L-3 Shares Rally Despite Succession Uncertainty

“L-3 Shares Climb After CEO Death” – API can’t make this stuff up. That is the headline of an Associated Press story talking about the $5 jump today in shares of L-3 Communications (LLL), a large defense contractor. L-3 has been a small Peridot Capital holding for several years. I wrote back in November that a sell-off from $85 to $74 was overdone. The stock subsequently hit a new all-time high of more than $88 per share.

L-3’s CEO Frank Lanza, 74, passed away suddenly yesterday and when I saw the headline this morning, I figured we would see some selling pressure today. Lanza co-founded and led L-3 on an acquisition spree that built the company into a $12 billion a year defense giant. Given Lanza’s age and lack of a solid succession plan in place, many investors have been wondering what would happen if Lanza left, or worse, passed away.

Such uncertainty usually breeds fear on Wall Street. Not so today, however, as the stock is rocketing ahead by 7 percent. L-3 itself has been rumored to be an acquisition target, and with no clear leadership in place right now, investors seem to think one possible succession plan will be to sell the company. I’d put the odds at no better than 50/50 that such a scenario materializes.

Time to Unload Commodities?

Days like Tuesday don’t feel too great when you have bets in the energy and industrial metals sectors. Many stocks were down as much as 6 percent yesterday alone. Despite the huge moves we’ve seen dating back to last year, the combination of strong fundamentals and low valuations continue to explain my bullishness.

Commodities are cyclical, and one day the party will certainly end, however I think the bull market in energy and materials still has ways to go. Really, it’s simple supply and demand. Even at today’s elevated prices, demand worldwide should remain strong. On the supply front, there is no reason to believe the world is going to all-of-the-sudden find lots more oil. Metals such as copper and gold take years to be mined, and unmined supply is fairly limited as well.

The stocks will always be very volatile, as a one-year chart of any company in the sector will show, but I can’t help but think sell-offs like the one we saw Tuesday are opportunities for those who have yet to jump in.

Take Anadarko Petroleum (APC) as an example. Late Monday, the company reported earnings of $3.88 per share on sales of $2.25 billion, easily surpassing estimates of $3.35 and $2.09 billion. In fact, actual results even beat the highest printed estimate on the Street ($3.77/$2.23B). However, the stock fell more than $3 to $102 per share as crude oil prices dropped by a decent amount.

APC also announced a 2006 capital expenditure budget of $4 billion versus $3.4 billion in 2005. Production growth is expected to be in the 4-8 percent range this year. It’s not just an oil price story, but production is growing too.

After seeing last quarter’s results, I have no reason to think the highest 2006 estimate coming into that report, earnings of $15.73 per share, is unattainable. That would put the stock’s forward P/E at 6.5x. Most investors will tell you such a multiple signifies peak earnings, and they’d be right. Price-earnings ratios are always lowest at cyclical tops and highest at cyclical bottoms. The bullish case for Anadarko centers around the idea that 2006 might not be the top.

If China and India continue to grow as a percentage of the world economy, and other nations follow their lead, oil could reach at least $100 per barrel by the end of the decade. That might not happen, but I think it very well could, and the odds of $30 oil anytime soon are very, very low. Energy and materials represent 10% and 3% of the S&P 500, respectively. I think investors should be overweight these areas for the next several years.

Defense Stocks Continue Dropping

Shares of the country’s leading defense companies have been fairly weak in recent weeks as worries of budget cuts in the U.S. defense budget have surfaced. It’s true that the Pentagon has actually asked the government to not fund certain projects that it deems unneeded. However, not all defense companies will see a reduction in spending growth.

Most of the cuts will likely center around missile defense systems and certain models of fighter jets. Other areas of the defense sector, such as homeland security, intelligence, and surveillance equipment based on new technologies, should continue to thrive.

One of the leaders in this area is L3 Communications (LLL). Along with the rest of the sector, LLL shares have dropped in recent months, and now trade under $74 per share, about $11 below their 52-week high.

L3 is trading at a market multiple of 15 times earnings, despite above-average growth for the defense industry. CEO Frank Lanza continues to make small, strategic acquisitions to fill out the company’s new product offerings, and the L3’s solid performance should be able to weather any small cuts in less important areas of the U.S. defense budget.