Protect Your Country, Protect Your Portfolio

This week, we all experienced a national feeling of sadness over the terrorist attack at the Boston Marathon. We all have seen the horrible images of the cowardly attack, and have heard the heart wrenching stories about men, women, and children who have lost lives and limbs. Personally, I found myself remembering back to September 11th - sitting around the TV and anxiously watching the reports coming out of Boston.

Unfortunately, as we have learned this week, despite the advances made by governments to combat both foreign and domestic terrorism the threat still looms large. Deranged people have easy access to propaganda that spreads baseless hatred, and even more dangerous, have easy access to instructions, which give them the tools to act out on their hateful ideas.

From September 11th, and through today - with the rise of terrorist threats - governments have gotten more serious about how to defend their citizens. Immediately after September 11th, President Bush created the Transportation Security Administration (TSA), which originally fell under the jurisdiction of the Transportation Department, but has since relocated to the Department of Homeland Security. The TSA has a $558mm annual equipment budget (p.67) that they spend on a range of security devices. One of those devices is called an Electronic Trace Detection (ETD), which as its name implies picks up trace amounts of explosive residue on people's clothes, bags, and other items. Out of the $558mm the TSA plans to spend this year, $4.5mm on that will get spent on ETD equipment (p. 1334), and the TSA plans to spend another $85mm on ETD equipment over the course of the next few years.

More significantly, the TSA recently launched the Electronic Baggage Screening Program, which has an $11bn budget over its lifetime and a $1bn budget over the next three years. The TSA notes that the ETD portion of this program represents, "the second largest component of equipment cost within the ... program" (! p. 1340).. In short, the TSA plans to seriously ramp up its spending across two programs in the short run - general TSA budget, and more importantly the Electronic Baggage Screening Program - and any company getting involved in this space will find themselves rewarded.

Currently, three main companies supply security equipment to the TSA - Safran (SAFRY.PK), Smiths (SMGKF.PK), and Level-3 Holdings (LLL). All three of these companies sell the whole range of their products to the TSA, with an ETD offering included. Recently, however, a new company, Implant Sciences Corporation (IMSC.PK) received approval from the TSA to begin selling their ETD equipment to airport security professionals. This approval has opened the door for IMSC to begin taking some market share away from the more established players in the US and beyond.

Importantly, for investors looking to take full advantage of the past and future government spending in this area, IMSC offers a compelling investment for the following three reasons. First, IMSC is a pure play when it comes to the security space, whereas the above companies only derive a small portion of their revenue from the security space. Second, IMSC has the newest technology, having received the most recent approval from the TSA. Considering the TSA approval, and the advantage in the technology, IMSC offers compelling products for customers around the world. Third, TSA has a strong board who have deep relationships with decision makers in charge of security purchases.

In this article, I will explore these three points in more detail, and from there try to build a compelling investment thesis for IMSC.

IMSC: Pure Play

Above, I named three main companies that provide security equipment for the TSA -- Level 3 Holdings, Smiths, and Safran. All three of these companies operate in essentially a conglomerate form, with airport security equipment making up a tiny fraction of their revenue. See table:

Company	! Total Revenue	Revenue From Airport Security	% of revenue from airport security
Level 3	$11.76bn	$340mm	3%
Safran	13.5bn (Euros)	~500mm	~3%
Smiths	3.03bn (UK, pounds)	326mm	11%

Safran does not break out its specific revenue from security, but I based my estimates on the following two assumptions. First, Safran reports security equipment, get ready for it, in the security segment. That segment accounts for 1.5bn Euros of Safran's revenue. Safran has three sub segments within the security segment - Cards, Identification, and Detection. While Safran does not report the revenue from each of these segments, it does report how much goodwill it holds on its books for each of these segments. See table:

Sub Segment	Goodwill (in Euros, millions)	% of Goodwill
Identification	949	70%
Cards	52	4%
Detection	357	26%

Considering Safran made 1.5bn Euros from the security sub segment, based on its accounting of goodwill, the Detection sub segment made ~400mm Euros.

Now, we need to make a new second assumption. Safran originally bought their security business from GE (GE), last year they bought out GE's remaining 19% stake in the detection business for 90mm Euros, thereby valuing the whole unit at 450mm Euros. Assuming Safran wants to get a 15% return on equity that would leave them with 68mm Euros of net income from the detection business. Further assuming that Safran has a 10% net margin from this business that gives them 680mm Euros in revenues from this division. In the above table, I too! k the rou! gh average of these two assumptions and came to a 500mm Euro revenue number.

Bottom line, none of the above companies give you pure access to the security space. Smiths gives you the most exposure at only 10% of total revenue. Investors looking for a more significant amount of exposure should consider IMSC.

Impact of TSA Approval

The TSA approved IMSC's device for use in January of this year. One month ago, the US government followed up their approval with a small order of IMSC products. This important test order sets the stage for IMSC to eventually generate significant business from the TSA and other US government organizations. Additionally, the TSA approval will obviously go a long way in giving IMSC access to the world ETD market. Homeland Security Research Corporation estimates the worldwide market for ETD's should reach $1.5bn by 2015 - a very large market indeed.

In fact, in the first quarter of this year alone, IMSC announced a new customer in the Middle East and further expansion to an Asian country postal service. Undoubtley, the TSA approval played a major role in these decisions, as they will for the foreseeable future.

But, at a higher level the TSA approval holds meaning because it serves as a stamp of approval for IMSC's technology advances. Meaning, in order for IMSC to compete against the established players it must show that it offers a better product. While on the face of it IMSC might seem to have a better product, without the confirmation of this by an organization with the weight of the TSA the advances mean very little. I won't go into too many specifics about IMSC's improvements over their competitors, but briefly:

IMSC trace detection does not use any radiation to detect for explosive materialsIMSC trace detection has superior self-cleaning and self-calibrating functions

The first improvement marks the biggest selling point for IMSC - obviously a device that uses radiation for detection has both higher liability, and ongoing maintenance costs,! somethin! g IMSC does not have to deal with.

Strong Management Team

Without a doubt IMSC faces stiff competition from the companies mentioned above, and they can only get their foot in the door if they have the right connections. As the saying goes, it's not what you know, but who you know. In this area, IMSC does not disappoint.

IMSC retained two people with intimate knowledge of the inner workings of the TSA. First, it has hired Todd Swearingen as GM for North America. Mr. Swearingen previously served at Safran's Detection Group, and head of security at Dallas-Ft Worth Airport. Second, it has retained as a consultant Mr. Mo McGowan, widely considered one of the founders of the TSA and one of its lead management people prior to his retirement. Mr. Swearingen represents a more significant hire than Mr. McGowan, because Mr. Swearingen left Safran, a more established player, and has decided to join the more exciting (and higher potential) team at IMSC.

IMSC has two members on its board with significant experience in government security. First, Robert Liscouski spent 11 years with the state department both as the official liaison to Interpol and as a mobile training leader in Beirut, and Rome. Second, Howard Safir held the positions both of commissioner at both the NY fire and police departments. Mr. Liscouski's role in international affairs should put IMSC in a strong position to profit in the international sphere.

Conclusions

Obviously, I don't intend in any way to make light of the tragedy at the Boston Marathon by trying to think about the way to profit from such a tragedy, but I have written about IMSC in the past, and the tragedy forced me to think about it again. I did not go into too many of the risks associated with IMSC, but we should note that while the technology looks promising, and has indeed received TSA approval, they still have not scored a large order from an organization like the TSA. Further, considering that their ETD product represents substantially their onl! y revenue! stream, failure to capitalize on this opportunity could mark the end of IMSC. Lastly, IMSC has faced consistent liquidity risks, which has forced them into some unusual financing agreements that could continue to dilute the equity. Nonetheless, for investors looking for higher risk, but higher reward security business stock IMSC might work well.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)