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On Feb 11, we reiterated our Neutral recommendation on L-3 Communications Holdings Inc. (LLL - Analyst Report) based on the company’s fourth quarter results and a fair guidance for 2013. However, loss of key contracts, a backlog skewed toward fixed price contracts and possibilities of cuts in future defense budgets remain areas of concern.

Why the Reiteration?

L-3 Communications Holdings operates through its wholly owned subsidiary, L-3 Communications Corporation. L-3 Communications is a leading supplier of a broad range of products and services used on a number of aerospace and defense platforms. In addition, the company is a prime system contractor for aircraft modernization and maintenance; simulation and training; and government systems support services.

We believe that L-3 Communications over the longer run is one of the best-positioned pure defense players based on its non-platform focus, prominent position as sub-contractor/supplier to other defense primes, broad diversification of programs and strong order bookings. Its strong balance sheet also provides financial flexibility to increase its dividend, indulge in share repurchases and earnings accretive acquisitions.

We believe future growth will come from its strong presence in the areas it currently focuses on. These include command, control, communications, intelligence, surveillance and reconnaissance (C3ISR) equipment; precision-guided weapons; unmanned aerial vehicles (UAVs); and other electro-mechanical robotic capabilities, networked information technologies, special operations forces, platform upgrades and counterterrorism initiatives.

On the flip side, however, a substantial portion of L-3 Communications’ business is generated within the U.S, with government and commercial sales accounting for more than 80% of total sales. Budget deficits and political uncertainty loom on future defense budgets with high chances of shrinkage.

Moreover, more than half of L-3 Communications’ sales come from fixed priced contracts. Consequently, the company will only be able to make a profit if costs stay within the set limits. Given these headwinds, we maintain our Neutral stance on L-3 Communications. The company now has a Zacks Rank #3 (Hold). For fiscal 2013 and 2014, we have an earnings ESP (Read: Zacks Earnings ESP: A Better Method) of +0.5% and +0.6%, respectively.

Others Stocks to Consider

In the aerospace and defense industry we presently prefer the Zacks Rank #1 (Strong Buy) stock, European Aeronautic Defence and Space Company (EADSY), as well as the Zacks Rank #2 (Buy) stocks Huntington Ingalls Industries Inc. (HII - Snapshot Report) and FLIR Systems, Inc. (FLIR - Analyst Report).


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