(By Mani) Through 2012, shares of defense contractor L-3 Communications Holdings Inc. (NYSE:LLL) have managed to keep pace with a strong market as well as the resilient gains in large-cap defense. Moreover, cash should remain a key attractor, while dividend increases are likely to continue.
L-3 is a prime contractor in Command, Control, Communications, Intelligence, Surveillance and Reconnaissance (C3ISR) systems, aircraft modernization and maintenance, and national security solutions. L-3 is also a leading provider of a broad range of electronic systems used on military and commercial platforms.
The relatively in-line performance is a nice turnaround from the underperformance of 2010/11, and it is partly driven by portfolio enhancement.
New York-based L-3, which spun off Engility Holdings in July 2012, has cut its costs and divested low margin service related work, which was currently 15 percent of sales compared to 30 percent of sales in 2011.
"As investors get more and more comfortable that owning LLL has a similar risk profile to other defense names, we expect some of the discount being seen in free cash flow yield (30% better) and P/E (13% discount) to narrow," Deutsche Bank analyst Myles Walton said in a client note.
Meanwhile, cash flow yield remains in the midteens, and with or without sequestration the company is expected to generate $1 billion plus free-cash flow in 2013.
The cash deployment strategy into 2013 will likely be similar to 2012 with a dividend increase, continued share-count reduction, debt reduction and small bolt-on acquisitions.
In addition, 2012 earnings and cash performance is on track to hit the company's and consensus targets, while there could be some modest upside to the bookings target for the year.
"We're currently forecasting a 2-3% organic decline in 2013 revenue, with a touch of margin pressure offset by 7% share buyback driving EPS growth of about 5%. Sequestration, if enacted, is likely to shave another 5% from 2013E growth," Walton noted.
Though L-3 doesn't have as much of the noncash cumulative catch-up earnings revision benefit being seen in other large-cap defense names, the 4Q risk of the department of defense (DoD) pulling back on buying in advance of the sequestration seems lower following Pentagon guidance to continue to spend.
For the second quarter, L-3 reported that net income allocatable to common shareholders decreased to $205 million from $242 in the year ago quarter. Earnings per share were $2.08, compared to $2.26 in the same quarter last year. Consolidated net sales of $3.6 billion were 6 percent lower than last year. Analysts polled by Thomson Reuters expected the company to report earnings of $1.88 per share on revenues of $3.20 billion for the second-quarter.
The company sees earnings per share from continuing operations to be in the range of $7.70 to $7.85, and net sales of $12.950 billion to $13.150 billion for fiscal 2012. Analysts currently expect the company to report earnings of $7.82 per share on revenues of $13.04 billion for fiscal 2012.
"Overall, we continue to like LLL as a contrarian defense play, with its discount valuation, sustainable free cash flow ($1B+ even under sequestration), a continuing improving portfolio profile and achievable guidance giving the stock a favorable risk/reward profile, in our view," Walton added.