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Finally, a Premium for Security Stocks?

Televised images of blown-out buildings in Riyadh, Saudi Arabia, on May 12 underscored the frightening reality that the war on deadly terrorism and the resultant security concerns are far from over. On Wall Street, however, even this grim situation can create a positive opportunity: The latest attack also underscores how companies in the security sector might be good stocks to own right now.

Take CompuDyne (CDCY). This maker of blast-proof windows and doors, and security systems used to protect embassies and sensitive buildings around the world has seen its stock fall 44% in the past year as investors grew tired of waiting for the long-awaited homeland-security dividend.

Their wait may be over. With real money finally flowing through the federal pipeline to initiatives in border and aviation security, the much talked-about Washington injection seems close at hand. Corporations holding back on big decisions also now appear ready to ratchet homeland-security investments above previous, albeit low, levels.

Some investors have already jumped back in. CompuDyne shares rose by 5% in the early part of May and 14% in the first quarter. On May 5, the Hanover (Md.) company posted sales of $46.8 million for the quarter ending Mar. 31, an increase of 53.4% over the $30.5 million from the same period in 2002. Yes, $10.4 million of the gain came from completing an acquisition. But even subtracting that, CompuDyne pulled a healthy 19% sales increase.

"IN THE FOREFRONT." Earnings per share rose only by 1 cent over last the same period last year, to 12 cents, but that's partly because CompuDyne paid to close out some unprofitable contracts, a step that should boost earnings in the future. And it managed to decrease debt by 26.9% during the quarter, from $27.4 million to $20.1 million. "They're one of the companies in the forefront of the homeland-security push," says Jack Mallon, managing partner at Mallon Capital and editor of the newsletter Mallon's Security Investing.

Compudyne and other security-focused companies may enjoy even better days ahead. The new Homeland Security Dept.'s budget will hit $38 billion in fiscal 2004, and many other government agencies are likewise upping their spending on security. In the private sector, sluggish corporate profits will certainly keep a lid on purchases of new security equipment, services, and software. Nevertheless, security companies have fared better than most in this conspicuously slack environment. And with several newer technology sectors appearing to be ready to deliver in the coming year, investors should be able to find several homeland-security plays.

The Riyadh attack was a reminder that when things blow up, it can mean an increase in business for companies making explosives-detection equipment. So, InVision (INVN) and L-3 Communications (LLL) might expect new orders for the devices they make that have already become standard in U.S. airports. Both companies posted significant share-price run-ups over the past month after Homeland Security revealed its budget and the White House tacked on supplemental spending. L-3 shares have risen 24.5% in the past four weeks, and InVision's are 12.3% higher.

NETWORKS OF SENSORS. Bearish analysts already worry that both stocks have seen their best days as airports nationwide scrambled to meet the Federal Aviation Administration's late 2002 deadline that every bag be checked for explosives. But Mallon thinks these companies still have upside. "That's an area where we see continued growth taking place," he says.

Another area he's bullish on is corporate security integration. Once the province of guys with guns and banks of video cameras, corporate security increasingly means creating networks of sensors. These systems make it possible to track everything from temperature to video images to biometric entry badges and provide a unified view of security at one location or multiple sites.

Mallon believes this market will see 10% annual growth over the next few years. That's not gangbusters, but it's not so bad either, compared to typical low-single-digit corporate growth rates lately. Bigger players in the security-integration field include: Tyco (TYCO), Diebold (DBD), Honeywell (HON), and Ingersoll-Rand (IR). Security remains a small portion of their business, so they're not pure plays. But their offerings in this area could help these companies outperform rivals that aren't in the market at all.

BOUNCING BACK. And don't forget biometrics. That field -- the science of digitizing unique physical characteristics -- is set to boom, and an industry consolidation in 2002 has left just a handful of stronger players. Biometric equipment can match the thumbprint of a bank customer seeking a big withdrawal to a thumbprint taken when the customer first opened an account. These volatile stocks could be poised for another run-up if data start to bear out the promise of the technology.

One of the largest biometrics companies is Identix (IDNX) in Minnetonka, Minn. It sells facial- and fingerprint-recognition and biometric-management software. Identix stumbled badly when its revenues fell from $81.8 million in 2001 to $73.2 million in 2002. It's back on track in 2003 with annual revenues projected at $87.1 million. Identix is still losing money as it tries to build its customer base. But analysts expect that loss to shrink from 28 cents per share in 2003 to 20 cents in 2004.

Long a controversial area, biometrics has picked up steam as more federal agencies have started to using the technology to automate ID processes in secure buildings or at border crossings. Biometrics in general got a big lift when the respected National Institute of Standards & Technology (NIST) posted test results validating the comparative accuracy of many biometric products. Accuracy or lack thereof had been a major beef against biometrics and a key sticking point with civil libertarians.

UNFORTUNATE REMINDER. A likely outcome for Identix could be a takeover or buyout, in which shareholders would probably get some sort of premium. Its stock has risen 20.5% in the last four weeks, but at $5.30 it remains well off the 52-week high of $8.90. Identix is definitely a risky play, as biometric adoption remains in its early stages, and growth is particularly hard to predict. That's why the six analysts covering have collectively given Identix a 2.5 rating, about halfway up the 1-to-5 scale at Thomson Financial First Call.

The latest attack in Saudi Arabia is an unfortunate reminder for everyone, including investors, that homeland security remains an ongoing concern. There are no guarantees in security -- or investing -- but a number of companies are positioned to take advantage of the still-growing demand for products and services aimed at keeping innocent civilians safe. By Alex Salkever, Technology editor for BusinessWeek Online

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