Defense contractor L-3 Communications (NYSE:LLL) enjoyed a banner year for its stock in 2013, gaining 39% in 12 months of trading. But heading into its Thursday earnings report, things were looking pretty bleak for the company. Earnings for the year were expected to be only $8.30 or thereabouts, less than a 4% increase over 2012 levels, and probably too little growth to support the stock's 13-times earnings P/E ratio. But then the numbers came out, and a miracle happened:

  • 2013 sales declined 4% to just $12.6 billion, setting the stock up for a big drop in profits.
  • Operating profit margins slipped 30 basis points (to 10%), potentially magnifying the drop.
  • Yet somehow, L-3 managed to grow its earnings per share anyway -- up nearly 7% to $8.54.


Well, a couple of factors worked to L-3's benefit in 2013. For one thing, with profitability being a bit lower, taxes didn't bite as deep. L-3's effective income-tax rate declined by four full percentage points, to 28.2%. For another thing, this defense company did what it could to defend its shareholders, deploying cash in a series of buybacks that shrank its share count by nearly 7%.

Result: Even though overall net profits declined, the fact that these profits were spread out among fewer shares resulted in a modest increase, rather than a decrease, in profits per diluted share.

Second verse, same as the first
L-3 shareholders had better hope L-3 makes even more buybacks this year. Otherwise, 2014 could prove painful. The company is projecting further slippage in sales, with full-year 2014 revenues estimated at no more than $12.1 billion -- another 4% decline. Curiously, however, the company believes it will find a way to squeeze extra profits out of these reduced revenues, and grow its operating margin back up to 10.5%.

That would be a neat trick, but even if L-3 manages to pull it off, an anticipated rise in effective tax rates, to 33%, could end up reducing profits per diluted share to as little as $8.15 per share. Absent further help from buybacks, that could result in an earnings decline of as much as 5% in 2014 -- even worse than what analysts are already expecting.

Given that the analysts already aren't expecting much out of L-3, and are projecting long-term earnings growth of only 2.4% annually, a failure to clear an already low bar could trip up L-3's stock pretty badly.

Rich Smith has no position in any stocks mentioned. The Motley Fool owns shares of L-3 Communications Holdings. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.