4 Stocks Set to Gain from Rising Security Needs

The images, released days after the bombing at the Boston Marathon, seemed to depict young men who could be two of the many thousands of college students in the area. How much help could those pictures be in solving the crime? A great deal, it turned out, as the suspects were identified in a matter of hours. It's a sharp reminder that surveillance technology is dramatically improving — and that the companies that sell it and other "homeland security" products continue to have opportunities in a world where terror can strike at seemingly any time.

Many major defense contractors make security-related products, but those units play a relatively small role at companies that sell multibillion-dollar weapons systems to the Pentagon. To find stocks that could benefit from increased spending on security equipment, we looked at some smaller companies. These stocks, all with market values of $1 billion to $4 billion, look appealing for investors with a high degree of tolerance for risk, and a belief that long-term security needs will win out over recent cuts in government spending.

Verint Systems (symbol VRNT) and NICE Systems (NICE) are leaders in video surveillance technology. They don't manufacture the cameras; instead, they produce the software and systems that analyze what the cameras are seeing. "Verint and NICE are kind of the brains behind the video cameras," says Daniel Ives, an analyst at FBR Capital Markets. Their systems "give municipalities, airports and transportation agencies, in real time, the ability to improve security and detect threats."

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An example: Pattern-detection systems can tell if a bag has been left unattended for a certain amount of time. "If you're at the airport and see some guy drinking coffee and looking at 50 video screens, well, a human cannot detect threats by sight that way," Ives says. A pattern-detection system may be able to.

Verint is regarded as a pioneer in video surveillance, Ives says, but today, the company's largest division sells data services to corporate customers. The video-intelligence segment represents 14% of sales, and its revenue fell 13% in the fiscal year that ended last January. However, the video-surveillance business "is a potential crown jewel of the company," Ives says.

Verint shares have been on a tear since bottoming in March 2009 at $3. At their current price of $34.90, they trade at 13 times estimated earnings of $2.76 per share for the fiscal year that ends next January (all prices and related data are as of May 20). Ives, who has a one-year price target of $37 on the stock, gives Verint a neutral rating because its recent results have been inconsistent. If the company is "able to execute over the next one or two quarters, this is a name that has the potential to gain a lot of investor interest."

Similarly, NICE garners the majority of its revenue from data services to corporate customers — just 20% comes from video security — but its emerging video-surveillance unit has signed some important deals. For example, the Israeli company won a contract from the city Sochi, Russia, site of the 2014 Winter Olympics, for video security.

NICE's video-security sales also declined in 2012, although by only 3%. But its international reach and smaller exposure to U.S. government spending make it less risky than Verint. Brian Ruttenbur, an analyst at CRT Capital Group, a Stamford, Conn., research firm, rates the stock a buy with a $40 one-year price target, 9% above the current $36.68. NICE "generates a lot more cash flow and has been growing at a faster rate than Verint," says Ruttenbur. NICE trades at 14 times estimated 2013 earnings of $2.61 per share, a reasonable price for a company with an estimated long-term earnings growth rate of 11% a year.

FLIR Systems (FLIR), a maker of thermal cameras and imaging systems, counts Uncle Sam as a major customer. That's not good news these days because federal agencies are cutting spending on the products they typically order on short notice. "They're just not buying these $100,000 systems right now," Ruttenbur says. But FLIR's handheld Fido Explosives Detector is "one of the niche areas that will grow" even in the face of government spending declines, he adds.

FLIR's shares seem reasonably priced. At $24.76, they trade at 15 times estimated 2013 earnings of $1.63 per share. S&P Capital IQ analyst Dylan Cathers raised his rating on the stock to "buy" from "hold" after the shares declined on the news that the company had hired a new CEO. His one-year price target is $27.

OSI Systems (OSIS), a maker of inspection systems for packages and people, provided screening systems for four of the six most recent summer and winter Olympics. Both Ruttenbur and Oppenheimer & Co. analyst Yair Reiner rate OSI a buy, with the former expecting the stock to hit $77 within a year and the latter forecasting a rise to $69 within 12 to 18 months.

Reiner says the company's latest results show an "eye-popping" expansion of profit margins — by nearly seven percentage points from the prior year — at OSI's Rapiscan Systems subsidiary, which makes security-screening equipment. That improvement "strongly suggests" profit growth for OSI over the next year. At 18 times forecasted earnings of $3.34 per share for the fiscal year that ends in June 2014, OSI is the most expensive of the stocks featured here. But Reiner says the stock is attractive in light of OSI's growth prospects. Analysts on average estimate earnings gains of 20% annually over the next few years.

Be aware that the stock has plunged twice since topping $80 last fall. The first stumble occurred in November, when a congressman suggested that Rapiscan might have manipulated test data for its airport body-scanning machines. OSI denied the charge but later acknowledged that its scanners could not meet the latest Transportation Security Administration requirements. The shares fell again in January after the company issued a disappointing outlook.

David Milstead is a Denver-based freelancer who writes “Vox,” a markets and investing column for The Globe and Mail, the national newspaper of Canada. Previously, he was finance editor of Denver’s Rocky Mountain News until it closed in 2009.