Thursday, October 25, 2012

Carbo Ceramics ( NYSE - CRR ) -- Improves Core Technology

Carbo Ceramics (CRR $71.00) said it has identified a new technique for manufacturing ceramic proppant.  The company already makes the highest performing products in the industry.  The process currently is in the development stage.  If it is commercialized Carbo expects the new line will deliver even higher levels of conductivity to the fracking industry, both in the petroleum and natural gas segments.  Projected costs are expected to be similar to Carbo's existing products.  The effort was spurred by competitive factors.  Several start-up companies are trying to develop alternative ceramic based proppants.  Those projects have been taking longer than expected to reach fruition because of technical problems.  If Carbo's next generation reaches the market those efforts could become obsolete before they start.

New resin coated sand proppants are in the pipeline.  That's a less expensive technology that can be applied in less challenging formations.  Carbo has been gradually ramping up production of its lower cost sand based products.  New capacity is slated to come on line in 2013.

Marketing efforts are gaining a receptive audience.  Carbo has been swatting away competition from lower quality Chinese competition for the past several years.  A technical marketing campaign was launched in 2012 to demonstrate explicitly why its products generate a higher rate of return.  The data generally indicate that flow rates are 20% stronger using Carbo's proppants.  Their greater strength and more consistent shape produce better conductivity.

International sales are picking up.  They still represent a small fraction of total sales.  But in the September period foreign business jumped 33%, partly offsetting a decline in North America.  Carbo also benefited from growth in its non-proppant operations, particularly the Falcon spill containment business.  That unit also is a small part of the overall company but it keeps growing at a 15%-20% pace.

Third quarter results were unspectacular, as expected.  Income declined 32% to $1.09 a share.  Consolidated revenues slid 10% to $151 million.  Earnings could drop even further in the December quarter due to weather factors and holiday interruptions.  Low natural gas prices are continuing to weigh on the overall drilling industry.  Absent a complete economic wipe-out at least a modest improvement appears likely to develop next year, though.  Carbo is well positioned to boost its share of the market, moreover, creating the potential for a solid gain in financial performance.  The long term outlook already looked positive.  If the new production methods are implemented successfully results could accelerate at an even faster pace than previously thought.

( Click on Table to Enlarge )

Wednesday, October 24, 2012

Healthstream ( Nasdaq - HSTM ) -- Tax Adjustment Hits EPS

Healthstream (HSTM $27.00) reported excellent on target Q3 results.  Earnings were flat with the year ago quarter at $.09 a share.  Average shares outstanding increased 17%, mainly due to a stock offering earlier in 2012.  The tax rate also impacted profitability, coming in at 48% for the period.  Healthsteam made several adjustments at the state tax level which were non-recurring, sending the rate temporarily above the customary 40% mark.  Income additionally was affected by merger related expenses associated with two small acquisitions.  Revenues advanced 28% to $26.4 million.  Learning software grew 37%, representing 77% of the total.  Research business increased 4% and accounted for the balance.  That segment complements the core software operation, is more volatile, and follows a lower growth trajectory.

Government regulation continues to drive adoption.  Healthstream is the leading provider of computer based instruction and certification programs for the health care industry.  The company holds more than 50% of the market, which is mostly hospital based.  Subscriber growth was 13% in the September quarter.  Revenue per user, bolstered by new product introductions and wider use of existing packages, reinforced the uptrend.  New products continue to be added.  Most courseware is created by outside authors who earn royalties.  Healthstream also has made two small acquisitions in 2012, raising revenue directly.

The outlook remains positive.  Product development, marketing, and customer support costs are likely to keep rising over the next few years as Healthstream tries to cement its competitive position.  Royalties may creep higher as a percentage of sales, too, as more high value courses and programs are brought in.  Operating costs promise to decline on rising volume, though, keeping overall margins on the upswing.  We estimate 2013 income will rise 29% to $.45 a share on a 24% hike in revenue ($130 million).

Margins have the potential to widen substantially.  Pretax profitability could move into the 25% range over the long haul.  Sales also promise to keep rising at above average rates as Healthstream's market share expands further, average revenue per user rises, and penetration of related markets (clinics, outpatient surgery centers) is achieved.  International expansion is possible though it's not immediately on the horizon.

( Click on Table to Enlarge )

Tuesday, October 23, 2012

Ellie Mae ( NYSE - ELLI ) -- The Ghost of Elizabeth Warren

Ellie Mae (ELLI $23.00) appears on track to report excellent on target Q3 results.  The company is the leading independent provider of mortgage automation software.  Ellie Mae is expanding internally by increasing its average order size.  It also is gaining market share.  Results also are influenced by overall mortgage activity.  Performance has been surging over the last year in response to a pick up in refinancing volume.  Sales of new and existing homes have improved, too.  Fourth quarter results are likely to preserve the current momentum.  Beyond that, regulatory obstacles loom.

The Dodd-Frank legislation is poised to take effect after the 2012 election.  One of the law's elements is the creation of the Consumer Financial Protection Agency.  That was the brainchild of Elizabeth Warren, who now is a 1-to-10 favorite to become the next Democratic senator from Massachusetts.  A key regulation that's set to be implemented by the agency is the "QM Rule," short for qualified mortgage.  That's a scheme designed to prevent banks from engaging in predatory lending.  It establishes a set of government criteria that lenders have to abide by to make sure borrowers have the ability to repay the loan.  The metrics scheduled to go into effect are pretty strict.  It's legal for banks to write loans that don't comply.  But that makes them liable to civil penalties, and potentially criminal ones.  Like most laws being implemented these days, banks can be hit with sanctions under some conditions even if they do comply with the letter of the law.

Enough high quality borrowers have been in the market to keep Ellie Mae's growth intact up to this point.  In the September quarter the average FICO score of the loans processed by the company was 750 (top 40%) with an average 22% of the purchase price down.  More than half of those loans were refinancings.  The average FICO score of the rejected loans was 700.  A score like that used to go through almost automatically.  The expectation was that credit standards would loosen somewhat in 2013 and beyond, opening up a trove of potential refinancing business.  Rising new and existing home sales promised to reinforce the trend, both directly and by boosting home values.  Combine that with Ellie Mae's market share dominance and rising revenue per transaction, and the outlook was bright.

Barack Obama is a 1-to-3 favorite to win re-election.  Elizabeth Warren's rules are likely to be enacted.  And while the mortgage market may not turn down, the upside potential could be diminished.  These rules will affect everybody in the industry, not only Ellie Mae.  In the long run it's possible the company's competitive position could benefit.  We doubt the regulations will be of any genuine help, though.  Still, we think Ellie Mae will continue to fare well over the next several years.  Investors with long term gains and oversize positions might want to reduce positions, nonetheless, to manage risk and beat the imposition of higher capital gains taxes next year.

( Click on Table to Enlarge )

Friday, October 19, 2012

Acacia Research ( Nasdaq - ACTG ) -- Speed Slows Down the Game

Acacia Research (ACTG $25.00) reported lower than expected Q3 results.  Quarterly results are an important data point in the company's performance.  But they don't correlate on a year to basis.  Acacia is the leading provider of intellectual property monetization services.  Some people call it a patent troll.  It joins forces with patent holders to force infringers to pay up, according to the law.  In the past large companies would string inventors along with an endless series legal maneuvers, forcing them to give up because they ran out of money.  Acacia teamed up with the small fry, usually going 50-50 with them.  Acacia had the resources to keep going and force a fair settlement. 

The winner take all economy has made intellectual property increasingly valuable.  Acacia currently is under political pressure, created by large companies that don't want to pay.  A variety of laws are under consideration in the U.S. and Europe to reduce those liabilities, mainly by creating a new class of IP called "standards based" patents.  Those are inventions that everybody in an industry would like to use.  It's impossible to tell where this might lead.  But it seems likely that politicians here and abroad have stumbled upon a gravy train when it comes to the subject.  The big companies don't have a leg to stand on.  But they may win a concession here and there from the various legislators, to keep the campaign contributions coming.

Legislative uncertainty has slowed Acacia's deal flow.  The company also has been adding aggressively to its patent portfolio over the past year, making potential settlements more complex.  In the past Acacia would threaten to sue an infringer with a single patent, and they'd work it out.  Now Acacia has multiple portfolios under its control.  The targets it's talking with are interested in working out a package deal.  How much everything's worth, that comes back to Barney Frank.  There's an election coming up.  Rep. Frank is retiring.  There's a lot of stuff going on.  And there's a lot of money on the line.

The company is going for it.  On its recent earnings conference call several analysts pestered Acacia's management about repurchasing stock or issuing special cash dividends.  The company said, "We feel your pain.  But we're investing our cash in the business."  That's as bullish a statement as you can get.  The loser companies buy back stock. 

This is a great company.  We've reduced our estimates.  From what we can figure, though, Acacia is negotiating with at least 50 companies that could generate $50 million or more in revenues over the next 2-3 years.  Maybe that wiill prove optimistic.  Let's face it, Congress is a crooked place.  But it's on the level, too.  Getting paid a fair price for your invention is the American Way.  Multiply it out.  And remember those deals will come up for renewal in 3 years, creating a decent recurring revenue stream.  And unlike most companies, Acacia has the ability to reinvest its cash flow at a superior rate of return.  These shares have a lot of upside potential.

( Click on Table to Enlarge )

Tuesday, October 16, 2012

Performant Financial ( Nasdaq - PFMT )

Performant Financial (PFMT $10.75) is the leading provider of debt collection services for student loans.  The company also identifies and retrieves improper Medicare payments.  Additional services are being developed to help state and local governments collect a variety of delinquent obligations.  Performant has been involved in the debt collection business since the mid-1970s.  The company has computerized most of its expertise and data bases since then, boosting efficiency among its agents who deal directly with the public.  Formal contracts are in place with the Department of Education.  Those deals generally pay a percentage of the funds collected.  The company competes with approximately 20 other providers.  The government typically steers more business to those companies that generate the best results.  The total potential market has been expanding at a 12% annual rate over the past decade.  More than $70 billion of student loans currently are overdue.  Over $1 billion in student loans are outstanding altogether.  More than $100 billion in new loans are written each year.  The default rate has increased from 5% to 9% during the last five years.

The U.S. Government took over the student loan industry in 2010.  Before then private lenders issued loans that were guaranteed by the government.  The Department of Education now handles all of the government guaranteed student loans.  Approximately 45% of the student loans outstanding still are held by private companies, though.  Performant has contracts with 11 of those (out of 30), in addition to its deal with the Department of Education.  Both channels generally pay a fixed percentage of funds collected (15%).  Competition is based on the amount of money retrieved, not the commission rate.

Medicare uses four separate companies to identify and collect improper payments.  Performant manages the Northeast quadrant, representing 23% of total claims.  That segment currently provides about 25% of the company's revenue.  Student loans represent most of the balance.  Software upgrades have been implemented over the past two years to identify incorrect billings more systematically.  That effort not only has lifted Performant's addressable market.  It also has improved work force productivity.  The increase in student loan default rates combined with superior automation in the Medicare sector is helping sustain overall revenue growth in the 20% range.

New markets promise to add further leverage.  Medicaid and other state and local government programs are rife with incorrect billings.  Bad debts are on the rise, as well, reinforced by the weak economy.  Performant is signing new government agencies at an accelerating clip to enforce fairness and compliance, number one.  Those outsourced efforts also generate substantial incremental revenue without any real expansion in direct budget costs.  Performant typically retains a share of the money retrieved, similar to its core operations.

We estimate 2012 sales will rise 26% to $205 million.  Earnings appear headed towards $.60 a share (+33%).  Performant recently went public at $9.00 a share.  Most of the money raised was retained by the private equity firm that bought the company earlier in the decade.  Earnings dilution was less than 5%.  The deal left Performant encumbered with significant long term debt.  Cash flow is ample to cover the related interest costs and repayment schedule.  But the financial leverage does constrain Performant's ability to expand via acquisition.

Next year sales of $250 million (+22%) appear attainable.  Income could reach $.75 a share (+25%).  Our projections assume the sale of an additional 5 million shares over the coming 2-3 years to shore up finances.  Even so, earnings could achieve $1.00-$1.25 a share within that time frame.  If any capital raised is applied towards acquisitions a stronger showing is possible.  Our target price is $25 a share, potential appreciation of 130% from the current quote.

( Click on Table to Enlarge )


Thursday, October 4, 2012

Carbo Ceramics ( NYSE - CRR ) -- China Retreats

Carbo Ceramics (CRR $63.00) appears on track to report unexceptional Q3 results.  The company has been under pressure for the past year from a combination of declining demand and rising competition.  Carbo is the leading producer of ceramic proppants used to keep the rocks open during oil and gas fracking operations.  The company has been expanding into the lower priced ceramic covered sand market, as well.  A lot of wells don't require the strength of a 100% ceramic product.  The proppants are manufactured to a round shape, which maximizes the flow rate of the oil and gas being recovered.  The industry originally boomed in the natural gas segment.  A tremendous surge in drilling activity ensued, much of it in Pennsylvania and surrounding areas.  Carbo was unable to supply the entire market.  So a number of drilling companies found alternative sources, most of which were based in China.

Natural gas prices subsequently collapsed.  Once a fracking operation starts there's no way to turn it off, without turning it off forever.  Many mid-level exploration companies had to worry about lease expirations, too.  They also had shareholders and lenders to satisfy.  So the drilling continued even though losses were incurred on a full cost basis.  Once natural gas prices dipped to $2.00 per Bcf the marginal cost began to exceed revenue.  At that point new activity died.

Amazingly, the market shifted to oil.  A midsized oil company (Mitchell Energy) had been working on oil fracking for years.  It showed everybody how to do it.  And the equipment build-up in Pennsylvania rushed to North Dakota where massive oil deposits were identified.  Carbo followed the industry.  But the company was slowed down by a lack of rail lines and warehouse facilities.  It also continued to face tremendous Chinese competition.

Many operators still have contracts to purchase Chinese proppants.  With experience they've discovered that Carbo's products deliver a much  higher rate of return.  But they remain obligated to work off their existing contracts.  Distributor inventories of Chinese proppants still are elevated, moreover.  So the lower quality lower price competition is likely to remain a factor over the next 2-3 quarters.

But Chinese products now are entering the U.S. at a diminshed rate.  Many China based producers have exited the business.  Others are supplying the Chinese fracking market, which itself is booming.  The overhang of low priced Chinese goods is wearing down.  And awareness among customers about the superior performance of Carbo's products is rising.

Natural gas prices have rebounded to $3.00 per Mcf.  The combination of declining production and rising utility consumption has reduced the amount of gas in storage.  That combination almost certainly will force prices back into the $4.00-$5.00 per Bcf range.  Which is where it once again becomes economical to drill.

Once that happens Carbo will enjoy excellent fundamentals both in the oil and gas segments.  Competition will continue, for sure.  But the company likely will be able to sustain margins at lofty levels. Carbo has largely completed its infrastructure build-out in North Dakota to capitalize on the oil segment.  That should be reflected in upcoming periods.  A pick-up in natural gas combined with reduced Chinese competition promises to amplify the forthcoming improvement.  In 2-3 years income could reach $9.00 a share.  International expansion could provide further leverage.

( Click on Table to Enlarge )

Wednesday, October 3, 2012

Cyanotech ( Nasdaq - CYAN ) -- Barrels Back

Cyanotech (CYAN $5.75) appears on track to report reasonably good Q2 (September) results.  The high potential astaxanthin line has continued to build momentum.  New growing ponds have entered production.  And average selling prices are drifting upward as output is diverted from bulk sales to higher margin packaged products.  The legacy spirulina line continued to encounter problems, though.  That segment still represents more than 50% of Cyanotech's growing capacity.  A variety of production issues have curtailed volume.  That's put a crimp in sales directly.  It also has incurred extra costs, as the company strives to fix the problem. 

Margins may be affected by the addition of two sales and marketing executives.  That's laying the groundwork for a pick-up in direct to consumer sales, via social media and other techniques.  It also is boosting distribution to a broader group of specialty retail stores.  Legal expenses will impact margins, as well.  Cyanotech is battling it out with a bulk customer that is trying to force the company to keep selling astaxanthin at abnormally low prices.  That issue probably won't be resolved for another two quarters, although there's little reason to think Cyanotech will be forced to continue the arrangement once the existing contract expires.

Meantime, worldwide astaxanthin demand still exceeds supply.  Industry growth has begun to moderate, following last year's surge.  But plenty of opportunity remains.  A large majority of specialty health food retailers don't carry astaxanthin products.  Large potential exists in the chain store segment, as well.

Our estimates are unchanged.  Near term performance is hard to predict due to the spirulina problem.  How fast Cyanotech can transition to higher margin retail products is another unknown.  The impact of legal and personnel expense is another question mark.  Still, a strong showing is likely due to the underlying strength in demand.  New competition has not emerged.  Astaxanthin and spirulina are complicated products to grow.  The long term outlook remains bright.  In 3-5 years sales could reach $50-$100 million to produce income on the order of $1.00-$2.00 a share.

( Click on Table to Enlarge )

Acacia Research ( Nasdaq - ACTG ) -- Major Patent Acquisition

Acacia Research (ACTG $27.00) obtained the rights to a valuable patent collection from one of the world's largest medical device manufacturers.  The acquisition amplifies the company's burgeoning medical operation, which was bolstered by a similar deal in the June quarter.  The latest arrangement is a partnership where Acacia Research will divide any winnings generated with the manufacturer.  Many large companies are seeking ways to make money on their intellectual property.  Joining forces with Acacia Research is becoming a popular way of accomplishing that.

A string of settlements likely provided strong Q3 financial results.  Acacia Research doesn't reveal the size of individual payments.  But based on previous deals and the size of the infringing companies a potent performance looks realistic.  Our full year estimates are unchanged.  December period results could accelerate if Acacia Research can unlock the potential of its recent acquisitions without delay.  The company also is working on several "structured agreements."  Those are unusually large deals that typically involve Acacia Research's entire portfolio.  Past agreements have been made with Microsoft, Samsung, Oracle, and Cisco. 

( Click on Table to Enlarge )

Monday, October 1, 2012

Simulations Plus ( Nasdaq - SLP ) -- Wins Another Government Contract

Simulations Plus (SLP $4.75) landed a contract with the U.S. Army.  The company is a leading provider of drug simulation software.  The military laboratory will use the technology for toxicology testing.  That's a similar application to one already underway at the F.D.A.  Simulations Plus already is widely known in the drug industry, with a particularly strong customer base among larger companies.  The Government business promises direct benefits.  It also is likely to reinforce demand among commercial users, since the software has a de facto stamp of approval. 

Fourth quarter revenue was pre-announced by the company.  Sales were up 15% to $1.64 million, excluding last year's contribution from a non core business that subsequently was sold off.  Earnings were not commented on.  But we continue to estimate full year income of $.20 a share (+11%).  The fiscal year just ended (August) was affected by a downturn in third party collaboration revenue, and a fall-off in consulting activity.  Both of those segments are poised to re-accelerate in the upcoming year.  License sales continue to grow at a 15% pace, moreover.  We estimate income will improve 25% to $.25 a share in fiscal 2013.  The market opportunity remains lightly penetrated.  Above average gains could be sustained well into the decade.

( Click on Table to Enlarge )