The Company will host an investor call at 11:00am EST today.

Overall Take:  I like the potential of this company, but the balance sheet (slightly less of an issue given cash flows and recent rework of credit facility) and limited near-term visibility keeps me sidelined.

Recapping Earnings and Guidance:  The company reported ($0.01) on $168m versus analyst estimates of ($0.01) on $169m.  For Q3 L-1 issued negative guidance of $0.00-$0.02 on $175m-$180m versus estimates of $0.05 on $195m.  Finally, for FY09 the Company guided to $0.06-$0.12 on $700m-$725m versus consensus at $0.09 on $732m.  While the organic growth rate looks pretty solid and FY guidance doesn’t appear that far off, investors will likely view the backend loaded guidance as negative. 

A Few Additional Thoughts on Guidance:

• I’m guessing that the passport business looks fairly soft for the rest of the year.  The acceleration leading up to the June 1, 2009 WHTI deadline (the program that requires United States Citizens to carry about a passport in returning from Canada, Mexico, etc) is over and the negative effects of the recession on passport volumes are likely to impact performance.  The passport business could still be a nice catalyst, if the Company is successful in landing a few of the international ePassport contracts, as that market looks very healthy for the next few years. 
• The Company also cited Registered Traveler (the program for pre-screening airline passengers that was effectively shut down in June, but which is trying to be revived) and delays in international orders as contributing to the lowered guidance.  I’ll bite on the international delays, but I would guess that Registered Traveler was a fairly minimal contributor.  The original contract was worth up to $50m over five years.

Conclusions:  Overall, I expect volatility in shares of L-1 to remain.  The company continues to have a relatively leveraged balance sheet, though terms on its debt have recently been reworked in its favor, and the model remains somewhat ”lumpy” given a host of acquisitions over the past few years and the impact of large government programs. 

I expect L-1′s state and local sales and passport business will be somewhat stagnant over the next year.  As such, I believe growth will be constrained in the near-term.  With a valuation of roughly 1.6x NTM EV/Sales and 11x NTM EBITDA and given my conservative investing approach, shares aren’t quite into my range yet. 

The real opportunity in its market, at least for the next 12 months, will be internationally (see what Sagem is doing and take a look at ePassport and eID expansion) and possibly in DOD biometric programs (a wildcard).  L-1 hasn’t done much outside of the United States, especially pre-Digimarc, and given I still believe the overall business model is attractive, I may be inclined to re-evaluate my position should the Company show signs of being able to capture the international opportunity.

Included in the analysis were United Technologies (UTX), Stanley Works (SWK), Johnson Controls (JCI), and Ingersoll Rand (IR).  Honeywell (HON) reports next week.  On average security segment results outperformed consolidated results.  Pro forma revenues were down (18.5%) versus (5.8%) for security.  Generally, the conglomerates reported tough commercial construction environments, likely to continue, with the expectation that residential construction would stabilize in 2H09.  Net profits were down (27.5%) with security sector profits roughly flat at down (0.5%).  With other large caps reporting better than expected earnings, it appears that, for whatever reason (leverage, future outlooks, etc), these companies haven’t been as effective in maintaining profit levels in their overall business.  However, security margins remain relatively healthy.

Given the diverse nature of their overall businesses, share price movements isn’t well correlated to the small-cap counterparts, so we won’t discuss it yet.  However, it will be interesting to watch the results from newly spun off firms, Broadview Security (CFL) and Tyco (TYC), as well as some of the smaller counterparts.  There’s a large list of these companies listed domestically and on international exchanges, but highlights will include China Security and Surveillance (CSR), Protection One (PONE), Napco Security (NSSC), Vicon (VII), Axsys Technologies (AXYS), and Applied Signal (APSG).

I’ll be going back to my own portfolio and scouring for short-term trades based on what the conglomerate results suggest of the overall environment versus expectations for the small-caps getting ready to report.

In the next two weeks I expect to conduct similar analysis for the Cybersecurity and Homeland Security players.  A few of the larger players have reported, but we’ll get a better indication by mid-next week.

1.  Cost Cutting In Force.  The impact of aggressive cost cutting measures implemented over the past year by most companies in the sector is showing up in force via better than expected earnings results.
2. All Aboard the "Stabilization" Bandwagon.  Has anyone heard "stabilization" mentioned so many times by company management?  I’m a bit skeptical here.  Even companies with lackluster results are promoting cautiousness, but some stabilization in relation to Q2 business and guidance.  Seems like a positive way to put spin on largely unimpressive results without having to put any substance into guidance. I’m not really faulting management.  While it was pretty clear at the end of 2008 that the first half of 2009 was going to be ugly, I see visibility as being extremely limited into how the rest of 2009 will play out.  Additionally, I’m not sure shareholders would be too happy with a management team being overly negative on the rest of 2009 when everyone else is preaching "possible" stabilization.
3. Sector Still Defensive.  While results are largely down year-over-year, security continues to be relatively defensive, especially for those players dealing in the federal government space.  Shares will continue to be disproportionately tied to swings in the broader market versus straight fundamental performance and, in some cases, may be negatively impacted by pure Defense comps under pressure from the unknowns of the Obama administration.  However, while stocks will trade with the market, given underlying performance should remain stable, the extreme downside risk associated with balance sheet issues should be limited in the sector overall.  As such, I believe investors will continue to be presented with positive risk/reward opportunities in small-caps with solid stories.

Thanks to all those that helped get T2SA going and for your continued interest in the blog.

Josh

Thoughts

1) It’s interesting that Thoma Bravo had to increase the bid.  While the original deal was approved by Entrust’s Board, there has obviously been issues with getting the 66% shareholder approval required for the acquisition.  The vote has now been pushed off to July 28.  This is the second time the vote has been pushed back.  There are no other offers being considered.

2) I sold the rest of my shares today.  I made the original purchase when the deal was first announced.  I figured downside was limited (cash purchase, no regulatory issues) and thought the odds of them finding a better offer were high enough to take the risk.  However, with no potential acquires going public with an offering following the "go-shop" period, it looks like a better offer coming through in the near-term is unlikely.  If the deal falls through, I expect share prices will fall significantly and may take another look at that time.

3) With the company generating cash and valuations obviously depressed, I had hoped prior changes at the Board level would have led to an internal focus with changes at the management level and in the sales organization (minimally a decoupling of sales and corporate roles) and a repositioning for sale once market conditions improved.  I could have lived with shares falling back to pre-acquisition levels, as I believe there is value here above what is being offered by Thoma, but management and the Board looks to have put its "eggs in the Thoma Bravo" basket and assuming the deal doesn’t go through, a recovery could take some time.  This is especially true, since no real change occurred following the Board reorgaization.  Entrust needs to be broken up and/or part of a larger organization, but I would have cleaned things up a bit first.

3) At $2.00/share, I still think the offer is light and more in-line with a Company that is distressed, which it isn’t, or at least wasn’t.  Treating $14.8m in unused-facility lease obligations (from earlier restructuring) as debt and incorporating $31.7m in cash, the valuation represents just over 2x its service and maintenance revenue stream only (versus 3.5x to 5.5x typical valuations).  Obviously, there is value in the rest of its operating business and revenues, especially given the recurring stream built out in its SSL and PKI offerings, as well as $0.50/share to $1.00/share in NOLs.  I was hoping the changes at the Board level would have led to more of a strategic reorganization than what we’ve seen, helping the shareholders unlock value in a sale. Maybe the sale was short-sighted on the part of the Board, maybe management was too intertwined with daily operations and from a contractual perspective, maybe I’m missing something.  Who knows?

What does it mean for AS&E?  I actually think this could be a good thing for AS&E (at least better than what the 14% slide in shares so far today reflects).  If the contract would have remained in protest it would have impacted at least the March quarter and probably the June quarter with possibly no units shipped until the protest was completely resolved. Additionally, no matter how remote the chance, there would have been a possibility that AS&E could have lost the entire contract.  

However, today’s announcement means AS&E will get at least $39.3m (mitigating risk of a complete loss of contract) and, more importantly, can start shipping units.  I have no contribution from these items in my March estimate of $59.9m and getting a few shipped would mean the company could hit the consensus estimate of $63.6m.  Additionally, the company still stands a very good chance of getting at least part, if not all, of the remaining request that will be competed against the traditional x-ray/gamma mobile truck vendors (Smiths, L3, OSI, GE).

With the rest of the market continuing to get punished, the stock still trades at a premium.  However, as typical with AS&E, it looks like investors are over-reacting to today’s news.  If I held shares, I’d not be selling down here and think there could be an opportunity as the stock gets back below $65.

The biggest direct gainers of the supplemental funding look to be construction companies, security screening vendors, and communications equipment manufacturers.  It is unclear how detailed reporting on appropriations will be, but Congress mandated that DHS provide a detailed plan for expenditures within 45 days.  I’d recommend investors monitor fbo.gov and recovery.gov to get a leg-up on contract announcements.

Here’s a link to the final bill (view)

Items of Interest

1. $100m for procurement and employment of non-intrusive inspection systems (Customs and Border Protection)
2. $60m tactical communications equipment and radios (Customs and Border Protection)
3. $100m for border security technology on the Southwest border (Customs and Border Protection)
4. $420m for construction border ports of entry (Customs and Border Protection)
5. $20m for tactical communications equipment (Immigration and Customs Enforcement)
6. $1B for an additional amount for checked baggage explosives detection systems and checkpoint explosives detection equipment (Transportation Security Administration)
7. $150m for Public Transportation Security Assistance and Railroad Assistance (Federal Emergency Management Agency)
8. $150m for Port Security Grants (Federal Emergency Management Agency)

Potential Impact

In comparing the emergency funds to the actual FY09 budget, we see that the potential impact to vendors is meaningful.  I’ve left out discussion of the funding for communications equipment, as this funding will likely go to large cap firms where it will have little impact for investors.

• CBP’s $100m for non-intrusive inspection technologies roughly doubles the $117m included in the FY09 budget and is a 107% increase y/y.  Possible beneficiaries will include Smiths, L3 (LLL), OSI Systems (OSIS), SAIC (SAI), and American Science and Engineering (ASEI)
• $1B to TSA for checked baggage and checkpoint explosives detection equipment.  As I discussed in the January 26th post, the language in the final FY09 DHS budget related to airport explosive detection systems and checkpoint equipment is fairly vague and which vendors benefit really depends on how funds are ultimately split between the two categories.  However, at $1B, the overall amount is significant considering Congress authorized $621m for these purposes in the actual FY09 TSA budget.  A bit more on the two areas referenced in the stimulus.
       a. Checked baggage Explosives Detection Systems (EDS).  These systems refer to CT-based scanners.  While TSA initially deployed stand-alone systems in airport lobbies across the U.S. after 9/11, the focus over the past few years has been in removing these labor intensive systems in favor of faster backroom (large airport) or behind the counter (small airport) systems.  However, construction costs associated with the backroom systems are very high (roughly 4x the cost of the systems themselves) and currently only about 25 airports have active systems.  Companies likely to benefit from increased expenditures for EDS include Reveal Imaging (private), GE (GE), Analogic (ALOG), and L-3 (LLL).  What’s interesting here is that OSI is introducing its first CT system, based on new technology that is expected to offer significant advantages in speed (which reduces cost due to the way in which systems are implemented).  Recently the company won a $6m contract for this system from TSA.  The increase in funding could both help and hurt OSI.  Should TSA buy additional CT systems before it is finished testing OSI, the company miss out on sales in may have got should funding have been delayed.  However, if TSA gets far enough through testing, the company could see awards for the system well ahead of analyst expectations (no analyst has any revenue from this platform built into their model until at least FY10).
       b. TSA was authorized $250m in new money in FY08 to upgrade its X-ray technology at airport passenger checkpoints as part of the Advanced Technology program.  By the end of CY08 half of passenger carry-on luggage was expected to be screened by these systems.  Currently the only two authorized suppliers are OSI Systems (OSIS) and Smiths. 
  c. Given how vague the language is in the stimulus, I think it’s possible that funds could be used to procure other checkpoint security equipment including whole-body imagers.  While TSA continues to test both millimeter-wave (mmw) and backscatter systems, it appears that they are leaning more toward mmw.  The most likely beneficiary would be L-3 with its mmw solution.  Smiths has also introduced a mmw system and TSA would also likely buy a few backscatter systems, which are supplied by AS&E and OSI. 

The last thing I found somewhat surprising was the focus of funds distributed to DHS.  I’m guessing that funds went primarily to programs in which Congress felt comfortable that DHS could get the money spent in a short period of time and, more importantly, to programs that were likely to remain intact as the new administration gets its priorities implemented within DHS.  While SBInet did receive a relatively small amount of funding, other areas were left out.  For example Secure Flight, the Secure Freight Initiative, Air Cargo screening, Cybersecurity, National Preparedness, US Visit, and the Western Hemisphere Travel Initiative didn’t receive any funding.

Highlights

1. At $21.5m bookings were light (the second lightest quarter since 2005), but backlog remains near record levels at $153m.  AS&E’s bookings are notorious lumpy and given the numbers reported in the December quarter, strong backlog, and the $68m Marine order it booked in the current quarter, the company will likely get a pass on the bookings.
2. It finally looks like the momentum the company has seen in cargo orders is starting to positively impact performance.  Cargo revenue finished at $11.7m versus my $10.4m estimate.  I remain pretty positive on the companies new product line-up as backscatter looks to fit well with passenger vehicle screening applications being tested by Cargo and Border Patrol.
3. Parcel remains an important category to watch for the longer-term investor.  The Gemini line, which integrated AS&E’s highly successful backscatter technology with traditional x-ray, was launched in 2006.  Following some initial success, the line has yet to meaningfully impact results and the company was unsuccessful in its first attempt at getting the devices approved for deployment at U.S. airports.  While ZBV and cargo sales and an associated ramp in service revenue are likely to sustain the growth over the next few quarters, parcel will likely need to kick in during the out quarters to offset a likely flattening or decline in ZBV sales.  In the end, I think the company may get approved for the freight forwarder program, but investors shouldn’t rely on the systems getting deployed at the airports.
4. Importantly, gross margins finished at a very impressive 44% in the quarter.  We had estimated each product category given the mix of sales over the past few years and it had tracked fairly well until this quarter.  With the increase in cargo our model would have assumed gross margins around 39% versus the 44% reported.  Assuming this was purely related to the company’s focus on cost reductions, the improvement most likely will require a significant positive adjustment to the models on the Street. 
5. Finally, the company acknowledged that its $67.1m Marine contract for the ZBV trailer is being protested.  While not stated on the call, Rapiscan, the security division of OSI Systems (OSIS) is the company that lodged the complaint.  I have no idea how credible the protest is, but protests are pretty common in the Defense industry and most don’t go through.  I’d recommend investors watch very closely in the near-term to how things proceed.  The case isn’t due until Apr 27, which could impact AS&E’s results for the March quarter.  I’m not factoring in any sales under this contract until June, but as of yesterday consensus was $2m ahead of my projections for revenue in the March quarter, which means the company will likely need to stretch to meet views if it can’t ship until the protest is over.

Overall Thoughts

ASEI remains a highly volatile name and one that can be very rewarding to investors willing to put in a little extra work on understanding the model and the government procurement process (action in the stock has shown that there are plenty of interested parties not putting forth the effort).  My best recommendation on the name is don’t trade on speculation without something at least moderately credible to back up the spin.  During its last run-up in April 2006, when big ZBV orders were effectively priced in, the stock continued to run on crazy rumors (Air Force buying a ZBV for each aircraft, one SmartCheck for each airport checkpoint, etc) and when there were no signs that any of this was credible (no TSA tests, no budget request by the AF) the speculators were punished.  During the past year momentum shifted in the opposite direction.  The Army and the Marines (via the Navy) delivered clear signals that they wanted ZBVs and the trailer and shorts continued to speculate in the other direction. 

So where are we today?  The large DOD awards are obviously old news and given the backlog and improving margins the next few quarters look pretty good versus consensus.  That said, given the valuation and a crazy macro-environment I’d take advantage of the recent run-up and today’s action to pair back the position.  However, I wouldn’t be running for the exits, investors currently holding the stock have a bit of time to see if CAARS, CBP interest in Z-portal and ZBV, or a formalized DOD program can come together in time to impact FY10 results.  For the short-term trader, I’d look more into the protest.  It’s unclear if the company can ship units (most likely not) and if so March and June quarter results will likely be a bit soft.  If the protest isn’t decided before the second week of March, I’d probably be short the March quarter.  If it’s still not decided early in the June quarter, I’d be short that quarter as well.  At the same time, I’d bet there is better than a 65% chance the protest is decided in AS&E’s favor which could present an entry point on the back side of a potential sell-off. 

Click on image for full size table