Flipping the Switch on FARO

Editor's note: FARO is a recommendation of the Motley Fool Hidden Gems newsletter. Seth Jayson's opinions are his own and do not necessarily represent those of the Hidden Gems team. Seth is not a Hidden Gems analyst.

The breakup
There comes a time when we must step away from things we formerly held dear, and such is the case with me, the Lazy Portfolio, and FARO Technologies (NASDAQ:FARO).

A brief catch-up: I conceived the Lazy Portfolio a while back to see if I couldn't find a better way to make money through my investing. Simply put, I was hoping to harness my inner sloth to help me find investments that had market-beating potential but required a minimum of investor oversight. I was looking for businesses that did simple things, did them well, and were led by straight-talking managers who could be trusted to do the right thing for shareholders.

As of a few weeks back, Lazy was beating the Street -- as represented by shares of the S&P 500-bogeying SPDRS -- pretty handily, by about 14.4 percentage points over a year and a half. One of the few laggards in the bunch was Motley Fool Hidden Gems pick FARO, a stock that also occupied a large position in my own portfolio.

The initial infatuation
I liked FARO because it has interesting, "gee-whiz," next-generation industrial measurement technology (laser beams, even!) that was producing good revenue and earnings growth. As an off-and-on hobbyist designer of things like custom bike parts, I drooled over the possibilities and saw the enormous potential of the company's measuring systems, which can be used to verify production standards or even reverse-engineer important machine parts. That's why companies that make everything from airplanes to computers, such as giants Boeing (NYSE:BA) and Hewlett-Packard (NYSE:HPQ), use FARO products.

I still think this is great stuff. But my view of the company's predictable potential for outside shareholders has changed.

Things get ugly
In retrospect, the problems should have been obvious to me from changes in corporate communications over the past several months. Back when the company was underpromising and overdelivering, earnings releases carried titles like "FARO Reports EPS of $1.06 in 2004." Earlier this year, they started to get a tad wordy, at the exact same time that the results started to get worse than expected -- or even predicted by the company itself.

"FARO Reports 21.8% Net Income Increase in First Quarter 2005; Raises EPS Guidance for 2005" was the title on May 9, when the company predicted $1.15 to $1.45 per share. But when you parsed the information, you could see the equivocation creeping in. The company's bottom line for shareholders was actually being forecast to drop because of dilution from a recent acquisition, and the bulk of the "increase" was simply owed to a deadline shift for mandatory stock option expensing. (I guess "increase" is in the eye of the beholder.)

Management stubbornly clung to that full-year guidance for months, even after a foul second quarter made it look all but impossible to achieve. In the end, it proved to be a complete pipe dream. After the most recent quarter's disastrous results, CEO Simon Raab finally came up with new guidance for 2005. The hoped-for $0.75 to $0.83 per share is not only a big drop from last year's $1.06 per stub, but it's also light-years from the $1.15 to $1.45 predicted in May.

Behind the bumbling
By itself, this change wouldn't damn an investment for me. Stuff happens. Business plans change. Sometimes you need to pay up now for growth later, especially if you're trying to get ahead against a big competitor, as FARO is. The problem for me is how management has handled this process. I'm made increasingly uncomfortable by the rank salesmanship and pre-buttals in the earnings reports headlines (The Q3 release was titled "FARO Reports Record Third Quarter Sales and Reiterates Strategy." Reiterates strategy? Since when is that good news?)

And I've got an even dimmer view of the way CEO Simon Raab's promotion of the "all is well" story dovetailed with the big stake in the company he was shedding in the name of "diversification."

On May 12, the last big chunks of what had been planned as a longer-term, three-tranche sale contract came through. By pushing up these two tranches (by five months and 10 months, respectively), to only days after that sunny earnings release, he finalized the deal at a price of $28 per share. You need only look at the chart between then and now -- the original maturity date for the second tranche was yesterday -- to see what a difference that little bit of fortunate timing made.

(By the way, Raab's April 1 SEC Form 4, which describes the March 30 closing of the first tranche, makes no mention of accelerated dates for the second and third tranches, suggesting to me that the decision to accelerate was made some time in April, the first month of Q2, which turned out to be the beginning of the tough times.)

I find this far too convenient for Raab, especially in light of the poor results that followed. It wasn't until July 18 that the spit really hit the fan, when Raab and FARO finally admitted to major margin pressures -- a situation that was already creeping into evidence in that May 9 press release -- in a new Q2 preview press release titled "FARO's New Orders Grow 57% in the Second Quarter; Earnings Expected to Be Lower."

Pick an excuse
The rotating panoply of explanations from management for the second- and third-quarter failings no longer holds water with me. In Q2, the anemic results were blamed on increased costs of expansion on various fronts, especially a ramp-up of the sales force. I thought this was a reasonable explanation at the time -- to the point that I found myself defending the company's strategy against the criticism of some of my increasingly skeptical colleagues.

But by Q3, the excuses changed to a shift in product mix and inability to get a handle on the cost of goods sold because of the implementation of some new systems. Still reasonable? Maybe. But hey, we were told, now look at how we did with SG&A! I did look, and I came away uneasy. How is it that suddenly the effects of that Q2 sales ramp-up seem to have disappeared? The amount spent on sales actually dropped -- as a percentage of revenue and in total dollars from Q2 to Q3. This strikes me as all kinds of wrong.

I don't know for sure whether management is being duplicitous or is just subject to occasional fits of ineptitude. (In comments in this audio interview available to Hidden Gems subscribers -- or those who take a free trial -- Raab seems to prefer that we all assume the latter, as well as to trust that things have been fixed.)

Foolish bottom line
My colleagues at Hidden Gems may still be on the fence with FARO, but the judgment of this investor is clear. I no longer trust these guys. I don't trust what they say about their chances with ongoing patent litigation. I don't trust their guesses for industry potential, their market share, or their guesses as to their long-term margins.

Therefore, I no longer trust them with my money. (I sold my stake just after Q3 earnings.) And I don't trust them with the pretend money in this portfolio, either. We're scratching Faro from my Lazy List, effective today. Good luck to those who stay.

In the next update, I'll see if we haven't found a replacement for FARO. In the meantime, here are the current results for the Lazy 6, with FARO's returns to date still included.

They're still the kind of returns that make me wonder why I spend so much time hunting for other kinds of stocks. Is there a lesson here?

*Nike was purchased with the proceeds of a 10/13/2005 sale of Reebok, which had already turned in a 67.1% return. Thus, it began as a larger position ($3,200 and change, versus the $2,000 for others.)

For related Foolishness:

• Do lousy offices make great investments?
• So far, lazy beats the Street.
• Should you be stoic on FARO?

Seth Jayson is thinking he should be even lazier. At the time of publication, he had shares of SanDisk, as well as covered calls, but no position in any other firm mentioned. View his stock holdings and Fool profile here. FARO is aMotley Fool Hidden Gemspick, and Reebok is aStock Advisorpick. Fool rules are here.