The Defense Department recently announced its plans on how they will improve "the Pentagon's buying power.”
So what does that mean for defense stocks like Northrop Grumman and Lockheed Martin? I
sat down with Michael Chertoff, former Homeland Security Secretary and founder of The Chertoff Group—which, among other things, helps private equity firms hone in on potential acquisitions of companies that might be developing the next big thing for defense.
LL: Where are the investing opportunities in defense during a time where the government will be spending less?
MC: We are seeing an uptick in transactional activity in the defense, security and intelligence space. It’s largely driven by three factors:
Regulation, such as the "conflict of interest rules" which has created a couple of spin-offs from large contractors with their systems engineering units.
The second issue is people are trying to get a handle on what the new budget environment is like and that's causing people to reorientate their capabilities to match what they think the new landscape will be.
That often involves growth through acquisitions rather than organic growth.
And in some ways, the economic environment lends itself to acquisitions. There are some companies out there that are having a hard time with credit so they are looking for salvation in terms of dealing with their cash flow issues. On the other side is a bunch of people sitting on cash, who are looking to deploy it in a way that is effective given the economic uncertainties right now. So I think all of this has resulted in a significant increase of activity compared to the previous year.
LL:There is a lot of policy uncertainty out there. In light of this, how are you counseling your clients? What's their biggest concern?
MC: One issue is about an organization's conflicts of interest. One of the themes of remarks coming out of the procurement sector has been a negative attitude toward the idea of contractors who are hired to review their own work. That has resulted in Northrop Grumman selling TASC. (For full disclosure I'm on the board of TASC now.) TASC is now being purchased by a couple of private equity firms.
Lockheed Martin has also put up Enterprise Integration Group (EIG) up for bid. So the perception is that "conflicts of interest" are going to become more and more of an obstacle for companies when competing for contracts, and therefore in order for the systems engineering piece to grow, it has to be separated from the piece that is doing the integration and build out of whatever is being called for in a particular contract. We'll see more of these deals in the future.
Everyone is also unsure of where the Defense Department and Homeland Security are going in terms of acquisitions down the line. Bob Gates is committed to $100 billion in cuts over the next five years from cutting down on contractors to duplication. But the question is what does that really mean? It’s clear in some areas you can't function without contractors.
What seems clear is there will be a cut back on the "big ticket" deals- the once in a lifetime contracts where you get an airplane that produces countless units and you're feeding off it for the next 10 years. That is being cut back. So my clients are curious to see where the investment will be and that's what we're spending a lot of our time talking to our clients about.
Is Washington prepared for the fight against terrorism?
LL: Where are the areas of growth?
MC: I think there will be more and more premium placed on acquiring nimble and flexible types of equipment and systems and services that are adaptable to a lot of different things. For example, those kinds of products or services that are important in counter insurgency or fighting piracy.
I think we'll need to see flexible services like language skills, the ability to analyse and decipher both encrypted messages and cyber security. I think those are the areas of investment and growth.
The third major area of opportunity I think is sensory capabilities.
It’s going to involve in the capability in analyzing data that comes from different kinds of sensors. I believe it’s going to be around identity management and control and the ability to have a secure identity. Because now, the security and defense area have blended. You have to look at the whole part as a continuum rather than two completely different sets of tools and two completely different sets of customers.
LL:Where are we now in terms of this blending transformation?
MC: It is underway now. You see some cut backs in some of their large weapons programs. The transformation will be less rapid than perhaps the Secretary of Defense would like to see. I still think if you look at this over five to ten years, you are going to see continued emphasis on smart, scalable, flexible types of services that are adaptable for use in the homeland security arena, as well as border security, defense, counter piracy, narcotics as well as a whole host of similar, anti-threat activities.
LL: Where are these exciting innovations coming from? Are they coming from the Grummans of the world or smaller companies?
MC: The interesting part of this is we are seeing development of these kinds of products coming from companies of all sizes. If I was going to pick the one area that I think is the best candidate for accelerated growth is cyber security. There you are not dealing with your traditional defense community. You are dealing with Silicon Valley and similar places around the country. The key is to take the work they are doing and making it scalable for the kinds of requirements the government is going to have.
The biggest thing for these companies to understand what it is like to deal with the government. Because, to be honest, the culture of these government contractors and the culture of Silicon Valley are not identical. So bridging that gap and trying to figure out what the way it is to get some of the cutting edge things that are being done in small companies into a format that it can be acquired and deployed by the government is a huge challenge and that is an area where we are spending a lot of time.
LL:Putting on your old Homeland Security hat, how would rate what is going on in Washington in terms of the readiness of the United States against terrorism?
MC: The challenge to Homeland Security is this: they are hiring more people which means the personnel costs are going to absorb a greater and greater portion of the benefit. The negative side of that is that it will have a downside effect on the investment in technology because there is less money to allocate to it. In some ways, the best way to leverage the people you have and make them move effective is to enable them with technology. So if you hire a whole lot of additional people, and you crowd out your technology budget, you will be less productive than if you balance personnel growth with technology.
My understanding now is there is a lot of focus on aviation security, there's talk in trying to eliminate the requirement of taking off your shoes before you go through the airport screening. But the problem is, I don't think there is a technology that allows you to avoid that. I also don't know if there is a technology that allows you to avoid unpacking your liquids which they are also talking about eliminating.
So what's going to happen, is the demand for more efficient security will collide with the budget and that's where I think we're going to see interesting decisions being made. They'll have to look at this balance.
What parts of the private sector are not secure?
LL:So you think the government in hiring more people will impact safety?
MC: I think the government needs to balance personnel costs and technology investment and development. You don't want to hire up to a point where the entire budget growth is absorbed with personnel costs.
In the end, its the technology that will enable your workforce to be more effective. If you just hire more people at the airport security gates sure you are moving people faster, but that is not solving the problem of liquids in shoes. The pressure from the public for more efficient screening will hopefully push the government to investment of technology.
LL: How would you rate the infrastructure security in the United States?
MC: I think it is very unbalanced in the sense that some parts of the infrastructure are quite secure. For instance, nuclear power plants are quite secure. Many chemical plants are quite secure.
But there are parts of the infrastructure that are not secure at all.
Including critical infrastructure which is in the hands of the private sector. How will we change that? One way is by having the government make them do it. As much as Congress likes making grants and grant programs, I think that is going to dry up. I don't think there is enough money for that kind of stuff. Another possibility is through regulation and I think you're going to see an increase in mandates that require the private sector to protect themselves.
The third thing is liability which I think is the dirty little secret that's the most effective way to obtaining an increase in infrastructure security. All you need to have this happen is have lawyers go into the boardroom and say if you don't increase security you're going to get sued into bankruptcy. That has a very mind focusing effect on a board of directors. A great example of this is Mumbai. That attack was totally different in how we perceive terrorist attacks. It’s not the bomb; its the dynamic moving force with firearms. The brunt of that attack was felt on restaurants.
LL: What examples in the private sector are not secure?
MC: Power plants, electric grid, oil refining capability, the banking system, financial system, communications.
But what I would put at the top of the list is cyber security. As we speak, every day huge volumes of confidential information and trade secrets are being stolen from our country and other countries. The Deputy Secretary of Defense wrote a piece in Foreign Security that revealed more in what we have lost in terms of intellectual capital through the cyber penetrations of our system. And according to published reports on this latest computer virus, if those reports are true, we are looking at the control systems themselves that would be affected. I'm talking about computers freezing up or not having them functional at all. So translate that into an attack on our financial system, our air traffic control system, or the electric grid. We are suffering from cyber attacks as we speak.
Where is the US Gov't falling behind?
LL:Is the U.S. government behind on this?
MC: The current administration is moving forward on this. That being said, it is not moving as far ahead as we would like it to be. The architecture and technological questions are very complicated so it is hard for policy makers to really figure out the right answer. But part of it is you get sensitive reaction when you put the words "government" and "Internet" in the same sentence.
I don't know if the right model is to have the government sitting on the Internet for the entire civilian sector and watching things go back and forth. So the question is, how do you build the system that leverages not only the government's unique capabilities but makes them available and owned in the private sector so we can protect our critical infrastructure? Is that through trusted mediators?
This is hard to address so that is why it is taking a while. But I also have to tell you that I've heard we are also a little skeptical because "nothing has happened" yet. But in 2007, when people were saying we are in a housing bubble and there could potentially be an economic dislocation and housing prices would precipitously drop, there were plenty of people saying "oh it would never happen" and in 2008 it did. I think we need to get focused and get things done before something does happen.
I believe we are in an economic downturn and everyone is feeling the impact. I will tell you while there will be policy and budget changes in this space, there is no doubt in my mind that defense security and intelligence will continue to be a very vibrant part of the national budget and economy. I say that for two reasons. No one in government misses the fact that job one is to protect the American people. And if there is an attack on the U.S. and you haven't done everything reasonable to stop it, that pretty much shuts down the rest of your agenda. So this is the base line requirement of government. And second, I think the private sector is going to be more proactive because people are realizing the battlefield is not at the perimeter any more. It is in every body's office buildings, power plants and all over the world. And to some degree, you will have to make investments in the private sector to protect those assets.
LL:While it is also the private sector's responsibility to up hold the base line in protecting Americans from terrorism is the government meeting their baseline requirements as well?
MC: One area I would like to see more investment in is bio security. I think we are beginning to lag a little behind in terms of being able to respond to biological threats. Now, for full disclosure, we do represent companies that make sensors and technology of that sort. But I do think while we can put first generation sensors around the country, we have to get to the next generation of those capabilities.
The other area we need to work on doesn't deal with technology at all.
It deals with taking the counter measures that we have and distribute and stockpile them to communities around the country. Right now, the FDA objects to that because they believe you should only distribute them after you see a doctor first. But the problem is if you have an Anthrax attack, there are not going to be enough doctors to see everyone say in New York City in 24 hours. We are going to have to get our heads around the fact that to prepare for a catastrophic, biological event we are going to have to change the order in the way the FDA does business.
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A Senior Talent Producer at CNBC, and author of "Thriving in the New Economy:Lessons from Today's Top Business Minds."
