Why the Short Interest in AS&E?

Motley Fool Rule Breakers selection American Science & Engineering (NASDAQ:ASEI) has rewarded shareholders with great performance over the past year, with the stock having climbed some 90%. But there are ominous dark clouds on the horizon: namely, extremely high interest in shorting the stock. Do longs have reason to be worried?

Short story
AS&E makes X-ray and other inspection equipment used in security applications. Its stock has spiked along with sales of the Z-Backscatter Van (ZBV) -- a unique product that's used in dangerous places like Iraq to find hidden threats, such as improvised explosive devices. Competitors, including OSI Systems' (NASDAQ:OSIS) Rapiscan division and L-3Communications (NYSE:LLL), don't have anything to compete with it.

But despite the ZBV's success, AS&E is trying to avoid becoming a one-trick pony. Its SmartCheck system is currently under evaluation by the Transportation Security Administration, and its OmniView Gantry system may be gaining traction at American ports.

However, a quick glance at the rising interest in short positions -- which currently stands at 19% of shares outstanding, according to Yahoo! Finance -- might make you think there are some thorns in the garden. In an earlier column, I noted the high short interest, which then stood at 15%, but commented that I thought the shorts were playing with fire. Since my column was published, the share price has risen -- but the short interest has risen along with it.

Guess what? Short sellers don't generally like losing money any more than the rest of us do, so it looks to me as if the shorts are awfully confident they have an eventual loser (or a winner for them) on their hands. Why else would they increase their short positions in the face of a rising stock price? Given the persistence of short interest, I thought it was worth spending some effort trying to understand the short argument.

After doing a bit of digging, I have found some things that may be the focus of the short sellers -- and if you are short these shares, I'd love to hear the rationale for your position. These are the things I have found:

1. Heavy insider selling.
2. Excessive dilution because of stock options.
3. Quarterly revenue volatility.
4. Tough comparisons this year because of strong results last year.
5. A sharp drop from a year ago in the raw-materials component of inventory.

Let's look at each of these.

Insider selling
Insiders sell for a variety of reasons and are not necessarily great stock-sale timers. However, the sales at AS&E stand out, I believe, because the total shares sold amount to 44% of insider holdings, according to Yahoo! Finance. So who's been doing all of the selling?

The table below shows the number of shares that four insiders held, as reported in the proxy filed in July 2005. The last column shows the total number of shares sold since August 2005 (data, again, from Yahoo! Finance). While some of these sales were undoubtedly due to exercises of stock options (how else can the CFO sell more shares than he owns?), I still find this troubling, because members of management are electing not to hold on to the shares they receive when exercising their options. It's also worth noting that insider ownership at this company is low anyway -- it currently stands at 1.5%.

Insider Sales

Dilution
During fiscal 2004 and 2005, the diluted share count grew from 6,627,000 to 8,565,000 shares -- a 29% jump over a two-year period. Strong growth is continuing this year also. In the quarter ended Dec. 31, 2005, there were 9,321,000 diluted shares outstanding -- another increase of almost 9%.

So why does this matter?

A corporation's earnings are divided by the number of shares outstanding to obtain the earnings per share. By spreading the earnings over a larger number of shares, an individual investor's portion of AS&E's earnings is lower. According to Yahoo!, analysts expect this company to grow by 20% per year for the next five years. Unfortunately I can't tell whether this is the earnings growth or EPS growth, but if it is EPS growth, then overall earnings will need to grow quite a bit stronger than 20% to counteract the effect of dilution.

Quarterly-revenue volatility
Many companies that sell to government customers have to live with volatility in their sales, since governmental priorities can change quickly. Besides the inherent lumpiness in these orders, AS&E's revenues are made up of a relatively small number of expensive products. If one customer decides to order just a few less (or just a few more) ZBVs in a quarter, it has a large effect.

The table below shows AS&E's revenues over the past 13 quarters. While they have obviously grown strongly overall, there have also been four quarters during which revenues declined from one quarter to the next.

AS&E Quarterly Revenues
(In Thousands)

Tough comparisons coming up!
Looking at the performance over the past four quarters brings up a related issue: Is AS&E going to be able to continue its recent strong growth this year? The record revenues of the past year will make comparisons awfully tough. AS&E is going to have to continue getting large orders for the ZBV from the U.S. government, along with some large orders from other organizations. Of course, if the TSA accepts the SmartCheck system or the OmniView Gantry inspection system takes off, then this coming year should be just fine.

As I mentioned earlier, analysts do expect earnings to grow 20% annually over the next five years. I think there is a good chance that growth during the rest of the decade will be strong, but even 20% growth in earnings would be a big drop from last year's growth rate.

The inventory situation
Over the past few years, the raw-materials component of inventory has not shown much correlation to sales a quarter or two down the road -- until recently. AS&E started bumping up its raw materials in Q3 of 2005 (ending Dec. 31, 2004) and peaked in Q4, a quarter later. The company's best quarter ever occurred in Q2 2006, six months after the inventory peak, so it looks to me as though management anticipated a big order coming up.

The latest quarterly results show that raw materials have fallen by more than half. Is this an acknowledgement that AS&E's managers expect upcoming business to weaken? I obviously don't know for certain, but that is my guess. I will definitely check the level of raw materials when management reports results for Q4 later this month.

Foolish bottom line
Despite my concerns about the potential for a share-price decline in the near term, I'm definitely not going to join the short sellers. As discussed, there are a number of developments that could send these shares sharply higher -- increasing ZBV sales, a larger OmniView Gantry order, or acceptance of SmartCheck by the TSA, to name several.

Nevertheless, if you own these shares, I think you have to be sure that you won't panic in the event of a 50% decline in the stock price. If you get nervous seeing red in your portfolio, then you should consider selling now and watch this one from the sidelines.

Fool contributor Dan Bloom doesn't own shares of any stock mentioned in this column. He tried a bit of short selling in the past, but has since realized that a good, long-term investment can earn a far higher return. It also allows him to sleep better.