Insiders Are Buying This Defense Stock, But Should You?

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Esterline (NYSE: ESL) is a leading world-wide supplier to the aerospace and defense industry, specializing in three core areas: Avionics & Controls, Sensors & Systems, and Advanced Materials. Recent significant insider buying has been reported at the company. Should investors follow the insiders and buy the stock?

Valuation

With regards to valuation, Esterline trades at a P/E of 19.51, close to the industry average. Its price-to-earnings ratio is lower than that of competitors like AMETEK (NYSE: AME), but higher than that of others like Lockheed Martin Corporation (NYSE: LMT). The situation is similar when taking into account future earning estimates: Esterline's forward P/E is 11.59, sitting halfway between AMETEK's 17.40, and Lockheed's 10.67. However, the situation is different when one looks at the stock's PEG and P/B: Esterline beats its competitors in both ratios (the stock is trading at a P/B of 1.34 and a PEG of 1.30). All in all, Esterline is neither overvalued nor undervalued when taking into account price-to-earning ratios (both current and forward), but, relative to its peers and industry, the stock does seem to be slightly undervalued when taking into account its price-to-book and P/E-to-growth (PEG) ratios.

Analysts

Wall Street analysts are slightly bullish on the stock: it currently has an average recommendation of 2.20 (overweight-hold) and an average price target of $76.89, which implies 7.7% upside potential from current prices. However, AMETEK seems to be the most favored by analysts, as it has an average recommendation of 1.90 (buy-overweight), and a price target that implies more than a 13% upside potential. With regards to Lockheed, even though it beat most of the industry's stocks in the P/E arena, analysts are mostly neutral on this one: the stock has a 2.80 average recommendation, and its average price target is actually lower than the current stock price.

  P/E Fw P/E P/B PEG Avg Rec Avg PT (%implied upside) Div Yield
ESL 19.51 11.59 1.34 1.30 2.20 $76.89 (+7.7%) N/A
AME 21.38 17.40 3.86 1.52 1.90 $45.56 (+13.33%) 0.60%
LMT 11.50 10.67 802 1.59 2.80 $95.67 (-0.63%) 4.78%
Edge LMT LMT ESL ESL AME AME LMT

Price movements

Despite defense spending reduction fears, Esterline has had a good run YTD, as the stock has gained roughly 12.5%. Its price has dropped from its 52-week high attained in mid-March (it is currently 8.36% off its high of $77.90), but it is almost 40% above its 52-week lows of $51.13. The stock is also trading close to its all-time high of $80.57 (July 2011) and far from its low of $19.76, which was reached in March 2009 amid the financial crisis.

Insider buying

On April 11, Director Henry Ward Winship IV bought 18,500 shares of Esterline Technologies in the open market, at an average price of $75.56. That is a purchase of almost $1.4 million. The next day, he bought 9,500 more shares, at an average price of $75.12, spending more than $700,000. So in just two days, Mr. Winship, a director with unique insight into the company's business, invested $2,111,500 of his own money to buy Esterline Technologies shares in the open market. This is significant insider buying, and is therefore a bullish sign for the stock.

Earnings looking ahead

On Feb. 2, the company reported net income of $25.1 million and sales of $458.0 million. One year ago, first-quarter net income was $22.8 million, and sales were $470.9 million.

Esterline also reported a gross margin of 35%, up 1.4% from the same period last year. The most spectacular improvement came in the cash flow arena: cash flow from operations in the quarter was $86.5 million, almost doubling last year's $46.6 million figure. New orders for the first quarter ($473 million) were also up from last year's $467.8 million. EPS for the quarter also grew to $0.81 per share, up from last year's $0.74 per share.

Despite the growth in earnings, the stock price is almost identical to that of one year ago. The key is if earnings growth can continue this year, amid the significant defense spending cuts. However, the company seems well-poised to sail through the defense cuts relatively unharmed due to its diversification strategy; by focusing on a balanced global approach between defense markets and commercial aerospace, Esterline should keep revenue and earning numbers solid. In fact, only 25% of the company's revenue comes from US defense spending. So, while the defense cuts might impact its earnings (especially during the first half of the year), a strong commercial aerospace cycle, coupled with the growth opportunities in the company's adjacent markets (casino gambling installations, China high speed rail, nuclear power initiatives in the UK) could keep earnings growing at healthy rates this year.

The bottom line

Defense-related stocks have been out of favor as fears of drastic defense cuts spooked investors. Esterline, however, seems to have a solid balanced model that not only seeks to protect the company's earnings from cyclicality, but also seeks to grow in additional markets. However, the stock is not drastically undervalued, and is in better shape than some of its competitors, so bargain-hunters or bottom-fishers might want to look elsewhere. As a solid aerospace play, however, the stock looks attractive. The recent insider buying helps support this assertion.


Alex Bastardas has no position in any stocks mentioned. The Motley Fool owns shares of Lockheed Martin. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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