Marcial: L-3, a Stellar Pick in Security Tech

Vigilant preventive action worldwide against terrorism is in high gear. And that is boosting global demand for an array of surveillance and reconnaissance systems, as well as devices that detect explosives and firearms at airports, seaports, train stations, and government buildings. Analysts expect sales of such protective equipment will only accelerate in the years ahead.

Investors looking into homeland security technology plays may find L-3 Communications (LLL) on their radar. The company is a leading provider of secure high-data communications systems, defense electronics, and other related products, primarily for military and government uses. Some 75% of L-3's total orders come from the U.S. Dept. of Defense, with its "specialized" products accounting for 39% of operating profits and 34% of sales. These include little-publicized undersea warfare equipment and sophisticated security and detection systems,

Although the business of providing security systems is regarded as recession-resistant, L-3's stock has been beaten down along with other issues that investors dumped because of the recession and financial crisis.

From a 52-week high of 115.33 a share on Apr. 24, the stock had been battered to 50 by Nov. 21. By Dec. 19 it had bumped up to 70.

But that sharp decline from 115 "has all the more made L-3 an attractive buy," says Marian Kessler, co-portfolio manager of Becker Value Equity Fund (BVEFX), who figures the stock will snap back to 95 in a year (Becker owns shares).

picture of health

In these bleak economic times, most investors flock to companies that are financially healthy, and L-3 fits that bill. Since 2006, L-3 has posted an annual growth rate in operating profits of around 51%, and in sales of about 35%. Its return on invested capital (operating profits after taxes, as a percentage of long-term debt, plus equity) was 8.8% in 2007, up from 7.2% in 2006. And free cash flow (cash flow from operating activities minus capital expenditures) as a percentage of sales was 8% in 2007, vs. 7.4% in 2006.

At its current price of 72 a share, the stock is trading at 9.7 times Kessler's estimated earnings of $7.40 a share in 2009—below the stock's p-e range of 19-13 in 2007. This indicates, says Kessler, how undervalued the stock is.

With the incoming Obama Administration, the demand for homeland security systems and equipment in the U.S. is likely to continue, if not increase, argues Kessler. "These are not the big-ticket defense items like missiles or jet fighters that may get careful scrutiny in a review of the defense budget by the Obama administration," opines Kessler. If anything, Obama, as President, may substantially increase government spending on all anti-terrorism programs, she adds.

transition play

Indeed, L-3 may just be the right stock for investors now, even before Obama gets sworn in on Jan. 20. "It is our safe-haven defense play," says analyst Cai von Rumohr of investment firm Cowen & Co. (COWN), who rates the stock outperform.

The company's "broad products and service mix, low pension risk (the pension fund is fully funded), and coherent plan for 10% or more [annual] earnings-per-share growth," he says, make L-3 an attractive buy during the Administration changeover. The analyst's 2009 earnings estimate for L-3 of $7.70 a share is higher than Kessler's, although his 2008 estimate of $6.80 is lower than Kessler's forecast of $7.30.

Standard & Poor's analyst Richard Tortoriello, who rates L-3 a buy, has a price target of 100 a share, based in part on the company's mix of defense electronics and specialized military products, and government services. And the company's "good organic sales growth, strong cash-flow generation, and attractive valuation," he says, should benefit investors. (S&P, like BusinessWeek, is a unit of The McGraw-Hill Companies (MHP.)

L-3 is gaining traction in large part because, whether or not another terrorist attack occurs, investors expect government spending on the kinds of products and services the company provides will expand. And the general belief that no country can be overly vigilant against terrorism underscores the importance of L-3's products and technology.

Unless otherwise noted, neither the sources cited in Gene Marcial's Stock Picks nor their firms hold positions in the stocks under discussion. Similarly, they have no investment banking or other financial relationships with them.

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