Defence stocks have had a good run for the past five years, coinciding with the U.S.-led war in Iraq that began in early 2003. In the coming years, however, it seems likely that spending in the U.S. will slow down — perhaps dramatically.

From 2002 to 2007, the U.S. defence budget, which accounts for more than 60% of the North Atlantic Treaty Organization’s combined military spending, increased by 10% annually. Total outlays in the U.S. reached $544 billion in 2007, compared with $348 billion in 2002. (All dollar figures are in U.S. dollars unless otherwise noted.)

But no matter which party occupies the White House after this fall’s presidential election, the U.S. is set to reduce its presence in Iraq and its generals appear resigned to the prospect of flat military budgets for the next year or two.

Despite this, there are several defence companies worth considering. Many of them are global players, offering a hedge against currency risk. As well, many get significant chunks of their revenue from long-term government contracts, offering some stability in the event of a U.S. recession.

The top pick among large-capitalization companies is Hartford, Conn.-based United Technologies Corp., which is rated a “buy” by 95% of the analysts who cover it. UTC operates eight business units, including manufacturing aircraft engines and Sikorsky military helicopters. Defence products account for roughly 16% of its total revenue.

On Jan. 24, UTC reported sales of $54.8 billion for the fiscal year ended Dec. 31, 2007, up 14.5% from $47.8 billion in 2006, while 2007 earnings jumped by 13.2% to $4.2 billion, or $4.27 a share, vs $3.7 billion, or $3.71 a share, in 2006.

Nicholas Heymann, an analyst with Sterne Agee & Leach Inc. in New York, states in his Jan. 24 report that UTC has delivered above-average earnings growth for at least a decade. He rates the stock a “buy,” with a 12-month share price target of $86. This is based on his estimate that UTC’s revenue will jump by 7.2% in 2008 to $58.7 billion and another 8.7% in 2009 to $63.8 billion. Earnings will rise by 13.5% to $4.85 a share this year and by another 15.5% in 2009 to $5.60 a share.

Two European military suppliers — France-based Thales SA and BAE Systems PLC of London — are expected to do well this year despite some general weakness in their defence markets.

Military products such as electronics and weapons systems make up 42% of Thales’ total sales. The firm is projecting that its aerospace electronics and security products units will more than make up for lacklustre growth in military sales.

In a Jan. 22 research note, Olivier Brochet, an analyst for Natixis Securities in Paris, predicts a 21.6% surge in net earnings for Thales to 681 million euros, or 3.23 euros a share, in 2008 from 560 million euros (2.38 euros) in 2007. This reflects several acquisitions, including the space and security systems businesses purchased from Paris-based Alcatel-Lucent SA this past year.

Thales’ total sales in 2008 will jump by 10.1% to 13.6 billion euros, vs 12.4 billion euros in 2007, Brochet reckons. The military products group, he estimates, will see its revenue rise by only 6.6% over the same period to 5.6 billion euros vs 5.2 billion euros in 2007. Brochet rates the stock a “buy” with a price target of 51 euros, which he acknowledges is “ambitious in the current climate.”

However, Brochet justifies the target by noting that Thales has completed its merger-related restructuring, with the result that earnings should continue rising faster than revenue. The company also has very little exposure — less than 10% of sales — to customers that pay with U.S. dollars. Thales’ major business is in Europe and the Middle East.

BAE is another military electronics giant that offers steady growth from a wide range of customers. In a Jan. 22 report, Tina Cook, an analyst for Charles Stanley Equity Research in London, maintains her “buy” rating on the company. (For more on BAE, see page 44.)

Despite the strength of these global juggernauts, one of the industry’s more intriguing investment opportunities is Ottawa-based Allen-Vanguard Corp., which markets a wide range of counter-terrorism technologies. After acquiring Ottawa-based Med-Eng Systems Inc. in September for C$600 million, A-V operates three main units.

@page_break@The biggest unit, which accounts for two-thirds of total revenue, markets electronic countermeasures technology in the form of jammers that thwart the remote detonation of roadside bombs.

A-V has a major contract to supply the U.S. Marine Corps through one of its partners, General Dynamics Corp. of Falls Church, Va. A-V also does significant business with Iraqi and coalition forces through another partner, Lockheed Martin Corp. of Bethesda, Md.

A-V’s next-biggest unit, courtesy of the Med-Eng purchase, develops protective suits for jobs involving bomb disposal or chemical warfare.

The third division is dedicated to intelligence and training.

News of the Med-Eng acquisition helped push A-V’s share price to a historical high of C$11.95 on Sept. 4, 2007. But a good portion of this run-up was driven by a rapid rise in orders from General Dynamics for A-V’s jammers. A-V’s share price has tumbled, however, following the U.S. Department of Defense’s Dec. 7 announcement that the firm had not been selected for a research and development contract — known as CREW3 — to develop next-generation jamming technology.

By Jan. 24, A-V had closed at C$4.25 a share — down 64% from its peak. Neil Linsdell, an analyst with Versant Partners Inc. in Montreal, believes this makes A-V a strong buy. Linsdell points out in his Jan. 21 research report that the loss of the CREW3 contract will have no bearing on A-V’s business in fiscal year ending Sept. 30, 2008.

Linsdell expects A-V’s revenue will soar to C$512.9 million in fiscal 2008 vs C$96.2 million in fiscal 2007, paced largely by jammer orders from General Dynamics. He also predicts earnings before interest, taxes, depreciation and amortization will surge to C$156.2 million in fiscal 2008, compared with C$23.1 million in fiscal 2007. (The firm reported a net loss of C$14 million in fiscal 2007 due to an amortization charge related to the Med-Eng acquisition.)

Sales of A-V’s electronic countermeasures technology will remain relatively steady in fiscal 2009, while the rest of A-V’s units pick up, Linsdell predicts.

He projects fiscal 2009 revenue of C$555.4 million (up by 8.3% from fiscal 2008), while earnings continue to climb to C69¢ a share (up by 130% from fiscal 2008).

Linsdell has a one-year share price target of C$10.50. IE