Between the Balance Sheets at L-3

Wall Street analysts are effusive in their praise of L-3 Communications (LLL - commentary - Cramer's Take), a defense communications conglomerate with a $5 billion market cap, saying the company "should trade at a premium valuation to its peers," that its "valuation is compelling" and that it has "a strong balance sheet."

After reviewing L-3's financials, I've concluded that such opinions are sorely misguided. Prudent investors -- even speculative investors -- would likely do well to avoid this stock.

That's my assessment of the stock. Now, let's talk analytic process, stepping back to review the process that I use when reviewing a company's financials, using L-3 as an example.

Step 1: Look at the Current Balance Sheet

The balance sheet is the nexus of my risk assessment. My analysis moves forward on two fronts, with evaluations of financial risk -- e.g., the risk of insolvency, strength as a going concern -- and accounting risk. With the latter, the risk is that the financials, while in compliance with generally accepted accounting principles, are often misleading. That's the case here. The financials of L-3, at first glance or after a cursory review, don't tell the underlying story of the business.

I have no idea why one Wall Street analyst says L-3 has a strong balance sheet; it is heavily leveraged, lacks tangible assets and provides no margin of safety for investors.

Because the company does lots of acquisitions, it has lots of goodwill. (That's an intangible asset that represents an accounting entry; it can't be converted to cash.) Below, I've simplified the balance sheet and made an adjustment to take out goodwill in order to determine the tangible net worth. As you can see, as of March 31, the result is that L-3 had negative net equity of $1.122 billion.

With a feeble balance sheet and an overvalued stock, L-3 management should, of course, sell lots of stock. And that's what it did in June, selling $1.5 billion in stock and debt. Although post-offering balance-sheet information isn't yet available, I've done my own calculations: The tangible net worth of the company is still negative, at roughly $350 million.

Step 2: Look at Five Years of Balance Sheets

The current balance sheet is simply a snapshot, a singular moment in time in the life of a company. I like to look at several years' worth of balance sheets to see how a company's financial condition has evolved.

I'm reminded of the Folgers instant coffee commercials, popular many years ago, when I look at several years of L-3 balance sheets. In the commercials, fancy restaurants would secretly switch from fresh brewed to Folgers instant coffee, in the hope that customers wouldn't notice the difference.

At L-3, a look at several years of balance sheets shows there's been a similar switch, as tangible assets have been replaced with intangible assets. It's as if the company thought -- or hoped -- that investors wouldn't notice the change.

Step 3: Compare and Contrast the Financial Statements

Analytically, this is where it gets challenging for the unsophisticated, but this is also where anomalies can be spotted. Review and compare each of the financials, side by side: the balance sheet, income statement and the statement of cash flows. I like to do this with a few years of financials, but a lot of space on your desk is required!

If L-3 didn't do any acquisitions, the change in current liabilities from period to period, marked by (2) above, would match the change recorded on the statement of cash flows, marked by (3) above. But they are going in opposite directions. This tells me that while reserves are entering the balance sheet at a decent clip, they are being unwound as well, exiting the balance sheet as earnings (as offsets to expense).

In a word, L-3 is generating balance-sheet income. Is this GAAP? Yes. Is there any way to justify a premium valuation for L-3 in this context? Absolutely not -- quite the opposite. Reported earnings that are augmented by balance-sheet adjustments should be discounted, not granted a premium. Once L-3 stops making acquisitions and reserves are used up, inflated earnings levels will adjust downward to reflect true underlying profitability.

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The Turnaround Report

Some current trends that I see in L-3's financials are not sustainable, and I think L-3 is getting close to "hitting the wall." If you're interested in my calculations on this issue (and additional analysis), I'll be including that in the next issue of my newsletter, The Turnaround Report. On that matter, I'm not objective at all: I recommend a trial subscription. Click here to sign up.

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Arne Alsin is the founder and principal of Alsin Capital Management, an Oregon-based investment advisor specializing in turnaround situations. At time of publication, neither Alsin nor ACM held a position in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Alsin appreciates your feedback and invites you to send it to [e-mail]. Click here to receive Arne's latest favorite stock picks from his newsletter, The Turnaround Report.