Bears Take a Bite Out of Security Investors
Publicly traded security companies in 2011 suffered worse performance than reflected by major U.S. market indexes. Yet industry M&A activity grew year over year and is poised for continued growth in 2012.
Many electronic security industry firms and observers wonder what happened in 2011. Stock prices were down and valuations experienced compression; while industry sales were generally up and most profit levels remained relatively solid. It appears the aftershocks from the 2008-09 financial crises and the ongoing global debt/budget concerns proved too much for this historically strong industry segment.
Where 2010 was a year when security sector stocks performed well and finished the year strongly, the industry enjoyed no such repeat act in 2011. Stocks got off to a good start and maintained that performance through most of the second quarter. During the summer months all markets experienced a deep sell-off, but security stocks never recovered.
For 2010, industry stock prices closed aggregately trading at 85% of component companies’ 52-week highs, whereas 2011 yielded a disappointing 71% end point. Industry stocks finished the year down approximately 9%. By comparison the Dow Jones Industrial Average finished +5%; the S&P 500, -1%; and the NASDAQ composite, -5%.
So why didn’t industry stocks regain their footing? Certain macro fundamentals are changing the industry and therefore impacting participants’ valuations and performance. The overall industry is concurrently experiencing revenue stagnation in legacy markets; increased convergence with the defense and IT sectors; competition against those and other new entrants for slow-growing revenues; and suffering due to a continued reliance in U.S.-based markets on material public-sector economic support.
Not surprising, with valuations off, there was a significant amount of strategic and opportunistic mergers and acquisitions (M&A) activity. Buyers consisted of legacy industry companies, IT companies, defense primes, as well as new entrants and financial buyers. For 2011, aggregate deal values and volumes rose.
The financial and investment well-being of the security industry is detailed here in SECURITY SALES & INTEGRATION annual stocks report. We examine the financial performance of the industry for 2011 and offer some perspective on what can be expected in 2012.
Large Caps Delivered Stability
Let’s start in by examining which security market segments (as measured by equity market capitalizations) were worst hit in 2011. As you’ll see, the scale of capital played a key role.
Smaller stocks suffered more than their larger capitalization peers. Large-cap firms finished the year with an almost 2% gain, beating the S&P100 index by almost 3%. Mid-cap companies lost approximately 19% of equity value versus their comparable index, which was down less than 5%. Small-cap companies were worse off, respectively losing approximately 23% (their comparable index was off 7%).
Hardest hit were micro-cap companies, which collectively experienced a more than 31% contraction in equity value. The broad market axiom of safety in larger capitalization stocks proved out. Large caps experience less volatility and therefore may not enjoy huge gains, but nor do they experience such acute fall-offs when selling occurs.
Some of these results were impacted by aggressive share repurchases where companies saw the opportunity to buy their shares at discounted values. Also impacting the results were capital markets that remained relatively closed to issuers for much of 2011.
Industry Sector Performance
The chart titled “2011 vs. 2010 Security Sector Performance” shows the harsh realities of where valuation multiples for individual industry sectors ended in 2011. The only sector to turn in positive year-over-year gains was Credentialing/ID Solutions.
For Alarm Equipment/Physical Access companies, equity values contracted approximately 15%, driven in part by an almost 20% contraction in sector EBITDA (earnings before interest, taxes, depreciation and amortization) margins. Notwithstanding Kaba’s margin improvements, lower revenues drove the stock down. In contrast, NAPCO‘s return to profitability yielded year-over-year stock appreciation of 40% and thereby outperforming much of the rest of the pack.
Despite a double-digit increase in sector sales, Asset Tracking/Intelligent Traffic Systems companies experienced an average decline in equity values of more than 30%. Sector heavyweight Trimble was the sole price gainer, in part due to year-over-year revenue and margin gains. Many sector companies have very strong margins but weak valuations, suggesting a vulnerability to opportunistic M&A.
C4ISR/Threat Detection firms saw sector sales increase slightly and margins were up, but sky-high valuations came down as markets penalized outliers. More than 15% of sector companies used the depressed markets to repurchase shares they felt were undervalued. Cepheid turned in an impressive 61% gain in equity value on the back of margins increasing by 20%. The big disconnect in the sector was Kratos Defense & Security Solutions, whose stock was down 16% despite having turned in sales growth of 53% and EBITDA growth of more than 95%.
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