A Question of Security

Times staff writer Edward Silver writes regularly about technology investing

"Only the paranoid survive."

When Intel's Andy Grove popularized that phrase, he was talking about rivalry in the warlike chip business.

But managers of computer networks have made Grove's motto their own amid threats from hackers, viruses and intrusions of all kinds.

Their domain has become more vulnerable as computer links get more complex and companies seek opportunities on the Internet. In fact, many analysts believe that security is the No. 1 issue preventing electronic commerce from blasting off.

The burgeoning need for security has given birth to a handful of hypercompetitive software companies that provide antivirus, firewalls, encryption and other, even more arcane products that are becoming essential to running modern networks.

The most common industry estimates have this young sector expanding at a 50% annual clip and reaching $5 billion in revenues in 2000.

"No one has to be sold anymore on the power of the Internet," said Ted Julian, an analyst at Forrester Research. "It's crucial to how companies will be doing business going forward."

But, he added, "none of that happens unless the networks are secure. If you buy into that idea, you see the potential of this industry."

For investors, however, there's little security in this marketplace.

An intense consolidation cycle is underway, as the larger players take over single-product innovators, many of them private, to offer customers one-stop shopping. Just last week, Network Associates (NETA) announced it will acquire Dr. Solomon's of Britain to broaden its antivirus line and get a foothold in Europe.

Also, with corporate spending beginning to flow in this direction, many analysts expect Goliaths like Cisco Systems, Microsoft and others to invade. That issue weighs heavily on the stock of firewall leader Check Point Software Technologies (CHKPF).

In a game of leapfrogging technology and shifting partnerships, assigning reasonable values to these companies is more of a puzzle than sizing up mainstays like Procter & Gamble.

"The Street is wrestling with how to define and value these companies," said Paul Merenbloom, an analyst at Prudential Securities. "You can make almost what you want of it because the business is so young."

For instance, both Yahoo and Check Point base their businesses on a hot Wall Street theme--the Internet. Check Point reported a booming profit of 41 cents per diluted share for the March quarter, compared with Yahoo's 8 cents, and edged it out in revenue, $30.9 million to $30.2 million. Both grew stupendously during the previous 12 months.

Yet Check Point's market value, $1 billion at Monday's close, is less than one-fifth that of Yahoo.

Why? One big reason is that investors believe they know where Yahoo is going, and they like the destination. Bulls expect the search engine to become entrenched as a primary provider of content and services on the Web and attract boatloads of advertising dollars.

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Investors are gradually learning that security is part of that scenario, but they are unsure which companies in this emerging industry will survive to provide it.

The same is true, in large part, for customers. Last year they might have purchased firewalls, which act like sentries around the perimeter of networks to control access. This year, they may want to add encryption for scrambling data, perhaps credit card numbers.

Deployments are getting more expensive and more complex, and the pieces have to reflect a strategy that won't be obsolete in a year.

"The need today is for a road map," Merenbloom said. "They need to know that what they are investing in today will be viable tomorrow."

The company with the clearest road map is Network Associates Inc. Itself born of last year's merger between antivirus leader McAfee Associates and Network General, a network management specialist, Santa Clara, Calif.-based NAI is making acquisitions at a manic pace.

The relentless appearance of new viruses--currently pegged at 350 a month--has opened the Fortune 500's doors to NAI. Now it plans to sell those customers suites that include firewalls, encryption, intrusion detection and more. Not every item in the arsenal is best of breed, analysts say, but that's not the point.

"NIA is wise to put together this portfolio. It is getting very aggressive about packaging and pricing and distribution, which is appropriate as the market matures," said Julian.

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The company's financials are robust. It earned a split-adjusted 37 cents per share in the March quarter, beating Street forecasts. Most estimates for the year hover at $1.65 and $2.15 for 1999. So at a recent $41, the company sells at a price-earnings ratio that's similar to that of the S&P; 500 index, though it's growing at a much faster rate. Analyst Michael Stanek of Lehman Bros. has a price target of $60.

If Network Associates has an Achilles' heel, it's the challenge of creating harmony among the disparate software code and corporate cultures stitched together so quickly. Paul Saunders of SoundView Financial Group rates the company a "short-term buy" but a "long-term hold," waiting to see if "integration issues lead to a hiccup in performance."

While NAI's security road map is clear, Check Point's is less visible. The Israeli company, with U.S. headquarters in Redwood City, Calif., has been dogged by a perception of isolation.

The bears call Check Point a one-product company and that one product is in danger of being reduced to a feature in Cisco's networking hardware. Indeed, Cisco sells low-end firewalls in high volume with its routers. Also, as it sits out the merger frenzy, Check Point risks losing business to full-service firms.

But bulls argue that Check Point's firewalls are becoming platforms for complete security solutions. The company has created a de facto standard by partnering with about 140 firms, and its line is broadening.

New products include "bandwidth management" software that reduces network clutter by assigning priorities to various kinds of data and "virtual private networks," which allow firms to create secure channels within the Internet.

Momentum investors abandoned the stock when the March quarter's results showed little sequential revenue growth. But most analysts call that a nonissue, particularly since revenue was up 125% over the previous year and profit beat forecasts handily.

If consensus estimates are on target, Check Point will earn $1.52 per share this year. The $27 stock, therefore, is clearly selling at a pessimistic multiple.

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Like NAI, Security Dynamics Inc. (SDTI) has built on its niche through acquisition, and like Check Point, it's facing a tough audience on Wall Street. The stock crashed when it announced weak profits for the most recent quarter, and the bad news darkened investors' view of the entire sector. But as the clear leader in two important areas, Security Dynamics may have better times ahead, analysts say.

The Bedford, Mass.-based company's bread and butter is called authentication, a token-based system that confirms a user's right to get access to data. It acquired the world's premier encryption organization, RSA Data Security, in 1996.

This year, the company has been jolted by the kind of troubles that often plague fast growers, mainly executing with precision while trying to integrate new units and launch a new product cycle. And with the federal government limiting encryption exports, Security Dynamics investors have had little to cheer about.

Nevertheless, the firm is developing a suite called SecurSight that could bring life back to the stock. Reflecting the two sides of the story, Saunders rates it a "short-term hold," "long-term buy." If the company can get its house in order, he expects 50% earnings growth in 1999.

The encryption stalemate also hasn't been healthy for shares of Cylink (CYLK), a pure play in that niche. Cylink of Sunnyvale, Calif., had a difficult 1997, but Merenbloom predicts steady improvement and recommends purchase.

His reasoning: Cylink is gaining share in a market with few vendors and increasing demand; it has become the provider of choice to the banking industry and has close ties to Cisco. He expects per-share earnings of 33 cents this year, and a leap to 72 cents in 1999.

With success stories already built on antivirus, firewalls and authentication, what's the next wave? Intrusion detection, many analysts say.

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You might say these products check all your doors and windows, set the burglar alarm and call the cops if someone breaks in. Starting from a tiny base, detection specialists are expected to double and even triple revenue this year.

As the niche takes off, Internet Security Systems (ISSX) of Atlanta is a leader of the pack. ISS had a splashy initial public offering in March, almost doubling in its first day of trading. Its heady market cap may be the only thing that's keeping ISS independent--NAI, Security Dynamics and Cisco recently snapped up rivals. Axent Technologies (AXNT), another consolidator in the security group, also plays in this niche.

While analysts are positive on ISS, they admit that a $600-million valuation for a company that reported $6 million in revenue last quarter is hard to justify.

Rakesh Sood of Goldman, Sachs expects ISS' long-term profit growth to exceed 70% and rates it "outperform," based on "the momentum of the story and an opportunity to exceed estimates."

Profits often flow as momentum builds around a great idea, but investors should note that hot technologies like intrusion detection and virtual private networks are likely to be absorbed into other products. "We are watching the evolution of a platform," said Merenbloom, and the platform companies often dictate the winners and losers.

Some analysts expect the eventual shakeout to leave only Network Associates, Check Point and Cisco standing. Others expect platform behemoths--IBM or Computer Associates--to find network security an irresistible opportunity.

"At first, the industry was like a bunch of guppies fighting over fish flakes," said Julian. "Now the piranhas and sharks are in the tank, and the whales are on the way."

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Times staff writer Edward Silver writes regularly about technology investing. He can be reached at emsilver@msn.com.

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Feeling Insecure

Software companies that provide security for computer networks are having a rocky year on Wall Street, but analysts still expect the field to boom.

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Year-to-date Ticker Monday percent Projected Company symbol close change P/E* ISS Group ISSX $34.75 58%** Negative Axent Technologies AXNT 25.00 45 33 Network Associates NETA 40.50 15 25 Cylink CYLK 9.25 -5 28 Check Point Software CHKPF 27.63 -32 18 Secure Computing SCUR 8.13 -31 26 Security Dynamics SDTI 18.25 -49 26

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