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Friday, March 6, 1998
Detection Systems Inc.
Detection Systems investors probably wish that the company sold a device that warned of collapsing stock prices. Last fall the stock hit its 52-week high on the heels of solid increases in revenue and a return to profitability. The company had more than doubled revenues in 1997 with a combination of strong sales and strategic acquisitions. The stock started sliding after the announcement of a secondary stock offering brought concerns about earnings dilution. However, it was when the company announced second quarter earnings in November that the trouble started in earnest. Earnings were expected to hit $0.24 per share. Instead, the company announced that it had made only $0.20 per share, blaming the shortfall on high production and shipping costs as well as difficulty ramping up new Asian production facilities. The stock promptly dropped 25%. The next big problem came in late February when the company announced a second earnings shortfall and also announced that an accounting mistake had led to an overstatement of the aforementioned second quarter earnings. BUSINESS DESCRIPTION Detection Systems produces and sells equipment for the security and fire protection industries. The company's products include burglar alarms and motion and fire detectors. It also makes the equipment for the sensors to transmit signals. Detection Systems makes several types of detectors: passive infrared body heat, photoelectric beam interruption, combination passive infrared and microwave; acoustic glass break; and vibration detectors. The company believes it is in the top five of security equipment makers. Competitors include Pittway Corp., Berwind Group, and C&K Systems. FINANCIAL FACTS
Income Statement
Balance Sheet
Ratios HOW COULD YOU HAVE SEEN IT COMING? Earnings surprises are just that, surprises. It is difficulty to see how an investor could have predicted the earnings shortfall. However, a prudent investor might have been on the sidelines based on valuation. Prior to the earnings announcement, the company was trading at a PE of 23 with long-term growth estimates of 17%, which might have given an investor pause. After the earnings surprise an investor could have still escaped with a modest loss by selling after the initial drop. One negative surprise is often followed by another, as Detection Systems nicely illustrates. It is situations such as this where valuation really matters. Stocks trading at the high end of valuation are vulnerable to negative surprises and have positive surprises already figured into the stock price. The risk/reward relationship points towards trouble. WHERE TO FROM HERE? The dust has not yet settled on the company's latest negative news. Over the next few weeks the stock could still drift a bit lower. In the earnings announcement, the CEO said that the company has its Asian act in order and that the accounting problems have been resolved. He is confident that the company is back on track. In spite of all of the difficulty on the earnings side, the company still has grown sales at a nice clip. The current price-to-sales ratio of 0.49 is near a five-year low; the PE of 18.9 is in the middle of the historic range; and the stock has traded down to a PE multiple of 11 in the past. That would imply a "bottom" for the stock of around $5 per share. Detection Systems has become a "show me" stock. The company needs to demonstrate that it truly has turned things around and is back on the road to growing profits. A Foolish investor would do well to watch the earnings reports. If a turnaround is indeed in the offing, the stock could do very well. But if there are more negative surprises, the trouble has only begun.
-Mark Weaver, MD
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