Editor's Choice

Investing In Companies That Keep Us Safe

Brian is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Editor's Note: This article originally referred to L-3 Communications as Level 3 Communications, the article has been corrected.

The Federal budget is a hot topic this election season; as you are likely aware, automatic budget cuts scheduled for Jan. 1 will result in significant reductions in government spending, including a $55 billion reduction to the defense department's baseline budget (down to around $500 billion) for 2013 and will not provide for any budget increases over the next decade.  Combined with similar budgetary pressure around the world, there seem to be plenty of reasons to steer clear of all aerospace, defense and security stocks.  While spending reductions are certainly important to companies that rely on government contracts, it is not necessarily reason to run away from this sector all together.  

Governments Will Keep Spending to Keep People Safe

Governments around the world are still spending plenty of money.  For example, just last week the TSA announced $490 million in new contracts for smaller, faster scanners at airports.  The two lucky winners of $245 million contracts for this work are American Science & Engineering (NASDAQ: ASEI) and L-3 Communications (NYSE: LLL).  This contract award is particularly meaningful to American Science & Engineering, which boasts a market capitalization of just $559 million.  As I discussed in a recent article on small cap dividend payers, the small size of the company and the lumpiness of its business can make for a wild ride.  However, with state of the art x-ray scanning technology that has numerous applications and an apparent growing foothold in personnel scanning, there are lots of reasons to be excited by the company.  

L-3 Communications operates in a wide range of niche national security and defense markets in addition to personnel screening.  For example, L-3 is a full-service provider of unmanned aerial vehicles (or UAVs), provides cyber security services to the government and is even involved in the provision of missle defense systems.  

Keeping our soldiers safe will continue to be a top priority for the military, so spending on the development of high-tech tools to accomplish this will remain in demand even after budget cuts and the draw down of troop deployments.  Companies can provide a range of solutions to achieve this, including mine-resistant ambush protected (or “MRAP”) vehicles manufactured by Oshkosh Corp (NYSE: OSK), PackBot bomb disposal robots developed by iRobot Corporation (NASDAQ: IRBT) and UAVs made by AeroVironment Inc. (NASDAQ: AVAV).

Revenue Diversification Is Critical

For each of the companies listed above to thrive, it is critical to not only excel in each's high-tech government niche (through continued contract wins), but also to grow business from non-military business lines.  Here is a brief summary of the other product lines that each company can continue to develop:

  • American Science and Engineering's backscatter x-ray technology may have taken off as a result of government spending, but there are plenty of commercial applications for these security products.  In addition to military, law enforcement, border protection and TSA markets, AS&E has targeted critical infrastructure (e.g., power plants), ports, air cargo, events and other privately owned facilities for its products.
     
  • L-3's aviation products have a military focus, but 37% of that segment's sales are to commercial and international customers.  Still, 80% of the company's revenues are generated from the U.S. government; more on this in a moment.
     
  • Oshkosh generates almost half of its revenue from defense contracts, but as I discussed further in a recent article, Oshkosh makes everything from aerial lifts to fire trucks and snow plows, which provides significant diversification.  
     
  • iRobot is actually best known for its line of home robots such as the Roomba vacuum, and roughly 80% of its revenue this year has been from its home robot segment.
     
  • AeroVironment generated 85% of its revenue in 2011 through the sale of UAVs to the military.  However, the company has been a pioneer in the development of testing and charging stations for electric vehicles.  This emerging opportunity has the potential for tremendous growth as plug-in vehicles become more prevalent.

Growth Projections

The big question is how each of these companies will fare in an era of reduced defense spending.  So, here's look at analysts' 5 year expected growth rates:

 

5 Year Estimated 
Growth Rates

ASEI 15.0%
LLL 0.5%

OSK

13.5%
IRBT 9.1%
AVAV 11.0%

It is pretty obvious from the table above that the market doesn't expect L-3's non-government business to make up for anticipated cutbacks in spending in L-3's core defense businesses.  The other four companies, with estimated growth rates between 9%-15% per year, are projected to keep growing despite the looming spending cutbacks.  9%-15% may not appear impressive at first glance, but these growth rates are quite a bit higher than leading aerospace and defense companies such as General Dynamics and Lockheed Martin, both of which are expected to grow 6% per year over the same period.

Which One to Pick?

If I had to pick just one of the companies discussed above, I'd opt for American Science & Engineering.  The 15% growth rate noted above is a reflection of the wide market opportunity for the company's products.  Not only are TSA contracts and commercial applications growing in the U.S., but there is also tremendous opportunity internationally.  International sales represented 34% of AS&E's revenue in fiscal 2012, and this area remains a major focus for the company as it markets its solutions for airport, cargo, border and other applications abroad.  

While AS&E's TTM P/E of 30 looks a bit pricey, there are a few reasons not to be alarmed.  First, TTM free cash flow yield is a solid 6.3%.  Second, AS&E's balance sheet is pristine, with no debt and $186 million in cash.  Third, management's confidence in the strength and stability of the company's business is evident in the healthy quarterly dividend; AS&E has been paying a dividend for the past 5 years and the stock currently sports a dividend yield of 3%.  

While there are multiple reasons that AS&E is a solid small cap holding for the long term, there are of course risks.  First, the business is lumpy; you need to look no further back than March 2012, when AS&E reported earnings of $0.15, a whopping $0.68 below analyst expectations.  It is important (and not always easy) to look beyond the short term volatility in order to measure the health of this business.  Second, there is plenty of competition in this business beyond L-3; examples range from other smaller companies such as Analogic Corporation and OSI Systems, privately held Smith Detection, and much larger players such as General Electric.  

While AS&E may not be an instant multi-bagger in the making, it does have strong potential to outperform the S&P 500. Currently, 298 of 304 CAPS all-stars that have rated the company agree that AS&E will outperform the market.  

 


BrewCrewFool has no positions in the stocks mentioned above. The Motley Fool owns shares of L-3 Communications Holdings. Motley Fool newsletter services recommend AeroVironment, American Science & Engineering, and iRobot . Try any of our Foolish newsletter services free for 30 days. 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 Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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