Right now, somewhere in the skies over Iraq, Afghanistan or someplace else in that troubled region, lurks an all-seeing bird of prey, silently scanning the terrain below in search of a target.
If you thought this narrative was about one of the many breeds of falcon that make this region home, you'd be wrong. For the "eyes" of this particular bird of prey consist of an advanced digital imaging system, and in its "talons" are a clutch of Hellfire missiles.
I'm referring to the Predator; the most advanced reconnaissance and attack unmanned aircraft currently deployed by any military anywhere.
Robot Warriors on the 21st Century Battlefield
While matters of national security limit what we know of the Predator's service record, the occasional media report suggests that its performance has exceeded expectations.
That's probably why the U.S. military is now investigating the development and deployment of other Unmanned Aircraft Systems (UAS) onto the 21st century battlefield.
Relative to other more established defense programs, new and existing UAS initiatives are still in their infancy and only involve a fraction of the dollars committed to developing more traditional systems. However, the UAS market is expected to grow at a rate significantly ahead of the overall defense budget over the next few years.
Major Defense Contractors have Little Exposure
In light of this, are there any opportunities for investors in this emerging defense industry trend?
Unfortunately, in the case of a highly advanced system like the Predator, there is no direct pure-play investment available. The aircraft is currently manufactured by a private defense contractor, General Atomics, which has never been nor is ever likely to go public.
But there are a number of public companies that provide key components to the Predator. Both L-3 Communications (NYSE: LLL) and Raytheon (NYSE: RTN) provide radar, cameras and various sensors, and Honeywell (NYSE: HON) will be supplying the turboprop engine to a more advanced and lethal variant of the Predator known as "The Reaper".
The Navy is now in the final stages of selecting a contractor to build its own unmanned aircraft which will reportedly incorporate stealth technology, be capable of landing on an aircraft carrier and have an operational range of 3000 nautical miles. Boeing (NYSE: BA) is currently competing against a joint Northrup Grumman (NYSE: NOC) and Lockheed Martin (NYSE: LMT) team to win a $1 billion contract to build the prototype. (To learn more about investing in defense contractors and other "sinful" companies, read A Prelude to Sinful Investing.)
While all this looks promising for the companies participating in these programs, the sums involved are so small relative to their total revenues that there's virtually no meaningful exposure to the UAS market through share ownership in any of them.
One Company has a Niche
So, if big doesn't work, perhaps small will. While it may not make anything nearly as advanced as the Predator, AeroVironment (Nasdaq: AVAV) does have a small and potentially high-growth piece of the $1.6 billion UAS market. The company makes small, tactical aircraft, roughly the size of a large model airplane, that provide real-time video surveillance for ranges over six miles. It's a cutting-edge way for a commander on the ground to get an over-the-hill view of where the enemy might be.
While the primary customer for AVAV's products is still the Department of Defense, which involves standard military contracts with limited profit margins, there are a wide range of civilian applications that have yet to be fully penetrated for these small and inexpensive reconnaissance aircraft This includes forest-fire watch, border protection, monitoring of pipeline or utility assets and numerous applications in law enforcement.
Of the $170 million in total revenue the company expects to realize this fiscal year, about 85% comes from these small UAS aircraft. Sales have been strong of late, up over 35% in the latest quarter. Overall revenue growth should easily exceed 25% per year over the next couple of years.
With strong growth prospects like this, don't expect a discount on the stock's valuation. It now trades at a fairly hefty forward P/E of 25-times 2008's expected EPS of 89 cents. But, I think its worth paying up the premium to own a piece of the only pure play in this emerging new market.
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