Markets & Finance

More Than Playing Defense


From Standard & Poor's Equity Research

Investors looking for exposure to the defense sector have traditionally bought shares of big blue-chip military contractors and aircraft makers. Companies like Lockheed Martin (LMT), Boeing (BA), Northrop Grumman (NOC), Raytheon (RTN), and General Dynamics (GD) can be found in many ETFs and mutual funds, including the $1.06 billion Fidelity Select Defense & Aerospace Fund (FSDAX), which is the only fund mandated specifically to buy stocks in this sector.

However, the tragic events of September 11 and ongoing wars in Iraq and Afghanistan, along with terrorist strikes in Madrid, London, and Bali, and the continued threat of terrorism, introduced another aspect to defense investing: homeland security. Efforts by the U.S. government and corporations to increase security and surveillance, and to prevent further terrorist strikes, created a new subsector of companies providing homeland-security services. This follows the Homeland Security Act of 2002 and the establishment of a Homeland Security Dept.

Standard & Poor's tracks several companies that focus on homeland security, mainly in the aerospace-defense and technology sectors. S&P has a buy recommendation on L-3 Communications (LLL), which makes electronics and communications equipment for the defense industry.

Another favored stock is Harris Corp. (HRS), a communications equipment company that provides products and services to the government and commercial customers. Harris recently received a one-year design contract for the secure wireless-transmission system architecture of the U.S. Army's warfighter information network tactical program.

MILITARY SUPPLY. Kenneth Leon, a telecom equipment analyst for S&P, thinks Harris' sales, which rose 19% in fiscal 2005, will gain another 14% this year and 11% next. "This reflects our view of strong government-related product demand -- 53% of estimated total sales in fiscal 2006 -- from increased spending to support the war on terrorism, as well as improved capital spending for microwave and broadcast equipment," he says. "We believe the U.S. government will remain an important driver of future orders."

Leon thinks Harris' shares, currently trading at about $45, could reach $55 in 12 months. He recently upgraded the stock to strong buy from buy.

Harris Corp. is also a top holding in the $75 million Schwartz Value Fund (RCMFX). "They have a very successful product called the Falcon II tactical multiband radio, which has been used by soldiers in Iraq and Afghanistan," notes Tim Schwartz, an analyst with Schwartz Investment Counsel. "Harris dominates this niche business. While they have a few other divisions, about 65% of their sales are tied to U.S. military contracts."

NICHE AREAS. As portfolio manager of the Schwartz Value fund (which is ranked 4 STARS by Standard & Poor's), George Schwartz says he currently has about 7%-8% of assets invested in companies focused on homeland security. "We began studying homeland security as an investment idea about two years ago," he says. "We concluded that even after the wars in Iraq and Afghanistan wind down, homeland security will be an issue Americans will have to face for generations to come as long as terrorism remains a global threat." Schwartz believes budgets of both the U.S. government and corporations will keep a significant allocation to homeland-security initiatives, thereby solidifying revenue streams for years.

"Homeland security" includes a range of companies working in disparate areas such as scanning and detection, surveillance, biometric technology, and airport security, among others, Tim Schwartz explains. "While many large companies may have small divisions with businesses related to homeland security, we define homeland-security companies as deriving a majority of their revenues from this area," he says. Consequently, homeland-security stocks tend to be small-caps. "These companies operate in niche businesses and they have very unique technologies. Large-cap companies don't necessarily want to deal in niche areas."

American Science & Engineering (ASEI) is a direct play on homeland security. "This is a very unique company," Tim Schwartz says. The company makes X-ray detection and scanning equipment used at airports, seaports, border crossings, and government buildings, including the White House, Capitol, and Supreme Court. One very successful product is Backscatter Van X-ray System, which can efficiently scan people, buildings, and vehicles, he says.

INTERNATIONAL MARKET. George Schwartz notes that President George W. Bush's plan for more surveillance at the U.S.-Mexican border to prevent illegal immigration could greatly benefit American Science & Engineering. With revenues of $88.3 million in fiscal 2005, the company has already booked sales of nearly $123 million through the first three quarters of fiscal 2006.

Robert Stimpson, manager of the River Oak Discovery Fund (RIVSX), also includes American Science and Engineering in his portfolio. "ASEI is by far the most pure play we have with respect to homeland security," he says. "We think ASEI's technology offers opportunities in both domestic and international markets. It can be applied to borders and cargo ports in the U.S. and also Europe." (River Oak Discovery Fund is too new to carry a Star rank from Standard & Poor's.)

Some homeland-security companies existed before September 11, but under the shadow of global terrorism their products and services have new applications. Other homeland-security firms emerged after September 11. "You have to look at these companies on a case-by-case basis," Tim Schwartz says. "For a company like American Science & Engineering, their scanning technology was a direct response to Sept. 11." He notes that prior to the World Trade Center terrorist attacks, American Science & Engineering was selling at $6 per share; by the end of 2001, it was trading at $25.

VARIOUS PLAYS. However the success of many homeland-security companies does not depend wholly on terrorism prevention. "These firms have products and services with wide security applications, so they would still be profitable even if the terrorist threat disappeared overnight," Tim Schwartz says.

Fargo Electronics (FRGO), which makes printers and software that personalize plastic ID cards, electronically coding them with information, is another favorite of his. "These items have been sold to both government and corporations," he says. "In fact, Fargo will benefit directly from President Bush's directive requiring all federal employees to carry an ID card." Fargo Electronics recently agreed to be acquired by a subsidiary of Assa Abloy, a Swedish lockmaker.

Other homeland-security holdings in Schwartz Value include Applied Signal Technology (APSG), a maker of reconnaissance and surveillance equipment; Mine Safety Appliances (MSA), which manufactures military helmets, gas masks, and body armor; and TVI Corp. (TVIN), a supplier of chemical/biological decontamination systems.

Another security play held by River Oak Discovery Fund is DRS Technologies (DRS), a defense electronics company that provides technology services to the U.S. military and government intelligence agencies. Its products include radar, sensor, and homeland-security systems.


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