Living in New York, and having an intense interest in the world of finance, I have spent a lot of time closely watching a number of prominent hedge funds. Over the years, one of the more interesting of this group has been Platinum Partners. Platinum, a $930mm fund has marched to the beat of its own drum, while compiling an impressive track record for its investors. It ranked No. 56 on Barron's annual hedge fund performance survey for 2010 and No. 16 for 2009. One of its more intriguing investments has been its debt investment in a company called Implant Sciences Corporation (IMSC.PK). IMSC makes security equipment that can scan cargo, luggage and people's clothing for traces of explosive residue, a technology known as Explosive Trace Detection (ETD). On January 16, 2013, IMSC became only the third company to get approval from the TSA to implement their ETD equipment in US airports. In this article, I will closely analyze IMSC's competitors in the ETD space, what this approval means to IMSC, how much money they can generate from TSA contracts, and future possible revenue streams. In my analysis, I will quote heavily from the detailed TSA budget, which I will henceforth reference as "Budget."
TSA: A Background
After the horrific attacks of 9/11, The Bush Administration created the Transportation Security Administration (TSA), which originally fell under the umbrella of the Department of Transportation, but subsequently got moved to the newly created Department of Homeland Security (DHS). As most of you know the TSA (amongst its many responsibilities) provides security at airports in the USA. In this capacity, they contract a lot of work to equipment providers to assist them in achieving their goals. In 2013, The TSA Aviation Security Unit (henceforth, TSA) has a total proposed budget of $5.1bn (Budget p.67). Of that $5.1bn, TSA will spend approximately $558mm on equipment, with the balance spent on employee salaries and other items (ibid). Importantly, this $558mm budget covers only one year of the equipment budget, meaning, any company that can start tapping into this budget, could see a nice continuous revenue stream.
The more established names in this space - Safran (SAFRY.PK) - until recently part of GE (GE), Smiths (SMGKF.PK) and L-3 Communication Holdings (LLL) - have taken the lion's share of TSA equipment contracts until now. I will now turn my attention to the current $558mm equipment budget, its specific breakdown, and the approximate take of the above three players.
TSA Equipment: A Breakdown
As mentioned above, The TSA has a $558mm equipment budget for the upcoming year. This budget gets divided between three divisions of the security unit:
- Explosives Detection Systems/Explosive Trace Detection Systems ($426mm).
These two category of items do the following:
Explosives Detection Systems (EDS) - function much the same way as an X-Ray machine for bags, except that instead for seeing the inside of a passenger's bag, it detects for explosives.
Explosive Trace Detection (ETD) - see above.
2. Checkpoint Support ($120mm)
Included in this category:
Full Body Scans
3. Air Cargo ($12mm)
Air Cargo has the same equipment as the above two units.
The TSA doesn't give an explicit list of its largest contractors, but it does give its equipment maintenance cost where it identifies the items it currently own and their quantities (Budget p. 1345). Additionally, TSA gives the cost it currently pays for these items (Budget p. 1335), and we can assume future prices paid by the TSA will fall well within the range of past prices paid.
In short, Safran, Smiths, and L-3 Holdings all have strong relationships with the TSA. These relationships have allowed these companies to generate long term and sustainable cash flows, which has benefited their shareholders. We will now move to a deeper discussion about ETD systems, and the unique opportunity IMSC has in this space.
Implant Sciences Corporation: A New Player In The ETD Game
As noted above, ETD equipment represents one of the largest expenditures for the TSA. These expenditures extend beyond the specific EDS/ETD segment, and find their way into the Checkpoint Security and Air Cargo segments as well.
Breaking this down further, in the Checkpoint Support program TSA plans to spend $4.5mm this year, and $85mm over the course of their current program (Budget p. 1334) in adding ETD equipment. In the EDS/ETD segment TSA has launched the Electronic Baggage Screening Program, a huge program with $11bn equipment budget over its lifetime, and $1bn budget over the next three years. Importantly, TSA notes that the ETD portion of this program represents, "the second largest component of equipment cost within the ... program" (Budget p. 1340). More importantly, this program launched in Feb 2012, giving a new player, IMSC, a chance to gain market share in this new field.
In short, IMSC can benefit from two large government programs - the Baggage Screening Program valued at $1bn over the next three years and the Checkpoint Program with a specific ETD budget of $85mm. The Baggage Screening Program budget doesn't break out their specific ETD spend, but based on their comments cited above, I think we can assume at least 10-15% of their budget dedicated towards ETD equipment. If so, The TSA will spend roughly $200mm over the next 3 years on ETD equipment.
What This Means For IMSC
With IMSC's recent TSA recognition, they have taken a major step forward in gaining access to the huge government contracts described above. We can only guess how much of these contracts IMSC will get, but if we use the maintenance schedule mentioned above, it seems that TSA likes to spread their business around. According to that list, TSA employed 715 Smiths ETD detectors and 1,035 Morpho (Safran) ETD detectors, with market value of the products roughly following the same ratio as quantity. Therefore, I don't see it as unlikely that IMSC could gain at least a 20% market share in this arena. Further, assuming an approximate $65mm TSA spend for the next three years, IMSC should have the ability to pick up $13mm in annual TSA contracts. IMSC has historically operated at 30% gross margins in their ETD business, meaning they would increase their revenue and operating profit fivefold over the previous year to $19mm and $5.6mm respectively.
IMSC In The Long Term
In order for IMSC to start turning a profit, they will have to reach $33mm in annual sales, just to cover COGS and SG&A expenses. Considering the important TSA development, we can now assume that IMSC can more easily compete with Smiths and Morpho on a global scale. In addition to aviation security concerns, the global market for ETDs includes general transportation security, force protection, law enforcement, critical infrastructure protection, public safety, and finally corporate security. Taken together, Homeland Security Research Corporation projects global spending on ETDs across all sectors to reach $1bn by 2015. Additionally, and this news came out after Homeland Research Corporation's study, as of Dec 2012 TSA requires screening for all packages inbound to the USA. This new legislation will drive further sales of ETD detectors.
Assuming a 20% adoption of IMSC products, IMSC will see $66mm in annual revenue, $20mm gross revenue, and $10mm of EBIT on average of the next 3 years. Both Safran and Smiths trade at about 12x EBIT, if so, IMSC should see a market cap of about $120mm, or double its current valuation over the next three years. Importantly, IMSC as a growth stock should trade at a much higher EBIT multiple than the established players, but I would prefer to show that even using more conservative modeling, IMSC has tremendous upside.
One final word on IMSC. As I mentioned in the opening paragraph, my original interest in this company came from the loan Platinum Partners extended to the company almost two years ago. The loan balance currently stands at $30mm, and it comes due in March 2013. If Platinum does not roll the debt, the company will go bankrupt, pure and simple. However, I think that there is no chance Platinum will take such action.
Firstly, Platinum has already extended the debt two times - in September 2012 and October 2011. Secondly, I cannot believe that just as IMSC begins to turn the corner in a major way, Platinum would ruin all of the work they have put into the stock by sending them into bankruptcy.
TASER International (TASR): An Instructive History
We all know the famous TASER stun gun used by law enforcement agencies all over the world. The company has an interesting history whose lessons we can apply to IMSC. Briefly, TASR struggled in their early existence because for patent issues they could not sell their products to law enforcement agencies. In 1998, with the patent issues lifted, they began selling their guns to law enforcement agencies, sales moved briskly, but TASR still had troubling turning a profit. After the tragic events of 9/11, airlines across the world began arming their pilots with TASER guns, and business began to pick up significantly, setting TASR on a path to long-term stability.
I once heard Tony Blair say, "we can't really imagine a world without the attacks of 9/11, it changed us, and our security outlook, so fundamentally we can't even remember what life was life before it." Life has changed, permanently, and government organizations, and increasingly other segments of society realize that security professionals need the proper tools to defend their citizens and countries. Let us hope that companies like IMSC and TASR gives the brave security professionals around the world another tool that allows us to live in a safe, peaceful world.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.