Wednesday, February 27, 2013

Cyanotech ( Nasdaq - CYAN ) -- Production Miscue Intensifies

Cyanotech (CYAN $4.25) has been battling poor Spirulina yields over the past year.  That's the company's legacy product.  Overall growth is being generated by the high potential Astaxanthin line, despite the setbacks in Spirulina output.  That segment continues to gain momentum, both in terms of consumer demand and better than expected production volume.  Cyanotech thought it had the Spirulina issue fixed during the December quarter.  Harvests improved in response to some modifications in growing cycles, returning nearly to previous levels.  Spirulina recently took a new turn for the worse, though.  Sufficient material is being produced to keep up with packaged goods demand.  But the excess that Cyanotech customarily sells in bulk to other packaged goods producers has been lost, at least temporarily.  That's relatively low margin business so the impact on financial performance is likely to be modest.  But the fact the problem has not been resolved creates uncertainty about Spirulina's future.  Draining those production areas and starting over would be expensive.  Converting them to Astaxanthin also would incur expenses.  Cyanotech has been building up retail demand for Spirulina, hoping to fill the pipeline with multiple products, not just Astaxanthin.  Our estimates are unchanged for the moment.  But they could could down if the issue is not resolved in a timely fashion, and with a high degree of confidence.

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Friday, February 22, 2013

Acacia Research ( Nasdaq - ACTG ) -- Risk and Reward Increase

Acacia Research (ACTG $29.00) reported excellent on target Q4 results.  The company completed two large settlements in the period.  A string of smaller deals were signed, as well.  Revenues advanced 219% to $66.3 million.  Earnings topped our estimate, coming in at $.31 a share (fully taxed).  Margins expanded more than anticipated because few royalties were paid to Acacia's partners.  Most patents are jointly owned by the company and the original inventor.  In the past licensing proceeds usually were divided equally, after expenses were deducted.  Over the past year, though, Acacia has begun to frequently pay inventors some upfront cash in exchange for a higher percentage of any future payouts.  No money is paid to the partners until that upfront fee is recovered first.  A number of deals in the quarter reflected that arrangement, creating the appearance of higher margins.  An alternative accounting method would show those payments simply as a return of capital.  Acacia's method is the one used by GAAP accounting rules.

Spending on patent purchases surged in 2012.  Acacia spent $328.3 million to acquire intellectual property rights in 2012, compared to $14.7 million the year before.  Some of those purchases resulted in 100% ownership, eliminating the need to pay future royalties altogether.  The rest were partner deals where the inventor received upfront cash.  Under the old model risk was limited to the cost of prosecuting patent infringers.  The use of upfront payments heightens risk because that cash needs to be recouped before true profits can be realized.  The potential rewards are greater, as well, because once break even is achieved Acacia is in line to earn a higher percentage of the subsequent winnings.

Government regulation has become a factor.  Concern that technology companies have used patents to corner their markets led to the passage of the America Invents Act in 2010.  Compliance with those rules has raised the price of pursuing patent claims.  The U.S. Department of Justice also has begun hearings on the potential for using third party companies, like Acacia, to accomplish the same purpose.  Key patents could be licensed to an intermediary, shielding the original holder from liability while still enabling it to corner its market.  Acacia says the law is helping its business by knocking out less well capitalized competitors.  It also says the Justice Department's investigation probably has merit but doesn't directly affect any of the company's licensing programs.

Revenues and reported earnings are poised to advance sharply in 2013.  Acacia's growing inventory of patents is boosting its average revenue per settlement, particularly in the technology industry.  Margins are improving, too, because it's almost as easy to negotiate a 15 patent deal as it is for a single patent.  Legal expenses are falling, moreover, as more deals are settled instead of going to court.  With multiple patents available to work with, quantity discounts ("structured transactions") become more feasible.

But the court room remains an option.  On April 8, 2013 the company will square off with Apple Computer to enforce its smart phone patent portfolio.  Acacia already has won large settlements from several companies, most recently Nokia.  Based on valuations proposed by Apple itself during its recent court case with Samsung the potential payoff to Acacia and its partners could be several hundred million dollars.  Samsung is a licensee of Acacia's technology.  If Acacia prevails Apple no doubt will challenge the verdict and try to delay payment.

We estimate fully taxed 2013 income will rise 38% to $2.00 a share.  Revenues could advance 34% to $335 million.  Performance could vary considerably from those estimates.  New industries -- medical technology, energy, and automotive -- are being addressed.  Those patent portfolios are being built up currently.  They could yield significant leverage down the road.

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Monday, February 18, 2013

Proto Labs ( NYSE - PRLB ) -- Margins Near a Peak

Proto Labs (PRLB $47.00) reported excellent better than expected Q4 earnings.  Sales were on target at $33.6 million (+31%).  Income widened 94% to $.31 a share.  That was $.07 a share above our estimate.  Fourth quarter results ordinarily are seasonally pressured due to the holiday season.  This year performance was impacted by weakening economic conditions in Europe, too.  Demand surged among U.S. customers, though, offsetting the headwinds.  Gross margins leaped 3% beyond the high end of Proto Labs' target range (60%-62%).  A portion of that was consumed by start up costs associated with several key new materials the company is introducing.  For the year income finished at $1.07 a share, up 19%.  Average shares outstanding rose 23% due to a pair of public stock offerings.

Margins could stay elevated.  Proto Labs manufactures small production runs for engineering groups and makers of specialty products.  The company is expanding the variety of materials it works with to deliver real parts customers can evaluate and use, not mock-ups like 3-D printers tend to make.  Orders fluctuate unpredictably, though.  While Proto Labs manages order flow with innovative techniques, invariably there are times when personnel are underused or required to work overtime.  Those expenses were on the low side in Q4 but are likely to stay in the expected range over the long haul.

Volume is mounting.  Existing customers are sending in more requests.  And new customers are being added with clever marketing techniques.  We are raising our 2013 earnings estimate by a nickel to $1.30 a share.  A stronger showing is possible if margins remain at an elevated level.  Above average growth appears likely to continue well into the decade.  Performance is not immune to poor economic conditions, though.  It's been four years since the last recession.  Another slowdown could interrupt Proto Labs' earnings progression.  Even a brief reversal could blast the stock price in light of its high P/E multiple.

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Sunday, February 17, 2013

Ellie Mae ( Nasdaq - ELLI ) -- The Mortgage Automation Leader

Ellie Mae (ELLI $21.50) reported excellent on target Q4 results.  Pretax margins widened to 31.4% to deliver earnings a nickel above our estimate at $.22 a share.  Revenues were as anticipated at $29.9 million (+60%).  The company built up its sales force and network operations earlier in 2012.  As those costs subsided margins improved on a sequential revenue gain.  Ellie Mae is the leading provider of computer based mortgage production services.  At year end 74,000 mortgage professionals subscribed to its software.  Approximately 190,000 potential users exist in the U.S., excluding the nation's 20 mega banks which rely on their own systems.  (Mega banks account for 50% of the industry's volume.)  Existing customers are pumping more business through Ellie Mae's network.  New users continue to be added.  And a sizable backlog of users are still being converted from legacy systems.  Those users were brought on board when Ellie Mae acquired its primary competitor in 2011.

Average order size is rising.  Most mortgages are processed through Ellie Mae's "success based pricing" format.  That's a cloud based system.  Originators are charged only for mortgages that get funding.  No money is generated when applications are rejected.  A declining share of the volume still is done with on premises software.  Customers purchased those programs years ago and are not required to pay per unit fees.  Many of the latter are converting to the variable pricing model, nonetheless, because software updates are delivered automatically via the cloud.  Software running on a local computer needs to be serviced individually, creating delays.  Demand for reliable updates is surging in response to the proliferation of mortgage regulations.  Five groups within the Obama Administration are now involved.  All 50 states are ramping up oversight, too.  Revenue per loan is increasing as more elements of the lending process flow through Ellie Mae's system.

More billable features are being added.  So far Ellie Mae has steered away from providing its own credit reporting and other key services.  Moving directly against existing partners could provoke retaliation.  High tech innovations are in the pipeline, though.  Allowing home owners to provide information directly from smart phones and computers could be implemented before long.

Larger banks are signing up.  In the past most of Ellie Mae's software customers were small banks and mortgage brokers who didn't have the resources to manage their own technology.  Larger institutions have become candidates, mainly as a result of the Obama Administration's regulatory crossfire.  Those banks haven't junked their existing systems yet.  And that may never happen in many cases because they want to retain an in house technical staff.  Some offloading has begun, though.  And that trend is likely to continue as the need for fast turnaround time grows in a complex regulatory environment.

Mega banks have become customers, too.  Wells Fargo and Citibank both are using Ellie Mae's data structure to collect mortgages from outside originators.  Many of those originators use Ellie Mae's systems to begin with, making it easy to structure the data the way the big banks want it.  Ellie Mae currently generates about $125 per loan from the origination side.  Another $25 per loan is being collected from the mega banks, kind of as a license fee for using the company's standard format.  That business remains unprofitable due to the start up costs associated with implementing the systems inside the mega bank's IT departments.  But some profits are likely to emerge in 2013 as the programs exit the testing phase.  Bigger impacts are possible beyond.

Our estimates assume that refinancing activity will decline in 2013.  Those loans have dominated the industry over the past two years.  New construction and resales may pick up some of the slack.  Volume has the potential to increase even if refinancing rates stay flat or rise.  Most home owners simply have rolled over existing balances to date.  If home values climb new cash out loans could become a more significant factor.  Assuming a falling mortgage market, we estimate sales will advance to $135 million to produce earnings of $.90 a share.  Market share gains are likely to continue over the next several years.  Average order size promises to expand.  And the $25 fees from the mega banks could escalate, forming another river of recurring revenue.

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Saturday, February 16, 2013

IPG Photonics ( Nasdaq - IPGP ) -- Margins Compress

IPG Photonics reported excellent on target Q4 results.  Performance was affected by the punk macro economic backdrop.  European business was especially slow.  Despite that sales achieved our estimate, improving 17% to $145.0 million.  Earnings were a nickel above our projection at $.69 a share (+3%).  Manufacturing margins declined to 51% compared to 53% in the year ago quarter.  IPG Photonics aims for a range of 50%-55%.  Product mix was the main factor behind the decline.  Competition began to emerge for the first time, moreover.  IPG Photonics created the high power fiber laser industry.  Other laser producers have a background in Yag crystal and CO-2 gas systems.  Fiber units eclipsed the older technologies in 2011 and have been gaining market share ever since.  Competitors have been racing to develop fiber systems of their own.  IPG Photonics remains far ahead in terms of overall price performance.  But competitors have zeroed in on some niche markets.  And while their production costs are substantially higher for now they are pricing aggressively to gain a foothold in the business.

Large scale users continue to rely on IPG Photonics.  New applications are being developed, moreover.  So even if competitors take slices of the company's existing markets overall volume is poised to keep rising.  The fiber category is likely to capture a larger portion of the overall laser industry in future years, as well.  Margins probably will come down a little bit as IPG Photonics enters new areas and competition exerts a modest degree of pressure on the more straighforward parts of the business.  But profitability is poised to stay high as IPG Photonics sustains its industry leading technology.

Our 2013 forecast assumes more economic weakness.  If demand picks up a significantly better showing could develop.  For now we estimate sales will climb 15%-20% to $650-$675 million to provide income of $3.15-$3.35 a share.  Longer term growth might be amplified with acquisitions.

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Monday, February 11, 2013

Napco Security Technologies ( Nasdaq - NSSC ) -- Weather or Not

Napco Security Technologies (NSSC $3.40) reported Q2 (Dec.) results that were below potential.  The company is a leading provider of security systems for commercial and residential customers.  Most sales are made through dealer networks in the Northeast.  Napco had been suffering from the poor housing and construction markets for the last several years.  Momentum began to pick up in 2012.  But Hurricane Sandy interrupted that progress.  Several of Napco's largest distributors provide a range of services, in addition to security systems.  The damage forced them to work on more immediate problems, like heating.  That diversion of resources is likely to continue impacting Napco's results over the next few quarters.  The delay ultimately may prove to be a positive development for Napco, though.  A transformational change to digital technology is underway in the security systems industry.  The company has a diverse product line on the launching pad already.  But this will be a software driven business.  Improvements likely will be made over the next quarter or two, laying the groundwork for a major acceleration in fiscal 2014 (June).

Television advertising by competitors ADT and Comcast is taking off.  Napco serves the independent dealer market, which competes with the giants.  Independent dealers currently serve approximately 70% of the security system market.  Penetration is especially robust in the commercial building segment.  Dealers also do well with residential customers who want a specialized system.  The giants probably will capture a larger percentage of the market as the cable companies bundle security with their other offerings, to make it a "Quadruple Play."  That will just expand the market, though.  Napco is well positioned to win a sizable portion of the dealer segment as digital security goes mainstream.

We have lowered our fiscal 2013 (June) estimates due to the hurricane's impact.  But we think business will return to normal before long.  An eye popping increase in sales and earnings could develop over the coming 2-3 years. 

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Friday, February 8, 2013

Cyanotech ( Nasdaq - CYAN ) -- Transition on Track

Cyanotch (CYAN $5.00) reported unexceptional Q3 (Dec.) results.  Sales advanced 8% to $7.24 million. Fully taxed income declined 33% to $.10 a share.  The shift from bulk shipments to branded product sales exhibited steady improvement, though.  Bulk revenues comprised 56% of the quarter's total, compared to 67% in the year ago period.  Both astaxanthin and spirulina showed 42% gains in the packaged goods segment.  The decline in bulk volume resulted mainly due to lingering spirulina production problems, which limited output.  Performance has improved but remains below full potential.  Marketing costs accelerated in the period as Cyanotech widened its retail distribution network.  Those expenses likely will remain elevated as expansion continues.  Margins are likely to improve in the March quarter as the production improvements take effect.  Sales probably will be level, though, due to seasonal growing factors (less sunlight).  We have reduced our full year earnings estimate by a nickel to $.35 a share.

Margins should keep improving next year as more business goes through the retail channel.  End user demand remains vibrant.  Better capacity utilization could lift physical output.  Packaged goods should deliver higher revenue per kilogram.  Some capacity might be switched from spirulina to astaxanthin to supply that faster growing segment.  The long term outlook remains positive.  Sales and margins could keep improving well into the decade.

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