RealMoney Silver - Defense Stocks Are Priced to Take Off

Defense Stocks Are Priced to Take Off
By Bill Trent
RealMoney.com Contributor
6/30/2008 11:15 AM EDT

New orders for manufactured durable goods in May increased slightly to $213.6 billion, the U.S. Census Bureau announced last week. This was the first increase in three months, and it followed a 1.0% April decrease. Excluding transportation, new orders decreased 0.9%. Excluding defense, new orders decreased 0.6%.

Behind that bland summary, though, is usually a wealth of information that I believe could be useful for picking the best industries in which to invest.

This month, the signal was clear. Get defensive. Among a sea of industries seeing declining sales and orders, one stood out for its strength: defense aircraft and parts.

Click here for larger image.

Source: U.S. Census Bureau

Unless you run a socially responsible investment fund, you can capitalize on this nugget.

Of course, in the defense aircraft and parts industry, the big news right now is the fight between Boeing (BA) and Northrop Grumman (NOC) over the Air Force tanker contract. If I want to get exposure to the industry, I'd avoid these two because of the event risk. Besides, Boeing has too much civilian aircraft exposure.

In his recent post about how to play defense stocks going into the election, Jim Cramer said, "This is one of those compelling risk/reward situations where you could find yourself picking up some Raytheon (RTN) , Northrop Grumman or General Dynamics (GD) (Lockheed Martin (LMT) refuses to come in, so it is now my least favorite), and you can win either way. I believe Obama has to tack extremely right to win, and the easiest way to do that is simply to call for a strong defense and ram it home by visiting defense plants and talking about the need for non-Iraqi strong defense elements."

High Fliers

To me the most interesting name on that list is General Dynamics. The consensus earnings estimate has risen to $5.91 from $5.74 over the last couple of months, and the company's 1% accrual ratio suggests that the earnings are high quality. Unfortunately, aerospace accounts for just 17% of the company's revenue, and much of that is civilian (Gulfstream), so it probably isn't the best way to play the durable-goods report either.

Jim Cramer said "L-3 Communications (LLL) might be best because it is the Democrats' defense company, with all of the homeland security counterterrorism plays." At least L-3 has more defense aircraft exposure, and the stock has come down nearly 20% from its recent highs. Meanwhile, earnings estimates continue to rise.

Esterline (ESL) and Heico (HEI) could be interesting small-cap aircraft electronics plays. Esterline's stock is down 17% from the recent high, even though its earnings estimates have risen from $3.51 to $3.60 over the last month. Heico is down about a third, even though its estimates have also been edging up.

With consolidation still rampant in the sector (Italy's Finmeccanica recently sent DRS Technologies (DRS) up nearly 25% after offering to buy the company), Esterline and Heico could also be attractive consolidation plays. The same could even be said for Rockwell Collins (COL) , though that company's $7.8 billion market cap would be a larger bite.

It's unusual for a sector to be seeing rising earnings estimates, rising orders and falling stock prices. This could be a time to take advantage.