After commodities, there's another bull area we've mentioned in the past: defense. Even before President Eisenhower warned against the "military industrial complex," defense contractors were benefiting from our seemingly limitless appetite for multibillion-dollar military programs.
Thanks to America's new budget realities, future defense outlays will probably be more limited, and this will put a brake on growth for some of the major players in defense. But the U.S. won't – and can't – abandon defense spending. The current American defense doctrine recognizes the necessity of securing scarce resources and dictates a forward military strategy. This means healthy (although more carefully directed) defense spending. One area that seems to be a sure bet for more funding, from both the government and private industry, is cyber security … security for both the Internet and for individual information systems.
The Internet is already critical to our society, and every day it becomes more enmeshed in every aspect of our lives, from our government to our financial markets to our power grids to our transit systems. Internet failures and attacks have already been responsible for billions in dollars of damages to companies, countries and individuals. One year ago, it was malfunctioning computers that caused the "flash crash," when the market plunged some 8 percent within a few seconds. Some stocks dropped by more than 50 percent. We still don't know if the errors were accidental or the result of a deliberate hack.
In fact, some have argued that the entire 2008-2010 financial crisis was at least partly caused by the Internet … specifically, by the massive amounts of data the Internet can generate. British central banker Andrew Haldane and leading British zoologist Robert May, in an article published in Nature's January 20 issue, claim that extraordinarily complicated financial engineering created an "ecosystem" that was designed to maximize profits for individual participants, but created vast systemic risk for the market as a whole.
Advanced derivatives and nanosecond trading systems are complex and sophisticated – but that doesn't mean they're secure or "robust." Compared to most creatures out there, we humans are complicated beings with great gains in brainpower … but we can be struck down by a single primitive organism. Complexity means both power and weakness. So as our Internet-based systems become more complex, our safeguards must evolve as well, which requires greater and greater outlays of time, brainpower, and money.
And our cyber systems are not yet ready to deal with the complexity of the data we generate. Last February, a leading genomics researcher predicted in the journal Science that the massive amounts of data being generated from DNA analysis "will swamp our storage systems and crush our computer clusters." Our analysis and control capabilities are trailing our data creation by a wide margin.
Nowhere is this more disturbing than in the field of cyber security. Cyber defense is the newest arena of asymmetric warfare, leveling the playing field for smaller, poorer countries - or even individuals - that want to take a run at the major nations. Ten well-trained computer hackers can now accomplish more damage than an armored battalion, at one-millionth of the expense … and anonymously. The U.S. (probably) turned this fact to its own advantage when it unleashed the Stuxnet computer worm on Iran's nuclear facilities. But China has been cognizant of this reality for years, and Chinese hackers are suspected to be the force behind dozens of finished and ongoing attacks, from the CodeRed worm to ongoing cyber-espionage against the U.S. military and other American interests. If these attacks evolve from espionage and vandalism to something greater, they have the potential to truly unleash Armageddon. The U.S. military relies on its superior command and control functions, which are primary cybernetic. If those systems were breached, how long could the DoD maintain security?
Espionage protection, communications security, infrastructure defense – with so much at stake, both corporate and government spending on cyber space will rise. Below you'll find several companies that are ready to take advantage of the new emphasis on cyber security and the Internet.
Only one of our picks is a major defense contractor. The percentage of business devoted to cyber security by most of the big defense players is too small to affect the bottom line significantly. The exception is Raytheon (RTN), which we've placed in our Growth Portfolio. Raytheon differs from the other defense majors because of the diversity of its operations. Since it has fewer major defense projects, it is less vulnerable to big defense cutbacks. Raytheon derives more than 10% of its revenues from cyber security operations, far more than any of the other big defense companies. Both acquisitions and internal growth will probably increase this percentage in the near future.
Raytheon also derives more than 20% of its sales from outside the U.S. With the recent turmoil in the Middle East and North Africa, we expect foreign sales growth to outpace domestic growth.
Defense majors generate a lot of free cash flow. In the case of Raytheon, that currently tops 10%. We expect this cash to fund share repurchases and acquisitions – and we think many of those acquisitions will have a cyber security focus. Raytheon is a cheap stock by anyone's standards. If the company's growth outpaces the Street's estimate of 5% (we think it will), then its stock should radically outperform the market over the next five years.
Our next pick, CACI International (CACI), is much smaller than Raytheon, and gets most of its revenues and profits from defense IT. It may also be the world's smallest de facto monopoly: It deals with highly classified information and its employees require high-level security clearances – so any potential rivals would have a tough time poaching employees, information or business methodologies.
Since so much of its work is secret, CACI is something of a "black box" to investors. However, the public indicators are very persuasive: CACI has one of the strongest long-term growth records for an American small-cap defense company: CACI's profits have risen in all but one of the last 15 years – a period that has included several slowdowns in defense spending growth – and its most recent quarter was spectacularly successful. It has a consistently high free cash flow, which has allowed it to grow by internal development and by acquisitions. The free cash flow yield is currently near 10%, so we expect this growth capability to persist for at least the next three to five years. Combine this with CACI's prominence in cyber security forums and the increased emphasis on the field, and the company should average growth above 15% at least until the middle of the decade.
The most recent quarter was another success – with record revenues, operating and net income and earnings per share. CACI also raised its guidance – and all this was achieved despite budget pressured on its government clients. With the opportunity pipeline for CACI as strong as ever, this is a very cheap stock by any measure.
Like CACI, ManTech (MANT), in our Income/Value portfolio, is a small-cap standout in the defense industry, with a specialization in IT, including cyber security. Its primary clients are the U.S. intelligence community and Federal agencies from the Department of Homeland Security to the Army to DARPA.
ManTech enjoys some of the same competitive edges as CACI, including a "security clearance monopoly" that puts would-be rivals at a disadvantage. Founded in 1968, ManTech was a beneficiary of the early 21st Century defense boom. It anticipates revenues of $3 billion this year and $5 billion annually in the near term, goals that seem eminently achievable – since both revenues and earnings per share have grown by about 20% compounded annually since 2002. Given these factors, it's astounding – and a terrific opportunity – that company is currently at a rock-bottom valuation of about 11 times next year's expected earnings and at 1.7 times book value. Some of this is due to worry about defense spending during the current budget negotiations. The most recent quarter for ManTech, however, might help in proving the skeptics wrong: Revenue was up 19 percent and earnings per share were up 14 percent from the year-ago period, pointing to good execution and strong growth.
Moving from the public/defense arena to the private/corporate one, we have a cyber standout in VMware (VMW).
VMware is a player in the new IT sector of "cloud computing," in which data and software are stored on remote servers instead of on-site computers. Fees are then charged for the data storage and use of the software. This new computing model is useful for companies that need massive data storage and manipulation but don't want to invest in expensive IT infrastructure that is difficult to maintain, and likely to be outdated quickly.
VMware is a leading provider of virtualization solutions – software that allows one computer to run several different operating systems at the same time. This basically turns one powerful machine into several somewhat weaker virtual machines, which allows organizations to combine the capacities of their servers, networks, and storage infrastructure and allocate resources to different applications as needed, optimizing efficiency and cutting costs. Virtualization is one of the technologies that underlie cloud computing, and is widely viewed as the future of corporate information technology. More and more companies are turning to virtual machines rather than on-site physical servers to meet their needs, and this trend is clear in VMware's robust growth: Its 2010 revenues were $2.9 billion; it counts 99% of the Fortune 1000 as customers; and it is the fifth largest infrastructure software company.
For those looking for a cheaper play, EMC (EMC), in our FundFinds, owns about 80% of VMware and trades at much cheaper valuations.
Disclosure: Leeb Group, its officers, directors, shareholders, employees and affiliated entities and/or clients of such affiliated entities may currently maintain direct or indirect ownership positions in financial instruments (i.e., stocks, bonds, options, warrants, etc.) of companies or entities whose underlying exposure is in the companies mentioned in this article.