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If you want to explain to someone the joys and terrors of investing in small-cap tech stocks, simply point to them to FSI International (NASDAQ:FSII). The maker of surface conditioning equipment for semiconductor manufacturers bottomed below $2 per share in October as the entire semiconductor sector hit year-long lows. But while reporting fiscal year earnings that month, the company offered some hope:

The company believes that its order level bottomed at $15.5 million in the fourth quarter of fiscal 2011 and expects orders to increase significantly in the first quarter of fiscal 2012 as several leading foundry, logic and memory producers proceed with their 32/28 nm investment plans. Based upon an expected first quarter increase in orders, the company anticipates that revenues will bottom in the first quarter of fiscal 2012 and expects revenues to increase significantly in the second quarter of fiscal 2012.

FSII management was right. The announcement of two large orders in late November and early December buoyed the stock. In late December, fiscal first quarter earnings were modest. But better-than-expected guidance for the second quarter boosted the stock 16%. By the end of 2011, FSII had doubled.

The stock wasn't finished. FSII continued to rise along with the broad market before those eagerly anticipated second quarter earnings beat even the elevated expectations. FSII spiked to a 5-year high at $5.44. The stock had tripled in less than six months. The stock would fall soon after, but rebound over $5 per share in late April.

As May began, the broad market sneezed, and FSII caught pneumonia. The stock fell over 40% in May alone, on literally no news. Come June, the stock finally rebounded; bargain-hunters moved in, and FSII spiked nearly 50% in two-plus weeks heading into today's earnings, including a 6% spike during regular trading as investors tried to get into FSII before what they hoped would be another earnings beat.

Of course, they were disappointed. Earnings per share of 25 cents actually came in ahead of the company's guided range between 17 and 23 cents, but weak fourth quarter guidance for below-consensus revenue, a 50% sequential drop in net income, and a fall in order volume appears to have frightened investors. FSII is, as of this writing, off over 15% in after-hours trading, at $3.75 per share.

The schizophrenic nature of FSII's last eight months is perfectly reflected in today's earnings report. Fourth quarter guidance, though apparently disappointing, still anticipates earnings per share of 10-12 cents. At the midpoint of the company's fourth quarter projections, FSII's fiscal 2012 (ending August) will see revenues of $145 million and earnings per share of 38 cents, representing year-over-year growth of 50% and 81%, respectively. Yet the P/E based on expected FY12 earnings sits just below 10, while net cash increased to $1.27 per share -- about one-third of market cap at the current after-hours price -- as the company generated an impressive $28 million in operating cash flow. Given that capital expenditures for the first three quarters totaled just $3.3M, free cash flow for the quarter appears to have exceeded one-fourth of the company's approximately $100 million enterprise value (sharply lower inventories appear to be a primary cause of the FCF jump).

The question is whether the seemingly strong fundamentals are pricing in a sharp decline in the company's business. While fourth quarter guidance still anticipates 30-50% growth in revenue year-over-year, and a doubling of net income, sales are likely to drop sequentially, with the company also anticipating a decline in orders (which would be felt into the first half of FY13). "Despite the growing demand for 32/28nm devices, we believe that global economic uncertainty is causing customers to reassess their near-term capital spending," FSII said in its press release. Given their accuracy in forecasting the company's jump in sales earlier this year, the company's worrisome short-term projections and order weakness cast doubt on the company's fiscal 2013 earnings potential. Certainly, the nearly 70% earnings growth that had been projected by analysts seems far less likely -- at best.

On a sequential basis, FSI is seeing revenue decline between 12% and 20%, with earnings being halved between the third and fourth quarter. If that kind of weakness continues into the first half of fiscal 2013, FSII stock will suffer, and could see a drop back toward its lows in late 2011. At the very least, if after another quarter or two, trailing earnings move down from the currently projected 38 cents per share to 25-30 cents by the end of the calendar year, it's hard to see FSII -- a small-cap player with a tiny market share in a cyclical sector facing short-term challenges -- being given a double-digit earnings multiple. Such movement would likely push the stock down below $3 per share and possibly even cause FSII to flirt with the $2 per share price it had seemingly discarded back in the fall.

Such is the nature of small-cap tech stocks. As our own Stephen Simpson noted in February, FSII is trying to compete with far larger players such as Dainippon Screen (OTC:DINRF) and the recently expanded Lam Research (NASDAQ:LRCX). FSI's new ORION product line -- whose orders sparked the bull run back in November -- is an attempt to challenge the dominance of the entrenched leaders. But FSI still has a long way to go.

With such a daunting road ahead, the stock's roller-coaster volatility makes a bit more sense. As Simpson wrote, FSI is a "pretty standard high-risk / high-reward small-cap tech story." Today, the risk shone through. Given the company's short-term challenges, and the recent unwillingness of investors to show any real patience with FSII, the risk/reward profile still seems a bit too skewed toward risk -- at least for the near term.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: FSI International Earnings: There's Good News And Bad News