Another week, another defense stock analysis. As promised, I return this week with my second instillation of Pick That Defense Stock. Last week, I found Alliant Techsystems (NYSE: ATK) has some real positives going for it driven by its diversified product portfolio, skilled management, and cheap valuation. This week, let's take a look to see if L-3 Communications (NYSE: LLL) is poised to also stand out in an already beaten-down sector. In analyzing the company, I'll look at its long-term business model, financial standing, management strength, and current valuation to see whether the company seems appealing.

What L-3 does
L-3 operates four reportable segments: C3ISR, Government Services, Aircraft Modernization and Maintenance (AM&M), and Electronic Systems. C3ISR, which stands for the long-winded Command, Control, Communications, Intelligence, Surveillance, and Reconnaissance, sells products and services to the global intelligence market. Government Services provides various engineering, technical, IT, advisory, training, and support services to different portions in the U.S. defense establishment. As you could probably guess, the AM&M division supplies modernization and upgrade services for government aircraft. Finally, the Electronic Systems Segment sells sophisticated electronic equipment (such as navigation equipment) to various U.S. defense-related agencies and contractors.

For the fiscal 2010, each segment contributed to L-3's operating results as follows:

Segment Name

% of Total Revenue

Total Revenue Amount (in $M)

Operating Margin

C3ISR 21.7% 3,399.1 11.6%
Government Services 25.3% 3,963.0 8.7%
AM&M 17.7% 2,780.9 8.2%
Electronic Systems 35.3% 5,536.6 14.1%

From this, I see no one segment really drives the business; none of the segments comes close to accounting for more than half of the company's revenue. This bodes reasonably well for L-3 since it means its business fortunes won't rise and fall with a single product line. This kind of diversification within their product offerings could help potentially cushion L-3 even if defense spending gets squeezed in coming years.

Does this same kind of diversification exist along customer lines? For fiscal 2010, L-3's customer base broke down as follows:

Customer Name

2010 Sales (in millions of dollars)

% of Total Sales

Air Force 3,981 25
Army 3,843 25
Navy/Marines 2,538 16
Other defense 1,570 10
Other U.S. government 1,145 8
Foreign governments 1,142 8
Commercial -- foreign 791 5
Commercial -- domestic 670 4

This signals a potential red flag for me. While I obviously expect a defense contractor to do the majority of its business with the federal government, I generally prefer to see at least some reasonable diversification among customers. In aggregate, L-3 generates more than three-quarters of its business directly from the U.S. military. Contrast this with the 46% of revenue Alliant Techsystems derives from military spending. Which company do you expect to suffer more if/when potential defense cuts occur?

Financial performance
Throughout the past decade, L-3 has produced consistent performance. I like to examine current financial ratios versus their 10-year averages. Performing this kind of check helps to provide a better sense of trends within a business. It also helps to smooth numbers to get a better sense of that business's performance. Since 2001, the company generated an average return on equity of 12.8%, steadily growing it in the latter part of the last decade to 14.3% in 2010. Although not by any means eye-popping, I do appreciate the consistency L-3 shows in creating such returns. This becomes more impressive considering the company slowly decreased its debt-load during the same period. Starting at 102.5% of equity and falling to today's 60.5% level, the company shows commitment to keeping its finances in order.

L-3 also shows some glimmers of hope in looking at its margins. Over the past decade, L-3 has expanded its net income margin despite enduring regularly shrinking gross margins. This indicates a cost-conscious management, another plus in my book.

Having said all those positives, the overall size of their numbers doesn't blow me away. Gross margins in the teens and net margins hovering in the mid-single-digits point to the competition inherent in defense contracting. Without a specific niche the company really dominates or other groups to sell to, L-3 seems pretty exposed to defense cuts. So here, L-3 gets both a plus for its consistency and a minus for its relatively low margins.

Management evaluation
As long-term investors, we want to know that the people who receive our hard earned dollars have our best interests at heart. I ideally prefer management to own a meaningful number of shares in the company. Fortunately, both executives and directors widely own respectable numbers of shares in L-3. Although no management team can guarantee results, a well-incentivized management will certainly do their best to deliver for shareholders (both us and themselves).

Valuation
In looking at the business, I find mixed signals in L-3's investment potential. On an absolute scale, the stock looks cheap, with a P/E of 9.8. For comparison's sake, its peers Lockheed Martin (NYSE: LMT), Northrop Grumman (NYSE: NOC), Raytheon (NYSE: RTN), and General Dynamics (NYSE: GD) each trade at 11.3, 10.0, 11.1, and 11.4 times earnings, respectively. Given the industrywide price depression, L-3's current pricing probably reflects investors' bearish opinion for the defense industry more than some fatal flaw with the company itself. However, considering that the S&P 500 currently trades at 17.2 times earnings, the stock does seem really cheap. For around half the price of the overall market, you get a reasonably leveraged, well-managed company with a consistent operating history in L-3 Communications. Depending on your view of the future, perhaps this is a compelling buy.

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Andrew Tonner owns no shares of any of the companies mentioned in this article. The Fool owns shares of General Dynamics, L-3 Communications, Lockheed Martin, Northrop Grumman, and Raytheon and has written puts on L-3 Communications. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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.