Ducommun Incorporated: Clear Skies Ahead

Lately the broader markets have been a bit grounded. The Dow finished down for the month of December for only the third time in eleven years. The 3.5% return that the S&P 500 posted in 2007 left much still to be desired. Not to mention the fact that the Russell 2000 fell to 15-month lows earlier this week. However, one segment of the market that’s been taking off has been the aerospace and defense sector. The Dow Jones U.S. Select Aerospace & Defense Index posted a mighty return of 28.2% in 2007.

One small cap that’s been leading the boom is Ducommun Incorporated (NYSE: DCO). And the results that this Carson, Calif.-based company have posted have been anything but common. At a market cap of just $331 million, the company struck it rich in 2007. Ducommun’s stock soared nearly 67% last year.

Founded in 1849 at the height of the Gold Rush, Ducommun is the oldest continuously operating business in Los Angeles. Back then the company repaired watches for prospectors. Today it engineers and manufactures components and assemblies for commercial aircraft, military aircraft and space programs.

A prominent example of Ducommun’s work is its support for a subsidiary of United Technologies Corporation (NYSE: UTX), which manufactures the Black Hawk helicopter for the military. In November, Ducommun locked up a five-year, $60 million deal to provide titanium erosion shields for the helicopter program. The shields are designed to protect the Black Hawk’s main rotor blades. Some of the company’s other major customers include the U.S. government, The Boeing Company (NYSE: BA), Lockheed Martin Corporation (NYSE: LMT), and Raytheon Company (NYSE: RTN).

The Black Hawk contract win is reminiscent of the wave of success that Ducommun has had recently. For the third-quarter ended Sept. 29, management reported net income of $5.8 million, or $0.55 per diluted share on $94.7 million in sales. These figures handily topped analysts polled by Thomson Financial, who were expecting EPS of $0.45 per share on $90.6 million in sales. The results also represented a 42.3% increase in net income and a 16.1% increase in sales versus the year-ago quarter.

So what has been driving this company’s growth into the stratosphere? In years past, Ducommun has been no stranger to acquisitions — it made 13 acquisitions since 1994. The story more recently, however, has been one of organic growth with a significant jump in sales to Ducommun’s commercial clients. Sixty percent of the company’s sales are military-related, but a recent uptick in its commercial base has played a key role in the recent strides the company has made. Commercial sales now account for 38% of total company sales, versus 31% in the prior year quarter.

The company’s operational expertise as well as an industry-wide boom will likely provide plenty of fuel for Ducommun to maintain its current momentum. Gross margins continue to remain consistently strong, which gives the company adequate pricing power. Margins for the company’s third quarter improved by nearly a percentage point from a year earlier. Ducommun’s order backlog is healthy as well. It now sits at $333 million, up from $321 million at the end of 2006. All of which points to the likelihood of a favorable future.

“Ducommun is a very healthy, well-run company in a popular sector,” says Alex Hamilton, a senior analyst at Jesup & Lamont. “It is a great way to play the aerospace cycle.”

For the year ended Dec. 31, Hamilton is forecasting EPS of $1.85 on revenue of $362.4 million, up 13.6% and 33.1%, respectively, from the previous year. The good fortune for investors is not expected to stop there. Hamilton then sees EPS growing at an 8% to 11% clip in 2008 and 2009. His current price target of $42 compares with close Tuesday of $31.58.

For the fourth quarter, four analysts surveyed by Thomson Financial are expecting Ducommun to report EPS of $0.50 per share, compared with $0.41 a year earlier. Q4 Revenues are expected to rise 4.9% to $92.1 million. In the past three years, Ducommun has released its year-end earnings in late February.

One of the bigger risks with this stock, though, is Ducommun’s revenue concentration.

Approximately half of its revenue comes from its top five programs and although Ducommun does not face any known threats of losing any of these programs, clearly the loss of even just one at some point in the future would have a significant impact on the company’s bottom line. In a research note published at the end of October, Hamilton wrote, “We believe that with Ducommun trading at a discount to the [peer] group, some of this concern is taken into account.” The stock presently trades at a P/E of 17.87, which is in line with its industry average of 18.1 as tracked by Morningstar.

Even as the opening trading days of 2008 have proven to bring a great deal of turbulence to the markets, a smooth landing for Ducommun (DCO) should not be ruled out. Shareholders of the small cap are one class of passengers that have their eyes set on clear skies ahead.

Disclosure: none