The Valuentum analyst team discusses trends in US and global defense spending and the explosion of Internet crime that is fueling investment in cyber security both in the public and private sectors. ~7 mins.
This podcast was originally published November 3, 2016. If you cannot view the video below, please view the transcript that follows or click the link here.
Software – Security: CHKP, FEYE, FTNT, IMPV, PANW, PFPT, SYMC, VRSN
Aerospace & Defense – Prime: BA, FLIR, GD, LLL, LMT, NOC, RTN
Brian Nelson, CFA:
This is Brian Nelson for Valuentum Securities, and today I have joining me on our podcast Mr. Kris Rosemann and Mr. Chris Araos. Today, we are going to talk about the landscape for defense spending as well as commercial aerospace. Just a little background as we get started here, defense spending for 2017 looks to be marginally up versus 2016 levels which are still significantly higher than those defense spending levels following 9/11. During the Obama administration, total defense spending still was robust at least during his first term, but during his second term it has trailed off somewhat. That being said, there are still some areas of strength. Mr. Kris Rosemann do you have anything you can add on that topic?
Kris Rosemann:
Yes, as you said, defense spending is largely flat, expected to be largely flat in fiscal 2017, compared to fiscal 2016 for the Department of Defense. But we’re seeing a bit of a shift in what they are spending that budget on. The Department of Defense is prepared to pursue more technologically-advanced warfare, a more smaller, agile fighting force, and we think we are going to see the spending trends shift more to the research and development of these advanced weaponries — and that is going to continue to shift in that direction as global warfare evolves.
Brian Nelson, CFA:
That’s right, I think a few areas that we see of strength in particular spending on next generation ISR, that being Intelligent Surveillance and Reconnaissance technologies, advanced data analytics, missile defense–I think you hear a lot out of North Korea more recently. Nuclear modernization, precision strike, and counter terrorism are a number of other areas.
But also more in the traditional sense areas such as ship building remain a key priority, including the production of destroyers, submarines, and of course the next-generation Air Force combat equipment from fighters to bombers, munitions and whatnot are still areas of strength. The reality is that there is always going to be the threat of ongoing geopolitical uncertainty: ISIS being one, tensions with Iran and North Korea. This specific threat for cybersecurity is an interesting one though, wouldn’t you say so Mr. Chris Araos?
Christopher Araos:
Yes, currently cybercrime is costing the global economy about $400 billion each year. As an example for a more localized North American cybercrime, there was the Yahoo (YHOO) hack that occurred in 2014 where 500 million user accounts were compromised; in 2011, there was the Sony (SNE) PlayStation Network outage, which led to 77 million accounts being compromised. As more time passes, more and more people will be online such that online security will become more valuable as time passes. As an example, right now the market size for cybersecurity (spending) is $106.3 billion in the year 2015 and is expected to grow to $170.2 billion by 2020.
Brian Nelson, CFA:
And that is public and private numbers right? That is together right, government and public sector?
Christopher Araos:
Yes, both government and public sector.
Brian Nelson, CFA:
That is a pretty big chunk.
Christopher Araos:
It is an exploding market.
Brian Nelson, CFA:
When we think about areas within this Cyber Security market, even among the most well-known brands have been hit. You mention Yahoo, Sony, and there was Target (TGT), even Home Depot (HD). There’s not only the spending for these publically traded entities, but also there is the spending on the government side.
One interesting way one gains exposure to both avenues is through the ETF, Purefunds ISE Cyber Security ETF (HACK) — Probably appropriately named there. But it’s interesting that this is still an evolving dynamic. The players within there (the ETF) is some legacy large contractors in there that have applications to prevent cybersecurity intrusions, but there are some new players on the block as well.
One of the interesting dynamics within the defense budget in itself is personnel costs. This continues to be a large portion of the defense budget itself. As this continues to grow, it’s also crowding out some of the spending pie that’s allocated to defense contractors. There is an interesting dynamic within the defense spending budget–not only is it shifting as we modernize the warfighter but also the amount of budget allocated to personnel costs is crowding out the amount of spending for R&D, for example.
That being said, a lot of what we do like about defense companies has to do with their financials. A lot of them are very, very strong free-cash-flow generators, and they pay very healthy dividends wouldn’t you say so Mr. Rosemann?
Kris Rosemann:
Definitely yes, if you look across the aerospace and defense you have companies like Boeing (BA), companies like Lockheed Martin (LMT), and they are throwing off tons of free cash flow, which allows them to have strong Dividend Cushion ratios — and I just wanted to take a second and talk about Lockheed Martin. As we talk about missile defense and next-generation of fighter jets, their F-35 is a very important piece of the next generation of global weaponry, and that makes up about 20% of their sales.
You mention spending around the world–they’re citing Allied forces, replacing aging equipment, and the general expansion of defense spending across the world. It is really driving demand, particularly for their F-35 fighter jet. We are also happy to see them spin off their information systems segment that has been kind of been underperforming.
But in contrast to Lockheed Martin where a very large portion of their revenue is generated just from defense, whether it be domestic or international, you continue to point to Boeing as one of our favorite ideas because of the opposite dynamic in its business, if you want to speak to that?
Brian Nelson, CFA
Sure, yes. Boeing, as many of you are aware, is one of the largest defense contractors, but it’s also one of the largest suppliers of commercial aircraft. Over the past several years as commercial aerospace demand has increased, the number of deliveries has increased. Boeing’s breakdown for revenue is two-thirds commercial, one-third defense, so Boeing has an inherent hedge against whatever might happen in the defense budgeting process.
We hope you enjoyed our topic of defense, and thank you very much for tuning in. This is Brian Nelson for Valuentum.
Video tickerized for stocks held in the HACK, ITA, and XAR.