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President Obama has requested the support of Congress for limited military action in Syria as a punitive action against the Assad regime, who the President believes, based upon what he claims is irrefutable evidence, has used chemical weapons against the Syrian people resulting in over 1,400 deaths. This has put the defense contractor stocks in the spotlight.

Looking at the Aerospace and Defense Sector for possible investments in the space, one sees a high degree of correlation between the major names. The big boys, Raytheon (NYSE:RTN), Lockheed Martin (NYSE:LMT), General Dynamics (NYSE:GD), Northrop (NYSE:NOC) and Boeing (NYSE:BA) have all had substantial moves upwards in their stock prices. This is seen clearly in the movement of the Aerospace and Defense ETF (NYSEARCA:ITA), which has rallied over 40% since November:

(click to enlarge)

This impressive performance is double the S&P, and achieved against the not inconsiderable headwind of the spending cuts associated with sequestration. In reviewing the space, I found one small-cap contractor that stood out from the group and seems to be outperforming its peers by a considerable margin.

Arotech (NASDAQ:ARTX) is an $80 million annual sales provider of defense and security products for the defense, security and law enforcement industries. It has two main product groups: specialty batteries and training simulators. The case for ARTX, as this article will show, is based upon low valuation and upon earnings growth.

  1. Valuation

ARTX compares favorably with the larger defense contractors on both a price to book (P/B) basis and a price to earnings (P/E) basis, as shown in the table below: (data in tables sourced from yahoo.com)

P/B

P/E

RTN

2.85

13.06

LMT

57.05

13.88

BA

19.39

10.69

NOC

2.26

11.57

GD

2.54

11.68

Avg

16.818

12.176

ARTX

0.76

11.07

P/B ratios for LMT and BA skew the results, but even if you take those two out of the sample, average P/B is 2.55, well ahead of ARTX which trades at .76 times book value. ARTX is only one turn of earnings less than the majors, but as we shall see, earnings momentum at ARTX is considerably stronger, and consequently it compares very favorably on a forward P/E basis.

2. Earnings Growth

On both an annual and quarterly basis, ARTX has been delivering superior results to industry averages. (Sales figures are in millions of dollars.)

2012 sales

2011 sales

% gain

RTN

24,414

24,791

-1.52%

LMT

47,182

46,999

0.39%

BA

81,698

68,735

18.86%

NOC

25,218

26,412

-4.52%

GD

31,513

32,677

-3.56%

Avg

1.93%

ARTX

80

62

28.83%

Revenue growth among the major contractors has been anemic, averaging less than 2%, year over year. ARTX annual growth of nearly 29% is impressive.

ARTX has been improving margins as well. This is a function of focusing on the training and simulation side of the business which is the more profitable. During the latest 12 months, training and simulation accounted for 74% of revenues. ARTX had also made the strategic decision several years ago to sell its armored vehicle division to allow greater focus on the training and simulation and specialty battery sides of the business. The results below demonstrate the merit of that business decision.

The June quarter showed substantial improvements in all operating metrics, swinging the company to a profit from a loss in the corresponding quarter a year earlier. (source: company filings)

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED) (USD $)

3 Months Ended

6 Months Ended

Jun. 30, 2013

Jun. 30, 2012

Jun. 30, 2013

Jun. 30, 2012

Revenues

$ 22,396,842

$ 20,373,130

$ 44,449,973

$ 36,480,838

Cost of revenues

16,088,195

17,013,427

32,865,162

28,832,494

Research and development expenses

594,785

455,808

1,128,170

1,046,961

Selling and marketing expenses

1,383,252

1,328,301

2,620,258

2,613,194

General and administrative expenses

2,466,247

2,000,779

4,854,058

5,001,385

Amortization of intangible assets

273,618

299,934

550,112

601,305

Total operating costs and expenses

20,806,097

21,098,249

42,017,760

38,095,339

Operating income (loss)

1,590,745

(725,119)

2,432,213

(1,614,501)

Importantly, quarterly gross profit margins improved year over year from 16.5% to 28.2%. Total operating costs came down slightly notwithstanding the increase in revenue.

As at the quarter end, ARTX had a sales backlog of $76 million. Since then ARTX has announced an additional $9.6 million in recent new orders.

With a fully diluted share count of 16 million shares, this translated into a $0.09 EPS for the quarter. If ARTX can sustain that level of earnings throughout the coming 12 months, this would translate to $0.36 EPS and bring their forward PE down to 5.4, a substantial discount to the defense sector average.

An investment in ARTX is obviously more inherently risky than investing in the other defense contractors mentioned in this article due to ARTX's much smaller size. However, the growth in sales and earnings, and the valuation metrics are compelling. ARTX stock also appears timely at this juncture, as it has pulled back from the recent spike that followed the Q2 earnings announcement.

(click to enlarge)

With conflict in Syria bringing focus to the defense sector, investment exposure to some defense contractors makes sense. ARTX has the potential to get carried higher in the short term as newspaper headlines capture investor attention and direct it to the defense industry. For the longer term, ARTX offers a compelling investment case based upon favorable valuation and strong earnings growth supported by a substantial backlog and recent sales wins.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in ARTX over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Syria Puts Defense Contractors In Spotlight: Arotech Shines