Carbo Ceramics ( NYSE - CRR ) -- Shrugs Off Competitive Threat

Carbo Ceramics (CRR $140) reported excellent on target Q3 results.  Sales advanced 41% to $167.1 million.  Earnings climbed 81% to $1.61 a share (excluding stock option expense).  Carbo is one of the two leading manufacturers of ceramic proppant used by oil and gas producers in shale production.  The tiny spheres are inserted into the rock after it's been fractured to let the oil or gas flow to the surface.  Most wells are drilled horizontally and typically are 10x longer than straight up and down wells.  So more material is required.  The proppant is injected into the well with a mixture of water and a jello like material.  The water drives it in.  The jello keeps it in place until everything settles.  Then it disolves.  Since the proppants are round plenty of area remains for the oil or gas to flow back up the well bore. 

Most wells are 8,000 feet or more below the surface, far below the water table.  Occasionally natural gas escapes towards the surface during the fracturing process.  When that happens it can mix into the water supply.  Technically speaking the jello material is made from chemicals, though it isn't much different than actual Jell-O.  That gets loose once in a while, too.  The Environmental Protection Agency has moved aggressively against those contamination issues, blocking natural gas development in large sections of the country.  The EPA additionally has blocked Carbo from building new production facilities in some areas.  For all the hoopla the amount of actual damage is negligible in relation to the volume of energy produced.  So while expensive remediation efforts might be required the industry appears likely to keep growing at a brisk pace well into the future.

Growth is accelerating in the oil shale segment.  Carbo got its start in shale gas.  Its ceramic proppants worked better than conventional sand at keeping those new age wells open.  Sand continues to be used in straightfoward applications because it's less expensive.  But operators increasingly are switching to manufactured proppants to maximize the flow rate.  In the shale oil segment, that conductivity advantage is even more pronounced.  Drilling activity is surging because the market price of petroleum is 5x greater than natural gas on a Btu equivalent basis.  The potential profit is much greater.  In 2011 an estimated 32,500 oil wells will be drilled in the U.S., up 75% from the year before.  The entire increase is coming from the shale oil segment.  Natural gas wells are seen coming in at 19,500, up 5%.  At this point Carbo is sold out and can't keep up with demand.  New capacity is being brought on line, the EPA notwithstanding.  But the tight supply situation has caused drillers to seek alternative sources.  The resulting advent of new competitors has created some question marks about Carbo's long term outlook.

Saint Gobain, the other leading producer of ceramic proppant, is expanding capacity.  More ominous is a build-up in Chinese production.  The Chinese have entered the market with lower quality products but they've offered lower prices, as well.  The surge in industry demand has allowed Carbo to maintain margins and keep expanding to date.  And that trend could continue if the international market begins to adopt shale drilling.  For now the technology remains a North American specialty.  At some point the number of drilling rigs could max out, or energy prices might skid and cause some rigs to go out of service.  If proppant capacity keeps jumping an oversupply situation could develop.

Today, performance remains vibrant.  We have lifted our 2011 earnings estimate by $.15 a share to $5.65 a share.  A stronger showing is possible if the customary Q4 industry slowdown fails to develop.  Next year $6.60 a share (+17%) is a realistic target, in light of the economy and the Administration's efforts to promote green energy at the expense of fossil fuels.  New manufacturing capacity is in the pipeline.  If prices and margins aren't disrupted earnings could keep advancing at a 20%-30% rate well into the decade.

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Stratasys ( Nasdaq - SSYS ) -- New Products Fuel Surprising Q3

Stratasys (SSYS $30.00) reported better than expected Q3 results.  Earnings surged 81% to $.29 a share.  That figure excludes a loss of $.02 a share on the sale of an investment security.  Revenues climbed 31% to $39.7 million.  Stratasys is the leading producer of direct digital manufacturing printers that take CAD-CAM designs straight from a computer and make the part directly without any set-up.  The systems create their own molds on the fly and apply layer after layer of various plastics to create a finished product.  The machines come in a wide range of sizes and performance levels.  Low cost U-print and 3D printers typically are used by engineers to create prototypes.  Larger Fortis machines are employed in everyday manufacturing situations.

A joint venture with Hewlett Packard went haywire last year.  Stratasys signed up H-P to distribute its lower cost systems to the engineering market, where it already had a strong presence with blueprints, plotters, and an assortment of related products.  H-P has fiddled around with the technology in five small European countries to date.  Stratasys was hoping it would expand its efforts worldwide.  The hiatus in expanding the market caused sales of the less expensive machines to stall in 2011.  Fortunately, Stratasys maintained control over marketing its Fortis line for manufacturing applications.  Those sales are soaring.

A lower cost manufacturing machine achieved widespread penetration in Q3.  Stratasys also enjoyed rising sales of its consumables, particularly among its manufacturing customers.  A service business the company operates posted solid gains, as well.  A high end Fortis machine was introduced this year, moreover.  That unit is providing further momentum.

The near term outlook is unclear.  Stratasys obviously produced superior financial results in Q3.  But costs are expected to rise significantly in Q4 as marketing efforts ramp up to fill in the gap left by H-P.  Sales commission accelerators are likely to lift expenses, too.  We are raising our 2011 earnings estimate ($1.00 a share) by a dime to reflect the powerful Q3 showing.  But a large sequential improvement appears unlikely.

Margins may continue to be constrained in 2012.  Still, a 15% earnings gain to $1.15 a share appears achievable.  One of the company's few competitors, 3D Systems, recently announced lower than expected Q3 results.  So the overall climate may not be as robust as Stratasys' numbers might suggest on the surface.  The long term outlook remains bright, though.  The share price appears a little elevated at current levels.  If Q4 results stall a lower entry point might become available.

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Healthstream ( Nasdaq - HSTM ) -- Plenty of Operating Room

Healthstream (HSTM $14.00) reported excellent on target Q3 results.  Non-GAAP earnings (fully taxed) advanced 80% to $.09 a share.  The company netted an additional $.03 a share in tax benefits.  Revenues improved 24% to $20.6 million.  Performance dipped slightly on a sequential basis due to summer related seasonal factors.  Healthstream is the leading provider of e-learning solutions to the health care industry, serving more than 2.5 million workers with a recurring SAAS ("software as a service") delivery format.  The company's Internet platform enables third party content providers to sell state of the art instructional material to both medical and administrative employees in a more convenient and productive manner than traditional CD-based and classroom approaches.  Healthstream books the revenue and pays royalties to the authors.  The company also provides research surveys and other data services, representing about 33% of revenues.  Most of that business is performed on a subscription basis, too. 

A joint venture with industry giant Laerdal Medical is advancing the technology into the simulation area.  Laerdal is the leading producer of medical mannequins.  The two companies have teamed up to computerize those models so health workers can practice their skills and receive immediate feedback on how well they're doing.  Currently, a teacher usually has to supervise the performance.  The core e-learning business is growing due to market share gains, the addition of more content per subscriber, and continued growth in the market's overall size.  The simulation segment is just getting off the ground but promises to deliver substantial leverage in upcoming years.  Expansion into international markets has been modest to date but the combination with Norway-based Laerdal could provide a sizable boost in that direction, as well.

Mobile applications are slated for introduction in Q4.  That technology will enable users to obtain content on phones and tablets, in addition to personal computers and notebooks.  The mobile links also may facilitate access to databases for everyday reference, moreover, besides just studying.  Additional simulation components will be launched over the next two quarters.  Healthstream also recently gained exclusive access to several high potential accreditation programs.  Those packages will be available only through the company's e-learning platform.  Revenues should benefit directly from the captive audience.  Being the sole source for that material also could attract new customers to Healthstream's other offerings.

We estimate 2011 income will finish in the $.35-$.37 a share range.  (See "Accounting Notes.")  Hiring is slated to accelerate in Q4 to prepare for a major expansion next year.  So margins may not widen in the period despite further sales gains.  Next year $.45-$.50 a share remains a realistic target.  Faster gains are possible in subsequent years as margins continue to improve, international markets are exploited, and the simulation line becomes a bigger factor.  Periodic bursts could amplify results.  In 2013, for instance, new hospital billing procedures are scheduled to take effect as a result of the national health insurance law.  Healthstream will distribute a series of courses designed to train administrative personnel in the revised scheme.

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Acacia Research ( Nsadq - ACTG ) -- Outlook Keeps Improving

Acacia Research (ACTG $38.00) reported excellent on target Q3 results. The company didn't sign any structured deals in the period.  In the year ago quarter it concluded at $40 million transaction with Microsoft.  So while Acacia earned some large settlements in the period its revenue was produced entirely from regular business.  Revenues declined 21% to $50.6 million.  Excluding the Microsoft deal, though, they were up 111%.  Reported earnings (fully taxed) were down, as well, at $.24 a share.  But that was a record for any quarter in which Acacia didn't sign a structured transaction.

We originally set our $1.10 a share full year earnings estimate based on the assumption three structured deals would be completed this year.  Acacia did complete one deal in Q1 with Samsung for $45 million.  But that's been it to date.  Our estimate is unchanged but now assumes no further structured deals.  The potential value of any such transaction has increased dramatically due to the addition of more high value patents to the company's portfolio.  So if a transaction or two are consummated in Q4 a substantially stronger showing is possible.

New partners are signing up at an accelerating pace.  Acacia teams up with patent owners to enforce those rights more efficiently than the owners can do it themselves.  Activity is rising because more large corporations are trying to monetize their R&D efforts.  Those companies also are trying to offset payments they have to make.  It normally takes two years to fully prepare a new patent portfolio for commercialization.  So much of the intellectual property now flowing into the company won't turn into revenue until 2013 or even later.  But Acacia already has been bulking up over the past few years and now controls 192 portfolios, 70 of which still haven't even begun to earn anything.  The upward progression is likely to be maintained well into the decade.

We estimate income will advance 27% in 2012 to $1.40 a share (fully taxed).  A stronger showing is possible if the company realizes it's implied target of signing four structured agreements.  In 2-3 years income could top $2.50 a share and keep rising at a superior rate beyond.

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Data I/O ( Nasdaq - DAIO ) -- Economy Hinders New Product Acceptance

Data I/O (DAIO $4.50) reported lower than expected Q3 results.  The company launched its next generation hardware line in the period.  Data I/O is the leading provider of semiconductor programming systems.  The machines take blank semiconductors produced in large volumes by companies like Texas Instruments and loads them up with specific applications.  One batch might be programmed to control a Camaro's brakes; the next could be for a Cadillac.  Data I/O also introduced a series of software products that provide new features, particularly in the inventory control and security areas.  The company had hoped to sell those software packages to its installed base, in addition to including them on new machines. 

Slowing sales of semiconductors around the world impacted demand.  Most of the company's customers are independent middle men that customize chips for a wide range of end users.  Data I/O's new systems offered those customers the ability to boost throughput and provide more value added functionality.  The downturn in economic conditions encouraged Data I/O's customers to stick with the tried and true, however, slowing the sales cycle and adoption rate.  Start up costs should decline in upcoming quarters.  So earnings are likely to improve over the unusually low Q3 level.  But a major acceleration in 2012 appears less likely than before.

Earnings (fully taxed) fell 71% to $.02 a share in the September quarter.  Sales improved 7% to $7.05 million.  Even with an expansion in profit margins in Q4 we've reduced our fully estimate by 33% to $.20 a share.  Next year a gain to $.35 a share appears attainable.  We estimate next year's sales will climb 14% from $29 million to $33 million.  Data I/O is a well financed company with an industry leading market share.  Downside risk is limited as a result.  Value investors realistically can maintain positions with an eye towards an industry recovery over the next 2-3 years.  Aggressive investors are advised to close out positions and reinvest the proceeds in a Special Situation with more dynamic growth prospects.

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Ellie Mae ( Amex - ELLI ) -- Automating the Mortgage Industry

Ellie Mae (ELLI $5.00) is the leading provider of software used by lenders to automate the mortgage origination process.  The company provides a wide range of products and services that enable lenders to enhance productivity, reduce costs, comply with regulatory requirements, improve accuracy, and connect directly with various funding sources and investment outlets.  Ellie Mae is the industry's largest independent software provider.  About 50% of all new mortgages written in the U.S. currently are produced by 20 mega-banks.  Those giants handle their technology needs internally.  The rest of the market is served by smaller banks and a host of mortgage brokers.  Ellie Mae focuses mainly on the banking segment (90% of sales), which has been gaining market share at the expense of mortgage brokers (10% of sales) since 2007.  They now generate 39% of all mortgages written, compared to 11% for brokers.  Total industry volume remains depressed, of course, so many banks have reduced personnel over the last three years despite their relatively better performance.  Demand for Ellie Mae's software has climbed as result as customers replace labor with technology to boost productivity.

A recent acquisition cemented Ellie Mae's industry leading position.  In mid-August the company purchased Del Mar Datatrac for $17.2 million in cash, plus $8.0 million in contingent payments.  Before the transaction Ellie Mae's technology was being used to originate 20% of all U.S. residential mortgages.  That figure is expected to reach 30% with the Del Mar acquisition.  Since the mega-banks account for half the total market Ellie Mae actually now holds 60% of its addressable market.  Reported earnings will be impacted by the combination over the next two quarters because GAAP accounting rules prevent the recognition of deferred revenue by an acquiring company.  Ellie Mae will be responsible for the associated cost of fulfilling the backlog, though, putting the squeeze on margins.  Once that obligation is worked off margins should revert to normal, then benefit from economies of scale.

A shift in pricing strategy is restraining near term profitability, as well.  Until two years ago Ellie Mae licensed its software at a fairly high upfront price, and earned additional income from software upgrades and  a variety of transaction fees.  Following the real estate crash the company switched to a success based model ("software as a service") where customers pay each time a mortgage closes, the exact amount depending on how much software is used.  Last year 29% of its customers employed the SAAS model.  By Q2 that figure had risen to 42%.  Within 2-3 years Ellie Mae hopes to convert 90% or more to that transaction based approach.  The reduction in upfront licensing fees is affecting short term profits.  But long term income will benefit from the enhanced recurring revenue stream.

Superior growth is likely even if the housing industry remains depressed.  Only 1% of all loans presently are produced 100% electronically.  Revenue per loan promises to expand as more elements are computerized.  Costs to the originating mortgage banks are likely to decline as a result of that greater productivity, even as the revenue to Ellie Mae expands.  Direct competition is scant, following the Del Mar purchase.  R&D spending is being maintained at elevated levels (25% of sales, enabling the company to enhance its competitive advantage while broadening its revenue potential. 

Mortgage activity could triple from current levels if it returns to the long term trend line.  Mainstream economists have predicted a housing market recovery in each of the last three years.  Now they've thrown in the towel, predicting further malaise in 2012.  Two factors make that unlikely.  First, there is a tremendous pent-up demand to move for job-related and retirement purposes.  After three years of price declines and foreclosures the market now has cleared in many parts of the country, making those moves possible at last.  And second, it's virtually certain the Federal Government will enact legislation allowing homeowners who are current on their loans to refinance at today's lower rates, even though they technically don't qualify due to income or collateral reasons.  A mammoth surge in mortgage activity could rise from the ashes next year and continue to climb well into the decade.

Any pick-up will reinforce demand among lenders.  Most already have cut staff to the bone.  Even servicing today's low level of activity is a strain without computer assistance.  Once the surge begins the rush to automate is virtually certain to accelerate.  With 60% of the market and the best technology available Ellie Mae is likely to be the prime beneficiary.

We estimate 2011 sales will advance a modest 16% to $50 million.  The Del Mar acquisition is likely to contribute little to the top line due to the backlog accounting rules.  Income may in fact decline 23% to $.10 a share (see "Accounting Notes") due to acquisition related costs, elevated R&D spending, stepped up marketing efforts, and 22% more shares outstanding.  The company went public in April, issuing 5.0 million shares at $6.00 apiece.  We estimate revenues will advance 40% in 2012 as the Del Mar acquisition kicks in, margins improve, and further market share gains are realized.  A stronger performance is possible if the mortgage market generally improves.  Our estimates assume a flat comparison with 2011.

In 2-3 years revenues could attain $125-$150 million as the industry rebounds.  Income could reach $.75-$1.00 a share as recurring revenue builds, revenue per loan expands, and R&D costs fall as a percentage of sales.  Applying a P/E of 20x to the low end of the range suggests a target price of $15 a share, potential appreciation of 200%.

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Pros Holdings ( NYSE - PRO ) -- The Price is Right

Pros Holdings (PRO $14.00) is the leading provider of pricing and margin optimization software.  The company's systems combine huge databases with advanced mathematics to help large enterprise customers manage complex product lines.  The technology takes a wide range of inputs into account to set prices dynamically.  In the past many companies could handle pricing decisions without significant computer analysis.  The advent of worldwide competition, commodity price swings, floating exchange rates, and a host of other factors have made those decisions increasingly difficult.  Pros' scientific approach enables its customers to keep pace in a fast changing world so they can better maximize their return on sales.

The company got its start in the airline industry.  That area continues to be its largest segment.  All of the major American carriers have their own pricing systems and are likely to stay beyond Pros' reach.  But the company has been very successful with Far East carriers.  It also handles pricing for several smaller American and European carriers.  Several years ago Pros diversified into the manufacturing, distribution, and leisure industries.  Industrial customers tend to use simpler versions of the company's technology, although their return on investment in Pros' software tends to be at least as high as more transaction oriented users.  At this point the average selling price is in the $2.0 million vicinity.  Pros generates recurring revenue by selling more products to existing customers and by collecting annual maintenance fees which average 20% of the current price.

Margins were crushed during the 2008 recession.  New business dried up.  Add-on sales were scaled down.  But Pros decided to keep moving forward to improve its competitive advantage.  Growth in spending on R&D and sales personnel was maintained at the long term trend line.  Prior to the crash pretax margins were in the 25% range.  Last year they were about half that level.  Now that sales have perked up they are beginning to expand again.

Sales advanced 34% in the June quarter to $23.8 million.  Pros front loaded its sales force expansion this year so costs jumped as well in the period.  Even so, income improved by 80% to $.09 a share.  (See "Accounting Notes.")  International customers represent 60% of sales, so the recent downturn in worldwide economic activity threatened the company's momentum in the September period.  Order rates remained intact despite the storm clouds.  Large corporations generally are well capitalized these days.  Most seem willing to keep investing in products and technologies that produce superior returns.  Demand promises to remain solid even if the macroeconomic picture deteriorates further.  We estimate full year earnings will climb 40% to $.35 a share on a 28% improvement in sales ($95 million).  A stronger performance is possible.

A new cloud computing product recently was introduced.  That "software as a service" offering is aimed at smaller companies.  Pricing will be variable depending on usage but Pros is targeting average annual revenue per customer in the $100,000-$250,000 range.  Performance won't be as high powered as the company's top of the line systems.  But most mid-size customers probably won't require that much firepower.  The actual delivery mechanism might change over the long haul.  It doesn't necessarily have to be cloud computing.  But penetration of the mid-size market could amplify results substantially down the road, no matter how the technology is implemented.

We estimate 2012 earnings will keep rising and finish at $.45 a share (+29%).  Sales could attain $115 million (+21%).  Start-up costs associated with the cloud computing initiative may limit margin expansion.  Pros also has been willing in the past to give customers a break when they encounter tough times.  That's probably going to happen next year so price concessions may also prevent margins from widening to their full potential.  Still, despite the headwinds Pros could top our estimates.  The payback period on the technology is remarkably quick in most cases.  And companies have surplus cash to spend.

The long term outlook is promising.  The cloud computing business probably will keep overall margins from returning to the mid 25% level over the next 2-3 years.  Once it gets established, though, the potential for even greater margins will be created.  Plus, Pros has penetrated only 5%-10% of the potential market to date.  And that market is likely to keep expanding as companies in India, China, Russia, Brazil, and elsewhere scale up.  Maybe they'll have their own mathematicians.  Chances are Pros will capture a big share of the market, nonetheless.

In 2-3 years sales could reach $175 million to produce earnings of $.75 a share.  Applying a P/E multiple of 40x to those earnings suggests a target price of $30 a share, potential appreciation of 115% from the current quote.  Downside risk is moderated by Pros' acquisition potential.

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Stratasys ( Nasdaq - SSYS ) -- Wait 'till Next Year

Stratasys (SSYS $18.50) appears on track to report unspectacular Q3 results.  In 2010 the company formed a joint marketing relationship with Hewlett Packard in the expectation the larger company would quickly expand distribution of Statasys's 3-D printing systems.  Hewlett Packard is the leading producer of engineering tools and the company's rapid prototyping systems looked like a natural fit.  H-P rolled out its marketing effort in five minor European countries, but never expanded into more prominent foreign markets or the United States.  While that was going on Stratasys abandoned its own program of recruiting independent distributors.  The company did build up its sales efforts for larger production units.  But the lack of contribution from Hewlett Packard left overall results short of potential.

This summer Stratasys threw in the towel and reinstituted its own U.S. sales efforts.  The company hit the ground running and has been successful at recruiting new distributors.  But it takes time to train those people and get their sales efforts up to speed.  So the lull in reported results is likely to continue through the end of 2011, perhaps a bit into 2012.  Growing economic headwinds are presenting an additional hurdle.  Our estimates are unchanged although a somewhat lower performance is possible.

The long term outlook remains bright.  The H-P snafu cost Stratasys some time.  But the company kept up its R&D efforts and remains the technology leader by a wide margin.  The direct digital manufacturing industry remains in an early stage of development.  The potential market is enormous.  Direct competition remains scant.  Professors, students, engineers, and entrepreneurs all are using the company's technology to leverage their innovations.  Large corporations are testing it out, as well.  The idea is to make one off products just as cost effectively as mass produced parts.  Stratasys already has gotten pretty effective using a variety of plastics.  The company now is adding more materials as inputs.  It's also making the machines easier to use, more directly compatible with CAD/CAM software programs, faster, and less expensive.  The technology will remain in the hands of engineers for the foreseeable future.  Someday, though, it could become possible for consumers to design whatever product they want using their own computer.  Stratasys has some short term problems but it's ultimate business potential remains unusually high.

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