L3 Communications: Value Play Or Value Trap?

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

Company: L3 Communications (NYSE:LLL)
Recent: $58.94

A few weeks ago, Chuck Carnevale wrote an excellent article that identified L3 Communications as a value play. Strictly looking at its fundamentals, L3 Communications looks like a huge value play.

In the last decade it has increased sales by more than 568% from $2.3 billion to $15.6 billion, while its net profit has gone up more than 8 fold from $115 million to $955 million. Oh, and let's not forget about the Buffett indicator (a.k.a. book value), which rose from $15.46 to $62.27 at a rate of 14.45% annually. More importantly, if you had bought the stock back in 2000 and held it until today, you would have made 200% on your money with dividends and share appreciation.

Currently, the stock is trading with a price to earnings multiple of 7, an all-time low for a company that historically trades around 17 times earnings. This too would signal that the company is discounted by the market; however, it could be a trap.

Here's why...

First, past profits and book value growth do not predict the future. Look at a company like Blockbuster Video, which had a long history of growth and then within 5 years claimed bankruptcy. This is not likely to happen in the case of L3, yet we are in a changing political environment where it is no longer fashionable to the public to be at war.

This is a big concern considering L3’s main customers include the U.S. Department of Defense (76% of sales) and its prime contractors, U.S. Government intelligence agencies, the U.S. Department of Homeland Security, U.S. Department of State, U.S. Department of Justice, allied foreign governments, domestic and foreign commercial customers and select other U.S. federal, state and local government agencies.

Second, if you haven't been keeping up with the news, as a country, we're broke! According to www.usdebtclock.org the total unfunded liabilities come to over $1 million per taxpayer. I really doubt that we will be able to afford to keep the huge defense budget going forward.

As for L3 Communications, the company now faces the challenge of increasing cash flows and earnings in the face of spending cuts and recent program losses. We will not be spending the same $500 billion a year throughout the next decade and that will be very challenging for LLL, as the company has not carved a large enough economic moat to sustain its growth in my opinion.

It's sad for me, because when I first look at company like this (i.e. low P/E, solid growth, at 52 week low), I get very excited, but when I start thinking about it, I realize that it probably deserves to be in my "no-go" stock pile. Maybe I'll be wrong, but it's better to say no to a good deal than yes to a bad one.

Obviously, if you believe in the Mohnish Pabrai approach, then even LLL will be a good buy at a certain price, but that could be 50% lower than its current quote. Maybe for a long term buy and hold investor, owning the stock at these levels might make sense? For all we know, the market could decide that L3 is worth a 15 price multiple over the next few years. Crazier things have happened - NFLX with 100 P/E or CRM with 500 P/E - come to mind, so it could easily double based on that alone.

The question you have to ask is: How likely is that? What is more likely is that they cut estimates and the stock drops or flat lines and doesn’t get back to the Joel Greenblatt price levels of $80 per share it saw a few months ago, at least not for some time. So, while the consensus of 15 leading analysts reporting to Zacks expects L-3 Communications Holdings Inc. to continue to grow earnings over the next five years at 8.3% per annum, I have to disagree with them on this one.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.