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2 top small-cap stocks to profit from cyber security

Data security breaches seem to be in the news on a daily basis at the moment, and Symantec’s latest Internet Security Threat Report confirms that cyber threats are indeed growing. There were 253 security breaches in 2013 up from 156 in 2012. Even more concerning is that a total of 552 million identities were exposed in 2013, compared to 93 million in 2012. Savvy investors will be wondering how they can profit from this alarming trend.

Businesses are rapidly switching to cloud-based technologies making them more vulnerable to data breaches. Hacking causes severe reputational damage and so there is growing pressure for organisations to invest in the security of their data.

Two ASX-listed companies benefiting from growth in the industry are Prophecy International Holdings Limited (ASX: PRO) and Senetas Corporation Limited (ASX: SEN).

Prophecy is an international software developer. One of its products, Snare, is a network monitoring and analysis tool. It can be used to manage user authorities, identify network attacks and intruders, and provides a complete audit trail of network activity. Sales of Snare have been strong over recent years and it is now responsible for a significant percentage of total sales for Prophecy.

On 19 March, in the latest of a series of Snare market updates, Prophecy announced that sales for the product are up 100% on last year. Sales for the first half of the financial year grew by 85%, and therefore revenues have accelerated since 1 January.

Prophecy’s latest half-year result was the best in its history, with profit before tax and impairments of $2.1 million, up from $1.4 million last year. There is $6 million in cash and no debt on the balance sheet and at current prices the stock has a fully franked dividend yield of 4.7%.

Senetas provides high speed data encryption hardware to governments and major global corporations. In October 2014, the company announced it had been awarded NATO Certification and therefore its encryptors are now certified by more leading authorities than any other products of its type. It takes years to achieve these certifications and so they provide a barrier to entry for would be competitors.

The company benefits from the trend of increasing data traffic because its encryptors are layer 2 network solutions which are much faster than alternatives. They also represent a cost effective solution for data centre providers which have to store duplicate data in multiple locations. However, one thing to consider is that Senetas is highly dependent on its international distributor Safenet for sales.

In the latest half-year report, revenue grew by 68% to $8.1 million and recurring maintenance revenue rose by 97% to $2.7 million. Recurring revenues are important because they provide a platform for sustainable growth. Capital requirements are low, margins are high and consequently the business generates strong free cash flows. Indeed, Senetas has already accumulated a healthy $12 million cash pile and has a market cap of $108 million.

Foolish takeaway

It is worth noting that these are both tiny companies and therefore subject to a high degree of volatility in both earnings and share price. Also, rapidly growing industries attract fierce competition and therefore it is unlikely that such eye-watering growth metrics can be sustained over the long term. Nevertheless, conditions currently couldn’t be better for these two companies and it seems the market is yet to fully wake up to this reality.

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Motley Fool contributor Matt Brazier owns shares in Senetas and Prophecy. You can find him on Twitter @MatthewBrazier1

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policyThis article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.