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L-3 Communications Holdings Inc. (LLL - Analyst Report) reported its third quarter 2012 earnings per share of $1.97, surpassing the Zacks Consensus Estimate of $1.86. However, on a year-over-year basis, earnings were down 17% from $2.24. Even strong orders failed to offset the challenging U.S. defense budget environment.

Operating Statistics

Quarterly net sales were down by 0.5% year over year to $3.28 billion. However, net sales were above the Zacks Consensus Estimate by $26 million. Sales were up in the three segments, namely Aircraft Modernization and Maintenance (“AM&M”), Command, Control, Communications, Intelligence, Surveillance and Reconnaissance (“C3ISR”) and Electronic Systems. However, this was offset by lower sales from the National Security Solutions (“NSS”) segment.

Key contract wins during the quarter included continued operations and sustainment for the U.S. Army Constant Hawk aircraft, an indefinite-delivery/indefinite-quantity (ID/IQ) contract to supply VideoScout products and related upgrades to the Marine Corps, communications systems for NASA’s Common Communications for Visiting Vehicles program, and an ID/IQ contract to supply medium-speed explosives detection and ProVision Automatic Target Detection advanced imaging technology systems to the Transportation Security Administration. Funded order backlog was $11.0 billion versus $9.9 billion at fiscal-end 2011.

Total operating income for the reported quarter decreased 8% year over year to $331 million. Operating margin contracted 80 basis points to 10.1%. Overall net income decreased 9% year over year to $193 million.

Segment Performance

Electronic Systems: Electronic Systems generated net sales of approximately $1.40 billion in the reported quarter, up 1% year over year. The upside reflects higher sales for Microwave Products, Sensor Systems, and Simulation & Training products. These increases were partially offset by sales decrease for Marine & Power Systems, reduced shipments of tactical quiet generators for the U.S. Army, and lower volume for Precision Engagement products. Segment operating income was $158.3 million, down 5% year over year.

C3ISR: The segment recorded net sales of $885.9 million, up 1% year over year, driven by higher volume for airborne ISR systems. These increases were partially offset by lower sales for networked communication systems primarily from fewer deliveries of remote video terminals and lower volume on the Hawklink contract. Segment operating income was down 7% to $92.9 million.

AM&M: Net sales at the AM&M segment were up 4% year over year to $648.9 million. The upside reflects higher platform system sales due primarily to volume on new contracts, including the Australian order for C-27J aircraft and international head-of-state aircraft modification contracts, and increased scope on the EC-130 aircraft for the U.S. Air Force (“USAF”). This was partially offset by decline for logistics support services due primarily to the competitive loss of a task order for U.S. Army contract field team support services in Southwest Asia. The segment generated operating income of $65.0 million, up 8% year over year.

NSS: The NSS unit generated net sales of $352.6 million, down 16% year over year. The results reflect less demand for U.S. Special Operations Command information technology (IT) support services, decline in IT support services for select non-DoD U.S. Government agencies, competitive contract losses, and lower sales from intelligence support services due to the drawdown of U.S. military forces in Iraq. Segment operating income was down 55% to $14.5 million.

Financial Position

L-3 Communications ended the quarter with cash and cash equivalents of $514 million versus $538 million at the end of the third quarter of 2011. Long-term debt was $3.88 billion versus $4.13 billion at fiscal-end 2011.

Net cash generated from operating activities was $692 million during the first nine-month period of 2012, a decrease of $57 million from $749 million generated in the year-ago period. The decrease in net cash generated from operating activities was primarily due to the decline in income from continuing operations and higher income tax payments. This was partially offset by lower interest payments.

Capital expenditures, net of dispositions of property, plant and equipment, were $118 million for the 2012 year-to-date period, compared with $119 million for the comparable period last year. Following the trend of deploying capital and free cash flow, the company repurchased $504 million of common stock and disbursed $149 million as dividends.

Guidance

L-3 Communications narrowed its revenue guidance range for fiscal 2012 to $13.00–$13.10 billion versus the earlier guidance range of $12.95–$13.15 billion. It however raised its earnings per share guidance to the range of $7.80–$7.90 versus the earlier range of $7.70–$7.85. Operating margin is expected to be 10.3%.

Engility Spin-off
 
On July 17, 2012, L-3 Communications Holdings completed the 100% spin-off of a new, independent, publicly traded government services company – Engility Holdings Inc. (EGL - Snapshot Report) – to L-3 shareholders. The company has retained its cyber, intelligence and security solutions businesses.

Going forward, the segment was renamed as NSS that develops unique solutions to deal with the challenges faced by the U.S. Department of Defense, intelligence and global security customers.

Outlook

L-3 Communications’ top and bottom line surpassed the corresponding Zacks Consensus Estimates with ease. Going forward, we expect the company to continue to post strong earnings based on its opportunities in growth areas, including Intelligence, Surveillance, and Reconnaissance, Electro-Optical/Infrared systems and cyber security.

Moreover, the company’s balanced business mix, improving operational efficiencies and focus on research and development allow it to pursue strategic opportunities in the commercial arena and overseas.

Also, with the completion of the spin-off, the company will be able to focus more on core areas by providing market-leading, value-added products and solutions to its customers. In the long run, we expect the company to be one of the best-positioned pure defense players based on its broad diversification of programs and its focus on shareholders’ value. However, we remain concerned about the loss of key contracts, defense spending cuts and the lack of near-term catalysts. Currently, L-3 Communications has a Zacks #3 Rank, which implies a Hold rating in the near term (1-3 months).

L-3 Communications Holdings operates through its wholly owned subsidiary, L-3 Communications Corporation. L-3 Communications is a leading supplier of a wide range of products and services used in a number of aerospace and defense platforms. The company supplies subsystems on many platforms that are used for secure communication networks; mobile satellite communications; information security systems; shipboard communications; telemetry and instrumentation; and airport security systems.

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