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What's in Store for These Defense Contractors?

Paul Chi
February 6, 2012

Defense companies have been dealing with headwinds for quite some time now, and further budget cuts loom. Exposure to the U.S. government was once a plus for defense companies, since it meant stability and growth. These days, increased commercial and international revenue is the name of the game, since the government is unlikely to increase the defense pie anytime soon. Despite these headwinds, I would still watch developments in this space. Valuation multiples are very low across the board, so it's quite hard to stay away without peeking in.

Cheap valuation, plenty of free cash flow
Last week, L-3 Communications (NYSE: LLL  ) reported 2011 sales of $15.2 billion, down 3% from 2010. The book-to-bill ratio for the full year was 0.97, signifying that the company could not book more orders than it had in sales. That's not very surprising, given the tough operating environment. For the year, the company returned $1.1 billion in cash in the form of share repurchases and dividends in 2011, quite a hefty sum given the company's market cap of just over $7 billion. 

In fact, what I like about this company is the steady free cash flow generation paired with its cheap valuation. This has enabled the company to repurchase its shares at an incredible rate: 13.6% of shares outstanding have been retired in just the past two years. As long as investors continue to shun shares of defense companies, this is likely to continue. Over the longer term, since the inception of L-3's share repurchase plan, about one-third of the company's outstanding stock has been retired.

So far, the company projects 2012 sales of $14.4 billion to $14.6 billion, which would represent a decline of 4% to 5% versus its 2011 figure. Most of that is related to the US military drawdowns in Iraq and Afghanistan. For the year, free cash flow is expected to be just under $1.2 billion, which implies a price-to-FCF multiple of less than 6 on the stock. That's an extremely low multiple, one that offers extremely attractive valuation for share buyback purposes. I expect the company to continue spending the majority of its free cash flow to repurchase stock for as long as this remains the case.

Finally, the company expects its book-to-bill ratio for the first quarter to be 0.95, with the full-year number to be slightly less than 1.0. Based on the company's expectation for future bookings, that means the company expects a further sales decline in 2013, albeit a very small one.

Lifted by jets
General Dynamics (NYSE: GD  ) , unlike L-3, managed to eke out a small increase over 2010 sales for 2011 at $32.7 billion. While General Dynamics has an impressive array of incumbent programs such as the Virginia-class submarine that provides it with most of its revenue, the biggest reason to be excited about this company is actually its aerospace segment, home to its Gulfstream business.

The company's aerospace sales were up $1.9 billion in the fourth quarter, up 50% YOY and 30% sequentially. In fact, aerospace was the reason for the company's modest sales increase over 2010. Its other three segments actually had $488 million less in sales in 2011 than in 2010. 

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