L-3 Communications (NYSE:LLL) is an economic-value-creating defense contractor, and we think the firm is worth keeping an eye on as geopolitical uncertainty heats up. Let's examine shares to get a feel for how the company's valuation compares to its current price. We'll also run them through our process to derive the firm's Valuentum Buying Index rating.
The Valuentum Buying Index
Within the Valuentum process, if a company is undervalued both on a discounted cash flow basis and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores high on our scale. L-3 Communications posts a Valuentum Buying Index score of 6, reflecting our "fairly valued" DCF assessment of the firm, its neutral relative valuation versus peers, and bullish technicals.
Let's examine each of this considerations, save the technicals. Though a 6 is not a poor score on the index, we generally prefer firms with ratings of a 9 or 10 (a "we'd consider buying" rating), many of which are included in the Best Ideas portfolio.
L-3 Communications' Investment Considerations
• L-3 Communications earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has averaged 40.4% during the past three years.
• L-3 is a prime contractor in C3ISR systems, aircraft modernization and maintenance, and government services. The US government accounts for roughly two-thirds of revenue, and budget pressure could hurt results.
• L-3 Communications has a good combination of strong free cash flow generation and manageable financial leverage. We expect the firm's free cash flow margin to average about 7% in coming years. Total debt-to-EBITDA was 2.3 last year, while debt-to-book capitalization stood at 37.6%.
• Though shifting defense priorities will pose challenges, L-3 will benefit from demand related to replacing aged military fleets and DoD affordability initiatives. Geopolitical threats will always remain, and Congress has reduced sequester cuts through 2015.
• The company should gain share in the international market as well. The non-US market is a large and growing one, particularly for ISR systems, simulators, and aircraft modifications. L-3 is targeting the UK, Canada, Saudi, Australia, UAE, among others.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. L-3 Communications' 3-year historical return on invested capital (without goodwill) is 40.4%, which is above the estimate of its cost of capital of 9.6%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. L-3 Communications' free cash flow margin has averaged about 8.3% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At L-3 Communications, cash flow from operations decreased about 15% from levels registered two years ago, while capital expenditures expanded about 9% over the same time period.
Our discounted cash flow model indicates that L-3 Communications' shares are worth between $74-$123 each. Shares have currently breached the high end of this range ($125 each at present), and we would expect a lower score on the Valuentum Buying Index upon its next update. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $98 per share represents a price-to-earnings (P/E) ratio of about 11.5 times last year's earnings and an implied EV/EBITDA multiple of about 7.7 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of -0.4% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -7%. Our model reflects a 5-year projected average operating margin of 10.7%, which is above L-3 Communications' trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 1.6% for the next 15 years and 3% in perpetuity. For L-3 Communications, we use a 9.6% weighted average cost of capital to discount future free cash flows.
We understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money managers -- those that drive stock prices -- pay attention to a company's price-to-earnings ratio and price-earnings-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. For relative valuation purposes, we compare L-3 Communications to peers Boeing (NYSE:BA) and Lockheed Martin (NYSE:LMT), among others.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $98 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for L-3 Communications. We think the firm is attractive below $74 per share (the green line), but quite expensive above $123 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate L-3 Communications' fair value at this point in time to be about $98 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of L-3 Communications' expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $126 per share in Year 3 represents our existing fair value per share of $98 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.