1 Security Stock Facing Hidden Dangers

Like Superman, American Science & Engineering (Nasdaq: ASEI  ) fights crime with X-ray vision. Its technology helps federal agents scan air travelers, luggage, and cargo containers for lurking dangers. But for this supposed security superhero, shrinking government budgets and bloating inventories could prove more dangerous than Kryptonite.

X-ray specs
After the Sept. 11 attacks, government demand for better security tech soared up, up, and away. So did AS&E's stock, which peaked around $93 a share in early 2011. Despite a steep drop to around $55 since then, it remains more than 842% higher than it traded the day before the attacks, compared with a 24% total gain for the S&P 500.

What tugged on AS&E's cape last year? Budget cuts. The company drew 62% of its 2012 revenue from the U.S. government. It gets 23% of all sales from one unnamed agency -- presumably the Department of Homeland Security, which buys AS&E's next-generation X-ray machines for airport screening, among other equipment. Ominously, the DHS's total 2013 budget request shrank by 2% from 2012, including a 3% cut for the Transportation Security Administration. AS&E clearly can't rely on government largesse to fuel future growth.

Its own worst enemy
Even a small slice in federal budgets can wreak huge havoc on AS&E. Its FY 2012 numbers took a swift, sharp plunge:

AS&E Metric

2012

2011

Change

Full-year net sales $203.55 million $278.57 million (26%)
Operating margin 15.6% 23.1% (7.5%)
Net margin 10.5% 15.3% (4.8%)

Source: Company 10-K for FY 2012.

AS&E still has $192.5 million in backlog waiting, including $112 million from Uncle Sam. But total backlog dwindled 10.5% from 2011, while the U.S. government's portion plunged 26%. Worse yet, AS&E notes that the feds could still cancel those orders at any time.

Despite this, the company's inventory rose 2% year over year in 2012, which AS&E attributed to preparations for future demand. While raw materials fell, and works in process stayed roughly flat, the dollar amount of finished goods increased 192% to more than $7.78 million. Meanwhile, previous years' products aren't flying off the shelves. The company's reserve for excess or obsolete inventory leaped 27% to $6.2 million.

The Legion of Doom
While few stocks offer AS&E's pure play on security technology, the company battles numerous competitors. Massive L3 Communications (NYSE: LLL  ) spars with AS&E in scanning airport passengers and bags, cargo containers, and entire vehicles. But amid L3's $12 billion in fiscal 2011 sales to the U.S. government, including $1.1 billion to non-military agencies, these products barely register for L3. The defense juggernaut doesn't even bother to break them out in its annual report.

Analogic (Nasdaq: ALOG  ) and OSI Systems (Nasdaq: OSIS  ) seem more in AS&E's league, but both offer medical imaging alongside their security tech. Neither has released a 2012 annual report yet, but last year's numbers offer helpful comparisons. Analogic's $52 million in 2011 security sales represented just 11% of its total, suggesting that it's more at home in hospitals than airports. In closer competition, OSI booked $294.7 million in security sales in 2011, composing 45% of its overall revenue.

AS&E's trailing P/E of 23.6 looks cheaper than OSI's 29.9 but seems massive compared with L3's 7.7. The latter company pays a 2.8% dividend yield, but its exposure to Uncle Sam's imperiled spending leaves L3 in the same danger as AS&E. OSI pays no dividend, but its more diverse product lines may make it a safer option for potential investors.

Escape from a doomed planet
It may face formidable foes, but AS&E's not powerless. A portfolio of 48 patents, with more on the way, sharpens its competitive edge. To fuel further discoveries, it boosted research and development spending roughly 12% in 2012, to $25.54 million.

The company offers a 3.5% dividend yield. After a 40% increase last year, its payout consumes 68% of its net income. But when you measure AS&E's dividend against its $45.86 million in fiscal 2012 free cash flow -- up 24% year over year, despite fluctuations along the way -- that ratio shrinks to 38.8%.

Furthermore, just as Superman's folks rocketed him away from dying Krypton, AS&E aims to flee dwindling government contracts by landing new business abroad. International sales shrank more than 20% in 2012 but represented a greater proportion of AS&E's overall revenue, at 34% compared with 32% in 2011.

Not a hoax, dream, or imaginary story
Since government spending ebbs and flows, and our need for better security persists, I wouldn't count AS&E out yet. Even Superman came back from the dead. But unless it can dramatically accelerate its international expansion, you don't need X-ray vision to see that this company's near-term prospects look anything but heroic.

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Mild-mannered Fool writing coach Nathan Alderman fights a never-ending battle for clarity, active voice, and the Oxford comma. He holds no financial position in any companies mentioned. The Motley Fool owns shares of L-3 Communications. Motley Fool newsletter services have recommended buying shares of L-3. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.


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