L-3 Communications Holdings, Inc.: Why Did an Earnings Slip Spook Shareholders?

For the past few weeks, defense investors have been treated to a series of happy news announcements from the likes of Northrop Grumman (NYSE: NOC  ) , Lockheed Martin (NYSE: LMT  ) , and Raytheon (NYSE: RTN  ) . Nearly to a "man," these corporations have all reported declining revenues. But thanks to improving profit margins on the revenues they had left, they've all managed to grow earnings regardless.

But now comes rival defense company L-3 Communications (NYSE: LLL  ) to report its own earnings this morning -- and it's got another story to tell, entirely:

  • Sales for the first fiscal quarter of 2014 slumped 7%, a result worse than most have reported. All four of the company's key business segments reported lower sales in Q1 2014, than they had enjoyed in Q1 2013.
  • Profit margins expanded 50 basis points, much like its peers.
  • Yet despite the improve profitability, L-3 was unable to achieve profits growth in the quarter, as earnings per diluted share slipped 5% to $2.01 per share
  • Free cash flow turned negative, with L-3 burning through $91 million worth of cash in Q1, versus the $98 million in positive free cash flow the company generated in the year-ago quarter.

Little wonder, therefore, that investors are punishing L-3 stock this morning, sending the shares down more than 1% in a fluttering stock market.

CEO Michael Strianese blamed "continued reductions in U.S. defense spending" for the quarter's weak results. He expressed little confidence, too, that the Pentagon will open its wallet anytime soon, instead describing plans for continued cost-cutting, and a turn to "international and commercial customers" -- now accounting for 29% of L-3's sales -- to shore up its business: "We remain focused on improving efficiencies across our businesses, increasing market share and pursuing opportunities in adjacent markets."

Aside from that, Mrs. Lincoln, how was the play?
So did L-3 have any good news to report? Actually yes, a few things. For example, new funded orders received in Q1 ($3 billion worth) exceeded the amount of revenues booked in the quarter, giving L-3 a book-to-bill ratio of 1.01. These new orders even bumped up L-3's backlog number a bit, to $10.4 billion, which is enough work to guarantee L-3 about 10 months worth of revenues.

And speaking of the future, L-3 still thinks it can maintain and even expand its improved profit margins. Expectations for full-year operating profitability are at 10.5%. Management still expects to generate $1 billion in positive free cash flow over the course of this year, despite the Q1 stumble. And from a GAAP perspective, things might even improve a bit. L-3 raised guidance for full-year earnings per share by a nickel -- to $8.20-$8.40 per share.

Foolish final thought
Granted, even if L-3 hits these targets, they would still represent declines of about 5% in both profits and free cash flow year over year. The hope, of course, is that L-3 can execute on its plan to get more business from abroad, and more business from private businesses, too, and thus start growing again.

Analysts polled by S&P Capital IQ give the company good odds on achieving this, averaging a consensus forecast of nearly 5% annual earnings growth over the next five years. Let's hope they're right, because if continued earnings declines are all L-3 can offer its investors, it's unlikely they'll stick around for just more of the kind of news the company gave us in Q1.

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