It’s Time to Buy These 2 Defense Stocks

Whatever deal gets struck to resolve the imminent “fiscal cliff,” the U.S. budget mess will be far from fixed. There will still be a yawning gap between government revenue and government spending, let alone the fact that we still have an existing $16 trillion debt load we need to start whittling down.

One of the most vulnerable arms of the federal government will be the Department of Defense (DoD). Our current military is so large — more than 10 times bigger than its nearest rival — that a bit of shrinkage seems inevitable. Nobody is calling for plans to gut our nation’s military in an extreme fashion, but a DoD that is 5% or 10% smaller than current levels seems increasingly inevitable.

And that spells top-line weakness for many defense contractors. A wide range of multibillion contracts with firms such as Lockheed Martin Corporation (NYSE:LMT) and General Dynamics Corporation (NYSE:GD) are coming under tighter scrutiny, as the DoD seeks ways to find less-expensive solutions to fielding a more nimble military.

Out with the bath water
Simply being associated with this sobering trend has been toxic for many defense-oriented stocks. Indeed, a pair of smaller, but more promising defense contractors have been tossed aside. They now trade far from their 52-week highs, even though they represent some of the few growth niches in the military.

I’m talking about iRobot Corporation (NASDAQ:IRBT), which make robotic search and detection devices, and AeroVironment, Inc. (NASDAQ:AVAV), maker of unmanned aerial drones. They also have appealing non-military divisions as well, as I’ll discuss in a moment.

iRobot
One of the charms of working with Uncle Sam and the DoD is that you get paid to do research. iRobot has invoiced the DoD for millions of dollars over the years to develop a range of ruggedized, remote-controlled robots that can safely enter into a battle environment when it’s too risky to send in soldiers. The good news: the company now owns the rights to the knowledge it has accumulated and can parlay that research into other products. You won’t find this spending in the research and development (R&D) line of an income statement, as it is recorded as revenue.

iRobot is augmenting the DoD-funded research with its own funds: Internally-funded R&D has risen from $15 million in 2009 to $36 million in 2011. This spending has helped the company develop an ever-broadening product line, which explains why sales rose from under $150 million in 2005 to $465 million in 2011.

iRobot’s main source of revenue is the PackBot disarming robot, which has already saved countless soldiers’ lives. On the consumer side, the company’s Roomba vacuum cleaner is a top seller, though iRobot is also developing and selling a number of other robotic consumer devices.