Flying Under the Radar

Today we'll look at a company that has proven adept at snatching up tier 3 players in the aerospace and defense industry. Bellevue, Wash.-based Esterline Technologies (ESL) has bought 25 such outfits over the years, including eight of them since 2002. Its management boasts that every acquisition had added to earnings after one year of integration. That record is reflected in the stock, which has more than doubled in price over the past three years. Its recent appearance on our Bargain Growth screen suggests that it's still too cheap.

The rationale behind our Bargain Growth screen isn't complicated. Low price/earnings ratios are good. Projections for fast long-term earnings growth are good, too. Finding the two in the same stock is even better. One way to do that is by using the price/earnings-to-growth, or PEG, ratio. It divides a company's P/E by the annual rate at which analysts figure its earning will grow over the next several years.

Our screen looks for PEGs below 1.0, and it doesn't distinguish between industries. A cement maker with a P/E of 8 can make the cut, but so can an Internet highflier with a P/E of 32, so long as the two are forecasted to grow their earnings by more than 8% and 32% a year, respectively. Of course, we make a few other demands. We look for manageable debt levels, earnings estimates that are on the rise and a history of upside earnings surprises come reporting time. See our recipe for details on all of our demands, and use our stock screener anytime to run our search for yourself. Recently it produced a list of 10 survivors from a starting database of more than 9,000. Let's look at Esterline.

Think of Esterline as a wartime and peacetime profiteer. It brings in about 40% of its sales from defense contractors, and another 40% from commercial aerospace companies. The rest comes from industrial manufacturers. Revenue diversification is one of the potential benefits of being a clearinghouse for tier 3 suppliers, while bidding for tier 2 and tier 1 jobs. Esterline's trailing 12-month sales total $816 million, with no single customer contributing more than 5% of the take.

The company divides its operations into three niche segments: avionics and controls, systems and sensors, and advanced materials. Respectively, these three groups focus on the cockpit, engines and frame of jet planes. Of course, missiles, bombs and weapons systems use similar parts to those used on planes, so Esterline supplies components for them, too.

Fiscal third-quarter results for the company, reported Sept. 1, showed sales jumping 42% year-over-year. Most of that came from Esterline's largest-ever acquisition, announced in June 2004. It bought Leach Holding, a maker of components for planes and medical devices with annual sales of about $120 million, for $145 million in cash. Ignoring that buy, sales in Esterline's third quarter still increased a healthy 15%. Earnings from continuing operations doubled to $14.2 million. Earnings per share of 55 cents met analysts' expectations. Most business lines did well, though management mentioned sales of "combustible ammunition components" to the Army as a soft spot. True to form, management noted that they've boosted Leach's margins since the acquisition.

"ESL continues to benefit from a rebounding commercial aerospace business and a fairly solid military business," wrote L. Alan Davis, an analyst with Seattle-based investment bank McAdams Wright Ragen, in a Sept. 9 research note. Davis figures that fourth-quarter earnings growth for the company will probably be 2% or so, thanks to a blowout quarter a year ago, when some third-quarter business was pushed back into the fourth quarter. So the 2% next quarter won't really reflect the company's underlying growth. But then, neither did the doubling in third-quarter profits. All told, analysts figure that the company will boost its earnings by 45% this year over last, and by 15% next year. (Davis doesn't own shares of Esterline Technologies; McAdams Wright Ragen doesn't have an investment-banking relationship with the company.)

Zacks Investment Research puts the average of analysts' long-term earnings growth estimates for the company at 19.7% a year. Shares trade now at just less than 19 times forecasted 2005 earnings. Divide the P/E by the growth outlook, and you get a PEG ratio of just under 1.0. The average PEG for aerospace and defense companies is 1.4. The S&P 500 index's PEG is about 1.5.

Esterline shares are down about 11% since the beginning of September, possibly because investors are focused on the lackluster year-over-year growth projected for the fourth quarter. Bargain hunters with a longer-term perspective might want to explore the dip as a buying opportunity.