Stock Mart: L-3 Communications

Forgive L-3 Communications (LLL) its indulgent shopping habits.

Since defense behemoth Lockheed Martin (LMT) set it loose in April 1997 as the industry consolidated, L-3 has nearly doubled its quarterly revenue and acquired a string of companies, including SPD Technologies, Microdyne and Interstate Electronics. And plenty of targets remain for CEO Frank Lanza, who was a top officer at another acquisitive company, Loral, itself acquired by Lockheed Martin.

But some investors have expressed concern about L-3's strategy, and its stock has suffered. It reported that second-quarter profits doubled and revenue grew 36%, but investors were more concerned that revenue excluding acquisitions was flat, thanks to delays in a few international contracts. Shares have slipped 16% since the company reported earnings July 19. They closed Friday at 40 1/4, up 1/2.

Some investors who unloaded found a buyer in Richard Freeman, manager of the Smith Barney Aggressive Growth fund. He has no quibbles with L-3's growth.

"I'm drawn to companies that can make accretive acquisitions," says Freeman, who since late 1998 has grown his stake to 400,000 shares, or 1% of his portfolio. Freeman says L-3's acquisition strategy reminds him of longtime holding Tyco (TYC), which has acquired more than 10 companies in the last two years. In the June quarter, Tyco grew operating profits 75% from one year earlier and expanded margins partly by absorbing newly acquired units.

L-3 now trades at 3.5 times book value, 28 times profits in the trailing four quarters and 1.1 times revenue. While some peers such as Litton (LIT) trade at lower multiples, analysts Will Chiewchanpanich and William Kidd with C.E. Unterberg Towbin point out that L-3's price-to-earnings multiple based on 1999 earnings of 24 is less than the 34% earnings growth they predict this year. Litton and others in the industry trade at higher P/Es than their expected growth rates. Unterberg Towbin has acted as banker for L-3.

New York-based L-3 makes instruments that range from spy antennae for Apache helicopters, to "black boxes" for airplanes, to power systems for Naval ships and submarines. L-3 also develops explosive detectors for airports. Uncle Sam accounts for roughly two-thirds of revenue these days; foreign governments and commercial customers such as AT&T (T) comprise the remainder.

L-3's heavy defense exposure is worrisome to some. For instance, when the House of Representatives voted to eliminate funding for the F-22 Raptor fighter jet, concerns arose among defense industry investors. But L-3 is filling its arsenal of smart weaponry, as evidenced by its $60 million purchase of Interstate Electronics from Scott Technologies (SCTT). Interstate furnishes the Navy with equipment such as missile tracking systems for its Trident submarines. And the military needs sharper eyes and ears.

L-3 is "benefiting from increased spending on tactical intelligence as opposed to dumb hardware," says Colin Morris, senior vice president with the investment firm Arnhold & S. Bleichroeder in New York. His firm's hedge fund, long active in the defense sector, snapped up shares of L-3 when they traded below 40 this week.

Analyst Pierre Chao with Credit Suisse First Boston still expects L-3's sales excluding acquisitions to grow 8% to 10% this year.

"Almost all [this year's] projected growth is in current backlog and is a matter of timing and delivery, not winning new work," writes Chao in a recent report. L-3's backlog swelled to $952 million in the second quarter from $875 million in the first quarter and $856 million at year-end. Chao, whose firm has banked deals for L-3, rates the stock a buy and sets a 12-month price target of 57.

Meanwhile, expect no apologies for L-3's shopping binges. While the company is cagey with Wall Street about future targets, bullish investors and money managers alike believe L-3 will continue acquiring in a consolidating industry.

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