On September 15, Guggenheim analyst Michael Ciarmoli initiated coverage of almost two dozen defense stocks, with a bullish, sector-wide buy-the-pullback call.
He issued 13 Buy ratings with an average upside of roughly 50%, with the standout being Applied Aerospace & Defense, Inc. (NYSE:AADX). The analyst sees the stock around $30, up by about 150% from the share’s closing price that day.
Ciarmoli described AADX as a “merchant supplier of established and proven military subsystems and components”. The analyst believes the company is well positioned to benefit from favorable growth trends across the aerospace, defense, and space industries.
Several defense stocks have struggled since the advent of the Iran war. Investors are also concerned about the possibility of a split Congress after the midterm elections, which could result in a spending gridlock.
However, Ciarmoli says the fears are overblown. The Guggenheim analyst is urging investors to be buyers on the pullback. He expects the current trend of increased spending on autonomous systems, space, and replenishing depleted stockpiles to sustain.
Bull Case
Applied Aerospace & Defense, Inc.’s inclusion in Guggenheim’s list is directly linked to the analyst’s thesis about the defense sell-off being tied to an overreaction, rather than fundamentals.
While the company had its IPO in June this year, it has been in the business much longer, and its subsystems and components are already deployed on several existing programs. This carries a reduced program risk compared to a pure R&D stage supplier.
AADX ended the second quarter with a backlog of $1.1 billion, which supports Guggenheim’s view about the sector-wide backlogs being in good shape, helping in locking in short-term revenue.
Lastly, much of the stock’s post-IPO gains have reversed, and this is exactly the kind of pullback that Ciarmoli is pushing investors to buy into.
Considering that AADX is newly public and has a smaller float and higher beta compared to legacy contractors, it has greater potential to re-rate sharply if the sentiment normalizes.
Bear Case
Ciarmoli’s sector-wide call is based on the premise that base budget spending is enough, without clarity on new appropriations. However, if the split Congress produces the gridlock investors are fearing, AADX may have reduced pricing power and flexibility to adapt to the change compared to a defense prime.
Applied Aerospace & Defense, Inc. also does not have the same track record as larger contractors. The company has only had one quarterly result so far, in which it posted a significant loss. It has so far not demonstrated its ability to convert backlog into profitable growth.
The case for a 150% upside is an outlier even in Ciarmoli’s own coverage. This is 3x the average upside across the 13 Buy-rated names, meaning the stock would require much more than a rebound in defense sentiment for its share price to jump that much.
Beyond Guggenheim’s overview, AADX has a controlled company status and does not have a multi-year trading history, offering added risks.
Hedge Fund Ownership
AADX went public on June 2. According to Insider Monkey’s database, 33 hedge funds held a stake in the company at the end of the second quarter. A breakdown of the holdings is not available.
Closing Take
The news should be taken as a sector call by Guggenheim, with Applied Aerospace & Defense, Inc. as its highest conviction.
The analyst’s overall thesis is sound and well supported, but a 150% upside compared to a 50% basket appears outsized for a company that is young, controlled, unprofitable, and without any long-term public trading record.
This is a stock for risk-tolerant investors who can stay invested over a longer period of time and brave the volatility that comes with it.
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