Good Things Come in L-3s

We'll check in with L-3 again today, and for the same reason as before. A price/sales ratio of 0.9 once again earned it a spot on our screen.

The Price/Sales screen is based on our belief that the metric is better at predicting stock gains than the more commonly used price/earnings ratio. We premise that belief on the work of researchers like James O'Shaughnessy, who pitted several valuation metrics against each other using four decades of data and found that the P/S ratio had the most predictive power of the bunch. (His findings are documented in the 1996 bestseller "What Works on Wall Street.") He also found that the combination of low P/S ratios and decent sales momentum was particularly good at rooting out stocks poised to outperform.

We also prefer the price/sales ratio to the price/earnings ratio because of its simplicity. Earnings appear at the bottom of companies' income statements, and can be affected by a long line of special charges, one-time gains and aggressive accounting. Sales appear at the top, before any deductions have been made, making them less susceptible (though not immune) to tampering. And sales are less volatile than earnings thanks to the absence of those special charges. That means that while a company's P/E ratio may offer a skewed view in any particular quarter, its P/S ratio will likely be more reliable.

Use our stock screener and Price/Sales screen recipe anytime to run our search for yourself. Recently it produced eight survivors from a starting database of 8,000. Let's look at L-3.

Northern Virginia is home to most defense contractors, but L-3 is run from Third Avenue in Manhattan. The location in the world's investment-banking capital makes sense; while more than three-quarters of L-3's sales, which totaled $9.4 billion last year, come from the U.S. government, much of its growth comes from chasing down attractively priced competitors to buy. Its latest purchase, that of TRL Electronics, a British satellite outfit, was announced Thursday. L-3 will pay $168.8 million; TRL had sales of $26.3 million for the six months ended in September.

L-3 provides things like battlefield-communications, weapons-guidance, surveillance and reconnaissance systems to the military. It also makes commercial products like flight recorders and air traffic control systems. Business is brisk. L-3 increased its first-quarter sales, operating income and earnings per share by 48%, 45% and 31%, respectively, vs. a year ago. About nine percentage points of the sales growth was organic (in other words, not from acquisitions). Analysts say the company should be able to generate 7% to 9% organic growth at least through 2007, and that its suite of services and products makes for a reliable income stream in wartime and peacetime.

Shares of L-3 carry a P/S ratio of 0.9 at the moment. That's where they stood at the time of our last story (which means sales have kept up with the shares since then). The average defense contractor has a P/S ratio of 1.7. The stock also has a free cash flow yield of about 8% right now. Free cash flow is the money left over each quarter after a company pays its bills and spends on big-ticket investments like plants and equipment. It's the money available for things like dividends, share repurchases and acquisitions. L-3's FCF yield of 8% suggests the only danger facing its 0.9% dividend yield is that it looks too small. It also means the company should have plenty of funds coming in to continue operating as a sort of defense-industry mutual fund, rolling up small competitors, squeezing out costs and passing the profits on to shareholders.