When last we heard from defense contractor L-3 Communications (NYSE: LLL), it had just wrapped up a year of consistent outperformance. Sales rose 12% in the fourth quarter, and with margins expanding, profits did even better. Will the new year be as successful as the last?

What analysts say:

  • Buy, sell, or waffle? Fifteen analysts follow L-3, down two from last quarter. Eight of them think the stock's a buy, six more say hold, and one's a seller.
  • Revenues. On average, they expect to see 7% quarterly sales growth to $3.52 billion.
  • Earnings. Profits are predicted to rise 17% to $1.51 per share.

What management says:
CEO Michael Strianese termed 2007 "a successful year," and it would be hard to argue otherwise. Sales came to nearly $14 billion last year, with profits of $5.98 per share and free cash flow of $1.1 billion. This year, Strianese expects to do even better. L-3 is predicting $14.3 billion in sales, about $6.55 per share in profit, and $1.2 billion in free cash flow.

What management does:
Hold up a sec. If I read that right, L-3 expects to increase its sales by a bare 2% this year. Yet somehow, management intends to transform that nearly flatlined growth into almost 10% profits growth. How in heaven's name does L-3 think it can do that?

Just as it's been doing all the past year long -- by continuing to expand its profit margins. Strianese is targeting a 10.8% operating margin this year. If he achieves that goal, it would make the company more profitable, dollar for revenue dollar, than either Lockheed Martin (NYSE: LMT) and Boeing (NYSE: BA). And it would close the gap with, but not pass, General Dynamics (NYSE: GD) and Raytheon (NYSE: RTN).

Margins

9/06

12/06

3/07

6/07

9/07

12/07

Operating

10.1%

9.9%

9.9%

10.3%

10.3%

10.4%

Net

4.2%

4.2%

4.3%

5.2%

5.3%

5.4%

All data courtesy of Capital IQ, a division of Standard & Poor's. Data reflects trailing-12-month performance for the quarters ended in the named months.

One Fool says:
L-3's anticipated slow revenue growth sounds a lot like what Lockheed was threatening to post just a few days ago (but happily failed to deliver today). It's also, if I might add, something that I predicted a few months back, when trends in L-3's backlog were suggesting that the blistering pace of sales growth at the company had to slow up eventually.

Apparently, "eventually" is now, but Strianese's profit-margin promises suggest that management has a plan in hand to keep profits growing even as revenues begin to cool. Unless these predictions change dramatically tomorrow, therefore, I'm thinking this might well turn into a bad news-is-good news situation.

So if investors get spooked and sell off the stock tomorrow, I'd suggest you take a good, hard look at the valuation. Last time I checked, L-3 was selling for a mere 12.5 times its trailing free cash flow but was expected to grow at better than 21% per year going forward. There's a lot of pessimism already baked into these shares, and I have to wonder whether Mr. Market is serving us up a bargain.

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Fool contributor Rich Smith does not own shares of any company named above. The Motley Fool has a disclosure policy.