The Naked Truth on AS&E

American Science & Engineering, Inc. (Public, NASDAQ:ASEI)

By now, most people have read or heard about the new airport screening system the Transportation Security Administration (TSA) is piloting at Sky Harbor International Airport in Phoenix, Arizona. When the news first broke in early December, there wasn’t a shortage of media coverage or distortion of facts.

When you heard the news of the TSA pilot, what went through your mind? Were you concerned your image taken at a security checkpoint would somehow find its way onto the internet? Were you concerned the radiation exposure would leave you glowing in the dark like a firefly? If you are an investor, you were probably thinking….What is the ticker symbol of the company that makes the screening machines?

Perhaps you are an investor and it crossed your mind to do a little due diligence but you never bothered for any number of reasons. Maybe you figured the company was a one hit wonder that would fall into bankruptcy if the TSA pilot program was a failure. Or, perhaps you figured the company was behemoth like GE and a large TSA contract would be relatively insignificant in the grand scheme of things. Or, perhaps you figured the company was likely already way overpriced.

If you are an investor and didn’t bother to do a little due diligence, I suggest you take the time get to know American Science & Engineering, Inc. (ASEI).

Not Your Father’s X-Ray Inspection System

American Science & Engineering, Inc. (“AS&E”) is a leading provider of X-ray inspection and screening systems. Founded in 1958, this Billerica, MA (go Red Sox) company has a rich history of scientific innovation that laid the groundwork for its current portfolio of products.

AS&E’s incorporates a combination of its patented Z Backscatter, Forwardscatter, Shaped Energy, and Radioactive Threat Detection technologies along with transmission X-ray technologies into its products to provide customers with the most comprehensive threat detection in the industry. AS&E’s high resolution scanning systems are capable of identifying smuggled goods and various threats to human life such as: traditional explosives; liquid explosives; plastic and metal weapons; radioactive devices; drugs; alcohol; and other contraband. Examples of scanned images can be found at AS&E's image library.

No One Trick Pony

Anyone that assumed AS&E was a one trick pony that would live or die by the success of the TSA pilot couldn’t be any more wrong. AS&E has a complete suite of inspection and screening systems to combat terrorism, drug and weapons smuggling, trade fraud, and illegal immigration. These systems can detect threats that may exist in cargo containers, trucks, cars, parcel, baggage, and mail. Furthermore, the SmartCheck system, the system being piloted by the TSA, is capable of identifying threats and illegal substances on a person’s body. Details of existing products can be found in the Products & Solutions section of the AS&E website.

Building the Pipeline

Despite its existing portfolio of scanning technologies and products, AS&E is not sitting back on its heels. AS&E’s long-term target for R&D spending is roughly 6% of sales. In recent quarters, R&D has been below managements’ long-term target level. The lower level of R&D spending is partly due to a reallocation of R&D resources from internally funded development projects to contract research and development (CRAD) projects. AS&E is making adjustments to its hiring plans and expects R&D spending to return to management's long-term target levels.

AS&E’s pipeline of activity is exciting and the successful commercialization of any one of these projects will have a favorable impact on the future success of the company. For the most part, R&D and CRAD projects are not detailed on the company’s website. As such, I have consolidated information from past press releases and conference call comments relative to these programs.

Cargo Advanced Automated Radiography System (CAARS) Program

The CAARS Program is a $50 million development program funded by the U.S. Department of Homeland Security’s (DHS) Domestic Nuclear Detection Office (DNDO). The goal of the program is to develop and deliver a next-generation cargo inspection system that automatically detects shielded nuclear threats at the nation’s point of entries. According to AS&E, a successful performance in the development phase of this program could lead to a substantial procurement contract up to …………….$450 Mmmmmillion (said like Dr. Evil in Austin Powers).

While development contracts on the CAARS Program were also awarded to two other firms (L3 and SAIC), AS&E received over 58% of the funding. When Anthony Fabiano, President and CEO, was asked on the last earnings call why AS&E received a disproportionate amount of the funding, he responded by saying AS&E has a very sophisticated solution that could deliver the best results by a long shot.

Oh wait, what’s that? You don’t want to take the CEO’s word for it? Read this from the DNDO in response to Smith’s Detection Inc.’s protest of the agency’s evaluation and source selection decision:

“The SSA concluded that AS&E’s approach had the potential to provide performance far beyond the [DELETED] industry standard proposed by the other offerors. The SSA further concluded that, in comparison, AS&E’s technology with its ability to portray high Z detections [DELETED] has the potential to significantly improve the accuracy and speed of detection and alarm against threat materials, with an exceptionally low false alarm rate. The SSA recognized that there was a risk associated with the development of AS&E’s technology, but determined that the potential payoff of such a technology outweighed the risks especially when the technology has already been demonstrated in a laboratory environment.”

Note that sensitve details are [DELETED].

(thanks to bobbur11 on the Yahoo board for posting the link)

Ruggedized Z Backscatter Van

Z Backscatter Vans (ZBVs) are commercially available vans equipped with AS&E’s scanning technology. ZBVs are part of the company's Cargo and Vehicle Inspection product group. In November, AS&E announced it received a contract from the U.S. Government to deliver a ‘ruggedized’ Z Backscatter Van for operation in harsh environments. According to management comments in the last earnings call, AS&E would likely be partnering with a manufacturer of armored vehicles, whereas AS&E would provide its scanning technology and its partner would provide the ruggedized vehicle. How this partnership affects revenue and margins will depend on the structure of the partnership agreement but the end result should be an increase in deployment opportunities and earnings.

Management is optimistic that the ‘ruggedized’ ZBV will obtain type classification. Type classification would make the ‘ruggedized’ ZBV a standard budget item as opposed to a special order item. With type classification, the ‘ruggedized’ ZBV would be more readily available for widespread military use. Futhermore, type classification will facilitate the order process for the military agency placing the order and the planning and fulfillment process for AS&E. There is no certainty as to if and when the ‘ruggedized’ ZBV will obtain type classification but the process is underway.

In early March, Stifel Nicolaus issued a research note on AS&E, which was subsequently reported on by SeekingAlpha. According to the SeekingAlpha article, details of the FY07 Supplemental Budget Appropriation bill indicate that the ‘ruggedized’ ZBV is ready for deployment. If the ‘ruggedized’ ZBV is ready for deployment, AS&E will likely receive orders in the near future for both new ZBVs and upgrades to existing fleets.

Other Research Programs

Some of the other programs mentioned by management on the last conference call include long range scanning, a robotic mounted X-ray system, and vehicle-born and human born IED detect and defeat sub-systems. While there are little details on these programs, the opportunities are clear.

Bankruptcy from a TSA Failure?

In looking at the balance sheet and cash flow statement, clearly bankruptcy is not at all a concern. To date, personal scanning products like the SmartCheck system being piloted by the TSA have accounted for only a small portion of the company’s sales. Yet, AS&E has over $118 million or $12.93 per share in cash and short-term investments with only $9.8 million in debt, including current portion of lease financing. Furthermore, AS&E generated $24.8 million in operational cash flow in the first three quarters of fiscal 2007. Operational cash flow in the same period exceeded net income by over $6 million.

AS&E’s positive operational cash flow and large cash position gives the company flexibility to do a lot of things to increase shareholder value such as: buying back shares; paying down debt; funding capital expansion; paying a dividend; or, making an acquisitions. On the last earnings call, one caller asked management if they considered utilizing their cash position to buy back shares. Management said they have discussed the possibility of a share buyback with its board and both management and the board believe there are other opportunities to employ cash that would be more beneficial to the company and its shareholders. In particular, management alluded to acquisition opportunities that would fill vertical gaps that would in turn bring the company closer to achieving its five year plan.

No GE

AS&E’s success does not depend on the success of the TSA pilot. At the same time, AS&E is no GE and a broad scale domestic rollout of SmartCheck would have a noticeable impact on revenue and earnings.

AS&E has a market cap of less than $500 million and annual sales of less than $150 million. A SmartCheck system sells for about $110,000. Multiply that number by the number of airports, by the number of checkpoints, by the number of systems per checkpoint, by a hypothetical penetration rate, and it is clear that a broad scale rollout of SmartCheck in the U.S. would be significant to AS&E.

After doing the above math, consider the fact that a broad scale rollout in the U.S. will get some recognition abroad (i.e. Canada).

Overpriced?

At a price of $52 per share, AS&E is trading nearly 45% off of its 52 week high and has a PE of 22.6x trailing twelve month earnings. On my own pro forma income statement, which reasonably excludes the warrant adjustments (discussed below) and utilizes a 37% tax rate, I have AS&E trading at a PE of just under 20x trailing pro forma earnings. Oh but wait, don’t forget AS&E has nearly $13 dollars in cash per share. Given its large net cash position, a better ratio to consider would be enterprise value divided by earnings before interest, taxes, depreciation and amortization (EV/EBITDA). AS&E trades at a reasonable EV/EBITDA of 8.25.
In my opinion, AS&E is trading at a discount to its fair value and I believe the market is failing to award AS&E for its superior margin performance and returns.

Gross Margins 46.22%
Operating Margins 23.78%
Profit Margin 15.91%
My Pro Forma Profit Margin 16.40%
ROA 14.85%
ROE 17.83%

Furthermore, I don’t believe the share price reflects the future potential of AS&E’s current product line and programs in development, including the TSA pilot.

Why No Love?

Stocks very rarely trade at their intrinsic value. In reality, intrinsic value per share is best thought of as the price a stock will pass through when going from overvalued to undervalued and vice versa. A stock may trade above or below its intrinsic value, which in and of itself is not a static value, for any number of reasons and for extended periods of time.

When a stock is trading at a premium or discount to what I consider to be its intrinsic value, I feel it is important to understand why this may be the case. In the case of AS&E, I believe part of the reason it is trading at a discount to its intrinsic value is the historically low level of predictability of financial results from one quarter to the next. Investors frequently rely on past performance along with a number of other factors to predict future performance. When past performance has a high degree of variability, it is more difficult to predict future results, and this makes investors nervous. There are several factors behind the variability of past financial results.

Timing of Large Contracts

On occasion, AS&E will receive extraordinarily large contracts that have a considerable impact on quarters in which the company recognizes revenue on those contracts. When shipments are made on a large contract in one quarter but not in the same quarter of the subsequent or prior year, there may be a substantial impact on year-over-year comparisons. Furthermore, AS&E is heavily dependent on contracts from the U.S. Government. As such, there is some seasonality to orders relating to government budgets and timing on the availability of funding.

While the company will continue to receive large contracts, I expect the frequency of contracts to increase; thus, removing some of the lumpiness. I believe the frequency of contracts will increase as a result of recently developed products gaining traction in the marketplace and through the diversification of revenues across geographic regions.

Field service revenue is steadily increasing with the growing install base. As field service revenues increase, lumpiness associated with contract revenue will decrease.

Warrant Adjustments

In 2002, AS&E closed on a private placement offering of common stock and warrants. Due to certain cash conversion features associated with the warrants, a liability equal to the fair value of the warrants at the date of closing was recorded on the balance sheet. Each quarter there is a mark-to-market adjustment (adjustment based on share price at the end of one quarter versus the prior quarter) on the value of the warrants. In the fourth quarter of fiscal 2006, the mark-to-market adjustment had a negative impact of nearly $4 million. In the first quarter of fiscal 2007, the mark-to-market adjustment had a positive impact of over $2.1 million. Obviously, these adjustments can distort bottom line results and quarterly comparisons. While the warrant adjustments may be confusing, it is important to note that they are not an actual expense of the business and therefore should be ignored.

The warrants expire in May of 2007.

Variability of Tax Rate

Quarterly tax provisions have had a high degree of variability. This variability has been largely driven by the recognition of tax loss carryfowards and the quarterly warrant adjustments, which are not taxable. As the company has moved substantially to a full tax rate and the warrants will expire in May, the quarterly tax provision should be more consistent going forward.

SFAS123(R)

On April 1, 2006, the company adopted SFAS123(R), which deals with the valuation and recognition of costs associated with stock based compensation. Since the company adopted SFAS123(R), it has recognized over $6 million in compensation costs. As prior periods have not and will not been restated to reflect SFAS123(R), year-over-year results have been difficult to reconcile.

After the fourth quarter of fiscal 2007, ending March 31, 2007, there will be a full year of comparables under the new accounting rule. As such, year-over-year comparisons will be easier to reconcile.

While the above factors have influenced the variability of past financial results, it is clear that these influences will go away or at the least will be mitigated in the future.

Conclusion

Whether or not the TSA pilot is a success or failure, the future looks bright for AS&E. Given the company’s current financial position, past performance, and prospects for future growth, I believe AS&E shares are attractively priced

Disclosure

I am long AS&E and I have to credit downtowntrader for pointing this one out to me a couple of months ago. Maybe he will be kind enough to give a quick technical analysis over the weekend.

One Last Note

SmartCheck is not going to make you glow in the dark and your scanned image is not going to like this image printed by the New York Times. Factual information regarding the TSA pilot is available here and here.

Good luck,
Tuff