1 Defense Stock Worth a Closer Look

FLIR Systems (NASDAQ: FLIR  ) is a thermal imaging systems company that markets its products to commercial and government customers. Unfortunately, U.S. government-funded customers' demand  for its products and services has begun to wane. But certain factors might still make FLIR Systems the best investment compared to its peers. 

Mixed Results  

FLIR's second-quarter revenue jumped 15.1% year over year to $389.3 million, which might give you an impression that the company's knocking the cover off the ball. While it isn't doing poorly by any means, FLIR Systems stated that it owes that revenue jump mostly to its acquisitions of Lorex and Traficon late last year.

These purchases led the Thermal Vision & Management segment to increase revenue by an impressive 22.7%; without them, its revenue might not have risen at all. The Integrated Systems segment has also performed well, with revenue skyrocketing 160.1%. But in this case, its improvement stems from strong shipments, which indicates organic growth. 

The good news for segments ends there. Raymarine (providing marine electronics to monitor boat speed, direction, and location) revenue dropped 0.6% year over year. While Asia-Pacific sales have stayed strong, Europe remains weak. Surveillance revenue declined 0.7%, and the segment has suffered from lower gross margins and increased operating expenses. Detection revenue plummeted 8.6%; management referred to a lack of large product orders and lower R&D contract revenue due to program timing.

Overall, international sales have declined from 55.1% of revenue (Q2 2012) to 45% of sales (Q2 2013). Management states that international sales should remain a significant portion of the company's revenue, but this is still somewhat concerning, since domestic demand is likely to diminish due to the sequester's nearly $1 trillion in military budget cuts.

FLIR's cost of goods sold has increased 14.8% to $193.3 million year over year, and SG&A expenses have increased 11.8% to $80.2 million. However, this is mostly due to recent acquisitions and increased revenue. 

R&D expenses also moved higher, from $37.5 million to $39.6 million, and this expense is expected to remain high due to a challenging revenue environment. That might sound a little confusing, considering the company saw an impressive revenue improvement year over year. But over the past three years, the company's revenue (in millions) hasn't exactly posted steady growth:

  • 2010: $1,385
  • 2011: $1,544
  • 2012: $1,405
That's hardly an inspiring trend. However, recent acquisitions should help FLIR's drive top-line growth going forward.
 
And while revenue is the most important metric, earnings results for the past five years suggest that the company's got capable managers at the helm. Observe its diluted EPS:
  • 2008: $1.28
  • 2009: $1.45
  • 2010: $1.54
  • 2011: $1.38
  • 2012: $1.45

While we don't see an uninterrupted ascent, earnings look to be on the right track again after a downside move in 2011. And as I'll discuss in the section below, important evidence suggests that this trend will likely continue.   

Also, note that FLIR Systems managed to stay profitable during The Great Recession. While this might have been expected given the industry, it's still a big positive, since so many companies throughout the broader market couldn't follow suit.

Bigger isn't always better

With a market cap of $4.57 billion, FLIR gets dwarfed by rivals L-3 Communications (NYSE: LLL  ) and Lockheed Martin (NYSE: LMT  ) , who carry market caps of $8.27 billion and $39.29 billion, respectively.

L-3 Communications regularly delivers big profits. However, like FLIR Systems, its revenue declined in 2012. L-3 Communications revenue over the past three years (in millions):

  • 2010: $15,680
  • 2011: $15,169
  • 2012: $13,146

L-3 Communications is also feeling the heat of the sequester, and it lowered its FY2013 revenue guidance to $12.5 billion-$12.55 billion from $12.6 billion-$12.75 billion. Additionally, it lowered its FY2013 EPS guidance to $8.05-$8.15 from $8.15-$8.35. While it's possible L-3 Communications is sandbagging, based on industry circumstances, it's not likely.

Comparatively, FLIR Systems has reaffirmed its FY2013 EPS guidance of $1.56-$1.66. And it expects total revenue to be approximately 10% higher than in 2012. As if that's not enough good news, FLIR Systems sports a debt-to-equity ratio of just 0.25, showing stronger debt management than L-3 Communications and Lockheed Martin, with debt-to-equity ratios of 0.64 and 8.85, respectively. 

As you read about Lockheed Martin, you might assume it's the best investment of the group, simply because it's the largest defense contractor in the world. It also has a strong history of generating cash flow that leads to excess capital returns to investors in the form of buybacks and dividends. Furthermore, Lockheed Martin is the only company of the three covered here that managed to increase revenue in 2012. Check out its revenue over the past three years (in millions):

  • 2010: $45,803
  • 2011: $46,499
  • 2012: $47,182

That's impressive consistency. That said, investors care about stock performance more than anything else. Therefore, consider the chart below:

FLIR Chart

FLIR data by YCharts

As you can see, FLIR Systems has outperformed its larger peers, but size plays a role here. FLIR Systems isn't just the top performer; it's also the most volatile. This tends to happen with smaller companies, since they can more quickly reflect changing market trends.

If you're looking for something steady, Lockheed Martin will likely be a better option for you than FLIR Systems. That said, Lockheed Martin has the most to lose with sequester effects. It's capable of getting what it wants, but thanks to government cutbacks, it will now face a more challenging environment than it has in the past.

Conclusion

All three aforementioned companies are likely to offer solid long-term returns, but the next decade isn't likely to be easy in regards to stock appreciation. Considering FLIR Systems has reaffirmed its full-year guidance, and since it doesn't expect any significant capital requirements throughout the remainder of the year, it has strong potential to be the best investment of the three at this point in time. 


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