This Defense Company has 24% Upside - Even with the Pentagon's Spending Cuts

When George W. Bush was first sworn into office on January 20, 2001, shares of defense contractor Lockheed Martin Corp. (NYSE: LMT) traded for $31.

By the end of his first term, they had doubled to about $60. And by mid-2008, prior to the October crash, Lockheed Martin had climbed to nearly $120 a share.

Those were the boom years - not just for Lockheed, but for most defense contractors.

Northrop Grumman Corp. (NYSE: NOC) shares doubled in the period stretching from December 2000 to January 2008, and General Dynamics Corp. (NYSE: GD) surged more than 133%.

But times have changed.

The last U.S. troops left Iraq in December and forces are expected to end combat operations in Afghanistan next year.

Meanwhile, the Pentagon is looking to cut spending by a half trillion dollars over the next 10 years. And war spending, which is funded separately by Congress, will likely fall from $115 billion this year to $88 billion in 2013.

Indeed, it's a new, leaner military that's taking shape amid talks of belt-tightening and austerity.

"Capability is more important than size," is the way General Martin Dempsey, the chairman of the Joint Chiefs of Staff, put it.

That means a change of tactics is in order for defense companies.

Some will rely on share buybacks and dividend increases, but that still might not be enough to fortify their stock prices. True success will only be accomplished by adapting to the new military's changing needs.

And right now there's only one company that fits the bill. We're talking about...

... AeroVironment Inc. (Nasdaq: AVAV).

Death From Above

The military of tomorrow will focus more on tactical strikes and espionage than it will manpower.

That's why AeroVironment, a leading manufacturer of unmanned aerial vehicles (UAVs), or drones, is in such a good position.

AeroVironment provides 85% of the drones used by the U.S. military in Iraq and Afghanistan, and UAVs are one of the few growth areas in the Pentagon's military budget.

Since 2005 there has been a 1,200% increase in combat air patrols by UAVs. In fact, there are now more hours flown by UAVs than by its manned aircraft and more pilots are being trained to fly them than traditional fighters.

AeroVironment's Raven B drone is the most commonly used UAV in the U.S. military, and the company's newest product - the Switchblade - could be an even bigger success.

The Switchblade was developed jointly with the U.S. Air Force and can transform into a weapon if an enemy is spotted. The U.S. Army recently put in a $6 million order for Switchblade.

More importantly, UAVs and drones are starting to find work in the private sector.

The Federal Aviation Administration (FAA) is about to issue its first rules to let businesses and local law enforcement fly drones in U.S. civilian airspace without special permits. The agency has until June to open six U.S. test sites where drones will fly with other traffic.

The possibilities are endless. Police organizations, for example, could use these tools to look for escaped prisoners or lost civilians. AeroVironment has already developed a 5.5- pound mini-helicopter for law enforcement, called the Qube, which would cost about $50,000.

Big energy also has expressed interest in using drones to check on remote assets like oilrigs and pipelines.

AeroVironment's second-quarter earnings for fiscal 2012 blew away the results of the same quarter last year. Profit soared to $6.6 million, or 30 cents a share, from $262,000, or 1 cent a share. Revenue was up 26% to $80.4 million.

Analysts surveyed by Thompson Reuters predict income of 45 cents a share on revenue of $89 million for the third quarter.

The company also has huge margins. Over the trailing 12 months, gross margin are 41.4%, while operating margin are 15.9% and net margin is 10.8%.

As a result, the company has no debt and $177 million in cash, which is equivalent to about 30% of its market cap. This gives the stock a cash value of $8.15 per share.

Goldman Sachs Group Inc. (NYSE: GS) on Monday upgraded AeroVironment stock from "Neutral" to "Buy" with a price target of $38. As a result the stock is up about 7% on the week, closing yesterday (Tuesday) at $30.77.

Still, there's a 24% upside from here. Not bad for a defense company in a new era of cutbacks.

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