A Forecast for Defense Stocks in 2006 & 2007

In March 2006, the Department of Defense published details of the defense budget President Bush took to Congress. It projected a U.S. defense budget for 2007 about $28.8 billion less than the one for this year. It also estimated that we would not see defense spending on par with 2005 levels for at least the next three years:

With a lull in budget growth already expected even before last week's Democratic sweeps, defense stocks would seem like a place you would not want to have money.

In fact, over the last week, that sector has seen some bloodshed -- with the minnows of the group taking it the worst.

Our scan of performance in the aerospace and defense sector over the last week shows that eight of the top 10 losers since the November 7 elections have been small-cap and micro-cap names:

VirTra Systems (OTC: VTSI), a manufacturer of military simulation systems, took the biggest hit, dropping over 23% in the seven-day period. Moller International (OTC: MLERE), down 11%, designs and builds vertical take-off and landing (VTOL) airplanes. These are similar in concept to the Hawker Harrier Jump Jets the British military has used for decades. Down almost 9% was United Industrial Corporation (NYSE: UIC) -- makers of many defense-related products, including systems for drone aircraft.

The major defense companies, like Lockheed Martin (NYSE: LMT) and Northrop Grumman (NYSE: NOC), held up well to the Democratic win. The reason is most likely because the 2007 defense budget will still be the largest portion of the total Federal budget. Another major reason is that no political party would want to be seen denying troops of their necessities while they are on the ground in a combat theater. So until the Democrats engineer a troop withdraw, adequate funding should remain in place.

Not all defense stocks took this shift in power badly, though:

One of the big winners of the week was small-cap Hi-Shear Technology (AMEX: HSR). This is a diversified company that makes many aeronautical components, but one of the more interesting military products it makes is laser ordnance for the U.S. Army. It was up almost 26% on the week. Military aircraft engine-part maker Kreisler Manufacturing (NASDAQ: KRSL) was up over 8%. This micro-cap announced huge sales and profit increases for their September quarter.

So the big question is: Are defense stocks a good play these days or should investors now stay away?

The answer: You need to be selective, as always... Let me show you.

Take HEICO (NYSE: HEI), for example. It's a $1 billion, small-cap aerospace and defense company that provides engine parts and services for commercial aircraft, and an extensive suite of test systems for military applications. And with the specter of a falling defense budget in the near term, the company is actually prospering. On August 30, the company reported 3Q06 results, which included record net sales and record operating income. This was the sixth consecutive quarter in which they did so. And in the last six months, its stock has gone up 25%.

Insiders have been making many purchases recently of HEI shares. Four directors and the chairman of the board made purchases at the end of August -- many of which represented substantial percentage increases to their HEI holdings.

HEICO's debt-to-total capital is a very attractive 12%. However, the company has been making a lot of acquisitions, which has been eating into its ability to produce free cash flow. The market, though, is looking beyond this, and sees the cash-generating ability of this business when it does stop its growth-through-acquisition phase.

Unfortunately for us, HEICO's strong performances over the last several years have attached a premium to its shares -- and the stock is now pretty pricey. This is a stock, though, that I would consider recommending if its price pulls back. Make this "one to watch."

Craig Walters
for The Daily Reckoning

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