Despite the appearance of turmoil, many folks on Wall Street are bullish about shares of defense contractor L-3 Communications Holdings Inc.
L-3's stock price has bounced around more than its competitors' this year, outperforming the Standard & Poor's 500-stock index by 12 percentage points in March before sinking to 12 percentage points below the index's year-to-date pace early this month. Despite the recent corporate shocks, the New York company looks set to expand faster than its defense counterparts, giving bulls reason to bet that the stock has plenty of room to rise.
Always quirky because of its eclectic portfolio of defense and homeland security products and its frenetic acquisition strategy, L-3 has become a highly speculative play. Frank Lanza, the company's chairman and chief executive, died in June, six weeks after disclosing he had undergone throat surgery. The day his death was announced, L-3's stock jumped nearly 5 percent, to $76.93, on conjecture that the company would become an acquisition target. The conventional wisdom was that, deprived of the founder's vision, L-3 would have to be sold intact or parceled off.
Management sought to quell such rumors, saying L-3, with expected 2006 sales of $12 billion, has enough critical mass and growth potential to go it alone. No sale appears to be in the offing, but that hasn't dampened some investors' enthusiasm. It closed last week at $75.81 in New York Stock Exchange composite trading, giving the company a market value of more than $9 billion. L-3 trades at about 13 times estimated 2007 per-share earnings, cheaper than the current average for defense-industry stocks.
''The stock is significantly undervalued right now,'' says Matthew Halbower, a portfolio manager at Deephaven Capital Management, a Minnetonka, Minn., hedge-fund firm with about $3 billion in assets that is a significant institutional investor in L-3. ''One thing that has kept the stock languishing is the lack of a full-time leader and the perceived lack of strategic direction. We expect that to get resolved [this month].''
Michael Strianese, L-3's chief financial officer and interim CEO, is the front-runner to succeed Lanza, according to investors and Wall Street analysts. L-3 has interviewed at least one outside candidate, a senior executive at a large defense contractor, people familiar with the process say. L-3 lead director Robert Millard parried CEO-succession questions during the company's second-quarter conference call, saying only that he and two other directors are ''moving expeditiously and thoughtfully'' with the search.
That the next CEO probably will come from within suggests that the board hasn't found an outside candidate who meshes with what some L-3 insiders consider - not always fondly - a scrappy, family-style corporate culture. Strianese also is familiar with L-3's complex finances.
As interim CEO, Strianese impressed investors by acting decisively to remove uncertainty over the backdating of stock options. As soon as the problem emerged in June, he hired outside lawyers to investigate and promptly took a $25.5 million after-tax charge to prevent the issue from lingering.
The inquiry found no fraud was committed in the backdating of some stock options between 1998 and 2003.
When L-3 disclosed the full details in a Securities and Exchange Commission filing Aug. 9, the stock slumped to a 52-week low of $66.58. Citigroup defense analyst George Shapiro described the moment in a research note as a ''unique buying opportunity, as L-3 is trading in line with defense primes but is expected to grow at least 50 percent faster than the industry.'' Shapiro forecasts a target price of $93. Citigroup owns L-3 shares and has provided investment-banking services for the company.
Robert Spingarn, a Credit Suisse defense analyst, said that despite a second-quarter loss because of the stock-options charge and a charge from a court ruling, which the company is appealing, L-3 has ''perhaps the best earnings power in the sector.''
From earnings per share of $4.20 in 2005, he forecasts $4.30 this year and $5.93 in 2007. Credit Suisse has done investment-banking work for L-3 in the past year.
Excluding acquisitions, L-3's second-quarter sales grew 10 percent, and Strianese estimated full-year sales growth, also excluding acquisitions, would be at the high end of L-3's guidance range of 8 percent to 10 percent. He also touted two recent acquisitions made to gain technology to upgrade L-3's explosives-detection machines for an ''advanced checkpoint solution for airports, because we think that is the next big wave of product that could be sold into the airport or U.S. market.''
In addition to homeland security, L-3 is moving from supplier to an aspiring prime contractor. It leads a team bidding for a multibillion-dollar Pentagon program for small cargo planes. L-3 also has growing franchises in maintenance and military training.
To be sure, L-3 faces risks, such as losing one of its biggest contracts - the Army linguist program inherited from Titan Corp. - in a fresh competition to renew the contract early next year.
Analyst Joseph Nadol of J.P. Morgan Chase & Co., who has an ''underweight,'' or sell, recommendation on L-3, wrote that recent comments by the lead director raise questions about whether the board or the next CEO will be directing corporate strategy. J.P. Morgan doesn't own L-3 stock or have an investment-banking relationship with L-3.
The Utah connection
* L-3 Communications is the parent company of Communications Systems-West, which employs 2,300 people at its northwest Salt Lake campus. Much of what CSW does is top secret because of its communications technology products for military and government clients.
* CSW in its present incarnation is the largest division that was spun out of Lockheed Martin to found L-3 in 1997.
