Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...
When a stock suddenly cuts its guidance for sales and earnings, raised price targets and analyst upgrades are not the reactions you'd expect to see from Wall Street -- and yet, that kind of seems like what's happening at L-3 Technologies (LLL) today.
Yesterday, L-3 held an investor conference in New York City, at which CEO-elect Christopher Kubasik updated investors on his plans for the company over the next few years. Among the key revelations were L-3's plan to earn profits of only $8.60 to $8.85 per share next year -- as much as $0.46 below consensus analyst targets of $9.06 per share -- and to do so on sales of about $9.95 billion, or about $1 billion below Wall Street's goal of $10.9 billion. Now, StreetInsider.com (subscription required) reports Jefferies & Co. has raised its price target to $201 per share, Drexel Hamilton upped its target to $214 per share, and RBC Capital out and out upgraded the stock to outperform and assigned a $239 price target.
As RBC explained in its write-up today, L-3's plans are "credible," offer a "path to continued margin improvement," and give L-3 stock "the best runway for revenue growth and margin improvement in defense." But is RBC right?
Let's find out! Here are three things you need to know from L-3's investor day.
1. The big reveal
Let's not bury the headline: L-3 Technologies says it expects to grow sales only about 5% year over year in 2018, to $9.95 billion (give or take $100 million). Furthermore, L-3 will earn an 11.3% operating profit margin on that revenue, resulting in operating profits of roughly $1.12 billion for the year.
This is where soon-to-be-CEO Kubasik plans to begin his term as CEO.
2. What comes next
L-3 plans to grow these numbers in three phases. Phase 1, beginning in 2018, will focus on divesting low-margin businesses, "integrating" higher-margin businesses, and expanding profit margins.
Phase 2 begins in 2019 and runs through 2021, as L-3 works to strengthen its business and grow its revenue. Management plans to spend more on research and development in hopes of winning more contracts and driving revenue growth. Management is expecting to reap mid-to-high single-digit revenue growth from its sensor systems and communications systems divisions over the medium- to long-term, mid-single-digit growth in electronic systems, and low-to-mid single-digit revenue growth in aerospace systems.
Finally, in 2022 and beyond, L-3 will work to win more prime contracts from the Department of Defense, grabbing a greater share of the profits and free cash flow from contracts on which it participates than what it could expect to earn as a subcontractor. Renewed merger and acquisition activity should also be expected in this phase.
3. L-3 by the numbers
Division by division, here's how L-3 sees itself in 2018:
Electronic systems remains L-3's flagship, earning 13.8% operating profit margins on $3.25 billion in sales, and growing sales at 6%.
Communications systems (which is the former electronics unit, minus sensor systems, which has been separated out) will be L-3's second-biggest division. Communications will earn respectable 11.2% margins on $2.28 billion in sales, and grow these sales at 5%.
The smaller but more profitable sensor systems group will power L-3's growth in the near term, earning 11.5% operating profit margins on $1.75 billion in sales, and growing those sales at a 10% annual clip.
And aerospace systems will bring up the rear, earning only 8.1% margins on $2.7 billion in sales. These sales will trend downward as L-3 de-emphasizes this less-profitable sector. In particular, L-3 plans to divest its Vertex Aerospace business, which does aircraft maintenance work for NASA and the U.S. Navy, among others, by the middle of next year.
The big picture
In the U.S., the defense industry has historically been dominated by five big "prime" contractors -- Boeing, Lockheed Martin, General Dynamics, Raytheon, and Northrop Grumman -- which win most of the Defense Department's big-ticket contracts. L-3's ultimate goal is to turn itself into the "6th Prime" on this list, picking and choosing "non-traditional" projects on which it can compete to become prime contractor.
In the nearer term, L-3 will focus on improving its numbers. Divesting Vertex (and not counting its results in forward guidance for this reason), L-3 says sales will grow 5% to $9.95 billion in 2018, with earnings rising likewise 5% to about $8.73 per share.
At today's share price of $195 and change, that works out to a forward P/E ratio of about 22.5 on L-3 Technologies stock. L-3 also hopes to grow free cash flow 7% to $865 million next year. Against a market capitalization of $15.2 billion (with $2.2 billion in net debt expected at the end of next year), that's an enterprise value-to-free-cash-flow ratio of 20.1. RBC appears to find these valuations attractive enough to justify upgrading L-3 stock to outperform, but as for me...
Much as I'd like to see L-3 succeed in becoming America's "6th Prime" defense contractor (because we really could use some more competition in the defense space), these prices simply seem too rich. Growth of 5% to 6% just isn't fast enough, in my view, to justify paying a 20-plus multiple to earnings or free cash flow.
Despite RBC's endorsement, I'm staying away from L-3 Technologies stock.