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ACTIVIST SHAREHOLDER DISCLOSES 5.98% STAKE

Government contractor, L-3 Communcations (NYSE:LLL) recently rallied 4.65% on nearly 5.5x normal daily trading volume after activist hedge fund Relational Investors LLC disclosed a 5.98% stake in the company. In their SEC filing, they cited the company's recent underperformance versus their peer group as well as the broad market as reasons for motivation to breakup the company either through a spin-off or sale of underperforming businesses.

MACRO HEADWINDS DOMINATE STOCK

While the company could benefit from a corporate reorganization, there are macro factors that could overshadow the effects of spin-offs or sales. More specifically, the company and the industry face potential headwinds because of potential spending cuts. In 2010, defense spending represented about 20% of total government expenses and as such, it is reasonable to expect companies in these industries to face pressure to their top line. As we detailed in "Defense Sector Under Attack: Sift Through These 7 Stocks," the low stock valuations are largely related each company's respective dependence on government revenues. For example, the most depressed stocks in the sector are the ones that have the largest government revenue shares. At General Dynamics (NYSE:GD), L-3 Communications, Lockheed Martin (NYSE:LMT), Northrop Grumman (NYSE:NOC) and Raytheon (NYSE:RTN), the percentage of total sales in 2010 ranged from 72% to 92%. At companies like Boeing (NYSE:BA) and United Technologies (NYSE:UTX) with less depressed valuation ratios, they also have a lower dependency on government sales.

L-3 COMMUNICATIONS TRADES ROUGHLY IN-LINE WITH PEERS

While Relational Investors points to L-3 Communication's underperformance as a motivation for a reorganization, at face value, the company appears to trade roughly in line with other competitors. Here is a brief snapshot of LLL's key valuation metrics as well as those of notable peers:

L-3 Communications has a trailing P/E of 10.46, a forward P/E of 8.24 and a price/sales of 0.58.

Lockheed Martin has a trailing P/E of 9.92, a forward P/E of 8.06 and a price/sales of 0.60.

Raytheon Corp. has a trailing P/E of 10.42, a forward P/E of 4.71 and a price/sales of 0.69.

Northrup Grumman has a trailing P/E of 9.40, a forward P/E of 7.08 and a price/sales of 0.56.

Boeing Corp. has a trailing P/E of 15.93, a forward P/E of 4.53 and a price/sales of 0.83.

General Dynamic has a trailing P/E of 10.60, a forward P/E of 6.92 and a price/sales of 0.84.

SUMMARY

Relational Investors LLC is one of the heavyweights among activist hedge funds. They have a strong reputation and there is no doubt that they have the potential to impose their will and improve shareholder returns, but we think investors should be cautious buying into the stock after the recent price jump. While the Relational Investors stake could be a positive development, it does not change the macro story for the company and the industry. At some point in the future, the government will have to make a more serious effort to cut spending because entitlement cuts risk angering large and motivated portions of the voting base.

Source: Activist Hedge Fund Share Disclosure Doesn't Change L 3's Macro Fundamentals