Is L-3 Communications the Right Stock to Retire With?

Now more than ever, a comfortable retirement depends on secure, stable investments. Unfortunately, the right stocks for retirement won't just fall into your lap. In this series, I look at 10 measures to show what makes a great retirement-oriented stock.

Defense contractors have been out of favor for a long time, as many investors have feared the possibility of government budget cuts hammering the industry. Yet unless you believe the Defense Department can cut its budget to zero, there will inevitably be winners and losers in the spending-cut fallout. As a smaller company, L-3 Communications (NYS: LLL) provides some mission-critical technology, but will it be enough to survive the chopping block? Below, we'll look at how L-3 Communications does on our 10-point scale.

The right stocks for retirees
With decades to go before you need to tap your investments, you can take greater risks, weighing the chance of big losses against the potential for mind-blowing returns. But as retirement approaches, you no longer have the luxury of waiting out a downturn.

Sure, you still want good returns, but you also need to manage your risk and protect yourself against bear markets, which can maul your finances at the worst possible time. The right stocks combine both of these elements in a single investment.

When scrutinizing a stock, retirees should look for:

  • Size. Most retirees would rather not take a flyer on unproven businesses. Bigger companies may lack their smaller counterparts' growth potential, but they do offer greater security.
  • Consistency. While many investors look for fast-growing companies, conservative investors want to see steady, consistent gains in revenue, free cash flow, and other key metrics. Slow growth won't make headlines, but it will help prevent the kind of ugly surprises that suddenly torpedo a stock's share price.
  • Stock stability. Conservative retirement investors prefer investments that move less dramatically than typical stocks, and they particularly want to avoid big losses. These investments will give up some gains during bull markets, but they won't fall as far or as fast during bear markets. Beta measures volatility, but we also want a track record of solid performance as well.
  • Valuation. No one can afford to pay too much for a stock, even if its prospects are good. Using normalized earnings multiples helps smooth out one-time effects, giving you a longer-term context.
  • Dividends. Most of all, retirees look for stocks that can provide income through dividends. Retirees want healthy payouts now and consistent dividend growth over time -- as long as it doesn't jeopardize the company's financial health.

With those factors in mind, let's take a closer look at L-3 Communications.

Factor

What We Want to See

Actual

Pass or Fail?

Size Market cap > $10 billion $7.05 billion Fail
Consistency Revenue growth > 0% in at least four of five past years 4 years Pass
  Free cash flow growth > 0% in at least four of past five years 3 years Fail
Stock stability Beta < 0.9 0.95 Fail
  Worst loss in past five years no greater than 20% (29.5%) Fail
Valuation Normalized P/E < 18 8.56 Pass
Dividends Current yield > 2% 2.5% Pass
  5-year dividend growth > 10% 20.5% Pass
  Streak of dividend increases >= 10 years 7 years Fail
  Payout ratio < 75% 19.8% Pass
       
  Total score   5 out of 10

Source: S&P Capital IQ. Total score = number of passes.

With a score of five, L-3 lacks the stability that conservative investors prefer to see in a stock. Although the company has a healthy history of dividends, growth has been harder to come by -- and it's exactly that growth that's threatened by budget concerns.

L-3 sports a number of amazing products that help in gathering intelligence. One particularly promising projects involves the company modifying existing planes to help with surveillance, with sensors and electronic communications tools to collect and transmit data to decision-makers in the military.

But the problem that L-3 faces is that defense cuts may turn out not to be particularly rational. Thanks to the inability of Congress to agree to a budget deal last November, additional automatic cuts took effect. That will not only hurt contractors further but also focus scrutiny on wasteful spending and cost overruns. Boeing (NYS: BA) has apparently seen some overruns on its KC-46 tanker, and Lockheed Martin (NYS: LMT) similarly went over budget on its F-35 project.

L-3 also faces direct competition. In unmanned aerial vehicles, AeroVironment (NYS: AV) has captured the Pentagon's attention with its small aircraft, making it harder for L-3 to hold its own. Northrop Grumman (NYS: NOC) is also in the hunt, although earlier this week, the Air Force decided to halt the Global Hawk unmanned high-altitude surveillance plane program in favor of extending the lifespan of its U-2 spy planes for another decade.

For retirees and other conservative investors, though, the biggest problem is simply the uncertainty throughout the industry. It's entirely possible that a small player like L-3 could get bought out by a larger rival at a nice premium, especially given L-3's very attractive valuation. But unless you want to take considerable risk in your retirement portfolio, you may want to steer clear of L-3 and defense stocks until the budget situation resolves itself further.

Keep searching
Finding exactly the right stock to retire with is a tough task, but it's not impossible. Searching for the best candidates will help improve your investing skills, and teach you how to separate the right stocks from the risky ones.

L-3 may not be the right stock to retire with for you, but we've got some other promising candidates. Read all about them in the Motley Fool's latest special report, which gives all the details on three smart stocks for a rich retirement. But don't waste another minute -- click here and read it today.

Add L-3 Communications to My Watchlist , which will aggregate our Foolish analysis on it and all your other stocks.

At the time this article was published Fool contributor Dan Caplinger doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of L-3 Communications, Lockheed Martin, and Northrop Grumman. Motley Fool newsletter services have recommended buying shares of L-3 Communications. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool has a disclosure policy.

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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