A Few Favorite Things

11/26/2007 12:00 am EST

Focus: STOCKS

Michael Murphy

Former Editor, New World Investor

Michael Murphy, editor of New World Investor, recommends two of his favorite picks for your stockings, just in time for the holidays…

Rochester Medical (NASDAQ: ROCM) recently reported earnings. The company had $8.4 million in sales and 10 cents a share pro forma during their fourth quarter. On the conference call, management said that they will continue to invest in growing their sales force, because they have a large new opportunity in hospitals.

The change in Medicare reimbursement policy I told you about some time ago, where as of next October Medicare will no longer reimburse a hospital for treating a hospital-caused infection, is starting to have a big impact. Management said they are finding that the infection control clinicians not only have a lot more influence now in each hospital, but they are very interested in looking for new technologies that are going to help them do their job better.

In addition to the pressure from Medicare, about 18 states have passed legislation requiring state hospitals to report infection rates for a number of different types of infections. This information will be made available to the public and also reviewed by the legislature.

Management also talked about completing another acquisition, probably of a distribution or sales-force type company. Their most recent purchase in the UK is working out very well. ROCM remains a Top Buy up to $23 for my $40 target.

American Science & Engineering (NASDAQ: ASEI) reported a quarter that missed the consensus, and the CEO said: "No apologies here. It's a lumpy business." The shareholders took the lumps, as the stock plunged below my $59 buy limit.

But it is a lumpy business, and Wall Street's seeming expectation that it will somehow magically smooth out is hard to understand. ASEI did $37.6 million in sales, below the low end of the $38.3 million to $47.0 million range, and well below the average of $42.9 million. Earnings also missed, coming in at 48 cents a share, also below the range of 50 cents to 72 cents and average of 62 cents).

The problem was the usual suspects: they didn't deliver enough of the high-margin Z-Backscatter vans due to one order that slipped, so revenues were light, profit margins were light, they kept spending on R&D as they always do, they kept booking orders as they always do, and—oh, yes—they increased the backlog to a record $122 million.

The way to deal with this is to understand that the smoothed results for this company will be up and to the right for many, many years to come, until terrorism ceases to be a problem. Buy ASEI only on dips back under my $59 buy limit, which would be caused by quarterly results below the average consensus, and otherwise hold for my $93 target.

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