Sensor designer RAE Systems (AMEX:RAE) specializes in being ahead of the curve, making sensors that can detect trace chemicals, radiation, or other potentially harmful products before it's too late. Some investors might have viewed the 17% short interest in RAE shares as a warning sign of its own. Sure enough, the stock was hit hard on Friday after an earnings report and outlook that disappointed some of the more optimistic followers of the company.
RAE reported revenues of $15 million for the fourth quarter, up about 75% over last year. Without the benefit of the company's KLH business (acquired earlier in 2004), growth would have been about 20%. Margins also dropped significantly due to the much lower margins of the KLH business and higher selling, general, and administrative expenses.
RAE has historically sold its sensors to industries like chemicals, mining, and refining, but has also expanded into public safety and security. RAE's sensors have recently been used as part of comprehensive security plans for events like the Super Bowl and the Republican and Democratic political conventions.
During 2004, though, shares climbed to lofty valuations on anticipation of greater sales to the homeland defense market -- specifically, the opportunity to fit shipping containers with a remote sensing product called the RAEWatch.
Over 21,000 containers come into U.S. ports every day, and even the Coast Guard and U.S. Customs acknowledge that there is minimal security oversight in the loading and unloading of these containers. Since containers are often taken directly off a boat and put straight away onto inland carriers like rails or trucks, they could conceivably be used as a vehicle for terror attacks almost anywhere in the country.
Unfortunately, the container business is taking a lot of time to develop. The biggest problem is, not surprisingly, money. Nobody -- whether it's shippers, freight handlers, customers, or government entities -- wants to step up and pay for port security, and there's no government mandate yet to do so.
In the 2005 Homeland Defense budget, for example, most of the relevant spending went to airline security and practically nothing was left for port security. Consequently, investors may have been left disappointed on Thursday evening when management didn't guide toward any near-term revenue from the container opportunity.
What's more, investors counting on a big increase in spending on chemical/radiation sensors must realize that strong competitors like Motley Fool Hidden Gems recommendation Mine Safety Appliances (NYSE:MSA) and PerkinElmer (NYSE:PKI) aren't going to just roll over and cede the business to RAE Systems. While neither company is a "pure play" like RAE, they each have more than enough resources to continue to be formidable competitors in the various sensing markets.
Certainly there is room for more than one or two competitors in this market. What's more, RAE Systems has considerable growth opportunities in emerging markets like China, where public and workplace safety is less developed (as witnessed tragically by recent mine explosions). For Fools who believe that the container market will deliver, current valuations might seem acceptable. But to this Fool, paying six times next year's revenue for a tiny fish in a big ocean sets off my own alarms.
Could RAE eventually join Mine Safety among the ranks of Tom Gardner's Motley Fool Hidden Gems selections? What's Tom looking for from his small-cap companies? Take a free, 30-day trial today to find out.
Fool contributor Stephen Simpson, CFA, has no ownership interest in any stocks mentioned.
