ECON 134A
CASE STUDY 1
Equity Research Report on L-3 Communications
Instructions
This case study is based on a report written by two sell-side equity research analysts working for Credit Suisse First Boston Corporation. Such reports are typically used by investors to determine which stocks to invest in, and usually include a short overview of the industry, key financial estimates computed from the company’s financial statements, and a valuation. In this example, the company of interest is L3-Communications.
To complete this assignment, you will have to read through the report and answer the questions below. Note that for several of the questions there are no strictly right or wrong answers. Instead, a good answer will provide sound arguments based off clearly-stated assumptions and clearly-explained reasonings. Also, some of the numbers reported by the analysts may be a bit off compared to the calculations you may make. This is mostly due to rounding errors on their parts, so you should not worry about it.
Note that for parts 1 to 3, you should only use information contained in the report (i.e., you do not need to--- and should not---look up extra information online).
Your answers must be typed and contained to a single pdf document.
Questions
Part 1 – Overview
1.1. What kind of company is L3-Communications? What are its key strengths?
1.2. When was the report issued? At that time, at what price was L-3 Communications’ stock traded? How many shares were outstanding? What was the company’s market capitalization?
1.3. According to the table on page 1, what was the company’s P/E ratio in 2000? What was the company’s estimated P/E ratio for 2001? Explain how the analysts obtained this estimate.
1.4. According to the analysts, at the time when the report was issued, what had been recent drivers of growth for the company? What did they predict to be expected drivers of growth for the future?
Part 2 – Understanding the income and cash flow statements
2.1. Table 4 reports a margin of 10.2% for the first quarter of 2001. How was this number obtained? What would the margin have been had cost and expenses amounted to $300,000,000 that quarter?
2.2. Table 4 reports earnings per share of $0.40 for the first quarter of 2001. How was this number obtained? What would EPS have been had the company issued 2 million additional shares that quarter? What if the tax rate had been 50%?
2.3. Compute the company’s 2000 EBITDA using the formula learned in class. What was EBITDA/share for that year? Does it correspond to the number reported in the table on page 1?
2.4. What was the company’s enterprise value in 2000, using the book value of equity? What was it using the market value of equity? (hint: to compute the 2000 market capitalization, you may use a share price of $73.) Which of the two was used to compute the 2000 EV/EBITDA ratio reported in the table on page 1?
2.5. What was the price-to-book value of equity ratio for the company in 2000? Do you think that this ratio would be a helpful multiple to value L3-Communications?
Part 3 – Understanding the valuation
3.1. What is the 12-month-ahead share price predicted by the analysts?
3.2. How was this prediction made? More precisely, which ratio was used? What multiple was used? How does this multiple compare to that of 2001? What does it imply for the assumptions made by the authors regarding the future growth of the company?
3.3. Had the authors made the valuation using P/E ratios, assuming a 2002 P/E ratio equal to the 2001 P/E ratio, what would the estimated 2002 share price have been?
3.4. Check that in 2000, the company’s debt to (book) equity ratio was 1.58. Assume that the company instead had had much less leverage, financing its operations with 50% less debt and making up the difference by issuing more shares. This would imply a new debt-to-equity ratio of 0.44. How many shares would then be outstanding? How would P/E and EV/EBITDA multiples be impacted? What does it imply for the usefulness of these multiples?
Part 4 – Assessing the valuation
4.1. Look up L3-Communications historical stock prices around the date at which the report was written (the stock’sticker is LLL). You should find a stock price roughly equal to half of the price you reported in question 1. How can you explain this discrepancy? (hint: to answer this question, you may have to do some extra research about the history of the company).
4.2. Look up L3-Communications’ stock price around May 2002. Report on the accuracy of the analysts’ 12- month-ahead price target, considering the change in scale mentioned above. Assuming that the authors’ EV and EBITDA estimates were correct, what multiples should they have used to make a correct 12-month -ahead prediction?
Part 5 – Performing a new, current valuation
5.1. In 2016, L3-Communications was renamed L3-Technologies. In 2018, L3-Technologies merged with Harris, giving rise to a new company named L3Harris. Look up the company’s current financial indicators and statements online and report relevant information (stock price, multiples, etc.).
5.2. Perform. a valuation and forecast the 12-month-ahead stock price. You may want to look up the typical and/or historical multiples for companies in the same industry as L3Harris. Make sure to carefully lay out and explain your assumptions.
5.3. Perform. and report on a sensitivity analysis to explore the robustness of your main forecast to changes in assumptions.