War-Play War Plays

(Stocks in this article: NYSE: PCP, NYSE: ATK, NYSE: LMT, NYSE: COL, Nasdaq: AVAV, Nasdaq: ATRO, NYSE: HON, Nasdaq: CRDN, NYSE: BA, NYSE: CGT)

If, as it appears, we are going to war with Iran, then it is certainly wise to consider a few war-play war plays. The most logical place to look, and the stone we are going to turn in the paragraphs that follow, is the Aerospace and Defense Industry.

The rhetoric is as intense as ever between the United States, Iran and ancillary parties like Russia and Israel. The Administration’s latest round of sanctions announced last Thursday and Vice President Cheney’s recent statements pounded home what we view as the obvious. America, Israel and most European nations view it as incomprehensible for Iran to possess nuclear weaponry or the skill to build such weaponry. Meanwhile, Iran whistles and works its way to Armageddon.

Logically, the most direct beneficiary of war would seem to be the aerospace and defense sector. Oh sure, if we go to war with Iran and light a powder keg in the center of the Persian Gulf, energy plays without direct risk to assets would also seem like clear beneficiaries. But the energy sector leads all S&P 500 component groups year-to-date through October 26, up 29.6%. Thus, I wonder how much near-term value is available to add to the group versus the risk of holding such shares in the presence of the economic slowdown counterweight. Also, as I outlined in a recent article, the Fed's neutral bias should impact the price of oil. Thus, energy stocks could begin to give back gains.

The Aerospace and Defense component of the S&P 500 Index is also up a bunch (22.9% through October 26). However, the risk of economic slowdown is less relevant to this group, especially those firms most levered to defense. Also, war or no war, the industry has proven a strong long-term performer, at least while under Republican reign, providing an average annual return of roughly 20% over five years. So, I thought it might be interesting to consider ideas in the group.

I ran a basic screen to generate a list to look over. I wanted to find the best couple names that were in a position of solid footing. I screened for:

1 Aerospace & Defense Industry
2 $5 or more
3 $200 million market cap or more
4 15% growth in EPS from the trailing twelve months over the year ago
5 Projected 5 Year Growth of 10% or more
6 ROE of 20% or more

My criteria were very simple, looking for a solid company, possessing solid return on capital and generating earnings, while interestingly showing growth projections below its most recent period. My reasoning here is that as an analyst I’ve found that conservative forward projections can sometimes hide a poorly understood growth story that is evident in recent results. Even so, the higher growth ideas should have also showed up.

Company	Ticker	P/E	5 Yr. Gr.	P/E/G	ROE
Lockheed Martin	LMT	16.1	11.56	1.4	34.2
Honeywell	HON	18.8	11.8	1.6	20.2
Precision Castparts	PCP	22.2	18.86	1.2	24.7
Rockwell Collins	COL	22.1	16.52	1.3	44.4
Alliant Techsystems	ATK	18	10.74	1.7	31
Ceradyne	CRDN	13.3	12.33	1.1	39
Aerovironment	AVAV	19.7	22.5	0.9	24.2
Astronics	ATRO	29.8	25	1.2	20.2

(Values from Oct. 30)

I immediately pulled Boeing (NYSE: BA) out of the pool, because of its economic sensitivity to its commercial aircraft operations. Also, CAE, Inc., (NYSE: CGT) is a Canadian company, and I found it impossible to verify the data at a second source. Anyway, I expect that its flight simulation offerings are not going to get the same kind of benefit from war as some of the other product categories. I eliminated Precision Castparts (NYSE: PCP) and Honeywell (NYSE: HON), because of their diversified end markets, but I left them in the table for your benefit as PCP’s numbers look interesting anyway.

Taking a closer look at valuation, a couple names that are exhibiting high growth, while valued cheaply, stood out. AeroVironment, Inc. (Nasdaq: AVAV) is screaming “look at me,” while it trades at a forward P/E below its five-year forecast EPS growth rate. Beware the trap though, as sometimes there is good reason for this. It’s a clear case where a closer look is absolutely necessary. The reason for its valuation could be as basic as light analyst coverage, or as dangerous as serious fundamental cause. Taking the brief look that the scope of this article allows, I found a company participating in more than one innovative industry. This is a company I will prepare an in-depth follow up on in the days to come.

Astronics (Nasdaq: ATRO), which reports earnings today, also looks appealing on the basis of valuation. However, it is too sensitive to the commercial aircraft market for the purposes of this search, where we are specifically targeting defense. Finally, Rockwell Collins (NYSE: COL) and Lockheed Martin (NYSE: LMT) may provide more of a sure thing, in regards to defense benefit, while still presenting a reasonable valuation. I would have avoided one of my personal favorites of the past Alliant Techsystems (NYSE: ATK) because of valuation, if not for one simple fact. War could bring upward adjustment to its five-year growth projection, and would justify its valuation. However, the margin of safety is clearly narrower with ATK.

If we argue that growth rates across the group could expand, then Ceradyne (Nasdaq: CRDN) becomes interesting as well. So, for the various reasons outlined above, I prefer COL and AVAV, and would consider LMT, ATK and CRDN for defense exposure in the war-play scenario.

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