NEW YORK L-3 Communications Holdings Inc (LLL.N), which faces breakup pressure from an activist investor, is expected to divest some low-end services assets but does not plan a broader portfolio restructuring such as a breakup, people familiar with the situation said.
The U.S. defense contractor, with a market value of about $9 billion, is considering spinning off or selling a portion of its government services division that it views as non-strategic, these people said.
Those assets could collectively have revenues in the neighborhood of $1 billion -- or roughly a quarter of the division's $4 billion sales last year -- the sources said.
Such a move is in line with what L-3 has been contemplating for almost a year as the company reviews its entire portfolio in the face of a slimmer U.S. defense budget, the people said. But it appears to be short of what Ralph Whitworth's Relational Investors has urged since amassing a near-6 percent stake in the company.
Relational, the largest single shareholder in L-3, wants the company to sell or spin off its government services as well as aircraft modernization and maintenance operations, a person close to the investor told Reuters previously.
Relational sees those two divisions, which accounted for more than 40 percent of L-3's sales last year, as a drag on the company's two better performing units: defense electronics and intelligence and surveillance, according to the person.
The services and aircraft divisions both had operating margins of just above 8 percent in 2010. In comparison, the electronics division's margins exceeded 14 percent, while the intelligence unit saw 11.6 percent in margins.
Despite the uneven performance, its businesses are all defense related and depend heavily on the U.S. government, and the company is not convinced there would be an additional value created from breaking up the company into several pieces, people familiar with the situation said.
Earlier this year, Relational pressured industrial conglomerate ITT Corp (ITT.N) to split into three companies, separately focused on water purification, industrial components and defense. While defense generated only half of total revenue, uncertainty about U.S. budget cuts held back the entire company's share performance.
But the argument for breakup is less clear in L-3's case, industry experts have said, since its businesses are all defense related and the stock is trading at a decent premium to giant defense conglomerates like Lockheed Martin Corp (LMT.N), Raytheon (RTN.N) or Northrop Grumman Corp (NOC.N).
There could be some gain if L-3 were split into multiple divisions and those units would then get acquired at a premium by rivals in a two-step process, some sources said. But what are seen as most attractive takeover targets -- electronics
and intelligence divisions -- are where the company wants to focus its growth.
Instead, L-3 would like to do a small divestiture within the services division at this point, separating the labor-intensive military support business while keeping the high-end intelligence and cyber-focused part, people familiar with the matter said.
Whether L-3 will pursue a spin-off or a sale of these assets will depend on how big a tax burden associated with any sale is likely to be, the people said.
The company is also expected to focus on returning capital to shareholders by a share buyback or increased dividend, people close to the situation said.
Shares of L-3 were up 1.2 percent to $85.24 on the New York Stock Exchange on Wednesday morning, valuing the firm at more than $9 billion.
Representatives for L-3 declined to comment. Relational was not immediately available for comment.
Activist investors are increasingly scouring the aerospace and defense industry for breakup targets as shares of large defense contractors have languished on fears of softening military spending as the U.S. wars in Iraq and Afghanistan wind down.
Billionaire investor Carl Icahn earlier this month reported a 9.5 stake in Oshkosh Corp (OSK.N), which makes tactical vehicles for the military and specialty trucks for construction, and said he was seeking talks with the management to enhance shareholder value.
Industry experts also mentioned Cessna aircraft maker Textron Inc (TXT.N) as a potential target because its products range from helicopters to automotive parts and golf cars, while a subsidiary finances sales of them.
The increased activism across the sector is putting additional pressure on the defense contractors as they seek ways to compete in a shrinking budget environment after a decade of booming defense spending.
"Many of the biggest defense companies are generating strong profits and carrying billions of dollars in uncommitted cash, but the market is undervaluing shares because of what it fears lies ahead for military contractors," defense analyst Loren Thompson said.
"Activist investors are stepping up the pressure on them to bolster shareholder returns, even if that means abandoning strategies aimed at making companies more resilient for the long term," Thompson said.
(Reporting by Soyoung Kim, additional reporting by Nadia Damouni; Editing by Tim Dobbyn)