L3: Investing in Homeland Security

10/10/2003 12:00 am EST

Focus:

Richard Moroney

Editor, Dow Theory Forecasts

"It’s no secret that 9/11 inspired our nation to ramp up its security and defense capabilities, and one firm positioned to benefit is L-3," says Richard Moroney, editor of Dow Theory Forecasts. "Increased military spending and more dollars for homeland security should keep profits headed higher over the next several years." Here are the details.

"L-3 Communications (LLL  NYSE) provides products in four basic areas. Its secure communications and ISR (information, surveillance, and reconnaissance) products (around 25% of total sales in 2002) include global intelligence-gathering systems. Training, simulation, and support services account for around 20% of sales. The firm’s aviation products include collision-avoidance systems and cockpit recorders. The largest segment in terms of revenue—specialized products (37%)—includes explosive-detection systems for airports and shipping ports. Approximately two-thirds of the firm’s 2002 revenue came from the Department of Defense. While the company is dependent on the US government for the bulk of its revenue, its diversified base—L-3 has about 800 US government contracts with values exceeding $1 million—should help shield it from cutbacks in any one area.

"A major part of L-3’s growth strategy in recent years has been acquisitions. Long term, the company should benefit from further opportunities to work with the Department of Homeland Security. One area of likely growth is the securing of our nation’s ports. Customs and Border Protection officials estimate that of the 16 million containers that flow through US ports annually, fewer than 10% are X-rayed or opened by hand. L-3 has developed an X-ray device that can penetrate the tops of cargo trucks to detect explosives inside.

"L-3 Communications trades for less than 17 times the 2003 consensus earnings estimate. That multiple seems low given the company’s strong earnings growth and healthy organic revenue growth. To be sure, increasing concerns about the nation’s budget deficit could limit further increases in defense spending. And a prolonged delay in the commercial aviation rebound—L-3 expects this business to recover toward the end of next year—would hinder profit growth. Still, the company has enough on its plate to generate the type of growth that should draw investors. These shares traded in the upper $60s in 2002, and we are looking for a move back to at least the mid-$50s over the next 12 months. The stock is our "analysts’ choice" recommendation and we have initiated coverage with a buy rating."

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