Investment Trends With…

Jeffrey T. Kessler - Senior Vice President at Lehman Brothers (NYSE: LEH)
(article from www.securitystockwatch.com)

1. SecurityStockWatch.com: Jeffrey, it's safe to say that you are one of the most well-known and well-respected analysts covering the security industry. Please give us an overview of your background.

JTK: I began my career at Argus Research in 1983, and was chosen, at the time, "kicking and screaming" into covering ADT Security, Sensormatic Electronics (now both owned by Tyco), and Checkpoint Systems, which I still cover. I have been covering security companies ever since, which included a 1983-86 stint at what was then known as Cowen & Co. I have been at Lehman Brothers since 1989, and I have covered the entire range of the security industry from the major public alarm monitoring companies to all the major manned guarding companies, from security equipment manufacturers to security systems integrators. In the early 1990's we added to such other, such other logistics-related "asset tracking" companies, like Symbol Technologies and Telxon (now owned by Symbol). I have been covering Brinks since the early 1990’s.

Of course, over the last several years, the areas of background screening, personal identification, digital video technologies, explosives and materials detection, biometrics, and, of course, radio frequency identification (RFID) have increasingly received a large portion of our attention. Back in 1989, the security industry was initially envisioned as a potential "I.I." ranked category, but consistently, every time a company in the industry rises to the billion-dollar revenue level, or reaches the top of its niche, one of the big industrial companies seems to acquire it. We have to keep our eyes on General Electric, Tyco, Honeywell, Stanley Works, Ingersoll Rand, Securitas (Sweden), and Diebold, all the time! The constant M&A has kept the market capitalizations of my sector generally between $500 million and $5 billion, which in today's market, is not considered large. So, the sector never developed into the mega-industry envisioned back in 1989, and I am not an I.I. superstar. And yet, despite this fragmentation, we estimate the total security industry marketplace at over $120 billion in revenues, which is still quite formidable.

Two of the things we do at Lehman to keep these generally small and mid-cap companies in front of our investors is (1) to sponsor, along with two other consulting firms and the largest security industry magazine (SDM),. a conference, "Securing New Ground," every fall, which focuses on themes in the industry, not simply company info-mercials; and (2) in conjunction with this conference we put out an annual "Security Industry Review" (October 2004, 200 pages) which analyzes nearly every sector of the industry.

If there is one thing that I have learned, it is that the security services and equipment industry is a relatively conservatively run business, because their customers (either the government or the commercial/institutional user) know the system has to work well, the same way, every way. These systems are selected after horribly long bureaucratic and political wrangling. That is why when we listen to analysts and chat boards arguing over who has the best anti-theft technology, or RFID system, or digital recorder technology, we simply walk away.

Ultimately, sub-contractor based security sales comes down to who does your client (the government, a large integrator, a large Fortune 500 company) trust and want to business with. Is it the "L-3's" or "Identix" of the world who live with the large integrators like SAIC or Lockheed, or is it the $1 million company whose new super-sensitive baggage detection or biometric system has wowed some young analyst, but needs $25 million of financing just to see if it can be integrated.

2. SecurityStockWatch.com: According to your recent research report, Lehman's Index of 26 Security Industry stocks has appreciated 317% since August 31, 2001, compared with a 5% rise for the S & P 500 during the same period. Since the beginning of 2004, that same list has grown 36% compared with 2% for the market. Quite impressive! Please give our audience a brief overview of the make-up of the Index and which companies have been the best performers?

JTK: Our index is comprised of 26 companies, ranging alphabetically from Armor Holdings (a company we cover) to Verint (a company Israel Hernandez at Lehman covers). While it is easy to say the surge in the index was related purely to "hot" homeland security technologies (like FLIR, or Taser or Verint), we also saw impressive stock performances from the more "mundane" companies we cover, like Brinks (cash logistics and alarm monitoring) and Corrections Corporation of America (private corrections).

3. SecurityStockWatch.com: Your report also discussed security sectors which you feel are particularly well positioned for the next five years. Please give us an overview of these sectors, the market drivers behind them, and please discuss any particular companies which you are covering in each sector.

JTK: We believe that asset and personal identification technologies will become major investment themes over the next five years. It is critical to understand that for years, biometric, video, background screening and materials screening companies attempted to sell either sell directly, or through dealers into the commercial market -- mostly without much success. Simply put, there was enough conflict already between the security directors and IT personnel at corporations to make the process contentious turf wars. As a result, security executives, installing some "new fangled" biometric or object tracking video technology that didn't work perfectly, risked being dismissed by the senior corporate staff, or perhaps worse, ridicule by the IT compatriots.

September 11 changed all that in ways that many investors underestimated. True, it has taken far longer for government projects that appeared on paper in budgets to make their way into actual implementation than most of us expected (airport explosives detection being an exception). Nevertheless, we are now beginning to see sophisticated background screening & data linking programs, biometric systems and databases, object and poor visibility digital video system, and RFID tracking systems all appearing on the walls of airports, in government offices, on rolling stock, working the same way, every time. This has become an unbelievably large "beta test" or "reference site" for all of those corporate security people we talked about above. As a result, we believe that Government, eventually followed by the corporate world (with its inherent recurring revenues) will adopt these identification technologies that have been rejected by the business world for so long. It has also helped that security executives are becoming quite IT savvy. The heads of security at Lehman Brothers were also with the CIA and Secret Service. It is no accident that Lehman is testing both iris-scanning fingerprint biometrics at two of its own extrance/exit turnstiles. This is a direct result of the "government beta test” for these systems" working its way into the corporate world.

We see the leading integrators (we are making no investment recommendations here) as IBM, Accenture, SAIC (private), Lockheed Martin, Tyco, and L-3.

We see the leading companies in the identification area (again, we are making no investment judgments) as:
1) Biometrics (a) Identix as a full service provider to large integrators, and (b) Cogent, NEC, Sagem, as providers of database identification systems, and (c) Cross Match and Smith's plc Heimann division as providers of "live scan" systems (along with Identix) to law enforcement agencies
2) Background Screening and data-linked analytics: Choicepoint, USIS (owned by two private equity firms), the Kroll division of Marsh McLennan, Fair Isaac, and First Advantage.
3) Intelligent video and tracking: Verint, FLIR, Pelco (private), Extreme CCTV, and two private technology companies DV Tel and Object Video.
4) Finally, in the asset tracking and logistics area, there are many companies that stand to gain a lot of business. Some of these include Tyco/Sensormatic, Checkpoint Systems, Symbol Technologies, the Intermec division of Unova, Alien Technologies (private), Refsac (European). There is an entire range of integrators and software/middleware companies like Acsis, RedPrarie, Manhattan Associates (public), which mainly produce warehouse logistics systems, but which could grow their RFID software rapidly from currently very small basis.
Of course, the thorny issue privacy and anonymity rights, versus the rights of society, can be magnified by the accidental or unintended loss of data related to personal identity will become a larger and larger issue as the databases created by the background screening and biometrics companies grow. The current issues and negative publicity over the illegal use of database company data, which faced Axxiom last year and now bludgeons Choicepoint in the press every day, points this out in spades. What rights do we have as citizens, some of whom may have committed heinous crimes or have profiles that might point that way, versus our rights to protect our personal identities will become one of the single biggest debates in this country as more and more "identification equipment, databases, and database analytics" are used over the next 3-5 years.

4. SecurityStockWatch.com: Of all the promising security business segments, RFID (radio frequency identification), has received a significant amount of attention. Why so? What is the market now and where do you see it in 5 years?

JTK: We have been covering RFID for ten years, mainly in the form of the larger, "active" tag producers which tracked airplanes, rail cars, rolling stock, and other large objects. We all know the so-called "toll road" tags, like "Easy Pass" from Transcore (formerly private, now owned by Roper Industries), or in defense (privately held Savi Inc.). These markets have grown to a little over $1 billion over this period.

What drove the market into a frenzy in early 2004 was speculation over retail/distribution-related logistics RFID systems (and multiple-billion dollar markets) as mandated by Wal-Mart stores, the United States Department of Defense, and later, by European retailers like Tesco and Metro. Some of the consumer product manufacturers have complained that the ROI from these projects amounted to a "Wal-Mart tax," and many are complying minimally with Wal-Mart's dictates by simply "slapping and shipping" truckloads, cartons and pallets. Nevertheless, potential over the next 3-5 years not just for the major retailers, but for increased efficiencies at the manufacturers themselves. Why? Unlike static bar codes, you can read from and write to the RFID tags, changing instructions and information in real time, you can store more information, you can create location technology easier, you can read multiple tags at once, and you don't have to discretely read each bar code in the right perspective, one by one.

However, for the $5-$8-$10 billion market (and that's before we get to the largest market of RFID on each SKU) that some consultants are projecting to occur, we must first overcome some significant obstacles.
(1) The cost of establishing an infrastructure will be daunting for everyone from the retailers, health care companies, travel companies, to the large integrators (like IBM and Accenture), to the systems producers (like Symbol and Intermec), to the RFID software producers, like privately held Acsis, RedPrarie and GenuOne. Indeed, the cost of setting up the infrastructure may ultimately outweigh the cost of the tag as an issue;
(2) The standards issue is very vexing, though progressing slowly. Following up on work by the MIT-Auto ID project, a standards body in the U.S. called EPC Global has attempted to put together a body of standards that can be accepted not only by some of the holders of intellectual property and patent in RFID (Intermec, being the most aggressive) , but by the ISO, the international body based in Switzerland, which will be critical in ensuring that, for example, a tag put on by Gillette in the US is read the same way, every time by a reader, whether they be in Europe, or in Asia.
(3) Third, forget RFID tags on individual jars of Tylenol for many years -- that will require RFID tags to compete with bar codes, which are virtually free, and antitheft tags, which are about a cent. Current costs of tags are $0.30-$0.80, and falling. That is fine for logistics purposes, and probably for investing in the leading stocks. However, the billions of unit volumes required to drive RFID tag prices down to a stock-keeping unit (SKU)-based level are at least 5-10 years off.
(4) Finally, there are some of the same privacy issues we are witnessing today with ID theft. Large privacy groups are already formed on the Internet, worried about tags remaining active on persons or objects after they have been purchased, and worried about unauthorized information gathering by marketers just outside the point-of-sale, even when tags are deactivated. While it may seem comical to be worried about being tracked by satellites in outer space, simply because the RFID tag in your hat wasn't deactivated, don't try telling that right now to the 140,000 private citizens whose ID's might have been compromised by the illegal use of some of Choicepoint's personal data, hitting the press every day.
Ultimately, the biggest mistake investors are making right now is assuming that RFID will immediately cannibalize bar codes and antitheft (called electronic article surveillance) tags. I cannot stress this point strongly enough: Bar codes will remain a critical part of the supply chain for many years to some, regardless of the growth (or lack thereof) in RFID. This is not a "binary" logistics decision driven by either the manufacturers or the end users. It is driven by common sense economics. Both Checkpoint Systems, and Tyco's Sensormatic division have been developing "combo-anti-theft/RFID" tags for years. Symbol and Intermec have already developed readers that will read combo bar code/RFID tags. The large integrators, as well as the logistics software companies are focused on a slow, and deliberate shift in technologies over many years. Investors haven't focused on this evolutionary process yet.

5. SecurityStockWatch.com: The war on terror continues and additional hotspots may be emerging with North Korea, Iran and Syria. What does a 2nd term for President Bush and the recently announced budget mean for the security industry?

JTK: There is $49.9 billion proposed in the US Government’s 2006 Homeland Security budget, spread out over nine agencies and 13 separate organizations. The Department of Homeland Security is slated for about 55% of these funds, while the DoD is supposed to get about 19%. If we divide the pie up a completely different way among various funded organizations, US Customs & Border Protection should get about 16% of the funds, followed by the US Immigration & Customs Enforcement division, with 11%. What I can promise is that these numbers will change as the proposals move through Congress. The security services and technologies we have described in this interview fall under multiple agencies and operational organizations. For example, Identix has won a $27 million blanket purchase agreement from the US Government. Any one of 13 organizations could ask for biometric funding and support from Identix. At the same time, after two years of funding, there is no specific funding for "Project Bioshield" in the proposed 2006 budget. That is ridiculous -- of course there will be funding out of various organizations for biological protection. In sum, funding growth is slowing, but remaining at levels that are three times that of 2000. It is just too early and too hard to pin down, who will specifically benefit, although our comments on our favored areas above make it clear to where we think the funding will filter.

6. SecurityStockWatch.com: Regarding Homeland Security Projects now underway, the US - Visit program is in initial stages at approximately 115 airports. Can you summarize for us the other major projects now underway.

JTK: This is an overview of the projects now underway.

• US - VISIT Program (10-print systems and Backend Matchers + others)
• UK-Passports, Passports and Visa Trial programs.
• Worldwide - A number of facial programs for passports/visas
• Saudi Arabia National ID Program
• UK--PITO National Law Enforcement System
• CAC/TWIC DOD/Transportation worker biometric IDs
• Worldwide 10-print systems for law enforcement/civil IDs
• Container Security Initiative (CSI)
• Customs Trade Partnership Against Terrorism (CPAT)
• Free and Secure Trade (FAST)
• NEXUS
• Secure Electronic Network for Travelers Rapid Inspection (SENTRI)


7. SecurityStockWatch.com: Jeffrey, many thanks for your time today. Are there any closing comments you would like to make?

JTK: Perhaps because so many analysts who have taken up the "Homeland Security" mantel over the last two years are focused on defense technology and RFID , nearly everyone is missing a trend that is occurring below the radar screen. That is, the recycling of former, highly experienced, alarm monitoring executives, bringing back practices which once made that industry great. The key will be to combine commercial business and sensible, economically viable residential business models. There is no magic to this. The alarm monitoring industry should be a huge provider of free cash flow to its owners. However, in the 1990’s many companies lost their bearings buying both accounts and other companies for ridiculous multiples of EBITDA, and recurring revenue. They forgot about the need to drive “steady-state cash” (recurring revenues minus the costs of attrition). The industry was guilty of paying high multiples (then lying about attrition rates they couldn't contain because of poor integration). There are private companies in the $50-$100 million range that continue to have low (sub 10% gross attrition rates), and very high EBITDA (over 40-50%) margins. We continue to cover Brinks, and continue to view Brinks Home Security as the public paragon of a well run mass-market residential company with nearly 90% of its accounts generated internally. Specifically, we cite the welcome change in internal growth tactics at ADT's residential business, the near miraculous turnaround and prevention of Chapter 11 by the relatively new executives at Protection One, and the return of such well-known executives such as Steven Ruzika (former CEO and CFO of ADT, pre-Tyco), and James Colvert (who is running Honeywell Alarm). There is a lot of private equity investment looking at the business now: Quadrangle Associates owns the majority of Protection One, GTCR owns the majority of Honeywell, and Sonitrol, Inc. (audio and video verification monitoring), a leading commercial security provider in North America, announced in March 2004, that its parent company, Tyco International, Ltd., has sold Sonitrol to a group of private investors: Spire Capital Partners, L.P., Carlyle
Venture Partners, and Wachovia Capital Partners for $125.5 million. While the public market goes ga-ga over which digital video camera sees more clearly in dark spaces, the private equity market is increasingly looking at the very industry which got me started as an analyst back in 1983.
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Disclosures:
* First Advantage Corp. and Symbol Technologies are or during the
past 12 months have been investment banking clients of Lehman Brothers.
* Lehman Brothers has received non-investment banking related
compensation from Identix Inc. within the last 12 months, and Identix
Inc. is or during the last 12 months has been a non-investment banking
client (securities related services) of Lehman Brothers.
* Lehman Brothers Inc. and/or its affiliates beneficially own(s)
1% or more of any class of common equity securities of Symbol
Technologies as of the end of the last month.