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Invest in Defense

10/29/2004 12:00 am EST


Neil George

Editor, Profitable Investing

"While the big defense contractors get the headlines, the real action can be with the second- and third-tier defense firms," says Neil George. Here, the editor of  Personal Finance offers an exceptional overview of some lesser-known defense names.

"Aside from their symbiotic relationship with big defense firms, smaller defense companies need one of two qualities: their products need to be innovative enough that they command a valuable and unassailable market niche; or their technology/products must be adaptable to a variety of applications beyond defense. That way, when defense spending slows, they don't shrivel up and blow away.

"A prime example of creative opportunity-making is DRS Technologies (DRS NYSE), which holds leading market positions in thermal imaging devices, combat display workstations, electronic sensor systems, power systems, battlefield digitization systems, and deployable flight incident recorders. Its most exciting opportunities of late are being on the teams that won the US Navy's multi-mission littoral combat ship programs, which are focused on reinventing the US naval fleet using innovative technologies and materials. DRS's electric drive components will be essential elements. Never forget how much oil it takes to service a fleet, or any military endeavor for that matter. Using the high-torque, low-revolution electric engines and drives that DRS specializes in could save enormous amounts of increasingly precious crude. DRS is trading near its 52-week high but well under its three-year high, so there's still solid long-term upside. It's also under-followed by Wall Street analysts, therefore it will have a better chance to perform on its merits and not by Wall Street vagaries. Buy up to 41.

"Harris Corporation (HRS NYSE) is a quiet giant when it comes to national security. This firm is one of the top players in defense and commercial communication equipment in the world. In fact, when the White House needed a hotline to the Kremlin during the Cold War, Harris got the job. Soldiers have used its secure, integrated radios in the mountains of Afghanistan during Operation Anaconda and in the deserts of southern Iraq and Kuwait. That's battle-tested credibility. Defense communication technology is only going to become more necessary in a post-9/11 world. And Harris is the leader. It also has a huge commercial division, selling everything from radio and television broadcast to microwave communications equipment. Basically, that means if you listen to it, speak through it, or blankly stare at it, Harris likely has a piece of the business. Harris is a great long-term buy below 60.

Another smaller player in the tech world of defense is Anteon (ANT NYSE). Its most compelling niche is information technology and integration solutions for the intelligence community. For some contractors, successfully jumping through all hoops at the CIA, NSA, FBI, HSA, DIA, the Pentagon, and a number of other ultra-high security agencies and departments is a tough but rewarding course. The barriers to entry are enormous and winning the trust of the agencies for those willing to make the gargantuan efforts necessary means a solid stream of contracts. Want proof? In 1996, Anteon's annual revenue was about $110 million. By 2003, its revenue topped $1 billion. The company is at the forefront of communications integration among intelligence agencies and Homeland Security. No matter who is elected, this is a huge job that will be well funded years into the future. Buy Anteon up to 40.

One more sure thing for this sector is that Israel will remain our top strategic ally in the Middle East, regardless whether red or blue states carry the day. And one company in this tiny country that carries a lot of clout in the global defense industry is Elbit Systems (ESLT NASDAQ). If there's anything positive to be said of the challenging circumstances that exist in Israel and its region more broadly, it's that the conditions provide the ultimate R&D platform for upgrading flight and ground combat systems. This has made Elbit one of the most sought-after developers of system upgrades for aircraft, helicopters, and unmanned aerial vehicles. Its helmet mounted system technology is the basis for the US Joint Helmet Mounted Cueing System program; all frontline US F-15, F-16, F/A-18, and F/A-22 pilots will be equipped with the system. With Honeywell, it's leveraging its technology by developing a heads-up display for commercial transport aviation. If you want to buy one of the best niche defense companies in the world, buy Elbit Systems below 22.

"Since modern warfare requires more, not less, men on the ground, the companies that provide the basics for the guys (and gals) in the foxholes will continue to get steady work. It might not be whiz-bang equipment the previous companies develop, but it's the stuff that enables the grunts to get the job done. From tents to trailers and everything in between, Engineered Support Systems (EASI NASDAQ) is usually the first called up by the Pentagon when we send troops into the field. The company's sales have climbed by more than 40% in the past trailing 12 months, and that growth won't be retreating anytime soon. And Engineered Support is valued at a fraction of its larger competitors, just slightly above its rising trailing revenues. From bio-defense tents to air conditioners and water-supply systems and all the rest of the everyday necessities of forward deployment, EASI is a long-term buy up to 50."

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