Zagg ( Nasdaq - ZAGG ) - Product Line Diversification Takes Root

Zagg (ZAGG $7.75) appears on track to produce better than expected Q4 results.  Demand for the company's core "Invisible Shield" line remains vibrant, fueled by the ongoing boom in smartphone sales.  Zagg's protective covering is available for all of the major offerings.  The new ZaggMate for the Apple iPad (tablet computer) has gained meaningful adoption since its launch in mid Novemeber, too.  That line already has generated $2.0 million in sales so far in Q4.  Further gains are likely in upcoming periods as the new line expands beyond the limited distribution network originally employed.  The "Invisible Shield" line still holds substantial potential itself as smartphones grow from their current 15%-20% share of the entire cell phone market to a projected 35%-50% over the next 2-3 years.  Zagg is poised to broaden its distribution channels for that line, as well, providing additional impetus.  The ZaggMate probably will remain a complementary offering, delivering perhaps 10%-15% of the Invisible Shield's sales volume over the long haul.  That diversification should enhance and stabilize financial performance, though, and it could lay the groundwork for additional product introductions.  We are maintaining our 2010 and 2011 estimates for the time being, but a stronger performance appears achievable.

Data I/O ( Nasdaq - DAIO )

Data I/O (DAIO $5.75) is the leading provider of programming systems used to load data onto semiconductor chips.  The company's automated machines convert blank semiconductors into intelligent devices.  Demand is rising due to the expanding complexity of electronic products, and the proliferation of computer chips into an ever widening array of applications.  Data I/O's systems are employed in a broad spectrum of devices, but are particularly relied upon in high end chips containing large data files and programs.  Demand is fueled by the volume of data that has to go in, along with other factors such as physical chip size, production line rates, and geographical proximity to final assembly plants.  A mitigating factor is Data I/O's own ability to speed up its machines' performance, enabling customers to process more chips per minute.  Competition exists, but much of that resides at the low end of the market.  Several prospective customers rely on in-house solutions, which also limits the company's potential somewhat.  Economic factors play a significant role, although those cyclical ups and downs tend to balance out over the long haul.  Right now Data I/O appears to be in the early stages of a major upturn that could last well into the coming decade.

Financial results experienced a nosedive in 2009 due to the recession.  Performance has rebounded in 2010 to prior levels, and momentum is continuing to build.  For the entire year we estimate sales will finish at $27 million, consistent with the 2008 level, and up 46% from the year before.  Non-GAAP earnings (see "Accounting Notes") could reach $.28-$.30 a share.  Data I/O ended the September quarter with $17.5 million in cash, moreover, representing 60% of total assets.  That figure might expand further in the seasonally strong December period.

Next year sales of $32 million (+18%) appear to be a realistic target.  Margins promise to widen on the higher volume to provide a 25% gain in earnings to $.35 a share.  Booming smartphone growth combined with solid gains in other electronics intensive industries could support a stronger showing.  Data I/O also could put its cash reserves to work via acquisitions or joint ventures, creating the potential for further leverage.  The company has increased its diversification efforts of late, so a material transaction is a realistic possibility.  A variety of targets have been identified, both in Data I/O's core market and in related areas. 

In 2-3 years sales could attain $40-$45 million, exclusive of acquisitions.  Margins may continue to widen, propelling earnings into the $.50-$.60 a share vicinity.  Acquisitions could provide an additional $.10-$.15 a share in earnings (assuming $10 million invested at a 10%-15% rate of return).  Applying a P/E multiple of 18x to the midpoint of the range suggests a target price of $10 a share, potential appreciation of 75% from the current quote.  A higher valuation is possible if Data I/O succeeds on the acquisition front.  The company's industry leading position could make it an attractive takeover target itself. 

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Ansys ( Nasdaq - ANSS )

Ansys (ANSS $50.00) is the leading provider of engineering simulation software products.  The technology is used to design new products faster, cheaper, and better than traditional methods.  The software covers the entire development process from initial concept to final stage testing and validation.  Complex mathematical analyses are performed automatically with simple drop and drag desktop interfaces, allowing engineers to discover right away what will work and what won't.  The software includes interfaces with all of the main Computer Aided Design systems, so the design can go straight to manufacturing when it's ready.  Ansys dominates the market worldwide, having acquired all of its chief competitors over the years.  Just a handful of niche players remain.  Industries served include automotive (14% of sales), aerospace (19%), electronics (18%), industrial equipment (14%), and materials and chemical processing (11%).  Up and coming segments include biomedical and clean technology.

Financial results stalled last year due to the global recession.  Revenues only increased by 8% to $516.9 million.  Non-GAAP earnings rose 1% to $1.78 a share.  (See "Accounting Notes.")  Customer hesitation impacted performance in all geographic markets.  Business is divided pretty evenly at this point among the United States, Europe, and the Far East.  Renewal rates remained sturdy at 95%.  Ansys sells its software both on a  perpetual basis (with annual maintenance contracts equal to 20% of the selling price) and as annual licenses (40%-45% of the perpetual charge).  R&D spending is maintained at 15% of revenues.  Demand remained subdued through the first nine months of 2010, although the rebounding economy contributed to a somewhat faster growth rate than the year before.  For the entire year sales appear headed towards $575 million (+11%).  Income of $2.05 a share (+15%) appears achievable.

A major software upgrade in November has rekindled customer enthusiasm.  Improving economic conditions are providing further impetus.  And many customers are starting to bite the bullet and purchase more "seats" to the company's software to maintain their own competitive positions and expansion strategies.  Beta testing earlier in 2010 indicated a positive reception was in the cards.  Ansys responded to those indications by boosting hiring substantially, particularly in product development, sales and marketing, and customer service and support.  The company's beefed up workforce is reinforcing the emerging upturn in sales, laying the foundation for an acceleration in 2011 results.

We estimate 2011 income will advance 15%-25% to $2.35-$2.55 a share.  Revenues appear set to climb 15%-20% to $660-$690 million.  The split between perpetual and annual license sales will influence the final amount.  A restructuring of the company's two Japanese subsidiaries (one was picked up as part of an acquisition) will benefit margins and help earnings rise a little faster than sales.  Contribution margins on software sales are high, moreover, so pretax margins could benefit if sales achieve the upper end of the range.  Leverage is less dramatic than for most companies, though, since Ansys already produces exceptional profit margins from normal sales activity.  Pretax margins typically exceed 45%.

The long term outlook is bright.  The engineering simulation market is fairly well developed but much of its potential still remains untapped.  Larger customers could expand usage.  And smaller and midsize manufacturers are likely to rely increasingly on Ansys' automation tools.  Within a decade or two, moreover, it might become possible for consumers to customize highly complex products directly from their own computers.  Cash flow is unusually positive.  Cash on hand totalled $496 million at the end of September, up $153 million year to date.  Future per share results could be amplified with acquisitions and stock repurchases.  Assuming moderate growth by the world economy sales could reach $925 million in 2-3 years to provide earnings of $3.40 a share.  Applying a P/E multiple of 30x to those earnings suggests a target price of $100 a share, potential appreciation of 100% from the current quote.

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Female Health ( Nasdaq - FHCO ) - Follow-up Report

Female Health (FHCO $5.75) reported excellent on target Q4 results.  Revenues declined 1% to $7.80 million.  Fully taxed earnings advanced 40% to $.07 a share.  Unit volume expanded by 19%.  Female Health's second generation product line comprised 100% of shipments in the period.  That new design has a 30% lower selling price but generates more absolute profit per unit than its predecessor.  The old design accounted for approximately one third of business in the year earlier quarter.  For the entire fiscal year (September) income finished at $.14 a share on sales of $22.2 million.  Two large contracts that originally were expected to start contributing in Q3 remained delayed.  Other business actually was stronger than expected in the September period, enabling Female Health to hit its performance targets.  Those deals are likely to be signed before long, which should bolster fiscal 2011 results.

Even with those contracts, results probably won't attain our estimates for the coming year.  The company suggested that sales are likely to expand 15%-20% to provide a 10%-15% increase in earnings.  We'd anticipated a stronger sales showing combined with some margin expansion to drive fully taxed earnings into the $.35 a share range.  As it is, $.20 a share now looks like a more realistic target.

Female Health enjoys substantial tax loss carryforwards in the United Kingdom.  Those benefits can be transferred without penalty in the event ownership of the company changes hands.  In America, significant restrictions typically are imposed, making those tax benefits less valuable.  The downside is that the tax situation might limit the kinds of deals which would be viable in the event of a merger.  Even so, share price risk is moderated by the tax benefits.  Female Health remains cash flow positive and its business is poised to keep expanding in future years, fueled by AIDS prevention programs and a lack of direct competition.  Growth has begun to moderate, though, and that trend may continue if funding sources tighten.  A contemplated diversification into the commercial market hasn't gained momentum to date.  Government funding is likely to remain the company's main source of revenues well into the decade.  With the shares trading at a premium valuation (40x trailing twelve month earnings) and growth slowing down, our advice to aggressive investors is to close out positions and reinvest the proceeds in a higher potential issue.  Value investors can realistically maintain their holdings.  Soros Capital Management recently purchased a 5% holding.  Other socially responsible funds may get involved, as well.