A Democratic Congress likely will shift spending priorities for homeland security. Here's a way to cash in on the change in direction.
The Republicans' version of homeland security is to seal off the Mexican border, beef up protection of military bases and limit screening at ports and transportation lines. The Democrats' version is to focus more on the ports and transit systems, especially by using gee-whiz tech devices. That contrast may oversimplify things, but with the new Democratic Congress there's sure to be a push to spend federal dollars on technology to thwart terrorists.
So says Oppenheimer's William L. Peters, a young analyst who has emerged as one of the most respected voices in the budding homeland security sector. "This is not a short-term problem," says Peters, 29. "Terrorism is not going to go away."
Partisanship aside, change is afoot in this area. After all, the initial phase of erecting an antiterror apparatus is over. The Department of Homeland Security, created in 2002, first set out to plug the holes in U.S. law enforcement and beef up manpower. Now the agency is refining its mission, and Congress is eager to kibitz.
After the Dubai Ports World fiasco lawmakers have harbor protection on the brain. (When the United Arab Emirates-owned company took over six U.S. ports, it touched off a political firestorm and was forced to put them up for sale.) Congress is turning its attention to the screening of seaborne cargo. Meanwhile, the airport scanning detection gear rushed into place post-Sept. 11 is now being upgraded. Better technology is coming on the market.
A lot of money is involved. President Bush is proposing a 9% increase in the department's budget, to $34.6 billion. Jockeying for those dollars are some 50 publicly traded tech firms, many of them small and many still in the red. Giants like General Electric (nyse: GE - news - people ) and Honeywell (nyse: HON - news - people ) are involved, too, but Peters argues that the best chance for investors to cash in on the security trend is with the pure-play small fry (albeit ones with commercial applications, too). His favorites have market caps of $2 billion or less ( see table).
Peters' firm created the Oppenheimer Homeland Security Index in 2004 to measure stocks involved in the sector. Backtrack the 31-stock index to January 2001 and it shows that homeland security issues have advanced fourfold, far outpacing the S&P 500. Much of the increase came after the March 2003 Iraq invasion.
The sector is volatile. The index tends to climb in the fall, when new federal budgeting plans gain visibility on Wall Street, then to drop back in the beginning of a new year--unless a terror attack occurs, such as the March 2004 Madrid train bombings. If the pattern holds, a buying opportunity should appear soon.
Security concerns are in Peters' blood. His father fought in Vietnam in the 1960s. His younger brother is in the Navy ROTC and wants to serve on a nuclear submarine. His older brother is a New York State Trooper, who serves as his reality check for the security schemes. One was a radar system for police cars that brother Gregory found wanting. Reason: The device took the place of a cruiser's stereo, and cops on patrol want to listen to music.
Peters homes in on three areas: biometrics, scanning and protection (meaning armor and the like for cops and terror targets). Because the companies rely on iffy government orders, Peters also looks at potential commercial uses.
BIOMETRICS
This is Peters' favorite, the stuff of Mission: Impossible. An electronic eye can read random patterns in a person's iris. These unique markers can substitute for fingerprints in identifying people. In commercial applications biometrics is still mostly fingerprint-based. Peters likes L-1 Identity Solutions, founded by the former chief financial officer of Pentagon supplier L-3 Communications (nyse: LLL - news - people ). L-1 has built a portfolio of biometrics companies via acquisition and is still on the prowl. L-1 products include machines that recognize people by their fingers, faces and irises. Helping the company land federal business are two big names it has signed up as board members: former FBI director Louis Freeh and former CIA chief George Tenet. These hires "can do nothing but good for this company," says Peters.
L-1's four acquisitions in 2006 helped triple revenue to $164 million but put the company further in the red ($31 million last year), mainly from merger-related costs. One growing application is for background checks for truck drivers applying to transport hazardous materials. Another plus for the company, Peters says, is its lock on U.S. passport production. New U.S. passports have biometric features. Volume for the documents is rising: Now you need a passport to cross from Mexico or Canada. Before, a driver's license would do.
An Israeli outfit called On Track Innovations (nasdaq: OTIV - news - people ) has developed chips that carry biographical and biometric data to be inserted in ID documents. The technology is also used by trucking companies as a fraud-prevention method to monitor how much fuel a driver puts into his tank. Some of these guys have reportedly used their employers' cards to fill up vehicles other than the company trucks.
A third promising company here is LaserCard (nasdaq: LCRD - news - people ). It burns data onto a strip in a card via laser. While this may seem antiquated compared with chips, the laser version is apparently more difficult to forge. The government employs laser burning for temporary work visas and green cards.
SCANNING
The science of probing containers and luggage for bombs, radioactive material and plastic guns is still in its infancy. In seaports the U.S. currently scans only 5% of containers. In airports less than 10% of checked baggage is scanned. Congress wants to boost this to 100%.
That equals a lot of customers for American Science & Engineering (nasdaq: ASEI - news - people ). Peters likes its X-ray technology, called the Z Backscatter, which goes beyond traditional security X rays because it can pick up nonmetallic objects. The Z Backscatter is able to detect explosives and contraband, rendering them as photolike images and giving them a special bright hue so inspectors can readily spot them. The machines are mounted in vans deployed in the Middle East and in large U.S. cities to monitor bridges and tunnels.
The company, which is profitable, has a large order backlog. Peters expects sales to climb substantially by 2008. The Transportation Security Administration is testing American Science's Z Backscatter for use on passengers pulled at the gate.
Then there's OSI Systems, half of whose revenue comes from homeland security and half from medical applications like anesthesia machines. The security side of the business, Rapiscan Systems, sells a range of scanners from walk-through metal detectors to those for large cargo inspection areas. In December the company announced contracts worth $10 million with several large (undisclosed) international airports for its new screening system for checked baggage.
FORCE PROTECTION
Peters is a fan of Armor Holdings (nyse: AH - news - people ), a profitable company that makes products like body armor and armored vehicles for the military and police departments. High government officials may travel in the company's armored sedans. It has added a new commercial component by buying Schroth Safety Products, maker of advanced safety restraints for racecars.
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