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Shares of armored vehicle maker Force Protection Inc. (NASDAQ:FRPT) stepped on an Improvised Explosive Device [IED], closing at a new 52-week lows, on reports that the U.S. Marine Corps will cut its orders of bomb-resistant transports.

Friedman, Billings, Ramsey analyst Patrick McCarthy wrote in a client note the impact to revenues in FY 2008 would be approximately $206.0 million (at approximately $550,000 per vehicle) and cut profit to about $1.36 per share from his current estimate of $1.57 per share.

On the surface, an investor might view the sell-off as overkill, with shares priced at only 7.1 times FY 2008 revised earnings. But then again, maybe the stock of Force Protection is efficiently priced, discounting our anticipated sales/profit guidance cuts to come from management.

SIGNIFICANT ACCOUNTING POLICY ISSUES

1. Working Capital

For the nine-months ended September 30, 2007, Force Protection hit on all cylinders, delivering an operating profit of $34.6 million; however, cash flow decreased by $84.0 million. The 2007 decrease was due to increased working capital—including increases of $44 million and $123.4 million, respectively, in capital expenditures and inventories to support anticipated higher production volumes.

The Company has working capital of $244.3 million. Back out inventories and prepaid assets of $182.4 million and $16.3 million, respectively, and the company’s short-term financial health is not as robust, with liquidity of only $45.6 million.

Force Protection's recently spent $31 million for a 430,000 square foot assembly line in Roxboro, North Carolina for production of the Company’s Cheetah vehicle. Future armed forces cutbacks would idle manufacturing facilities, increasing fixed costs—and forcing a write-down of recent inventory build-ups.

2. Revenue Issues

The Company’s revenue is derived principally from the sale of its vehicles, and, to a lesser extent, sale of associated spare parts and training services to the U.S. government. For the three-months ended September 30, 2007, revenues from sales to military units of the U.S. government accounted for 98% of total revenues.

The Company recognizes revenue when earned under the unit of delivery method (after a material inspection and receipt of invoice is received from a representative of the U.S. government). As discussed by the 10Q Detective in October 2006, operating results at Force Protection are sensitive to fluctuations, a result of the government contracting process, including the right of the U.S. government to delay or cancel contracts. In our view, management has under-estimated its "Allowance of Contractual Adjustments," setting aside only $15.9 million for contractual adjustments as of September 30, 2007. In our view, in coming quarters, the company will probably record contract revenues less than estimated upon final audit and will need to increase its contractual allowances, leading to reduced gross income.

Buyout Possibility

The stock has been volatile in the past year, trading as high as $31.00 a share due to buyout rumors. Despite announcements of new orders and vehicle production records being broken monthly, we expect coming book-bill numbers to decline.

Force Protection’s market capitalization has been shelled in the last two months, losing more than $1.0 billion. In our view, even at a 52-week low in enterprise-value of about $600 million, a buyout by the likes of its manufacturing partner General Dynamics is less likely today than a year ago, for Force Protection is no longer a sole-source manufacturer of ballistic- and blast-protected wheeled vehicles.

In May 2007, New York Representative Louise Slaughter, Chairwoman of the Rules Committee, requested a report on the contracting for armored vehicles and up-armoring equipment headed to Iraq. The report, entitled Procurement Policy for Armored Vehicles, uncovered that no-bid deals resulted in delays and questionable contracting practices. Pentagon procurement guidelines now require Force Protection to participate in competitive bidding

Valuation Analysis

Force Protection Chief Operating Officer Raymond Pollard:

Force Protection’s history has been a remarkable one. By every measure, it is an impressive American success story as a small start-up entrepreneur has become a mainstream assembly line manufacturer and industry leader in an astoundingly short period. The vision, expertise, and hard work of the company’s founders and workforce, along with the support of its shareholders and partners, have brought Force Protection to where it stands today. The leadership and infrastructure are in place, the product is proven and continues to be critically needed, and the future of Force Protection is bright.

Two roads diverged in a wood,and I--
I took the one less traveled by,
And that has made all the difference.
~ American poet Robert Frost, The Road Not Taken (1874 – 1963)

If the $6.00 drop in its share price in the last two trading days is any indication, Wall Street may be signaling that the bullish tailwinds that provided strong earnings growth in FY 2007 may stall in coming quarters. In fact, we believe that future troop cutbacks and stalled military spending bills in Congress could obfuscate earnings visibility and margin improvement through the balance of this decade, a factor that calls into question management’s spending initiatives. Still, even a dead cat can bounce—short-term.

Force Protection’s road yet to be traveled is laden with buried IEDs.

Author David J. Phillips and the 10Q Detective do not have a financial interest in Force Protection. The 10Q Detective has a Full Disclosure Policy.

Source: Force Protection Hits A Land Mine