Which Defense Stock?

You don't have to be a history buff to know how armed combat has evolved over the past few hundred years. Lines of soldiers once attacked at close range when long-range communications and weaponry were both ineffective. Later, evolving technologies allowed combatants to disperse while still attacking in coordinated fashion. Further development of advanced weaponry eventually led to the advent of dogfights in the skies and missiles that could travel thousands of miles to reach their targets.

Today, combat continues to change, and with weapons that allow a small group of people, or even a single person, to wreak havoc, the nature of fighting has changed. In fact, the preface to the Department of Defense's Quadrennial Defense Report states that "technological advances, including dramatic improvements of information management and precision weaponry, have allowed our military to generate considerably more combat capability with the same or, in some cases, fewer numbers of weapons platforms." How quickly has the military actually changed its budget to match this vision, though?

In an article earlier this week, fellow Fool Brian Gorman talked about the problems that the Army has had because of a lack of funding in the face of heavy wear on ground vehicles, as well as the need to outfit ground troops. Brian concluded that in the face of this dilemma, in conjunction with an incoming Democratic Congress potentially eager to cut military spending without appearing weak on defense, large defense contractors could experience some hits to big-budget projects as funding is both cut and shifted to other areas.

While we can't run out and invest in Colt Defense (it's privately held) as the military scrambles to make sure it's got M4s in the hands of all of the soldiers heading out to Iraq, we can try to figure out which defense stocks have the greatest potential to continue to collect Uncle Sam's cash or, better yet, get more of it. With that in mind, I turned to Motley Fool CAPS and its tags for Aerospace/Defense Products & Services and Aerospace/Defense -- Major Diversified. Both groups have gained more than 30% for the year, though the products-and-services group has performed better over the past month.

Of the two groups, it's only in the products and services that we can find any five-star stocks:

Protect this house!
Ceradyne is an obvious choice when talking about equipping soldiers, since it produces a lightweight, ceramic-based body armor that it sells to the U.S. military. Though the company is a broad-based manufacturer of ceramics and also makes products for the industrial, automotive, and commercial markets, sales to the military made up more than 75% of its revenue for the first nine months of this year. It's very likely that concentration of sales that has the stock trading at 12.4 times 2006 EPS estimates. Although the company has had a 70% compound annual growth rate in sales over the past five years, investors are afraid that the spigot for military money could get abruptly shut off.

CAPS members and Wall Street firms alike have been undeterred, though. Kaufman Brothers, Wedbush Morgan, and Wachovia, all of whose tracking pages are ranked in the top 2% of CAPS, have rated the stock an outperform. Another 354 active CAPS members have also rated the stock an outperform, against just nine doubters. CAPS member lawdymama, who gives the stock a thumbs-up, sums things up this way:

The biggest problem with this stock is that Wall Street doesn't believe in it. [The company has] great products (thank you for saving our soldiers), consistently good returns, [and] good management. But in spite of management's guidance, which seems to always be on target, Wall Street looks at every DoD spending blip as a reason to dump this stock. If it doesn't go up, it's not because of the company performance.

Droning on
Though it's had far fewer total ratings, United Industrial sports a perfect 32 outperform ratings, including one from Kaufman Brothers, without a single detractor. United Industrial gets the majority of its revenue from its subsidiary AAI, which manufactures the RQ-2 Pioneer, an unmanned aerial vehicle (UAV). The company has been working with unmanned aircraft since the mid-'80s, and the Pioneer has seen use in Desert Storm, the Somalian and Bosnian conflicts, and the current Iraq war. The company has also produced a next-generation UAV to replace the Pioneer, the RQ-7 Shadow; it's also currently in use in Iraq.

The stock currently trades at 18 times 2006 EPS estimates. It's been a bumpy ride for shareholders this year -- the stock managed to find itself up 62% for the year by May, only to have 20% hacked off the top on a bad first-quarter earnings announcement. After some further declines in the next two months, the stock started to recover, only to be met with more disappointing earnings. Recently, the stock has seen some life again, with an announcement that it plans to sell off its energy subsidiary, Detroit Stoker.

From where this Fool sits, it doesn't appear that our soldiers will be coming home from Iraq anytime soon. So the need for the products that protect them, as well as those that allow them to fight, will continue to be in demand. Even after the war is over, though we are bound to see a decline in overall defense spending, a significant amount of procurement spending will be necessary to repair and replace a lot of the equipment used in Iraq. Further out still, the companies that are producing the equipment that will be outfitting the changing face of our military are likely to see plenty of Uncle Sam's green.

Further fighting Foolishness:

• SAIC shows its numbers.
• Smith & Wesson gets shot down.
• Ceradyne's looking fine.

Fool contributor Matt Koppenheffer prefers his body armor to be lightweight ceramic -- now if only somebody made some that wicks moisture. He does not own shares of any of the companies mentioned. The Fool's disclosure policy is never conflicted.