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(BAZ RATNER/REUTERS)
(BAZ RATNER/REUTERS)

VOX

In times of defence cuts, prepare for value Add to ...

Here’s a recipe for out-of-favour stocks: Canadian companies that rely on the U.S. military for their sales.

That is the perception, at least, of AirBoss of America Corp. and Héroux-Devtek Inc., two companies whose shares have sunk deep into value territory as continued U.S. fiscal wrangling has put defence spending in doubt.

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Perception may not be reality, however: While each company’s military sales have indeed been flat or in decline, both AirBoss and Héroux have robust operations that sell to the commercial sector — for which they seem to be getting little credit.

The delightfully named AirBoss, based in Newmarket, Ont., produces a wide variety of rubber-based products. Its defence business, based in Vermont, makes gas masks, boots and gloves designed to withstand all manner of nasty stuff.

Analyst Tim James of TD Securities Inc. says AirBoss is the sole supplier of what are called “chemical, biological, radiological and nuclear” boots and gloves to the U.S. military, and is also the exclusive supplier of gas masks to the Canadian Department of Defence.

But AirBoss’s defence sales of just under $5-million in the first quarter represented only about 6 per cent of quarterly revenue. The decline in its “engineered products” division served to wipe out a 6-per-cent revenue gain in its much-larger rubber compounding business, where AirBoss makes products for tire companies, conveyor-belt manufacturers, and miners.

Mr. James allows that AirBoss’s first quarter was disappointing, as the company missed his expectations and posted earnings that were down significantly year-over-year. Yet, management is guiding for big volume gains in most of its compounding business.

In the meantime, the valuation makes it too compelling to ignore. AirBoss shares trade at a forward price-to-earnings ratio of 9.4, according to Standard & Poor’s CapitalIQ. Its enterprise value — market capitalization plus net debt — is about 5.5 times its forward EBITDA, or earnings before interest, taxes, depreciation and amortization.

As a bonus, AirBoss pays a 5 cent per quarter dividend, raised by 33 per cent in May, that yields 4.3 per cent on the company’s shares. And it’s engaged in a stock buyback designed to purchase up to 10 per cent of shares outstanding.

“We believe that the valuation is attractive and that the company remains committed to returning cash to shareholders through quarterly dividends and share repurchases,” says Mr. James, who has a target price of $6.50, a 12-month return that tops 40 per cent when dividends are included.

Héroux, of Longueuil, gets more than 90 per cent of its revenue by making and selling aircraft parts, particularly landing gear; its smaller business is producing industrial components, such as turbines. In fiscal 2012, which just wrapped at the end of March, 55 per cent of its sales were due to military aircraft, with Lockheed Martin and the U.S. Air Force and Navy all major customers.

Analyst Cameron Doerksen of National Bank Financial says that, while “there is understandable anxiety amongst investors for any company with a large exposure to military programs,” Lockheed Martin’s F-35, which represents roughly 10 per cent of Héroux’ revenue, is expected to have a flat level of deliveries in 2013 and “at worst, down modestly” for the next few years after.

In the meantime, says Mr. Doerksen, the rest of Héroux’s defence exposure is largely from repair and overhaul sales, or spending programs already in progress.

The worry about the company’s defence business overshadows what Mr. Doerksen believes is a very favourable outlook for its commercial business, where it supplies popular lines at Airbus, Boeing, Bombardier, and Embraer.

Héroux shares have slid roughly 10 per cent since May 25, when it gave conservative revenue guidance for the current fiscal year. It now trades at less than nine times forward earnings, and its enterprise value is just over four times forward EBITDA.

Mr. Doerksen has an “outperform” rating and $12.50 target price on the shares, which would represent a gain of nearly 70 per cent from current levels. He’s not out of line with others. Analysts from Desjardins Securities Inc., Raymond James Ltd. and Scotia Capital Inc. have target prices of $11, $12 and $14.50, respectively.

It sounds as if AirBoss can bounce and Héroux can soar even if the United States military cuts back.

 
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