L3 downgraded: defense update

6/30/2008


L-3 Communications ($95; NYSE: LLL) is being downgraded to Neutral and dropped from the Focus List and Buy List, reflecting discouraging share-price action and a worsening cash-flow picture. After more than 10 quarters of double-digit growth, per-share cash from operations rose 4% in the December quarter and fell 55% in the March quarter. L-3 trades at a discount to its historical norms based on price/earnings and price/cash flow ratios, but the stock is not particularly cheap relative to the defense group.

L-3 is among the defense contractors most vulnerable to a cutback in spending on Iraq. Recent share-price action suggests it may take more than a solid quarter or two for Wall Street to be confident in L-3’s ability to sustain its profit momentum without an acquisition. Subscribers tracking our Focus List or Buy List should sell L-3, but we remain comfortable having exposure to the defense group.

Wall Street is worried about the budget priorities of a new president in January, a likely slowdown in supplemental defense spending for Iraq, and the June 5 ouster of the Air Force’s top brass. All are legitimate concerns, but several factors support our bullish posture on select defense stocks:

The next president won’t change much. Already accounting for half of discretionary federal spending, defense spending has little room to sustain the brisk growth seen this decade. Military spending has jumped 59% since Sept. 11, 2001. Few analysts expect such robust growth to continue, and we think defense stocks already reflect expectations of slower growth.

Contractors have time. The first budget on which the next administration will have its say covers fiscal 2011. A troop withdrawal from Iraq will likely take at least 18 months. Sen. Barack Obama has pledged to end most military operations within 16 months if elected.

Iraq exposure is minimal. Apart from Harris ($52; NYSE: HRS), with about 12% of sales coming from Iraq spending, our other defense picks General Dynamics ($87; NYSE: GD) and Lockheed Martin ($104; NYSE: LMT) generate no more than 6% of sales from Iraq.

Quadrix® scores and valuations are attractive. Our three defense recommendations earn Overall scores above 80, with above-average scores for Value, Earnings Estimates, and Performance. With a return to three- or five-year norms for price/earnings ratios, share prices would range from $67 to $92 for Harris, $94 to $97 for General Dynamics, and $127 to $153 for Lockheed.

News roundup
National Oilwell Varco ($89; NYSE: NOV) surged more than 8% following an analyst upgrade on the strength of higher orders for land- drilling rigs and deepwater equipment. Consensus estimates project per-share-earnings growth of 27% this year and 19% next year. After the recent run-up, National Oilwell sells for 19 times estimated 2008 earnings, a reasonable valuation considering the company’s growth potential. National Oilwell is a Buy and a Long-Term Buy.

The U.S. Supreme Court reduced Exxon Mobil’s ($87; NYSE: XOM) punitive damages from the 1989 Valdez oil spill to $508 million from $2.5 billion. In other news, Exxon is selling about 2,200 retail gas stations to distributors who will continue to use the company’s name and products. Several oil giants have already taken similar steps. In other news, Exxon Mobil is a Long-Term Buy.

The Wall Street Journal reported that Citigroup ($19; NYSE: C) plans to cut 10% of its 65,000 investment-banking jobs worldwide. The cuts are part of a broader effort to trim $15 billion in annual expenses. Citigroup is rated Neutral.

Coventry Health Care ($30; NYSE: CVH) warned that June-quarter per-share earnings would be between $0.55 and $0.57, well below the $1.04 consensus estimate. The company said it was seeing higher-than-expected claims at its Medicare and commercial businesses. Coventry also lowered its guidance for 2008, projecting per-share earnings of roughly $3.70, versus the $4.42 consensus. The stock fell more than 20% on the news. Coventry is rated Neutral.

The Government Accountability Office ruled that the Air Force unfairly awarded a $40 billion tanker contract to European Aeronautic Defence and Space, the parent company of Airbus, and Northrop Grumman ($69; NYSE: NOC). The decision opens an opportunity for Boeing ($70; NYSE: BA), which has traditionally made the in-flight refueling tankers. The Air Force plans to determine whether or not to reopen the contract process by mid-August. Boeing is rated Neutral.

Shares of Yahoo ($22; NASDAQ: YHOO) rose nearly 3% on reports from some news providers that the company had renewed talks with Microsoft ($28; NASDAQ: MSFT) about selling part or all of the company. However, other news organizations have said there are no talks, and neither company has disclosed any new information. Microsoft is a Buy and a Long-Term Buy. Yahoo retains its Neutral rating.

May-quarter earnings
Oracle ($22; NASDAQ: ORCL) reported a 27% increase in May-quarter earnings to $0.47 per share, beating consensus estimates by $0.03. Sales rose 24% to $7.24 billion, powered by growth of 26% in software and 18% in services. In fiscal 2008 ended May, operating profit margins rose to a record 43.0%. In other news, the company said it would buy the applications business of Skywire Software, a developer of software for insurance companies, for an undisclosed amount. Oracle said it was pursuing business from many financial-services end markets, including insurers. Oracle is a Buy and a Long-Term Buy.


Walgreen ($34; NYSE: WAG) reported May-quarter earnings of $0.58 per share, up 4% and $0.01 below the consensus estimate, on a 10% increase in sales to $15.02 billion. Same-store sales increased 3.4%. The company said expense controls and continued store expansion helped boost earnings. Walgreen is a Long-Term Buy.


Nike ($66; NYSE: NKE) reported May-quarter earnings of $0.98 per share, up 14% and $0.02 above consensus estimates, on 16% revenue growth to $5.09 billion. Orders for delivery from June through November jumped 11% to $8.8 billion, rising at double-digit rates for every region except the U.S., which remained flat. Nike is rated Neutral.

News digest
Bunge ($110; NYSE: BG), a maker of fertilizer and food products, announced it would pay $4.8 billion in stock, or $56 per share, to acquire Corn Products ($50; NYSE: CPO). Bunge is rated Neutral.


Duke Energy ($18; NYSE: DUK) increased its quarterly dividend 5% to $0.23 per share, payable Sept. 16. Duke, rated Neutral, is a component of the Top 15 Utilities portfolio.


A month after raising prices 20%, Dow Chemical ($37; NYSE: DOW) said it would further increase prices by up to 25% to recoup high energy costs. Dow is rated Neutral.


General Motors ($13; NYSE: GM) announced it would cut production and raise prices on 2009 models while reducing prices and offering interest-free financing on 2008 models. GM is rated Underperform.


Shares of Monsanto ($136; NYSE: MON) fell despite a stronger-than-expected 42% increase in per-share earnings for the May quarter. Monsanto is rated Neutral.


MasterCard ($294; NYSE: MA) agreed to pay up to $1.8 billion to American Express ($42; NYSE: AXP) to settle an antitrust lawsuit. American Express is rated Neutral.


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