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Sometimes it pays to be small, or at least smaller.
L-3 Communications competes for defense contracts with companies twice its size. The New York City-based company can hang with the giants because it focuses on products that improve the efficiency of existing military projects and develops tools and services that will work for a broad range of customers.
Meanwhile, the five major defense behemoths, such as Boeing and Lockheed Martin, have to rely on concentrated portfolios of big projects. Should a giant lose a major contract, the company will take a big haircut on its sales and earnings.
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L-3, which has grown over the years through a series of acquisitions, is not dependent on a couple of major projects for its success. Instead, it earns its keep with a basket of smaller contracts.
The current demands for military equipment play to L-3's strengths, says Bob Sweet, managing editor of Dow Theory Forecasts newsletter. The U.S. Defense Department, the company's top customer, wants more guided weapons, unmanned aerial vehicles, communications equipment and missile defenses. These are niches in which L-3 has an advantage.
For example, the company develops software that relays information from unmanned surveillance planes to troops on the ground. It also provides encryption technology and manages satellite communications for the military.
Homeland security is the company's fastest-growing business. For the first nine months of 2007, sales at its specialized-products division -- the one that caters to homeland-security customers -- grew 12% year over year, to $3.4 billion. (The company had total sales of $10.2 billion in the first nine months of 2007, up 11%, and analysts estimate that L-3 generated revenues of $13.7 billion for the entire year; fourth-quarter earnings are due out on January 31.)
The budget for the U.S. Homeland Security Department rose 9%, to $35 billion, for the fiscal year that ends this September. "L-3 is a major contractor for the department and most of these organizations prefer to work with contractors they know," Sweet says. "So I expect L-3 to be a main beneficiary of the budget increase."
One drag on defense stocks may be a growing perception that the Democrats will win the White House and try to cut defense spending. Yet, L-3 is less sensitive than most contractors to declines in overall defense spending because of its smaller contracts.
"If you need to trim $50 billion from the defense budget, you're not going to try to find 100 $500 million contracts to ax," Sweet says. "You are more likely to look for a couple $20 billion weapons platforms to scale back or cut."
That's not to say L-3 hasn't experienced contracting setbacks. In December, the U.S. Army denied L-3 the opportunity to renew a contract to provide translators in Iraq. L-3 is appealing the Army's decision, but there's only a slim chance of a reversal.
"The loss of the contract is already reflected in the stock price and the shares have recovered substantially since that news has come out," Sweet says. He places L-3 stock (symbol LLL) on Dow Theory Forecasts' focus list, which includes the newsletter's top 20 picks over the next 12 months.
The stock closed at $104.03 on January 8, down only 0.2% on a day when the Dow industrials fell 1.9%. L-3 carries a market value of $13 billion and trades at 16 times the $6.49 per share that analysts expect the company to earn in 2008 (analysts estimate that the company earned $5.92 per share in 2007). "The valuation seems reasonable for the kind of growth this company should be able to put together," Sweet says.
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