My first investment analysis is of L3 Communications. I believe that L3 is a buy at about $71/share. I think it is a strong buy below $67.50 if it gets that low. I recently interviewed for a position with an asset management company focused on high-yield fixed income investments. After handed the 10K and the offering information of the 6 3/8% senior subordinate notes due October 2015 I assumed that they were primarily wanted me to evaluate the fixed-income securities of the company. So I decided to evaluate the fixed-income securities by comparing them against other fixed-income securities of L3 as well as compare them against fixed-income indentures of other aerospace/defense companies. I found out during the interview that they wanted less company specific analysis and more aerospace/defense industry analysis. Another thing during the interview process is that I attempted to make the point in my analysis that I really needed to complete a thorough analysis of other comparable companies in the aerospace/defense industry before I felt comfortable making a recommendation for or against L3 Communications. Overall, I am of the opinion that if someone wants to earn a decent return from investing that they need to do it full-time, with all of their effort, as well as have intelligence, and the right character in order to ride out the highs and lows. I don't think that this point that I tried to make in a round-about way won me any points in the interview because they seemed to want me to commit to a buy, sell, or hold recommendation. Below is my analysis of L3 minus the excel file that accompanied the analysis that I did.

L3 Communications Fixed-Income Analysis

Industry
The proliferation of WMD, increasing threat of international terrorism and WMD falling into terrorist hands, proliferation of nuclear technology and compliance problems of individual countries has heightened security fears and correspondingly will likely drive a strong defense market. For the foreseeable future the global defense industry appears to be virtually depression proof. Although the defense budget as a percentage of GDP rose from 3.8% in 2000 to 4.7% in 2005, by historical standards the US defense budget as a percentage of GDP is low. The percentage was 35%/15%10%/6% during World War II, the Korean War, the Vietnam War, and the Gulf War respectively.1 Even if the United States withdraws from Iraq within the next year I expect the defense and/or homeland security budget to remain robust for at least the next 2-5 years because of diminished U.S. popularity/growing antagonism towards the U.S. and perceived insecurity within the country.

For the purpose of this analysis any quantitative reference to industry financials, ratios, or averages is derived from the most recently reported financial results listed in Valueline and/or Yahoo Finance as appropriate of the following companies: Alliant Techsystems-ATK, Armor Holdings-AH, Aviall Incorporated-AVL, DRS Technologies-DRS, Esterline Technologies-ESL, General Dynamics-GD, Goodrich-GR, L-3 Communications-LLL, Lockheed Martin-LMT, Moog Inc-MOG-A, Northrop Grumman-NOC, Precision Castparts-PCP, Raytheon-RTN, Rockwell Collins-RTN. Industry giant Boeing was omitted from this group because the size of its financial data would skew the Industry averages calculated. The attached excel spreadsheet “Ratios” tab lists these Industry averages and ratios.

Company

There has been an air of uncertainty surrounding L3 Communications since founding CEO, Frank Lanza, passed away unexpectedly on June 7th and stock option backdating questions have been raised regarding the company. Mr. Michael T. Strianese CFO, corporate ethics officer and senior VP since March of 2005 is now the interim CEO. An executive committee consisting of three independent board members was formed to search for a permanent CEO to succeed Mr. Lanza. Mr. Lanza was largely responsible for developing the business model and identity of the company as a number one or number two supplier to prime contractors of DoD C3ISR, wireless communications, and aircraft modernization products and services. Mr. Lanza’s clarity of direction and ability to simplify complex yet key elements of the DoD industry will be greatly missed and it is uncertain how effectively new management will guide the company.

The company was dealt a black eye in its latest quarter results from a charge of $78.2 million, to cover a jury verdict against the company; and a charge of $25.5 million to expense stock options awarded between May 1998 and July 2003 that were improperly accounted for. This raises questions of the credibility and/or capability of interim CEO and CFO Mr. Strianese. Why weren’t the stock option expenses properly accounted for in the period in which the options were exercised? The likely scenario is that either Mr. Strianese knew about the stock option backdating and he did not want to make the expense public at the time or that he did not recognize that the options should be expensed in order to properly account for the cost to shareholders. Either scenario does not shed a favorable light on L3 management and Mr. Strianese in particular.

L3’s leadership as a specialized product supplier to many DOD programs empowers the company with strength and flexibility as it begins to turn its marketing sites toward commercial customers of simulators, mobile broadband communications, aircraft navigation, and aircraft maintenance products and services. Although sales to DoD provided 73.7% of sales for 2005, L3’s broad and diverse business mix, a favorable balance of cost-reimbursable and fixed-price contracts, significant follow-on business opportunities and an attractive customer profile limit L3s reliance on any particular program, service, or product. L3 is seeking commercial markets for several of its top defense products. Among these are spread spectrum secure communications which allows communications across a broad range of radio frequencies, effectively “noise”, and permits some relief from otherwise strict FCC regulation. L3 is venturing into commercial and non-federal government markets with simulators and light-weight mobile imagery access devices. L3’s aircraft maintenance and modernization division also has the potential to grow into commercial aircraft markets.

Debt Analysis

This analysis is primarily of the 6 3/8% senior subordinate notes due October 15, 2015. This is a general unsecured debt obligation that is backed only by the ongoing earnings of the company. It is ranked pari passu in right of payment with the 2002 Notes (7 5/8% senior sub notes), the May 2003 Notes (6 1/8% due 2013), the December 2003 Notes (6 1/8% sen sub notes due 2014) and the November 2004 Notes (5 7/8% sen sub notes due 2015), but will be subordinated in right of payment to all current and future Debt of the company. The fundamental features of this note are:

6 3/8% Subordinated Notes due Oct 15, 2015
6.375% semiannual coupon notes. Interest due April 15 and October 15 of each year.
Rated BB+ by S&P, BB by Fitch, and Ba3 by Moody’s

Redeemable at the following rates:
Price (% of FV plus accrued and unpaid interest)
Thru
106.375
10/14/2008 (35% max from equity offer)
103.188
10/14/2010
103.188
10/14/2011
102.125
10/14/2012
101.0630
10/14/2013

Recent Price $95.44
Current Yield = 6.68%
Yield to first call = 8.4%
Yield to second call = 7.8%
Yield to third call = 7.5%
Yield to first par = 7.2%
YTM = 7.14%
Duration = 6.68
(see attached excel file LLL.xls “6.375% Notes” worksheet for supporting calculations)


5 7/8% Subordinated Notes due Jan 15, 2015
5.875% semiannual coupon notes. Interest due January 15 and July 15 of each year.
Redeemable at the following rates:
Price (% of FV plus accrued and unpaid interest)
Thru
105.875
1/14/2008 (35% max from equity offer)
102.938
1/14/2010
102.938
1/14/2011
101.958
1/14/2012
100.979
1/14/2013

Recent Price $92.60
Current Yield = 6.34%
Yield to first call = 8.7%
Yield to second call = not calc
Yield to third call = not calc
Yield to first par = not calc
YTM = 7.10%
Duration = 6.51
(see attached excel file LLL.xls “5.375% Notes” worksheet for supporting calculations)

The L3 notes YTM is higher than similar fixed-income investments within the aerospace & defense industry with comparable maturity dates. From Standard and Poor’s data Harris Corp 5.0% Notes maturing 10/01/2015 YTM is 6.16%, Martin Marietta 7.375% Notes maturing 4/15/2013 YTM is 5.79%, Litton Industries 6.75% Notes maturing 4/15/2018 YTM is 5.96%, and several other fixed-income securities in the industry have YTM of the high 5% to low 6% range.

L3’s EBIT/total fixed charges ratio has been steadily improving over the past several years. L3’s 6 year average EBIT/total fixed charges ratio is 3.65. The company’s reported annual results show a clear increasing trend of the ratio from 2.3 to 4.2 over the same period ending Dec 31, 2005 (Exhibit 12 from 2005 and 2004 10K). The industry’s ratio for the year ending March 31, 2006 is 7.4.

From March 31, 2006 to August 4, 2006 L3’s stock price dropped 16%. Undoubtedly, much of this deterioration of market value is due to the death of Frank Lanza and stock option backdating issues plaguing the company. The ratio of market capitalization to bonded debt, a rough measure of debt coverage has deteriorated from 2.25 to 1.86 during the same period. In comparison the most recent ratio for the industry is 4.5.

It appears that total debt may be underestimated because of estimated or lack thereof of pension obligations. Estimated 2006 “Other long-term liabilities” (in $million) is 145.9. Compare this to the estimates for the periods 2007-2008, 2009-2010, and 2011 and thereafter at 64.6, 14.1, and 58.3. Footnote (5) on page 48 of the 2005 10K says, “Due to the current uncertainty of the amounts used to compute our expected pension and postretirement benefit plan funding, we believe it is not practicable to reasonably estimate such future funding for periods in excess of one year.” Therefore it appears that L3 has opted not to estimate long-term pension liabilities for all years beyond 2006. If so, Long-term debt is underestimated and its leverage ratios are worse.

Also L3’s pension benefit assumptions are more aggressive compared to its largest competitors. L3’s discount rate estimates for 2005 was 6.0%. In comparison the same rates for Lockheed Martin, Raytheon, Northrop Grumman, and Rockwell Collins were 5.75. COL 2005 discount rate assumption is 6.25%. L3’s expected pension plan ROA is 9.0% versus 8.5, 8.6, 8.5, and 8.75 for its respective competitors.

2005 assumptions used in determining pension benefit costs


L3
LMT
RTN
NOC
COL
Discount rate
6
5.75
5.74
5.75
6.25
Rate compensation increase
4.5
5.5
4.49
4.0
4.5
Expected LT ROA
9
8.5
8.66
8.5
8.75

2005 assumptions used in determining pension benefit obligation


L3
LMT
RTN
NOC
COL
Discount rate
5.75
5.625
5.72
5.75
5.3
Rate compensation increase
4.5
5.0
4.5
4.0
4.5


In brief some important covenants for L3 debt include:

“The Company’s Senior Credit Facility contains covenants that require . . . the Company’s Consolidated senior leverage ratio be less than or equal to 3.0 to 1.0 and the Company’s consolidated interest coverage ratio (will) be greater than or equal to 3.0 to 1.0.”

“In addition, the Senior Subordinated Notes indentures contain covenants that restrict the ability of L-3 Communications to incur indebtedness and issue capital stock that matures or is redeemable 91 days or less after the maturity date of such series of notes, and the ability of its restricted subsidiaries to incur indebtedness or issue preferred stock, unless the Company’s fixed charge coverage ratio would have been at least 2.0 to 1.0 on a pro forma basis.”

“In the event that the long-term debt rating of L-3 Communications is reduced below BBB−, or the
equivalent, by two of the three rating agencies, Standard & Poor’s Ratings Services, Moody’s Investors Service, Inc. or Fitch Ratings, L-3 Holdings will be required, within 45 business days, to pledge 100% of the capital stock of L-3 Communications, and L-3 Communications and each subsidiary guarantor will be required to pledge 100% of the capital stock of each of their material wholly-owned domestic subsidiaries and 65% of their material wholly-owned foreign subsidiaries, in favor of the lenders under the Senior Credit Facility.”


Cash Flow and Operating analysis

L3 continues to do an excellent job procuring contracts, executing, and generating cash. It is doing well at turning those Contracts into Sales which is evident from its high Inventory Turnover and sales growth. Rapid contract procurement seems to ultimately fuel good cash flow coverage for its debt obligations as stated. L3’s Cash Flow Yield (Net cash flows from Operations/Net Income) has been 1.66, 1.66, 1.62, 1.64, 1.79 for 2006 ending 30 March, and years ending 30 Dec 2005-2002 respectively. (Cash Flows/Sales) has been .087, .09, .09, .09, .079 respectively. Cash flows to assets: .082,.086’05, .087, .078. An encouraging sign is that (Cash Flows from Operations/Capital Expenditures) have steadily improved from 5.50 to 7.09. Also the company’s current Working Capital is strong; its Working Capital to Debt ratio is .45 compared to the industry’s of .37 and its Current Ratio is 1.8 compared to the industry’s 1.2.

Summary

Although L3’s debt level is higher than the industry average and may actually be higher than reported because of pension plan assumptions, the likelihood of default on its bonded debt is low for several reasons. First its cash flow and current assets position is strong and continues to strengthen, the company continues to grow sales and acquire government contracts with its smart business model, it possesses leadership in its products and services, and with growing inflation and robust military and/or homeland defense budgets the burden of paying off those debts in the future will probably ease. I recommend further investigation of the defense industry’s debt market because I expect that I could find fixed-income securities from a company with a similarly strong business model, more conservative income and liability assumptions, free of dubious management behavior, and with a yield as good or greater than the L3 notes.
It will likely be a rocky road for owners of L3 equities over the next 6-12 months. It is important for the executive committee to quickly find a new intelligent, trustworthy, and driven CEO who is untainted by the ire of the stock-option backdating investigations. The sooner that they find this new CEO the sooner he will bring relative calm back to the company and its securities.