American Science & Equanimity

Near the end of last week, the stock price of Motley Fool Rule Breakers pick American Science & Engineering (Nasdaq: ASEI  ) resembled nothing so much as a superball dropped from extreme height.

Early on Wednesday morning, the company reported fiscal first-quarter 2007 sales 15% weaker than last year's Q1, and profits per diluted share down 48%. The stock began a rapid descent, falling 21% in value in just a few short hours of trading. Thursday's news of an aborted terrorist attack on 10 airlines flying from London to the United States, however, provided an immediate rebound to the backscatter X-ray specialist, driving the stock back up near its previous closing price. And where does the stock sit today, less than a week after the earnings release that so shocked the Street? About a buck higher than it fetched before the "bad" news.

With your indulgence, here's how I'll tackle this story. First, I'll hit the highlights of the company's news. Second, I'll note a few interesting bits from the conference call; if you could use a more detailed analysis, feel free to click through to Andy Cross' (TMFOpie's) digest of the call right here (Rule Breakers members and trial subscribers only, please). Finally, I'll address what I found most interesting in the call.

News at 11 (points)

  • AS&E sold $29.9 million worth of sales for Z Backscatter Vans, OmniView Gantry systems, Gemini parcel inspection systems, and related services during the quarter.
  • The company netted $6 million per share in profits on these sales (versus $7 million last year).
  • AS&E again failed to include a cash flow statement in its earnings releases. On the conference call, however, management revealed that it generated $10 million in operating cash flow, minus $1.6 million in capital expenditures. That yields $8.4 million in free cash flow for the quarter. (Why management makes ordinary investors wade through the earnings calls to find this figure, when it could easily provide it in the earnings release, is beyond me.)
  • Gross margins for the quarter grew 380 basis points to 45.2%.
  • Operating margins slid 420 basis points to 18.6%.
  • Net margins barely budged at all, up just 10 basis points to an even 20%.
  • The trailing-12-months (TTM) gross margin continued its rise, hitting 48.8%.
  • The TTM operating margin dipped for the first time in two years, falling to 29.8%.
  • The TTM net margin held steady at 18.2% for the second quarter running.
  • For the first time in two years, the trend in TTM sales reversed, falling to $158.3 million.
  • And finally, the diluted share count has grown 4.3% over the last year.

Conference call color
Two analysts on the call, from Jefferies (NYSE: JEF  ) and Kensico Capital, respectively, asked about a change in its standards for "materiality" -- how valuable a contract must be in order for AS&E to publicize it in a press release. CFO Ken Galaznik clarified that the company now uses a $2 million threshold as a rough cutoff for materiality.

An analyst once told me that AS&E's sales numbers are highly transparent because "they announce the lion's share of their orders." According to CEO Anthony Fabiano, that is no longer exactly true. He noted that, "As our business has grown, we just have tried to make announcements that we feel are material . so the one-sie, two-sie orders, we haven't been announcing every one...." Moral of the story: Investors cannot simply add up the values of contracts announced over the course of a quarter to arrive at a sales total. Such a strategy could well miss multiple, smaller-than-$2 million orders, each of which can potentially nudge total sales up by 5% or so.

Before moving on, I'd like to mention one other point that jumped out of the conference call. Regarding the profitability of the company's sales, CFO Galaznik laid out two broad rules of thumb for understanding how the margins are affected by "product mix." Specifically, the greater the percentage of revenues that Backscatter vans and field-service contracts constitute, the higher the firm's gross margins will be.

X-raying the forest to find the trees
Here's the most important part of last week's news. In my opinion, one big reason that the stock declined on Wednesday was that management refused to play Wall Street's earnings game. It seemed like half the questions the analysts posed to Galaznik and Fabiano, trying to elicit concrete statements about the company's future sales and earnings, garnered little more than variations on "no comment" in reply. Needless to say, the analysts were not pleased with this response. They wanted assurances about what the future held. Wouldn't we all?

But the thing is, it's even harder for AS&E to predict the future than it is for most companies. Consider that even consumer-products companies like Johnson & Johnson (NYSE: JNJ  ) or Procter & Gamble (NYSE: PG  ) sometimes "miss estimates." And these are companies for which repeat business is pretty predictable. If Customer A uses J&J's shampoo in Q1, or Customer B shaves with P&G's razor blades, you can be pretty sure that Q2 will find A & B still buying the companies' products. In contrast, predicting whether the government of South Asiastan will buy Backscatter vans in any given quarter is a much iffier proposition. This tends to burden AS&E with so-called "lumpy earnings." Some quarters, it's feast; others, it's famine.

Obviously, fiscal Q1 2007 was a bit of a famine, especially compared to recent feasts. But it's extremely difficult for AS&E to predict how well it will "eat" in any given quarter. As Fabiano put it, "I probably have a really good idea of how I'm going to do for the year, but I don't really have a clue quarter-to-quarter how things are going to fall." (A bit blunt, but it gets the point across.)

Fabiano cautioned that if you examine AS&E "from a quarter-to-quarter standpoint, you're going to get yourself into trouble...." To illustrate, he noted:

Last year, we just hit a grand slam. We had a great year and I think what happens is the folks on Wall Street take the last quarter and they project the future based on it ... Last year, we had one quarter that was just off the charts, and everybody said 'Gee, great,' but no one turned around and said 'My God, that's terrible. You had a high quarter. When are you going to have a low one?' So I just think it's endemic of the nature of our business, and if people continue to look at one quarter and then make judgments about the future of it, they're just not seeing the forest through the trees.

In conclusion.
That's really the point of last week's events. One quarter, AS&E may be brilliant; the next, lackluster. One day, the stock may fall 21%. The next, it may rise 26%. Investors rarely get to see such a stark illustration of the market's short-term thinking -- its dangers and its irrelevance to the long term. But when it sits up and smacks you in the face, as it did last week, pay attention.

To wrap things up, I'd like to suggest an article that points to one possible, ultra-long-term future for AS&E: The company looks to me like an ideal buyout target for GE (NYSE: GE  ) . Before you leap to disagree, read GE: InVision Is Da Bomb. It just might convince you.

For the latest news on AS&E and other stocks on the cutting edge of technology, join David Gardner and theMotley Fool Rule Breakersteam in their search for the next ultimate growth stock. You can try it free for 30 days.

Fool contributorRich Smithdoes not own shares of any company named above. Johnson & Johnson is a Motley Fool Income Investor pick, while Procter & Gamble is a Motley Fool Inside Value selection. The Fool has a disclosure policy.


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