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Is It a Bird? A Plane? No, It's a UAV!


Wars can be a boon for new technology. This time around, robotics are coming back home with the troops, especially eyes in the sky.


Many defense-industry stocks are out of favor, as investors worry that the winding down of operations in Afghanistan and Iraq, combined with nearly $500 billion in US military spending cuts over the next decade, will drastically curtail defense companies' earnings.

These fears are overwrought. Despite political rhetoric about the need for fiscal austerity, the US Department of Defense has a history of dodging the budget knife, especially when it comes to weapons systems specifically geared to fight terrorism.

One class of anti-terrorist weapons that will prevail over the long term, regardless of budget deficit concerns: unmanned aerial vehicles (or UAV). For defense strategists, pilot-less aircraft outfitted with ultra-sophisticated sensors are a vital tactic in fighting the asymmetrical guerrilla wars of the 21st century.

These UAVs are the darlings of reformers in the Pentagon, and Raytheon (RTN) is the leader in the field by virtue of its unparalleled expertise in sensor technology.

UAVs are aircraft that fly without a human crew on board, making them completely reliant on sensors. Many are armed with missiles and see action in Iraq, Afghanistan, and Pakistan. Sometimes called pilot-less drones, UAVs are undertaking increasingly sophisticated missions that range from high-altitude surveillance to taking a hunter-killer role on the battlefield.

Raytheon, based in Waltham, Mass., develops products for defense, homeland security, and other government markets. Raytheon doesn't build the actual UAV airframes, an intensely competitive line of business. Instead, the company provides the sophisticated sensors that make a UAV work. Raytheon's growth is driven by this specialty.

A Missile Heritage
Combine new military and homeland security priorities with contemporary society's squeamishness about human troop casualties, and UAVs are the perfect solution for launching as well as preempting attacks. The fast growth of the UAV market has translated into soaring demand for UAV sensor technologies.

Raytheon currently supplies the sensors onboard many UAVs, including the high-altitude RQ-4 Global Hawk. The US Air Force is seeking $1.6 billion in 2013 to buy Global Hawks, making these sensor-intensive machines a big winner in the latest military budget.

Sensors account for 50% of a UAV's cost. Raytheon's sensors are also prized by the military for their unique ability to penetrate cloud cover. Raytheon continually develops lighter, high-reliability sensors - exactly what the military covets most.

The company got a head start in the UAV sensor business because of its long heritage in the missile business. As the world's largest missile maker, Raytheon possesses proprietary legacy technology that enables it to create innovative, versatile sensors and guidance systems.

Raytheon's unmanned system sensors account for 17% of its revenue mix and 20% of its operating mix. The company also contributes content to a wide range of other weaponry popular with Pentagon planners, notably the Tomahawk cruise and Patriot missiles.

Raytheon's leadership in these futuristic technologies has enabled the company to rack up a dramatic return on equity in fiscal 2011 of 19%, compared to an aerospace and defense industry average of 17.1%.

Despite the impressive long-term trends in its favor, the stock still appears undervalued and currently offers a dividend yield of 3.8%. With comparatively little debt and a strong earnings outlook for the next two years, Raytheon's healthy dividend should be sustainable.

Raytheon's price-to-earnings ratio of 10.1 is well below the average of 17.2 for the aerospace and defense industry as a whole, and pales in comparison to the S&P 500's price-to-earnings ratio of 15.8. Also, Raytheon has surpassed earnings estimates by at least 6% in each of the past three quarters.

For fiscal year 2011, Raytheon reported earnings per share (or EPS) of $5.90, compared to $5.51 in 2010, an increase of 7%. Raytheon pleasantly surprised investors yet again on April 26, when it reported a 16% rise in first-quarter profit and boosted its full-year guidance.

Earnings rose to $448 million in the three months ended March 31, from $384 million a year earlier. EPS increased to $1.33 from $1.07. Full-year revenue is expected to reach between $24.5 billion and $25 billion, but the company raised its EPS guidance by $.10, lifting the range between $5.00 and $5.15.

Sensor-leader Raytheon is a sensible investment for investors seeking growth and income. Raytheon is a buy up to $60.

Infiltrating Civilian Space
UAVs pervade the civilian sector as well. AeroVironment (AVAV) is positioned to benefit from the civilian and parapublic sectors' increasing adoption of unmanned drones for firefighting, aerial law enforcement, pipeline monitoring, search and rescue, and airport security.

AeroVironment, based in Monrovia, Calif., designs and produces a wide portfolio of UAV systems that it supplies not only to the US Department of Defense but also to civilian agencies. The company's core technological capabilities include lightweight aerostructures and electric propulsion systems.

The Federal Aviation Administration (or FAA) is expected to release proposed rules later this year that would allow ultra-small drones to operate commercially in the US without special government permission. The FAA also is working on a plan for integrating unmanned flights into the civilian aviation system by 2015.

AeroVironment is best equipped to take advantage of this trend because its highly miniaturized UAVs are embraced by the civilian sector. This innovative company also pioneered electric vehicle (or EV) home charging stations and has entrenched relationships with EV manufacturers, making it a "green" play as well.

In March, the company reported that revenue in the third quarter of fiscal 2012 increased 15% and EPS grew by 50% from year-ago levels. AeroVironment's revenue for the first nine months of fiscal 2012 was $214.3 million, up 15% from the first nine months of fiscal 2011. Earnings for the first nine months of fiscal 2012 were $12.7 million, an increase of $4.4 million from the same period a year ago.

Meanwhile, AeroVironment holds more than 30% of the growing market for miniaturized reconnaissance UAVs, far outpacing its rivals. Despite these strong results and a commanding market share, the stock is trading at a 7% discount to large-cap defense names. AeroVironment is a buy up to $38.

Editor's Note: This article was written by John Persinos of Personal Finance.

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