Is Now the Time to Buy L-3?
L-3 Technologies ' (NYSE: LLL) long, and at times quixotic, quest to be at the same level as the massive defense prime contractors remains under way. But the company's second-quarter results and outlook did at least show signs of progress. And with that progress, the stock is increasingly looking like an attractive buy.
L-3 was formed in the late 1990s from assets carved out of Lockheed Martin after that company purchased a majority of the assets of the former company Loral (the three Ls in the name stand for co-founders Frank Lanza and Robert LaPenta and Lehman Brothers, which put up the capital). Over its first 20 years, the company completed more than 130 acquisitions, building a portfolio of businesses that supplied components to top-tier contractors and niche products directly to the government.
In recent years, management has talked of L-3 evolving into what they call a "non-traditional sixth prime," level with Lockheed, Raytheon , Northrop Grumman , General Dynamics , and Boeing even though the company doesn't manufacture the tanks, warships, or fighters traditionally associated with those companies. L-3 has divested more than $1 billion in revenue and refined its focus toward areas including sensors, electronics, and communications, as well as specialty areas like undersea drones, where it believes it can compete with the biggest contractors.
But for all the talk, L-3 still has a way to go before it can be included among the titans. At just under $10 billion in annual sales, the company is less than half the size of the smallest prime, and it trades at a significant discount to the group in terms of price-to-earnings and price-to-sales.
A noisy, but strong, quarter
On July 26, L-3 reported second-quarter earnings of $2.47 per share, adjusted for discontinued operations, easily topping analyst expectations for $2.32. Revenue, at $2.58 billion, beat expectations by about $100 million. L-3 had said in May it would sell Vertex Aerospace and two other units to American Industrial Partners for $535 million, and over the last year has acquired at least eight companies, making its numbers a jumbled mess, but the underlying results were strong, as was the outlook. After announcing the quarterly results, L-3 hiked its full-year guidance for adjusted earnings per share guidance to a range of $9.80 to $10, an increase of $0.40 per share.
L-3 also used the proceeds from the Vertex sale to reduce its net debt to $1.9 billion, or about 1.6 times EBITDA . The company has the borrowing ability, coupled with free cash flow -- projected to be about $915 million for the year -- to continue to acquire its way into new businesses.
The acquisitions from the last few years are beginning to bear fruit. Case in point: L-3 did a series of deals to build a commercial-pilot training program around its flight simulator business, and now is bringing in about 1,600 candidates annually for an 18-month program that prepares them to get a job in aviation.
Reshuffling toward growth
Christopher Kubasik, the onetime heir apparent at Lockheed Martin who has been CEO of L-3 since July 2017, has spent the last year revamping management ranks, investing in research and development, and more tightly integrating operations.
The company plans to complete the consolidation of IT and HR functions by year's end, laying off upwards of 500 employees, in a bid to more closely align different divisions and improve results. It's also reducing its operating units from four to three, combining aerospace systems with sensors into a new intelligence, surveillance, and reconnaissance systems unit -- worth $4.7 billion in sales -- which will stand alongside the company's existing electronic systems and communications segments.
"In order to move up the food chain and deliver more integrated solutions, we need to be better coordinated in developing technology and agile in addressing customer needs," Kubasik said during a July 26 earnings call with analysts and investors.
Moving up the food chain is the long-term goal: L-3 hopes to find spots where it can deal directly with the government and get the margins that come with it, instead of being relegated to simply supplying components. On that front, during the quarter, L-3 was awarded a $390 million deal for 13,000 next-generation night vision goggles. The initial order puts the company in a strong position to compete for the Army's planned purchase of 100,000 night vision goggles in the years to come. Even if one was to assume a discounted price on a larger order of the goggles, a win on that bigger order could significantly move the needle for L-3, which currently brings in less than $10 billion in sales.
The time is right for L-3 to expand into new areas, with the Pentagon set to increase spending thanks to a two-year budget deal signed earlier this year.
The company is also investing in R&D: It expects to spend 3.5% of sales this year compared to 3% in 2017; has added new management positions focused on engineering, international sales, and organizing the transformation; and is reshuffling its troubled communications division. Overall L-3's funded orders were up 32% year over year, while its backlog increased by 4% to $8.8 billion.
The plan is on track
L-3's second-quarter organic growth was 7%, the highest rate the company has achieved in nearly a decade. The company is only guiding to about 5% in 2019, but with the night-goggle contract and other new awards, 7% to 8% seems possible. L-3's book-to-bill ratio -- future orders booked over current revenue -- for the quarter was 1.1.
There are other prime opportunities on the horizon, including Transportation Security Administration bomb detection support and Federal Emergency Management Agency IT support. L-3's management team expects to get to 12% margins by 2019, compared to an operating margin of 10.6% in the most recent quarter, and said on last week's call it believes it can expand margins further into 2020.
L-3's always had an impressive collection of assets, but under Kubasik, the company is at long last beginning to function like a cohesive entity. Shares of L-3 are up 7% year to date, besting the performance of most of the primes, but the company still trades at a 46% discount to Lockheed and 20%-plus discount to Raytheon and Northrop Grumman on a price-to-earnings basis.
Time will tell whether L-3 will be able to one day grow to be that nontraditional sixth prime management talks of. But growth is on the horizon, and the shares should react accordingly. Now looks like a great time to buy shares of L-3.
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