Salomon says L-3 convertibles rich unless you're bullish on the story

By Ronda Fears

Nashville, Tenn., Nov. 26 - Given the positive outlook for defense electronics names like L-3 Communications Inc., Salomon Smith Barney is fairly upbeat on the stock story. But, in a report Monday convertible analysts at the investment firm said the two L-3 convertible issues looked rich although they may be of interest to L-3 bulls.

"Stepped up spending for both defense and anti-terrorism measures is likely to fuel earnings growth for L-3 Communications," said Stuart Novick, a convertible analyst at Salomon Smith Barney, in the report. "L-3 fans may want to consider purchase of either one of the company's outstanding convertible issues. Both of the L-3 convertibles may be of interest to fans of the company and LLL shares in spite of the bonds' slightly rich valuations."

The 5.25% convertibles due 2009 show up as about 1% rich and offer a paltry 1.8% yield to maturity, implying that they would be of only marginal interest to classic debt investors, the report said. However, with more than two years of remaining call protection and a 4%-plus current yield, the report suggests the 5.25% issue would likely to appeal to convertible paid-to-wait buyers.

The newer 4% convertibles due 2011, which Salomon estimates are about 2.5% rich, offer a slightly more enticing 4.2% yield to maturity. The 4s carry almost a full year of additional call protection, however, possibly making them more interesting than the 5.25s to L-3 bulls, the report said.

In third quarter, L-3 posted a 20% increase in revenues that helped the company beat analysts' earnings expectations. Looking ahead, the Salomon analysts continue to think that L-3 will post solid annual income gains. For the current quarter, Salomon net expects earnings per share of $1.07, which would bring the full year total to $2.94, well above 2000's EPS of $2.32. L-3 management recently reaffirmed its confidence in generating free cash flow of $60 million in fourth quarter, which would come on top of third quarter free cash flow of $41 million and bring the full year figure up to $115 million. For 2002, Salomon estimates an increase in share earnings to $3.51.

"The fourth quarter should be a good one for the company as defense spending is firmed up," the report said. "Gains should be driven by a friendlier defense and anti-terrorism spending environment, along with acquisitions."

L-3's balance sheet has shown improvement over the past year, Salomon analysts noted. Cash has tripled since Jan. 1, weighing in at $98.5 million after third quarter and would come to about $520 million including the proceeds from the 4% convertible deal. Add in a fully available $400 million five-year revolver and a $200 million 364-day revolver and liquidity seems more than adequate for now, the report said. Debt after three quarters was lower by $100 million from start of the year, at $905 million, or about $1.32 billion including the new convertible. At Sept. 30, EBITDA was up 23.7% to $247.5 million versus the first nine months of 2000, putting interest coverage at 3.8 times. Leverage has also shown improvement, as total debt to capital has declined from 63.4%, including pension benefits, at the end of 2000 to a recent 46.5% although the new 4% convertible bond issue would boost it to 53.8%.

"All of these figures would suggest that if the company's underlying credit isn't up to investment grade standards, we would still consider it to be more or less comfortable and trends are pointing towards improving coverage ratios ahead," Novick said in the report. "Of course, any number of factors, including heavy spending for acquisitions, could stretch L-3's financials and derail the positive developments in the company's financial situation."

L-3 5.25% convertible due 6/1/09

Convertible price 123.75

Common price $83.00

Conversion price $81.50

Conversion ratio 12.27

Call 12/3/03 at 102.625

Spread 450 basis points

Volatility 49%

Fair value 122.187

Investment value 79.428

Current yield 4.24%

Yield to maturity 1.86%

Percent premium 21.5%

Delta 75.2%

Breakeven 4.17 years

L-3 4.0% convertible due 9/15/11

Convertible price 98.535

Common price $83.00

Conversion price $107.625

Conversion ratio 9.2915

Call 10/24/04 at 102

Spread 525 basis points

Volatility 40%

Fair value 95.70

Investment value 62.453

Current yield 4.06%

Yield to maturity 4.18%

Percent premium 27.8%

Delta 75.4%

Breakeven 5.35 years

End

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