at a discount to its peers), a value story looks to be in place. Moreover, L-3 pays a modest dividend and posts ROE that's roughly in line with the industry average; technical support is at the $75 level and a dearth of sell recommendations on the Street (1 vs. 12 buy/hold) makes us comfortable with the risk/reward.
As a pioneering mezzanine defense contractor, L-3 delivers multifaceted, value-added products and services to a plethora of different constituencies (airports, the military, and marine ports), in effect mitigating its exposure to the industry-wide risk of contract cancellations and/or unpredictable government orders, which subsequently jolt earnings and revenue streams. Level 3 has plenty of debt on its books (debt/equity of .99 = 4 x industry median of .23), but since operating cash flow covers debt obligations by at least 4 x, we're hesitant to raise our discount rate above 11.5%. We think that going forward, it would be in shareholder's best interest for L-3's board to move as fast as possible in finding a permanent CEO replacement for Frank Lanza, the visionary founder who abruptly passed away last week after a long bout with esophageal cancer.
Any slowdown in defense spending -- or more pessimistic findings related to L-3's rapid-fire acquisitive growth from 1997 to 2006, in which sales ballooned 900% to over $10 billion -- could adversely impact the firm's equity value and lower returns for short-sighted investors aiming to arbitrage the possible sale of the firm.
LLL 1-yr. chart: