L-3 Communications: Extremely Undervalued?

Background:

L-3 Communications (NYSE: LLL), the sixth largest defense company in the United States is in the sweet spot for today’s defensive budget. Under President Obama’s proposal for 2010, the defense budget actually contains modest increases for several items in the aerospace/defense industry. Although Defense Secretary Gates has expressed the desire to cut back the Army’s big future combat systems program, we believe his proposals are positive for L-3 in the aggregate. We believe the government intends to increase spending on intelligence, surveillance, and reconnaissance. In addition, homeland security remains high on the list of government attention. These are all important businesses for L-3.

Business Segments:

L-3 Communications is a leading contractor in what they dub: (C³ISR). The C³ is Command, Control and Communications. The ISR is Intelligence, Surveillance and Reconnaissance, all critical to keeping America safe. This important segment generates $2.8 to $3.0 billion dollars of their $15 billion to $18 billion total and generates double-digit operating margins.

Their Government Services segment provides communications system support and soldier training services, to include marksmanship, that are cost effective tools to keep our fighting men and women highly trained and strong. This segment includes state-of-the-art communications and information technology. This is L-3’s second largest segment with sales of $4.3 to $4.4 billion that markets to the DoD, U.S. Government intelligence agencies as well as foreign allies of the United States.

The Aircraft Modernization and Maintenance (AM&M) segment should benefit from the government’s desire to keep costs as low as possible. Upgrading existing aircraft is more cost-effective than total replacement. This segment generates $2.7 billion to $2.8 billion in sales, has the lowest margins of approximately 9%, however it is the smallest of the four segments.

L-3’s largest segment by far is Specialized Products, generating approximately $5.7 billion to $5.8 billion dollars in sales and enjoys the highest margins at approximately 11.5%. Business areas in this segment include the following: Avionics, Displays and Specialty Products; Marine and Power Systems; Microwave, RF, SATCOM & Antenna Products; Security and Detection; Sensors, Guidance, Navigation & Simulation.

Opportunities for Growth:

From guiding unmanned aircraft to detecting threatening contraband, L-3 contributes to homeland security, the war on terrorism and all military engagements the U.S. is forced to defend and protect. According to their website, they “support the Homeland Security market in areas of airport, cargo, and facility security; deepwater and port security; U.S. Customs and Border Protection (CBP); Law enforcement and first responders; crisis management planning and exercises and protection of U.S. airspace. Major products include explosives detection systems, maritime radars and monitoring systems, cargo screens, mine detections, video surveillance systems, thermal imaging cameras, weapon sights for law enforcement and infrared defense systems.” Consequently, given the state of today’s world, we believe L-3 is extremely well positioned to grow for years to come.

Strong Operating History:

An attribute that we highly covet in a company is a consistent record of operating excellence. As evidenced by our Fundamental Research Tool (Figure 1), L-3 Communications perfectly fits the bill. Since 1998, earnings per share have grown at a very consistent 27.1% compounded rate. As you can also see in Figure 1 by the blue line marked with an “*”, the market has historically capitalized L-3’s earnings at a normal PE of 17 or higher. Therefore, the current PE ratio of 9.8 is almost half of normal, which we believe indicates a very attractive entry point for investors with a long-term view.

FIG 1 12 Year Historical Earnings-Price Correlation. (see short video)

click to enlarge

Figure 2 supports the old adage; earnings are optional but cash is king, and L-3 generates strong operating cash flows (Dark Orange area marked with “O”) and importantly free cash flow (Orange Line marked “F”) that closely approximates earnings per share. So even though debt represents 44% of their total capital, they clearly generate more than adequate cash flows to handle it.

FIG 2 12 Year Historical OCF/FCF (see short video)

Historical Shareholder Returns:

As Figure 3 illustrates, even at today’s, in our view, ridiculously low valuation, L-3’s strong operating history has richly rewarded shareholders since 1998. Over a time period where the S&P 500, a proxy for the general stock market, lost a compounded (-1.8%/year), shareholders of L-3 enjoyed a compounded 15.8% return not counting dividends. Since they initiated a dividend in 2004 it has grown from $.40/share to $1.20/per share in 2008 and is estimated at over $1.30 for 2009. Their dividend (not reinvested) raises the total return for L-3 shareholders to 16.5%. At today’s valuation, L-3 can be acquired with a current dividend yield of 1.8% (See Figures 1 or 2).

Figure 3 12 Year Historical Track Record (see short video)

Summary & Conclusion:

Comments made by U.S. Government officials at last week’s Paris Air Show had bullish implications for L-3’s future prospects as sales to numerous foreign allies could top $40 billion dollars. Brigadier General David Heinz, who heads the Pentagon’s F-35 program told Reuters that “6000 of the new fighter jets could be sold over time as world fleets of F-15, F-16, F-18 and other fighter jets need replacements.” L-3 has contracts to provide cockpit display systems and several other components for the F-35. Additionally, Bruce Lemkin, deputy undersecretary of the U.S. Air Force spoke to Reuters of opportunities regarding transport planes built by Boeing, L-3, and Lockheed Martin Corp., as well as strong interest in the C-27J Joint Cargo Aircraft built by L-3 and Alenia, an Italian company.

When you add all the above up to include several recent key contract wins, it paints an attractive picture for L-3 shareholders. We believe that L-3 Communications (LLL) is an excellent company with a terrific history and a bright future. As long-term investors we seek opportunities to invest in strong businesses over a business’ cycle which we define as at least 5 to 7 years. At under 10 times earnings we feel this is an excellent opportunity to invest in this well-run business. As the world economies eventually improve, we believe that L-3 Communications is well positioned to enjoy a resurgence of long-term growth.

Full Disclosure: Long LLL at time of writing.

Comments

[Jake Silberman:]

What is your performance compared to your benchmark?

Jun 25 07:46 PM

[SimpleInstr...:]

Would have to agree; but they will not get one dollar from me. Know people working for them... this is straight up end time stuff. Invest to your hearts content.

Jun 26 09:37 AM

[Grizzly-Red...:]

Would strongly agree. But since I am the video compression hardware Engineer at L-3 CSW, and one ot the original Design Team Members for Rover 3/4/5, I'm biased. I stayed in my 401K too long through the crisis, as L-3 went from $120 to it's current $68. If the recent downturn brings it to $64 or less, it's a Super buy. The Engineers of my team are a very determined lot. Excuse me for being bullish on my own Company, hope that's not against some rule.

Jun 26 06:48 PM