Favor Accenture, Juniper, Websense Over Traditional Defense Stocks

By Bill Edson - July 30, 2012 | Tickers: ACN, INFY, JNPR, LMT, WBSN | 0 Comments

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Austerity threatens funding for conventional military-spending stocks. Instead of considering companies that make bombs, jets, and missiles, investors should consider cyber security firms as ways to play tomorrow's national security budget. In the following article, I will explain why investors should choose three cyber security plays, Accenture (NYSE: ACN), Juniper Networks (NYSE: JNPR), and Websense (NASDAQ: WBSN), over peers like Infosys (NYSE: INFY), Fortinet (FTNT), and Lockheed Martin (NYSE: LMT), for their investment portfolio.

Here Comes Austerity

Austerity is coming to a nation near you. The reluctant demilitarization of advanced, indebted nations has been kicked-off by the United Kingdom. The UK has announced its decision to cut back on military funding. Although the UK has chosen to save money by supporting less military personnel rather than by cutting corners on equipment, fewer troops ultimately means fewer expenditures on equipment. Weapons such as Lockheed Martin's 227-millimeter M270 Multiple Launch Rocket Systems will either be redistributed, or their use will be discontinued altogether because the regiment that used them has been eliminated under the Army 2020 plan.

The United States could easily follow the UK. The United States accounts for 44.4% of the world's military spending. The United States economy is not large enough to justify such a share with GDPaccounting for 19.8% of the world total and a population that is only 4.47% of the total world population. This means that on a GDP basis the United States could reduce military spending by half and still be in line with the rest of the world. Crazier still, on a per-capita basis the United States could reduce military spending by 90% while maintaining an average defense budget. Clearly, the United States has an oversized military budget in today's world.

The role of the United States in the world is changing and the vestigial military spending of a Cold-War past and escapades as a global policeman is unsustainable. As the United States government reacts to the constraints of promised entitlements and an aging population, more funding will be yanked away from military funding and many military-focused aerospace contractors. Avoid these companies.

Crime and Terrorism will Continue

Austerity will not be a "time out" for international criminal organizations, hackers, or terrorists. These threats might actually become bigger and more pervasive, despite the fact that our governments have squandered resources in the past to try to quell them.

Consider the recent malware threat crack-down. AT&T (T), Verizon (VZ), and other internet providers had to take measures to ensure that their customers will not be off the Internet for long or even at all on July 9th. In November 2011, the FBI allowed servers infected with malware to operate until July 9th, at which point the infected computers would be denied Internet access. This malware issue has been festering since 2007, infecting 64,000 computers after a group of hackers attempted to reroute internet users to fake versions of real websites. While the FBI caught the culprits, the malware left behind has been left to be cleaned up by the Internet System Consortium, which ensured server safety until July 9th.

Starting on July 9th, however, the malware on computers that has not been removed by anti-virus programs will need the help of their Internet providers to reestablish connection to the Internet. Verizon has assured their customers that they will connect them to technicians who can give users step-by-step instructions on how to fix their computers should they lose Internet access, and will also help them contact a professional contractor to help right the problem. AT&T plans to connect users to the legitimate websites through the end of the year, giving their customers time to address their malware issues so that their Internet service will not be interrupted. Clearly, cyber security is a big deal if giant telecom companies have to make special efforts to address 4-year old viruses.

Another big deal is money laundering. Though such activities are not as trendy as reports of terrorist threats or cyber security, financial institutions go to great lengths to train their employees about money laundering and to create systems to detect questionable customer activities.

Money laundering is alive and well, as demonstrated by recent news of a Mexican drug-trafficking cartel's use of a Bank of America (BAC) account to launder money. Jose Trevino-Morales, the brother of the alleged leader of Los Zetas cartel, used both an account in his own name and a business account registered as Tremor Enterprises LLC to invest in horse racing using the profits from smuggling thousands of kilograms of cocaine each year. Los Zetas spent over $4 million on quarter horses in a four year span. The FBI has not accused Bank of America of committing any crimes and Bank of America is aiding authorities in their investigation.

Investing in the Future of Security

The macro outlook for cyber security looks more attractive than the outlook for traditional military projects. The valuations of different firms involved in aerospace and cyber security reflect this:

The price-to-book ratio is not useful for comparisons between companies so heavily involved in research and development spending. (R&D projects are not capitalized, and thus are off-balance sheet.) Instead, price-to-earnings, price-to-sales, and price-to-free cash flows multiples can serve as valuation metrics for these companies.

A holistic view of valuation metrics favors Accenture, Juniper Networks, and Websense as cyber security plays. I urge investors to consider these three stocks now. In contrast, Infosys and Fortinet are too expensive based on P/S and P/FCF considerations. Unfortunately, the reasonable valuations of traditional defense companies indicate that short positions on these firms are not appropriate, even though they may see structural changes in the near future.

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