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), 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.

Over the past year, Orbital earned $85 million on $658 million in sales. About a quarter of its potential revenue will come from testing of a new missile defense system, a project that is expected to expand over the next few years. Shares traded as high as $50 in the mid-1990s and as low as $1.25 in 2001 as defense spending faltered. The recovery from that low has been slow but steady, and a price around $20 per share appears possible if you assume current growth will continue apace or accelerate and assign a reasonable market multiple on estimated 2006 earnings.

Two other small-cap names have potential, one of which is Heico ( HEI.A), recently at $14.98, which makes jet-engine parts and defense electronics. It is trading at a considerable discount to its growth potential in the 18%-plus range. The other is Argon ST ( STST), recently at $25.33, which makes electronics systems for major defense contractors and directly for the Pentagon and intelligence agencies. It is also trading at a discount to its 22%-plus earnings growth potential.

P.S. Don't forget -- now is a great time to get in on bargain stocks before the prices go up. Get my picks with a free trial to TheStreet.com Value Investor.


Please note that due to factors including low market capitalization and/or insufficient public float, we consider Heico and Argon ST to be a small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

Jon D. Markman is publisher of StockTactics Advisor, an independent weekly investment research service, as well as senior strategist and portfolio manager at Pinnacle Investment Advisors. At the time of publication, he had no positions in stocks mentioned. He also writes a weekly column for CNBC on MSN Money. While Markman cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at jon.markman@thestreet.com.

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