Saturday, August 18, 2012

Carbo Ceramics ( NYSE - CRR ) -- Price Pressure Intensifies

Carbo Ceramics (CRR $70.00) appears on track to produce lower than expected Q3 results.  Energy prices have been rising lately, creating optimism that demand for Carbo's fracking technology will swing higher in upcoming periods.  The company's C.E.O. says the outlook is still bleak, though.  And there is ample reason to believe him.  Carbo Ceramics is the leading producer of ceramic proppants used by natural gas and oil drillers to keep the rocks open after they're fractured, so the energy can flow to the surface.  The company has become a victim of its own success.  Natural gas production went through the roof in 2010 once the technology became perfected.  Demand for proppants surged as exploration companies began working their leases, which had expiration dates.  The demand exceeded Carbo's ability to supply, and the ability of Saint Gobain's, too, the other principal propprant manufacturer.  Oil and gas operators turned to China for an answer, and the Chinese delivered proppants that worked well enough.  The technology was in an early stage of development and few people knew the science involved.

The Chinese were in a position to force U.S. exploration companies to sign long term supply agreements.  Those deals still are being worked off.  The surge in natural gas production, combined with weak GDP growth in the U.S., caused natural gas selling prices to plummet.  So new natural gas drilling ground to a halt.  That situation has continued and may persist in light of the the latest economic statistics.

Carbo has been able to replace some lost business with oil related fracking in North Dakota.  Demand remains elevated in that sector, which is affected to a lesser extent by Chinese competition because it's new business for the most part.  But Carbo has had trouble delivering the goods due to infrastructure problems -- where was that infrastructure stimulus money spent anyway.  There just aren't enough railroads and depots to support the business potential out there.

The combination of higher costs and residual Chinese competition is likely to wear on profits over the next few quarters.  Production of proppants in China is believed to be declining, because U.S. operators have learned the technology better and realize now that Carbo's products deliver superior returns on investment no matter what the Chinese price is.  Some of the earlier Chinese contracts are lingering, though.  And the infrastructure build up out West probably will take a while, since the Obama Administration basically remains opposed to fossil fuel development.

These shares have tremendous potential.  The natural gas side of the business is essentially dormant for the moment.  But that segment holds exceptional opportunity for the United States of America.  It could give us the lowest fuel costs in the industrial world.  Production is virtually certain to rebound.  The oil market has great potential, too, since 60% of the oil we use still is imported.  Much of that comes from Mexico and Canada, which is fine.  But plenty of room exists to replace OPEC imports.

Will Wall Street crush the stock when Carbo reports lower than expected Q3 results?  Answer that question, and be on your way.  Buy the stock here and don't worry if a sell off materializes.  Or play the market, and try to get a better price.  This is a great company.  You can't really lose either way.

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Napco Security Solutions ( Nasdaq - NSSC ) -- Solid Execution

Napco Security Solutions (NSSC $3.00) appears on track to report excellent on target Q4 (June) results.  The quarter normally is the company's strongest from a seasonal perspective.  Performance was amplified this year by lower borrowing costs, contributions from high potential new products, and better results at a division (Marks) that had been a drag on results since it was acquired in 2008.  Napco is a leading provider of security systems for residential and commercial use.  Marks was an established provider of door locks for the commercial market when Napco bought it out, right before the real estate industry collapsed.  That transaction was financed with debt.  Higher interest costs and declining sales created a double whammy which has been plaguing income ever since.  Napco has been repaying principal over the past four years.  A few months ago it also refinanced the loan to provide reduced interest payments.  The commercial real estate market has stabilized, moreover, laying the groundwork for improved lock sales in upcoming periods.

The high potential Internet based security systems are building momentum.  Napco invested heavily in R&D over the past several years to develop a family of innovative products.  Those include remote video monitoring, remote control (turn on the lights, the heat, the television, whatever you want, with your phone), wireless break-in reporting (notify the police somebody is breaking in even if they cut the phone line, or you don't even have a land line), and a variety of other next generation systems.  The company probably would not have made those moves, as logical as they were, if the C.E.O. didn't own more than 40% of the stock.  The fact it did, Napco now is set to capitalize from the shift to digital technology.

Economic headwinds continue to prevent Napco from realizing its full potential.  The base business, selling standard security systems to local dealers, is improving, though.  The digital products are gaining acceptance.  The Marks operation is turning the corner.  And the giant cable companies continue to examine security as a prospective new revenue source, part of a "quadruple play."  That hasn't happened yet.  It's possible Napco will have to drive the new digital technology to consumers itself.  Even if the industry takes that slower path Napco promises to deliver increasingly positive results in upcoming years.  If the cable companies step in, explosive gains could materialize.  Our estimates don't reflect the cable industry's potential, and are unchanged. 

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Wednesday, August 15, 2012

Acacia Research ( Nasdaq - ACTG ) -- Return of the Jedi

Acacia Research (ACTG $25.00) suffered a steep sell off following its publication of Q2 results.  Those financial measures were excellent.  Earnings advanced 162% to $.21 a share on revenues of $50.5 million (+27%).  But they coincided with a series of external events that caused dismay among investors.  Legislation was introduced in Congress ("Shield Act") to reduce the value of software patents.  Apple Computer and several other hardware manufacturers promoted the effort, to minimize their exposure to lawsuits.  Product development cycles have become so short in the electronics industry that companies have no time to investigate possible infringement beforehand.  In the past they were able to settle claims for small amounts or wear down their opponents altogether, because the patent owners didn't have the financial resources to stay the course.  When advocates like Acacia Research arrived on the scene, that strategy no longer worked.  And judgements escalated in value. 

Apple Computer and its cronies hope to escape that liability now by changing the law.  Software industry stalwarts like Oracle and Microsoft have fought back because the scope of the proposed legislation encompasses far more than cell phone technology.  Modifications to the law are possible despite that, of course.  But the effort has stalled for the moment.  The outlook for sweeping change has grown slim for the time being.

Eastman Kodak put its patent portfolio up for sale over the summer, as well.  That company bandied about huge sums initially ($2.0 billion).  The bidding has proved less enthusiastic than hoped, though ($500 million).  The final round ended with Kodak avoiding a decision, to extend the process.  The poor result may have caused investors to fear that patent values in general are peaking and perhaps headed lower.  Many experts think the shortfall is specific to Kodak, that its patents largely have been exploited already and that their potential is diminished.

The Apple versus Samsung court case has contributed further tension.  Samsung is a "structured transaction" customer of Acacia Research's.  The patents involved in that deal aren't connected to the Apple donnybrook.  But the showdown between the two cell phone giants has generated concern that Acacia Research will suffer collateral damage if its customer loses. 

That's unlikely.  Earlier in 2012 Acacia Research purchased an expensive portfolio of wireless patents ("Adaptix").  If Apple prevails in its lawsuit with Samsung the Adaptix technology is likely to become easier to assert in an upcoming court case Acacia is scheduled to fight with Apple itself.  In addition, the methodology Apple is using in its Samsung case could be used without alteration to contemplate damages of $1.0 billion or more.  That's Acacia Research's thinking anyway.  However the Apple v. Samsung matter is resolved the result could be a positive for the company.

Short sellers have increased their position by over 400,000 shares.  At the same time Acacia Research has expanded its patent portfolio at the fastest pace in its history.  It also has diversified its technology base into several new areas, especially medical technology.  Cash remains at high levels despite the acquisition spree.  And Acacia Research is believed to have half a dozen or more Fortune 500 companies in "inventory," ready to sign massive structured transactions if only Acacia Research lets them do it.  The company has been holding off on those deals while the patent market was going up, and its portfolio was being expanded, to extract maximum value. 

The company has the ability to report gigantic financial results any time it wants.  Now that patent valuations are leveling off and the stock is under pressure, Acacia Research has plenty of incentive to pull the trigger.  Our earnings estimate (which is fully taxed) excludes any further structured transactions this year.  Income could surge far beyond our target if even a small number of deals are consummated.  That would provide a windfall for Acacia's patent partners, too, who share in the license income at a 50-50 rate.  It also could reward shareholders with a substantially higher stock price, and blow the short sellers' death star to bits.

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Monday, August 13, 2012

Cyanotech ( Nasdaq - CYAN ) -- Gets Drilled

Cyanotech (CYAN $5.75) reported lower than expected Q1 (June) results.  The company is a leading producer of dietary supplements that are derived from algae.  Production is based in Hawaii to take advantage of the abundant sunshine there.  Cyanotech also pipes in cold water from the bottom of the Pacific Ocean to treat the algae after it's harvested, to boost potency.  Until recently Spirulina was the company's key product.  Athletes use it to enhance recovery after work-outs and for a wide range of other health benefits.  Demand for Spirulina is growing at a 5%-10% annual rate.  Astaxanthin is a newer product that now has become Cyanotech's hottest selling line.  Astaxanthin contains high levels of antioxidants and provides an even broader range of health benefits than Spirulina.  Demand for Astaxanthin is burgeoning, and that trend appears likely to continue.

June quarter results were affected by production shortages.  Sales rose 9% to $6.51 million.  Backlog increased due to the inability to meet demand.  Earnings (fully taxed) were flat year to year at $.07 a share.  Cyanotech increased growing capacity by 33% in April.  The new ponds all were devoted to Astaxanthin.  They were rolled out throughout the quarter, though, so the incremental production built up over time.  That material is shipped out to third parties which perform an intermediate step called extraction, moreover.  So the impact of the new ponds was limited.  The Astaxanthin side of the business now is getting into full swing.  A stronger contribution is likely in upcoming periods.

The Spirulina operation has become a drag.  Abnormal costs impacted income by $.02 a share in the June period.  Output was below target, as well, which affected sales.  Measures have been implemented to contain the damage but Spirulina probably will remain below potential at least for another quarter or two.

Legal costs are likely to affect margins, too.  A bulk customer is trying to force Cyanotech to keep selling it a low margin version of Astaxanthin.  Cyanotech has rebuffed the effort so far.  The dispute is headed to court.  A settlement appears achievable but until a resolution is reached legal costs could impair income in future quarters.

New marketing efforts promise to reinforce growth.  Cyanotech traditionally has sold most output in a bulk format to companies that combine it with other ingredients for sale to consumers.  The company has beefed up marketing to address that higher margin opportunity directly.  Those costs could impact profitability in the near term.  But sales of packaged goods already are climbing.  And that trend promises to support expanded margins despite the rising marketing, legal, and production costs Cyanotech is facing. 

We have reduced our earnings estimate to $.50 a share to reflect the rising expense levels.  Next year $.65 a share represents a realistic target as more output heads directly into the retail channel.  Major new retail accounts are being cultivated.  Growth could be sustained at above average levels well into the decade.

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Friday, August 10, 2012

Argan ( NYSE - AGX ) -- Monster Project Moves Forward

Argan (AGX $16.00) appears on track to produce excellent on target Q2 (July) results.  Progress on existing contracts is being achieved without meaningful setbacks.  The company employs percentage of completion accounting.  Near term results should parallel the amount of work performed.  The deals typically pay performance bonuses if Argan finishes on time and under budget.  Upside revisions could develop in upcoming periods.  Our estimates are unchanged.

The Moxie project is advancing on schedule.  Argan has a contract to build two 800 megawatt natural gas powered electricity generators on the Marcellus Shale in Pennsylvania.  That's a prolific fracking region.  Each plant could yield $350-$400 million in sales.  The facilities are sited next to pipelines that are supplied by low cost fracked natural gas.  So input costs are likely to be among the lowest in North America.  The plan is to sell the electricity into the Northeast grid.

Poor economic growth is curtailing demand for clean energy.  The natural gas plant Argan is constructing in California, plus the two slated for Pennsylvania, are anomalies in the current environment.  The California project is benefiting from political support.  The Marcellus Shale units will replace coal fired units that are being decommissioned.  Coal replacement is likely to keep fueling demand for natural gas and other green energy systems, particularly if the Obama Administration remains in power after the upcoming elections.  Even a modest hike in GDP growth could amplify performance down the road.  Argan has proven experience with natural gas, wind, solar, and biofuel generation systems.  The company easily could become a billion dollar company with the help of a modest economic tailwind.

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Thursday, August 9, 2012

Boingo Wireless ( Nasdaq - WIFI ) -- Static

Boingo Wireless (WIFI $6.75) reported lower than expected Q2 results.  The main culprit was the company's legacy consumer business.  Advertising revenue failed to expand, as well.  The core WiFi hotspot operation continued to grow at a superior pace.  The company expanded its network of affiliated locations to more than 550,000 worldwide.  It also signed up several new partnerships, where it retains an economic interest.  Wendy's 6,500 unit restaurant chain was among them.  Income declined a penny sequentially but rose 20% year to year to $.06 a share.  Total sales gained 11% to $24.3 million. 

Advertising revenue is poised to re-accelerate in Q4.  Boingo purchased an advertising specialist in the June period.  That group currently is being integrated and expanded.  By the December quarter the unit is likely to start handling the advertising functions that previously were outsourced.  That promises to boost revenue directly.  Margins should benefit, as well.  The closer integration also could yield better overall performance.  The consumer operation is being made more profitable, too.  That effort has been underway for a while.  Pricing adjustments have caused casual users to leave.  But they are being replaced by higher margin subscription customers.

The venue business remains strong.  Boingo continues to win 75% of the projects it bids on.  Besides Wendy's, the company recently landed a 2,000 store retailer.  Boingo will include sophisticated software in that operation, allowing the retailer to monitor where customers are heading on the Internet when they are in the stores.  If they're checking out product reviews or pricing at on-line retailers, the system will be programmed to intervene with special offers to try to keep the sale in house.  That could help thwart the problem of "show-rooming."  If the technique works substantial growth could be realized by penetrating other retail accounts.

We are reducing our 2012 earnings estimate a nickel to $.30 a share to reflect the Q2 slowdown, and Q3 transition effort.  A solid Q4 rebound appears achievable, laying the foundation for resumed expansion next year.

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Monday, August 6, 2012

Ansys ( Nasdaq - ANSS ) -- Juggernaut Intact

Ansys (ANSS $66.00) reported excellent on target Q2 results.  The company is the leading provider of engineering simulation software systems.  Competition is provided by niche participants with specialties in narrow areas.  Ansys is the industry's only broad based supplier.  As a result it has extensive relationships with large corporations, spanning all geographic markets.  Margins are high due to the lack of direct competition.  They also benefit from the high rate of return the software delivers, which allows Ansys to charge high prices and collect additional fees for upgrades and consulting services.  Customers buy the packages either as perpetual licenses, which involve upfront fess and a 20% annual maintenance charge for upgrades; or as annual licenses, where they pay approximately 40% of the perpetual amount every year.  Revenues currently break down 40% annual licenses, 30% perpetual licenses, and 30% maintenance.

March quarter results revealed a shift from perpetual to annual licenses.  That affected near term revenue and income.  Ansys also experienced a handful of order delays, impacting reported results further.  The pendulum swung in the opposite direction in the June period.  Perpetual deals bounced back to normal levels and orders closed on time.  Performance benefited further from a pick-up in large (over $1.0 million) contracts (19 versus 8 the year before).  Revenues improved 20% to $195.0 million as a result.  Non-GAAP earnings rose 16% to $.72 a share.  Part of the revenue improvement stemmed from an acquisition that was completed in 2012.  Organic growth was 10%.

Wall Street estimates were lifted following the strong showing.  That enthusiasm probably was misplaced.  Sales cycles have grown longer due to the economic slowdown.  And the shift back and forth between perpetual and annual new business is likely to continue.  Our full year estimates are unchanged.  Income appears on track to rise 13% to $2.85 a share.  Next year $3.25 a share (+14%) remains a realistic target.

The long term outlook remains bright.  Existing customers are likely to expand the number of engineers with access to the technology.  Europe's largest airplane maker, EADS, recently announced a broad based expansion, for example.  Ansys is developing the mid-sized business market more thoroughly, as well.  Penetration of emerging geographies promises additional leverage.  And the company earns so much money, per share results are certain to be amplified by share repurchases and acquisitions.  Organic growth is likely to be maintained in the 10%-15% range, moreover, providing an ongoing tailwind.

Engineering simulation technology remains in an early stage of development.  Ansys has the potential to keep growing at above average rates into the next decade.  In 2-3 years earnings could attain $4.25 a share.  Applying a P/E multiple of 30x to those earnings -- realistic in light of the company's dominant market share, fantastic profitability, and the industry's open ended growth potential -- suggests a target price of $125 a share, potential appreciation of 90% from the current quote.

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Wednesday, August 1, 2012

Ellie Mae ( NYSE - ELLI ) -- Margins Remain High

Ellie Mae (ELLI $19.50) reported excellent better than expected Q2 results.  The company had indicated costs would rise sharply in the June period to lay the groundwork for further expansion.  Sales came in above target, though.  So those expenses were swallowed up with ease, enabling pretax margins to remain at superior levels (25%).  Earnings advanced 800% as a result to $.18 a share (fully taxed).  Sales climbed 106% to $23.6 million. 

Customer adoption of Ellie Mae's unique "success based" pricing model continued to rise.  The company charges a small amount to implement its technology at customer locations.  But most revenue is generated on a variable basis when mortgages are completed.  Lenders typically earn $750-$1,000 per loan and pay Ellie Mae a piece of that for the work performed.  The company still has a sizable installed base which uses licensed versions of the technology.  Those customers pay annual fees and don't participate in the recurring revenue scheme.  That group is transitioning to the pay as you go format.  That arrangement is more profitable for Ellie Mae because the ups and downs among its customers are averaged out.  Customers prefer it because the downside risk is reduced.  There's no potential for loss.

Revenues are being reinforced by Ellie Mae's service business.  The company operates a network that links mortgage originators with outside vendors that deliver services electronically.  Those include appraisals, title searches, income verification, and fraud detection.  The company charges for those transactions, but the price usually is far less than what it would cost to do manually.  The software checks the work, moreover, to ensure consistency and accuracy.  A recent stock offering raised $58 million in fresh capital.  Some of that might be deployed to purchase some of those providers, allowing the company to retain those incremental fees.

We are raising our full year earnings estimate by a dime to $.50 a share.  Our estimate assumes a modest decline in margins over the second half of the year due to moderating unit volume.  Refinancing activity has begun to slow.  While new mortgage activity is improving, the poor economy may inhibit its growth rate.  Our sales estimate has been lifted, too, by 12% to $90 million.  Next year $.65 a share represents a realistic target even if the economy remains in the doldrums.  Implementation of a broad-based Federal mortgage re-write program could provide substantial leverage.  Acquisitions might yield additional impetus.
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