Competition heats up for homeland security dollars

The "war on terror" has brought the homeland security industry into the financial limelight. Screening technologies, biometric identification, "smart" detectors, network security, background and database checking, among other things, are in high demand as the US government strives to boost transportation and border security and improve intelligence gathering.

Security companies have scooped billions of federal dollars in contracts and seen company stocks skyrocket. As a result, a number of new stock indices and investment banks catering to the security sector have appeared on the scene. But industry analysts wonder just how many new security companies the market can sustain, especially with the bulk of the contracts coming from the federal government.

"Since 9/11, hundreds of new companies have appeared," says Jack Mallon, founder and principal of Mallon Associates, an investment bank focusing on the security sector. "But with strong competition and a highly fragmented market, consolidation is inevitable."

On average, homeland security stocks tripled in value within three months of the Sept. 11 attacks, says equity analyst Brian Ruttenbur of Morgan Keegan, an investment firm, although growth has since slowed significantly. One example is InVision Technologies, a California company that installs sophisticated explosive detectors in major US airports. Four months after 9/11, InVision (now owned by GE) saw its stock grow an unprecedented 2,000 percent. Since then, the company has secured billions of federal dollars in contracts, making it one of the single largest recipients of homeland security dollars.

Stock indices focusing on security companies, such as the Spade Defense index or the SecurityStockWatch index, claim a close to 100 percent increase over the past four and five years, respectively – clearly outstripping the Dow Jones and Nasdaq.

Industry watchers are convinced that security is a lucrative issue here to stay, as made evident by the Department of Homeland Security's (DHS) steadily increasing budget. (For fiscal year 2007, President Bush has asked for a record $42.7 billion for the DHS – almost $2 billion more than 2006.)

The hope of securing more government contracts has persuaded some defense contractors to branch out. For instance, Boeing, Lockheed Martin, and Raytheon have dedicated corporate divisions to homeland security or acquired smaller companies in the sector.

War and associated defense spending is "cyclical," says Mr. Ruttenbur. In contrast, "spending on homeland security grows continuously as the threat persists," he says. Ruttenbur expects the DHS's budget to increase by 5 to 7 percent annually over the next 10 years.

According to the Federal Procurement Database, the DHS has awarded at least $15 billion in contracts to the private sector over the past 12 months. Of these, more than one-third were granted after limited or no open bidding.

Despite the large offerings of tax dollars, however, the industry seems uneasy about most of the money coming from just one source. Bruce Aitken, president of the Homeland Security Industries Association insists, not surprisingly, that the private sector needs to vastly increase spending in this area, too.

Presently, the biggest government contracts typically end up in the coffers of the established players, namely defense contractors with a track record of delivering military equipment and services. The government is more comfortable dealing with them, says Mr. Mallon.

Further, continued growth in the industry will largely be affected by the particular needs and priorities in the homeland security agenda. Some sectors can expect to fare better than others, says Ruttenbur.

For instance, as governments and authorities in the United States and abroad move to equip citizens with biometric IDs, companies offering products or services related to biometric identification (such as scanning and processing of a person's fingerprints, irises, facial features, etc.) have a promising future, he says. He adds that prospects also look good for any business involving chemical, biological, and radiation sensors and "smart" cameras – devices that not only monitor an area but also detect unusual behavior of individuals.

Even now, these sectors, together with companies offering computer and network security solutions, already clock an average 20 percent annual rise in stock value – more than double the growth rate of the general security industry, says Mallon.

But the market remains highly fragmented. Hundreds of small- and medium-sized companies – many of them startups – offer narrowly specific services or products. Whether they fit the requirements of the DHS or the large defense companies who may hire them for DHS contracts is vital to their success. Market consolidation is inevitable, says Mallon. And many of the smaller firms with complementary products will likely merge.

However, "we have not seen large-scale acquisitions of small homeland security companies by the big defense contractors," says Mallon. Instead, smaller firms prefer to link up with larger players in the general security business. Organizations like Mallon's, which advise security companies on mergers and acquisitions, may be getting more business in the near future.

But as competition in the marketplace grows, the industry understandably looks for a still larger pie to share. To attain remotely adequate provisions for homeland security, "we need a threefold increase in government spending," according to Mr. Aitken, head of the security industry trade group.