Two Ways to Play the Growth in Radio Frequency Identification (RFID)

	Paul Tracy Street Authority.com
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In the Smithsonian Museum of American History in Washington, D.C. there's an exhibit that features a pack of Wrigley's Chewing Gum. The significance: That very pack of gum was the first product ever scanned by a barcode reading system. The gum was scanned successfully back in June of 1974 at a supermarket in Ohio.

Nowadays, of course, barcode readers are ubiquitous. Estimates suggest that approximately 10 billion barcode tags are read each day around the world. That's nearly 3.7 trillion tags every year.

Barcodes are so common, in fact, that many consumers fail to recognize the tremendous significance of these simple machine-readable codes. But just imagine how much longer it would take to check out at the supermarket if each and every item had to be keyed in and the prices totaled by hand. More importantly, imagine how much more difficult it would be for retailers to keep track of inventory in their warehouses.

But as important and familiar as the barcode is, most consumers have more than a passing knowledge of the drawbacks of this technology. For example, items must be carefully scanned one-by-one by hand -- a time-consuming and labor-intensive process. And barcodes do little to prevent what retailers euphemistically refer to as "shrinkage."

Shrinkage refers to the loss of inventory and is mainly caused by theft by customers and employees alike. Unfortunately, barcodes are simply printed labels and there's no way for these labels to alert shopkeepers when an item is being illegally removed from a store.

And if you think that's a minor problem, think again. According to the Center for Retail Research, shrinkage cost U.S. retailers about $30 billion in 2002 and in Western Europe the total was closer to $50 billion. A quick glance at our chart of shrinkage rates -- the percentage of sales lost to shrinkage -- for a variety of retail groups illustrates the full scope of this problem.

Enter, RFID

Thanks to modern technology, retailers now have a solution to all of these problems. Best of all, that solution offers myriad new benefits for retailers and consumers alike. Imagine, for example, being able to scan a whole shopping cart full of groceries at once by simply walking under a scanner. Or, imagine the efficiency gains for retailers if items could provide electronic alerts when they're removed from the store.

That technology is called radio frequency identification (RFID) and it's already in use at retailers around the country. As my staff and I pointed out above, the barcode is quite literally a museum piece; RFID tags will soon become the dominant technology.

RFID tags consist of a small chip that holds data, as well as a coiled antenna that transmits that data over short distances using radio waves. RFID tags can be coded with a great deal more information than barcodes. For example, these tags can store and transmit data such as: when the item was manufactured, expiration dates for perishable items, and even a record of the temperature at which an item is shipped.

Of course, the tag is only one piece of the puzzle -- RFID transmissions have to be read and interpreted in order to be of use to retailers. RFID readers can be simple handheld devices that detect and read RF transmissions from up to a few yards away. In addition, RFID readers can be mounted to collect data as customers walk to checkout. Stores also have readers near the shelves and in their warehouses to keep track of unsold inventory.

For RFID to be of use, retailers must use software to collect, analyze and interpret this data. For example, retailers need software to analyze consumer purchases and automatically send orders for popular items to suppliers. Equally important, they also need to be able to detect items that aren't selling well. In this way, retailers can prevent overstocking and can remove expired perishable items from the shelves. In short: RFID tags help retailers to mange their inventory more effectively.

And given that inventory mismanagement is one of the largest costs for retailers, this is a major advantage. In fact, market research and consulting firm Accenture (ACN) estimates that retail and manufacturing inventories could be reduced by anywhere from 10% to 30% after RFID deployment. By lowering their inventory levels, retailers will be able to free up large amounts of cash, helping to enhance profitability.

Moving Forward

Although you may not know it, you have probably already used some form of RFID technology. For example, CVS drugstores already place RFID tags on many of their products to track inventories and detect theft. In addition, for well more than a decade, apparel retailers have used a form of RFID technology to prevent customers from removing items from stores -- RF technology is behind those alarms that sound near the entrances of most department stores.

And outside the retail space, RF technology is already being used in E-Z Pass toll collection tags. What's more, RF tags are also used to speed progress across international borders.

Going forward, we see several major catalysts for rapid RFID deployment over the next few years. For starters, the world's largest retailer, Wal-Mart (WMT), has now mandated that all of its suppliers support this technology by the end of 2005. Given that many companies simply can't afford not to sell to Wal-Mart, the entire retail industry tends to change when Wal-Mart makes a strategic move. You can bet that all sorts of retailers, ranging from supermarkets and drugstores to expensive clothing stores, will soon follow Wal-Mart's lead.

Wal-Mart's top 100 suppliers have already installed this technology. Those suppliers alone account for the production of nearly 8 billion RFID tags annually. Meanwhile, many other Wal-Mart suppliers are expected to adopt RFID later this year.

On the consumer front, Wal-Mart is already rolling out RFID technologies in a few test stores nationwide. By the end of 2005 the company hopes to enable 600 stores nationwide with RFID equipment. It's only a matter of time before RFID comes to a store near you.

And, the U.S. Department of Defense (DoD) is also adopting the same RFID technology. The DoD has a total of nearly 50,000 suppliers, and all of these companies will be required to adopt the new technology over the next few years.

Finally, a uniform standard for RFID is finally taking shape. The importance of an effective, widely adopted standard can't be overstressed. Without a standard, different manufacturers make products that are incapable of communicating or reading competing RFID tags. Thankfully, an industry consortium, EPC Global, has now produced a workable standard called the Electronic Product Code (EPC) that's being widely adopted.

Technology research firm IDT estimated that RFID spending hit $91.5 million in 2003. Preliminary estimates for 2004 put the total spending at around $200 to $300 million. And by 2008, IDT estimates companies will spend a whopping $1.3 billion on the technology.

Although that kind of growth can power some impressive returns for investors, it's not without risk. The RFID market is chock full of many small companies that might never manage to grab real market share. What's more, competition is fierce in almost all RFID markets.

With that in mind, my staff and I recently combed the RFID space in search of companies with an established market presence and solid contracts with major companies. We also looked for firms that boast a sustainable competitive advantage in the emerging RFID space.

The table below shows some of the largest companies leveraged to the RFID revolution, as well as some basic fundamental data on each stock. In the report that follows, my staff and I will examine two of the most promising plays from this industry.

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CHECKPOINT SYSTEMS (CKP, $16.96)

Business Overview

Checkpoint Systems produces inventory management and theft-prevention systems for retailers. The company's electronic article surveillance (EAS) tags are small RFID devices that can fit onto almost any product and activate an alarm if an item is stolen. The company also makes RFID tags used to help identify items and manage inventories.

The firm's other business lines include closed-circuit television systems (CCTV) employed by retailers around the world, as well as traditional barcoding and price labeling products.

Competitive Advantages

CKP's advantage lies in its well-established position in the RF market, as well as the firm's unmatched relationships with many of the nation's major retailers. For example, CKP recently installed EAS systems throughout all 5,300 CVS drugstores in the U.S. using RFID tags. CKP is also the company behind anti-theft tags at Albertson's and Winn-Dixie supermarkets, as well as apparel retailers like Kohl's and Urban Outfitters.

Many of these retailers have also purchased other items from CKP, including CCTV systems and handheld barcode scanners. In addition, the company has provided inventory management systems to an equally impressive list of customers. This established customer base, coupled with Checkpoint's RFID experience, should give the company a leg up in winning new contracts.

Growth Drivers

We see two main growth drivers for CKP in the coming years. The first is the potential for new contract wins from the likes of Wal-Mart for RFID tags and tag-tracking systems. The second is solid growth in anti-theft RF tags, an area in which CKP is already a market leader.

Earlier we outlined the impressive growth that the RFID market is likely to see in the coming years. However, RF tags aimed at anti-theft systems are equally important. The simple fact is that while shrinkage rates are already high for most classes of retailers, they've been drifting even higher in recent years, especially in Europe.

In 2002, the average theft cost U.S. retailers a little over $207, up about +6% from 2001 levels. And according to a survey conducted by the Center for Retail Research, European retailers cited customer theft as their top security problem.

Grocery stores and supermarkets are particularly hard-hit by this problem. The average grocery store sees shrinkage of about 1.5 percent of sales annually. That might not seem like a lot until you consider that profit margins on groceries average only 1 to 2 percent. With this in mind, shrinkage can sometimes mean the difference between turning a profit and losing money. A study by Price Waterhouse showed up to a -70% drop in shrinkage at grocery and drugstores that have already adopted the technology.

Big store chains like CVS and Albertson's are now adopting this RF anti-theft technology, and this should spur growth in this segment in coming years.

Valuation and Outlook

CKP trades at less than 18 times 2005 earnings. Going forward, Wall Street growth estimates for the company vary wildly, and the firm's earnings growth will be clouded over the next year or so by some special charges. Looking ahead to the long term, however, my staff and I believe CKP can deliver double-digit earnings growth, giving the stock a PEG ratio (P/E-to-growth) of around 1.5. That's not terribly expensive for a stock leveraged to a growing industry like RFID.

My staff and I also like the fact that CKP has very little net debt and solid free cash flows. This will enable the company to extend its lead in the RFID market by spending heavily on research and development (R&D).

RETEK (RETK, $5.96)

Business Overview

Retek makes software for the retail industry. The company's products are primarily used to help manage and control inventories and to manage and optimize all aspects of retail business operations. Retek is using RFID technology to take its inventory management software to the next level, allowing retailers to know exactly where their products are at any given time, as well as how quickly those products are selling.

All of the company's software and management products are accessible via the Internet. That makes it possible for managers to stay on top of stores remotely.

The company doesn't focus on any one segment of the retail space. Customers for RETK's existing operations include department stores, e-tailers and grocery and convenience stores.

Competitive Advantages

RETK's main advantage lies in its existing relationships with some of the world's largest retailers. The company's customer base is impressive and includes such market-leading names as Best Buy, Gap, the Home Shopping Network and Great Britain's largest retailer, Tesco.

For the Home Shopping Network, for example, Retek's software tracks demand for products across the company's main selling platforms -- the Internet, television and catalogs -- to ensure that inventories of goods are readily available and can be shipped in a timely manner from HSN's warehouses.

Retek's software is closely integrated to operations at companies like HSN, making it expensive to switch to brand new software and inventory management systems. That should give Retek a leg-up as it adds RFID functionality to its systems. In addition, smaller retailers tend to follow the lead of their larger competitors -- as a supplier to many leading retailers, Retek stands to benefit from this as well.

GrowthDrivers

RETK should benefit from strong growth in the general RFID market in the years ahead. More specifically, the increasing complexity of retail supply chains should be a real boon for RETK.

Consider that just 15 years ago most retailers handled almost all of their sales directly from bricks-and-mortar stores. Apart from printed catalogues that required telephone orders, there were no other sales channels.

All of that has changed in recent years. Even retailers that primarily sell goods via traditional stores often have a significant Internet presence. And that opens up more complicated sales such as those to overseas clients. Basic tasks such as inventory management, billing and shipping have become more complicated due to these new sales channels. That makes managerial software such as that sold by Retek all the more important.

Valuation and Outlook

RETK trades at less than 20 times 2005 estimated earnings. The company's long-term growth rate is estimated at approximately +15%, giving the stock a PEG ratio of about 1.3. That's not expensive for a stock leveraged to a fast-growing trend like RFID.

Turning to the balance sheet, RETK is financially sound with no debt. We also like the fact that company insiders own over 40% of all outstanding shares -- a sure sign they're confident in RETK's future prospects.

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We sincerely hope you've enjoyed today's look at the emerging RFID market. Please stay tuned for our next full issue, which we'll publish on Monday, March 7th. In it, my staff and I will examine some of today's most popular exchange-traded funds (ETFs) and will show you how you can use these unique securities to not only diversify your portfolio, but also boost your returns. Good investing in the week ahead!

Paul Tracy will be available to take your questions until Monday, March 7. Please use the form below to submit your questions.