L-3 Takeover Fetches 21% More Than Value by Breakup: Real M&A

L-3 Takeover Fetches 21% More Than Value by Breakup
L-3 Communications Holdings Inc. has returned 1.1 percent including dividends in the past three years, compared with a 22 percent return for the 29-member Standard and Poors Supercomposite Aerospace & Defense Index. Photographer: Chris Ratcliffe/Bloomberg

L-3 Communications Holdings Inc., whose biggest investor is pushing for the defense company to dispose of underperforming assets, may extract as much as $2.2 billion more for shareholders in a takeover than a breakup.

L-3’s equity may garner a price tag of $12.9 billion in an acquisition, based on the median 8.7 times earnings before interest, taxes, depreciation and amortization offered for military electronics company deals in the past 10 years, according to data compiled by Bloomberg. Selling the New York-based company’s four units separately may generate $10.7 billion, estimates from Lazard Capital Markets LLC show.

Ralph Whitworth’s Relational Investors LLC said L-3 should consider selling “underperforming or low-growth, low-margin” assets to boost shares that returned 21 percentage points less than rival defense and aerospace companies in the past three years. While the company would be worth the most in a takeover, according to Lazard analyst Michael Lewis, the hurdle is finding a buyer big enough to swallow the entire portfolio and able to gain antitrust approval, said Huntington Asset Advisors.

“Certainly considering a sale of the entire company should be something the board entertains,” said Timothy Ghriskey, chief investment officer at Solaris Asset Management in Bedford Hills, New York, which manages $2 billion. “Whether a purchaser would want to take on the whole company might be another story.”

Jennifer Barton, a spokeswoman for L-3, declined to comment. Whitworth, 55, also declined to comment.

Activist Investor

Relational, the San Diego-based firm founded by activist investor Whitworth and David Batchelder in 1996, disclosed an almost 6 percent stake in L-3 last week, making it the biggest shareholder.

The investment firm -- which recently pushed for changes at companies from ITT Corp. to Genzyme Corp. and Electronic Arts Inc. -- said L-3’s shares are undervalued because of its “sub-optimal” business mix and current strategy, according to a regulatory filing. Relational said it’s talked with management about these issues “from time to time” and that L-3, currently valued at 10 times net income, would be worth more if it sold or spun off some assets, potentially to private equity firms.

L-3 has returned 1.1 percent including dividends in the past three years through yesterday, compared with a 22 percent return for the 29-member Standard and Poor’s Supercomposite Aerospace & Defense Index. The shares jumped 4.7 percent when Relational’s stake was disclosed June 22, the biggest gain since January.

‘Do the Math’

“When you do the math, the shares are undervalued,” said Howard Rubel, a New York-based analyst at Jeffries & Co. “If you look at some of L-3’s franchises, the market hasn’t fully appreciated them.”

The shares gained $1.07, or 1.2 percent, to $88 at 10:13 a.m. today in New York.

L-3 is comprised of four divisions that focus on government services, aircraft modernization, advanced electronic systems and secure communications and intelligence gathering products.

Relational made a presentation to L-3 months ago, during which it recommended selling or spinning off divisions including the government services unit, except for the cyber-security portion, and the aircraft maintenance and modernization unit, according to a person with knowledge of the matter, who declined to be identified because the discussions were private.

Defense Spending

Revenue from government services, which provides engineering and technical support to U.S. defense agencies, fell 7.2 percent in the last two years to $3.96 billion in 2010 as it lost contracts, according to the company’s 2010 10-K regulatory filing. It was the only unit with declining sales during both annual periods.

More than 83 percent of L-3’s $15.7 billion in revenue came from the U.S. government last year.

U.S. defense spending through 2016 is projected to grow no more than the rate of inflation after climbing 72 percent from fiscal 2000 to 2008, after adjusting for inflation and including spending for the wars in Iraq and Afghanistan, according to the Pentagon. In April, President Barack Obama proposed $400 billion in cuts in national security spending by 2023, in addition to the five-year plan for $78 billion in defense spending reductions Defense Secretary Robert Gates announced in January.

“They had a lot of contracts with the defense departments, and the budgets may get nicked,” said Ralph Shive, the South Bend, Indiana-based manager of the $1.8 billion Wasatch-Large Cap Value Fund, which includes L-3 shares. “There seems to be quite a bit of bearishness about the defense budget.”

Breakup Sale

While government services is underperforming, selling the whole unit would leave L-3 at a “significant” disadvantage to rivals that have such offerings, said Lazard’s Lewis, who’s based in New York.

Breaking up L-3’s four units and selling them separately would fetch a total valuation of 7.6 times his estimate for the company’s combined Ebitda next year, according to an analysis by Lewis. That equates to $10.7 billion plus $3.6 billion in net debt and compares with his estimate that selling the company as one entity would garner an 8.4 Ebitda multiple, or $12.1 billion excluding net debt.

While he estimates that three of the units would command a premium, he predicts the government services business would be sold at a discount.

“If you were to break up the firm into disparate segments, the value proposition erodes to a potential buyer,” Lewis said. “They can get a better valuation to their investors. This is assuming management decides that an exit is in their best interest. To sell the company all-out, because of the synergies that L-3 has built into that business, it is more valuable.”

Worth More Whole

L-3’s units are worth more as a whole because its information technology infrastructure is “intricately interwoven” throughout the company, Lewis said. A buyer would have to invest to integrate an individual unit into its system, he said.

Deals in the military electronics industry in the last 10 years have drawn a median of 8.7 times Ebitda. At that multiple a takeover of all of L-3 would be valued at $12.9 billion excluding net debt, based on analysts’ estimates for 2012 Ebitda of $1.89 billion. That’s 40 percent more than the company’s market value of $9.2 billion as of yesterday, and $2.2 billion, or 21 percent, more than Lazard estimated the pieces could fetch in a breakup.

“Right now the dynamic is that the public market valuations are at a discount to what an acquirer is paying,” said Michael Holland, who oversees more than $4 billion as chairman of Holland & Co. in New York. “It’s not a crazy thing to consider an acquisition of L-3 would come at a significant premium.”

Highest Valuation

The highest valuation would be realized by first selling off “non-core or underperforming” contracts within government services and then finding a buyer for the rest of the company at an estimated multiple of 9 times next year’s Ebitda, Lewis said.

BAE Systems Plc, Europe’s largest defense contractor, could be a potential buyer for all of L-3 after acquiring U.S.-based L-1 Identity Solutions Inc.’s counter-terrorism business and Fairchild Imaging Inc. this year, said Peter Sorrentino, a senior portfolio manager at Huntington in Cincinnati, which manages $14.8 billion, including L-3 shares.

Brian Roehrkasse, a spokesman for London-based BAE Systems, declined to comment.

A buyer would need to be in the defense business and have “the cash,” such as Honeywell International Inc. or Lockheed Martin Corp., Ghriskey said.

Warren Buffett

Robert Ferris, a spokesman for Morris Township, New Jersey-based Honeywell, and Rob Fuller, a spokesman for Bethesda, Maryland-based Lockheed Martin, declined to comment.

L-3 was also one of more than 40 companies that Bloomberg identified in March that met the acquisition criteria Warren Buffett listed in his annual letter to shareholders.

Buffett typically prefers “simple” businesses with pretax profit exceeding $75 million, “consistent” earning power, and “good” returns on equity while employing little or no debt, according to his report.

The hurdles to any sale would be the company’s size -- an enterprise value, or the sum of its equity and debt minus cash, of $12.9 billion -- and antitrust approval.

“A strategic investor in L-3 is not likely because other large-cap defense companies essentially have plenty of bulk and they don’t want to have all these services businesses that L-3 has,” said Cai Von Rumohr, an analyst at Cowen & Co. in Boston. The alternative may be a private equity firm buying up L-3 and “cutting it up and selling pieces,” which would involve tax consideration, he said.

‘Extensive’ Review

As early as October 2010, L-3 Chief Executive Officer Michael Strianese said the company had begun examining its portfolio to identify underperforming units.

The company has been doing a “rather extensive” review of its businesses, Strianese said in an interview on June 20 at the Paris Air Show.

“We’re targeting possible action on those businesses where we see lower growth, lower margin than our composite margins, lower barriers to entry, and conflicts of interest in services area,” he said, reiterating that he would update investors about the conclusions in July.

Despite Relational’s push for change and a potentially higher value in a takeover, some investors say the company is better off as is.

“It’s like pulling the fire alarm before there’s even smoke coming out of the windows,” Huntington’s Sorrentino said. “This is not a management team that has been a serial underperformer. Let’s give them a chance to see what they come up with.”

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