A Penny Stock to Bank On

CLIFTON, N.J. ( TheStreet) -- I had sworn off penny stock investing, but after enjoying some success with this market segement in 2009, I now find myself knee-deep in stocks trading for less than $1.00.

My addiction to risk keeps me coming back for more. Throughout 2010, I will continue to devote a portion of my portfolio to penny stocks while avoiding the pump-and-dump schemes that are all too common in this stock universe.

Following the same theme I did in 2009, I will attempt to identify penny stocks of companies that are rectifying liquidity issues or re-energizing their business models. Electronic Control Security ( EKCS.OB)

I first purchased shares of this Clifton, N.J.-based company after it was selected as a primary contractor for the U.S. Air Force IBDSS project and after it became a subcontractor for Lockheed Martin ( LMT) in an antiterrorism initiative for U.S. naval bases around the world.

Although the Lockheed contract is still going strong, the IBDSS contract did not pan out as the company had hoped. Consequently, my investment failed to yield any return.

Consequently, I recently asked the company's CEO, Arthur Barchenko, why the contract did not meet expectations. He explained that the problem originated from the company's earlier business model where it acted as a primary contractor for government projects.

Aside from the challenges of having to compete against much larger competitors, dealing directly with the government meant unpredictable order patterns and the risk of mispricing bids, which can quickly erode margins.

Furthermore, the original IBDSS contract, which has expired, was originally slated to address 34 Air Force bases, but in the end it only addressed five.

About two years ago, management decided to shift its business model. Instead of being a direct contractor to the government, it would become a technology supplier and subcontractor to giants like Lockheed Martin, Raytheon ( RTN) and Northrop Grumman ( NOC). This quasi-"partnership model" gives Electronic Control Security access to a much larger pool of government and commercial contracts. Also, the company no longer installs equipment for its subcontracted work. It just sells support services and equipment, which reduces its risk and should result in higher sustainable margins

The fruits of these efforts may be paying off. The company just reported its first profitable quarter in 13 quarters.

Although revenue declined because of the company's shift away from primary contract work, margins are improving.

If Electronic Control Security can devise a plan to increase sales, then we could have the best of both worlds. And this appears to be the case, at least for the near term.

The company will fill contracts during the second half of the year totaling at least $1.5 million, vs. about $1 million in the 2008 comparable period. (The company's fiscal year ends in June.)

Also, it is has submitted proposals on major projects for Department of Defense facilities and numerous nuclear power stations in the U.S. and South Korea valued at approximately $2,250,000. A decision relating to these proposals is expected during the third quarter of fiscal 2010.

Still, there are a few flies in the ointment:
  • A recent 10-Q filing with the Securities and Exchange Commission indicates that the company is past due on a convertible debt obligation, although Electronic Control Securities is still making monthly interest and principal payments.
  • Electronic Control Securities' business has been uneven, so the company will have to prove to investors that its new model can deliver consistent results.
  • Contract delays are always a risk when dealing with government projects.

I am certainly aware that existing uncertainties add a significant level of risk. However, the renewed focus on a higher-quality contract pipeline and the fact that the stock is selling for less than its book value of 28 cents per share may offer a significant opportunity for risk-tolerant investors. (Note that the stock currently has wide bid/ask spread.)

I will be following up this article with my findings on two other penny stocks: OBN Holdings ( OBNI.OB), which has ambitious goals of building a portfolio of profitable subsidiaries, and China Marketing Media ( CMKM.PK), a magazine publisher with a renewed focus that targets China's consumer appetite for electronics and associated growth in credit card transactions. Both firms sell for less than book value and are profitable.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider Electronic Control Security, OBN Holdings and China Marketing Media to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

-- Written by Maj Soueidan in Skippack, Penn.

At the time of publication, Soueidan held shares of Electronic Control Security, OBN Holdings and China Marketing Media.

Maj Soueidan founded The Market's Edge, Ltd. in 1994, The Markets Edge Hedge Fund in 2006 and GeoInvesting, LLC in 2007. Through his involvement with the equity markets, he developed the strategies that are now at the core of the hedge fund and geoinvesting.com. He currently leads a team of researchers and analysts (the GeoTeam) that help investors identify opportunities in today's volatile stock market. The team uses fundamental criteria to analyze stocks in the micro-cap to small-cap arena.

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