Shares of American Science and Engineering Inc. (NASDAQ:ASEI) are down another 23% since our latest bearish piece on the company. On the principle that a mediocre business can be a compelling investment at the right price, we decided to look in on the name. Also, there's much to recommend the shares, as the need for the company's products are great. Perhaps, that's what's kept shares trading at relatively lofty levels. In this piece, we'll look into both the current level of operating profit and sustainability of the dividend. Our view is that it is prudent to switch to a neutral stance on the shares at this point. Things are still not great, but we believe improvements from these levels may drive shares higher, endangering our heretofore bearish stance.
Before getting into a review of the cash flow statement, we should spend some time re-examining the level of operating profit the firm is generating, relative to the amount of capital employed. What we look for in our investments is a company that can generate a high (and stable) level of operating profits after tax relative to the amount of capital provided by owners and creditors. We compare profits over capital to the yield on a risk-free investment to understand if we're being adequately compensated for the various risks associated with the investment. In the case of companies like American Science and Engineering, we're looking for profits only about 4% greater than the risk free rate, since the products American Science sells are required and the competition is fairly light. Since the 10-year government bond is currently priced to yield about 1.9%, we're looking for about 6% of operating profits from American Science. The company does not deliver anything close to that. In fact, American Science generates a level of operating profit that is about 6.5% below the risk-free rate.
Source: Company filings
An investor may complain that this is a backward looking analysis. That is true, but it misses the larger point. The point of exercises like these is not to review the most recent operating performance of a particular company. The point is to see how near (or far) we are from an acceptable level of profitability. If we're close, we may be inclined to buy, as the world doesn't have to work out perfectly for the company to achieve the level of profitability that we require. If the company is quite far, then we can know we're better off avoiding the name. In this case, things would need to change quite dramatically for this company to be a worthwhile investment. In particular, the company would have to grow profits from the current $-5.6 million to ~$8.7 million. That's quite a dramatic change, we don't believe it'll happen, and therefore we can eschew the name. We believe these sorts of analyses allow us to apply some arithmetical rigor to our investment discipline.
Notes from the Cash Flow Statement
We believe the dividend the company has paid is a major pillar of the investment thesis for this company. If the dividend is cut or collapses, the shares will follow. For that reason, we want to think about the level of sustainability of the dividend yield.
We note the following:
- Over the past three years, the company has generated ~$33.5 million in net income. If we add back the ~$15 million in depreciation expenses, that means the firm has generated $48.5 million in cash from operating activities. We believe adding back depreciation in this way is actually not at all conservative, as depreciation represents a real economic cost against future earnings. We'll treat the company generously, though, and say that it has managed to generate just shy of $50 million.
- Over the past three years, the lion's share of the cash has come from proceeds from the sale and maturity of short-term instruments ($380 million, or about 11 times net income). Admittedly, $239 million of this was repurchased. The net increase of $141 million is still far greater than net income.
- Over the past three years, the firm bought back $106 million of shares (something's got to boost that EPS number!) and paid $48 million in dividends.
Dividend payments over the past three years were about equal to net income plus depreciation. Dividends plus buybacks obviously swamp the cash flows from the organic business. The trend over the past year is even more unsustainable. Over the past year, dividends were $15.6 million and cash from operations was -$11.1 million. The dividend is obviously at risk.
Putting all of the above together, we believe there's a better than average chance that the company runs the risk of cutting the dividend. We also believe the company doesn't generate anything close to a reasonable level of operating profit, given the capital employed. That said, the company sells products that are required by governments and the pieces may be in place for a turnaround in cash flows. For that reason, we're nervous about maintaining a bearish position on the name. We're therefore switching from outright bearish to neutral. We'll watch developments at the company in 2016 to see if it would be wise to move to a bullish stance.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.