Inside Wall Street: Turnaround at L-3?

The major US defense contractor's move to spin off some assets is seen as big boost for shareholders.

By Gene Marcial Jul 2, 2012 5:34PM

Image: Guided Missile Destroyer USS MacDonough (© The Stocktrek )Wall Street has been down on shares of defense contractors largely because of concerns about U.S. defense cuts and stiff competition, as well as worry over the projected accelerated decline in Afghanistan-related sales. So it wasn't surprising that the stock of L-3 Communications (LLL) had been falling.


In recent weeks, however, the stock has perked up, sparked by the scheduling of the spinoff of some parts of L-3's government services unit. The stock has climbed to $74 a share, where it traded Monday, from $71 in early June. A year ago the stock was at its peak, selling at $88 a share -- until it dived to a low of $58 on Sept. 22, 2011.


L-3, a major U.S. provider of defense intelligence, surveillance and reconnaissance systems and a wide range of engineering and technical services to the U.S. and foreign governments, is spinning off to shareholders some of its government services businesses. The spinoff company will trade as an independent entity, called Engility, on the New York Stock Exchange. L-3 shareholders on record as of July 16 will each receive one share of Engility for every six shares of L-3.


While most analysts who follow L-3 continue to be cautious about its stock, some big investors are starting to snap up shares. The reason appears obvious to them: They expect L-3's stock, a component of the Standard & Poor's 500 Index ($INX), to continue rising because they figure it is undervalued and because of a "gift" in the form of EGL shares. EGL will trade on a when-issued basis on July 9 through July 17 and start exchanging hands on a "regular way" basis on July 18.


Investment research company ValuEngine rates L-3 as a strong buy, based on its expectations that the stock will outperform.

"Based on available data as of June 26, 2012, we believe that L-3 should be trading at $91.30 a share," ValuEngine says.


L-3's management sees the spin-off as the best strategy to respond to changing and declining demand in the industry. It believes EGL will be better positioned to serve its key customers and achieve long-term growth while at the same time pursuing cost-effective and innovative solutions for them. L-3 expects to benefit from improved margins and growth as management focuses on its core capabilities.


As an independent company, EGL will be able to pursue contracts that it hadn't been able to take on as part of L-3 mainly because of "conflict of interest" issues because L-3 is a defense contractor. EGL's potentially robust growth has been constrained, some analysts point out, because of such conflicts.


After the spin-off, L-3 will have about 20% of sales from its government services operations and logistics support market. The company is trying to scale back its dependence on government sales, hence the spin-off. It's part of L-3's efforts to strike a more balanced sales mix between government and its commercial businesses.


Its sales profile is characterized by a large degree of exposure to war-related U.S. Army sales that are expected to decline over the next two years as the war in Afghanistan winds down. With the spin-off, L-3 will have roughly $1.2 billion in Afghanistan-related sales, which include small aircraft and electronics systems. Last year, L-3’s total revenues amounted to $15.16 billion and EBITDA of $1.88 billion, or a margin of 12%.


L-3's major customers for its government services unit include the U.S. Department of Defense, Department of Justice, USAID and the FAA. In 2011, the EGL unit generated revenue of 2.18 billion, mostly from the U.S. government agencies.


The continued skepticism of Wall Street toward L-3 should be an opportunity to buy the stock at a still relatively low price, according to the bulls. 

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