L-3 Communications: A Torrid Tech Stock

This maker of secure military networking gear and bomb detectors has seen its share price double since September. It may not be done yet

By Olga Kharif

Little-known L-3 Communications (LLL ) has been an anomaly during the tech downturn. While other communications equipment makers have been struggling, in 2001 L-3 increased sales by 23%, to $2.35 billion, and net income by 40%, to $115 million, or $2.87 per share.

This was no magic trick. It turns out L-3 that is in the right place at the right time. The New York-based company is a leading maker of components for secure networks the military and federal government use to direct missiles and disperse intelligence information. Big plans are in the works to expand these networks over the next few years.

Also, L-3 is one of the two companies certified by the Transportation Security Administration to make the bomb detectors that scan airplane passengers' luggage. All U.S. airports must install such devices by Dec. 31, 2003, and L-3 hasn't been able to pump out the $1 million machines fast enough.


  The company will report first-quarter earnings on Apr. 23. Analysts polled by First Call expect earnings per share to come in at 69 cents, an increase of 72.5% from the 2001 period. L-3 is in a "quiet period" and, consequently, unable to comment for this story. But since September, its stock price has more than doubled from $60 a share to a new high of $125.81, where it closed on Apr. 12.

Some analysts say the stock still has room to run. On Apr. 10, Stephen Murphy, an analyst at CIBC World Markets, increased his target price to $135 a share. "It's the best-positioned company in the whole defense sector," he says. Others agree: Ten of 13 analysts covering the stock rate it a buy or strong buy. Murphy says even if the stock stumbles -- as L-3 issues more shares to finance past and future acquisitions -- investors should regard dips as buying opportunities.

L-3 has robust growth prospects mainly because the military has made upgrading as much as 75% of its communications gear a top priority, says Murphy. Planes and ships need broadband connections. And intelligence gathered by one military agency needs to be made available to others: A jet crew that detects enemy troops should be able to make their location known to all friendly forces. According to Murphy, the secure-communications market should grow 50% by 2006, to $18.75 billion, from $12.5 billion in 2001.


  The company gets 60% of its revenues from the sale of communications gear and is the industry leader in secure connections. Its CDL data links are considered Defense Dept. standards and are used in U-2 surveillance planes, the Predator armed drones that have been deployed so successfully in Afghanistan, and Global Hawk unmanned aerial vehicles (UAVs). UAV use is expected to grow rapidly, and the communications-links market should double in 5 to 10 years, estimates David Rockwell, an analyst at Teal Group, a defense consultancy based in Fairfax, Va.

L-3 also scored with its acquisition of a unit of defense giant Raytheon (RTN ) that makes intelligence and surveillance systems, such as radar, which gather information for pilots and military commanders. The deal nearly doubled L-3's size and turned the company into one of the biggest players in intelligence-gathering systems. L-3 values this market at $6 billion in the U.S., and it should more than double within 10 years, estimates Rockwell. In addition, the acquisition should allow L-3 to market its own products, such as data recorders and encryption devices, to the Raytheon unit's intelligence agency clients.

Another growth area for L-3 lies in explosives-detection equipment, used in airports to scan passenger luggage. About 2,200 machines are supposed to be in place at the nation's airports by yearend 2003, but the target date is likely unachievable since L-3 and InVision Technologies (INVN ) -- the other company certified to make this equipment -- are just ramping up production. Still, L-3, which received a $162 million contract for 100 machines on Apr. 3, should record about $800 million in detector sales in the next three years, estimates J.P. Morgan analyst Joseph Nadol.


  Such an enticing market is sure to attract more competition. Yet Sergio Magistri, president and CEO of InVision, says other companies are unlikely to get certified soon. "At this time, [federal security] standards are more likely to become more stringent, not easier," he says. L-3 receives 2% of its revenues from the machines and holds a 10% share of the market. But it could hit 40% within several years, Nadol estimates.

Much of L-3's success will depend on how quickly the company can increase its production from the 25 units a month it now makes. Analysts estimate it could produce 450 machines this year. L-3's prospects also depend on how well the company is able to integrate its latest acquisition, although analysts point out that most of the more than 20 acquisitions L-3 has made since 1998 went well.

Meanwhile, about 30% of L-3's business comes from the commercial sector, such as aviation and telecoms. And that might not pick up until yearend, figures Philip McAlister, an analyst at aerospace consultancy Futron. Finally, there's the company's sizable $2.3 billion debt load. But as long as L-3 sustains its rapid growth, it should have no problems finding financing, either by floating bonds or selling equity, says Andris Kalnins, an analyst with credit agency Moody's Investors Service.


  Will L-3 grow at the expected 20%-plus per year? Most analysts give an emphatic yes. They also believe the stock isn't overvalued -- although quantitative analysis firm ValuEngine.com, which uses industry and company data to compute stock values, sees it as expensive at current levels and puts its fair value at about $106.

"Its valuation is in line," counters David Gremmels, an analyst at Thomas Weisel Partners, pointing out that L-3 has always traded well above the share prices of its peers. Investors who climbed aboard 12 months ago are reaping the benefits of that premium. But newcomers may still have a chance to score with a tech company that's beating the odds in a beaten-up industry.

Editor's Note: Since this story was originally published, L-3 reported first-quarter earnings in late April of 77 cents a share, exceeding analysts' estimates of 69 cents. Its sales of $697 million represented a 51% increase over the year-earlier period. On June 6, L-3 announced it would raise $750 million through a private placement of 10-year, senior subordinated notes. The proceeds will be used to repay a loan and to redeem or repurchase previously issued notes. L-3 also plans to sell 14 million shares in a public offering. As a result, on June 6, Standard & Poor's placed L-3's BB long-term credit rating on watch with positive implications. Considering a recent two-for-one stock split, L-3 has nearly doubled since September, from $30 a share to $58.74 on June 11.

Kharif covers technology from Portland, Ore.

Edited by Beth Belton

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