L-3 and the coming Budget Sequester

L-3 Communications (NYSE:LLL) stands out among pure defense players by virtue of its non-platform focus on shorter-cycle contracts. It has prospered the last few years because of the discretionary non-platform emphasis. Now with the looming defense budget cuts it may work against them.

"In the past the short-cycle business was favorable because of the constant increases in DoD budget; now with declining budget it works against them."

"So far the Pentagon has not actually reduced spending, but it has terminated programs deemed unnecessary or too costly and shifted the funds elsewhere." L-3's  pipeline of work is full but usually consist of 3 years or longer contracts cycle so the cuts haven’t been fully realized. A shorter cycle works against L-3.

L-3 has anticipated the budget cuts and debt crisis and has done a lot of adjustments last year; However, the  FY 2013 Budget has more cuts as the sequester threat continues.  In September, if the budget is not past again, sequester could make the cuts worse.


Budget cuts are in the Defense Department (DoD), but Homeland (DHS) & CIA/Intelligence Agencies monies have increased or remain the same.

Cyber and C³ISR  are divisions expected to prosper.

Spin-off  to be completed June 30th 2012.

L-3 is a good company in a bad sector.

L-3 is a serial acquirer with BIG goodwill - will probably be written-off next quarter or at spin-off?
p/e=7.52,p/bv=1.02, cash intensive in fixed asset, spin-off to reduce debt?, div increased
not favored by analysts - only 1 buy out 17 brokers in current month
10K - price=68.19, eps=9.07, fair value=201.89, long term potential 195%, bv=67.03
est earnings 1.88 vs 1.85 → eps=9.10, rev will go down, spin-off will break even?, earnings will break even?

L-3 spinoff

From the L-3 Communications Holdings (LLL) 10K filed 2/29/2012

On July 28, 2011, the Company announced that its Board of Directors approved a plan to spin-off a new, independent government services company that will be publicly traded. The new public company will be named Engility Holdings, Inc. (Engility). The spin-off, which is intended to be tax-free to L-3 and its shareholders, is expected to be completed in the first half of 2012. Upon completion, L-3 shareholders will own 100% of the shares of both L-3 and Engility. The spin-off is not subject to a shareholder vote.

OmniVision and OV8830

From the latest 10Q from OmniVision (OVTI)

In February 2011, we also introduced the OV8830, our most advanced 8-megapixel image sensor to date, and the first to use our second generation OmniBSI-2 pixel architecture. Implementing the latest developments in BSI pixel technology, the OV8830 combines low power consumption, small die size and best-in-class pixel performance with advanced image processing features. This combination allows the OV8830 to support enhanced, fast frame rate image capture and 1080p or 720p HD video recording, making it highly suitable for feature rich smart phones. OmniBSI-2 technology is our first pixel architecture built on 300 mm wafers using a copper process with 65 nm design rules, which enables a number of improvements over OmniBSI technology’s performance, including improved pixel layout, better isolation, and reduced crosstalk.

It continues with the following:

We also experienced a recent and unanticipated extension in the product development cycle of our OV8830 product. This delayed the production ramp up of this new sensor. Towards the end of our second quarter of fiscal 2012, we started to ship this product in very limited quantities. 

I feel the OV8830 is a perfect match for the iPhone 5. It would set the tone for the next generation of better quality video in the next couple of product introductions from Apple (AAPL). The iPhone 5 is rumored to be released in September. Even if it is released at the end of the year, with a 5 to 6 month ramp-up, production of the 0V830 line could begin as soon as May.

It could even have been squeezed into the iPad 3 production, rumored due on March 7th.

How do you know how Capital intensive a company is from the financial statements?

Hi Professor,

Thanks for taking the time to show us how to value a company. I am not a student,
but have used your on-line course and website to learn how to invest. You have blessed
us with great opportunities and a very valuable tool. Thanks so much for your generosity.

First I guess I need to define what I mean by a capital intensive company.
Is it the money required to get into a business?
Is it a mathematical way to measure how large a protective "moat" a company has?
Is it the amount of money required for a company to continue to generate income without putting in additional capital?

Method (1)
From the financial statements I can figure out Capital expenses(CapEx) from the cash flow statement. If depreciation is the maintenance capital expenditures, CapEx - depreciation would be the new capital expense.
The total reported 5 year average CapEx would be the upper bound of reported expenses. Either the depreciation or the maintenance capEx would be the lower bound.

R&D can be considered an expense.
Add in 5 year average R&D.

You don't have to do your own research and development. You can buy it.
Acquisition could be considered "investing in existing R&D".
Add in all acquisitions and minority interests.

Add in change in working capital.
Add in leases, net long-term debt and net buy-backs.

Equivalent to cash-flow calculation and the equity reinvestment rate.

Method (2)
But wait. There are three types of R&D, a)Basic research, b)Applied Research and c)Design and/or prototype. What about capitalizing all the costs associated with designing a new product?
What about fixed assets needed to run the production? What about inventory turn-over?
What about cash levels? What about write-off?

Shouldn't net intangibles be included as reinvestment capital? At least the patents that pertain to the products.

Does the amount of long term debt have to be accounted for? Maybe  a capital debt structure with anything over 40% is too much and should be adjusted for.
Aren't pensions to be included?

Aren't design cost to be included? Should not marketing costs be included in capital expense.

Where do you stop? Aren't all operating expenses part of the cost?
Use total operating expenses and operation margin + cash flow (including acquisitions+minority interest) + intangibles

Method (3)
Use COGS and gross margin + cash flow (including acquisitions+minority interest) + intangibles.

However, service oriented industries would come out ahead of manufacturer industries.

Results
Is the concept of equity reinvestment rate the same as how capital intensive a firm is?
If I experiment with the examples above, I end up with industries that appear to be equivalent but that in my gut I know are vastly different in required cash. I still don't see how I can differentiate industries that should be different but are not.

So that leads me back to the original question. If my assumption is to buy a company and not add any additional capital to run it,  what calculations should I use? Where can I find this information on the financial statements?

Thanks you for your time and patience.

OmniVision Notes

Feb 28th, 2012 Notes

OmniVision products are used in HTC Corp's (2498.TW) EVO and Motorola Mobility Holdings Inc's (MMI.N) Droid X reported strong third-quarter sales.

At least two brokerages raised their price targets on OmniVision's stock, saying the company was on track to recapture lost market share in the smartphone segment.

OmniVision's 8-mega pixel camera sensors should be a major revenue and earnings drivers, said Canaccord Genuity, which rates the stock "buy."

NeedHam reports that OmniVision has lost the iPad 3 slot.

The following is an alphabetical listing of Apple suppliers in 2011. These suppliers represent 97 percent of Apple’s procurement expenditures for materials, manufacturing, and assembly of Apple’s products worldwide. OmniVision is not included as a supplier. This precludes their presents in the Apple products releasing this year. Maybe they will be in the 2012 list, just in time for the iPhone 5.

Why did OVTI emphasize the entertainment division?

First, let me crunch the financial numbers.
OmniVision (Nasdaq:OVTI) is a good value right now. It has been on a 60+ day run. After the 3rd quarter earnings came out Friday, the stock price close for the day at 17.13 yielding the following highlights:

• p/e ~ 10
• book value ~ 14.31
• p/b value ~ 1.20.
• Z-score ~3.67
• fair value price $39.04, a potential of 127% upwards swing [using 14.8 p/e and 1.5 bv]

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
In OmniVision's 2nd quarter 10Q filing it was mentioned that prior guidance was revised down when the company's key customers unexpectedly cutback their orders. This action reduced unit sales of the OmniBSI and OmniPixel3-HS based products and adversely affected their revenues for the 2nd quarter of fiscal 2012.

Apple (Nasdaq:AAPL) is suspected of being one of OmniVision's largest customers. They usually try to get two sources for their manufactured parts. For the iPhone-4/iPhone-4S CMOS image sensors they used Sony (NYSE:SNE) and Omnivision. The Apple  iPhone-4/iPhone-4S  uses the OmniVision's 8-megapixel image sensor based on the new OmniBSI™ technology. There is a rumor that OmniVision lost the deal with Apple on the  iPhone-4S . The iPhone-5 is also rumored to be using Sony and Samsung as CMOS image sensors vendors, replacing OmniVision.

In OmniVision's 2nd quarter 10Q filing I found another sentence which stated the following:

"We also experienced a recent and unanticipated extension in the product development cycle of our OV8830 product. This delayed the production ramp up of this new sensor. Towards the end of our second quarter of fiscal 2012, we started to ship this product in very limited quantities."

The OmniVision OV8830 CMOS Image Sensor  (CIS Technology) is based on their new stacked Back-sided Illumination OmniBSI-2 Technology.
Wait! Extension of product cycle?  I'll explain in the Hard Facts section....

Rumors, rumors, rumors
There is a rumor that OmniVision lost the CIS technology deal with Apple on the iPhone-4S. The iPad-3 is coming out in March and there is no OmniVision production ramp-up for that.

[Edit: I could be wrong. - Robert W. Baird & Co, said Apple's iPad could boost OmniVision revenue by 30 percent over the revenue from iPhone last year. ]

The iTV successor may be release soon and could possibly use OmniVision; However, there seems to be no production ramp-up for that either. The iPhone-5, which is to be released later, is a possibility and the new OmniBSI-2 Technology 4mm width would fit into the new slimmer design. However, that is all speculation. But in the short run, where could the decreasing revenues be generated?


This quarter's earnings
Ok, back to last night's 3rd quarter earnings conference call from OmniVision. Everybody was asking or trying to confirm who the large customer that cancelled their orders was. Everybody was trying to confirm if the rumor about Apple was true. I don't think that is the take-away from the call. When asked what division will increase the most in the near future, the answer was the "entertainment business".

Ray Cisneros, VP of Worldwide Sales explained the product mix as follows:

"In terms of product markets, our mobile phone sales represented approximately 52% of our revenues in the third quarter as compared to 60% in our prior quarter. Our entertainment segment represented 28% of sales as compared to 20% in the prior quarter. Our sales of sensors into the notebook and webcam segment were approximately 8% of sales as compared to 9% in our prior quarter."

Hard Facts
OmniVision has signed a deal with Nintendo (NTDOY.PK) on their new Wii successor, Wii U. It is to be released after March 31, 2012.
OmniVision started mass production of the 0V10630/OV10635 based on  OmniPixel3-HS technology for the auto industry.
OmniVision is in mass production of the best-in-class 720p HD video performance chip.
OmniVision is in a deal with ASUS Transformer Prime Tablet which uses the OV8830 OmniBSI-2 Technology and is considered the most advanced Tablet out in the market at this time.
OmniVision and Sony signed a deal for a Video Camera using the CameraCubeChip design.

Conclusion
OmniVision seems to have other deals which will lessen the risk of revenue declines if Apple changes its mind. It has a very broad range of products. I haven't even scratched the surface of all their competitive advantages.

I have no stake in OVTI.

OVTI is under appreciated

Watch OVTI today, its earnings are released after the market closes today.

I'll give you the results & more on the next blogger post.
More to come...