Armor Holdings (AH) manufactures vehicle-armoring systems, body armor and other security products for the military, law enforcement, homeland defense and corporate markets. With the acquisition of Stewart & Stevenson, AH has diversified into the manufacturing of military supply trucks. The acquisition has not been well received by investors despite its impressive record of growth. My feeling is investors are missing the boat on this stock, and yes as per the disclosure I do own AH in my portfolio. In this piece I'll examine some of the main points of my investment thesis.

The acquisition of Stewart & Stevenson also weakened AH balance sheet, pushing its long term debt to capital ratio to 48% well above the industry average of 3%. This may be a short-term impact as AH continues to display strong earnings growth and free cash flow. The benefit of S&S, reduces the backlog risk associated with its armored systems. S&S does gives AH an opportunity to make inroads into the military supply truck market but also provides additional platforms for a variety of its armor systems.

The initial results of the acquisition were evident in the 4th quarter earnings report. Operating margins declined from 13.5% to 8.7%. The drop was due in large part to S&S which has lower profit margins. SG&A declined from 7.8% to 7.7% and due to S&S. It will be a few quarters before the full integration is complete and profit margins begin to rise, however AH is now trading at levels that discount any future return to higher levels of profitability. At the same time, AH is expanding its more profitable business of armor systems. The company's Centigon unit which provides armor systems for passenger vehicles used by private individuals. This segment currently accounts for about 18% of revenues. As geopolitical risks arise globally, demand in this business segment may expand. In addition, this segment is not tied to the whims of a budgetary government cycle.

The major risk to AH growth rate is the whim of the government budgetary and procurement process. Price escalation in raw materials is also a risk, although pricing pressure is abating in the current environment. The upside outweighs the risks at this point. Despite the quirks of the budgetary system, AH holds an exclusive contract Family of Medium Tactical Vehicles (FMTV) through 2008. Given the enormous need of these vehicles, it is likely the government will exercise its option to extend the contract. The military has also ordered that all future armoring will be completed by the vehicle manufacturer itself. All will benefit the future growth of AH.

The fundamental valuations of AH are quite compelling. Street consensus estimates for earnings for 2007 is $5.10, a 40% earnings growth rate. This is well above the industry consensus of 21% and 11% for the sector. The AH's stock is trading at a P/E of around 12 times this year's earnings, a 25% discount to the industry, sector and the market. On a PEG and P/S basis AH is selling well below stocks without the strong growth potential that AH is expected to deliver. AH is currently selling at a 0.8 PEG ratio and 0.98 P/S ratios.

AH also generates strong cash flow. In 2007 AH is expects have free cash flow of $100 million which is net of the projected $100-120 million in capital spending for the year. The excess FCF should be used to pay down debt to rebalance its overleveraged balance sheet. Demand has remained strong as recent quarterly sales has exceeded 25%. The sales expectations remain high, however earnings growth will slow as AH integrates S&S and extends it product platform. While growth will undoubtedly slow from the 40+% level, it will still top most industry and sector averages. As AH makes more headway in the integration of S&S, AH should be the beneficiary of multiple expansion. Given the current price level, a P/E expansion to a market multiple would push the stock up over 20%. The stock with its strong, stable earnings capacity should sell at a premium multiple to the market, especially given the expectations that the earnings growth rate will regress back closer to its long term average of about 7-9%. During this period of weaker earnings, the strong growth of AH can provide some protection to one's portfolio.

P.S If you're looking at AH it may be worth taking a peak at Ceradyne (CRDN), it has been a solid performer in the Investopedia Advisor's Undiscovered Growth portfolio.

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