Carbo Ceramics ( NYSE - CRR ) -- Pulls Away

Carbo Ceramics (CRR $80.00) reported excellent Q4 results.  Sales were slightly below our estimate at $153.6 million.  U.S. drilling activity experienced a larger than normal slowdown in December.  Earnings were $.25 a share above target, though, at $.93 a share.  (That excludes a $.03 a share one time expense associated with a discontinued operation.)  Prices stopped going down in the period as the company's educational efforts started bearing fruit.  Carbo conducted an extensive marketing campaign throughout 2012 to demonstrate its technology's superiority.  The company is the leading producer of high strength ceramic "proppants" -- tiny spheres that drilling companies shoot into horizontal wells to keep the rocks open during fracking operations, to maximize the flow rate of crude oil or natural gas.  The deeper the well, the greater the pressure on the proppant.  Chemical giant St. Gobain offers direct competition.  A variety of Chinese manufacturers sell less functional ceramic proppants.  Some drillers use resin coated sand as a lower cost alternative in shallow wells.  Carbo has a line of sand based offerings, although it contributes just a modest percentage of revenues.  Larger drilling companies have developed their own sand proppants.  The risk of using less sturdy proppants is that they can collapse under the pressure, shutting down the field.

A new technology holds great potential.  Carbo has developed an even stronger ceramic technology that currently is being rolled out for particularly deep applications.  Initial customers will be offshore drillers with wells 20,000-30,000 feet deep, plus the water weight.  At this point wells that far down have been exploited with straight up and down well bores.  Carbo's technology will open up the horizontal potential, enabling each well to retrieve more oil and gas.  The basic technology, which remains a secret, is expected to be applied to most of Carbo's ceramic products.  That could raise price performance materially, boosting profitability and market share.  The technology probably will be implemented in Carbo's general product line in 2014.

Financial performance is likely to improve gradually in 2013.  Carbo indicated it doesn't intend to increase prices until volume achieves sustained momentum.  Results should benefit from rising revenues, nonetheless.  Margin expansion could develop later in the year, particularly if the natural gas segment bounces back.  New natural gas wells have taken a back seat to oil, mainly due to the price discrepancy.  A commitment to LNG exports could stimulate development again.  Greater natural gas use by utilities and industry promise further gains.

Our 2013 earnings estimate is unchanged at $5.45 a share (excluding stock option expense).  The long term outlook is bright.  Almost all new drilling at least considers some degree of fracking.  Carbo's new technology could preserve its lead in the U.S. market.  International markets could become more prominent in future years.

( Click on Table to Enlarge )

Simulations Plus ( Nasdaq - SLP ) -- Mediocre Performance Continues

Simulations Plus (SLP $4.20) reported lower than expected Q1 (November) results.  Performance was impacted by an unusually high number of site closures among the company's pharmaceutical customers.  That caused a $450,000 reduction in renewal software licenses.  The amount was offset by the addition of 18 new customers.  But overall revenue increased by only 2% to $2.29 million.  Earnings declined 20% to $.04 a share.  Simulations Plus indicated that revenue growth is likely to be restored to a 15%-20% pace in upcoming quarters.  The site closures resulted from reorganizations that appear to be isolated cases.  Adoption of the company's drug development software is continuing to accelerate, helped in part by a demonstration project Simulations Plus conducted last year.  The company identified seven active molecules to treat malaria, just using its software without any laboratory testing whatsoever.  Many of the scientists who were relocated as a result of the customer reorganizations might resurface later in the year, moreover.  In the past most scientists who are familiar with Simulations Plus's products buy them again when they take new jobs.

We have reduced our full year (August) earnings estimate to $.20 a share.  The long term outlook remains positive.  The company's technology has a proven record in helping pharmaceutical companies develop new products more reliably and at lower cost.  New applications are being developed.  The sales force is expanding.  And another demonstration project is in the pipeline.  Performance could improve in future periods.  Downside risk is limited by a $.20 a share cash dividend.  Simulations Plus additionally is a prime acquisition candidate.

( Click on Table to Enlarge )

Proto Labs ( NYSE - PRLB ) -- Living in the Material World

Proto Labs (PRLB $38.00) is the leading provider of quick turn manufacturing services.  Engineers rely on the company to create prototypes with the actual materials and performance specifications their designs require ("real parts").  Proto also sells low volumes of custom parts to support initial pilot production and to facilitate products with a limited market.  The company specializes in computer numerical control ("CNC") machining and injection molding.  Customers provide 3-D computer-aided design software files via the Internet, which Proto loads into those machines to provide rapid turnaround times.  A wide range of machines are available.  The trick that separates Proto from its competition is the ability to evaluate incoming designs with a library of proprietary algorithms to make sure the part can be produced as expected.  That software often suggests improvements, helping customers fine tune their designs.  The ability to automate that process lowers costs by eliminating labor costs.  The interactive software additionally helps marketing.  Once a line of communication is established the company can cost-effectively maintain that dialog, nudging customers along.  Competition is provided by 3-D printers and other additive manufacturing techniques that produce facsimile parts.  Machine shops with similar tools also compete for the business.  Proto's interactive software and analytics generally provide faster results at lower costs. 

New materials are expanding Proto's potential market.  A series of new plastics were introduced in 2012.  Stainless steel, magnesium, and copper also were launched for use in the CNC segment.  The range of machinery at the company's facilities was broadened, as well.  The new materials already have begun to accelerate Proto's overall growth rate.  Demand for the company's historical materials is continuing to widen, moreover, as new customers are added and existing users expand their use of Proto's services.  About 75% of sales are made to repeat customers.  The new materials promise to help Proto reach a larger share of the prospective market, which remains in an early stage of development.  Geographic expansion also is likely.  Proto currently focuses on North America and Europe.  More emphasis on emerging markets is likely in future years.

The trend towards personalized manufacturing could amplify results over the long haul.  Tighter software integration between engineering and manufacturing, along with more versatile production methods, is likely to facilitate greater customization.  Consumers are likely to enjoy a greater selection of features, even in fairly complex and expensive products.  Manufacturers are likely to embrace more options as a method for increasing market share; perhaps total industry sales.  Producers may take some of that incremental production in-house, same as they do now.  But Proto's overall market could widen dramatically, nonetheless.

Meantime, expansion of the customer base combined with the availability of new materials and services promise to keep growth at a superior level.  We estimate 2012 sales advanced 26% to $125 million to provide income of $1.00 a share.  Shares outstanding rose 24% last year due to the company's initial public offering.  This year sales of $155 million (+24%) appear achievable.  Earnings could reach $1.25 a share.  In 2-3 years earnings could attain $2.15 a share on sales of $250 million.  Applying a P/E multiple of 25x suggests a target price of $55 a share, potential appreciation of 45% from the current quote.  The stock price already reflects much of Proto's 2-3 year potential.  Conservative investors are advised to wait for an entry point with more attractive risk reward characteristics.

( Click on Table to Enlarge )

Acacia Research ( Nasdaq - ACTG ) -- Gains Momentum

Acacia Research (ACTG $26.50) could report better than expected Q4 results.  The company completed a 2-way patent deal with Nokia-Siemens near the end of the quarter.  Details were not revealed.  But chances are good Acacia landed a sizable settlement for some if not all of its extensive smart phone portfolio.  Other technologies may have been included.  Nokia-Siemens separately agreed to provide some of its patents to Acacia, so it could enforce them against other companies.  Normally, when Acacia partners with an intellectual property holder, the two sides divide any winnings 50%-50% less whatever they pay in expenses and legal fees.  That ratio can fluctuate, usually in Acacia's favor, if Acacia pays an upfront fee to its partner.  It remains unclear how valuable the Nokia-Siemens patents are.  But they could provide a meaningful boost in future periods.

Acacia also won a favorable judgement against Apple Computer.  That settlement is believed to be relatively small.  Acacia has six additional infringement cases underway against Apple, including a potentially game changing case that's scheduled for court in April.  Acacia hopes to enforce several basic smart phone patents in that action. 

The pace of settlements overall has begun to accelerate.  Acacia has expanded its portfolio dramatically over the past year.  It usually takes 12-18 months for the company to prepare and implement a comprehensive legal strategy.  Those actions now are beginning to roll.  Many targets are becoming more inclined to settle with Acacia instead of going to court.  That saves money on both sides.  Plus it usually results in a better deal, greater certainty, and a quicker resolution.  Portfolios added last year in the medical device area and automotive technologies are starting to generate returns.  Our estimates are unchanged.  Substantially stronger results are possible.

( Click on Table to Enlarge )

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.

( Click on Table to Enlarge )