EUR 850.00 For Business Accounts Only

Morningstar | L-3 Delivers Solid 2Q, but Its Outlook for Next Year Is Even Better; Raising FVE

We're raising our $188 fair value estimate for narrow-moat L-3 on the back of a strong second quarter and an even better outlook for 2019. Management increased full-year guidance for revenue, EPS, and cash flow, and it also hinted at continued growth in 2019, while pulling forward its 12% operating margin  objective  to 2019 from 2020. We’ve moved up our 2018 forecasts and have also increased margins for 2019. Our fair value increased to $195 per share. While the fundamentals are strong at L-3 and we like the new CEO’s focus on driving margins and accelerating growth through selected investments, we view shares as a slightly overvalued.

Consolidated revenue rose 8.3% year over year thanks to 7.5% organic growth driven by 10% growth from Department of Defense activities. However, operating margins only moved up 10 basis points to 12.4%. At the segment level, operating margins dropped 170 basis points to 10.6% due to higher R&D at sensor systems and poor performance out of communication systems, which continues to struggle. Management had stuck with its 2018 guidance for communication systems after a tough first quarter, but it has now downgraded its outlook. We think hitting 12% consolidated operating margins by next year hinges on fixing communication systems’ broadband and traveling wave tube activities. We were surprised by aerospace systems’ growth this quarter (up 9% year over year) and management thinks the business should grow through the back half of 2018 and into 2019.

Adjusted EPS, which backs out a $0.31 gain on Vertex and a $0.45 debt retirement charge, grew 3% year over year to $2.47. L-3 maintained its operating margin guidance for 2018 but increased its revenue and EPS outlook; the new adjusted EPS midpoint sits at $9.90, up from $9.50. Considering the Vertex divestment, which should yield about $430 million after tax and assuming at least $300 million spent on acquisitions, we anticipate L-3 generating about $1.1 billion of free cash flow in 2018.

Chris Kubasik is proving to be an indefatigable CEO: hunting for acquisitions (in July L-3 entered into an agreement to buy two companies for $200 million), cleaning up the portfolio, ramping up R&D spending, revamping the executive ranks, and rationalizing L-3’s organizational structure continue to fill up his to-do list. Given how full the executive team's plates seem to be, we welcomed the news that L-3 plans to bring onboard a chief transformation officer.