A New Era in the Defense Industry

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A New Era in the Defense Industry: Lock And Load On Profits

by Tony Daltorio, Investment U Research

Over the past year, stocks of companies in the defense industry have taken a beating, down thirty percent… forty percent… or more.

Valuations have taken an even harder knock, with forward price-to-earnings dropping to just under nine times 2010 earnings… their lowest levels since the early 1990s, when the end of the Cold War led to the US cutting defense spending by more than half.

Today, investors fear a repeat performance, and let’s face it: The recon doesn’t look good.

Reports show that while the defense budget edges towards $600 billion a year, the supplemental budgets – which fund current operations – will actually decline sharply as the US winds down operations in Iraq and wages a more limited campaign in Afghanistan.

By 2010, total spending on research and new procurement by the United States will fall $45 billion from its 2008 peak. And Marty Bollinger, the head of the defense practice at Booz & Company, believes total investment spending could drop by 40% in real terms over the next three years.

Back in the 1990s, similar conditions led to a radical shake-up of the industry, reducing capacity through a wave of mergers in response. But with so few players left in the defense sector, those companies no longer have that option in the mix.

Most defense companies recognize that if they want to survive in this new era, they have to look for new ways to generate their revenues and profits. But one company stands out as everybody else scrambles to regroup.

Lockheed Martin (NYSE: LMT), the world’s biggest defense contractor, has already drawn its battle plans, and its ready for action.

Targeting Cyber Security

So far, Lockheed has situated itself perfectly to play a lucrative role in the newest facet of the defense industry as a systems integrator, countering the escalating threat of cyber crime, cyber terror and cyber warfare.

While those threats might not seem like much, they pose very real danger to everyone. IT security specialist McAfee, estimates that black hat hackers create 8,000 variants of malicious software every day, some of which were used back in July of this year, in attacks on the Pentagon, New York Stock Exchange, and government websites in South Korea.

In fact, these kinds of threats have become such a danger to national security, that President Obama has made cyber security a major policy priority of his administration.

Market estimates of how much the Unites States plans to spend in this area vary widely, but some experts predict it will exceed $50 billion in the next six years.

Over the past 15 years, Lockheed Martin stood out as the leading IT provider for the US federal government. And even while technology affects more and more of the global experience, it has marched right along by providing sophisticated security systems for government-related networks.

In order to combat the increasing threats, company executives first increased its research and development spending, which included setting up a Security Intelligence Center to defend its internal infrastructure, and a Center for Cyber Security Innovation to coordinate internal development.

And by November 2009, the company plans to launch a cyber innovation and technology center to work closely with customers, including a “cyber range,” commissioned by the Pentagon’s Defense Advanced Research Projects Agency to test various scenarios of coming under attack.

Changing Strategies For An Ever Changing Enemy

Charlie Croom, the man shaping Lockheed’s cyber strategy, says that the biggest problem the industry faces comes down to predicting attacks rather than reacting to them. “We are thinking about how to deal with unknown things,” he explained. “How do you defend against the unknown threat? How do you go from reactive to predictive?”

Staying ahead of the game has only become more crucial as data banks grow even more vast, and the scale and variation of assaults increases exponentially. The new systems that Lockheed is working on even now, will need to rely on the wonders of artificial intelligence to automatically seek out the most subtle changes in data patterns.

That includes what it calls cyber security “offense,” a measure against threats from other countries such as North Korea, which may still develop advanced cyber warfare techniques. Most of the company’s work in this area remains “classified,” so nobody has any clear-cut details on what this involves.

Knowing Lockheed Martin though, we expect it to be good.

You see, it has the experience working for US security agencies, as well as on IT systems for the FBI and the Federal Aviation Administration. Mr. Croom says that the company’s expertise in defending large and sensitive government networks leaves it well-placed to seek future opportunities in non-government areas such as protecting power grids for energy companies or health care databases.

Lockheed also has close ties with other technology companies such as McAfee, Cisco Systems and EMC in their unified fight to stop cyber criminals from targeting the vulnerable “gaps” between home desktops, computer networks and data centers. The company describes the approach as providing the “secret glue,” to its system integrator business model.

All of these moves prove that Lockheed Martin still has what it takes. It isn’t easy transforming from a 20th century defense contractor specializing in military transportation, to a 21st century defense company protecting against cyber threats. Yet that’s exactly what it has done.

Most investors haven’t caught onto this monumental shift yet, so it leaves a very profitable opportunity for those of us in the know.

Good investing,

Tony Daltorio

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