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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