Wednesday, October 29, 2014

IPG Photonics ( Nasdaq - IPGP ) -- New Applications Drive Growth

IPGP Photonics (IPGP $70.00) is the leading manufacturer of lasers that use fiber optics to deliver the beam.  Older technologies rely on CO-2 and YAG crystals.  Those technologies dominated the $4.5 billion industry four years ago.  IPG had been developing its systems for a decade prior to that, achieving success in niche markets that appreciated its smaller form factor and more precise tuning.  In 2011 the company was able to match its competitors selling prices, precipitating an explosive sales acceleration.  Costs have continued to decline, allowing fiber to establish a dominant position in several key industry segments.  Additional parts of the industry now are adopting fiber, as well.  IPG also is elbowing out non-laser technologies in a growing range of manufacturing operations.  Competitors are attempting to replicate IPG's success.  But the company has such a lead with key components and system integration know-how that those offerings are barely competitive in the low end.  And the company still remains largely without direct competition in the high power segment, the most profitable part of the business.

New applications are expanding IPG's horizons.  Cutting metal has been the largest sales driver to date.  Welding now is becoming a major contributor, as well.  A variety of fancier uses is emerging to provide further leverage.  Those include oil drilling, 3-D printing, brazing, coating, and engraving.  Non-manufacturing applications represent only 5% of sales currently.  But those are poised to expand over the next few years, as well, particularly in semiconductor processing, medical applications, and telecommunications.

Demand is strongest in Europe and Asia, especially China.  The U.S. accounts for approximately 10% of sales.  Core applications in both of those international regions continue to perform well despite reports of macro-economic problems.  New products are reinforcing that expansion.  Cash flow is positive, fueled by pretax margins that routinely exceed 35%.  That allows IPG to respond quickly and effectively when competitive threats develop.  Over the past year upstart producers in China cut into IPG's low end marking business.  The company engineered a low cost line of its own, with regular margins, that turned back the tide.  Traditional laser manufacturers have been attempting to break into the fiber business.  They've succeeded to a degree with specialized products sold to longstanding customers.  Margins are believed to be tight on those units, though.  And IPG stands ready to make selective price cuts if it becomes necessary to turn the screws.

We estimate 2014 sales will advance 17% to $760 million.  Earnings appear on track to rise 22% to $3.85 a share.  Margins probably will benefit 1.0% this year from favorable currency moves.  Much of the company's production is based in Europe.  The euro's decline is lowering costs.  Next year sales could improve 15% to $875 million to support a 12% gain in earnings to $4.30 a share.  Our estimates assume margins return to normal.  IPG has a $500 million war chest that might be deployed for acquisitions.  The company has been unable to find what it wants to date.  It's been looking for a while now, so a purchase in the laser segment has become increasingly less likely.  But a move into a related business remains a possibility.  3-D manufacturing, for instance, might provide a high rate of return on the surplus cash now being generated by the fiber laser business.  If nothing emerges, a stock repurchase or dividend program could be established.

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Tuesday, October 28, 2014

Cognex ( Nasdaq - CGNX ) -- Big Deal

Cognex reported unusually good Q3 results.  One customer bought $65 million of the company's machine vision systems, propelling total sales ($169.4 million) up by 87% year to year.  Earnings followed suit.  Cognex provided modest price concessions to the large buyer, causing its gross margin to narrow to 74%.  The company usually reports that metric in the 75%-80% range.  Overhead costs went up some, too, but not nearly as much as sales.  So operating income accelerated, driving earnings ahead by 126% to $.59 a share.  Business was excellent even if the large shipment was excluded.  Sales rose 15%, fueled by continued expansion in the factory automation sector.  Cognex did well to keep the rest of its operation intact despite the distraction created by the big transaction.

Fourth quarter performance won't benefit from the unusual contract.  Activity remains vibrant in all keys markets including the U.S., Europe, China, and other parts of Asia.  But a more conventional set of numbers is expected to be reported.  For the year we estimate earnings will finish around $1.45 a share (+56%) on sales of $485 million (+37%).

More large orders are possible in 2015.  Cognex is pursuing several opportunities that may not be quite as large as the one delivered this year, but they could be in the $50 million range.  The existing customer may outfit additional facilities, moreover, generating sizable repeat business.  Smaller customers might not generate the same kind of numbers individually.  But if they start installing machine vision throughout their operations, instead of just in specific applications, average order size could expand across the board.  Several new products and upgrades have been introduced, creating more versatility along with performance improvements.  New markets, logistics in particular, are being opened up, as well.

We estimate 2015 ales will advance 12% to $545 million.  Earnings could expand a little faster (+14%) to $1.65 a share.  Most Wall Street analysts are not inclined to think more large orders will materialize.  Their numbers are lower.  Machine vision remains in an early stage of development, though.  If the technology proliferates to its full potential in the manufacturing area, stronger results are possible.  Long term, the opportunities are almost endless.  Vision will be a central requirement to make machines of all kinds more autonomous and useful.  Cognex has amassed large cash reserves which could applied towards those opportunities.  Most likely the work will be done internally, although technology acquisitions could facilitate the process.

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Wednesday, October 22, 2014

Zix Corp. ( Nasdaq - ZIXI ) -- Hard to Read

Zix Corp. (ZIXI $3.25) is a leading provider of email encryption services.  Approximately 50% of revenue is generated by the health care industry, which is required by law to scramble patient records when they are transmitted over the Internet.  The financial industry provides another 25%.  Legal documents represent a large part of the rest.  Last year Zix expanded its product line with a cloud based system that inspected every email and attachment that left a corporation's network.  If key words or phrases were identified the message was sequestered for review by an administrator.  The company also launched a bring-your-own device ("BYOD") cloud based system last spring.  That service allowed employees to access email accounts and other corporate files with their mobile phones, without actually storing any data on the phone itself.  Zix hoped to displace competitive technologies that loaded software directly onto the employee phones.  When suspicions arose the boss could look at everything on the phone and even wipe it clean.  Zix's approach kept everything in the cloud.  It looked like a winner.

In the wake of Edward Snowdon's revelations it appeared the encryption line would expand its reach, as well.  Despite expanded marketing efforts, though, none of the company's products have shown any acceleration.  In fact, new orders unexpectedly hit an air pocket in the September quarter.  Revenues are recurring.  And the renewal rate is high.  So reported results are likely to stay intact.  But a major upswing has become a less certain outcome.

Zix probably will report some good quarters over the next 2-3 years.  And even the bad quarters won't be terrible.  New orders in the September period, as low as they were, probably exceeded cancellations on existing contracts.  Widespread adoption of the technology may never happen, though.  Corporate technology spending is tight.  There are lots of competing programs.  Encryption is certain to be used for critical applications.  But it may turn out to be one of those good ideas that never completely catches on.

The stock price is near where we originally recommended it.  Our advice is to sell the stock and redeploy the proceeds in a Special Situation with better defined growth prospects.

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Monday, October 20, 2014

Profire Energy ( Nasdaq - PFIE ) -- Oil Price Decline Masks Growth Potential

Profire Energy (PFIE $3.50) reported excellent better than expected Q1 (June) results.  The Wall Street analysts who follow the company pegged sales in the $10-$11 million range.  They actually came in at $13.1 million.  Further sequential improvement is likely in the September period.  Profire has been adding executive, sales, and engineering personnel at a blistering pace.  Margins likely will be affected in the September and December periods, as a result of those costs.  But sales promise to continue their explosive uptrend, keeping earnings intact.  Profire is the leading provider of automated burner management systems used by oil and gas producers in the U.S. and Canada.  The company holds an estimated 75% of the market.  And that percentage is expanding.  Competitors are exiting the business instead of moving in.  Profire has the industry's lowest costs, best technology, widest distribution network, and most dependable service operation.

The latest slide in oil prices caused a sharp selloff in the stock price.  Investors are concerned that drilling activity will moderate and that incremental spending on products like Profire's will be affected by declines in cash flow.  Those worries are likely to weigh on the stock until oil prices rebound or Profire demonstrates that it can sustain its growth despite the macro-economic conditions.

The company is confident it can keep its growth rate intact.  The sales force has doubled over the past six months.  New offices are being opened.  Additional services are being provided.  New products are in the pipeline.  And government regulation is growing.  Colorado recently mandated the use of automated burner management systems, following Canada's example.  Customers are thanking those regulators because the systems are generating payback periods of 6-9 months, while improving employee safety and sharply reducing the amount of methane escaping into the atmosphere.  Methane control could become a larger issue as the federal government expands its battle against global warming.

A majority of sales are made for use in existing wells.  New wells comprise a significant but smaller percentage.  Less than 5% of the potential market has been penetrated to date.  Complementary markets for burner management systems promise to expand Profire's horizons in the future.  The total cost per well is approximately $6,000 including installation and related equipment.  About half of that goes to Profire.  It's not a capital intensive sale.  Payback is achieved by reducing the amount of fuel spent to run the burner systems.  Those systems heat oil and gas coming out of the ground to remove impurities.  Non-automated systems run at full blast all day long.  Profire's are modulated according to how much oil or gas actually is going through at a given time.  Additional savings occur when the flame goes out.  Non-automated systems require an employee to visit the site and re-light the unit.  Profire's units just turn the flame back on.  The well operates continuously.  The revenues keep flowing.  Employee safety is a key issue, as well.  Two dozen oilfield workers died last year re-lighting non-automated systems by hand.

We think the price of oil will bounce back as the worldwide economy improves.  The United States and Saudi Arabia may remove their choke hold on Russia, as well, provided President Putin agrees to a realistic peace settlement.  Even if the price remains low, however, Profire is likely to keep thriving by providing systems with high rates of return to a huge industry without any real competition.  In theory, if prices do remain low oil for an extended time demand will increase and production costs will decline, laying the foundation for a stronger industry over the long haul.

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Sunday, October 19, 2014

RCI Holdings ( Nasdaq - RICK ) -- Takes Off

RCI Holdings (RICK $11.00) operates a network of 41 adult nightclubs.  The largest concentration is in Texas.  But the company has locations a number of cities from coast to coast.  Good looking women are the prime attraction.  RCI generates income in a variety of ways.  Liquor is the most profitable.  The girls who work at the clubs are independent contractors who typically pay the club for the chance to perform there.  Their income is provided by tips, which customarily are high.  RCI manages a broad spectrum of properties.  High end clubs in New York City and Miami are especially profitable.  Successful clubs also are owned in oil producing areas.  Those have benefited from the industry's expansion over the past several years.  RCI aims at less affluent customers, too.  That segment of the market nosedived with the 2007-2008 recession and still hasn't recovered completely.  Adult entertainment is a discretionary item.  Income disparity is a significant factor affecting demand.

RCI has reorganized its nightclub base to follow the changes in consumer spending.  Store level operations have been modified, as well.  Major investments were made in upscale markets to attract high income patrons.  Those have proved highly productive.  RCI also has moved away from the discounts it used to maintain traffic in the recession's aftermath.  That effort bolstered profit margins at some clubs but had negative impacts in lower income areas.  Under-performing locations now are being sold off, which should enable overall margins to improve further.

RCI recently branched out into the conventional restaurant business.  The company has launched four "Bombshells" to date.  Two more are under construction.  That segment is profitable at the store level with average annual sales approaching $4 million per unit.  Start-up costs are holding back reported earnings.  The new line promises to diversify risk while opening up a promising growth opportunity.  A move into franchising could provide further leverage down the road.

RCI owns the real estate where all its adult nightclubs operate.  Licenses to operate almost always specify a single location.  The company can't risk losing its lease, because it would have nowhere to relocate.  Debt is high ($69.3 million), as a result.  Fixed assets, mostly real estate, are carried on the books at $112.7 million.  Market value is believed to be higher.  RCI plans to simplify its capital structure by spinning off the real estate and related debt into a REIT, which the company itself will manage.  Shares in the REIT ("real estate investment trust") will be sold to investors in a private offering.  The company hopes to net approximately $50 million in cash ($4.50 a share), while extinguishing its mortgage liabilities.  Future earnings will be reduced by lease payments to the REIT.  But those are expected to be similar to the company's current mortgage interest outlays.  Earnings are unlikely to be reduced materially.  And RCI will have $50 million in extra funds to work with.

Meantime, margins and same store sales are improving.  Jettisoning the under-performing units plus the move into upscale markets helped same store revenue increase 6.9% in the September quarter.  Earnings have not been reported yet.  But they likely showed solid gains, as well.  We estimate earnings advanced 16% to $1.25 a share for the fiscal year (September).  Bombshells start-up costs and discontinued operations probably offset margin improvement in other areas.  Next year a 28% improvement to $1.60 a share appears achievable.  A stock repurchase program could provide additional leverage.  Our estimates don't reflect any use of the REIT proceeds.  The company has not indicated how it plans to deploy those funds but acquisitions, dividends, and higher buybacks are possibilities.

In 2-3 years earnings could achieve $2.35-$2.95 a share.  Applying a P/E multiple of 15x to the midpoint of the range suggests a target price of $40 a share, potential appreciation of 260% from the current price.

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Monday, October 13, 2014

Evolving Systems ( Nasdaq - EVOL ) - Loads Up

Evolving Systems (EVOL $9.25) is a leading provider of dynamic SIM card activation systems used by large mobile phone carriers.  SIM cards contain all the variable information that goes into every phone.  In the United States most subscribers select from a small selection of plans.  In international markets, though, carriers offer a wide range of options covering minutes and services and other features.  Mobile phone carriers traditionally have stocked SIM cards with all those permutations in their retail stores, an expensive and complicated proposition.  Evolving Systems allows them to stock blank SIM cards and then program them when a sale is made.  The back-end software integration is difficult because the carriers run complex systems that Evolving Systems needs to work with.  So a large majority of carriers still rely on the pre-loaded model rather than struggle through a major software project.  The companies that have done it enjoy substantial recurring savings, though.  And the flexibility enables them to customize a broader variety of packages for their subscribers, which tends to enhance marketing and reduce turnover.

Evolving Systems also provides service activation systems for mobile phone carriers.  That's a more mature market that automates the entire customer acquisition process.  It also updates accounts when new phones or features are added by subscribers.  For example, most Americans who upgrade to an iPhone-6 probably are incurring new billing amounts, and a re-start of a 2-year plan.  More than 50 mobile phone companies uses the company's service activation technology around the world.

SIM card activation is the primary growth driver.  It can take as long as a year to install the software.  Once the product goes live Evolving Systems ordinarily receives a large payment covering a "tranche" of SIM card activations, that the carrier works off as new subscribers are signed and existing ones modify their service.  Once those run out the carrier is allowed to abandon the whole thing and return to its old pre-loaded approach. That rarely happens.  Instead, the carriers buy another tranche, usually at a lower per-user price (to encourage the repeat order), generating another revenue surge.  The first of those renewals occurred in 2014, following on from deals that originally were implemented 2-3 years ago.  Several more are coming close and likely will renew before long.  That recurring revenue base, combined with the mature service activation business, is likely to provide a solid foundation in the future.

New sales promise to accelerate growth.  Evolving Systems's most fertile markets are competitors to its existing customers.  Once the company breaks into a geographic area with one carrier the others tend to follow suit.  The technology allows greater marketing flexibility which is expensive to match using the pre-loaded approach.  The greatest challenge is actually getting into one of those new areas.  In the past Evolving Systems relied on reference accounts to persuade prospects.  Over the last year the company has engaged in several pilot projects to prove without question that its technology is compatible with the carrier's core systems.  Several of those could be converted into sales in Q4.

A new product, the "AppLoader," could reinforce expansion.  That line is slated for introduction in the December quarter.  The system will allow new subscribers to select the "apps" they want from a list presented to them at the time of sale.  Large software and data providers like Facebook and Disney spend millions trying to convince users to download their apps after the fact.  If they can get those apps loaded right in the store, the savings promise to be large.  Evolving Systems expects to split the "AppLoader" revenue with the carrier and any third party sales agents.  Each deal is likely to be unique but likely will include a payment to get on the list, a payment every time that list is shown to a new subscriber, a bigger payment if the subscriber selects the app, and a recurring payment if the app isn't deleted over some period of time.  Broad based adoption could support a major revenue advance.

We estimate 2015 income will improve 30% to $.65 a share on a 25% revenue improvement ($40 million).  Start-up costs associated with "AppLoader" might reduce profitability but Evolving Systems thinks revenue should quickly catch up with those costs.  New SIM card activation contracts will generate professional service revenue.  "First tranche" income might leverage performance further, although some of that could fall in 2016.  Renewals on existing programs are likely to build.  The mature service activation line is likely to remain steady, although a modest gain is possible.  A cloud based version of both products was launched in 2013 to address the small carrier market.  That could provide a modest lift, as well.

In 2-3 years income could reach $.75-$1.25 a share.  Applying a P/E multiple of 20x to the midpoint of the range suggests a target price of $20 a share, potential appreciation of 115% from the current quote.  Widespread acceptance of the "AppLoader" could support a higher valuation.  Evolving Systems pays a $.44 per share annual cash dividend.  In 2011 the company sold its then-core business (a phone number management system that allowed users to keep their number when changing providers) for $39 million.  That cash financed the current product lines.

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Monday, October 6, 2014

Cyanotech ( Nasdaq - CYAN ) - Sees Daylight

Cyanotech (CYAN $4.55) is a Hawaiian based producer of specialty nutritional supplements.  Both of the company's products are strains of algae that thrive in the abundant sunlight that Hawaii provides.  Competitors exist.  But Cyanotech is the market leader in both segments.  Astaxanthin accounts for two-thirds of sales and currently is the faster growing product line.  Demand surged a few years ago after Dr. Oz recommended it on his widely viewed television show.  Sales have continued to advance since that time.  Astaxanthin reduces sunburn, joint pain, and macular degeneration.  It also contains anti-aging properties ("antioxidents").  Spirulina, the company's second product, is popular among serious athletes because it improves recovery time after strenuous workouts.  It also possesses large amounts of antioxidents.

Both lines are cultivated in outdoor growing ponds.  Production rises during the summer and falls in the winter due to the amount of sunshine available.  Cyanotech has developed a repeatable process that generates fairly consistent results.  Last year production was impacted by an unusual series of storms.  But weather conditions usually are excellent in Hawaii.  Technical innovation is helping to increase production at the company's existing facility, moreover.  The Obama Administration, as part of its stimulus package in 2009, spent billions in an attempt to develop algae based biofuels.  That effort fell flat.  But the research generated several new strains of astaxanthin with higher yields than Cyanotech's legacy version.  Last year the company established a relationship with one of those research groups.  Several new strains have been tested.  Three have demonstrated significantly higher yields with the same medicinal benefits.  They now are being introduced into more growing ponds.

Output per acre is expanding, too.  Over the past year Cyanotech reduced the size of a few growing ponds in a pilot program.  The algae concentration remained the same.  Total output was identical.  The company now is modifying more ponds to the shorter format.  Once that's completed it plans to construct additional ponds on the excess land created.  Cyanotech also has an option to lease an adjacent property, which could support further expansion.

Cyanotech has shifted its focus towards the consumer market.  For most of the company's history Cyanotech sold its output to other companies that combined it with additional ingredients.  When new management took the helm three years ago Cyanotech began to emphasize the retail channel, developing its own brand of pure astaxanthin.  Bolstered by the Dr. Oz publicity the company has gained more than 50% of the consumer market.  Most sales currently are made through specialty health food stores and similar internet sites.  Over the past year, though, the company has added larger retailers including Vitamin Shoppe, Whole Foods, and Sprouts to its network.  A test with Costco recently was started, moreover, which could amplify performance further.  Margins and revenue from consumer products are higher than on the old bulk sales.  Results promise to accelerate as the transition continues, reinforced by the larger retail partners.

Earnings were virtually erased over the last two years by costs associated with a patent lawsuit.  Cyanotech declined to settle the case, which would have required it to supply astaxanthin in large quantities at bulk prices.  The tables appear to have turned in Cyanotech's favor as the discovery process continued.  The patent in question hasn't held up under scrutiny.  The company still would prefer to settle the case.  But if it does go to court -- a date is scheduled for next March -- Cyanotech could win a large monetary award, in addition to ending the legal outlays.

Reported earnings promise to surge once the legal expense ends.  We estimate income (fully taxed) could jump to $.60 a share next year and keep advancing at a fast pace beyond.  In 2-3 years earnings could reach $.80-$1.00 a share.  That assumes additional stock will be sold to finance growth.  Applying a P/E multiple of 20x to the midpoint of the range suggests a target price of $18 a share, potential appreciation of 295% from the current quote.

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