L-3 Communications in Neutral Lane

Mar.25.11 | About: L-3 Communications (LLL)

We maintain our Neutral recommendation on L-3 Communications Holdings Inc. (NYSE:LLL) reflecting our concerns regarding the loss of key contracts, a backlog skewed toward fixed price contracts and possibilities of cuts in future defense budgets. L-3 Communications also holds a Zacks #3 Rank, which translates into a short-term Hold rating, and correlates with our long-term recommendation.

We however believe that L-3 Communications by virtue of its non-platform focus, prominent position as sub-contractor/supplier to other defense primes, broad diversification of programs, strong order bookings and an order backlog at the end of 2010 stands out among other pure defense players.

Its strong balance sheet provides it the financial flexibility to increase its dividend, indulge in share repurchases and earnings accretive acquisitions. The company recently hiked its quarterly cash dividend by 12.5%. In 2010, the company acquired four companies, which extended its product line, raised its expertise in niche fields, and expanded its reach to customers with specialized needs in the defense industry.

L-3 Communications’ fourth quarter EPS went up 23% to $2.37, comfortably surpassing the Zacks Consensus Estimate of $2.31. Revenues inched up 1% year over year to $4.3 billion, beating the Zacks Consensus Estimate of $4.2 billion. The top-line growth was driven by its command, control, communications, intelligence, surveillance and reconnaissance ((C3ISR)) and Electronic Systems segments partly offset by lower sales from the Government Services and the Aircraft Modernization and Maintenance segments.

However, the loss of the largest revenue generator contract of 2009 – a Special Operations Forces Support Activity (SOFSA) contract with the U.S. Special Operations Command (SOCOM) – pulled down revenues for the company and remains an overhang on the stock.

Recently, some of the product lines such as the commercial ship building and combat propulsion systems have put up a weak performance. The downward trend in margins for service-related work due to competitive pressure witnessed during service contract renewals and new contracts in the Government Services segment is a matter of utmost concern. Also, margins plunged for airborne intelligence-surveillance-reconnaissance logistics support and fleet management services to the U.S. Department of Defense (DoD).

A substantial portion of L-3 Communications’ business is generated within the U.S, with government and commercial sales accounting for 87% of sales in fiscal 2010. Budget deficits and political uncertainty make future defense budgets vulnerable to cutbacks. Moreover, more than half of L-3 Communications’ sales in fiscal 2010 came from fixed priced contracts. Consequently, the company will only be able to make a profit if costs stay within the contracted limits. Given these headwinds, we maintain our neutral stance on L-3 Communications.

L-3 Communications operates through its wholly owned subsidiary, L-3 Communications Corporation. The company is a leading supplier of a broad range of products and services used in a number of aerospace and defense platforms. It competes with the likes of Honeywell International Inc. (NYSE:HON), Lockheed Martin Corporation (NYSE:LMT) and Raytheon Co. (NYSE:RTN).