A Top Scout's Net-Safety Plays

Sean Jackson of SunTrust has high hopes for Rainbow Technologies' new encryption-acceleration card and SafeNet's VPN chips

Sean Jackson knows Net security. An analyst at Nashville investment bank SunTrust Equitable Securities, Jackson racked up an impressive track record in 2000 on software and service companies that cater to Internet-security concerns.

His stock picks, including such winners as security-services outfit Internet Security Systems ISSX and firewall maestros Check Point Systems CHKP , collectively returned 236% last year. That's a far sight better than the double-digit declines that hammered virtually every other part of the technology sector. And Jackson thinks that run will continue, as increased demand for security services and products drives growth at Net-security companies despite a market gone suddenly bearish. So BW Online asked Jackson for his top security-stock picks for 2001. Here are two of them:

Rainbow Technologies RNBO Based in Irvine , Calif., this small company builds a variety of security applications. They range from software that enables secure data transmissions for U.S. satellites to antipiracy devices that prevent the theft of intellectual property from computers. But Jackson likes Rainbow mainly for the company's encryption-acceleration card. When inserted into the big servers that run Internet operations for many companies, this card dramatically speeds up the complex numerical processes that govern the encryption of sensitive data. The upshot? Big savings for companies that otherwise might have to buy a whole other server to accommodate encrypted data coming in for secure transactions such as stock trades or orders for merchandise over B2B networks. Encryption-acceleration cards could also provide a big speed boost to e-tailers, which often lose customers because of slower response times on transactions. "Instead of buying another $50,000 server, they can buy a $4,000 encryption-acceleration card and place it in their servers," explains Jackson.

The encryption cards only represent 30% of Rainbow's revenues. But Jackson expects the still nascent market for the cards to grow 80% to 100% per year in the near future, with operating margins on the cards rising from 11% to more than 20%. At present, the company has only one competitor in the market, British-based nCipher. And it already has big customers, including online brokerage E*Trade and Net powerhouses America Online and Yahoo! A Dec. 11 deal with Sun Microsystems to include the cards in the server giant's powerful computers should fuel already sizzling sales. Rainbow posted $121 million in gross sales in 1999, but has already logged $119 million in gross sales this year. Still, Jackson cautions that "Rainbow continually has to update their acceleration to make it faster." With the stock at 9.88 per share as of the close of trading on Jan. 9, Jackson figures Rainbow is valued at only 17 times its earnings for the upcoming year -- a tempting figure for the security sector, where price-to-earnings multiples are usually twice or triple that number.

SafeNet SFNT Founded by former National Security Agency computer experts, Baltimore-based SafeNet has kept a low profile by selling its virtual private network (VPN) chips and software to big router makers such as Cisco Systems and Nortel Networks and staying out of the retail and consumer markets. These VPN chips and software allow corporate computer networks to send and receive encrypted data communications from employees or partners logging on over the public Internet or from their home connections. In effect, VPN creates an "encrypted tunnel" that is relatively impenetrable to hackers or other data eavesdroppers. SafeNet also offers managed VPN services for companies that don't have the manpower or inclination to keep these sometimes finicky systems up and running.

So why the strong buy from Jackson? Over the past 18 months, SafeNet has stealthily locked up more than 50% of the hardware market with the big router companies. So the routers and other networking devices with SafeNet VPNs inside are only now rolling out. As the likes of Cisco, Nortel, and Lucent unleash VPN marketing drives, SafeNet should see a steadily increasing stream of revenues. "I like them because they signed all these OEM [original equipment manufacturer] agreements in 1999. It has taken their partners this long to put out end products. A lot of the costs are already done, and now they are waiting for the revenue to kick in," says Jackson.

According to Jackson, Cisco estimates that in the first year of sales, 10% to 15% of customers will opt for a VPN service in their routers. In the second year of sales, that percentage should climb to 20% to 25%. With a market capitalization of only $330 million, SafeNet is still a definite small cap and subject to all the volatility of lightly traded issues. And shares, which closed on Jan. 9 at 34, hold a lofty price-to-earnings ratio of 106.

But SafeNet's total revenues have doubled over the past five quarters, growing from $3.8 million in the third quarter of 1999 to $7.6 million in the third quarter of 2000. As OEM agreements are often nifty gravy trains, SafeNet has a lucrative software profit model with nearly zero cost for each additional unit of production. That's why the company should see revenue increases "probably 50% to 60% each year for the foreseeable future," says Jackson. And that explains his strong buy position on the stock. If last year is any indication, Jackson could be ahead of the pack yet again.

By Alex Salkever in New York

    Before it's here, it's on the Bloomberg Terminal.