Whatever deal gets struck to resolve the imminent "fiscal
cliff," the U.S. budget messwill be far from fixed. There will
still be a yawning gap between governmentrevenue and government
spending, let alone the fact that we still have an existing $16
we need to start whittling down.
One of the most vulnerable arms of the federal government will
be the Department of Defense (DoD). Our current military is so
large -- more than 10 times bigger than its nearest rival -- that a
bit of shrinkage seems inevitable. Nobody is calling for plans to
gut our nation's military in an extreme fashion, but a DoD that is
5% or 10% smaller than current levels seems increasingly
And that spells top-line weakness for many defense contractors.
A wide range of multibillion contracts with firms such as
Lockheed Martin (NYSE:
General Dynamics (NYSE:
are coming under tighter scrutiny, as the DoD seeks ways to find
less-expensive solutions to fielding a more nimble military.
Out with the bath water
Simply being associated with this sobering trend has been toxic for
many defense-oriented stocks. Indeed, a pair of smaller, but more
promising defense contractors have been tossed aside. They now
trade far from their 52-week highs, even though they represent some
of the few growth niches in the military.
I'm talking about
, which make robotic search and detection devices, and
, maker of unmanned aerial drones. They also have appealing
non-military divisions as well, as I'll discuss in a moment.
One of the charms of working with Uncle Sam and the DoD is that you
get paid to do research. iRobot has invoiced the DoD for millions
of dollars over the years to develop a range of ruggedized,
remote-controlled robots that can safely enter into a battle
environment when it's too risky to send in soldiers. The good news:
the company now owns the rights to the knowledge it has accumulated
and can parlay that research into other products. You won't find
this spending in the research and development (R&D) line of
anincome statement , as it is recorded as revenue.
iRobot is augmenting the DoD-funded research with its own funds:
Internally-funded R&D has risen from $15 million in 2009 to $36
million in 2011. This spending has helped the company develop an
ever-broadening product line, which explains why sales rose from
under $150 million in 2005 to $465 million in 2011.
iRobot's main source of revenue is the PackBot disarming robot,
which has already saved countless soldiers' lives. On the consumer
side, the company's Roomba vacuum cleaner is a top seller, though
iRobot is also developing and selling a number of other robotic
To be sure, this is a lumpy business: Sales fell roughly 3% in
2009 when the globaleconomy slumped, and a deferral in government
orders, thanks in large part to a fiscal cliff-induced spending
freeze, are expected to push sales down 6% this year to $436
million (before rebounding roughly 10% next year to around $485
Shares appear to be oversold by a variety of metrics. For
example, netcash of $190 million is roughly 35% of the entiremarket
value of iRobot. They now trade for less than one times sales, on
anenterprise value basis, which is quite low for a company with 40%
gross margins and 10% operating margins. Those margins have risen
for four straight years -- which is always a positive sign. As
sales growth resumes in 2013, this beaten-down defense stock should
zoom back into favor.
Unmanned aerial drones have gotten alot of press in 2012 -- not all
of it favorable, as ostensible allies such as Pakistan grumble that
our military drones infringe upon their sovereignty. But the
military loves them. Not only are they more cost-effective to
operate than piloted planes, but they take fighter pilots out of
harm's way. And they fly in such a stealthy fashion that they are
less likely to be noticed by enemy fighters than a traditional jet
In early 2009, this was one of the hottest stocks in themarket ,
as shares briefly touched $40. Investors figured the company's
drones would lead to explosive sales growth. Instead, order flow
from the government has been merely good -- not great -- as sales
rose from $248 million in fiscal (April) 2009 to $325 million in
2012. This slower-than-expected growth has pushed shares down to a
Indeed sales growth is likely to be muted in 2013, at least
until the DoD starts to reformulate its spending plans. Drones have
become so crucial to the current military strategists, that an
expansion in the drone fleet is inevitable -- especially since they
are so much cheaper to operate than traditional planes.
My colleague Amy Calistri is a big fan of Aerovironment, having
added it to her
Stock of the Month
portfolio in March 2012. Curiously, Amy focuses on the domestic
aircraft market, especially helicopters used by police departments
and other government agencies. For example, she writes that "drones
are smaller and more maneuverable. For instance, a SWAT team
couldn't send a helicopter inside a building in advance of a raid,
but they could send in a drone." Using another example, shenotes
that the U.S. border patrol already operates nine drones, with
plans to have 24 of them by 2015. Amy backed up her confidence by
purchasing 250 shares of Aerovironment for her
Stock of the Month
Valuations are quite reasonable, as shares trade for around 14
times projected 2013 profits, amultiple that drops even lower when
you back out the company's $6 a share in net cash.
Risks to Consider:
The DoD has placed a freeze on many programs and these two
stocks won't spring to life until the DoD unfreezes them.
Action to Take -->
Although the DoD is set to shrink in the coming decade, iRobot and
Aerovironment appear poised to capture a larger slice of the pie.
Although 2013 sales growth forecasts are somewhat muted, these
companies are in the midst of a long-term growth phase that should
resume in 2014 and beyond. But you don't want to wait until then to
snatch up these oversold value stocks.
-- David Sterman
David Sterman does not personally hold positions in any
securities mentioned in this article. StreetAuthority LLC does not
hold positions in any securities mentioned in this article.