Fool on Call: AS&E

Listening in on AS&E's talk with the analysts.

Rich Smith
Rich Smith
May 23, 2007 at 12:00AM

"American Science and Engineering, Inc. (NASDAQ:ASEI) reports revenue and income for fourth quarter and fiscal year 2007... AS&E's Board of Directors Approves Stock Repurchase Program and Quarterly Dividend Plan for FY'08."

Reading the opening lines from this Motley Fool Rule Breakers pick's Q4 earnings release on Monday, my thoughts could be summed up in two words: "Uh-oh."

Why? Two reasons. First, the notable absence of words like "record" or "superb" or "best-ever" from the headline. (But then I remembered that unlike more self-promotional firms, the X-ray screening specialist takes an equanimious approach to earnings reports. It never uses exclamatory adjectives in its headlines -- not even in the Q3 2006 report, for example, when its sales doubled year over year.)

So the lack of adjectives was OK, but the subheading to the report worried me. You know, the bit about buying back stock and instituting a dividend. Oh, I understand that on the surface, dividends and buybacks represent a return of capital to shareholders and so are usually viewed positively. But when paired with news of contracting margins and declining profits, they're a bit too reminiscent of the kind of "damage control" practiced at perennial underperformers like Red Hat (NYSE:RHT), Gap (NYSE:GPS), or Sara Lee (NYSE:SLE). It's as if the company is saying, "Sure, we messed up, but here's a dividend. Now please don't sell us."

So it was that I turned to the firm's earnings call transcript with a sense of dread. What follows are a few excerpts, and comments on same, which explain why I'm no longer quite so worried.

The news
In contrast to earnings releases, though, post-earnings conference calls focus less on news and more on how an investor should interpret it, providing "color" to the black-and-white numbers. Not everyone has time to listen to these things, however, or has access to transcripts that can shave down the time involved. That's why we here at the Fool like to summarize the highlights for our readers. To keep an eye on the companies while you all go about your -- what are they called again? -- ah yes, "lives."

The news, now, in Technicolor
The big news at AS&E this quarter was almost certainly the decline in margins. Year over year, Q4 gross margins declined 9.5 percentage points to 39.3%.

CEO Anthony Fabiano tried to write this off as a function of the opaquely named "FAS 123R" and discouraged investors from trying to compare this quarter to last year's Q4 because it would be "very difficult." Actually, though, it's pretty simple: Last year, management gave a chunk of profits away to company insiders through stock options grants. This year, they did the same thing -- but had to admit it. It's no different at any other company that compensates its employees with stock options. Better-known firms like Cisco (NASDAQ:CSCO) or IBM (NYSE:IBM) have gone through all this before, as fellow Fool Bill Mann explained a few years back in his classic column, "Yes, Stock Options Really Are an Expense."

But Fabiano is right about one thing. If stock options drained earnings last year and this year both, and the only difference is that the accounting rules only now require this to be reflected in the margins, then really, nothing has changed about the firm's profitability.

The big question is: Now that the margins are sub-40, is this "the new normal" at AS&E? That's essentially the question that Morgan Keegan analyst Brian Ruttenbur posed to management during the call. CFO Ken Galaznik, after successfully dodging the question initially, eventually allowed himself to be nailed down in one respect. Asked by Ruttenbur whether "gross margins will dramatically increase from this quarter in 2008?", Galaznik finally admitted that, no, he "wouldn't look for dramatic improvement." So in the final analysis, it does sound like a sub-40% gross margin -- but by extension, perhaps still an upper-teen operating margin, and low-teen net margin -- is the "new normal" at AS&E.

Cash is king
One thing that was missing from AS&E's report was any mention of cash profitability -- free cash flow. Post-conference call, we still don't have a clear picture on this, but management did give us half the X-Ray when Galaznik confided: "In the '07 year, we've generated $44.8 million from operations as compared to $40.1 million from operations in the '06 year."

For one thing, that tells us that year-long cash from operations rose 12% -- the opposite of what one might surmise from the 17% decline in net profits. For another, knowing as we do that the firm generated $24.8 million in cash from ops through the first three quarters of the year, simple subtraction tells us that these cash profits soared in Q4. The correct number looks like $20 million for the quarter, or nearly as much cash as was generated in the first three quarters combined.

That said, management remained mum on capital expenditures for both the quarter and the year, making it impossible at this time to calculate free cash flow for either period. Although it was revealed that depreciation and amortization was "759 in the quarter, $2.425 million on the year," that's of little use to us. In the last two years, AS&E's ramped-up operations have necessitated capex far in excess of D&A costs. Fact of the matter is, we know that it had already spent $3.3 million on capex in the three quarters preceding Monday's report.

Better times ahead
One final point, and I'll end today's column before it begins to resemble the 18-pages of the conference call transcript. This one's on revenues, where they are, and where they're headed.

We know that sales declined 6% for the fiscal year and that things began turning around with a 13% rise in Q4. But will sales continue to mount? Booking and backlog trends suggest they will. Backlog, which represents orders expected to be converted into sales in the future -- a subject we discussed at length in dissecting fellow defense contractor SAIC's (NYSE:SAI) earnings report last month -- "shows the firm's revenue streams several quarters, or years, down the road."

At AS&E, the road looks both long and smooth, paved by new order bookings that are rising faster than revenues at 19% for the fiscal year, accelerating to 21% for the fourth quarter. As these bookings were placed in the backlog queue, they helped to boost that number to $105 million -- 53% higher in comparison with the level at this time, last year. And that's not even counting $61 million in unfunded backlog -- contracts that Fabiano said he was "very optimistic ... will be funded and exercised over the next year or so, as some are due for award in Q1 and Q2 of this year."

Foolish takeaway
Am I convinced that AS&E is going to do well in the future? No, not entirely. I still want to see the 10-K and check on whether raw materials and work-in-progress made up a sizable portion of the inventory hike. I still want to see the audited cash flow statement. That said, I'm glad I took the time to review the conference call (and that the Fool gave me a chance to share it with you), rather than panicking and selling immediately on the headline.

Fool contributor Rich Smith still owns shares of AS&E. In fact, he must continue to hold them for at least 10 days after this column is published. Panic or no panic, them's the rules.