Security is not a headline issue these days, but large amounts of money are still getting spent on everything from defending computers against viruses and hack attacks to figuring out what is really in the container that just arrived from Nigeria listing “handicrafts” on the bill of lading.
Why is this? People want to feel secure. Whether it is ordering the latest version of the iPod from the Apple website or flying across the country in a jet, people want to know that their credit card information isn’t being spread across the Internet and that there isn’t a chance of a gun or a bomb boarding the plane to California. And our government wants to make sure that our borders are secure and protected against any possible terrorist attacks, as well.
To take advantage of the large amounts of cash that are being spent to keep our nation and our personal information protected, we started investing in companies that were part of the Security MegaShift back in August 2005. In this MegaShift, we’ve had holdings that fought cyber crime, like Symantec (SYMC) and Check Point Software Technologies (CHKP). We exited Symantec and Check Point back in October before the consumer introduction of Windows Vista. That seems to be a good move so far, as the early feedback that I was getting about Vista security being miles ahead of the old Windows 2000/Windows XP level turns out to be true. It used to be a joke to use “Microsoft” and “security” in the same sentence, but now independent computer consultants are telling users to dump their Norton products (made by Symantec) in favor of Windows Live Update.
But the Security MegaShift isn’t limited to just cyber crime. It also covers vehicle tracking, the management of data traffic and smart cards. Plus, there are X-ray inspection systems that search trucks and containers at our borders, air cargo and, of course, the ones we walk through at airports.
One of the interesting areas of security is Biometrics — using technology to scan fingerprints, retinas or the whole body to positively identify someone. I had a lot of questions on biometrics at the Las Vegas Money Show, and I wanted to update you on this area, even though I am not ready to recommend L-1 Identity Solutions (ID), the leading company in this area. The company was formed by the merger of Identix (fingerprints) and Viisage (facial features). It has a $1.5 billion market capitalization, almost 10X sales, and is not making any money, yet the stock is near its 52-week high.
When most people think of biometric identification, using fingerprint readers, retina scanners or full-face video scan and compare, they immediately think of applications like stopping terrorists from getting on planes, or allowing access to top-secret government facilities. But it turns out that the real market is commercial applications to reduce the time required to wait in line while someone checks an ID. In the last year, Pay By Touch supermarket systems that combine a fingerprint scan with a seven-digit phone number have replaced credit and debit cards for three million users in the U.S. In Japan, more than two million people use a palm scanner plus a debit card and PIN to get cash from an ATM. The Dutch bank ABN AMRO uses voice technology to verify a customer’s identity for telephone banking.
You may have seen the built-in finger scanners on many new laptops, especially those shipping with Windows Vista, or on high-end cell phones. You can buy the same technology for your house and garage door locks, or a safe. It even comes in some memory sticks and flash drives, just in case you lose it or a bad guy gets hold of it. If you log on to your company’s computers from home, they may be tracking your typing rhythm to be sure you are you.
The sudden commercial interest in biometrics comes from the two benefits of all advancing technology: It got better and cheaper. Fingerprint and palm scanners used to have problems with farmers and others who worked with their hands, children or other people with small hands, sweaty hands, and so on. And the terminals cost a bundle to build and deploy. Now, with ever-cheaper and more powerful microelectronics to improve functionality and reliability, plus the Internet for virtually no-cost communications, biometrics can grow rapidly.
At the same time, Federal regulations are tightening. Banks are now required to have two-factor identification — something you know plus something you have — to reduce online fraud due to identity theft, since the simple stored account number and password is too easy to hijack. So they are using the password — something you know — plus things like RSA tokens, fingerprints or keystroke dynamics — something you have or are — to identify you. I used an RSA token for years to get on my Bloomberg system, but tokens can be lost or stolen — some people have been known to forget to bring them to the Money Show — and they are expensive. Bloomberg moved to fingerprint ID a couple of years ago.
At this point, the big drivers for biometrics adoption include: 1) Retail, which accepts a lower level of security in favor of convenience, and 2) Banking, which accepts a lower level of convenience in favor of security. In the retail world, there is always a clerk watching the transaction, so a thief only gets one or two chances to fake their ID. In online banking, a sophisticated hacker could get hundreds of tries, so banks demand more complex systems. But eventually these two applications will converge into something that is both more secure and more convenient than today’s systems. At that point, we should see an explosion in biometric revenues, as systems move to Internet and cell phone transactions. That will also drive the current proprietary systems into a common standard; so for example, any fingerprint sensor on any laptop will let the user log in directly to any website.
As I wrote in the December 2004 issue of Technology Investing on Korea, once commerce goes mobile onto cell phones, the market size explodes. Japanese and Koreans can use their cell phones to buy things in retail stores and restaurants, and the easiest way to secure the transaction is with a built-in fingerprint reader. The fingerprint market alone is growing rapidly:
From “The Economist” Nov 30th 2006
As you can see, in addition to the commercial applications, government will continue to be an important, if slower-growing, part of the market. All new U.S. passports have an identity chip in them, and this could easily be combined with a biometric ID system to provide a way to slash waiting times to get on a plane or re-enter the country. It’s ironic that the old “Big Brother” worries about these systems will be much less than expected, simply because people are likely to be using them commercially before the government can get its act together to deploy them.
Biometrics is just one part of the Security MegaShift that we will all be living in for the rest of our lives. And while I’m not ready to recommend L-1 Identity Solutions just yet — I’ll be sure to let you know when the price is right — we already have one of the leading companies in this area in our portfolio. This company is a very attractive stock right now, and they just reported excellent March fourth-quarter earnings.
American Science & Engineering (ASEI) reported $45.9 million in sales, up 12.5% from last year and 83 cents a share pro forma, up 18% and beating the Street estimate of 80 cents. It was a solid quarter, and management also announced a $35 million share buyback program plus cash dividends beginning in the current quarter. The stock jumped $4.52 on Tuesday in response, in part because there was a 20% short interest.
Consensus estimates for the normally-weaker first and second quarters average $37.9 million and 51 cents a share for June, followed by $38.7 million and 54 cents a share for September. But the range is huge: June-quarter revenue estimates go from $32.9 million to $45 million, and earnings range from 40 cents to 77 cents a share. ASEI has “lumpy” results depending on when they can recognize revenues on products that may have shipped weeks before the quarter closes, and also on the mix of products, as their gross profit margins also vary substantially by product. For example, there were two large orders for Z-Backscatter vans that slipped from the March quarter into the June quarter, which would have added $5 million to the already-good March-quarter results.
Instead of just looking at the March-quarter results, I think it is smarter to focus on the year. ASEI just reported $153.2 million in sales and $2.38 a share for the March 2007 fiscal year. (Pro forma earnings hit $3.18 a share.) I think they will do $175 million to $195 million in sales this year and report $2.50 to $3.00 a share. The consensus is roughly at the low end of those ranges, so there is room for an upside surprise. New orders grew 19% for the year to $190 million, and 21% in the March quarter, both faster than revenues. So the funded backlog is up to $105 million, 53% higher than last year, and there is another $61 million in unfunded backlog for add-on shipments where ASEI has already won the contracts. Some of those programs are scheduled to be funded in the June and September quarters, and most will be funded by the end of ASEI’s March 2008 fiscal year.
On the conference call, management said that the SmartCheck passenger screening system is working well at the Phoenix airport. It is used for secondary screening, where someone sets off the metal detector or is randomly selected, and then given a choice of a pat-down search or walking through SmartCheck. About 80% choose SmartCheck. These results should be announced shortly and then there will be an announcement of pilot projects at JFK and LAX. That should be big news for the company. Although it has started to move up, ASEI remains an excellent buy up to $59 for my $93 target.
Biotech MegaShift
Biogen Idec (BIIB) LEAPs went through another symbol change, with our January 2008 $45 call contracts going from YZU AI to IDK AI. Yes, I know that was the original symbol for the 2007 contract — apparently the Chicago Board Options Exchange is into recycling. The stock has been up on takeover speculation, and yesterday 51,943 calls traded, compared with 9,053 puts, on more than nine times the normal volume. BIIB would be a great acquisition for several different big pharma companies, near or at my $68 target for the common stock. That would make the $45 call worth $23. Continue to buy IDK AI under $12 for my $23 target.
Geron (GERN) said that researchers have been able to make human embryonic stem cells differentiate into clusters that secrete insulin in response to elevated sugar levels. The company thinks that it is feasible to produce therapeutic cells to treat Type 1 or juvenile diabetes, and they will now go on to animal tests.
If you need an example of “hero” just talk to a kid who has been waking up in the middle of the night from the age of one (or less) to have a finger pricked, blood tested and an insulin injection. It’s also the last thing they do at night and the way they greet the day. I think “hero” can be expanded to include the parents, too. Stem cell therapy would be a great advancement in treating this disease. Buy GERN under $9 for my $18 trading target.
Content on Demand MegaShift
There’s been some interesting consolidating going on in the video market that’s worth an update, as it leaves Harmonic (HLIT) in a stronger position to be the next company acquired. You probably remember that Cisco acquired Scientific-Atlanta in early 2006. Scientific-Atlanta’s strength is set-top boxes for cable systems, and their main competitor, General Instrument, was acquired by Motorola at the end of 1999.
In the last six months, Motorola has been acquiring companies and technology to give them the pieces that they need to compete with Cisco in Internet Protocol Television (IPTV). MOT still can’t compete with Harmonic in the “head end” at the broadcast studio, cable TV central office, or telephone company IPTV central office, but they have bought companies in video on demand, switched broadcast, DSL routing, ad insertion, video software and MPEG-4 encoding technology for a total of around $600 million.
In February, Ericsson agreed to buy Tandberg TV with similar technologies for $1.4 billion, so it looks like MOT got a pretty good deal overall. Alcatel-Lucent, the fourth big competitor, has been very successful in Europe and uses Harmonic equipment in its bids.
Once Tandberg is acquired, Harmonic will be the only independent video company with a complete head end solution. It also happens to have the technically best solutions. So any company that acquires HLIT freezes out the other independents, and if MOT makes the bid, Alcatel-Lucent winds up buying gear from a competitor.
While there is a reasonable chance of a buyout of HLIT at or above my target price, that isn’t why this is a good time to own the stock. Assuming the company hits the consensus 10 cents a share for earnings in the June quarter, they will have reported four straight profitable quarters totaling 40 cents a share, making the P/E ratio at today’s close a modest 22X. HLIT remains a Top Buy up to $10 for a $16 target — on their own or in a buyout.
Telkonet (TKO) was the subject of a new write-up from ThinkEquity on May 8 with a sell recommendation and a 50-cent target price. A week later, they issued a second recommendation, changing the target price to zero and predicting that the company would be in liquidation within weeks.
So my first question was: Why? ThinkEquity is an institutional firm. They haven’t covered TKO before, although the two authors from ThinkEquity who wrote this recent article also wrote a negative report on the company a couple of years ago when they were at Needham & Co. Telkonet is too small to be of institutional interest, and it is highly unlikely that any of ThinkEquity’s clients own it. Some of their hedge fund clients may be short it, but if the company is going into liquidation, why bother to write it up? The shorts will clean up anyway.
It is a very gutsy call on their part. I’ll have a full analysis of yesterday’s March 10-Q filing in next week’s Radar Report, but on March 31 TKO had $6.9 million in current assets, including $2.2 million in cash, and only $4.6 million in current liabilities. Companies with cash don’t go into liquidation.
I get some of the ThinkEquity research, but I haven’t seen the full text of this one yet. However, I understand the summary says: “Our concerns with Telkonet are company-specific. Telkonet is a low-quality company with a history of broken promises, limp investment in R&D, a terrific cash burn rate, a terrible balance sheet, a track record of increasingly desperate and dilutive offerings, a messy capital structure, a disjoint acquisition plan, secretive management, and an astronomical Price-to-Sales multiple.”
I assume the broken promise relates to the strategic investment that they were expecting, but it is curious that the other big event the company was promising at the time — the EDS contract — didn’t get mentioned as a kept promise. Bigger investments in R&D would just increase the losses and have not been necessary (yet) to maintain the #1 position in broadband-over-power lines for inside the premises. Like the ThinkEquity authors, I also have not liked some of TKO’s acquisitions, and think they were done for short-term reasons rather than as part of a strategic plan. Fortunately, most of them could be sold at a profit.
I don’t find management secretive, but it is bothersome to me that the CEO lives in North Carolina and runs the company from there, with frequent visits. I know that should be easy to do these days, but I am old-fashioned enough in this area to remember Bill Hewlett and David Packard’s MBWA — Management By Walking Around — and that was long after H-P was a development-stage company.
The “astronomical price-sales ratio” made me downright suspicious. That is true of any development-stage company, and it is a cheap, misleading shot that makes me wonder what the authors’ real agenda is.
I also found it strange that ThinkEquity liked TKO’s technology, but still trashed the stock and implied it has no value in an acquisition. Perhaps management will address these issues directly in their Rodman & Renshaw Conference presentation on June 19. In any case, I will have more next week on TKO, but this company has major contracts with the government, both directly and through EDS, plus their building monitoring program with GE that can be monetized. TKO remains a Top Buy up to $5 for my $15 target.
China MegaShift
Huaneng Power (HNP) moved over my $45 target for a few days last week, and it is now trading around $41. I am still very interested in the potential of the pebble bed nuclear technology, and I think we should stay in this stock. So, I’m raising the target price to $48 and keeping HNP as a hold.
New Energy Technology MegaShift
Energy Conversion Devices (ENER), via their Cobasys joint venture with Chevron Technology, won a nickel metal hydride (NiMH) battery system contract for U.S. Army hybrid electric heavy trucks under development by Armor Holdings. The Future Tactical Truck System will use a 280-volt power unit from Cobasys because it was the only U.S. supplier with an appropriate system. Obviously, this could develop into a very large contract, and puts Cobasys in a better position to go public. Buy ENER while it is under $35 for my $55 target, which I expect to see after they announce that Cobasys has filed for an IPO.
Video iPod MegaShift
Burst.com (BRST) jumped on very heavy volume a couple of weeks ago on a rumor that they were about to settle the Apple lawsuit or be bought by Apple, sending the stock briefly over my $2 target. I think a royalty deal with Apple would put the stock well over $2, but an acquisition price is more likely to be in the $3 to $4 range. A $250 million valuation would equal $6.25 a share, and that is not out of the question either. I am reluctant to raise the target price banking on an acquisition, so I think the best course of action is to move BRST to a hold for my $2 target. My experience is that it often takes two or three months from the time these rumors first hit to when a deal is actually announced. Be patient.
Market Outlook
Today was an important day. The S&P 500 ran up to 1530 on Tuesday, and I expected the usual correction back to the breakout point, 1510, before an assault on the old highs from 2000 at 1552. But Wednesday’s sharp decline set up an alternative possibility that 1510 would not hold, and sure enough, the S&P closed at 1507.51 today. If it does not immediately turn around on Friday and head back over 1510, at least, I think the big drop through 1495 to 1440 could be underway. From there, enough negative sentiment would have built up to propel us over 1552 and probably up to 1608 or so during the normally-weak summer months.
However, if we do get a recovery above 1510 tomorrow that holds, I think the S&P will wend its way up to 1552 and then have a tough time getting through there. We’ll know a lot more tomorrow, and I will send you a Flash Alert if there is a decisive move in either direction.
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