Reed's ( NYSE - REED ) -- New Age in Soft Drinks

Reed's (REED $5.60) is a leading producer of natural sodas for health conscious consumers.  The company has built up a loyal following for its non-alcoholic Ginger Brews, which are brewed instead of being manufactured and are based on recipes that pre-date commercial soft drinks.  Reed's also sells a line of natural root beer and natural cola through the same distribution channels.  Those outlets are predominantly specialty gourmet and natural food stores like Whole Food Markets, Trader Joe's, and Sprouts.  They additionally include mainstream supermarkets, retailers, and restaurants.  Organic growth is being maintained in the 10%-15% range as more consumers become familiar with the products.  Total sales are expanding more rapidly as a result of the recent introduction of private label products for Whole Foods and other health food oriented supermarkets.  Those are original recipes that Reed's invented to provide those stores with their own brewed offerings.  They don't compete directly with the company's own line.  That segment is gaining momentum as more products are introduced and existing customers expand the number of stores that carry them.

A new product offers huge potential.  Kombucha is a fermented tea based drink that originally was developed 100 years ago in Russia and Germany.  Despite evidence that suggested it provided a range of health benefits kombucha didn't gain popularity until the 1990s.  A privately owned company, GT Dave, created the U.S. market with a social media marketing program that emphasized those health benefits.  The primary topic was cancer prevention.  Other claims included liver detoxification, arthritis prevention, high levels of antioxidants, and probiotic benefits.  Ronald Reagan used kombucha to fight his cancer starting in 1987 and lived until 2004.  He got the tip from Alexander Solzhenitsyn, who used it to battle his stomach cancer.

Kombucha has grown into a $300 million (retail) industry in the United States.  GT Dave still controls 80%-90% of the market, perhaps more.  Other drinks manufacturers have tried to enter the lucrative business but have had difficulty making the product correctly.  Reed's appears to have solved the riddle, at least in small quantities.  In June 2012 the company announced the introduction of four flavors.  The official launch started in November.  Production currently is limited by capacity constraints.  Larger vats are slated for operation during the first half of 2013.  Reed's additionally plans to add four more flavors during the first quarter.  Distribution is ramping up at a brisk pace, although initial deliveries are relatively small and most of that will be sold at promotional pricing.  The retail channel is anxious for Reed's to be successful in lifting output and providing an alternative to DL Dave's offering.  The theory is that with two strong contenders the kombucha category will expand and become a mainstream product.

Our estimates assume Reed's is successful at expanding kombucha production.  We also think the company's traditional drinks and private label brands will continue growing at their current rate.  Start-up costs are likely to exert a drag on income, though.  And while the manufacturing expansion will raise volume we estimate the kombucha line will grow in fits and starts as the technology is fine tuned.  We estimate 2013 income (fully taxed) will advance to $.10 a share on sales of $40 million. 

Once the scaling up is complete results could skyrocket.  In 2-3 years sales could reach $75-$100 million to produce earnings of $.55-$.75 a share.  Cash flow will be stronger than that due to the availability of extensive tax loss carryforwards.  Reed's carries a fairly high debt load, so downside risk could be high in the event the kombucha line fails to develop.  Losses could be substantial if problems arise, potentially requiring dilutive financing.  If things pan out worthwhile appreciation could be realized.  Applying a P/E multiple of 20x to the midpoint of our projected earnings range suggests a target price of $15 a share (+165%).  Reed's could obtain an even higher valuation as an acquisition candidate.  A large buyer theoretically could enhance margins and expand distribution. 

These shares entail a higher than normal degree of risk  Limits are advised.  Conservative investors are advised to wait either for a lower stock price or more evidence that the kombucha launch will prove successful.

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Streamline Health ( Nasdaq - STRM ) -- Healthcare Information Systems

Streamline Health (STRM $5.35) is a leading provider of software products used by hospitals to enhance revenue and improve productivity.  New management took the helm in 2011 and converted most of Streamline's customer base to a software as a service ("SAAS") model where sales are recognized on a recurring monthly basis.  The new team additionally has beefed up marketing, improved product quality, and completed two high potential acquisitions.  Streamline's legacy content management line enables hospitals to integrate so-called unstructured data into standard computer records.  Those are mainly paper forms that are scanned in, allowing billing and medical experts to view the raw material when looking at patient records.  The company also provides workflow management systems that automate the process of combining different data sources into a single record.  Late in 2011 Streamline acquired a business analytics company that provided the expertise to examine those records automatically, to identify problems before they get out of hand.  In the October quarter of 2012 the company made another acquisition, this time of an automated coding provider.  The U.S. health insurance system is slated to implement a far more detailed billing scheme in 2014 ("ICD-10"), breaking down most medical procedures into more individual components than presently.  The latest deal positions Streamline to capitalize on that burgeoning opportunity.

Growth is accelerating.  The switch to a recurring revenue pricing model masked the upturn that's been building over the last two years.  Streamline formerly booked revenue up front.  Now sales are recognized as earned on a monthly basis.  Costs continue to be reported as incurred, though.  So profits were squeezed during the transition process.  Revenues and expenses now are back in balance.  Costs are relatively, fixed, moreover.  So while product development and marketing expenses still are advancing quickly, margins are starting to widen on improving volume.

Cross selling is enhancing growth further.  Streamline is integrating its three product lines on a single platform to enhance interoperability.  That's helping the company sell more products to its existing customer base.  The broader line additionally is leading to increased demand from new customers.  A large part of the potential market remains untapped.  Few hospitals have automated coding systems, and only a small percentage have business analytics software.  Even the content management side has significant potential since many hospitals are running outdated systems.

The Affordable Health Care Act could expand the total market.  As more people are covered by health insurance the volume of billing and related procedures is likely to rise.  The new coding rules, intended to save money, promise additional expansion.  Much of the health care industry is expected to come under greater regulation as a result of the new law.  Those rules could entail price controls and similar measures.  Hospital information systems appear likely to escape that pressure since better software is expected to improve overall productivity.  Streamline's margins are likely to reach their natural level in spite of the new regulations.

We estimate earnings (fully taxed) will rise 67% in fiscal 2012 (ends January 2013) to $.10 a share.  Next year a 50% improvement appears attainable.  Sales are headed towards $24 million this year (+40%).  Next year $35 million (+46%) looks achievable.  Fast gains are likely beyond as the ICD-10 coding rules take effect.  Sales of that line promise to lift Streamline's other products, as well, as customers try to reduce the number of suppliers they use.  Margins are poised to continue rising on the higher sales volume.  In 2-3 years sales could attain $50-$75 million to provide income (fully taxed) of $.30-$.50 a share.  Applying a P/E multiple of 25x to the midpoint of the range suggests a target price of $10 a share, potential appreciation of 85% from the current quote.

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Healthstream ( Nasdaq - HSTM ) -- Margins Set to Expand

Healthstream (HSTM $23.00) appears on track to produce excellent on target Q4 results.  The company is the leading provider of Internet based education, training, and certification programs for acute care hospitals in the United States.  That segment represents 77% of revenues.  Healthstream also performs market research surveys for the same clientele, to help them improve customer satisfaction and overall performance.  That business accounts for remaining 23% of sales.  The learning business is growing at a 35% rate.  The research portion has been relatively flat of late.  Healthstream has penetrated approximately 50% of the U.S. learning market, covering nearly 3 million hospital employees.  More hospitals are being added, both via direct sales and indirectly as a result of acquisitions by large hospital chains that already are Healthstream customers.  The number of courses taken by existing customers is rising, too.  And more workers per hospital are being trained these days, to comply with proliferating regulation.  Average revenue per user is up an estimated 15% in 2012.  Third quarter income was stifled by an unusually steep tax rate (48%).  Healthstream's reported tax rate is likely to stay elevated in the December period as the company works off most of its remaining tax loss carryforwards.  Still, the hit is likely to be less severe than the third quarter's.

New products are gaining momentum.  The core learning platform still is exhibiting superior growth.  But that line is bound to slow down as Healthstream fully saturates the market.  Three new areas were launched in 2012 that could pyramid on that large installed base.  The competency (assessment) and performance (performance reviews) platforms were bought by 12 hospitals in the September quarter.  Faster gains are anticipated.  Talent management (certification and workforce management) was bolstered by a pair of acquisitions this year and is being adopted even more quickly.  And a joint venture with medical mannequin producer Laerdal Medical is exhibiting steady gains.  The two companies are developing a high potential simulation technology that computerizes Laerdal's mannequins to grade how well a procedure is done automatically.  So while the core line's growth may start to moderate, the overall software business could keep expanding at a 25%-40% rate well into the decade.

Rising government regulation is fueling that growth.  Healthstream is ramping up for a major change in U.S. billing procedures scheduled for 2014.  In addition, more OSHA, HIPPA, and HCAHPS rules are forcing administrators to update their personnel's knowledge of the laws to ensure compliance.  Overall performance could be reinforced by a rebound in research surveys.  Healthstream is beefing up marketing to exploit existing customer relationships it already has in the education area.

We estimate 2012 sales will finish around $105 million to provide income of $.35 a share.  A 29% gain to $135 million appears attainable in 2013.  Higher margins and lower tax rates could yield a faster improvement in earnings.  Our estimate is $.50 a share (+43%).  Another strong performance could develop in 2014 as the new billing codes ("ICD-10") go into effect and the full sweep of the new national health insurance law kicks in.  The health care industry as a whole is certain to feel cost pressure as a result of that legislation.  Healthcare technology may be left unregulated, though, on the presumption it will improve productivity and performance.

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Ellie Mae ( Nasdaq - ELLI ) -- Market Share Expands

Ellie Mae (ELLI $27.50) appears on track to produce excellent on target Q4 results.  We estimate earnings (fully taxed) will more than double on a 50% sales gain.  Ellie Mae acquired its largest competitor (DataTrak) in 2011.  Over the last year the company has been integrating the two software platforms to improve the technology, and to retain DataTrak's installed customer base.  Those users now are shifting to Ellie Mae's "success based pricing" model, which is easier to maintain than a traditional on-site software package.  Updates are made automatically with cloud computing.  That format also aligns the amount of money each customer pays Ellie Mae with the amount of money they earn from new mortgage generation.  Average revenue per loan to Ellie Mae is $100-$110.  Mortgage bankers generally charge $750-$1,000 per loan.  The pipeline of new users has been amplified with direct sales, as well.  Ellie Mae is in the process of doubling its sales force again, a program that should be finished by the end of March.  Existing customers also are adding more seats.  That backlog of active users virtually ensures that revenue growth will be maintained at above average rates even if the U.S. economy stumbles next year.

R&D spending will finish 2012 in the 18%-20% range.  A major investment recently was completed to upgrade the company's network architecture.  That's a private system that lenders, borrowers, and vendors (credit bureaus, etc.) use to share information.  Ellie Mae also spent heavily on the DataTrak integration.  And several new products are under development.  Those are designed to raise Ellie Mae's revenue per loan or enhance productivity.  E-signing and mobile phone apps are likely to be introduced in 2013.  Development of more revenue boosting products is likely to keep R&D spending at an elevated pace next year.  But as a percentage of sales a modest reduction is likely.  One area of savings will be the network.  Ellie Mae is running both its new and old systems currently.  The legacy network will be decommissioned shortly.

Margins are beginning to benefit from the "total quality loan" initiative.  Ellie Mae licenses its technology to Wells Fargo and Citibank, enabling those mega-banks to structure incoming data in a consistent manner.  Both companies have their own mortgage processing computers, and are unlikely candidates to employ Ellie Mae's complete software package.  But just making sure the incoming data arrives correctly is generating about $25 a loan for Ellie Mae.  Start-up costs have consumed most of that to date.  As operations become routine, though, significant incremental income could emerge.  Additional large banks are believed to be investigating the technology.

Federal Government mortgage relief could bolster industry volume.  Tight lending rules have thwarted millions of homeowners from taking advantage of today's low interest rates.  Many prospective borrowers still hold less than 20% equity in their homes or fail to qualify for some other reason.  Looking just at the pool of loans Ellie Mae processes, the average credit score of the people who get loans is 750.  The average for those who don't is 700.  A fairly inexpensive loan guarantee program could help the latter group sharply reduce their borrowing costs. 

The extra paperwork created by the Dodd-Frank financial legislation is boosting demand for Ellie Mae's automation software.  Updates are delivered immediately to the entire user base because the software is cloud computing based.  Users of on-site software have to update each computer with the new and ever changing regulations.  The drumbeat of regulatory changes has begun to draw larger banks to Ellie Mae's technology.  In the past the company made its greatest inroads among smaller banks with limited programming staffs.  The Dodd-Frank rules are threatening to overwhelm much bigger operations, too.

Operating margins could improve in 2013.  Sales and marketing, and product development, will be maintained at high levels.  But revenues are generated with few direct costs.  So every additional sale is highly profitable.  We estimate sales will advance 35% next year to $135 million to support earnings of $.90 a share (+29%).  Average shares outstanding likely will increase 10% due to a stock offering earlier in 2012.  Direct competition has not emerged.  Two companies are believed to be developing mortgage automation products of their own.  By the time those are introduced Ellie Mae could have a majority share of the potential market locked up.  Users are unlikely to switch due to the technology risk, retraining cost, and lost time associated with moving to a different system.  So pricing is likely to remain firm over the long haul.  Margins could rise further in the years ahead as sales volume keeps expanding.

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Ansys ( Nasdaq - ANSS ) -- Acquisitions Raise Outlook

Ansys (ANSS $68.00) appears on track to produce good Q4 results.  Performance likely has been impacted by lenghtening sales cycles.  But underlining demand for the company's engineering simulation software products remains sturdy.  The company released its latest version (14.5) in December.  Download activity -- most customers are entitled to product upgrades as part of their original licenses -- exceeded previous levels by a wide margin.  The new version included a wide range of time saving automation features.  The Apache acquisition (2011) has provided a major lift to overall results.  A recent deal (Esterel) promises to deliver material benefits beginning next year.  Ansys has an established record of buying top notch technologies, adding related features, improving the user interface, and expanding the potential market by adding the new line to its worldwide distribution network. 

Profit margins are exceptional, in the 50% pretax area.  Approximately 70% of sales are recurring in nature.  So cash flow is abundant, enabling the company to pay what it needs to in order to make key acquisitions.  Organic growth has slowed due to the worldwide recession.  It now is 5%-10% compared to a more customary 15%.  But acquisitions are reinforcing the uptrend, while making Ansys increasingly protected from competition.  Most end markets remain in early stages of development.  New inventions are likely as time goes by, buttressing the long term outlook.  Emerging markets offer great opportunity, as well.  Above average growth could be sustained well into the decade.

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Performant Financial ( Nasdaq - PFMT ) -- Government Dims Outlook

Performant Financial (PFMT $9.00) appears on track to produce good Q4 results.  Results have been slowed in recent months by technology upgrades by the federal government, which has slowed the amount of business Performant has been able to pursue.  More worrisome is a modification in the student loan program.  The poor economy has made it increasingly difficult for graduates to repay their loans.  Ordinarily that would have expanded Performant's potential market.  The company is the leading provider of loan modification and collection services.  The government has implemented new schedules that tie repayments to a percentage of income.  At this stage Performant is continuing to handle the negotiations.  But if the format gains widespread adoption the whole repayment scheme could become more automated and routine, diminishing the value of the company's involvement.  The government eventually could bring the entire effort in-house, moreover, similar to the way it took control of the lending process. 

Performant's Medicare operation (25% of revenue) still offers above average growth potential.  The new health care law could expand claim volume.  New coding systems might make the billing process more complex, as well, boosting the need for oversight.  Performant carries a sizable debt load, however.  And if the student loan profitability declines the pressure on finances could rise materially.  The shares may rebound over the next few quarters as the government completes its technology revamp and volume improves.  But the long term outlook has become less certain due to the Obama Administration's more relaxed student repayment scheme.  Our advice is to reinvest in a more dynamic Special Situation.

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Napco Security Technologies ( Nasdaq - NSSC ) -- Digital Rollout Continues

Napco Security Technologies (NSSC $3.35) appears on track to produce solid Q2 (December) results.  The company is a leading provider of security systems for commercial (80%) and residential (20%) customers.  Based in the northeast, performance was impacted recently by Hurricane Sandy.  Product updates and greater marketing efforts have bolstered Napco's core performance.  Improving real estate activity is adding further impetus.  The introduction of a next generation Internet based technology promises to amplify results over the next several years.  Those products enable customers to control their systems remotely and perform a wider range of features.  The new line includes a recurring revenue component which promises to bolster margins.  The critical software included in the systems will need to be upgraded over time.  The recurring revenue ensures the technology improvements are delivered.  Adoption of the new wireless and Internet products is growing rapidly, albeit from a small base.  Broader acceptance is possible if the cable companies begin to market security products more aggressively.  Most have added them to their product lines but so far the selling effort has been muted.

Margins could expand materially down the line.  The recurring revenue should improve them directly.  Napco also is operating below capacity at present.  So higher sales will spread fixed costs over a broader base.  The tax rate is likely to remain at 20% due to offshore manufacturing.  In 2-3 years sales could achieve $100 million to produce income of $.75 a share.

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Argan ( NYSE - AGX ) -- Full of Moxie

Argan (AGX $18.75) reported better than expected Q3 (October) results.  We also revised our Q2 (July) income figure upwards by $.08 a share to exclude a non-recurring legal settlement.  Construction work proceeded on two projects.  The larger is a natural gas fired electricity plant in California.  The other is a so-called biofuel facility in Texas that burns scrap wood.  The latter is financed in part with government subsidies.  Backlog stood at $236 million at the end of the period.  New orders were $20 million, reflecting additions to the current projects.  Revenues advanced 71% to $74.5 million.  Income improved 150% to $.45 a share.

Progress was achieved on the Moxie project.  Argan is in line to engineer and build two natural gas fired electricity plants in the Marcellus Shale in Pennsylvania.  The operating company, Moxie Energy, plans to fuel the systems with low cost natural gas from nearby fracking sites, eliminating the need to deliver it by pipeline.  The electricity produced will be sold into the northeast market.  Argan's potential revenue is in the $800-$900 million range.  Final regulatory approvals and financing agreements are expected to be completed in the current quarter.  Our fiscal 2014 (January) estimates assume only a modest contribution from the Moxie project.  Work on the company's existing two projects will begin to wind down next year but the income generated should be sufficient to keep performance at a high level. 

The Moxie build-out could support a much higher baseline of activity.  That deal alone promises to lift revenues above current levels.  Power generation in the U.S. remains below 2007 standards.  But electricity consumption is rising, and the pace could accelerate if the overall economy improves.  New facilities are likely use natural gas, solar, and wind power.  Those are all Argan specialties.  Tighter regulations on coal plants promise to reinforce the trend. 

Argan is well positioned to succeed in what remains a competitive industry.  The company's overhead is lower than larger participants.  It also moves faster and fixes cost problems more quickly, minimizing over-run risk.  Argan has added a lot of management and engineering talent over the past few years, though, allowing it handle complex jobs that smaller competitors have a hard time coping with.  Assuming a modest inflow of new contracts in addition to the Moxie project, revenues could reach $500 million in 2-3 years to provide earnings of $3.25 a share.

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Acacia Research ( Nasdaq - ACTG ) -- Ready for Blastoff

Acacia Research (ACTG $24.00) is prepared to drive its financial results substantially higher over the next two years.  The company has expanded its patent portfolio to include 250 families.  Five of those are especially high potential collections.  Two are owned outright by Acacia.  The remainder of the company's intellectual property holdings are shared with the original inventors.  In most cases Acacia divides any proceeds received 50-50 with the original owners, less what they pay to outside patent lawyers to pursue the cases.  The three major families where Acacia has partners were designed on a more customized basis, where the company paid the holders some cash up front and retained a higher interest in the future proceeds.  It ordinarily takes 12-18 months for Acacia to prepare a new group of patents for commercialization.  That preparation phase is nearing an end for three of the company's five big portfolios.  The other two have been in something of a hiatus, too, for different reasons.  In 2013 a flood of settlement activity could develop. propelling earnings dramatically above current levels.

Acacia is negotiating 5-6 large "structured agreements."  Those are bundled transactions where infringing companies license all of Acacia's intellectual property for a three year period.  Past deals with Microsoft, Oracle, Samsung, and Cisco Systems have averaged $40 million.  Acacia's portfolio is far more extensive today than it was when those deals were signed, although it's much more diversified, too.  The company's initial focus was wireless and computer technology.  Recent expansions include medical devices, automotive, and industrial systems.  Future structured transactions probably will include only a subset of Acacia's total arsenal, relevant to the target's area of interest. 

Acacia is heading to court in April to sue Apple Computer.  The company owns the Palm patents, which created the foundation for the smart phone industry.  Apple recently won a $1.0 billion judgement against Samsung over the shape of the phone.  Acacia could win that much if not more if it's victorious in its claims concerning how the phones actually work.

In 2-3 years earnings could reach $2.50-$3.00 a share.  Faster gains are possible.  Acacia's existing patents still have plenty of shelf life.  And the company probably will reinvest some of its future cash flow in additional patent families.  Above average growth could be sustained well into the decade.

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Cyanotech ( Nasdaq - CYAN ) -- Restores Growth

Cyanotech (CYAN $5.00) appears on track to produce excellent on target Q3 (December) results.  The company experienced production problems with its Spirulina line during the past two quarters.  That issue has been resolved, enabling output to rebound to previous levels.  Astaxanthin volume wasn't impacted.  That line probably will diminish as it usually does during the winter, due to reduced sunlight.  But on a year to year basis production remains at a high level.  Cyanotech added several marketing executives earlier in the year to build the retail and Internet channels.  Those efforts are beginning to bear fruit.  Greater traction is likely in subsequent periods.  Average prices are rising as more output is shifted from bulk to retail customers.  Orders continue to outpace capacity by a sizable margin.  Income is poised to show a solid positive comparison in the December quarter.  Cyanotech currently outsources its "extraction" process, which purifies the output for human consumption.  Turnaround time tends to be a month.  Since the production fix occurred midway during the quarter some of the increased volume might not get shipped by December 31.  If a favorable turnaround is achieved a stronger performance is possible.

Any unfilled orders will be delivered in Q4 (March).  That quarter usually is Cyanotech's low point, due to the short days (less sunlight).  Still, output per acre has been improving with the exception of the recent Spirulina setback.  So another favorable comparison is likely in that period, as well.  Our full year earnings estimate is unchanged at $.40 a share.

Higher average selling prices should expand margins in fiscal 2014 (March).  Marketing costs probably will continue to rise.  But selling prices to retail chains tend to be 2x-3x higher than in the bulk channel.  Cyanotech is creating multiple products to address that market, moreover, creating the potential for greater revenues per store.  Demand continues to accelerate for Astaxanthin and Spirulina, fueled by athletes who use the products for energy and recovery, and health conscious consumers seeking immunity from disease, better eyesight, and sunburn protection, among other things.  We estimate revenues will advance 29% next year to $36 million, providing earnings of $.65 a share (+62%).

A key lawsuit seems to be going Cyanotech's way.  One of its bulk customers sued the company earlier in the year over patent infringement.  In reply Cyanotech completed its existing supply contract, but declined to renew it.  That output was diverted to other customers, which are willing to pay higher rates.  The litigant failed to show it even had a patent during the trial's discovery stage.  That company has been extracting settlements from other industry participants for several years with its non-existent intellectual property.  Cyanotech was the first to fight back.  A settlement remains possible but at this point it looks like the whole thing might be dropped for lack of evidence.

Physical expansion is in the pipeline.  Space is available in the office park in Hawaii where Cyanotech operates.  Additional growing capacity probably will be added on a sequential basis over the next several years. 

In 2-3 years sales could attain $50 million to support income of $1.00 a share.  Applying a P/E multiple of 15x suggests a target price of $15 a share, potential appreciation of 200% from the current quote.  Product line extensions, broader retail distribution, and production expansion could yield a substantially stronger showing.

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Simulations Plus ( Nasdaq - SLP ) -- Customer Mergers Slow Growth

Simulations Plus (SLP $4.25) announced preliminary Q1 (Nov.) revenue growth of 2% to $2.29 million.  Approximately $450,000 of normally recurring revenue wasn't re-signed because of mergers and consolidations.  In the past the scientists displaced in those types of reorganizations typically re-acquired their licenses once they started working someplace else.  New business offset the drop-off.  If the merger-related decline had not occurred, revenue growth would have been 22%.

Growth promises to be reinforced by consulting and professional service revenue.  Initial contributions from the fledgling toxicology line could deliver further impetus.  Demand from existing and new customers is rising in response to the company's in-house malaria project, moreover.  Simulations Plus used its technology to identify promising therapeutic molecules, using software engineers instead of medical researchers.  All seven candidates showed activity, with two warranting further development.  Those results have persuaded a growing segment of the potential market to take a closer look at the technology.  A second project, aimed at a different disease, will be started in upcoming periods to show the malaria effort wasn't a fluke.

The threat of higher dividend tax rates has exerted pressure on the stock.  Simulations Plus pays a $.05 a share quarterly dividend  .If interest rates remain low that payout should remain attractive to at least a segment of the investment universe (retirement plans).  Our full year estimates are unchanged.

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Carbo Ceramics ( NYSE - CRR ) -- Market Share Gains Continue

Carbo Ceramics (CRR $78.00) appears on track to produce excellent on target Q4 results.  The fourth quarter usually is seasonally slow due to the holidays.  So sequential performance may decline.  But drilling activity in the U.S. remains robust, particularly in oil regions.  And Chinese competition is continuing to abate.  Carbo has increased marketing efforts to demonstrate its technology's superiority.  Well output typically improves by 20% with the company's proppants, compared to lower priced sand or ceramic imports.  The company is continuing to focus on improving its products strength while reducing weight to provide increased price-performance characteristics.  Carbo also is developing a next generation line that could amplify its competitive advantage.  Introduction is likely inn 2013.  Our estimates are unchanged.  Faster gains are possible if natural gas drilling rebounds either due to improved economic activity or greater exports.

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Simulations Plus ( Nasdaq - SLP ) --

Simulations Plus (SLP $4.40) reported good on target Q4 (August) results.  Earnings doubled to $.02 a share.  Revenues improved by 15% to $1.64 million, after excluding last year's contribution by a subsidiary that later was sold off.  Margins were lower than expected due to increased hiring.  Research and development expenses also climbed somewhat.  The new scientific and sales personnel are slated to contribute in the upcoming year.  Performance was impacted by the soft overall economy.  Several pharmaceutical companies combined laboratories and pursued other cost saving initiatives, reducing the number of users running Simulation Plus's software.  New customers continued to be added at a brisk pace, though.  Approximately 25% of revenues for the fiscal year were generated by new buyers.

The malaria project continues to turn heads.  Last year Simulations Plus conducted a spec operation with its own personnel to apply its technology towards the discovery of a malaria treatment.  The company identified seven candidate molecules, all of which showed some activity.  Two were particularly potent, although further refinement still is required.  That effort raised interest in the technology among potential customers.  It also created the potential for direct funding by third parties to complete the fine tuning and come up with a finished drug.  Simulations Plus plans to perform a second demonstration project this year.  Another successful effort probably would jump start demand for the company's software products, boost consulting revenue, and possibly set the stage for another third party injection of research funds.

Our baseline fiscal 2013 (August) estimates see growth being sustained at a 15% pace.  A substantially stronger showing could develop if a third party funding deal is signed.  Long term growth could accelerate if the second demonstration project lifts overall demand.

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Napco Security Technologies ( Nasdaq - NSSC ) -- Demand Intact

Napco Security Technologies (NSSC $3.05) reported lower than expected Q1 (September) results.  Earnings were unchanged from the year ago period at a $.01 a share loss.  Sales declined by 6% to $15.2 million.  The entire $1.0 million slide was accounted for by inventory reductions at the company's home security dealers and commercial re-sellers.  Napco's high potential digital products were re-engineered in the period to reflect consumer feedback.  Those didn't sell as well as anticipated but they did expand year to year.  The digital products continue to hold explosive long term potential.  Sales to the cable companies and other "triple play" suppliers still haven't gotten off the ground.  Those companies are wrangling with other issues at present.  They are beginning to list home security products in their overall product catalogs, though.  Once active marketing starts a major acceleration could arise. 

Hurricane Sandy might impact performance in the December quarter.  Volume was poised to rebound.  But the rebuilding effort might cause some security projects to be postponed as other work receives greater attention.  Napco's largest market is the Northeast. 

Due to the headwinds we have reduced out fiscal 2013 (June) sales estimate to $75 million.  We also have lowered our earnings target by a nickel to $.25 a share.  The long term outlook remains bright.  Napco is well positioned to capture a leading role in the digital security industry.

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Ellie Mae (Nasdaq ELLI ) -- Big Growth in a Declining Market

Ellie Mae (ELLI $22.50) reported excellent better than expected Q3 results.  Earnings zoomed ahead by 320% to $.21 a share (fully taxed).  Revenues advanced 87% to $27.5 million.  Ellie Mae is the leading provider of mortgage origination software.  Its technology is used by regional and local banks to produce loans cost effectively.  That segment, along with independent mortgage brokers, who also rely on the technology, represent 50% of the entire market.  The rest is handled by the top 20 banks.  Ellie Mae has deals with Wells Fargo and Citibank to use its software to facilitate their operations.  Revenue per loan from the company's full service customers is about $100.  The big banks will retain most of the revenue on the deals they produce, since they use their own software for a lot of the work.  But $25-$50 a loan appears realistic.  Ellie Mae's system is becoming an industry standard.  The large banks love the idea of having data providers, like income verification and appraisals, using a consistent format.

Regulatory headwinds could impact mortgage activity in 2013.  The mortgage rules have made it more difficult for people with average credit to qualify for mortgages.  Most forecasters predict a decline of 10%-30% in mortgage origninations next year as a result. 

Rising average order size and market share gains are likely to sustain growth at a superior level.  Contributions from the large banks could provide a little kick.  We estimate income will rise 23% to $.80 a share on a 30% increase in sales.  More shares outstanding will offset the likely improvement in margins.  The long term outlook remains bright.  Ellie Mae basically has no competition and it participates in a gigantic market that is in an early stage of recovering.  In 3-5 years earnings could reach $1.50-$2.50 a share.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Performant Financial ( Nasdaq - PFMT )

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

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

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

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

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

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

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Carbo Ceramics ( NYSE - CRR ) -- China Retreats

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

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

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

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

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

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

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

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Cyanotech ( Nasdaq - CYAN ) -- Barrels Back

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

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

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

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

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

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

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

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

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

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

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