Whatever deal gets struck to resolve the imminent "fiscal cliff," the U.S. budget mess will be far from fixed. There will still be a yawning gap between government revenue and government spending, let alone the fact that we still have an existing $16 trillion debt load 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 inevitable.
And that spells top-line weakness for many defense contractors. A wide range of multibillion contracts with firms such as Lockheed Martin (NYSE: LMT) and General Dynamics (NYSE: GD) 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.#-ad_banner-#
I'm talking about iRobot (Nasdaq: IRBT), which make robotic search and detection devices, and AeroVironment (Nasdaq: AVAV), 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 an income 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 consumer devices.
To be sure, this is a lumpy business: Sales fell roughly 3% in 2009 when the global economy 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 million)
Shares appear to be oversold by a variety of metrics. For example, net cash of $190 million is roughly 35% of the entire market value of iRobot. They now trade for less than one times sales, on an enterprise 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 a lot 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 fighter.
In early 2009, this was one of the hottest stocks in the market, 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 recent $22.
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, she notes 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 portfolio.
Valuations are quite reasonable, as shares trade for around 14 times projected 2013 profits, a multiple 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.