While it’s still early, it appears that the killing of Osama bin Laden is a game changer for the stock market and the defense sector. The result could be an acceleration of drawdowns in Iraq and Afghanistan and a rethinking of the DoD budget and related aerospace contracts for defense stocks.
With high unemployment and slow economic growth, Americans want to find ways to bring back fiscal responsibility. No doubt, the military budget is a fat target and aerospace and defense spending will be targeted.
This is certainly bad news for the larger defense firms like General Dynamics (NYSE:GD), Lockheed Martin (NYSE:LMT), Northrop Grumman (NYSE:NOC) and Raytheon (NYSE:RTN). Already, they are feeling the pressure of lower bookings as well as increased cancellations.
If history is any indication, the lower spending could last five to ten years. Consider that the expected new Secretary of Defense, Leon Panetta, is a budget hawk. During the Clinton Administration, he was the chief of the Office of Management.
Despite all this, there are still opportunities for investors — that is, the smaller companies in defense industry. The wars of the future will inevitably require cutting-edge technologies.
This was certainly apparent in the operation to kill bin Laden. President Obama’s National Security team used real-time technologies to track the events. It also looks like the SEALS used a next-generation stealth helicopter.
Another advantage for smaller firms is that the Pentagon has introduced new regulations that try to avoid single-source contracting. As a result, these companies are likely to participate in higher-end projects.
So what are some of the top small companies to watch? Here’s a look:
Rockwell Collins (NYSE:COL): The company has a large commercial business, such as with communications and electronics for business jets and airliners. But there is also a military segment. The technologies include automated flight control, surveillance and simulation.
While this strategy can overstretch a company, Rockwell has actually been able to effectively leverage its platform. Often its commercial technologies are transitioned to military applications. It usually means lower-priced bids on projects.
Yet the driver for Rockwell is likely to be its commercial business. As the global economy continues to rebound, there will be more spending on airline investments and corporate jets. Rockwell has already landed key contracts for the Boeing (NYSE:BA) 787 and the Cessna CJ-4.
Rockwell also has operating leverage in its business. In the latest quarter, the company was able to improve its operating margins by 60 basis points. The margin improvement is likely to continue.
Harris Corporation (NYSE:HRS): The company develops sophisticated inflight-deck avionics, mission communications and cabin electronics. It also has a global platform, which spans 27 countries.
But about three-quarters of revenue come from the US government. Because of this, there has been much concern from investors. The price-earnings ratio is only 10 and the shares are trading at 6 times EBITDA. In other words, the valuation is quite low.
So how can Harris deal with its reliance on government business? A key strategy is acquisitions. Consider that Harris has already been ramping its dealmaking, with deals for companies like Schlumberger Global Connectivity Services (which provides satellite communications services for energy markets).
Harris definitely has a strong balance sheet to carry out more transactions. The company is expected to generate cash flow from operations of $775 million to $825 million in fiscal 2011 and boasts a dividend yield over 2% despite its small-cap status in the defense sector.
FLIR Systems (NASDAQ:FLIR): The company is a leader in infrared technologies. Over the next few years, it’s a good bet that the Pentagon will continue spending on these items, which have applications for things like night vision. But there is much broader appeal for FLIR’s offerings, such as in law enforcement, homeland security and border patrol.
In the latest quarter, revenues spiked 30% to $373.5 million. The main driver was the commercial business, which grew a sizzling 51%.
Then again, FLIR has had a long-term record of strong performance. Over the past ten years, the average annual growth rate of revenue was 23% and the earnings-per-share rate was 24%.
Vital to the success to FLIR has been its talented engineers. For example, the company has seen recent breakthroughs in areas like gas detection, food inspection, predictive maintenance and building monitoring.
Hilary Kramer is the editor of the GameChangers and Breakout Stocks Under $5 stock picking newsletters. As of this writing, she held no position in any of the stocks named here.
