Technology in the Defense Spotlight

By Andrew Leckey

The hot tickets in the defense industry are information technology, communication and high-tech equipment designed to assist soldiers in the field.

Reflecting this growing tech trend in the military, acquisitions of defense IT firms have become more frequent in recent months.

For example, General Dynamics Corp. is buying Anteon International Corp.; Lockheed Martin Corp. is acquiring Aspen Systems Corp.; and CACI International Inc. is purchasing privately held Information Systems Support Inc.

Companies with innovative products or the potential to be acquired are expected to prosper. Smaller companies have been especially impressive.

“The small- and mid-cap defense technology companies we focus on outperformed large caps throughout the whole cycle of upturns and downturns in defense spending,” said Christopher Donaghey, aerospace and defense analyst with SunTrust Robinson Humphrey in Atlanta. “That’s because they’re typically viewed as acquisition candidates that may be bought by large defense companies, and they receive a price premium on that alone.”

It’s no coincidence that acquisitions have become a driving force.

“The Department of Defense has rules to get money to small companies, so in a sense it is always creating new small companies that eventually get bought by larger defense firms,” said Scott Sacknoff, president of ISBN Inc. in Washington, D.C., and creator of the benchmark Spade Defense Index, whose group of defense industry stocks has outperformed the Standard & Poor’s 500 for six consecutive years. “In a typical year there are hundreds of acquisitions and mergers inside the defense sector.”

Driven by ever-escalating defense budgets, stocks in the sector have soared since 1992. President Bush’s $439.3 billion defense budget for fiscal 2007 is 4.8 percent more than the current budget and includes $84.2 billion in weapons purchases, up 8 percent from the 2006 request.

However, his budget defers decisions on large cuts to major weapons systems, which means that will have to be dealt with sometime in the future. It is unlikely the Pentagon could afford all the weapons systems currently in the budget without receiving a significant boost in defense spending over the next five years.

Because of such longer-term uncertainties, a number of defense shares trade lower than their earnings would justify. That despite the fact that, as Cai von Rumohr, managing director and senior research analyst with SG Cowen & Co. in Boston, points out: “All the companies are performing well.”

This offers investment possibilities, keeping in mind that deciding whether to invest in defense stocks is a personal decision. Many investors and socially responsible mutual funds avoid defense just as they do tobacco stocks.

Two potential takeover candidates in defense information technology are CACI International (CAI) and SI International Inc. (SINT), according to von Rumohr. ManTech International Corp. (MANT) also is interesting from an acquisition standpoint, he added. But ManTech Chairman and Chief Executive George Pedersen owns 90 percent of voting stock, so he’d have to be willing.

Some sought-after products provide profitable niches:

— Thermal imaging and infrared camera systems to see in darkness, smoke and haze are a growing business of Flir Systems Inc. (FLIR), whose stock is recommended by Donaghey. It’s a technology unlikely to be affected by a defense slowdown because equipment is dropping in price and the military wants to adopt it in a big way.

— Command, surveillance and reconnaissance systems used on ships and aircraft for military intelligence purposes are manufactured by Argon ST Inc. (STST), another Donaghey choice. Demand for products is so strong the company expects to grow 25 percent annually for the foreseeable future.

— Donaghey also recommends Orbital Sciences Corp., which produces an interceptor missile defense booster being installed in Alaska and California that would be launched if a ballistic missile were sent toward the United States. That program appears back on track after significant setbacks. The company’s main businesses are small rockets and space systems.

“The willingness to finance the defense sector is as much a political issue as anything else,” Sacknoff said. “But keep in mind there will be a decline in the growth of the defense budget, but not a decline in spending.”

His Spade Defense Index of 59 defense stocks, on which options are traded on the American Stock Exchange, also has spawned an Amex exchange-traded fund, the PowerShares Aerospace & Defense Portfolio (PPA).

Among the defense giants, von Rumohr favors Lockheed Martin Corp. (LMT) because it has the strongest, most sustainable cash flow the next couple of years. It has the cheapest valuation because investors “are paranoid that some of its major (aircraft) programs might get canceled,” he said.

Big defense already has military projects in its pipeline, and it’s not completely dependent on them anyway. These firms are diverse and can always turn to the commercial side of their businesses.

“Defense and homeland security portions of the companies that I follow are flattening out in their rate of growth after a substantial move from the beginning of the decade,” said Paul Nisbet, a principal at JSA Research Inc. of Newport, R.I. “However, the commercial side of aerospace is taking over and keeping the growth of most of these companies at a reasonable rate.”

Nisbet’s stocks “worth watching” are Northrop Grumman Corp., General Dynamics and United Technologies Corp.

Andrew Leckey answers questions only through the column. Address questions to Andrew Leckey, “Successful Investing,” P.M.B. 184, 369- B Third St., San Rafael, Calif. 94901-3581, or by e-mail at andrewinv@aol.com.