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 perhaps it should be? The few analysts who still follow the stock predict good news will come on Monday, when it reports Q4 and full-year 2006 earnings.

What analysts say:

  • Buy, sell, or waffle? Only four analysts still follow FARO. Three of them rate it a buy, and one a hold.
  • Revenues. On average, they expect to see quarterly sales rise 29% to $44.6 million.
  • Earnings. Diluted earnings per share are predicted to rise exponentially to $0.27 per share.

What management says:
FARO CEO Jay Freeland (then the co-CEO, now solo) characterized his company's 18% sales growth and 22% improvement in earnings as "performing well" last quarter. As evidence of the company's getting back on track, he suggested that investors examine its income statement and balance sheet, which we'll be doing in just a moment. Freeland argued that the firm's "top-line growth and gross margin remain on plan, and we're getting the leverage we expected from our sales and marketing organization." As noted above, Freeland took over sole possession of the CEO's chair, which he had previously shared with company co-founder Simon Raab, in December. Raab is still hanging around as chairman of the board.

What management does:
Reviewing the trends in profitability, we see that FARO went through a long spell of declining margins, but began turning things around last quarter. Rolling gross margins moved up sharply, operating margins stopped sliding as well, and even the net turned upwards.

Margins

7/05

10/05

12/05

4/06

7/06

9/06

Gross

60.7%

58.5%

58.1%

57.2%

57.3%

58.2%

Operating

12.1%

10.5%

9.1%

5.7%

4.4%

4.5%

Net

12.1%

10.8%

6.5%

4.0%

3.0%

3.3%
All data courtesy of Capital IQ, a division of Standard & Poor's. Data reflects trailing-12-month performance for the quarters ended in the named months.

One Fool says:
Now, on to examining the income statement and balance sheet, as Freeland instructed. Each quarter, in breaking out its selling, general, and administrative expenses (SG&A), FARO makes a point of describing how much of these expenses stemmed from dealing with the firm's ongoing FCPA investigation and patent litigation. That's a wise move; over the last two quarters, for example, SG&A rose nearly twice as fast as sales, up 36% versus 20%. All the gross margin improvement in the world would have a hard time dropping extra profits to the bottom line with FARO's lawyers eating up so much of the cash, and management wants to make sure that investors realize that when the lawyers finally go away, things will look a lot better.

I can't argue with that, but I would point out one thing. Back out the $3.5 million in expenses that FARO attributed to the lawyers over the last six months, and SG&A still grew faster than sales, albeit by a more modest 23% to 20% margin.

Moving on to the balance sheet, the picture is mixed. We see that inventories for the last two quarters averaged just 8% higher than last year. That tells us FARO is having no trouble selling its wares. It does seem to be having some trouble getting payment in a timely fashion, however. Accounts receivable have grown 30% since last year, markedly faster than sales growth.

So in summation, these are the two things I'd hope to see on Monday: SG&A growth more in line with sales growth, at least after backing out the firm's legal costs, and a similar closing of the gap between growth in sales and accounts receivable.

Customers:

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

Further FARO Foolishness findable in:

FARO was a former Motley Fool Hidden Gems pick. See what firms currently make Tom Gardner and Bill Mann's list of superior small-cap stock selections with a free 30-day trial subscription.

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