Saturday, January 31, 2015

Nobility Homes ( Nasdaq - NOBH ) -- Sun Dance

Nobility Homes (NOBH $9.50) is a regional producer of manufactured homes, specializing in the northern Florida market.  The company has been run carefully throughout its 45 year history, allowing it to participate in the industry's boom times while surviving the downturns.  Finances remain solid despite the most recent malaise.  Before the 2007 housing collapse Nobility established a broad-based retail network that leveraged sales volume and profit margins.  At the peak almost 90% of sales were made through the company's own retail network.  Following the crash Nobility scaled back that operation to conserve capital and reduce everyday costs.  Nobility currently has 10 retail centers compared to 21 in its heyday.  Only 40% of sales are going through the retail channel today.  The rest are sold to mobile home parks on a wholesale basis.

Total sales are approximately 50% of what they were before the housing market collapse.  Nobility expected the industry to rebound more quickly than it has.  Florida traditionally has been a volatile market, but one that has followed an upward progression over the long haul.  Activity has remained depressed longer than normal during this cycle.  Explanations vary.  A weak job market combined with strict mortgage requirements were primary factors.  Nobility has a relationship with a subsidiary of Berkshire Hathaway to provide mobile home financing.  So the company was able to help some marginal customers purchase homes.  But Dodd-Frank regulations have kept most banks out of the business, making it difficult for low income earners to buy what otherwise would be an economical place to live.

The market has turned positive during the past year.  Further improvement is likely in 2015.  And a lengthy period of progress is possible through the end of the decade.  The cancellation of extended unemployment benefits drove a large increase in new workers during 2014.  The U.S. unemployment rate declined to 5.5%, as a result.  Most of the new jobs were of the lower income variety.  Still, $30,000 a year is more than nothing.  If your wife makes that, too, now you're in the 600-700 credit score range.  That's a key demographic for mobile homes.  Retirement demand is on the rise, too.  Many 60-75 year olds held off on moving to Florida due to the uncertainty that prevailed during the last several years.  That continues to be a factor.  But the stock market is up.  And time is marching on.  More are making the move.

Manufactured housing continues to be a cost effective option.  Triple wides with 2,000 square feet or more still cost less than $100,000.  Resale values have improved over the years due to regular improvements in quality.  Younger buyers often purchase land and install the homes there.  Older customers gravitate to parks, which are like fraternity houses for retired people.

A large number of competitors have gone out of business.  The rest are mainly private companies.  Most of them are run by managers that, like Nobility, have been involved in the industry for decades.  Nobility's chief executive is more than 70 years old, although he used to be a pole vaulter and a marathoner and remains in remarkably good condition.

The industry is bouncing back.  Nobility's finances are in excellent shape and improving.  The company is in breakfast counter talks with several private companies about consolidating into a much larger operation, using Nobility's publicly traded stock as the investment vehicle.  The most likely outcome is that Nobility will remain independent, drive performance, and sell to Cavco or some other nationwide operator.  If the housing market keeps improving, which seems likely in the lower end of the market where Nobility operates, a decent premium from the current valuation could emerge.  If Nobility actually can persuade its local competitors to join forces and create a regional powerhouse, substantially higher gains are possible.

We don't have a target price.  The stock is trading at book value.  The industry is turning around.  Big operating income gains are possible if the industry just returns to normal.  A corporate maneuver could amplify appreciation.  Plus, if Jeb Bush or Marco Rubio is elected president, the great state of Florida is bound to benefit.


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Sunday, January 25, 2015

Simulations Plus ( Nasdaq - SLP ) -- Computer Monkey

Simulations Plus (SLP $6.45) is a leading software provider for pharmaceutical development.  Drug companies use the technology to simulate the performance of large numbers of prospective molecules.  That computer testing enables them to identify promising candidates efficiently, eliminating the need to conduct expensive and lengthy laboratory experiments.  Simulations Plus's products are built on mechanistic equations that explain the actual biologic reactions taking place.  That limits the software's scope because much of what occurs in the human body remains a mystery.  The company recently expanded its potential market with an acquisition.  The new operation ("Cognigen") develops statistical models that fit the data obtained during clinical trials, even if the correlation can't be explained scientifically.  The two segments currently operate independently.  But cross selling opportunities already are starting to emerge.  Penetration of existing accounts is likely to expand.  The broader product line promises to attract new customers more easily, as well.

Approximately 10% of sales is generated by non-pharmaceutical customers.  Most are chemical manufacturers.  Those customers employ simulation software to identify potential environmental risks and other toxicity problems.  The U.S. Environmental Protection Agency licenses the technology, as well.  The fact the regulators use the systems to assess risk endorses the products' quality.  It also encourages private sector users to buy their own copies so everyone is speaking the same language.

The U.S. Food and Drug Administration has become a significant user, too.  Government sales tend to be at discounted prices.  So the direct revenue contribution is insignificant.  The FDA's experience with the technology has expanded over the past several years, though.  Confidence in the results has grown to the point that new drug submissions are encouraged to include simulation data.  Simulation Plus's products are used by the drug companies in pre-clinical applications.  They also are applied in the entire clinical trial process, from Stage One to Stage Three.  Interaction with the F.D.A. occurs during the entire development process.  Simulation still represents only a small part of the entire new drug application.  The part the company can scientifically explain remains an important but incomplete element of the entire process.  The remainder of the approval process remains statistics based.  "What are the odds it will work?"  That's where the new Cognigen operation fits in.

Cognigen was acquired at the end of fiscal 2014 (August).  Results were consolidated for the entire first quarter (November).  Q1 performance was impacted by the transition.  Cognigen's main shareholder became president of Simulations Plus, which cut into the amount of time he had to sell the service.  New sales people were added to take up the slack.  But those deals won't contribute until later in the year.  The combination holds excellent potential, though.  Competition for new drug approvals is intensifying, fueled by a booming IPO market.  Funds are available to improve the likelihood of success.  Spending on simulation software and statistical modelling promises to keep rising at above average rates, accordingly.

International sales are advancing even more rapidly.  That's hard to explain intuitively.  American drug developers have more money to spend.  And the F.D.A. has endorsed the technology.  The biggest gains are being achieved in Asia.  Part of that reflects the superior growth that region is registering.  Asian drug companies also are protected by self-serving national regulations that tend to block foreign competition.  Asia also is the one area of the world where Simulations Plus employs third party distribution channels to sell its products.  Foreign sales are likely to keep rising at a superior rate as sales efforts move closer to end users.

First quarter (November) financial results were mixed.  The software business performed well.  The Cognigen operation generated lower than expected revenue, and low profitability.  We are confident the Cognigen segment will improve performance in upcoming periods.  Even without the industry tailwind there's little question the people involved would make the numbers improve.  Software sales promise to continue advancing at an above average clip.  A new biologics element could expand the addressable market by 25% or more.  A significant percentage of new drug development is biotechnology oriented.  The new product aims at that segment.  A separate niche product ("Membrane Plus") is being released, as well.  Renewal rates remain in the 95% range.  Pricing is on a recurring revenue basis.  Simulations Plus was a pioneer in the SAAS pricing model.  With volume up it now earns 40%-50% pretax on software sales (15%-20% on statistical modelling).

We estimate income will achieve $.25 a share in fiscal 2015 (August).  In 2-3 years that figure could reach $.35 a share.  Applying a P/E multiple of 30x suggests a target price of $10 a share, potential appreciation of 55% from the current quote.  Faster gains are possible.



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Thursday, January 22, 2015

Read's (Nasdaq - REED) -- Healthy Growth

Reed's (REED $5.50) is a specialty producer of soft drinks made from natural ingredients.  Ginger Brew was the company's original product and still represents 33% of sales.  It's a natural ginger ale that is brewed instead of relying on injection based carbonation.  Reed's has expanded the line with several derivative offerings over the years.  A variety of flavorings have been developed.  The company also offers a low calorie version employing stevia, a natural sweetener.  Virgil's Root Beer, acquired in 1999, now accounts for 33% of sales, as well.  That line also is manufactured from all natural ingredients, including a low calorie version using stevia.  A line of kombucha drinks was launched three years ago.  That's a fast growing category featuring fermented tea that is thought to contain health benefits in addition to refreshing taste.  Kombucha now contributes 10% of sales.  Reed's additionally makes specialty drinks under private label arrangements for supermarkets and other retail chains.  That segment is less predictable but now accounts for 15% of sales.  Other products, mainly candy, provides the remaining 10% of sales.

Sales have grown at a 21% annual rate for the last four years.  High sales and marketing costs have prevented profitability from expanding, though.  Product development expenses have remained elevated, too.  And production efficiency has been difficult to improve.  Reed's manufactures for the West Coast using its own facility in Los Angeles.  That operation also serves as a product development laboratory.  The company also makes third party offerings there, resulting in more short runs.  East Coast production is outsourced.

Several changes are underway to improve margins.  Capital equipment upgrades are being installed at the Los Angeles plant designed to triple the line speed.  That project will generate incremental benefits as each new piece of hardware is installed.  The entire upgrade is slated for completion by the end of the June quarter.  East Coast margins should improve, as well.  Until last year Reed's outsourcing partner replicated the company's brewing process, which led to errors and higher costs.  The company now does all the brewing in California and ships concentrate to the manufacturer, facilitating more consistent and lower cost production methods.  The use of concentrate also has opened the door to hiring conventional bottling plants.  Many of those facilities are experiencing excess capacity due to the decline in soda consumption.  Taste of the final product has not been impaired, moreover.  In fact, many people think the concentrate form tastes better.

Gross margins could widen by 4%-5% as the new Los Angeles system comes on line.  Further gains are possible as the East Coast relationships are restructured.  Sales and marketing efficiency is being improved, as well.  Reed's sells its products to supermarkets and health food stores.  The company relies on third parties for distribution.  Feedback has been incomplete and unreliable over the years, causing Reed's to err on the side of providing discounts and other customer benefits.  The company wanted to make sure sales growth remained intact.  Better reporting systems have been installed, though, which are allowing Reed's to target discounts more effectively.  Margins promise to improve as the company becomes more adept at that big data analysis.  Better information also should help Reed's expand existing accounts and penetrate new ones.

We estimate earnings will break solidly into the black in 2015.  Larger gains are possible in subsequent years as the full effect of the manufacturing and marketing improvements are realized.  Income could attain $.10 a share (fully taxed) this year and keep advancing to $.35 a share by 2016-2017.  Sales are poised to continue rising at a 15%-25% rate.  Reed's has penetrated just a fraction of the potential market, in terms of U.S. store count.  Existing stores may expand the number of offerings on their shelves.  Overall demand is expanding, moreover, as soda consumption falls.  Natural drinks are taking up much of the slack.  International potential is large and unexploited to date.  The soda market's malaise also may lead those producers to partner with Reed's as a way to reinforce their own growth rates.

Reed's carries a significant amount of debt.  In the past the company has issued convertibles and warrants to satisfy cash requirements when profitability stalled.  Setbacks in the future could create similar types of dilution.  If margins improve as anticipated cash flow should be sufficient to finance growth internally.  If that happens the stock's price-to-sales ratio could widen materially.  Reed's relatively small size is likely to keep margins below the industry norm as the company continues to grow.  Potential acquirers could strip out much of that overhead and marketing expense, though, creating a much lower PE ratio on a de facto basis.  Price-to-sales ("P-S") is a more relevant valuation metric at this stage.  In 2-3 years sales could reach $75 million.  Applying a P-S ratio of 4x suggests a target price of $20 a share, potential appreciation of 265% from the current quote.


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Tuesday, January 20, 2015

Deep Down (Nasdaq - DPDW) -- Engineers Success

Deep Down (DPDW $0.75) is a leading provider of engineering services for the offshore drilling industry.  The company has expertise in several niches, enabling it to land key sub-contracting work.  Deep Down currently is supporting 90-95 offshore projects.  Customers include private energy corporations, sovereign oil companies, and larger service providers that hire Deep Down for specific tasks.  The company also designs and manufactures unique products tailored for individual projects.  Deep Down recently has been able to re-use some of those designs, accelerating turnaround time and profitability.  Backlog stands at $30-$35 million.  It was $33 million at the end of September.  December quarter results have not been published yet.  Despite the fall-off in crude oil prices no orders have been cancelled or deferred to date.  Offshore oil development customarily takes 2-3 years to complete.  Production lasts 20-30 years.  Unlike onshore fracking operations, output can't be shut in temporarily without impacting long term flow rates.

Deep Down was poised to participate in the offshore bonanza in 2010.  Sales were booming.  Orders were accelerating.  The outlook was bright because huge offshore reserves had been discovered both in the Gulf of Mexico and internationally.  The British Petroleum spill brought development to a screeching halt.  Deep Down's sales slipped by a third over the next three years.  The company controlled costs and remained marginally profitable.  But it was challenging to keep its labor force busy and overhead paid for.  The offshore industry spent those years improving processes and technology.  Legal liability was established.  New drilling opportunities were identified with software analysis.  Break even prices declined to $50-$60 a barrel.  Projects came back to life in 2013-2014 as crude oil prices traded in the $90-$110 a barrel range.

Deep Dive rarely had a backlog in the past.  It performed business as it came through the door and was happy to get it.  Project activity surged in 2014, though.  That lifted backlog to $33 million at the end of the September quarter, essentially securing a full year's activity.  Additional orders were obtained in the December period despite the decline in crude prices.  Deep Down also is bidding on $300-$350 million in additional orders.  Those contracts won't be issued until the customers need the work done.  And there's no guessing what percentage the company might win.  The orders span two years, perhaps a little more given the current environment.  It appears the sunk costs on these projects already are high.  So the break even on moving forward at this stage could be $25 a barrel or less.  Considering the longevity of the reserves, most if not all are likely to go to completion.  Deep Down is well positioned to thrive over the next two years no matter what OPEC does.

The risk in the stock is that oil prices remain low 2-3 years from now.  In that case new offshore projects probably won't be pursued.  Deep Down might thrive for a few years.  But if new orders aren't forthcoming the company would be sure to struggle.

We don't know the answer to that.  The way we see it, the world has 7 billion people today.  About 5 billion are poor.  They all aspire to an American lifestyle.  That will create tremendous environmental pressure.  But gasoline is by far the best transportation fuel on earth.  Electricity, heating, desalination, and other requirements may be satisfied with cleaner solutions.  But we think oil is here to stay.  As cheap reserves are depleted new ones will have to be developed.  Offshore is a great opportunity.  Deep Down could be a big winner over the next decade, perhaps longer.