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Defense Plans Create Small-Cap Values

The estimated costs of the war in Iraq are heading north of $145 billion, as the price tag for more ammunition, gasoline, helicopters, armored vehicles and services increases every day. So while investors may well debate the capacity of U.S. consumers to continue spending like drunken sailors over the next few years, it's pretty hard to argue that the Pentagon will suddenly stop writing big checks.

Whether you consider that spending to be bullish or bearish on the economy, value investors seeking conservative capital appreciation should grasp the obvious and consider low-priced stocks with unappreciated growth potential in the military-industrial complex. On Thursday, I covered some of the undervalued large-cap and mid-cap growth stories that are getting contracts. Today I'll look at a few relatively inexpensive defense-industry small-caps and micro-caps.

Aeroflexx (ARXX), recently at $11.64, makes microelectronic, motion-control and test systems for the defense, aerospace and broadband communications markets. Many of its products are used in military communications and space systems. On Nov. 8, the company reported a big boost in fiscal 2005 first-quarter profit and sales, but it issued a forecast that fell beneath investors' expectations.

Shares were slammed 12% the next morning but rose to flat by the end of the day as investors warmed to management's declarations that the shortfall was a one-time problem related to a single customer and did not signal a broad slowdown. Shares are flat for the year but down 20% from their March peak.

Uncertainty has created what looks like a pretty good value, as Aeroflexx's 2005 price/earnings multiple is now 23 on expectations of 35% growth, and the 2006 P/E is 16 on expectations of 38% growth. The price/sales ratio, now 1.9, has historically been around 2.5 to 3 in better times, so there is ample room for multiple expansion to join earnings growth as a catalyst for a higher price. So figure a price target of $17.50 in the next 18 months, which would be a 50% move if it happens.

Orbital Sciences (ORB - Get Report), recently at $12.52, manufactures and operates small space and rocket systems for the Pentagon and other government and commercial entities. The company's rockets can place satellites weighing up to two and a half tons into low-Earth orbit for communications and military clients. Just this week, it launched a target rocket for a Patriot missile defense system and also provided its Hyper-X launch vehicle to push NASA's X-43 scramjet to a record speed of Mach 10 in a California test.

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