Three’s a Crowd

This won’t be the first time, but somebody is getting confused about similarly named stocks, and is confusing us in the process. In an AP story this morning, we get this following quote about today’s big move in L-3 Communications (LLL):

L-3 Communications Holdings Inc., down $5.65 at $72.22

CIBC World Markets cut the fiber-optic network operator to “sector performer,” citing uncertainty over option grant timing, pricey acquisitions and a lack of visibility with succession planning.

The problem is, L-3 is not a fiber-optic network operator. That would be Level3 (LVLT - Annual Report), which is up today.  The problem is, when we read the reasons for the downgrade we felt they could easily apply to either company, as both have made significant acquisitions, have issued options, and (like any company) could have succession issues.

We are assuming that CIBC and today’s active investors know one stock from the other and that the downgrade applies to L-3 (let us know if we are wrong – many seasoned investors have made the same mistake!) and that the gaffe was simple confusion on the part of the AP staffer putting together the list of today’s movers. Given the similarity between the two names, it is no surprise.

Meanwhile, Smart Money presents a more bullish outlook on L-3 (and they actually do know what the company does.) The reason for their positive take is that L-3 was one of eight survivors of their Price/Sales screen. They note:

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.

The problem with their characterization of free cash flow is that they are ignoring acquisitions. Acquisitions contribute to operating cash flow in future periods but are not deducted in most calculations of free cash flow. However, if one considers the age-old “build vs. buy” question it is easy to see that acquisitions are in essence a replacement for capital spending – which is deducted from operating cash flow to arrive at free cash flow. It doesn’t really make sense to treat them differently.

Also, they say the free cash flow left over is “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.” But even if you decide to take a look at the company this way (with acquisitions being something you use free cash flow for, rather than a deduction made before arriving at free cash flow) the second part of the statement doesn’t follow. Over the last three calendar years, by the Smart Money measure, L-3 has produced total free cash flow of $1.75 billion. In that same time they have made acquisitions totalling $5 billion (that doesn’t count this year’s Titan buy.)

If they are using free cash flow for “dividends, share repurchases and acquisitions,” as Smart Money contends, they are $3.25 billion in the hole. The reality is that they are issuing shares to make these acquisitions, not free cash flow. The shares dilute existing shareholders. Which gets back to our original point: logically it makes more sense to treat acquisitions the same way as capital expenditures, since both increase future operating cash flows. This gives us the more accurate picture: that L-3 is growing rapidly but not yet consistently generating free cash flow. In order to fund its growth it has to tap into the public markets.

There is nothing wrong with this. But investors should learn to look at it in a consistent way.

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Topics: L-3 Communications (LLL), Level 3 Communications (LVLT), Stock Market | RSS

2 Comments on “Three’s a Crowd”

  1. Trent

    One reader asked the question (on another page) of why we consider the acquisitions as part of free cash flow. The simple answer is that if you look at the operating cash flow, it includes the benefits of past acquisitions. If you never take out the acquisition you are pretending that it didn’t cost anything, but you still count the benefit from it. That just doesn’t work for us.

    If you are using a free cash flow measure that doesn’t count acquisitions, it is ok if you are making the assumption that they will not make any more acquisitions. Then, when you are estimating the growth potential you should be using the organic growth rate rather than one that is helped by acquisitions. As long as you are applying a consistent growth outlook with the cash flow measure it should work out.

    However, the relevant comment in the Smart Money story implied that cash flow was strong enough to support both acquisitions and dividends. Based on recent history, cash flow is not sufficient to support both.

  2. [...] Just last week L-3 shares were downgraded, with the analyst “citing uncertainty over option grant timing, pricey acquisitions and a lack of visibility with succession planning.” [...]

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