Bruce: “What is this?”
Lucius: “Oh, that old thing? That is the F9JMK-3,000.”
Bruce: “What does it do?”
Lucius: “We needed something that would tunnel through the Himalayas. So we created this machine with 18 fully-rotating bits made of a titanium/krytinium alloy capable of reaching top drilling speeds of 80 mph. It tunnels you through in a climate-controlled environment while you can enjoy your beverage choice from the built-in espresso machine. And yes Mr. Wayne, it comes in black.”
Such movie moments make you wonder, are the research and development branches of our nation’s defense contractors really like that? I mean, are they seriously just sitting on a bunch of awesome prototypes that the government will never use because they are too expensive?
No, not exactly. But even so, let me say this: if you’re thinking about investing in a defense contractor, it behooves you to get to know its R&D.
The issue with defense contractors
Why get to know its R&D? I believe the annual report from Lockheed Martin Corporation (NYSE:LMT) says it better than I could:
As we write this letter, the U.S. government is in the midst of addressing significant fiscal challenges and mounting national debt…We’re closely following the government’s efforts…We know, however, that we are not immune to future budget reductions in the U.S., and that the environment for 2013 and beyond will prove challenging.
Defense contractors, no matter how well run, have one main thing outside of their control: the U.S. budget. Unfortunately for these companies, no matter how good their products or management, if the national defense budget is cut that means that defense contractor’s income gets cut. This matter is completely out of the contractor’s hands.
| Company | US Gov Income 2012 | R&D Expenditures 2012 |
| Lockheed Martin | 82% | $616 million |
| Boeing | 33% | $3.3 billion |
| Northrop Grumman* | 90% | $520 million |
| General Dynamics | 66% | $1.6 billion |
*2011. Full 2012 information still pending.
When you look at this chart, a screaming advantage for The Boeing Company (NYSE:BA) immediately hits you in the face. The company is much less dependent on the national budget than the other companies listed. That’s good news for Boeing, at least in one sense. Any potential budget cuts won’t hurt this company as much as it would one of the other guys.
What is more pressing for The Boeing Company (NYSE:BA) is their Dreamliner situation. Plagued by bad batteries and leaky gas, these planes eventually got grounded. Now Boeing is on the path to getting them in the air again. How effectively The Boeing Company (NYSE:BA) is able to fix the problems will say a lot about this company. Only 50 of these planes have been delivered to date, but there are orders for 840 more. Another setback for the 787 at this point could be devastating.
Other defense contractors, having acknowledged the risk of being too dependent on Uncle Sam, are all seeking solutions that have application outside of the military.
Cyber security
In 2008, the Pentagon got hacked. They didn’t like that too much. Since that time we have been hearing more and more about the government, and large corporations, having sensitive information compromised by hackers. Because of the increasing risks, this year’s national budget includes increases in spending for cyber security. One of the leaders in this field is Northrop Grumman Corporation (NYSE:NOC).
Northrop Grumman Corporation (NYSE:NOC) should be one of the main companies to benefit from the budget increase for cyber security. I believe that this spending increase will develop into a trend. With each passing year, the cyber threat has become greater, and I look for Northrop Grumman to benefit for years to come as the government continues to spend more to keep our nation’s information safe.
Unfortunately, this means that the main source of revenue for Northrop Grumman’s cyber security is still the government, but this technology has applications for any large corporation. Big companies, including Facebook Inc (NASDAQ:FB), Microsoft Corporation (NASDAQ:MSFT), and NBC have all been victims of Internet hacking lately. The problem keeps getting worse by the day.
As a leader in this field, I’m looking for Northrop Grumman Corporation (NYSE:NOC) to grow its customer list. However, this company needs to pursue this commercial revenue to a much greater degree than it does currently. Currently, only 1% of their cyber-security revenue is derived from commercial sources.
