Sector Watch: Precision instrument stocks

Surveillance and targeting is one of the fastest-growing sectors in the DoD budget. The U.S. military is increasingly deploying unmanned vehicles and remote weapons stations to fight the "war on terror," and Axsys Technologies (Nasdaq:AXYS) and Argon ST (Nasdaq:STST) are on the front lines, providing the advanced optics and control systems vital to this transformation.

Axsys Technologies designs and manufactures precision optical systems for defense, aerospace, homeland security and commercial applications. Its technologies are deployed in weapons systems, long-range surveillance cameras and high-precision telescopes. Axsys’ principal customers are the U.S. military, the U.S. Border Patrol and large defense contractors who integrate its tools into larger platforms. The company’s Surveillance Systems Group produces high precision camera systems used in ground, marine and aerial vehicles. Its Imaging Systems Group builds optical and control subsystems deployed in larger systems such as visible and infrared lenses, scanning systems, laser-positioning devices, motion control components and imaging optics. Axsyx participates in large-scale U.S. defense department programs such as the MRAP vehicle, Apache helicopter, Stryker vehicle, M1A2 Abrams tank and thermal weapons.

Axsys ended 2007 with record contract backlog of $140.2 million. During the first six months of 2008, the company’s sales rose 49% year over year to $116.7 million from $78.5 million, and earnings improved 64% year over year to $11.2 million, or $1.02 per share, from $6.8 million, or $0.64 per share. Margins improved because of faster growth in the higher-margin surveillance systems segment. Axsys contract backlog increased to a record $174.1 million at the end of the June quarter as a result of new lens orders from DoD remotely operated weapons and thermal weapons programs. The company recently increased its full-year 2008 guidance and is targeting sales in a $237 million to $241 million range and per-share earnings in a $2.09 to $215 range. This compares with 2007 sales and per-share earnings of $171.6 million and $1.32, respectively. Analysts think Axsys can produce 21% annual growth over the next five years. My $85 price target for Axsys Technologies is above Tuesday's closing price of $71.57.

Argon ST, Inc. develops systems for C5ISR (command, control, communications, computers, combat systems, intelligence, surveillance and reconnaissance). The U.S. military uses Argon ST systems in surface ships, submarines, unmanned underwater vehicles, aircraft, unmanned aerial vehicles, land vehicles and fixed site and mobile installations. Its equipment detects and intercepts signals, counters adversary signals, simulates threats, analyzes images and enables tactical communications and networking. Virtually all of Argon ST’s sales are made to the U.S. military and 55% of its contracts last year were sole source contracts with no competitive bidding. The company’s year-end 2007 backlog was nearly $305 million. 

Both Axsyx Technologies and Argon ST benefit from DoD spending projected to rise to more than $516 billion by 2012 from $460 billion in 2008. The defense budget is further expanded by wartime supplemental appropriations totaling $153.6 billion in 2007 and estimated at $190 billion in 2008. Surveillance and targeting technologies are vital to current Iraq and Afghanistan combat operations and are also used extensively by law enforcement agencies. 

Argon ST’s revenues increased 30.5% year over year during the first six months of FY 2008 to $162.7 million from $124.7 million. However, earnings only improved 5% year over year to $9.8 million from $9.3 million because of a change in the business mix. Per-share earnings rose 7% year over year to $0.44 from $0.41.

Argon ST ended the FY 2008 second quarter with contract backlog amounting to $270 million. After the quarter ended, the company announced a new contract to supply telematics systems to ULD Logistics, a $44.7 million contract with Sierra Nevada Corp. for missile payload providers and a contract option for the next phase of the military’s Robust Surface Navigation (RSN) program. The RSN program is intended to equip military operations with GPS navigation capabilities in GPS-denied areas such as inside buildings or in urban canyons.

The company projects full-year FY 2008 revenues in a $325 million to $345 million range, up at least 15% from FY 2007 revenues of $282.2 million and operating income in a $29 million to $34 million range, at least 36% higher than FY 2007 operating income of $21.3 million.

Analysts forecast 20% annual growth over the next five years. My $30 price target for Argon ST is higher than Tuesday's closing price of $24.97.

Unlike defense contractors Axsyx Technologies and Argon ST, Badger Meter Inc. (NYSE:BMI) derives its revenues from industry and utility customers. This company manufactures residential and commercial water meters with automatic meter reading capabilities for utility companies and automotive fluid meters, precision valves, electromagnetic induction flow meters and turbine and displacement industrial flow meters for manufacturing and processing customers.

The second quarter of 2008 marked Badger Meter’s fifth consecutive quarter of record results. The company’s business is booming because municipalities are updating their water systems and, more specifically, their water meters. Badger Meter is the nation’s leading maker of drive-by utility meters. By purchasing its meters, utilities save time and minimize staffing; in-person meter reading is rapidly becoming a thing of the past.

Badger Meter’s sales rose 24.6% year over year in the first six months of 2008 to $143.1 million from $114.8 million, net earnings jumped 62.5% year over year to $13.1 million from $8 million and per-share earnings improved 60% year over year to $0.88 from $0.55. The company’s future results will benefit from a new Mexican manufacturing facility scheduled to come on-line in the third quarter. The new facility will expand manufacturing capacity and also reduce manufacturing costs. Analysts predict Badger Meter will generate 34% growth this year and 14% annual growth over the next five years. My $65 price target for Badger Meter is above Tuesday's closing price of $57.15.

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