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L-3 Comms Keeps Earnings Growing, but for How Long?

By Rich Smith - Oct 29, 2013 at 5:16PM

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A dearth of new orders, slowing revenues, and evaporating free cash flow threaten growth prospects.

Despite missing analysts' estimates for Q3 revenues, and posting a near-9% decline in such revenues versus the year-ago period, defense contractor L-3 Communications (LLL) saw its shares rise strongly in Tuesday trading. But why?

Actually, there are a few reasons. In its Q3 2013 earnings report, L-3 confirmed that it booked just under $3 billion in revenues for the quarter, increased operating profit margins 40 basis points to 10.5%, reduced its share count by 6.3%, and, partly because of this, grew its net profit 13% to $2.23 per share.

But the news wasn't all good. For example, much of the company's increase in profitability was due to the company's benefiting from a lower effective corporate income tax rate. In Q3 2012, L-3 calculated its effective income tax rate at 29.1%, but that rate declined in Q3 2013 as L-3 claimed a $14 million government R&D tax credit. Had L-3 paid taxes at the same rate this quarter, as it was paying a year ago, the company's net profit (but not its net profit per share) would actually have declined slightly.

Other points to note include a steep decline in cash profits in Q3 2013. Free cash flow for the quarter dropped to $185 million from the $320 million in FCF the company generated a year ago. That's a 42% drop -- and the difference between generating far more cash than the company's income statement was implying a year ago, and generating quite a bit less cash than its earnings would suggest this year.

Another reason investors might want to pause before cheering along with the buyers today: L-3 took in funded orders for new equipment and services of only $2.7 billion in Q3. That's a 16% decline year over year, and means the company's "book-to-bill" ratio was only 0.9. In other words, L-3 replaced every $1 worth of work done in the quarter with only $0.90 worth of new orders for work it's been contracted to do in the future.

Foolish takeaway
This suggests that the 9% decline in revenues that L-3 experienced in Q3 is a trend that will not soon reverse. Further revenue weakness lies ahead. Indeed, funded backlog at the company has now slipped 3% from where it stood at the beginning of this year, to $10.6 billion.

While for the time being, L-3's doing a fine job of keeping earnings growing through a combination of tax breaks and share buybacks, the tax breaks will eventually run out. And with free cash flow drying up, the buybacks are going to be hard to maintain. Unless L-3 can get its revenues growing again, the next few quarters could be hard rowing for shareholders.

Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool owns shares of L-3 Communications Holdings. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.

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