Protect Your Portfolio with These Defense Stocks

by: Glenn Rogers

We had an unwelcome Christmas shock from a would-be terrorist when a Nigerian student attempted to blow up an inbound flight to Detroit. The man now known as the "underwear bomber" is an unfortunate reminder that there are still crazy people out there who want to do harm to us.

Because there hasn't been a major attack on a U.S. plane in a few years, Americans had perhaps grown a little complacent. But the underwear bomber certainly provided a wake-up call for the Obama Administration. Not to be ghoulish, but I immediately started thinking of what stocks would benefit from the immediate reaction to the near tragedy. It didn't take long to find a few including L-3 Communications (NYSE: LLL) and Cogent Technologies (NDQ: COGT), which I have written about before, and a few more which I will detail below.

There are three leading U.S. companies that manufacture body scanners, which appears to be the technology that Homeland Security is looking at to stop incidents like the one that happened a couple of weeks ago. They are L-3 Communications, American Scientific & Engineering (NDQ: ASEI) and OSI Systems (NDQ: OSIS).

Three other companies that you could look at as possible beneficiaries to the on-going battle with global terrorism are Analogic Corporation (NDQ: ALOG), DigitalGlobe Inc. (NYSE: DGI), and ArcSight, Inc. (NDQ: ARST). I plan to concentrate on ASEI and OSI as new recommendations but here's a quick update on what I wrote about LLL and CGOT three years ago.

L-3 Communications Holdings

L-3 Communications Holdings has over 44,000 employees and operates in a large number of areas within the aerospace and defense sectors. The company offers solutions in secure communications, mobile satellite communications, shipboard communications, missile arming systems, radar and missile systems, and airport security equipment. They also design and manufacture screening systems for explosives, firearms in airports, security checkpoints, and commercial buildings. So if you are looking for a company that covers the waterfront and everywhere else on the security front, L-3 might be for you.

Since I wrote that comment, the company has also become a large manufacturer of unmanned drones which are playing a significant role in the war in Afghanistan. L-3 looks to be a bedrock part of our arsenal going forward.

The company recorded earnings per share growth of over 24% in the third quarter and it is trading at a P/E of only 11.23. L-3 had revenues last year of almost $15 billion (all currency figures are in U.S. dollars).

Action now: I am restoring L-3 Communications to our Recommended List with a target of $105. The shares closed on Friday at $89.45.

Cogent Systems Inc. (NDQ: COGT)

The next company on our list is considerably smaller than L-3 and is more narrowly focused. Cogent creates systems and devices that track individuals and materials.

The company's main business is producing automated fingerprint identification systems (AFIS). Its primary customers are the ones you would expect: law enforcement, government agencies, and large corporations. Cogent also manufactures systems that are used at border crossings, which is a high-need area worldwide.

Although the company is small, with only 137 employees and less than $90 million in sales, it operates internationally. The company showed strong growth in the second quarter as sales increased 131% year-over-year, to $39.4 million, and income grew at a blistering 96%. What I particularly like about Cogent is that it maintains a high profit margin of 42.1%. However, third-quarter figures were not as bullish as non-GAAP net income came in at $6.3 million (7c per share) compared to $12.6 million or (14c per share) in the same year ago period.

"While some revenue pushed into the fourth quarter, we believe we are on track to achieve our financial goals for 2009," commented CEO Ming Hsieh. "Orders and revenues to the Department of Homeland Security continue to be solid as the DHS expands the ten print database for the U.S. Visit program. Additionally, we won a civil program in a large state during the quarter that should generate solid revenues in 2010. Over the next three to six months, a number of international AFIS contracts are coming up for award and we hope to make progress with newer product offerings including handhelds, web-based software solutions and services. So far in 2009, the company has added over $53 million to cash and investments and ended the quarter with $533.7 million or $5.89 per share."

Cogent also announced that its board has authorized a new stock buy-back program of $100 million, expiring on Nov. 12, 2010 to replace the program that expired last November.

The company's main source of revenue has been the U.S. Visit program, which helps to identify foreign visitors to the country, but the company also had 13 significant contracts near the end of last year with the U.S. Army, the U.K. Post Office, and the Belgian police. They also recently won a contract with the New York State Office of Temporary and Disability Assistance. Standard & Poor's maintains a buy opinion as does Marketing Edge. The company next reports earnings on Feb. 25 and analysts are predicting that they will raise guidance for 2010 at that time.

Action now: Buy with a target of $14. The closing price on Friday was $10.51.

Now for two new recommendations, ASEI and OSIS, both of which will benefit from the ongoing counterterrorist efforts.

American Science and Engineering Inc. (NDQ: ASEI)

ASEI manufactures x-ray inspection equipment and other detection devices for Homeland Security and other countries around the world. They have equipment that can be used to inspect not only humans but also cargo containers, baggage, vehicles, etc.

This is a pure play on x-ray machines and the company has been flooded with orders from around the globe. For instance, they recently received a $39.7 million order for cargo x-ray inspection systems from an unnamed government agency and a $5.8 million follow-on order for cargo security equipment in the Middle East.

Understandably, the company and its customers are careful about how much information they release to the general public but suffice to say business is booming and is likely to continue doing so for the foreseeable future.

The company's profits are showing steady growth. Second-quarter 2010 earnings came in at $1.18 a share, up 42% from 83c in the same period last year.

The stock has run up lately and is trading at 19 times forward earnings but I would still take a small position here and add to it on any pull-back. Closing price on Friday was $78.68.

Action now: Buy with a target of $95.

OSI Systems (NDQ: OSIS)

Owning shares in OSI gives you x-ray equipment that competes with the companies that we discussed above along with the more traditional baggage equipment scanners that you are used to seeing in airports everywhere. The company also has a Health Care division that specializes in patient monitoring cardiology diagnostics and anesthesia delivery. A third division, Optoelectronics, manufactures devices for the aerospace and defense industries. OSI Systems was recently written up in Barron's as a turnaround story and even after the recent run-up still trades at 18 times earnings.

The company has received a number of new contracts lately including a $3.2 million deal to provide security inspection systems at the Vancouver Winter Olympics. Their latest financial statement showed earnings per share of 14c compared to only a penny in the prior year. In that report, OSI raised its 2010 earnings guidance to between $1.14 to $1.23 per share, which would represent year-over-year earnings growth of between 25% and 35%. They have a record backlog of $146 million.

The stock has almost tripled in value in the past year and closed on Friday at $30.69. I suggest taking a small position and watch for a pull-back to add more. OSI is trading near its 52-week high but terrorism is a long-term problem as is health care so OSI should continue to benefit over the long haul.

Action now: Buy with a target of $36.

Disclosure: Author holds long positions in ASEI and OSIS