Introduction: Changing Market Perceptions
The market is quite unforgiving to investors of all skill levels. Yet the most interesting phenomenon with the markets is that it is also the most forgiving form of business. The immense flexibility of market participants to make money is unmatched by any other form of business. The ability to reverse one's decision relatively quickly without incurring immense costs is one of the premier foundations to the wealth creating ability of the financial markets.
In other forms of business, a decision is met with board meetings, excel presentations, and high cost of capital to follow through with the choice of strategy. The ability to reverse a decision is tough and occasionally impossible. The cost has been incurred, and the time spent by the management team has allowed those involved to become emotionally attached to the project. What happens next is inevitable. The management team will often latch onto their initial decisions, and their hopes that the project will turn out fine. At this time, the project takes on a life of its own and balance sheets will show most of the capital expenditures being directed to this "pet" project.
However, there comes a point in this entire sequence of events that leads the management team to realize their wrong decision. These moments of epiphany are not signs of competence; they often come because the company is facing the choice between implosion or salvation. Either the management team cuts the funding and steers the firm in a new direction, or continue to become dogged in their stubborn and sometimes arrogant pursuit, resulting in a fully imploded company.
As one can clearly see, the ability of the markets to allow investors to change their direction and decision-making process to best suite the investment environment produces the ability to generate immense wealth for its participants. As traders/investors, we must take note of this ability. If we buy into a stock and it continually underperforms, it is entirely in the power of the individual to get out, change directions, and pursue a new avenue to wealth.
Diving In: Gaining the Right Perceptions, Buying the Right Stock
In the particular environment we are in, one of the strongest stocks has been American Science & Engineering, Inc. (ASEI). In general, with the entire world going into a form of equilibrium in terms of manual labor, where the cost of physical labor is becoming uniform, and the cost of being able to charge for one's own services is tougher--businesses need a competitive and service-wise edge to be able to charge a premium to their customers. In the case of engineering services, the competitive edge is knowledge-based and it is tougher for competitors to mirror. In this case, we are dealing with individuals and their own expertise of the engineering field. These technicians and engineering corporations have the ability to sustain higher profit margins for this knowledge oriented reason.
Getting To Know Your Stock
American Science and Engineering, Inc., together with its subsidiaries, engages in the development, manufacture, marketing, and sale of X-ray and other inspection solutions primarily for homeland security markets in the United States and internationally. An in-depth breakdown is offered here.
The company is at an inflection point in its business cycle. It is more than obvious that homeland security in the United States has sparked demand for product offerings by ASEI. And while current earnings may seem lackluster, what interests me is the surprising backlog the company has come to accept in the past few months.
In the recent quarter, backlogs grew 62% to $160MM (funded, plus $24 million unfunded), and order bookings were at $100 MM in the quarter, 88% of which were from international customers. Due to this recent activity, book to bill ratio has been 2.5. And despite what investors might think with current sales decline on a year over year level, costs have been maintained well, and the firm does have $105.3 million in cash, leading to an evaluation of about $11.82 in cash per share.
Moreover, the company generated great exposure to cash rich middle eastern areas such as Abu Dhabi, which contributed to $55 million in bookings. Abu Dhabi had ordered 18 of the ZBV products from ASEI, with the company shipping only 12 since the recent quarter began. The strategy by the management team to increase diversification is gaining the momentum it requires to bring sales growth back on board.
What is most compelling for ASEI, as a stock, is the similarity it shares with Bucyrus (BUCY) (which I am currently very bearish on) in the early stages of 2005. During the pre-commodity hype and boom, BUCY was not making any stellar growth in revenues. However, backlogs and book to bill ratios were very compelling, coming in at 2.5 (similar to ASEI) and then to around 4 near its peak levels.
Moreover, similar to BUCY, ASEI has very little coverage by analysts. And at the time, BUCY had been getting great macro-economic momentum, leading to above average bookings and then above average returns. In terms of where ASEI is in its own business cycle, they stand to profit from trends we have been seeing in the past 10 years of military spending globally that will, in effect, create a consequential outcome leading to an opportunity for ASEI to capitalize on. And with strong backing for its products by cash rich middle eastern areas like Abu Dhabi, it creates only positive momentum going forward.
The Macro-Economic Snowball
In 2007, 1,339 billion dollars (851 billion euros) was spent on arms and other military expenditures, corresponding to 2.5 percent of global gross domestic product, or GDP, and 202 dollars for each of the world’s 6.6 billion people. Britain, China, France and Japan — the next in line of the big spenders — lag far behind, accounting for just four to five percent of world military costs each. The factors driving increases in world military spending include countries’ foreign policy objectives, real or perceived threats, armed conflict and policies to contribute to multilateral peacekeeping operations, combined with the availability of economic resources.
So while the direction of capital may not be to increase arms exponentially, it will be toward devices and products that inspect and search for possible threats. This comes at a unique position during the Beijing Olympics and the future Olympics in London, 2012. To prove this point, registering the greatest regional growth of military spending was Eastern Europe, which saw its military spending skyrocket 162 percent between 1998 and 2007 and 15 percent from 2006 to 2007.
The uncertainty that resides in today's world allows countries, who, unlike corporations, have few spending limits, to spend magnanimously on military-defense services. In all, current trends and results from the large and impressive book to bill growth with ASEI leads to the foresight of the run up in sales and profitability. Moreover, with strong gross margins north of 25%, it allows the firm to capitalize on any immediate success. Strong cost management contributes to immediate profit potential.
Again, shares outstanding stand at below 25MM, which is a strong positive, as most of my biggest winners have been with companies with shares outstanding totaling less than 50MM. However with a share total of less than 9MM, I urge you to begin to scale out of your position once the volume grows to about 3x the current average traded. In addition, with the lack of any real analyst coverage, it offers the possibility of other firms initiating coverage, acting as catalysts for ASEI. However the biggest and most immediate catalyst would be the growth in the book to bill ratio specifically and the strong growth of military demand for its services in general.