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 (RTN), Lockheed Martin (LMT), General Dynamics (GD), Northrop (NOC) and Boeing (BA) have all had substantial moves upwards in their stock prices. This is seen clearly in the movement of the Aerospace and Defense ETF (ITA), which has rallied over 40% since November:
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 (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.
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 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.)
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
Cost of revenues
Research and development expenses
Selling and marketing expenses
General and administrative expenses
Amortization of intangible assets
Total operating costs and expenses
Operating income (loss)
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.
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.