Downgrade Dents Internet Security Systems

Shares of Internet Security Systems ( ISSX) tumbled on Tuesday after the company was downgraded by a Morgan Keegan analyst.

The security firm's stock dipped $1.41, or 5.6%, or to $23.61 in recent trading after its rating was lowered to market perform by analyst Chris Hovis.

"With ISSX up 20% since the beginning of the year, we believe the stock reflects the company's leadership position and solid growth in the intrusion prevention market. Near-term, we believe first quarter 2006 upside potential is limited, as ISS faces a slight currency headwind in a seasonally slower quarter," Hovis wrote in a client note.

Hovis believes that the company's new offerings in vulnerability management, anomaly detection, desktop AV and new managed services offerings should benefit the company in the second half of 2006 and beyond, but are not likely to provide much near-term upside.

"We believe ISS has outlined a sound strategy for bolstering its competitive position and future growth," Hovis wrote, adding that the company plans to ramp up research and development, and sales and marketing in support of its Proventia Scanner and Anomaly Detection products and in the growing areas of voice-over IP and mobile security. "In the meantime, this will likely constrain operating margin expansion through most of 2006, with the fourth quarter of 2006 and 2007 holding the promise of operating leverage meaningfully kicking in again."

Hovis noted that the stock currently trades in line with others in the sector, but at a healthy premium compared with large-cap security companies like Symantec ( SYMC), McAfee ( MFE) and Check Point ( CHKP). These competitors trade at 11 times their enterprise value-to-free cash flow ratio on average, while Internet Security Systems trades at 16 times.

"We believe further upside is primarily dependent on earnings outperformance, which is more likely" in the second half of 2006, Hovis wrote.

Morgan Keegan makes a market in shares of ISS.

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