Female Health ( Nasdaq - FHCO ) - Follow-up Report

Female Health (FHCO $5.75) reported excellent on target Q4 results.  Revenues declined 1% to $7.80 million.  Fully taxed earnings advanced 40% to $.07 a share.  Unit volume expanded by 19%.  Female Health's second generation product line comprised 100% of shipments in the period.  That new design has a 30% lower selling price but generates more absolute profit per unit than its predecessor.  The old design accounted for approximately one third of business in the year earlier quarter.  For the entire fiscal year (September) income finished at $.14 a share on sales of $22.2 million.  Two large contracts that originally were expected to start contributing in Q3 remained delayed.  Other business actually was stronger than expected in the September period, enabling Female Health to hit its performance targets.  Those deals are likely to be signed before long, which should bolster fiscal 2011 results.

Even with those contracts, results probably won't attain our estimates for the coming year.  The company suggested that sales are likely to expand 15%-20% to provide a 10%-15% increase in earnings.  We'd anticipated a stronger sales showing combined with some margin expansion to drive fully taxed earnings into the $.35 a share range.  As it is, $.20 a share now looks like a more realistic target.

Female Health enjoys substantial tax loss carryforwards in the United Kingdom.  Those benefits can be transferred without penalty in the event ownership of the company changes hands.  In America, significant restrictions typically are imposed, making those tax benefits less valuable.  The downside is that the tax situation might limit the kinds of deals which would be viable in the event of a merger.  Even so, share price risk is moderated by the tax benefits.  Female Health remains cash flow positive and its business is poised to keep expanding in future years, fueled by AIDS prevention programs and a lack of direct competition.  Growth has begun to moderate, though, and that trend may continue if funding sources tighten.  A contemplated diversification into the commercial market hasn't gained momentum to date.  Government funding is likely to remain the company's main source of revenues well into the decade.  With the shares trading at a premium valuation (40x trailing twelve month earnings) and growth slowing down, our advice to aggressive investors is to close out positions and reinvest the proceeds in a higher potential issue.  Value investors can realistically maintain their holdings.  Soros Capital Management recently purchased a 5% holding.  Other socially responsible funds may get involved, as well.

Female Health (FHCO - Nasdaq)

Female Health (FHCO $5.00) is the only manufacturer of female condoms in the world.  Male condoms account for 98% of the entire market.  Demand for the female variety has accelerated over the past decade in response to a rising HIV/AIDS infection rate among women, especially in developing nations.  International relief organizations represent Female Health's primary customer base.  They distribute the condoms, usually free of charge, to at-risk populations in Asia, Africa, and South America.  In recent years agencies in the United States and Europe have entered the market, as well, serving homeless and other at-risk women.  Over the past two years Female Health re-engineered its product line to bring down unit costs by 25%-30%, while increasing the absolute amount of profit on each unit sold.  Reported sales have levelled off despite continued expansion in unit volume and overall net income.  Compliance has climbed as women have become more familiar with how the condoms work.  In the early going a lot of them went unused.  Acceptance among women has reinforced the aid groups' willingness to distribute the products.  Lower costs resulting from the redesigned line ("FC-2") are bolstering demand, too.  And U.S. Government programs have picked up with the change in administrations, now that there is less political opposition to promoting birth control in general.

Two order delays caused Q3 (June) results to fall below target.  Neither contract was renegotiated and will be fulfilled in upcoming quarters.  But the uncertainty caused the stock to decline fairly sharply, and it remains below past levels.  Deliveries on those orders are believed to have resumed in Q4 (September).  But it's unlikely they jumped above the regular trendline.  As a result, full year earnings probably finished even with those of a year earlier at $.15 a share (fully taxed).  For the fourth quarter alone income likely advanced 60%-100% to $.08-$.10 a share.

In fiscal 2011 (September) financial results are likely to get back onto the long term trendline.  Absent the recent order delays income probably would have finished at $.20-$.25 a share in the current year.  Unit volume gains of 20%-30% combined with expanding margins could propel earnings up by 40%-50% from there into the $.30-$.35 a share range in fiscal 2011.  Above average growth in the foreign aid market could be sustained well into the decade, since there are no viable alternatives to protect women from HIV/AIDS infection.  Female Health is well capitalized and is on the lookout for related products it could sell through its distribution network.  It also is negotiating with several consumer product companies to develop a commercial product.  (In Washington D.C. female condoms are distributed by a local aid group.  Extensive advertising appears on buses that drive around the city, encouraging poor women to get the products for free.  That promotional activity recently encouraged drugstore operator CVS to introduce the line for commercial sale.)

In 2-3 years earnings could reach $.50 a share.  Applying a P/E multiple of 20x to those earnings suggests a target price of $10 a share, potential appreciation of 100% from the current quote.  If the consumer market shows potential Female Health could become a takeover candidate, targeted by the large male condom manufacturers.  A higher valuation could emerge as a result.