Friday, August 18, 2006

FARO Technologies: Measurable Success Ahead?

The specialty measurements and inspection systems maker, Faro Technologies (FARO-$17.82) leases its headquarters in Lake Mary, Florida from Xenon Research, Inc., all of the issued and outstanding capital stock of which is owned by Simon Raab, the Company's co-founder, and Diana Raab, his spouse. The fixed rent under the lease is $302,750.00 per annum payable monthly, increasing on an annual basis by three percent over the fixed rent for the preceding year (until the lease expires in July 2011). The lease is a “net lease,” meaning that the Company also is responsible for real estate taxes and insurance expenses covering the leased premises.

The term of the lease commenced as of July 1, 2006 (about the time that Raab started to feel the impact of a 50% reduction in his base pay because he went into ‘semi-retirement’). Pursuant to his employment agreement, Raab transitioned from Chief Executive Officer to Co-Chief Executive Officer during 2005 and altered his full-time commitment to no more than 80 hours per month. Dr. Raab, who holds a Ph.D. in Mechanical Engineering from McGill University, saw his salary slashed to $200,000 per annum.

Rabb is the beneficial owner of 1.25 million, or 8.6%, of the Common Stock of Faro, worth an estimated $22.3 million (which also includes an exercisable option to purchase 90,000 shares at $2.23 per share).

Raab’s reverse-engineering into semi-retirement could not have been better timed—for him. Back in March 2006, the Company, as a result of an internal review that it conducted, announced that it had “recently learned of suspicious payments in connection with foreign sales activities in China.” Specifically, an investigation—still ongoing—is underway to verify allegations that its salespeople operating in China and the Asia/Pacific region paid kickbacks to government officials (in possible violation of the anti-bribery, books and records and internal controls provisions of the Foreign Corrupt Practices Act).

The measure of success is not whether you have a tough problem to deal with, but whether it is the same problem you had last year. - John Foster Dulles, American statesman (1888 – 1959)

If this Co-Chief Executive appointment goes sour, Rabb, 53, can still measure his success in real estate management.
As an investment, the Common Stock of FARO looks compelling to us, for the Company appears to be moving beyond its bribery scandal. On August 3, corporate reported net income for the second quarter ended July 1, 2006 of approximately $900,000, or share-net of $0.06, compared with net income of $1.9 million, or $0.13 per share. Second quarter 2006 results included pre-tax expenses of approximately $3.4 million for legal and professional fees, of which $2.2 million was related to the Company's Foreign Corrupt Practices Act (FCPA) internal investigation.
Sales for the second quarter of 2006 were approximately $38.0 million, an increase of $7.1 million, or 23.0% from $30.9 million in the second quarter of 2005.
The Company outperformed consensus estimates of $0.04 per share on sales of $35.4 million.
Management said that the Company continues to show strength in the CAM2 (computer-aided manufacturing measurement) market, and therefore they are maintaining the original full-year 2006 sales guidance of $150-$157 million (and estimate gross margin to remain between 57-59%).
The Common Stock sells for 18.5 times forward December '07 consensus estimates of $0.96 per share. [A 50% discount to its average 3-year trailing P/E multiple.]
The catalyst(s) for an upward move in the stock price would be (i) a firming of gross margins in coming quarters [dependent on product mix] and/or (ii) resolution of the FCPA investigation.

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