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Iraq: Plugging Into The Networked War

by Diane Brady Business Week
April 21st, 2003

 When Frank C. Lanza pictures combat in Iraq, he sees the invisible links connecting the electronics installed on fighter jets and tanks to commanders sitting hundreds, even thousands, of miles away. He sees dumb bombs made "smart," and unmanned vehicles that can assess Saddam's strongholds. On the home front, the CEO of L-3 Communications Corp. already sees his company's equipment handling tasks ranging from airport security to training first responders for terrorist attacks. And after the war, he foresees helping to rebuild a shattered Iraq with L-3's networked software and infrastructure consultants.

 

As victory in Iraq appears imminent, this should be a sweet moment for Lanza and partner Robert V. LaPenta. After all, while Silicon Valley and defense giants such as Boeing (BA ) or Lockheed Martin (LMT ) get much of the attention, L-3 has become one of the crucial players working toward the Pentagon's goal of a fully networked battlefield. Since its founding in 1997, the New York company has more than quintupled sales, to $4 billion, with net 2002 income of $178 million, rolling up dozens of small specialty companies. "They are the most effective management team I've seen," says Brad M. Meslin, managing director of CSP Associates Inc., which has advised L-3's rivals on acquisitions.

 

But if L-3's penchant for acquisitions has wowed rivals, it also has clouded the company's reputation with some accounting observers and investors. One watchdog group recently questioned the company's accounting -- enraging Lanza. But investor skittishness over such issues did lead him to disclose far more detail about L-3's finances and accounting practices in its latest 10-K filing. Such transparency has reassured Wall Street analysts for now. But that whiff of impropriety, combined with the company's exposure to commercial aviation and a general downturn in defense-industry stocks, has forced the company's share price down to about $38 from a high of $67 last May.

 

Don't expect Lanza to change course, though. His strategy of growth through consolidation has built an impressive catalog of products that includes global positioning system receivers, command-and-control systems for unmanned planes, flight simulators, ground sensor systems, high-resolution displays, and encryption software, as well as surveillance and reconnaissance equipment for the Navy's F-18 fighter jets. Defense analysts praise L-3's solid organic growth and strong cash flow and argue that it has a manageable debt load of $1.85 billion. Some even think a short war may mean more orders for L-3's military business. The end of hostilities, they think, will free up the Pentagon to spend more on the gear needed to develop the network-centric military.

 

Lanza mastered his game plan while spending 15 years as president of Loral Corp. (LOR ), under the legendary dealmaker Bernard Schwartz. Lanza helped Schwartz -- a major Democratic Party donor who once made headlines for allegedly selling sensitive missile technology to China -- transform the New York company from a floundering defense firm to a leading-edge conglomerate. They acquired 25 companies before a chunk of Loral itself was bought by Lockheed in 1996. Lanza did a stint as an executive vice-president there -- an experience that insiders say was frustrating for the entrepreneurial executive. He soon arranged a deal to buy out 10 Lockheed divisions to form L-3 -- which stands for Lanza, LaPenta, and Lehman Brothers Inc., the investment bank that helped raise the $525 million to get L-3 off the ground.

 

Once on his own, Lanza sought out technologically sophisticated companies that lacked the resources or management expertise to grow. A good example is his acquisition of ComCept Inc. for $25.5 million in July, 2002. The deal let the small networking-software firm tap the resources of L-3 to develop military intelligence, surveillance, and reconnaissance systems. The sometimes tart-tongued Lanza has found that buying up small ventures can require more patience than big deals as "they go get a banker and some dumb lawyer" to handle the deal.

 

With hundreds of small defense suppliers angling for Pentagon money -- and many lacking the knowhow to get it -- the industry has been ripe for consolidation since the early '90s. And Lanza plans to continue pursuing companies, largely with borrowed cash. Most have revenues of $50 million or so, though L-3 did snap up a big-ticket target when it bought Raytheon Co.'s (RTN.B ) Aircraft Integration Systems in 2002 for $1.1 billion in cash. That helped L-3 snag a $1.5 billion contract in March to provide logistics products and services to the U.S. Special Operations Command. It also put L-3 a step closer to being able to package systems for aircraft on the level of the big boys of defense, although Lanza says L-3 will continue to focus on smaller deals.

 

Yet given the reputation of acquisitions-hungry companies these days, it's no wonder that the folks at the Center for Financial Research & Analysis put L-3 under the microscope. The accounting watchdog asked whether L-3's bookkeeping for its string of deals distorted the true financial health of the company. The center, which has raised questions about L-3's accounting since last June, won't disclose more details of its concerns. But analysts who have seen the reports say they mainly criticize L-3 for distorting the value of some acquired assets and liabilities.

 

Lanza and his supporters have circled the wagons in the company's defense. Schwartz, Lanza's former boss and an L-3 investor (he declines to disclose his stake) says: "It's very hard to defend oneself against innuendo." Lanza himself fumes that "when you're identified as a consolidator, that puts you in the category of a Tyco." Analyst Cai von Rumohr of SG Cowen Securities Corp. argues that L-3's accounting is no different from that of others in the industry. The company's organic growth mirrors the industry average of roughly 8% annually, says von Rumohr. Most important, its cash flow would have been $260 million last year if it had done no acquisitions.

 

Not only doesn't Lanza plan to cut back on his dealmaking, he is pushing harder into nonmilitary businesses, which now account for 15% of L-3's sales. Lanza sees a chance to leverage some of L-3's technologies in markets like airport security. Take last year's acquisition of PerkinElmer Inc.'s detection-systems business. PerkinElmer makes cargo scanners and luggage security scanners that are fast but have a relatively high number of false positives. L-3's scanners are more accurate, but slower. So L-3 won airport contracts in Singapore and Australia because it could offer machines with complementary strengths. But that success notwithstanding, the airline sector, which accounts for 4% of sales from the famous "black box" voice recorders and other products, is clearly a problem. Lanza predicts up to 10% more "degradation" in sales and a recovery that won't come until 2005.

 

A bigger challenge for L-3 investors may be who will replace the blunt, charismatic chief. Lanza has said he has no plans to retire. But he is 71. Co-founder, President, and Chief Financial Officer LaPenta, 57, may seem the logical choice. But industry insiders say he is more an operations expert than a visionary. More important, Lanza is viewed as the brains behind many of L-3's deals. For a company that's always hungry for acquisitions, he could be hard to replace.





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