Napco Security Solutions ( Nasdaq - NSSC ) -- Next Generation Rolls Out

Napco Security Solutions (NSSC $3.25) reported Q4 (June) results that were slightly below our expectation.  The company is a leading provider of security systems used by homeowners and commercial customers.  Both segments remain depressed by the weak domestic economy.  A broad line of new Internet based products has been in development over the past two years.  Those units have started to hit the market.  The new technology promises to create a competitive advantage over the next decade.  Most of Napco's competitors scaled back R&D efforts during the recession, leaving the company with an open field with the high potential cloud based applications.

Earnings rose 22% to $.11 a share in the quarter.  That figure was helped by a lower tax rate, though, which resulted mainly from higher R&D tax credits.  Sales were a little below our estimate at $19.9 million.  The combination of new product contributions and an improving real estate climate promises to reestablish sales growth in fiscal 2013 (June).  We estimate sales will bounce up to $80 million (+13%), to provide a 76% increase in income ($.30 a share).  Napco operates with a fairly high level of fixed costs, so margins have the potential to expand meaningfully on higher volume.  The company also renegotiated its long term debt late in fiscal 2012.  That will result in lower interest expense, as well.

The long term out look is bright.  The technology platform Napco has created is likely to support a broad base of Internet based security systems.  That structure also should make it relatively easy and inexpensive for the company to add features and make other improvements as the industry evolves.  In 2-3 years sales could attain $100 million to provide earnings of $.50 a share or more.

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Ellie Mae ( Nasdaq - ELLI ) -- Mortgage Rates to Stay Low

Ellie Mae (ELLI $28.00) appears on track to produce excellent on target Q3 results.  Future performance is apt to remain robust, as well, following the Federal Reserve's decision to artificially reduce mortgage interest rates.  Approximately 65%-70% of Ellie Mae's business now is accounted for by refinancing.  If rates had been allowed to rise there was a possibility the company's unit volume might have slowed down as refinancing activity moderated.  Business continued to boom in the September period before the Federal Reserve got involved.  Ellie Mae continued to add new customers, and it continued to generate higher revenues from the ones it already had.  The company now generates 25%-30% of all the mortgages written America.  That percentage is likely to keep rising as Ellie Mae becomes the industry standard.  Average revenue per loan is likely to continue rising, as well.  Our estimates are unchanged.

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Carbo Ceramics ( NYSE - CRR ) -- Price Pressure Intensifies

Carbo Ceramics (CRR $70.00) appears on track to produce lower than expected Q3 results.  Energy prices have been rising lately, creating optimism that demand for Carbo's fracking technology will swing higher in upcoming periods.  The company's C.E.O. says the outlook is still bleak, though.  And there is ample reason to believe him.  Carbo Ceramics is the leading producer of ceramic proppants used by natural gas and oil drillers to keep the rocks open after they're fractured, so the energy can flow to the surface.  The company has become a victim of its own success.  Natural gas production went through the roof in 2010 once the technology became perfected.  Demand for proppants surged as exploration companies began working their leases, which had expiration dates.  The demand exceeded Carbo's ability to supply, and the ability of Saint Gobain's, too, the other principal propprant manufacturer.  Oil and gas operators turned to China for an answer, and the Chinese delivered proppants that worked well enough.  The technology was in an early stage of development and few people knew the science involved.

The Chinese were in a position to force U.S. exploration companies to sign long term supply agreements.  Those deals still are being worked off.  The surge in natural gas production, combined with weak GDP growth in the U.S., caused natural gas selling prices to plummet.  So new natural gas drilling ground to a halt.  That situation has continued and may persist in light of the the latest economic statistics.

Carbo has been able to replace some lost business with oil related fracking in North Dakota.  Demand remains elevated in that sector, which is affected to a lesser extent by Chinese competition because it's new business for the most part.  But Carbo has had trouble delivering the goods due to infrastructure problems -- where was that infrastructure stimulus money spent anyway.  There just aren't enough railroads and depots to support the business potential out there.

The combination of higher costs and residual Chinese competition is likely to wear on profits over the next few quarters.  Production of proppants in China is believed to be declining, because U.S. operators have learned the technology better and realize now that Carbo's products deliver superior returns on investment no matter what the Chinese price is.  Some of the earlier Chinese contracts are lingering, though.  And the infrastructure build up out West probably will take a while, since the Obama Administration basically remains opposed to fossil fuel development.

These shares have tremendous potential.  The natural gas side of the business is essentially dormant for the moment.  But that segment holds exceptional opportunity for the United States of America.  It could give us the lowest fuel costs in the industrial world.  Production is virtually certain to rebound.  The oil market has great potential, too, since 60% of the oil we use still is imported.  Much of that comes from Mexico and Canada, which is fine.  But plenty of room exists to replace OPEC imports.

Will Wall Street crush the stock when Carbo reports lower than expected Q3 results?  Answer that question, and be on your way.  Buy the stock here and don't worry if a sell off materializes.  Or play the market, and try to get a better price.  This is a great company.  You can't really lose either way.

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Napco Security Solutions ( Nasdaq - NSSC ) -- Solid Execution

Napco Security Solutions (NSSC $3.00) appears on track to report excellent on target Q4 (June) results.  The quarter normally is the company's strongest from a seasonal perspective.  Performance was amplified this year by lower borrowing costs, contributions from high potential new products, and better results at a division (Marks) that had been a drag on results since it was acquired in 2008.  Napco is a leading provider of security systems for residential and commercial use.  Marks was an established provider of door locks for the commercial market when Napco bought it out, right before the real estate industry collapsed.  That transaction was financed with debt.  Higher interest costs and declining sales created a double whammy which has been plaguing income ever since.  Napco has been repaying principal over the past four years.  A few months ago it also refinanced the loan to provide reduced interest payments.  The commercial real estate market has stabilized, moreover, laying the groundwork for improved lock sales in upcoming periods.

The high potential Internet based security systems are building momentum.  Napco invested heavily in R&D over the past several years to develop a family of innovative products.  Those include remote video monitoring, remote control (turn on the lights, the heat, the television, whatever you want, with your phone), wireless break-in reporting (notify the police somebody is breaking in even if they cut the phone line, or you don't even have a land line), and a variety of other next generation systems.  The company probably would not have made those moves, as logical as they were, if the C.E.O. didn't own more than 40% of the stock.  The fact it did, Napco now is set to capitalize from the shift to digital technology.

Economic headwinds continue to prevent Napco from realizing its full potential.  The base business, selling standard security systems to local dealers, is improving, though.  The digital products are gaining acceptance.  The Marks operation is turning the corner.  And the giant cable companies continue to examine security as a prospective new revenue source, part of a "quadruple play."  That hasn't happened yet.  It's possible Napco will have to drive the new digital technology to consumers itself.  Even if the industry takes that slower path Napco promises to deliver increasingly positive results in upcoming years.  If the cable companies step in, explosive gains could materialize.  Our estimates don't reflect the cable industry's potential, and are unchanged. 

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Acacia Research ( Nasdaq - ACTG ) -- Return of the Jedi

Acacia Research (ACTG $25.00) suffered a steep sell off following its publication of Q2 results.  Those financial measures were excellent.  Earnings advanced 162% to $.21 a share on revenues of $50.5 million (+27%).  But they coincided with a series of external events that caused dismay among investors.  Legislation was introduced in Congress ("Shield Act") to reduce the value of software patents.  Apple Computer and several other hardware manufacturers promoted the effort, to minimize their exposure to lawsuits.  Product development cycles have become so short in the electronics industry that companies have no time to investigate possible infringement beforehand.  In the past they were able to settle claims for small amounts or wear down their opponents altogether, because the patent owners didn't have the financial resources to stay the course.  When advocates like Acacia Research arrived on the scene, that strategy no longer worked.  And judgements escalated in value. 

Apple Computer and its cronies hope to escape that liability now by changing the law.  Software industry stalwarts like Oracle and Microsoft have fought back because the scope of the proposed legislation encompasses far more than cell phone technology.  Modifications to the law are possible despite that, of course.  But the effort has stalled for the moment.  The outlook for sweeping change has grown slim for the time being.

Eastman Kodak put its patent portfolio up for sale over the summer, as well.  That company bandied about huge sums initially ($2.0 billion).  The bidding has proved less enthusiastic than hoped, though ($500 million).  The final round ended with Kodak avoiding a decision, to extend the process.  The poor result may have caused investors to fear that patent values in general are peaking and perhaps headed lower.  Many experts think the shortfall is specific to Kodak, that its patents largely have been exploited already and that their potential is diminished.

The Apple versus Samsung court case has contributed further tension.  Samsung is a "structured transaction" customer of Acacia Research's.  The patents involved in that deal aren't connected to the Apple donnybrook.  But the showdown between the two cell phone giants has generated concern that Acacia Research will suffer collateral damage if its customer loses. 

That's unlikely.  Earlier in 2012 Acacia Research purchased an expensive portfolio of wireless patents ("Adaptix").  If Apple prevails in its lawsuit with Samsung the Adaptix technology is likely to become easier to assert in an upcoming court case Acacia is scheduled to fight with Apple itself.  In addition, the methodology Apple is using in its Samsung case could be used without alteration to contemplate damages of $1.0 billion or more.  That's Acacia Research's thinking anyway.  However the Apple v. Samsung matter is resolved the result could be a positive for the company.

Short sellers have increased their position by over 400,000 shares.  At the same time Acacia Research has expanded its patent portfolio at the fastest pace in its history.  It also has diversified its technology base into several new areas, especially medical technology.  Cash remains at high levels despite the acquisition spree.  And Acacia Research is believed to have half a dozen or more Fortune 500 companies in "inventory," ready to sign massive structured transactions if only Acacia Research lets them do it.  The company has been holding off on those deals while the patent market was going up, and its portfolio was being expanded, to extract maximum value. 

The company has the ability to report gigantic financial results any time it wants.  Now that patent valuations are leveling off and the stock is under pressure, Acacia Research has plenty of incentive to pull the trigger.  Our earnings estimate (which is fully taxed) excludes any further structured transactions this year.  Income could surge far beyond our target if even a small number of deals are consummated.  That would provide a windfall for Acacia's patent partners, too, who share in the license income at a 50-50 rate.  It also could reward shareholders with a substantially higher stock price, and blow the short sellers' death star to bits.

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