We maintain a Neutral recommendation on L-3 Communications Holdings Inc. (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. The company holds a Zacks #3 Rank, which translates into a short-term Hold rating, and correlates with our long-term recommendation.
L-3 Communications Holdings operates through its wholly owned subsidiary, L-3 Communications Corporation. L-3 Communications is a leading supplier of a broad range of products and services used on a number of aerospace and defense platforms. In addition, the company is a prime system contractor for aircraft modernization and maintenance; simulation and training; and government systems support services.
Earlier, in July 2012, L-3 Communications completed the spin-off of a new, independent, publicly traded government services company – Engility Holdings Inc. (EGL) – to L-3 shareholders. We believe that L-3 Communications has ample opportunity for growth and profit expansion after the favorable conclusion of the spin-off of its Government Services businesses.
The company has retained its profitable Cyber, Intelligence and Security Solutions business. The spin-off also removes a lot of uncertainty with respect to revenue and takes away some of the low margin businesses of the company.
Over the longer run, we view the company as one of the best-positioned pure defense players based on its non-platform focus, prominent position as sub-contractor/supplier to other defense primes, broad diversification of programs and strong order bookings. Its strong balance sheet also provides financial flexibility to increase its dividend, indulge in share repurchases and earnings accretive acquisitions.
We believe future growth will come from its strong presence in the areas it currently focuses on. These include command, control, communications, intelligence, surveillance and reconnaissance (C3ISR) equipment; precision-guided weapons; unmanned aerial vehicles (UAVs); and other electro-mechanical robotic capabilities, networked information technologies, special operations forces, platform upgrades and counterterrorism initiatives.
On the flip side, however, a substantial portion of L-3 Communications’ business is generated within the U.S, with government and commercial sales accounting for 82% of sales in fiscal 2011. Budget deficits and political uncertainty looms on future defense budgets with high chances of shrinkage.
Moreover, more than half of L-3 Communications’ sales in fiscal 2011 came from fixed priced contracts. Consequently, the company will only be able to make a profit if costs stay within the set limits. Given these headwinds, we maintain our Neutral stance on L-3 Communications.
L-3 Communications mainly competes with Honeywell International Inc. (HON) and Raytheon Company (RTN).
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