Can Applied Energetics Zap Its Way to Revenue?

Being optimists, investors want to hear the good news. What's going to propel their stocks forward? What is their company's competitive moat? Many investors simply don't want to hear, or can't handle, the ugly truth about the companies they own.

That's not me. I want to know what can go wrong with my stocks. If my money's on the line, I don't want to be blindsided. When I crack open a company's annual report, the section on risks is one of my first stops. It's the dumping ground for companies to lay out all the things that could go wrong with their business.

Out of harm's way
Regardless of which side you happen to be on, the safety of U.S. soldiers in Iraq, Afghanistan, and other military hot spots has to concern you. The danger from improvised explosive devices (IEDs) remains high. Often triggered by electronic signals sent by the enemy, they remain one of the leading causes of U.S. casualties.

Applied Energetics (Nasdaq: AERG), known until recently as Ionatron, has been contracting with the U.S. military to develop some high-tech methods to defeat IEDs. Through proprietary systems -- what it calls laser guided energy (LGE) and laser induced plasma channels (LIPC) -- Applied Energetics seeks a seemingly futuristic use of lasers to guide a high-voltage electrical charge to defuse or detonate IEDs.  

It has received a number of contracts over the past few years to develop these "Star Wars" type systems. A year ago it got a $9.8 million contract from the Navy to support development of both the LGE and LIPC systems. That was followed by a $2.1 million Army contract, a 24-month contract from the Army Research Office, and $1 million from the Defense Department's Joint Improvised Explosive Device Defeat Organization (JIEDDO). It delivered a prototype to the Navy for evaluation.

Improvised reality
While there's a large "gee-whiz" factor when looking at Applied Energetics' technology, "futuristic" could also aptly describe the actual deployment of the systems. Sure, there have been a number of contracts, but they are for research and development. There's no product in production yet.

The laser company lives and dies by its government contracts, which comprise virtually all of its $12 million in 2007 revenue. Any change of heart by the Defense Department, and the largesse will dry up for Applied Energetics.

That's not totally far-fetched. JIEDDO, for example, has a proposed $4.4 billion budget for 2008, but its critics say it is willing to latch onto any high-tech solution at the expense of lower cost, low-tech ideas. In fact, some in the field contend that JIEDDO is adopting technology that does the same thing as C-4 explosive, but at greater cost. Should Congressional budgeters agree, it might spell the end of many such programs.

And even making it through the labyrinth is no easy task. JIEDDO estimates that over the past two fiscal years, it received 1,335 proposals for counter-IED systems and funded 349. Of those, 12 have become institutional military programs. The likelihood that an Applied Energetics system will make it through that maze is slim at best.

Joining the club
The problem with LGE, LIPC, and other such systems is that they are only effective once a device is located. And the military already has lots of technology at its disposal to defuse or detonate an IED once it's been found.

Alliant Techsystems (NYSE: ATK) deployed a prototype microwave generator to defeat IEDs in 2005, and a Humvee outfitted with a solid-state laser from privately held Sparta back in 2003. Boeing (NYSE: BA) is testing a similar device. One of the more effective methods the military has in the war against IEDs is signal-jamming, which stops militants from detonating the devices. As far back as 2003, the military invested heavily in the Warlock radio systems made by ITT (NYSE: ITT) subsidiary EDO.

While there may always be a need for this technology, if troop deployment in Iraq begins to wind down, the perceived need for the technology will wane as well. Investors need to consider that political reality.

During its years as Ionatron, the company was seemingly active in promoting itself through business news and press releases. At times, it has been involved in transactions that might have disproportionately benefited insiders. In February, for example, it spent $2.2 million to purchase property it formerly leased from family members of the company's founder and other insiders. With Applied Energetics' stock beaten down, investors should use caution if they think the company's dealings look too good to be true.

Foolish final thoughts
There's no perfect stock. Foolish investors would do well to know a company's flaws before committing money. There's nothing to say that the potential problems identified above will come to pass for Applied Energetics, but Fools can do right for themselves by knowing what can go wrong.