Saturday, July 25, 2009

Spotlight On: Aerospace & Defense

Spotlight On: Aerospace & Defense

After a six-year run of improving performance, resulting in a composit industry share price performance approximately three times better than the S&P 500 Index, the U.S. aerospace and defense industry finds itself in transition and facing uncertainty and, perhaps, leaner times ahead. 

With core defense spending expected to slow, U.S. defense contractors need to identify additional revenue sources for the coming years. The near term should see some interesting merger and acquisition activity, mostly smaller deals by larger contractors to fill in capability gaps - particularly in the security, defense electronics and aftermarket service business areas.

Taking the uncertainty of current economic conditions into consideration, it is difficult to predict overall aerospace industry performance in the near term. In the longer term, however, prospects are good for continued, steady growth. Large civil aircraft, rotocraft, general aviation aircraft, regional and business jets, engines/power plants, communications satellites, military unmanned aerial systems and airport infrastructure and safety equipment should continue to experience steady growth. Other sectors, such as launch services, are experiencing lower but steady growth as they recover from market disruptions and/or adapt to commercial markets. The launch services sector could experience faster growth if the demand for satellite telecommunications services increases. The maintenance, repair and overhaul (MRO) market has finally recovered to pre-9/11 levels, and growth in this sector will be led by expanding aircraft fleets in India, Eastern Europe, South America and China. The market for civil/commercial unmanned aerial systems remains stagnant in the absence of the civil regulations for certification and operation in the national air space; however, the Federal Aviation Administration and civil aviation authorities in Europe and Asia are working towards rationalization of civil certification procedures. Key markets for U.S. aerospace exports remain India, China, Russia, Japan, and Europe.

In summary, the overall level of defense spending will trend downward in response to unfocused threats, big budget deficits, a weak economy and an ambition domestic agenda. The business outlook for second-tier defense companies that grew rapidly during the Bush years will weaken as larger companies invade their market turf in pursuit of a more diverse business mix, leading a wave of consolidation in the sector that eliminates many smaller companies.

Our database categorizes 78 companies as being part of the aerospace and defense industry. Our screening criteria looks for companies with a healthy balance sheet, not too much debt and ROI and CFROI of at least 10%. This screen brings the number of candidates eligible for closer examination down to three: AeroVironment (AVAV), Cubic Corporation (CUB), and Force Protection (FRPT).

Our recommendation is to hold AVAV, sell CUB and hold FRPT.

Disclosure: Author has no position in any company mentioned in this post.

Saturday, July 11, 2009

Spotlight On: Medical Equipment and S...

Spotlight On: Medical Equipment and Supplies

The medical equipment and supplies sector includes surgical and medical instruments; orthopedic, prosthetic and surgical appliances and supplies; dental equipment and supplies; x-ray apparatus, tubes and related irradiation apparatus; electro-medical and electro-therapy apparatus; and ophthalmic equipment.

The main demographic change influencing this industry is the rapidly growing number of elderly in the United States. Projections show that the percentage of people 65 and older will increase from 12.4 percent in 2000 to an estimated 20.7 percent by 2050. According to Census estimates, there were approximately 35 million Americans over the age of 65 in 2000; due to the influx of "baby boomers" and an anticipated increase in overall life expectancy, by 2020 there will be more than 54 million people 65 and older, and more than 86 million by 2050.

The aging population is already influencing the future direction of the medical device industry due to their changing health needs and an accompanying shift in thinking on how and where seniors will be treated. baby boomers are living longer lives than previous generations, requiring more sophisticated and longer-term healthcare. This has driven the need for advanced medical electronic devices and raised expectations that new technologies will enhance the quality and length of patients' lives as they get older. As the U.S. population ages, and pressures to contain costs increase, expensive hospital stays will be discouraged, and health care will be increasingly delivered in alternative settings, such as nursing homes, hospices, and, especially, the patient's own home.

As a result, home health-care products are expected to become one of the fastest growing segments of the medical device industry. In recent years, these products have become increasingly more sophisticated and are now used in a wider variety of situations. For instance, unskilled health care workers who previously were limited to using only low technology products now have high-tech devices at their disposal for responding to critical care needs. In addition, patients will have access to an increasing array of sophisticated equipment to address their own medical care. Demographics and technological advances will continue to increase demand for pacemakers and defibrillators.

The mid- to late-nineties saw a tremendous number of mergers and acquisitions within the medical device industry, and this trend is expected to continue. The long-term effects are not known but consolidation of the medical device industry is already changing the structure of firms and the delivery of medical technology to patients.

There are a number of dynamics driving this trend. Small firms that find it too expensive to devote significant resources to providing "proof data" for their new innovations are merging into larger firms that have the financial resources necessary to bring new technology products to market. Larger firms receive the benefit of the new technology and, therefore, maintain market share, while small firms can afford to continue to produce and get the benefit of the large firm devoting resources to continued incremental improvements crucial to the industry. The rate of consolidation has been further augmented by two other trends in recent years:

  1. Larger firms generally have a greater capability for exporting products globally than do small stand-alone firms.
  2. Larger firms are better positioned to negotiate favorable deals with group purchasing organizations such as HMOs and health care companies with nationwide reach.

The federal government would like to implement incentives to encourage doctors, health care providers and patients to become actively involved in using technology to create a more seamless health care system. These initiatives fall under several broad headings:

  1. Adoption of electronic health records by physicians should result in workplace efficiencies as well as better levels of care for patients.
  2. Ensuring that clinicians can share information seamlessly with each other will make availability of patient records easier and more useful.
  3. From the patient's perspective, wide use of Personal Health Records that are truly portable and accessible could result in more educated patients able to make well-informed decisions regarding necessary treatments, as well as choosing qualified physicians and hospitals.

Medical device manufacturers are benefiting from a new generation of materials and manufacturing processes. As medical device and biotechnological products converge, one area that will see tremendous growth is drug delivery devices - many treatments and therapies derived from research will not necessarily be available in pill form. Medical devices will therefore act as delivery systems for new products resulting from genetic engineering and biotech research. Most industry experts view the impending convergence of medical devices with biotechnology with great enthusiasm, but also warn that if the regulatory and reimbursement issues are not addressed, problems will ensue as convergence takes place.

Of the more than 300 companies listed in our database as members of this sector, we would focus our attention on Steris Corporation (STE). Steris is currently trading at 3.84X trailing earnings, 3.5X tangible book and 13.8X free cash flow. The company has low debt, a strong balance sheet, and is highly profitable. Our price target is $30. 

Disclosure: At the time of this writing, author has no financial interest in STE.

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