Although the sector is challenging, select companies boast attractive returns
American society is melding with technology at an ever-increasing pace, especially as a way to cut costs.
The change in presidential administrations, budget priorities and the financial crisis have made investing in defense companies more challenging than ever.
The situation is similar to when the General Electric Co. of Fairfield, Conn., converted from building nuclear reactors in the 1970s to becoming the premier service provider for reactors, a business that has generated high margins.
Through our financial crisis, Americans have become quite familiar with the word “systemic,” even with the lack of recent headline attacks. The Internet grants access to all parts of American life, including essential services such as water and electricity.
Threat groups include nation states, terrorist groups, organized crime and hackers, all of which the United States tries to keep at bay with technology that can monitor their activities. By contrast, human intelligence requires a much longer time horizon to build and is an old-fashioned method of handling ¬problems.
American defense spending is shifting significantly as Defense Secretary Robert Gates leads the Quadrennial Defense Review, an effort designed to reshape U.S. capabilities. During the campaign, then-candidate Barack Obama used technology effectively in the election and sought signed agreements by Department of Defense officials to not discuss the 2010 budget with anyone outside defense agencies.
Real budget cuts of big iron were predictable, and potential reductions were unveiled last week.
Investors would be well-served to diversify in both size and type of defense company — recognition that future threats are real but future budget outcomes are essentially unknowable.
Three companies represent a good beginning for financial advisers who have an interest in defense stocks:
• Raytheon Co. (RTN) of Waltham, Mass., is a well-run $15 billion prime defense contractor with a strong balance sheet, excellent cash flow and a diversified product mix that includes integrated defense systems, missiles, cyberwarfare, space and airborne systems, among other offerings.
The company also enjoys robust international sales of 20%, which will benefit as the U.S. dollar trades down. Raytheon does have headline risk on a large ship contract and will continue to need to fund its employee pension plan.
However, the company has reduced its pension expectations, and it has a young work force. Raytheon is inexpensive at nine times the trailing four quarters of earnings.
Investors should take positions when negative headlines depress defense shares during future Washington defense budget scrums.
• SAIC (SAI) of La Jolla, Calif., has a $7 billion market capitalization, making it the largest pure-play government technology firm. The company boasts an 8% rate of organic growth, and it generates $500 million in free cash flow.
The company’s products are in intelligence, homeland security, health care information technology, energy and secure freight, among other areas. Contracts are diversified, with the top 10 representing just 13% of 2008 revenue, and no contract will account for more than 3% of 2009 revenue.
The company faces funding pressures in future combat systems, which are 3% of revenue, because they are a congressional target. However, these programs are key priorities for the president and the Army. The company, founded in 1969, has been public for just two years and is integrating financial and management systems in 2009, which might lead to expanded margins.
• McAfee Inc. (MFE) of Santa Clara, Calif., offers the investor a $5 billion civilian-oriented cybersecurity play, with some government exposure. The ordinary computer user is well-aware of the number of viruses that seek to infest their home PC.
Daily updates are necessary, and the subscription model for these updates provides stable cash flow to the company. McAfee is posting solid numbers in a weak PC market, indicating market share gains. The company has made strategic acquisitions, added to its sales force and kept expenses firmly in check.
Defense technology will be a solid driver of revenue growth for years to come. Although timing is never perfect, the investor that seeks to take advantage of a strong top-down theme, coupled with individual company catalysts, should be well-served by “integrating” an array of quality cybersecurity companies into their portfolio.
James Reed is the lead portfolio manager of the UMB Scout Stock Fund, from UMB Scout Funds of Kansas City, Mo.
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