Tuesday, January 31, 2006

Anika Therapeutics--An Injection for Growth?

On January 26, 2006, the Compensation Committee of the Board of Directors of Anika Therapeutics, Inc. (ANIK-$10.07) increased the annual salary of the Company's executive officers and exercised its discretion to approve cash bonus payments, despite slower than anticipated growth to end-users of several key products; product recalls of key opthalmic products [due to incomplete heat seals in the cannula pouches that are included with the viscoelastic syringe, which might have compromised product(s) sterility]; and a delay in the Company's clinical program for cosmetic tissue augmentation (CTA) during 2005.

On January 26, 2006, the Nominating Committee recommended, and the Board of Directors approved, too, that for fiscal 2006, non-employee directors receive an aggregate cash fee of $20,000, and be awarded a number of stock appreciation rights having a value of approximately $10,000. In addition, each non-employee director is entitled to be paid $1,000 for each regular Board of Directors meeting or committee meeting attended in person or by telephone and $500 for each special Board of Directors meeting or committee meeting attended in person or by telephone. All non-employee directors are also reimbursed for out-of-pocket expenses incurred in attending meetings of the Board of Directors and any committees thereof. [ed. note: not a bad gig--if you can get it!] One hand washes the other....

Anika Therapeutics, Inc. engages in the development, manufacture, and commercialization of therapeutic products and devices that are designed to repair, protect and heal bone, cartilage, and soft tissue. Its products are based on hyaluronic acid (HA), a naturally occurring, biocompatible polymer found throughout the body. HA enhances joint function and coats, protects, cushions, and lubricates soft tissues. All of the Company's products use hyaluronan that is extracted from the forehead of chickens'--"chicken combs."

The Company's HA products marketed in the treatment of osteoarthritis, for humans and horses, are ORTHOVISC and HYVISC, respectively. ORTHOVISC is currently being sold under marketing agreements with Ortho Biotech and Depuy Mitek, Inc., both Johnson & Johnson companies, under an exclusive license and supply agreement. HYVISC is distributed in the U.S. through an exclusive agreement with Boehringer Ingelheim Vetmedica, Inc.

The annual market for injectable viscosupplementation in the U.S. is estimated to be $400 million. While we expect unit volume to expand by 20% (+) per annum, the aggregate dollar volume will face continued pressure because of predicted competitive pricing and lower reimbursements rates. The other major viscosupplement competitors in the U.S. for osteoarthritis of the knee approved by the FDA, include Genzyme Biosurgery's Synvisc, Hyalgan from Sanofi-Aventis, Ontario-based Stellar Pharmaceuticals' Neovisc, and Smith & Nephew's Supartz.

Synvisc is the dominant product with an estimated 70% market share.

During ophthalmic procedure's such as cataract removal, intraocular lens implantation, and corneal transplantation it is vital to maintain normal eye shape and protect eye tissues. Sodium hyaluronate, a thick, transparent liquid similar to the natural fluid found in the eye, is ideal for this task. It acts as a tissue lubricant and maintains eye fluid volume during surgery. STAARVISC-II and ShellGel, each an injectable ophthalmic viscoelastic HA product, are distributed by STAAR Surgical Company, and Cytosol Ophthalmics, Inc., respectively. The Company also develops and manufactures AMVISC and AMVISC Plus, HA viscoelastic supplement products used in ophthalmic surgery, for Bausch & Lomb Incorporated.

There exists major competing products for the use of HA in ophthalmic surgery. LA VISC, LA GEL and LA LON, manufactured by LA Labs, contain Sodium Hyaluronate, derived from bacterial fermentation, designed for routine cataract or retinal surgery; the Healon and Vitrax family of viscoelastics, manufactured by Advanced Medical Optics; and Duovisc--Viscoat & Provisc--dispersive and cohesive viscoelastic products marketed together by Alcon--three among a plethora of competitors (not including collagen-based products)

For the nine-month period ended September 30,2005, product revenue was $15,760,000 versus $16,813,000 in the comparable period in 2004. Domestic OrthoVisc sales for 2005 have been negatively impacted by high inventory levels held by the company's distribution partner. Ophthalmic product sales were flat compared to the prior year period, primarily due to the aforementioned product(s) recall. ORTHOVISC, HYVISC, and the opthalmic products contributed 38%, 9%, and 53%, respectively, to net sales.

As of September 30, 2005, three customers, Bausch & Lomb, Inc. (46.4%), Pharmaren AG/Biomeks (22.8%), Boehringer Ingelheim Vetmedica (9%), represented 78.2% of the Company's aggregate product revenues.

Regarding investor concerns of concentration of sales risk--In December 2004, the Company entered into a new multi-year supply agreement with Bausch & Lomb for viscoelastic products used in ophthalmic surgery. Under the new agreement, which extends through December 31, 2010, and supersedes a supply contract that was set to expire December 2007, the Company continues to be the exclusive global supplier (other than with respect to Japan) for AMVISC and AMVISC Plus to Bausch & Lomb. A justification for senior management's aforementioned 2006 compensation schedule? Score one for corporate.

Anika Therapeutics will endure pricing pressures from current--and emerging--market competitors and reimbursement resistance from Medicare and other healthcare providers. For example, Medicare has been cutting reimbursements of procedures using HA-based material for cataracts and knee osteoarthritis.

The Company must shoulder [or enter into partnerships] R&D expenses to provide next-generation advances in HA-based biomaterial markets to compete for market share and to recapture pricing power. This should not be a problem for corporate. The Company has a strong balance sheet, with no long-term debt, approximately $45.9 million in cash, and $22.3 million in deferred revenue sitting on the balance sheet as liabilities--waiting to be recognized as income [when 'earned'].

Begrudgingly, we will give management the chance to earn their 2006 paychecks before we pass judgement on the dollars being doled out. Historically, corporate has demonstrated suffiencies needed to negotiate win-win licensing, royalty, and supply and distribution contracts--albeit this does not necessarily ensure future wins.

Anika Therapeutics' current research and development efforts are focused on its chemically modified formulations of HA designed for longer residence time in the body. A pivotal clinical trial for its product for cosmetic tissue augmentation (CTA), a therapy for correcting dermal defects, including facial wrinkles, scar remediation and lip augmentation, wrapped up last year. The trial was designed to evaluate the effectiveness of CTA for correcting nasolabial folds and was conducted by dermatologists and plastic surgeons at 10 centers throughout the U.S.

On September 1, 2005, the Company announced that it had mutually agreed with OrthoNeutrogena to terminate its development and commercialization agreement. Instead, flying solo, corporate filed its PMA application with the FDA seeking approval to market and sell its CTA product in the United States. The Company will continue the development effort on a go forward basis which will be self-funded.

For those seeking to disguise the effects of aging, the FDA has approved two injectable HA products, Restylane and Hylaform, for the treatment of facial wrinkles. Other HA injectible fillers available in Europe--and hoping to reach our shores, include Dermalive and Dermadeep (Dermatech), and Hyalite (Mentor).

According to Medtech Insight, LLC, the market is projected to grow from $65 million to approximately $175 million within three years. We predict that with the rollout of other dermal filler options, this dollar growth analysis has underestimated the actual demand for CTA products. For example, Facial Cosmetic Surgery and Rejuvenation Markets, predicts that over 21 million procedures from simple botulinum toxin injections to full surgical rhinoplasty will be preformed in 2006. Furthermore, the majority of the procedures will be simple injections or laser treatments for wrinkles.

For treating wrinkles and facial contours, patients and their dermatologists or plastic surgeons, have other biological implant/filler options: collagen (marketed as Zyderm, Alloderm, Cymetra, or Cosmoderm), Fibrel (freeze dried gelatin derived from pig connective tissue mixed with the patient's blood plasma and a chemical to encourage the formation of new collagen), subcutaneous injections of calcium hydroxyapatite (FDA-approved for over 20 years in powder and block form, CaHa is an inorganic substance that mimics the structure of bone. It is now marketed in the U.S. as Radiesse); "off-label" use of a medical grade injectable silicone, Silikon 1000; and, F-A-T injections.

In spite of the number of competitive options, we are attracted to the science of HA-fillers. Chemically modified HA has the capacity to hold more water than other natural or synthetic polymers, thereby increasing the resistance of tissues to compression. The unique biophysical characteristics and the inherent safety of HA make it an ideal material for treatment of dermal defects.

As previously noted, a number of companies are developing or have developed HA products for similar applications and have received FDA approval. Ergo, the successful commercialization of Anika Therapeutics' CTA will depend on the timing of the FDA's review, a distribution channel to go-to-market quickly (proprietary salesforce and/or joint-marketing agreement), and reimbursement endorsements.

The second product in the Company's product pipeline is a family of bioabsorbable, chemically modified hyaluronic acid (HA) therapies, called INCERT, intended to act as a barrier to prevent internal tissue adhesion and scarring following spinal, cardiac, pelvic or abdominal surgery.

The initial research for INCERT is for spinal surgeries such as discectomy, laminectomy or laminotomy. INCERT-S is designed to reduce post-surgical fibrosis following spinal surgery. The Company initiated a pilot trial in the U.K. in April 2004, involving about 45 patients undergoing spinal surgery. As of December 31, 2004, patient enrollment was approximately two-thirds complete. There are a large number of spinal surgeries worldwide susceptible to the complications of post-surgical adhesions, including approximately 700,000 each year in the United States alone.

According to a recent Frost & Sullivan study, there are a number of drivers that make HA-based companies like Anika Therapeutics an attractive biotech holding:

  • Key application markets for HA-based biomaterials, include viscoelastics for cataract surgery, viscosupplementation treatment for osteoarthritis, facial aesthetic implants, and vesicoureteral reflux implants.
  • Demand is expected to be buoyed by aging baby boomers. The number of people above 65 years is expected to more than double from 35 million in 2000 to 71 million in 2020 in the United States. People in this age group will be entering a stage where the incidence of osteoarthritis, cataract, and facial wrinkles increases. HA-based biomaterials have a significant role to play in the treatment of all these afflictions. Thus, the demand for HA-based biomaterials is expected to be spurred by the aging demographics.
  • Since the knee osteoarthritis patient population is expected to increase by 26 percent from 15 million in 2000 to 19 million in 2010, viscosupplements can expect an escalation in demand. Apart from a huge market for osteoarthritis medication, the post-surgical anti-adhesion barrier market also carries a huge potential. Internal adhesions after abdominal surgeries can cause problems, such as bowel obstruction and pain. Due to the critical nature of these complications, surgeons are demanding anti-adhesion barriers that perform consistently. Adhesion lysis surgeries are performed more frequently on those above 65 years than on younger age groups.
  • Hyaluronic acid (HA)-based biomaterials have wide-ranging applications in the healthcare industry. The materials derived from HA are being used to relieve the pain of knee osteoarthritis, in cataract surgeries, in abdominal and pelvic surgeries, and as a dermal filler to erase facial wrinkles. Moreover, an aging population, several product innovations, and underserved end-user segments are creating a huge market for HA-based biomaterials. Some existing end users include rheumatologists, ophthalmologists, plastic and reconstructive surgeons, anti-adhesive wound care specialists, and gynecologists.
  • Risks. Many market segments where HA-based biomaterials have become firmly entrenched are facing increasing competition. An example is the lower reimbursements for physicians for cataract surgeries and ostearthritic knee treatments, who, in turn, want reduced prices for HA-based viscoelastics. These market segments have not seen significant recent innovations with HA-based biomaterials. The market needs to fight price erosion by adding value to its products.

Anika Therapeutics stock is selling near its 12-month lows. Management is being paid handsomely to enable the development of growth strategies to increase its existing product market shares and to grow the top-line by entering new HA market segments. To date, it has done a good job in laying the foundation for future growth. Catalysts for an upward move in the share price are dependent on (1) approval of a CTA program and (2) positive news from the INCERT-S trial. However, given that these material events are probably months away, we are slapping a HOLD on the stock. BUY on any pullback below $8.00 per share.

Friday, January 27, 2006

TheStreet.com: No BOOYAHH!

In June 2005, after slumping to a 52-week low of $2.59, TheStreet.com (TSCM-$7.88), a pure-play Internet provider of a suite of subscription services for use by professionals and self-directed investors, has seen its stock jump 204 percent. In January 2005, the Company announced that New York investment bank Allen & Co. was hired to assist corporate in considering possible "strategic alternatives" for enhancing stockholder value--and as buyers of the stock have speculated, perhaps a possible sale of the Company. To date, however, save for the shuttering of The Street.com's money-losing subsidiary, Independent Research Group LLC., which operated as a securities research and brokerage unit, the smart-ones at Allen & Co. have come up empty in the idea gallery. Then again, just by mentioning corporate talks with Allen & Co., TheStreet.com put itself in play. Anyone seen a "For Sale--by Owner" sign on the front lawn?

Shareholders rode out a dismal summer and autumn. In November 2005, the 10Q filing revealed that subscription revenue decreased by approximately 2% to approximately $16.6 million, as compared to approximately $16.8 million for the nine-month period ended September 30, 2004. Corporate said that this disappointing performance metric was attributable to decreases in subscription revenue for several products, including TheStreet View, Street Insight, RealMoney.com, TheStreet.com Value Investor, and The Telecom Connection--which management blamed on "negative market sentiment." Subscription revenue, not online advertising revenue, dominates this business, and contributes roughly seventy cents to every dollar in sales.

However, looking at the glass as being half-full, management did stress that a more relevant indicator of future growth expectations was the fact that subscription revenue did increase slightly during the third quarter of 2005, compared to the prior quarter. Interestingly, this high-priced management team [more on that later] said that this increase was caused by several factors. First, strong deferred revenue in the previous quarter (a function of subscriptions that have been sold but not yet recognized as revenue) led to subscription revenue growth as this revenue was recognized. Second, the Company experienced "strong growth in both page views and unique visitors" during the quarter due to its success in (i) signing and implementing agreements with large, high-traffic portal companies to direct users to its web sites, (ii) promoting its brands, products and services through contributor James Cramer’s television television and radio programs, and (iii) introducing new content on its free, flagship web site (theStreet.com) to expand its appeal to a broader audience.

  • Red Flag #1. The base of paying subscribers increased by only 7,600 from the third quarter of 2004. Under GAAP accounting, revenue is recognized when it is earned. Sales at TheStreet.com are derived from annual, semi-annual, quarterly and monthly subscriptions. And this subscription revenue is recognized ratably over the subscription periods. The Street.com has collected more than $9.4 million, which is sitting on its balance sheet as a current liability called, deferred revenue. The 10Q Detective is clearly stating up front that we are not accusing corporate of any malfeasance. Theoretically--just for our readers' own edification--it would be easy for a 'less-than-honest' management team to 'massage' top-line growth. In an otherwise flat quarter, someone could pre-maturely move forward subscription activity dates; ergo, the liability moves to the cash-earned line-item on the income statement. [ed. note. If this concept still confuses any of our readers, please drop us an e-mail.]

    Red Flag #2. Good news for the bulls, for in a Form 8-K filed on August 5, 2005, it was dutifully noted that TheStreet.com and its co-founder, director and columnist, James J. Cramer, entered into a new employment agreement. Pursuant to the Employment Agreement, Mr. Cramer will author articles for the Company’s publications, provide on-air radio hosting services for the Company’s radio programming, and provide reasonable promotional and other services, subject to his personal and professional availability, through December 31, 2007. Nonetheless, the 10Q Detective is still left scratching this one unrelenting itch: A significant portion of the Company's subscription revenue is generated by the marketing power of "Mad Money" James J. Cramer. And let's be honest, Cramer aside, the Company's past brand development efforts to attract new subscribers is spotty--at best. And what inquisitive third-party would be willing to pay a premium for this content provider with a subscriber/advertising business business platform that has an accumulated deficit of approximately $155.3 million?
  • Red Flag #3. The Company's operating segments face competition for customers, advertisers, employees and contributors from financial news and information sources, and from many other types of companies. Truism--so to be succint--chief competitors include: (i) online services or web sites focused on business, finance, or investing such as The Wall Street Journal Online (www.wsj.com), Forbes.com, SmartMoney.com, CBS.MarketWatch.com (recently purchased by Dow Jones & Company) and The Motley Fool; (ii) traditional media focused on finance and investing, including print and radio, such as The Wall Street Journal; (iii) investment newsletter publishers such as Phillips Publishing, KCI Communications and Agora Publishing; (iv) information and analysis providers such as Standard & Poors, Moody's, and Morningstar; and (v) Blogs--that's correct, B-L-O-G-S.

Rhetoric aside, if you bought TheStreet.com last summer at $4.00 per share, you are sitting on an unrealized gain of approximately 97 percent--buy, sell, or hold? Thank the financial news media for your healthy gains. In December, 2005, The New York Post speculated that TheStreet.com was in play as a Target of Takeover.

Mad Money Man Cramer is fond of saying: "you can be a bull, a bear, but a pig gets eaten in all markets!" That said, there is some merit to an acquisition bid for TheStreet.com. Traditional media has been doing some shopping--and buying of online content providers with similar subscription/advertising business models:

  1. 1. Rupert Murdoch's News Corporation spent $580 million in cash to buy Intermix Media, Inc. The deal successfully closed on September 30, 2005. Intermix is best known for its MySpace.com site, which is an active online community that integrates social networking applications with proprietary online content to motivate its users to spend more time on its Network and to invite their friends to join them, too. When last checked, the Intermix Network (which also owned some thirty other websites) had grown to over 30 million unique visitors per month.
  2. 2. In January 2005, Dow Jones closed on its $519 million deal to purchase MarketWatch, Inc. (MKTW), a well-known provider of business news, financial information and analytical tools. According to ComScore Media Metrix, during the last months of its independent life, MarketWatch averaged around 5 million unique visitors each month and 230 million pageviews. On a valuation basis, Dow Jones paid 30 times estimated cash flows. Looking at a popular Internet performance metric--with 6.8 million unique visitors per month [NOW]--Dow Jones paid approximately $76 per pair of eyeballs acquired!
  3. 3. Feb. 17, 2005--The New York Times Company announced that it had reached an agreement to acquire About, Inc., a leading online consumer information provider, from PRIMEDIA Inc. in an all-cash transaction valued at approximately $410 million. About, Inc., through its Web site About.com, provides "practical solutions for everyday problems." Ranking among the most frequently visited sites, About.com reaches an audience of 22 million unique visitors each month. In this case, The Times purchased About.com on the cheap, for only $18.60 per pair of eyes! Or, in the traditional analysis, the purchase price reflected a multiple of over 10 times About's 2004 revenues

Compelling these transactions were similar strategic benefits, as noted by the acquiring firms in press releases: (i) Adding a fast-growing, highly profitable Web site to complement the acquiring company's existing portfolio of digital properties; (ii) Extending reach and scale by combining the traffic of the network of Web sites. This best positions the companies to further capitalize on double-digit growth in online advertising; (iii) The acquisitions should add complementary proprietary content, expanding the scope of proprietary offerings; and (iv) The mergers should provide significant opportunity for cost savings through operational cost synergies, including elimination of royalty fees and other overhead costs. Ergo, The transactions will be accretive to forward earnings.

Will TheStreet.com sell? Looking at the aforementioned comparables--what is the share-net value?

TheStreet.com is not a fast growing, profitable website. The Company did report a 26 percent increase in ad revenue in the third quarter, as sales picked up to $2,117,805, from $1,676,007 in the second quarter of 2005. However, this marked only the first sequential increase since 1999! Advertising revenues contribute just $0.26 per dollar in net sales. A salient factor that contributed to this growth in advertising sales was a strong demand for online advertising--which led to increased spending by the Company's advertisers. A large proportion of the Company’s top advertisers are concentrated in financial services, particularly in the online brokerage business. . For the three months ended September 30, 2005, one advertiser accounted for approximately 12% of total advertising revenue. The 10Q Detective suspects this client is Fidelity [given the size of its banner advertisements].

  • TheStreet.com did return to profitability in the 3Q:05. The Company's reported that net income from continuing operations for the three-month period ended September 30, 2005, was approximately $1.4 million, or share-net of $0.05, on 26.2 million diluted shares outstanding. However, the Company used cash in operating activities of $1.64 million for the nine-months ended September 30, 2005, primarily the result of the Company’s net loss of $1.5 million combined with a decrease in accrued expenses (primarily the result of payments related to incentive compensation), and in increase in accounts receivables.
  • Dow Jones & Co. and New York Times Co. bought Internet companies to gain a bigger piece of the fast-growing market for online advertising. Given that TheStreet.com does not have a strong cost-per-click advertising business, in our opinion, investors should not get too excited about the prospects of TheStreet.com as a takeout target.
  • TheStreet.com sells online subscription services for newsletters with names like Action Alerts PLUS, TheStreet.com Stocks Under $10, Street Insight, TheStreet.com Value Investor, TheStreet View, and RealMoney.com. In our opinion, The Street.com probably is not attractive to many media companies, too, because it's too much of a niche business.

Net sales' estimates for the current year ending December 31, 2006, are approximately $32.6 million. Sustainable operating profits are uncertain, in our opinion, given runaway expenses. SHAME! SHAME! In 2005, general and administrative expenses, consisting of compensation for general management, finance and administrative personnel, ate up $0.23 cents of every dollar in net sales.

A review of senior management highlights another case of substance--oh, we mean, salary abuses:

  • (i) On December 27, 2005, TheStreet.com, Inc. and Thomas J. Clarke, Jr. entered into a new Employment Agreement, effective as of January 1, 2006, upon expiration of his prior employment agreement with the Company. Pursuant to the Agreement, Mr. Clarke will continue to serve as the Chairman of the Board and Chief Executive Officer of the Company through December 31, 2007.

    In consideration for his service, Mr. Clarke, the CEO, is entitled to an annual base salary of $410,000 and is eligible to receive annual cash bonus compensation, with a target of such bonus being 75% of such salary. Mr. Clarke also will receive an annual grant of long-term equity incentive compensation. Each grant will have a value on the grant date of $300,000 and will vest ratably over the first three anniversaries of the effective date of the grant.
  • (ii) Annual salaries and cash bonuses for other insiders: James Lonergan, President and COO, Lisa Mogensen, CFO, and Jordon Goldstein, General Counsel, total $516,000, $448,000, and $380,000, respectively excluding equity options].
  • (iii) And let us not forget the one who drives top-line growth at the Company--James Cramer. From a recent 8K filing: "Mr. Cramer’s salary will be $500,000 per annum for the remainder of 2005, $750,000 for fiscal 2006 and $1,000,000 for fiscal 2007. In addition, he will continue to be paid the radio talent fee (currently $363,000 per annum) paid to the Company by Buckley Broadcasting Corp.-WOR under the Company’s radio agreement. Mr. Cramer is also eligible to receive stock option awards and annual bonuses under the Company’s annual incentive plan....

Just for these five insiders--excluding stock options--General & Administrative expenses totaled $2.8 million, or 8.5% of expected 2006 net sales! And these numbers do not include other G&A expenditures, including finance and administrative personnel, occupancy costs, professional fees, equipment rental and other office expenses.

This math activity eruditely casts a shadow on any belief that buying TheStreet.com would be accretive to a possible buyer's bottom-line.

TheStreet.com has a market capitalization of approximately $200 million and sells for a forward 12-month Price of 29.2 times earnings. Trailing twelve-month operating margins were (2.30%) and ROE was 1.50 percent. Trailing twelve-month EBITDA was (82.62K).

Online performance metrics do not favor the Company--We estimate online subscribers and monthly unique visitors to be approximately 83,000, and 3.1 million, respectively.

Murdoch spent $19.33 for each Intermix Media monthly visitor; Dow Jones paid $103.80 for each set of eyes and on a valuation basis, 30 times estimated cash flow; By comparison, The New York Times, bought About.com on the cheap, paying only $18.60 per set of eyes and a multiple of ten times sales.

At a share price of $8.00 per share and a market cap of $200 million, TheStreet.com would cost a potential acquirer $64.52 per eyeballs or a multiple of 5.5 times sales.

If Allen & Co. could find an Old World [European?] Media company willing to ante up a premium to buy itself an existing web-franchise, TheStreet.com might command $350 million [excluding debt], or $13.35 per share. Comparables: $112.9 million per set of eyes or a multiple of 9.7 times 12-month forward revenues.

Given that TheStreet.com lacks product diversity, has a business model unlikely to sustain profitability, a management team more interested in making portfolio manager salaries, and no original ideas [save for Mad Money Man himself--who ought to be peaking soon from 'overexposed' media time & unreliable"money-making" ideas] to combat the new competitor called BLOG, it is doubtful that this stock will "stay-in-play."

As there are no visible catalysts to move the share price higher, lock in profits and sell. Don't Back up the truck. And no "BOO-YAHHHH" for TheStreet.com.

Thursday, January 26, 2006

Telestone Tech.--The Peoples' Investment for 3G Wireless in China.

Telestone Technologies Corp. (TST:AMEX - $4.01), is a leading provider of wireless communications coverage to major telecommunication firms in the People’s Republic of China (PRC)—one of the fastest growing wireless markets in the world. According to research conducted by Nokia China, by 2007, the number of mobile phone users in China is expected to reach more than 500 million users, a 49.7% growth in users in less than three years!

The Company’s wireless coverage solutions are designed to enhance the quality of reception over wireless networks, while simultaneously reducing operating costs for the client carriers—a competitive advantage over competitors. Telestone is a small-cap company off the radar screen of most Wall Street telecom analysts. For investors--Telestone represents a pure play on the future of the Chiness wireless market, for 100% of sales originate in the PRC.
The catalyst for a sustainable upward move in the share price is the highly-anticipated rollout of the 3G (Third Generation)-related technologies for the PRC, for which Telestone is one of only four principal companies that are licensed and capable of delivering on 3G wireless technology and equipment to China’s two largest wireless phone companies, which are China Mobile and China Unicom.

The Chinese authorities are expected to award 3G licenses to service providers later this year, as the country readies its high-speed network in time for the 2008 Olympics in Beijing. China's future 3G mobile network will use a home-grown TD-SCDMA standard co-developed by Siemens.
The subsequent rollout of 3G cell-phones will open up a market with a projected value of $25 Billion per annum. Of this market, Telestone’s wireless coverage solutions’ opportunities is approximately $2.5 billion per annum over the next three-to-five-years. Currently, the Company owns 2.7% of this market. Given that Telestone has a strong domestic presence in the PRC, we are being conservative in our belief that the Company can grow the top-line from existing businesses and the expected new 3G opportunities to easily hit approximately $100 million in top-line growth—dependent upon the release date of the 3G licenses.

Telestone recently landed an OEM contract with China Ericcson, which has a potential value of approximately $50 million over three-to-five years. More importantly, this deal positions Telestone to deepen its market penetration and to develop and market a series of 3G products for use on Ericsson’s wireless network platforms in the PRC, other Southeast Asian nations, and India.

Telestone is financially sound, with a current ratio better than 2:1, and no long-term debt.

Even without the inclusion of revenue generated from the upcoming 3-G deployment in China, management still expects top-line growth and share-net EPS in the order of 20%-to-30% year-over-year. We do, however, expect a big impact on revenues and profitability, assuming a 2H:06 deployment of the 3G technologies in the PRC. Our early estimates call for Telestone to show top-line of approximately $55 million, throwing of share-net of $0.50 [assuming 10 million shares, fully-diluted]. For aggressive investors willing to assume the inherent risk of owning a small-cap company, we recommend dialing up your broker and buying some shares.
Our initial target price for Telestone is $12.50 per share. This valuation assumes a multiple expansion to 25x forward 12-month earnings.

Monday, January 23, 2006

RealNetworks--Skip this Digital Party

Two years ago, a fledgling RealNetworks, Inc. (RNWK-$8.19) , before it had 2.2 million paying subscribers, and before it became a leader of digital media services and software, including Rhapsody, RealPlayer 10, and casual PC games, filed suit against Microsoft Corporation, alleging that Microsoft had illegally used its monopoly power to restrict competition, limit consumer choice and had attempted to monopolize the field of digital media. Specifically, RealNetworks sought relief of more than $1 billion in damages, claiming that Microsoft had withheld information about the Windows operating system that made it more difficult for RealNetwork's to make its RealPlayer compatible with the world's most popular desktop platform.

On October 11, 2005, the Company and Microsoft entered into an agreement to settle all antitrust disputes worldwide between the two companies. Upon settlement of the legal disputes, the Company and Microsoft entered into two agreements that provided for collaboration in digital music and casual games:

  • Microsoft will pay $460 million in cash to RealNetworks to settle all claims and give Real long-term access to Windows Media technologies to settle the antitrust issues worldwide. Under the settlement agreement, RealNetworks agreed to dismiss its antitrust litigation in the United States against Microsoft with prejudice and agreed to take no further steps to participate in the antitrust proceedings pending against Microsoft instituted by the European Union and South Korea. In addition, pursuant to the settlement agreement, Microsoft and RealNetworks entered into a technology assurance pact. RealNetworks will receive more access to Windows code to enable it to build more compatible software. Microsoft has also ensured RealNetworks broad access to Microsoft's PC OEM distribution channel, and the two companies have also contractually agreed to work together to enhance interoperability between Microsoft’s Windows Media and RealNetworks' business Helix Digital Rights Management (DRM) systems (which enables RealNetworks' commercial customers to create and deliver their own digital media applications and services).
  • RealNetwork's will also receive another $301 million in cash scheduled to be paid quarterly over 18 months related to a collaborative music and games agreement. Microsoft agreed to enter into a "wide-ranging digital music collaboration" that includes promotional and marketing support of Real's Rhapsody subscription music service on the MSN portal. In addition, RealNetwork's digital video games will be promoted through both MSN Games and the Xbox Live Arcade for Xbox 360.
  • When the deal was announced, business headlines and investor message-boards alike crowed about this big win for RealNetworks: "Microsoft Settles Suit for $761 million!" ... And, the bulls promulgated BIG things to come for this digital music provider. Yes, in the short term, the agreement is a win, for it lets RealNetworks escape the onerous legal expenses, which corporate says have precluded profitability in several quarters since it filed the suit, which--to date-- has cost it $22.9 million. [ed note. Contrary to "corporate speak," litigation expenses were NOT the only reason the Company has not shown operational improvement. From the third quarter 10Q filing--To quote management: "In addition, our sequential revenue was adversely impacted by slowing growth of our premium music subscription service revenue."

The 10Q Detective hates [sure we do!] to break up a good party...but let's read a bit more from the aforementioned SEC filing: "....Our revenue growth was also impacted by an increase in the number of customer cancellations attributable primarily to our increasingly large subscriber base." [ed. note. Again more corporate speak--Management is telling us that the churn is a numbers game--the more customers who join--the higher the probability that more will quit, too]. "Finally, our Music business continued to face intense competition in the third quarter of 2005 as certain marketing channels became more crowded with competitive offers of lower prices. We currently anticipate that these trends and factors, particularly slowing growth of our premium music subscription service revenue, will result in slowing sequential revenue growth in the fourth quarter of 2005 as compared to prior periods." [The 10Q Detective calculated that for the nine-months ended September 30, 2005, Music-related services contributed approximately 35 cents to every dollar in top-line sales.]

Now back to the festivities....The champagne being drunk--Wall Street analysts and investors are now gossiping: What will the Company do with all this money? One, why not price and market Rhapsody music service aggressively (as a loss leader?) to compete and take some market share against Apple's iTunes Music Store, Yahoo! and Napster? According to a recent report by the International Federation of the Phonographic Industry, however, the digital downloading and streaming services market is intensely competitive, with some 355 other online premium music sellers.

Second. How about doing a few horizonal acquisitions? It would be easy for corporate to calculate acquisition cost per subscriber (ACPS) in a buyout compared to the costs of organic growth. For example, Napster, Inc. (NAPS), better known as the (once) free file-sharing network that helped popularize the digital music industry, has an enterprise value of $8.9 million. Even if RealNetworks paid a 20% premium to market, it would still only cost the Company $21.36 in ACPS to acquire an additional 500,000 subscribers [excluding churn]. RealNetworks does not breakdown its ACPS; instead, it lumps it together in Sales and Marketing expenses with the likes of salaries and related personnel costs, sales commissions, consulting fees, etc. Historically, corporate has declined to reveal practically anything about what RealNetworks has learned about selling subscriptions--and the related ACPS, too. For the stated nine-month period, Sales and Marketing expenses trimmed 39% from net revenue. That said, we are comfortable stating that RealNetworks' ACPS is probably in the range of (at least) $100 per subsciber.

Of interest, too, RealNetworks' 10Q filing for the three-months ended September 30, 2005, revealed music-related sales of more than $25 million--yet corporate still declines to say whether or not this "renter" platform (monthly fee for unlimited downloads) is profitable [as say...compared to Apple's "Buyer"/per download business model].

Third. Other analysts expect corporate to either increase R&D spending on the mobile content side, both on technology and on specialized, content development--or buy the treats they need to stay competitive. For example, in 2003, RealNetworks spent approximately $36 million to acquire Listen.com and its highly-regarded RHAPSODY subscription service, which came with assets the Company needed to build the music offerings of RealNetworks' RealOne subscription service.

Enough speculating--what has corporate announced to date to enhance shareholder value?

  1. 1. $40 million to $50 million is earmarked for contingent legal fees and other litigation costs.
  2. 2. On November 4, 2005, the Compensation Committee of the Board of Directors approved cash bonus awards to certain executive officers of the Company. Roy Goodman, the Company's Senior Vice President, Chief Financial Officer and Treasurer, will receive a cash bonus award of $50,000, and Michael Schutzler, the Company's Senior Vice President, Media Business, will receive a cash bonus award of $25,000.
  3. 3. On November 30, 2005, the Company granted cash bonus awards to a select team of employees for their efforts related to the aforementioned settlement and collaboration agreement. Only two of these VERY important employees were mentioned by name: (1) Robert Kimball, the Company's General Counsel and Corporate Secretary, received $1 million on November 30, and will receive an additional $1.5 million if he sticks around through November 30, 2008 (why leave)! (2) Daniel Sheeran, the Company's Senior VP, Premium Consumer Services, received a cash payment of $70,000 on November 30, 2005, and will receive cash payments of up to $65,000 in each of May 2006 and November 2006. Bob Glaser, CEO, Roy Goodman, CFO, and Dick Wolpert, Chief Strategy Officer--the 10Q Detective is comfortable in saying that these three are probably among the VERY important people selected to receive sugar-sugar rushes from the $460 million cookie jar, too.
  4. 4. December 06, 2005 — RealNetworks announced that the Board of Directors had approved--in the amount of $100 million--a stock buyback program. Repurchases may be made in the open market or through private transactions, in accordance with Securities and Exchange Commission requirements. So not only do the insiders take from the $460 million once--but they get to double-dip in the cookie jar if market conditions permit! By the way, the trailing twelve-month return on shareholder equity for RealNetworks was a meager 4.06 percent. Ten-year treasuries, currently yield 4.36%--with no risk to principal.

Add up all the DISCLOSED line items, and that cookie jar shrinks to about $260 million.

Oh, and that $301 million that RealNetworks is still owed, read the fine print and you'll notice that Microsoft earns credits--'finder's fee'--for every new Rhapsody subscriber who arrives from MSN. The agreement does not preclude Microsft from continuing to solicit a new pool of subscribers for its own online music and gaming services, too.

Is RealNetwork's business model economically viable in the long-run? The digital music party has legs, but given the apparent greed by insiders, building a competitive competence does not seem to be a top priority right now. The 10Q Detective likes RealNetworks' products, but until corporate stops stuffing its [collective] faces, we are going to avoid this party.

Sun Tzu, The Art of War, said: "...a wise general strives to feed off the enemy." RealNetworks should heed his advice.

Wednesday, January 18, 2006

Convergys Corp.--Ignore Reason and Buy!

Convergys Corporation (CVG-$15.82), a global leader in customer care, human resources and billing services, announced today that Sprint Nextel plans to end their Convergys billing relationship over time by migrating subscribers off the legacy Precedent 2000 platform during 2006 and 2007. Sprint is finalizing a new eight-year billing contract with Amdocs Ltd. (DOX) for its mobile phone services.

The Company has two reporting segments, which are identified by service offerings. The Customer Management Group (CMG) provides outsourced customer care and human resource services. The Information Management Group (IMG) provides outsourced billing and information services and software.

CMG, which contributed approximately 71% of total nine-month revenue of $1.9 billion for the period ended September 30, 2005, continues to face a variety of challenges, including pricing pressure, the impact of the weakened U.S. dollar versus the Canadian dollar, the Indian rupee and the Philippine peso, and realizing the returns it expects from ongoing restructuring of its employee cost operations. Despite these challenges, the Company believes that it can continue to capitalize on the trend of large companies and governmental agencies using outsourcing providers to provide cost-effective, high-quality customer support and employee care solutions.

The Convergys strategy is to capture the growing demand for outsourced customer care and employee care support service dollars by expanding the scale and scope of its service offerings. CMG has served its top 10 clients, in terms of revenue, for an average of 10 years. The Company is also growing its backlog through acquisitions and new customer wins.

In August 2005, the Company acquired the finance and accounting business process outsourcing business of Deloitte Consulting Outsourcing LLC, a subsidiary of Deloitte Consulting LLP. This business provides finance and accounting outsourcing services to clients in multiple industries ranging from communications to retail to professional services. This acquisition expands the Company’s outsourcing capabilities and is expected to help enable it to address the full service outsourcing needs of its clients.

In May 2004, the Company acquired Encore Receivable Management, Inc. a Kansas-based provider of accounts receivable management and collection services. This transaction provides CMG entry into the accounts receivable management market and the ability to expand its business process outsourcing capabilities.

Also in May 2004, the Company acquired DigitalThink, Inc., a custom e-learning company. Convergys can now provide its clients customized, on-demand courses; expand its capabilities in the human resource business process outsourcing market to meet the needs of large global organizations for full service learning solutions; and, support its human resource and customer care clients more efficiently by accelerating the effectiveness of customer support teams through on-the-job training for client programs.

Approximately 70% of new growth in 2005 was driven by these and other firms purchased by CMG during 2004 and 2005.

Convergys has also won a contract worth an estimated $1.1 billion (over thirteen years) to provide human resources services to DuPont Co. Specifically, Convergys will develop an online information system that will allow employees and managers to sign up for transactions such as enrolling in benefits and changing payroll information and to provide workforce data management.

The IMG segment serves clients principally in the telecommunications industry by providing and managing complex billing and information software that addresses all segments of the communications industry. IMG provides its software products in one of three delivery modes: outsourced, licensed or build-operate-transfer (BOT). In the outsourced delivery mode, IMG provides the billing services by running its software in one of its data centers. In the licensed delivery mode, the software is licensed to clients who perform billing internally. Under the BOT delivery mode, IMG implements and initially runs its software in the client’s data center while the client has the option to transfer the operation of the center to itself at a future date.

For the nine months ended September 30, 2005, 43.8% of IMG’s revenues were from data processing services that generated monthly payments from its clients based upon the number of client subscribers or bills processed by IMG in its data centers. Professional and consulting services accounted for 34.8% of IMG’s revenues for the same period.

In 2005, Convergys' IMG generated approximately $100 million in revenue, or roughly 4 percent of its expected total 2005 revenue, from Sprint Nextel.

IMG continues to face intense competition as well as consolidation within the communications industry. Despite these challenges, the Company believes that strong growth opportunities within its billing market remain. In order to survive in an increasingly competitive and consolidated industry, communications companies are continuously looking to expand their service offerings, which has resulted in increasingly complex and ever changing billing system requirements. Communication providers are not replacing their entire legacy billing systems with next-generation end-to-end billing systems, but instead have have shifted to augmentation and upgrading. In order to meet this demand, Convergys continues to invest in research and development of INFINYS, its proprietary billing platform.

Red Flag #1. The Company’s three largest clients accounted for 33.5% and 36.3% of its revenues in the first nine months of 2005 and 2004, respectively. Of note, the risk posed by this revenue concentration is reduced somewhat by the long-term contracts the Company has with some of its largest clients. The Company serves Cingular, its largest client with 17.3% of revenues in the first nine months of 2005. The Company’s relationship with Cingular is represented by separate contracts/work orders with various IMG and CMG operating units. On December 14, 2005, Convergys did announce a contract win-extension. The Company serves DirecTV, its second largest client in the first nine months of 2005, under a customer management contract. Sprint Nextel is/was the third largest customer.

The 10Q Detective has an 'intuitive' tug that Convergys represents an attractive BUY at current levels. These separate contracts/work orders with the above clients have varying expiration dates, payment provisions, termination provisions and other conditions. As a result, the Company does not believe that it is likely that its entire relationship with Cingular, DirecTV or Sprint Nextel would terminate at one time. We agree with corporate, therefore, that Convergys is not substantially dependent on any particular contract/work order with these clients.

Red Flag #2. Receivables represent 79.3% of current assets. Nontheless, Days sales outstanding (DSO), which is an accurate picture of how long it takes a company to collect on monies it is owed, remains stable. In fact, it decreased to 74 days at September 30, 2005 versus 75 days at December 31, 2004.

Red Flag #3. Goodwill, , currently accounts for 38.3% of the $2.27 billion in total assets--attributable to the Company's recent buying spree. [Assuming this does not blow up in our faces], we will believe corporate, which recently performed its annual impairment tests during the fourth quarter of 2004 and concluded that no goodwill impairment existed.

Convergys, which we previously mentioned has been building up other business interests outside of billing, said that Sprint's plan to move off its billing system in 2006 and 2007 would not hurt its earnings outlook for this year, and remains comfortable with share-net guidance of at least $1.07 for 2006.

Catalysts for share-price gains include sequential improvements in operating margins and sustainable top-line growth. To position itself for profitable growth, Corporate has taken the following steps:

  1. Streamlining its Customer Management and corporate operations. The Company initiated a restructuring plan during the second quarter of 2005 that resulted in a charge of $8.9 million. The actions, which affected approximately 300 professional and administrative employees, were substantially completed during the third quarter of 2005. Convergys is expecting incremental savings of approximately $34.0 million in FY 2006.
  2. The Canadian dollar continues to pressure operating margins. By hedging the U.S. dollar, the Company estimates that the realized impact improved margins by 200 basis points.
  3. New IMG Revenue Drivers. For comparative purposes, new license and service revenues for the 12-months ended September 30, 2005, jumped 24% to $427 million.
  4. New CMG Revenue Drivers. Ongoing growth with existing, long-term clients plus new wins with Boston Scientific, Texas Instruments, and DuPont should, according to corporate, double employee-care sales in two years.

Shakespeare wrote in Macbeth: "Or have we eaten on the insane root. That takes the reason prisoner." Yes, there are "soft spots" in Convergys' financial statements...That said--Management seems committed to enhancing shareholder value. IF Convergys can demonstrate sustainable quarterly-Earnings-Growth (year-over-year) of at least 5%, industry comparables show that investors would be willing to expand the Company's forward earnings multiple to at least 25, from the current 14.8 times. Target sell price for Convergys Corp. is $26.75 per share.

Sunday, January 15, 2006

Factory Card -- Where's the Party?

Factory Card & Party Outlet (FCPO-$7.69) based in Naperville, Illinois, is a chain of company-owned stores offering an extensive selection of party supplies (invitations, party favors, candles, and piƱatas), greeting cards, giftwrap, balloons, everyday and seasonal merchandise and other special occasion merchandise at everyday value prices. As of October 29, 2005, the Company operated 189 Company-owned retail stores in 20 states, pricipally in the midwest and the eastern seaboard. The Company's primary card supplier is Rhode Island-based Paramount Cards. FCPO filed for bankruptcy in 1999 and emerged in April 2002.

The share price of FCPO has plummeted almost 32% in the last year, for the Company has missed sales targets and experienced negative comparable store sales of 1.3% in the first-nine months of FY '05. Because of underperforming business trends, management performed an impairment review of each store in the third quarter ended October 29, 2005, resulting in a pre-tax charge of $200,000 (related to fixed asset impairment). No impairment charges were incurred in fiscal 2004.

On January 13, 2006, Cramer, Rosenthal & McGlynn (CRM LLC), a limited liability company that provides investment management services, and is one of the largest institutional holders of FCPO, filed a Form 13D. CRM LLC is noticeably upset with FCPO management, given that their 159,000 shares, or 5.07% stake, has lost 28.7%, or approximately $493,000 in aggregate value.

In the 13D filing, CRM LLC publicly stated their belief that the Company's stock trades at a distressed valuation as a result of a number of factors. These include, but are not limited to, (1)inadequate management, (2) misguided and failed sales growth strategies, and, (3) poor corporate governance. Ergot, CRM LLC is lobbying for extraordinary action, such as changes in Company management, changes in the Company's board of directors or retention of an investment banker to consider strategic alternatives, including a sale of the Company, which may be required in order to realize the Company's 'intrinsic value.'

The 10Q Detective decided to step into the fray and see if there was merit to CRM's concerns:

Management's strategies to increase sales in the past quarters has been wholly unsuccessful. One example CRM cited was management's determination to make a "strategic commitment" to the Halloween selling season in 2005 and the significant investments made to that end. FCRO made a substantial investment in store payroll and advertising with the anticipation of a larger and quicker ramp up to the Halloween season.

For the quarter ended October 29, 2005, net sales did increase 4.7 percent to $56.2 million. However, the Company still bled red ink, for the net loss in the third quarter of 2005 was $1.2
million, or a share-net losss of $0.39, compared to reported net income of $472,000, or $0.14 per fully diluted share, last year. The increase was attributed to an increased store count coupled with a modest 1.0% increase in comparable store sales.

Operating performance was negatively affected by higher store occupancy costs; net increases in advertising expense directly rated to FCPO's attempt to drive customer counts through use of a direct mail program; Internet advertising as well as billboards in the third quarter of fiscal 2005; and, an impairment charge related to fixed assets at under-performing stores.

The Company purportedly showed that cash flow from operations generated $4.0 million. If, however, you subtract an increase of $7.5 million in accounts payable and a $2.5 million increase in accrued expenses, operations would have used approximately $6.0 million!

FCPO's business is highly seasonal, with operating results varying from quarter to quarter. Historically, the Company experiences higher sales during the second and fourth fiscal quarters due to increased demand by customers for products attributable to special occasions and the holiday seasons during these selling months. Unfortunately, as CRM LLC has brought to light, management cannot seem to sustain top-line growth. On January 5, 2006, FCPO
announced that net sales for the critical December 2005 holiday month fell 0.6 percent, compared with the five-week period ended last year. And the more important performance metric--comparable store sales (for the same period) decreased 2.8 percent.

For the nine months ended October 29, 2005, corporate spent $4.5 million on investment activities. Significant expenditures incurred in the current year include new store openings, computer equipment and software, store remodelings, the rollout of a private label program, and warehouse equipment for a distribution center.

Where are the purported operating efficiencies from the Company's bragged about 300,000 square-foot distribution center? Gross profit was 35.8% for the third quarter of fiscal 2005 compared to 36.3% last year. This purported leverage of freight and distribution costs continued to be offset by higher store occupancy costs and the expenses of new, 'innovative' product roll-outs. While management was disappointed with these results, they still believe that this performance is not indicative of FCPO's future potential.

To unlock this future potential and to improve logistic efficiencies, corporate also recently installed a state-of-the-art 'Demand-Chain' replenishment system; revamped its entire greeting card category; enhanced its database marketing capabilities; and, launched an E-Commerce site. The 10Q Detective agrees with CRM LLC, for management is constantly cooking up new merchandising schemes in its kitchen, but the birthday cake always seems to taste stale: "We are well positioned for the graduation season and look forward to the full implementation of our new line of greeting cards from Premier Greetings in early May."--[Gary Rada, CEO, commenting on last year's results/BusinessWire, April 2005]

Sadly, CRM LLC is probably correct, too, that the current initiatives will not go far enough to position FCPO to improve future financial results. According to industry sources, the market for party and special occasion merchandise, comprised of party supplies, greeting cards, gift-wrap, and related items, was estimated at $14 billion in sales in 2003. And, as the highly fragmented market demonstrates, barriers to entry are low, and consumers purchasing party-related products embrace passive loyalty among party supply stores, designated departments in drug stores, general mass merchandisers like Wal-Mart and Target, supermarkets and department stores of local, regional and national chains.

Major chain competitors in the Company's markets include Party City, Hallmark Cards, and iParty. Recently, FCPO has also started to compete with internet and catalog businesses with similar merchandise and product offerings. Hence with all these comers crashing the paper party, the 10Q Detective is skeptical that FCPO can contain competitive pricing ressures. Too, continued costs to update older stores, salary expenses, costs of targeted ad campaigns, and [no-doubt] coming inventory writedowns from misread consumer demand, will expand future SG&A expenses.

CRM is also rallying against the conflicts of corporate governance, for the interests of management and the board are not aligned with those of the stockholders. According to CRM, actions taken by the board indicate a blatant disregard for the interests of stockholders, to whom they owe fiduciary duties. CRM alleges in its filing that salaries paid to senior management are not justified--having increased over the past three years--despite a quantifiable record of uneven quarterly operating histories. Looking at 8K-SEC filings through December 2005, the 10Q Detective was able to ascertain that the salaries of the top three executives (Rada-CEO/ Gower-Sr. VP/ Misch-CFO) --excluding bonus', incentive stock options, and understated severance packages--totaled $1.06 million for the current FY ended January 2006. Pro-rating for the first nine-months, the aggregate payroll of $817,500 contributed 13.45% to total SG&A expenses!

In light of all these disclosures, the best strategic alternative that CRM proffers to unlock shareholder value would be an outright sale of the Company. Looking at a recent comparative--a good example would be the acquisition of Party City Corporation by AAH Holdings. Completed
in December 2005, shareholders received $17.50 per share in cash for each share of common stock outstanding, without interest, for total consideration of approximately $364 million. Park City went quietly for 4x sales multiple. FCPO, with margins contracting and top-line growth stagnant, however, could never command that type of valuation. Currently, with a ROE of (10.8%) and a P/S ratio of 0.16x [reflecting this abysmal operating history], FCPO would be lucky to roll off the table for its enterprise value of $38.12 million, or approximately $12.00 per share.

Three years removed from bankruptcy, FCPO's business dream remains--to become the premier specialty retailer of greeting cards and party supplies in the United States through merchandising innovation, value orientation and controlled growth. We applaud FCPO for trying to control inventory costs. Still, despite the size and scope of its merchandise offerings, we doubt that corporate can do much about its variable costs. FCPO has an erratic history of cash flow, and the 10Q Detective believes that the only way FCPO can unlock its potential value is either growth through acquisitions, or by letting itself be acquired. That said, however, this is one party we'd prefer not to go to...."wife has the flu"--pass!

Friday, January 13, 2006

Hilton Hotels--Like Paris Hilton Better.

On December 29, 2005, Hilton Hotels Corp. (HLT-$25.00) said it would buy the hotel assets of Britain's Hilton Group PLC for 3.3 billion pounds ($5.7 billion) cash. Under the terms of the deal, Beverly Hills-based Hilton Hotel will only acquire the British company's lodging operations, totaling 40 hotel properties in Britain and Europe, along with 200 leased hotels. Hilton Group will change its name to Ladbrokes PLC and focus on its online and in-store betting operation, which has hundreds of locations in Europe.

The transaction, which is expected to close early this year, will be financed with cash on hand at the time of the closing (estimated to be approximately $1.2 billion) and a new bank facility.

The deal is being viewed favorably on Wall Street by many analysts. Prior to the transaction, the flagship Hilton brand was primarily vested in the U.S., Canada, and Mexico. Now, with a global lodging industry footprint, which also includes other Hilton Family brands like Embassy Suites, Hampton Inns & Suites, and Doubletree [that had previously been confined to North America], management is looking to expand its presence to places like India and China.

Management said it expects to save about $30 million per year going forward from consolidating technology, billing and other functions. The Company also anticipates realizing a number of revenue enhancing synergies, such as the worldwide implementation of Hilton's proprietary customer information system, called "OnQ."

This new business is a switch from the Company's previous strategy of selling off real estate to generate management fees and distribute the cash to investors. And... other non-industry-related activities: In 2004, the Company invested in a synthetic fuel facility--YES... we wrote that correctly: In August 2004, the Company acquired a 24% minority interest in a coal-based synthetic fuel facility for approximately $32 million. The facility produced operating losses, and Hilton's proportionate share of which totaled approximately $13 million for the nine months ended September 30, 2005. [BUT--the venture generated tax-credits.]

Hilton stock currently trades at a lower valuation [P/E, P/S, etc.] than its rivals because of its previously limited global presence. Contrary to analysts' sentiments, the 10Q Detective remains neutral on Hilton stock as an investment going forward.

On January 6, 2006, Moody's Investors Service cut Hilton Hotels debt-rating by two notches, from the lowest investment-grade rating to the second highest junk rating of "Ba2."

Paris Hilton may have to cut up her AMEX card to make this deal work. Prior to this acquisition, at 136.9%, total debt smothered shareholder equity. Adding in the additional financing needed to close the deal, the long-run solvency of Hilton Hotels Corp. is clearly a risk. This is not to say debt is bad, for on a trailing twelve-month basis, the Company is said to be trading on the equity at a gain. To illustrate, Hilton's rate of return on total assets is 5.76%, whereas the rate of return on the stockholders' equity was 16.22 percent. In other words, though highly leveraged, management has a history of using its debt profitably to earn such a higher ROE. Our concern is that SEC filings indicate that management is generating some of these returns by playing with derivatives. For example, for the first nine months of 2005, the Company is sitting on pre-tax gains of $7 million from derivative contracts covering 2.5 million barrels of oil!

As if the Company did not have enough debt to service, SEC filings also disclose that management has offered "franchise financing programs" with third party lenders to support the growth of its Hilton Garden Inn, Homewood Suites by Hilton, Hampton and Embassy Suites brands. As of September 30, 2005, Hilton had provided guarantees of $41 million on loans outstanding under the programs. In addition, there was guaranteed $36 million of debt and other obligations of unconsolidated affiliates and third parties, bringing the total guarantees to $77 million. Hilton Hotels also has commitments under letters of credit totaling $56 million as of September 30, 2005.

The Company also provided performance guarantees to certain owners of hotels under which Hilton operated under management contracts. Reclassifications, IRS audits--after reading some of Hilton Hotel's SEC filings we needed to take aspirin. We think it would be much more fun to follow the antics of Paris Hilton than Hilton Hotels Corp. stock.

Wednesday, January 11, 2006

Biocryst Pharmaceuticals--Buy Tissues instead.

Shares of Biocryst Pharmaceuticals, Inc. (BCRX - $20.08) have popped more than 32% in the past three weeks in apparent anticipation of the start of human trials of its investigational injectable flu drug, Peramivir (BCX-1812).

Biocryst is using an intramuscular delivery system because a Phase III clinical trial using an oral (pill) formulation of peramivir, in June of 2002, showed that the primary endpoint did not reach statistical significance. The company believed that the low bioavailability of the oral formulation was the reason for the drug’s clinical response in the Phase III study.

In preclinical studies, peramivir has shown potent, broad-spectrum activity against multiple strains of flu, including avian influenza (H5N1). There currently are no drugs yet approved specifically to treat the H5N1 strain.

Peramivir is part of a class of antiviral agents that work by inhibiting viral neuraminidase (NA), an enzyme essential for the influenza virus to replicate and infect its hosts. NA also plays a role in the initial penetration of the mucosal lining of the respiratory tract. Relenza (zanamivir), an orally inhaled powder, and Tamiflu (oseltamivir), are the first of two registered neuraminidase inhibitors for the treatment and prophylaxis of influenza (B) currently available. There are currently 12 other patented, NA-inhibitors that are being investigated in other U.S. research labs.

Also helping the stock price of Biocryst was an article published in The NE Journal of Medicine that Tamiflu may not be completely effective in combating avian influenza. In other words, H5N1 Influenza Virus Resistant-strains to oseltamivir have been isolated. Ergo, peramivir is being received by investors to be the the next best thing for the flu since the invention of aloe-based tissues.

Experts are afraid H5N1 will mutate into a form that can be passed from human to human. Although data on the effectiveness of Tamiflu and Relenza on the H5N1 strain are scarce, stockpiling of the drugs has become part of worldwide preparations for a possible avian flu pandemic.

Investor giddiness over peramivir might be premature. Investors have embraced a premise that peramivir is more clinically and biologically effective than the two NA inhibitors on the market. There is no substitute for solid clinical results. To date, investors are jumping onboard because the drug has been shown to be safe, well tolerated, and effective in mouse influenza models! The world is not flat....and investors ought to be prepared for what lies beyond the horizon.

Penicillin and anti-microbial history have demonstrated that resistance is not limited to just one drug in a class. That is, peramivir works by the same mode-of-action as others in the NA-inhibitor class. If the bugs are biting back, it will only be a matter of time before H5N1 virus-resistant strains develop to peramivir, too. Since investors seem so readily to embrace pre-clinical data, they might want to note that, published data has discovered that mutant viruses--have already--displayed increased resistance to zanamivir, oseltamivir and peramivir, with certain viruses displaying cross-resistance to all three drugs.

Biocryst has no product in its pipeline further along than Phase II trials. To date, with no drugs on the market, Biocryst has financed its operations primarily from the sale of equity securities and, to a lesser extent, revenues from collaborations and interest. Given an expected monthly burn rate increasing to approximately $2.5 million, the 10Q Detective estimates that the Company has about 12-months before it will need to tap the equity markets again.

Biocryst's current valuation is approximately $531 million. Given the Company's limited history of discovery research, no developmental infrastructure to speak of, and an unknown advantage over a litany of other companies pursuing similar therapies, we do not find the current valuation compelling. One sneeze, and this stock could surprise investors with an ugly downside surprise.

Monday, January 09, 2006

Rocky Mountain Chocolate--Just How Mouth-Watering?

Rocky Mountain Chocolate Factory, Inc. (RMCF - $16.94), headquartered in Durango, Colorado, is a franchiser of gourmet chocolate and confection stores and a manufacturer of an extensive line of premium chocolates and other confectionery products. The Company and its franchisees currently operate 294 stores in 41 states, Canada, Guam and the United Arab Emirates.

On January 5, 2005, the Company reported record revenues and earnings for the third quarter and first nine months of FY '06. Revenues increased 12.7 percent to approximately $8.0 million, compared with $7.1 million in the third quarter of FY '05. Share-net increased 17.1% from $.41 for the nine months ended November 30, 2004, to $.48 for the nine months ended in the current year. Management attributes these gains primarily to growth in the average number of franchise stores in operation and favorable comparable-store sales at franchised retail outlets.

In the Company's press release, management did note that they did ship an order to a major warehouse club customer (Costco) that schedules a pre-Christmas promotion of Rocky Mountain candies each year. What they failed to mention, and it took the 10Q Detective to do some sleuthing to find out, was that Costco bought 39.6% more goods than last year--and that Costco is the largest single customer outside the Company’s system of franchised retail stores.

We do not find the confections of Rocky Mountain Chocolate so mouth-watering in light of this material dependence on one customer.

Friday, January 06, 2006

IBM--A Woolly Mammoth in Disguise?

International Business Machine (IBM - $84.95) officials said Thursday that in 2008 the company will freeze pension plans for American employees and offer only 401k retirement plans thereafter.

For the nine-months ended September 30, 2005, IBM incurred retirement plan expenses of approximately $454 million.

The Company's restructuring actions were designed to yield a more competitive employee-cost structure, and allow the company to more efficiently manage escalating labor costs, including retirement-related costs. IBM estimates the changes will result in savings of $450 million to $500 million for 2006, and savings of $2.5 billion to $3 billion for the period 2006 through 2010. As of September 30, 2005, it is duly noted that retirement and nonpension post-retirement benefit obligations stood at approximately 50% of shareholder equity.


Not to stand on a soapbox,,,BUT the 10Q Detective sees this as an unimaginative move by a technological woolly mammoth to re-define its 'quality of earnings.'

If IBM management is truly looking to cut costs, instead of erasing future workers' retirement benefits, perhaps IBM officials should stop spending on wasted capital projects--like $4 billion recently targeted for IBM stock repurchase plans. It has been debated before on the pages of The Wall Street Journal and BusinessWeek, etc., but we're in the camp that believes $4 billion might be better spent on R&D, where it actually might lead to product and job creation.

If IBM stock were such a good investment for corporate dollars, why is it that in the last six months, net insider selling totaled 466,569 shares. Not to single any one senior VP out, but how is this for a vote of confidence? On November 7, 2005, Form 144 filings show that Steven A. Mills made a cool $3.9 million profit by simultaneously exercising/selling granted stock options.

Looking at its recent 12-month price history,IBM stock is trading down 11.3 percent.

About 11,000 years ago, something happened and big mammals--like the sabre-tooth cat, the woolly rhino, and the woolly mammoth--went extinct. Cool climates that grew warmer; hunted to extinction by humans; or no immunity against new pathogens--all are viable theories that explain the demise of these mighty animals. The common thread running through all these arguments--a failure to adapt.

The Company's restructuring actions are stop-gap measures. Management must execute on delivering on its previously stated business model founded on innovation. Simultaneously, unless IBM can adapt to shorter technological product cycles, we doubt that the Company will deliver on promised double-digit earnings per share growth.


Readers might want to avoid the shares of this woolly mammoth.

Thursday, January 05, 2006

Strata Oil & Gas--La Brea Tar Pits?

The 10Q Detective received this 'confidential' letter delivered to our Post Office Box yesterday from the desk of Ian Chambers:

  • A Massive Price Spike is Imminent...Buy Strata Oil & Gas, Inc. (SOIGF.OB - $2.22) now to lock in ten-bagger profits.
  • Behind closed doors, MASSIVE blocks of oil-rich properties are being turned over to select companies like Strata , who are picking them up for peanuts and turning them into MULTI-BILLION dollar oil projects.
  • Imagine my excitement when I discovered that Strata is quietly putting together a serious oil sands portfolio in [Northern Alberta] an area teaming with multi-billion dollar oil projects.
  • Strata is sitting on a vast underground lake of oil...estimated to contain 94 BILLION barrels of oil....that translates into a gross value of up to $4.7 TRILLION.
  • This stock could easily blast through $25 per share.

--Ian Chambers, Editor, OUTSTANDING PROFITS

Strata Oil & Gas is a company founded on shaky ground. The Company, formerly known as Stratabase, previously generated revenues by selling databases of sales leads and mailing lists, and providing technical services aimed to customize and improve the quality of the databases sold. Stratabase had an open source software that was designed to allow users to interface with and manage these databases, and customer relationships. It was the expectation of management that by giving the software away for free and making it open source, a demand could be created for the Company's database and technical services.

Unfortunately--for shareholders--this business plan did not work. Therefore, the decision was made by management to alter Stratabase's business model to focus on proprietary software. In 2004, the Company began charging a monthly fee for use of its software. Simultaneously, management sought to develop CRM Software, which was designed to enable corporations to save time and money by improving the efficiency of its workers. Sifting through Stratabase's June 30, 2004, SEC filing, however, revealed that this proprietary software, called "Relata," was released in beta form in June 2003, but never got past the testing phase! Interesting--in the first six-months of 2004, the Company generated ZERO dollars in revenue, yet had general & administrative expenses of $266,627. As Stratabase did not have an active sales staff to sell its database services (!!!), this means that G&A expenses consisted primarily of depreciation and amortization of databases and domain names, and salaries paid to the eight company employees.

Courtesy of Stocklemon.com, the 10Q Detective has also uncovered that Trevor Newton, CEO, CFO, Secretary, and Treasurer [NO KIDDING!] and Fred Coombes, Director of Business Development, were both former stock promoters. Epilogue: On August 19, and August 23, 2005 respectively, Trevor Newton and Fred Coombes resigned from each of their respective positions as directors and officers of the Company. [ed. note. sorry, at press time we were unable to determine how many--if any--Strata Oil shares these two guys might still own]

And this brings us to the present. In 2005, the company underwent further changes, acquiring four wells drilled on land for gas exploration. The property is in the Wabasca oil sands in Northern Alberta. That year, Strata Oil & Gas underwent a major management reorganization as well.

The editor of Outstanding Profits, Ian Chambers, touts that Strata is on its way to being a $25 stock. If that were so, why did insiders file, in September and October 2005, to sell approximately $2.0 million worth of company shares? Did the 10Q Detective fail to mention, too, that Tucker Banks Publishing, the owner of Outstanding Profits, was paid the sum of $210,000 to enhance investor awareness of Strata Oil & Gas!

Albeit we admit to not being qualified geologists, in the opinion of the 10Q Detective, Strata Oil & Gas owns the equivalent of sticky sand. This small-cap company is focused on the exploration and development of heavy oil / oil sands in Western Canada: (i) Oil sands are substantially heavier than other crude oils, are very viscous and do not flow easily, and (ii) no economic criteria has been applied to the analysis of drillings and the company has not determined how much if any of the resource may be recoverable with existing technology.

Do not be like a dinosaur and get stuck in this La Brea Tar Pit of a stock.

Wednesday, January 04, 2006

Rent-A-Way: Rent-to-Own?

Rent-A-Way, Inc. (RWY - $6.40) is one of the nation's largest operators of rental-purchase stores, renting quality name brand merchandise from 792 stores in 34 states. For the fiscal year ended September 30, 2005, payments under rental-purchase contracts for home entertainment products, furniture, personal computers, and major appliances accounted for approximately 34.9%, 29.5%, 17.1%, and 16.1% of the Company’s rental revenues, respectively. The Company also provides prepaid local phone service to consumers on a monthly basis through dPi Teleconnect, LLC., its 83.5%-owned subsidiary.

For fiscal 2005, the Company reported consolidated revenues of $515.9 million, up 2.2% from the prior year. Same store sales increased 2.1 percent. Net income was $8.3 million, or $0.27 per diluted share, versus $7.3 million, or diluted share-net of $0.25, in fiscal 2004.

The rental-purchase business offers an alternative to traditional retail installment sales and generally serves customers that have annual household incomes ranging from $20,000 to $40,000. The Association of Progressive Rental Organizations (APRO),the industry’s trade association, estimated that at the end of 2004 the industry comprised approximately 8,300 stores providing 6.9 million products to 2.7 million households. Despite significant fluctuations in the U.S. economy, the APRO estimates that from 1996 to 2004, revenues generated by the industry have consistently increased, with no year in the period reflecting growth less than 3.3 percent.

Rising loan-rates and higher gas prices, coupled with the impact of Hurricanes Katrina and Rita, have dampened investors' enthusiasm for Rent-Way. The stock price of Rent-Way is trending well-below its 200-day MA of $7.75, and is off 36.7% from its June 2005 high of $10.11 per share.

The 10Q Detective has reviewed management's strategies for pursuing growth and greater profitability in FY '06, and we are suspect that operating metrics will improve materially to drive Rent-Way's common stock higher in price.

The Company believes that nominal increases in prices on certain items are feasible and will enhance profitability. Customers may rent either new merchandise or previously rented merchandise. As of September 30, 2005, weekly rentals currently range from $7.99 to $49.99 for home entertainment equipment, from $6.99 to $41.99 for furniture, from $14.99 to $44.99 for personal computers, and from $9.99 to $31.99 for major appliances. Comparative same-store sales is an important growth metric. Despite increasing rental rates on certain products, same-store sales rose only 2.1% year-over-year, attributable to a decrease of 35,000 rental agreements. Perhaps management has under-estimated the pricing sensitivity of its customers. The cost of entering the rental-purchase business is relatively low; and, Rent-A-Center (RCII), Rent-Way's largest industry competitor, is national in scope and has significantly greater financial resources and name recognition than Rent-Way.

Management is planning to open new stores and to operate them profitably. The 10Q Detective doubts that the Company will smoothly execute on this growth strategy. Operating income of the household rental segment is a key metric that management uses to monitor how revenue growth and cost control measures impact profitability. Operating income of the household rental segment was 8.3% of total revenue for FY '05 versus 9.0% of total revenues last fiscal year. This decrease was attributable to the costs associated with the opening of 46 new stores. New stores generally operate at a loss for approximately eight months after opening.


Rent-Way is actively pursuing acquisitions to leverage existing infrastructure. For example, the Company is seeking out strategic acquisitions that fit within its existing geography to simultaneously enhance revenues and maximize profitability. The problem is that Rent-Way is weighed down in debt. Rent-Way has already incurred substantial debt to finance existing growth and has pledged substantially all assets as collateral for this debt. Total debt is 111.7% of shareholder equity, and the Company's times-interest-earned ratio of 1.42x shows that the Company must dedicate a substantial portion of its cash flow from operations to the payment of existing interest on debt. Given existing loan covenants, the Company’s ability to obtain additional financing is limited,too.

Management has said that customer traffic is rebounding, and that 2006 full year rental revenues will increase by 3-4% over 2005. Nonetheless, we would not rush out to buy these shares. SEC filings indicate that Rent-Way has pledged substantially all of its assets as collateral on existing debt. So much for "hidden" value. This is one stock that we would definitely not rent-to-own!