Foolish Forecast: FARO Frightens

Super-accurate measuring equipment-maker FARO Technologies (Nasdaq: FARO) is no longer a member of the Motley Fool Hidden Gems portfolio of undervalued small caps. But -- partly from sentimental attachment and partly because some of our subscribers think the company can still turn things around -- we continue to follow this little-engine-that-(apparently-)can't. Hence, what follows are a few facts and figures that might help those who still own the company to make sense of tomorrow's Q2 2006 earnings news.

What analysts say:

• Buy, sell, or waffle? Half a dozen analysts still follow FARO as well. One says to buy it; another to sell; and the other four say just hold and hope for the best.
• Revenues. Analysts expect, on average, to see tomorrow's sales number come in 15% higher than last year, at $35.4 million.
• Earnings. Profits are another matter entirely. They're predicting a 69% decline to $0.04 per share.

What management says:
Late last month, FARO made a top-level management change as it installed Keith Bair, an Arrow International (Nasdaq: ARRO) alum, in the CFO's chair (on an interim basis). While it's nice to know that someone's filling the position now that ex-CFO Barbara Smith has jumped ship, Fools should be aware that most of Bair's past experience is at private or pink-sheeted companies; also, he's been with FARO for less than six months, and may still be learning the ropes. In other news, the company continues to tangle with the SEC over the latter's investigation into possible violations by FARO of the U.S. Foreign Corrupt Practices Act. Amid all these distractions, FARO co-CEO Jay Freeland continues to insist that things are going well. Sales grew 16% year over year last quarter; bookings were up 21%; and (note the change in language here) "gross margin was 58.8%." [Emphasis added.]

What management does:
If you're wondering why there was no "improved" or "grew X basis points" attached to that 58.8%, it's because the margins actually moved the other way: down 400 basis points year over year. Moreover, from a longer-term, "rolling" perspective, we can see that last quarter's gross margin decline was just part of a longer-term trend. Over the last 18 months, each of gross, operating, and net margins have fallen steeply.

One Fool says:
After reading all of the above, by now I'm guessing you've got a good handle on why we grew disenchanted with this stock at Hidden Gems. But here's one more bit of disingenuity to add icing to the cake. In last quarter's earnings report, Freeland cited a $1.3 million reduction in inventory as evidence that the company is beginning to turn around. And I'll grant you: yes, FARO decreased its inventories from $28.7 million to $27.4 million in value, sequentially.

Year over year, however -- a statistic that FARO management appears to frown upon using -- inventories skyrocketed 43%, while sales grew only the above-mentioned 16%. Bragging about one statistic while talking around another statistic logically connected to it just doesn't sit well with this Fool. That's why, if you're still invested in FARO, I wish you the best and will continue to monitor the company for you. But if you're not in it yet, I'd think twice before buying -- at least until we see management start talking the straight-and-narrow.

Customers:

• Boeing (NYSE: BA)
• Caterpillar
• DaimlerChrysler (NYSE: DCX)
• GE (NYSE: GE)
• GM (NYSE: GM)
• Lockheed Martin (NYSE: LMT)

Not scared yet? Read Seth Jayson's own objections to FARO in:

• FARO Flops Again
• FARO's Chinese Payment Torture
• Flipping the Switch on FARO

If you want to take a look at a small-cap newsletter brave enough to admit when it got one wrong, a free trial is available.

Fool contributor Rich Smithdoes not own shares of any company named above.