Notoriously "lumpy" earner and eschewer-of-guidance extraordinare American Science & Engineering (Nasdaq: ASEI) reports its fiscal third-quarter 2008 results Monday. Want to know what Wall Street expects to see? Read on. Want to know what really matters? Read on a bit more.

What analysts say:

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  • Revenue. On average, they're looking for sales to slip 9% to $43.7 million.
  • Earnings. Profits are predicted to plunge 28% to $0.62 per share.

What management says:
Management blamed contracting gross margins and expansive R&D costs for its failure to achieve any earnings growth at all last quarter, despite growing its revenue 27% year over year. In fact, profits declined by a penny.

Fellow Fool Rick Munarriz was not amused. Nor were AS&E investors, who suffered a 14% haircut on the news, although they've since recovered most of those losses.

CEO Anthony Fabiano downplayed the significance of the slumping margins, emphasizing instead "the trend to diversify both backlog and future revenue across all product lines."

What management does:
The problem? The newest, fastest-growing business lines appear to have lower margins than the older ones. As a result, gross, operating, and net margins have all declined steadily over the past 18 months.

Now the good news: These margins have a long way to fall before they begin to approach the levels of profitability that AS&E's competitors pull down. L-3 (NYSE: LLL), the next-most-profitable competitor in the lineup, earns barely more than half the operating margin that AS&E boasts. Analogic (Nasdaq: ALOG), and OSI Systems (Nasdaq: OSIS) lag far behind.

Margins

6/06

9/06

12/06

3/07

6/07

9/07

Gross

48.7%

47.5%

46.2%

43.4%

42%

40.4%

Operating

29.4%

25.2%

23.6%

21.4%

21.1%

19.8%

Net

18.2%

18.1%

15.9%

16.1%

14.8%

14%

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:
At its root, AS&E's margin deterioration begins with the gross. With sales up 38% year to date, the cost of goods sold (COGS) has spiked 56%. So either component costs (and labor for the services business) are totally out of hand here, or AS&E lacks the pricing power to maintain its profit margins on new product lines.

In contrast, while many teeth have been gnashed over last quarter's rise in R&D costs, this line item is really a red herring. In fact, management has its operating costs well in hand. Selling, general, and administrative expenses (SG&A) rose a mere 6% year over year in the first two quarters of this fiscal year. And while R&D is up 45%, that's only a bit faster than sales growth. And as an absolute cost, research costs are less than half the expense of SG&A at this company, and barely one-tenth of what AS&E spends on COGS.

Unless and until the story changes, Fools will want to focus on gross margin trends to determine how good an investment AS&E will be for you. Where gross margin goes, operating and net margins will follow.

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Fool contributor Rich Smith owns shares of AS&E. The Motley Fool's disclosure policy sees all, shows all.