| Near-Term
Spotlight -- The Security Industry |
Published: April 12, 2004
The security sector has been red-hot as of late, with
the average firm delivering gains of +25.3% so far this year. By
comparison, the S&P 500 has gained just +2.5% in 2004. The bottom
line is that investors are once again taking a long, hard look at
promising companies that stand to benefit from the recent boom in
security spending.
To give you a better sense for just how hot this
sector has been, let's take a look at a few recent individual winners.
Taser International (TASR, $99.80), the poster-child for the security
group, has risen from sub-$2.00 levels to around $100 in less than a
year. More recently, an Israeli firm, Magal Security Systems (MAGS,
$37.96), has quadrupled in less than a month. Meanwhile, security camera
maker IPIX Corporation (IPIX, $15.50) has risen +800%! The entire sector
is getting bid up as investors race to find more great companies. While
it appears there may be a "bubble" forming in security stocks,
there is still room to get in on a select handful of smaller, overlooked
stocks that will surely benefit from this growing market.
The Big Trend
The future looks bright for security companies. Unless you forecast an
end of terrorism and believe world peace is near, there is a strong,
bullish case for this sector. For starters, government homeland defense
spending is skyrocketing. The U.S. alone spent $56 billion in 2003 on
homeland security, so there is a lot of money out there for firms that
develop or enhance life-saving security systems. The forecasted trend
sees annual growth of almost +4% compared to virtually no growth prior
to the September 11th terrorist attacks. As the threat of terrorism
appears more likely, the world is undoubtedly going to spend more on
security products and services.
Strong future demand is also going to be fueled by
much more than just government agencies. A recent PricewaterhouseCoopers
survey showed that 42% of businesses now see security spending as a
strategic endeavor. Instead of merely reacting when attacked, companies
want to be proactive in managing their security systems. Security
management today includes computer networks, asset protection and, of
course, personnel safety. Many companies no longer consider these
optional expenses, but instead view them as a cost of doing business,
much like buying insurance. Shareholders expect bosses to take every
reasonable precaution to protect company assets. All of this is driving
security spending higher each and every year.
Worldwide Opportunities
Since no nation is free of safety concerns, worldwide demand for
security is exploding. Although the U.S. spent an enormous amount in
2003, our government accounted for only 10% of the $550 billion spent
worldwide on homeland defense. Every airport, computer network,
government office and other "high-value" target needs
protection. And given that technology is changing at such a rapid clip,
systems that were considered sufficient just a few years ago may now be
deemed inadequate for new threats. Firms that can assist companies and
governments in upgrading their outdated systems are tapping into a very
lucrative market. New technology is constantly being developed that can
improve the welfare of the people it protects. Governments have
exhibited an almost insatiable appetite for better security,
surveillance and defense systems. Though government spending accounts
for the bulk of security spending, the most rapid growth is occurring in
the private sector.
Expected Performance
Security stocks do not necessarily follow the market as a whole. Demand
for security is not subject to the same budgetary constraints as many
other goods. Since most demand comes from government agencies, it is
much less sensitive to cyclical downturns. Because of this, security
stocks should be seen as a way to hedge against a terrorism-related
market downturn. If more attacks were to occur either overseas or in the
U.S., then the stock market in general would surely be discounted to
reflect the increased risk level. Security stocks, however, would most
likely rise in such a scenario since there would be an upward shift in
the demand for these products. Because of this characteristic, we
believe that security stocks should represent at least a small
percentage of most portfolios.
Security Companies
Top Near-Term Industry Pick: EFJ Inc. (EFJI, $5.16)
EFJ is a small, relatively unknown communications company. More
importantly for investors, it is also a leader in a rapidly growing
wireless communications segment that caters to government agencies. EFJ
is a holding company with an interest in two firms -- EF Johnson (87% of
sales) and Transcrypt (13% of sales). EF Johnson has been in business
for 80 years as a supplier of radio communications devices to local
authorities. The firm's products meet Project 25 (P25) standards that
are used by most government agencies. In the past, fire, rescue, police,
and other agencies have often had difficulty communicating with one
another during times of crisis since they all operated on different
frequencies. P25 addresses the problem of interoperability by more
efficiently using the available spectrum. This unique system can
transmit either clear or encrypted signals, as well as carry voice, data
or both. This has become the industry standard for almost all government
agencies, and EFJ has a growing presence in this market.
High-Growth Segment
Most government agencies have been mandated to upgrade their analog
communication systems to digital. The Department of Homeland Security
believes it critical that all first responders have excellent
communications networks, since these may be the only means of
communicating in an emergency. Network upgrades from analog to digital
have led to a -6% annual decline in the analog market. The digital side,
however, has been increasing at a blazing +50% annual rate. Although
analog was its core business in the past, EFJ is seeing significant
growth from the new digital transition. EFJ only faces two main
competitors in this arena -- Motorola (MOT, $18.15) and Tyco/MA-Com
(TYC, $28.69). EFJ has aimed to secure an advantage over these firms by
supporting both analog and digital systems simultaneously. This leads to
a reduction in the initial cost of the upgrade to customers.
Netelligent Product Line
In its 2004 annual budget, the U.S. government allocated $3.5 billion to
upgrade and maintain its first responder systems. With that tremendous
opportunity in mind, EFJ sees the backbone of its future growth in its
new Netelligent line. This is a secure, encrypted wireless
communications system that uses digital signals and voice-over-internet
protocol (VoIP) technology. Thanks to the fact that it is "switchless,"
the system is extremely reliable. And because it uses VoIP to break data
into packets of information, signals can efficiently be routed to the
best department. The bottom line is that the firm's Netelligent
system is widely regarded as the best on the market. And when it comes
to security and mission-critical applications, we believe the superior
system will eventually dominate the market. As governments around the
world upgrade or introduce first response communications systems, EFJ
will be a primary beneficiary.
Financial Condition
EFJ has weathered a tough turnaround from a near-bankrupt radio handset
producer into a profitable communications firm. From nearly $30 per
share during 1998, the stock fell to a mere $0.22 in late 2000. New
management has reduced product lines and streamlined costs throughout
the firm. After the September 11th attacks, EFJ found itself in a strong
position to supply the government with much-needed equipment and the
company is now in solid financial health.
EFJ's stock has risen 20-fold from the bottom, yet the
firm still carries a market capitalization of just $90 million. As of
the company's latest conference call (January 2004) the firm had access
to $14.3 million in cash ($0.84/share). Revenues rose +38% last year to
$56.2 million. The company holds virtually zero long-term debt, and with
$45 million in short-term assets it should have no trouble managing its
$20.8 million of short-term liabilities. Management is calling for +25%
sales growth in 2004, which would put company revenues at around $70
million. What's more, top executives have noted that these numbers are
fairly conservative. Here are three reasons why we feel EFJ might
provide potential upside earnings surprises throughout 2004:
- Non-Federal Government Purchases -- EFJ
currently derives the bulk of its business from federal government
agencies. However, smaller, local agencies are beginning to see the
need to upgrade their communication systems as well. In 2005, the
federal government will provide $500 million in funding to assist
more than a dozen states in upgrading their systems. Additional
opportunities also exist overseas. For example, EFJ recently
announced a contract with the Iraqi army, and we expect to see
further international expansion in the years ahead.
- Larger Contracts -- EFJ is now able to offer
government agencies a complete package of communications
infrastructure. In the past, the company was only able to bid for
pieces of larger contracts. EFJ is now in a position to make larger,
more profitable proposals.
- Netelligent Application -- EFJ has
submitted its Netelligent system to the Telecommunication Industry
Association (TIA) for consideration as an open industry standard. If
this system is accepted as an industry standard, then we expect
sales to soar.
EFJ Incorporated (EFJI, $5.16)
Market Capitalization: $90.7 million
Shares Outstanding: 16.9 million
30-Day Average Volume: 175,000 shares
2003 Revenue: $56.2 million
2001 EPS: $0.03
2002 EPS: $0.08
2003 EPS: $0.22
2004 EPS: $0.25 (estimate)
2005 EPS: $0.40 (estimate)
Five-year expected growth rate: +25%
Institutions own 4% of the firm's outstanding shares
52-week range: $1.06 to $7.31
----------------------------------------------
NAPCO Security Systems (NSSC, $20.88)
NAPCO is one of the world's most diversified manufacturers of security
products. The company's line includes: burglar and fire alarms, access
systems, electronic locks and panic exit hardware. NAPCO is renowned for
its innovative security technologies and reliability when it comes to
both commercial and residential applications. Recently, the firm added
alarms with wireless technology that will function regardless of whether
or not the phone system is operating properly.
NAPCO Security Systems (NSSC, $20.88)
Market Capitalization: $72.1 million
Shares Outstanding: 3.2 million
30-Day Average Volume: 110,000 shares
2003 Revenue: $57.3 million
2001 EPS: $0.07
2002 EPS: $0.47
2003 EPS: $0.30
2004 EPS: N/A
Five-year expected growth rate: N/A
Institutions own 17% of the firm's outstanding shares
52-week range: $6.60 to $22.19
----------------------------------------------
IPIX Corp. (IPIX, $15.50)
Commonly known as a provider of virtual tours of homes for sale on real
estate websites, IPIX is also a world leader in critical imaging
processes. The company recently announced that it had developed a 360°
security camera suitable for government and commercial use. IPIX
believes that a large percentage of banks and ATMs in the southwest will
soon begin to install this technology.
IPIX Corp. (IPIX, $15.50)
Market Capitalization: $134.7 million
Shares Outstanding: 8.7 million
30-Day Average Volume: 3.7 million shares
2003 revenue: $28.8 million
2002 EPS: -$0.43
2003 EPS: -$0.05
2004 EPS: N/A
Five-year expected growth rate: N/A
Institutions own 9% of the firm's outstanding shares
52-week range: $1.14 to $16.55
----------------------------------------------
Arotech Corp. (ARTX, $2.97)
Arotech's product line consists of three divisions: battery and power
systems, training and simulation, and vehicle armor. The firm's battery
and armor division recently won several large government contracts. In
addition, some of the company's batteries are used in highly popular
Taser products. The firm tripled revenues in 2003, albeit from a small
base, to $17 million. Even more encouraging is the fact that Arotech now
boasts a $23 million order backlog.
Arotech Corporation (ARTX, $2.97)
Market Capitalization: $127 million
Shares Outstanding: 62.3 million
30-Day Average Volume: 3.0 million shares
2003 revenue: $17.3 million
2001 EPS: -$0.76
2002 EPS: -$0.57
2003 EPS: -$0.23
2004 EPS: N/A
Five-year expected growth rate: N/A
Institutions own 12% of the firm's outstanding shares
52-week range: $0.52 to $3.39
----------------------------------------------
Magal Security Systems (MAGS, $37.96)
Magal is an Israeli security firm that markets advanced security
systems. It specializes in systems that automatically detect and
identify unauthorized intrusions. Its products are used in over 70
countries to protect high-value locations such as hospitals, airports
and national borders. Magal is expecting success with the launch of its
newest offering, "DreamBox," which is an all-in-one CCTV unit.
Magal Security Systems (MAGS, $37.96)
Market Capitalization: $299.7 million
Shares Outstanding: 7.9 million
30-day average volume: 800,000 shares
2003 revenue: $43.0 million
2001 EPS: $0.37
2002 EPS: $0.41
2003 EPS: $0.24
2004 EPS: N/A
Five-year expected growth rate: N/A
Institutions own 10% of the firm's outstanding shares
52-week range: $4.60 to $40.35
|
Please Note: The above article was merely a
small excerpt from an issue of our premium, long-term-oriented investing
newsletter -- the Market Advisor. To receive your copy of
our most recent Market Advisor newsletter, as well as other
guidance similar to this every other week, you'll need to subscribe to this
publication. To learn more, please visit the following link: https://www.StreetAuthority.com/subscribe-ma.asp |
Special
Deal for Our Web Site Visitors
