Cybersecurity Is The Way To Play Defense Spending

By Aaron Levitt | February 06, 2012 AAA

With skyrocketing debt, cost cutting seems to be the new trend of policy makers within Washington. To that end, military and defense spending is directly in the cross-hairs. The deficit-cutting super-committee's recent failure to decide where to cut at least $1.2 trillion in savings, will produce automatic and across-the-board cuts for defense programs beginning next January.

Meanwhile, President Obama and Defense Secretary Leon Panetta recently outlined a $525 billion defense budget that's around $6 billion less than current spending levels. These spending cuts have great potential to severely impact traditional military contractors such as Northrop Grumman (NYSE:NOC). However, as the U.S. begins to draw down its mechanized army, another "war" is brewing. This war of data breaches could be the best way to play future defense spending.

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The Growing Problem in Cybersecurity
Assaults by criminals, terrorists and various "hacktivists" on our nation's computer systems continue to rise at a rapid pace. The modern world's reliance on computer networks grows more interconnected every day. From smartphone adoption and email to digital banking and credit cards, it seems that we use the web for more things than ever before. This extends into infrastructure that is essential to our economic security, such as power grids and water-treatment plants.

Recent data breaches at Sony (NYSE:SNE) and the International Monetary Fund (IMF), highlight the recent surge in hacker activity. A recent survey by McAfee showed that 43% of respondents identified disruption to critical infrastructure as the greatest single threat posed by cyber-attacks, and nearly 57% believe that a cyber space arms race is occurring. (For related reading, see 3 Ways Cyber-Crime Impacts Business.)

However, despite the growing need for preventing these sorts of attacks, actual spending and preparedness in the area is nonexistent. A recent survey by Bloomberg of network managers at 21 energy companies, found that these firms only spend an average of $45.8 million a year on IT security. The utilities surveyed are able to prevent around 69% of cyber strikes against their computer systems. However, analysts estimate that to prevent 95% of all attacks, it would take an average annual budget of $344.6 million per company.

To put that into context, the U.S.'s largest utility, Southern Company (NYSE:SO), only made around $277 million in profit last year. Nationwide, the U.S. would need to spend a total of $46.6 billion to prevent 95% of all attacks. That's up from the current $5.3 billion spent on cybersecurity.

Given how vital our infrastructure is to national security and under-funded nature of the sector, cybersecurity will undoubtedly get a larger share of the shrinking defense budget. Democratic Senate Majority Leader Harry Reid, is currently working on a comprehensive cybersecurity bill and various House Republicans are pursuing similar measures.

Playing the Spending Gap
With cyber threats continuing to mount and the reliance on computer networks growing, adding an IT security component to a portfolio makes sense. Both the PowerShares Aerospace & Defense (ARCA:PPA) and iShares Dow Jones US Aerospace (ARCA:ITA) follow some of the largest defense contractors and could be used as proxy for the defense sector. However, not all the firms such as Precision Castparts (NYSE:PCP) have any exposure to cybersecurity. It might make sense to go the individual route.

As more businesses, utilities and computer systems move into cloud computing, protecting that data becomes ever more important. Communications defense contractor Harris (NYSE:HRS) has been increasing its security offerings in the space and could be great way to play the need for secured data systems. Shares of the firm currently yield a healthy 2.7% and growth in its cloud security division has been robust. Likewise, both Sourcefire (Nasdaq:FIRE) and Websense (Nasdaq:WBSN) provide cloud computing security options and could be future buyout targets.

The Bottom Line
While the broad defense industry braces itself for major spending cuts, the number of cyber attacks continues to grow. Firms that operate in this area will see the bulk of future defense spending. The previous stocks, along with Symantec (Nasdaq:SYMC), make ideal choices to play the trend. (For additional reading, check out Tips For Keeping Your Financial Data Safe Online.)

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At the time of writing, Aaron Levitt did not own shares in any of the companies mentioned in this article.

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