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Can This Defense Stock Outperform Its Bigger Rivals?

By Lou Whiteman – Updated May 9, 2018 at 8:20AM

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The nation's sixth largest defense contractor is revamping operations in hopes of outgunning the primes.

L-3 Technologies (LLL) missed out on much of the rally enjoyed by other defense contractors over the last year. The reason for the lagging performance was because the company was in the middle of a transformation plan aimed at propelling it into the ranks of those larger rivals. Judging by its first-quarter results, the efforts are already beginning to show results.

L-3, a maker of defense communications, electronics, hardware, and software, on May 1 reported quarterly earnings per share of $2.54, or $2.34 adjusted to account for discounted operations, easily beating the $2.01 per share consensus. The company reported a 10% year-over-year increase in orders and a 3% increase in funded backlog, and increased its full-year guidance for earnings per share to $9.40 to $9.60, from $9.30 to $9.50.

aerial view of the Pentagon

L-3 Technologies hopes to position itself as one of the Pentagon's preferred prime contractors. Image source: Getty Images.

Three of the company's four divisions came in ahead of estimates, and operating margin of 10.8% was up 0.4% year-over-year despite higher research and development spending. During its conference call with analysts, management noted that L-3's communications segment, the only part of the business to show weakness in the quarter, should pick up in the second half. That, plus the size of its backlog, makes those increased guidance numbers still appear conservative.

L-3 in December called 2018 a year of transition, with the 21-year old company refreshing its management ranks, investing in R&D, and more tightly integrating operations. Today, three of its four segment presidents have been on the job for a year or less. The company froze salaries and pension plans in December while altering incentive compensation plans to add organic sales growth and employee collaboration.

Company CEO Christopher Kubasik, on the company's analyst call, said L-3 is about 70% through its transformation.

"We're optimizing our processes, our technologies, and our talent to position us for future growth,' Kubasik said. "In 2019, we expect these investments and our increased R&D to drive incremental organic sales growth."

Expect a deal

Kubasik on the call said L-3 "can easily make $1 billion of acquisitions a year" without impacting its investment-grade credit rating and said the company could look to do an even larger deal if a good strategic fit emerges. In the wake of the Pentagon's recently completed strategy review, the CEO said L-3 has a clear view of where the Pentagon is headed, "and we'll be happy to do larger acquisitions if they make sense strategically and operationally and financially."

L-3 was built on dealmaking. The company was formed in 1997 from a collection of assets Lockheed Martin divested following its acquisition of Loral, and in the decade that followed did dozens of deals to expand its capabilities.

The company is building its cash reserve, expecting to generate about $400 million in after-tax proceeds from a just-announced $540 million sale of its Vertex services business to private equity. In terms of potential targets, something to do with the U.S. Navy or shipbuilding seems a likely bet. Last September, L-3 bought a start-up focused on undersea warfare and last April acquired unmanned submarine developer OceanServer Technology.

Kubasik said he hopes to position L-3 as "a non-traditional sixth prime," meaning a company with the heft to take on defense titans like Lockheed, Northrop Grumman, and Raytheon. That's a tall order, given that L-3 is currently less than half the size of the smallest of those rivals in terms of revenue.

L-3 is a buy

Shares of L-3 are up "only" 9.19% over the past year, a period where the S&P 500 is up 13.5% and defense titans like Raytheon and Northrop have appreciated by 28% and 27%, respectively. With L-3 seeing organic growth on the horizon, plus the prospects of M&A, the time is right to buy in.

L-3 trades at 21.62 times earnings, well shy of the multiples the market currently applies to Lockheed Martin (45.07), Raytheon (29.14), or Northrop (26.3). Over the next twelve months, L-3 looks primed to outperform its larger rivals. Expect the valuation gap to close.

Lou Whiteman has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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