Three Ways to Profit from Increased Homeland Security Spending

	Paul Tracy Street Authority.com
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In the wake of the September 11th terror attacks, homeland security and defense became a top priority for the federal government. And given that the threat of another major terror attack in the United States remains as real as ever, it's almost a certainty that government security spending will continue to grow for at least the next three to five years.

Below you will find a chart of federal outlays on homeland security since 1985. The chart uses actual spending data provided by the Homeland Security Department since 2001. Prior to that year, our chart depicts an estimate based on security-related spending by the Department of Defense and other arms of the federal government. As you can clearly see, spending rapidly accelerated from $13 billion in 2000 to over $32 billion in 2003.

And while the administration plans to cut the government's large budget deficit over the next few years, it's highly unlikely that any spending cuts will come from homeland security. According to figures provided by the Office of Management and Budget (OMB), the government plans to cut growth in discretionary spending in a number of key areas. The OMB estimates that in 2005 discretionary spending will grow at only +1% for non-defense and non-security budget items. However, the OMB expects +10% growth in outlays for the Homeland Security Department alongside a +7% jump for the Department of Defense.

Some private estimates peg spending growth at much higher levels. For example, brokerage firm Morgan Keegan recently estimated across-the-board growth in federal security outlays of about +16% annualized between 2004 and 2007.

What's more, spending growth is likely to exceed even that lofty figure for certain items. Consider, for example, the market for identification and tracking systems. This market includes fingerprint identification systems that are being installed at all major U.S. airports to offer another layer of identification for travelers. Also important are facial recognition systems that can scan a crowd of travelers to look for known terrorists -- these systems are now being installed at airports, train stations and government installations. Morgan Keegan projects annualized growth of over +30% annually for the identification between now and 2007 -- from about $4.8 billion today to over $10.7 billion in three years.

Even better, government spending should remain solid even if the economy turns sour. The reason is simple: polls show that Americans remain very concerned about terrorism. In addition, another attack could devastate key industries like tourism and travel. As a result, the federal government simply can't afford to cut spending on homeland security and defense.

Clearly, all that spending and the prospect for future growth has been a boon for companies that sell safety and security equipment. While there's no index that tracks these companies directly, my staff and I formed an index using 15 companies in several different sub-sectors of the security market. We also examined the S&P Supercomposite Aerospace and Defense Index and the S&P 600 Small-cap Aerospace and Defense Index. Both defense indices include several companies that stand to benefit from increased security spending. As you can see from our chart, all three of these indices showed strong growth last year and all three handily outperformed the S&P 500.

Below my staff and I will review three companies that we believe are likely to benefit from booming homeland security and defense spending in the years ahead.

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LASERCARD (LCRD, $10.49)

Business Overview

LaserCard supplies advanced identification cards to both the U.S. and foreign governments. These cards contain optical data storage chips and are able to store biometric identification information such as fingerprints and facial features. In fact, the company's chips can carry over 4 megabytes of digital data on a chip that can easily fit on a credit card sized identification card.

Outside of traditional ID cards, LaserCard's products can also be used to carry medical records, additional digital information on cargo manifests, or even supplemental information on bankcards for extra security.

LaserCard's technology is already in use on U.S.-issued green cards, on Canadian permanent resident permits and on national ID cards in both Italy and Saudi Arabia. In total, LCRD already sells its products in the U.S. and throughout 16 foreign countries.

Competitive Advantages

Although plenty of other companies make cards with magnetic stripes or imbedded chips, LCRD has virtually no competition in the optical card market. What's more, the company's core optical data storage card is patented. And even though the firm has licensed its technology to two other companies, neither is currently producing such cards. Thanks to its key patent wins, no new competitors are allowed to enter the market with a product designed around LaserCard's same technology.

My staff and I believe that this optical storage technology is superior to many of the other types of data storage cards currently available on the market. In addition, many big-name customers (such as the U.S. government) have agreed with that assessment and have signed deals with LaserCard in recent years, allowing the firm to gain an important first-mover advantage in this market. As such, we expect LaserCard to continue to win an outsized share of new contracts for national ID cards around the world.

LaserCard's key advantage is that its cards are capable of holding a great deal (over 4 megabytes) of data -- far more than traditional magnetic stripe ID cards. That allows governments to store more information about the bearer on these cards, including more biometric information and an audit trail -- a detailed record of where the card has been scanned in the past. Perhaps even more importantly, the company is able to put several layers of computer security on its cards. These security measures make it very difficult to counterfeit the cards and to illegally read data. Clearly, security and data integrity are of utmost importance when it comes to government-issued ID cards.

As we noted earlier, LaserCard has already started to win some very important contracts both in the U.S. and abroad. Other governments considering the issuance of a national I.D. card are also contemplating the use of LCRD's products. The firm's installed base of LCRD systems also represents another key competitive advantage. Specifically, the costs associated with recalling all existing cards and installing new card reading systems based on a competing technology would likely be high. That makes it less likely that LCRD's existing customers would desert the company for a competitor.

Growth Drivers

The most obvious growth driver for LCRD is increased spending on security in the U.S. and abroad. Higher spending will likely open new markets for LaserCard's products. That might include wider applications of data chips on cargo manifests or imbedded in certain import and export forms. That demand will also likely come from sources outside the U.S. government -- companies like banks, insurance firms and government contractors also have reasons to issue high-security data cards.

But my staff and I believe the company's most interesting source of future growth is overseas. Specifically, a variety of governments around the world already issue national identification cards, and many other nations are now considering such cards in light of new highly publicized security threats.

As we mentioned above, some foreign nations such as Italy and Saudi Arabia have already widely employed LCRD's systems on ID cards. But there is still plenty of room for growth here. Every time a foreign government decides to upgrade their ID card programs to enhance security, LCRD gains a new potential market. And with little real competition in its core optical card business, it's likely LCRD will win more than its fair share of any new contracts.

Valuation and Outlook

LCRD is projected to see long-term growth of over +25% per year. While the company will likely lose money in this fiscal year (ended March 2005), analysts expect the firm to reach profitability in 2006. Within the next few years the company should be earning upwards of $0.50 per share. Applying a multiple of 30 times those earnings, a slight premium to the firm's long-term growth rate, we could easily see the stock trading upwards of $15 per share, about 50% higher than current levels.

And there's upside to these estimates. For example, LCRD is likely to announce several important contract wins this year. That will likely include an expansion and renewal of existing contracts with the U.S. government, as well as new contracts with foreign governments. As the company is actively seeking to break into key new markets such as financial services, we would not at all be surprised to see some contract wins in this area as well. With these factors in mind, the stock could easily jump back to $15 by the end of 2005.

ARMOR HOLDINGS (AH, $45.45)

Business Overview

Armor Holdings makes physical security equipment, including ceramic body armor and vehicle armor. In addition, the company makes special crash-resistant seats for helicopters and airbags used in helicopter cockpits.

AH has a long history of supplying products to both the U.S. and foreign governments. The company's body armor consists of lightweight vests and other protective equipment used to protect troops from enemy small-arms fire. These vests are currently being supplied to U.S. troops in Iraq and Afghanistan as well as several other important areas.

Vehicle armor has both civilian and military uses. The military uses such armor to protect personnel carriers and HUM-V's. On the civilian side, AH's armor can be used to protect limousines or automobiles carrying celebrities or other high-profile individuals.

Competitive Advantages

AH faces competition in its core body armor market from the likes of Ceradyne (CRDN) and DHB Industries (DHB), among other smaller manufacturers. However, this market is by no means a competitive one at the current time, as all three major suppliers of body armor have been having trouble keeping up with demand.

Specifically, there seems to be no spare capacity in the production of body armor. Both AH and its competitors have reported a rising backlog of orders despite the fact that new production capacity has been coming on line in recent years. AH's own order backlog already extends well into the company's 2006 fiscal year. And my staff and I see little reduction in demand on the horizon, as body armor remains critical to protecting ground troops stationed in dangerous areas. As such, we believe there's plenty of room for several competitors in this market.

The vehicle armor market is more competitively friendly to Armor Holdings. While Ceradyne competes here, AH is by far the larger player in this market, and this size can prove to be a big advantage. Given that AH has already installed vehicle armor on many military vehicles, it often gets follow-on contracts to update and improve its existing installed technology. What's more, customer relationships are extremely important in the defense business relationships, and AH has a long history of acting as a primary supplier of vehicle body armor to the Department of Defense. That alone will make it difficult for other companies to break into this market and garner key new contracts.

Finally, AH recently announced that it could expand production of armored vehicles if the government needs them. This too is a competitive advantage. The company may well be the only contractor with spare capacity to ramp up production of such vehicles, and that should help it garner the lion's share of new contracts awarded by the military.

Growth Drivers

The growth drivers for AH are numerous. The military needs body armor to protect ground troops and has been awarding multiple contracts to AH and its major competitors over the past few quarters. What's more, vehicle armor was suddenly thrown into the spotlight in late 2004 when Defense Secretary Donald Rumsfeld was asked why all military vehicles weren't armored. In response to public outcry, we believe the U.S. government will try to armor most, if not all, of its vehicles over the next few years. That spells tremendous opportunity for Armor Holdings.

Foreign governments are also another source of future demand. Consider that American troops aren't the only ones stationed in Iraq and Afghanistan -- Britain, Poland and Japan, among others, have troops there. What's more, there are plenty of dangerous places in the world where foreign troops are stationed for long periods of time. Although the U.S. Army has been the company's largest customer to date, there's plenty of room for accelerated demand from overseas.

Finally, Armor Holdings is also likely to fuel further growth through acquisitions. The company has acquired several companies over the past year, beefing up its product line in the process. With over $230 million in cash on the balance sheet, AH has plenty of room for further acquisition activity.

Valuation and Outlook

AH trades at about 16 times forward earnings and has a long-term projected growth rate of about +14%. That gives the company a P/E-to-growth ratio (PEG) of about 1.2. That seems reasonable for this quality company, particularly given its stable revenue stream from government contracts. Armor Holdings' company earnings should top $4.50 per share in five year's time. Applying a multiple of 15, which is fairly standard for this industry, AH could easily reach $70 in the coming years.

My staff and I expect AH to continue its pace of new contract wins over the next year. This will include contracts to upgrade existing equipment as well as orders for additional bulletproof vests and armored vehicles. The firm's order backlog already extends into 2006, so Armor Holdings' strong earnings growth should be quite stable until at least 2007.

We also believe that AH is in the market for more small acquisitions. This is also a potential earnings driver. To date most of the company's acquisitions have been accretive within the first year of purchase, so AH is showing good managerial discipline. With all of these positive factors in mind, Armor Holdings should be a steady performer throughout 2005 and beyond.

AMERICAN SCIENCE AND ENGINEERING (ASEI, $35.33)

Business Overview

ASEI makes x-ray and scanning systems that the government uses to screen packages and vehicles crossing U.S. borders, as well as cargo at American ports. The firm offers three basic product lines: CargoSearch, Inspection Systems and ParcelSearch.

The company's CargoSearch systems are installed at borders or ports and are designed to screen air, sea and land cargo. That would include vehicles, pallets, seaport containers and railway cars. Meanwhile, the firm's Inspection Systems can be mounted inside a truck and used while the truck is in motion -- this allows the screening of vehicles without impeding traffic excessively through a border. Finally, ParcelSearch, as the name implies, is used by the Postal Service to scan mail and packages.

Competitive Advantages

The defense and government contracting businesses are all about relationships and proven technology. This is one reason that the government tends to go back to the same contractors repeatedly when awarding new deals. ASEI has certainly proven its ability to garner key contract wins and it's one of only a handful of companies that makes and sells sophisticated X-ray systems to the government.

ASEI is an established player in the screening business, having been involved in this market since the late 1950s. Even better, the company has been quite successful at garnering new contracts in recent months. That includes a recent order worth $25 million for its inspection vans and an additional $13 million contract for service and repair of an existing ASEI system. Even better, not all new contract wins are from the U.S. -- ASEI received an order from an undisclosed Middle East client in early 2005 for one of its high-priced inspection vans.

The firm's rapid-screening technology, which it has dubbed Z-Backscatter, also seems to be a particularly defensible niche. Very few other companies offer anything similar to this type of technology. This is part of the reason why the company has won so many contracts in recent months from both the U.S. and foreign governments.

Growth Drivers

ASEI's numerous growth drivers make it a particularly attractive investment proposition. President Bush recently signed the 2005 Homeland Security Appropriations Act into law. This bill provides for $28 billion in additional, discretionary spending by the Homeland Security Department next year. Given that Bush has proven his commitment to higher spending on homeland security, most analysts agree that the second Bush term will be a boon for companies that sell defense and security equipment to the U.S. government.

Even better, a primary focus of this new homeland security spending bill involves defending the nation’s ports and borders. Both have been identified as key weak points that remain vulnerable to terrorist activity. Meanwhile, it's also important to ensure that security operations don’t unduly slow cross-border commerce. As a result, a good chunk of this new spending will fall on companies like ASEI that sell products tailor-made for border and port protection.

Valuation andOutlook

Thanks to an increased volume of government contracts, ASEI is expected to earn $1.13 per share this fiscal year (ending March 2005). Longer-term, analysts are looking for growth of nearly +30% annualized. Some of that growth is even locked in by long-term government contracts.

Based on projected 2005 earnings (for the fiscal year ending March 2006), the company trades at around 20 times earnings. This is actually a considerable discount to ASEI's long-term growth rate, giving the company a PEG of under 1. Assuming ASEI's increased pace of contract wins continues to catch investors' attention, the company could easily trade at a more industry-average PEG of 1.1 to 1.2. And assuming ASEI's earnings continue to grow at a nearly +30% annual clip, the stock could easily reach $100 within the next few years.

Because the company's technology is unique, its products are a key component of maintaining border security around the world. Going forward, ASEI is should see a dramatic increase in contract wins from overseas clients in 2005. Demand from the U.S. government should also remain strong. In fact, according to Morgan Keegan, the detection and screening market is likely to be one of the fastest-growing sub-sectors of the security market in the years ahead. Estimates peg the industry's current size at $8.5 billion -- a figure that's expected to nearly double to $15.3 billion by 2007. Thanks to its proven technology and existing relationships, ASEI is poised to benefit from this strong industry growth more than most.

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We sincerely hope you've enjoyed today's look at three high-quality companies that are poised to benefit from increased government spending on defense and homeland security. Good investing in the week ahead!

Paul Tracy will be available to take your questions until Thursday, January 20. Please use the form below to submit your questions.