Tuesday, July 31, 2007

Can Traffix Avoid ValueClick's Earnings and FTC Pile-Up?

Traffix, Inc. (TRFX-$5.73) is an interactive media company that owns and operates a variety of websites with a broad range of content. The websites feature content ranging from music for downloads to sweepstakes. Virtually all of its websites generate revenue from client advertisements.

In addition, Traffix builds end-to-end online marketing solutions for clients who seek to generate new customer contacts and increase user transactions and sales. Its full solution marketing services group delivers media, analytics and results to third parties through its four business groups:

  1. Hot Rocket Marketing is an online direct-response media firm servicing advertisers, publishers and agencies by leveraging vast online inventory across sites, networks, search engines and email to drive users to client web properties, generating qualified leads, registrations and sales. The marketing strategy integrates affiliate-marketing networks with [controversial] promotion-based lead generation programs;
  2. mxFocus develops and distributes content and services for mobile phones and devices and provides interactive mobile media solutions for advertisers, marketers and content providers;
  3. SendTraffic is a performance focused, search engine marketing firm focused on building online presence, optimizing marketing expenditures and retaining customers by leveraging proprietary solutions, such as search engine optimization and website analytics; and,
  4. Traffix Performance Marketing offers marketers brand and performance based distribution solutions though the Traffix network of entertaining web destinations, via its proprietary ad-serving optimization technology.

Traffix generates and records revenue primarily on a performance-based model, whereby revenue is recognized upon the successful delivery of a qualifying lead, customer, survey, completed application, ultimate sale or the delivery of some other measurable marketing benefit as defined in the client’s underlying marketing agreement.

Second Quarter Highlights

On July 16, Traffix
reported net income for the second-quarter ended May 31, 2007, of $765,000, or $0.05 per share, compared to net income of $637,000, or $0.04 per share, in the comparable quarter of 2006.

Net Revenue for the quarter was $19.8 million, representing an increase of $0.8 million, when compared to net revenue of $19.0 million for the second quarter of fiscal 2006. The 4.4% increase in sales was driven principally by Search Engine Marketing services ($2.6 million, or 61%), offset by a nominal decline in Online Advertising ($0.51 million, or 4.0%).

Search Engine Marketing service revenue increased as a result of an increased focus on the identification of new third party clients and the enhancement of existing Search client relationships. We view the decline in online advertising as transient, for management continues its focus on generating revenue via Websites for new wireless client relationships (offset—in the short-run--by anticipated declines in other historically traditional clientele).

Gross Profit as a percentage of net revenue fell 590 basis points to 31.5% during the three months ended May 31, 2007, primarily attributable to a decrease in the gross profit margin of the Online Advertising component, which due to its higher relative revenue contribution (58.2% of net sales) yields a higher proportionate impact on the total relative decline.

The 10Q Detective is cognizant that net income was boosted by an increase in consolidated Other Non-operating Income of approximately $305,000 for the three months ended May 31, 2007, up from approximately $140,000 for the three months ended May 31, 2006.

The factors contributing to the increase were (i) a 16% increase in interest income of approximately $40,000,the result of more favorable rates available during Fiscal 2007; (ii) a $17,500 in realized gains on the sale of marketable securities.

Liquidity & Capital Resources

As of May 31, 2007, the Company had aggregate working capital of $30.5 million, compared to aggregate working capital of $31.7 million as of November 30, 2006.

Free Cash Flow provided by operating activities was approximately $1.9 million for the six months ended May 31, 2007.

Future plans and business strategy continue to call for Internet-based Online Advertising and Media Service activities to be the sole operating focus—as it was for the three and six-month periods ended May 31, 2007. Cash demands for capital expenditures and equipment lease obligations declined to $239,990 during the six months ended May 31, 2007, compared to $257,749 during the six months ended May 31, 2006. The significant portion of such capital expenditure was for email servers that substantially reduced Traffix’s reliance on and related additional costs associated with third party email delivery suppliers.

We observed that days-sales-outstanding ("DSO") in accounts receivable at May 31, 2007 improved: at 42 days, compared to 44 days at February 28, 2007, 45 days at November 30, 2006, and 56 days at August 31, 2006. The two day, or 4.5% decrease in the current quarter’s DSO compared to the first quarter of this fiscal year was due to continued efforts in monitoring clients and improving rates of collection across all of client relationships.

Investment Risks & Considerations

The income tax provision for the three months ended May 31, 2007, was approximately $643,000, or 45.7%, that differed immaterially from Traffix’s annual effective rate of 46.2% recognized during the year ended November 30, 2006.

Under its current tax structure, the Company’s Canadian subsidiary’s foreign earnings are fully taxed in Canada, and as such, based on the lack of any foreign source income, a foreign tax credit is not available to Traffix on the related foreign taxes. Ergo, with such taxes being fully included in the US tax provision; the result was inordinately high tax rates. Management is formulating tax planning that should be in place for the 2H:07, whereby the future effective tax rate should decline in the range from approximately 36% to 39 percent.

The Company’s Success Depends On Its Ability To Continue Forming Relationships With Other Internet And Interactive Media Content, Service And Product Providers. Today’s online lead-generation space is a crowded and highly competitive industry. The Company is modifying its business methods and practices, including diversification of its revenue drivers, in an effort to diversify its customer base. However, as in prior fiscal periods, a significant portion of the Company’s revenue is still dependent on a limited number of major customers. Albeit no single customer exceed 10% of the Company’s consolidated net revenue, Traffix’s five largest customers during the six months ended May 31, 2007 accounted for 8.3%, 8.1%, 8.1%, 6.1% and 4.3% of consolidated net revenues during this period.

Demand For Traffix’s Services May Decline Due To The Proliferation Of "Spam" And Software Designed To Prevent Its Delivery.

On May 18, 2007, online advertising competitor ValueClick, Inc. (VLCK-$21.01)
received a letter from the Federal Trade Commission ("FTC") stating that the FTC was conducting an inquiry to determine whether the Company's lead generation activities violated either the Federal Trade Commission Act or the CAN-SPAM Act. Specifically, the FTC is investigating certain ValueClick websites, which promised consumers a free gift of substantial value, and the manner in which the Company drives traffic to such websites, in particular through email.

ValueClick defines the use of ValueClick websites that promise consumers a free gift as "promotion-based" lead generation.

During the six months ended May 31, 2007, Traffix recognized a decline in its email marketing revenue of approximately 55% when compared to the six months ended May 31, 2006. In our view, the potential for state and/or federal legislation to further limit the Company’s ability to contact consumers online is already discounted in its share-price.

Buy Thesis

The Internet operating landscape is changing. Numerous studies show that it is easier and as much as six times less expensive to sell to an existing customer than to acquire a new one. Consequently, the demand for lead generation and customer value management and retention demands more complex customer intelligence processing—entailing
a 360-degree view of the customer.

Management previously said that future plans and business strategy called for Internet-based Online Advertising and Media Service activities to be Traffix’s sole operating focus; however, we believe that the product-mix should be inclusive of the Internet Game Development subsidiary, too—given gross profits of 69 percent!

Traffix rewards its shareholders with a 5.6% dividend yield to patiently hold the stock while management works to re-define its growth strategy and execute on growing its bottom-line. The catalysts for a sustained upward swing in share valuation will come once management demonstrates its ability to execute on prior promises: sustainable online advertising sales combined with sequential profits generated by the build-out of Traffix’s proprietary search optimization platform.

The valuation is compelling—despite the heretofore risks. Market capitalization, Price/sales, Book Value/share, and debt of $86.20 million, 1.15 times, $3.08, and nil, respectively.

Editor David J Phillips holds a financial interest in shares of Traffix, Inc. The 10Q Detective has a Full Disclosure Policy.

Friday, July 27, 2007

Blood Pressure Rises for Flamel Tech. Stockholders, Coreg CR 2Q Sales Slow

Shares in Flamel Technologies (FLML-$19.05) slipped 5.1% yesterday, following word that Glaxo (GSK) sold only $20 million in Coreg CR in its second quarter.

In its 2Q earnings conference call, GSK said sales momentum was lost for Coreg CR when its sales forces, which are the same ones that are responsible for detailing the diabetes treatment, Avandia, had their attention turned in June to defending the Avandia franchise, following
worries about alleged increases in the risk of heart attacks.

The Company now has made adjustments in its field force coverage, and has about 2,000 reps with Coreg CR in a first position, which should give it the promotional visibility it will need as Coreg IR moves closer to the anticipated launch of the first generic carvedilol (expected in September – October 2007).

The renewed sales initiative seems to be paying dividends: (i) key commercial insurance plans have now moved Coreg CR into a tier 2 coverage; (ii) based on the most recent retail prescription data, Coreg CR now represents about 21% of new prescriptions for the total Coreg franchise, up from 11.5% for the week-ended June 22, 2007; and GSK market research indicates that more than 90% of cardiologists have prescribed Coreg CR and expect to increase their future use.

The first patent for Coreg currently expires in September 2007. Albeit carvedilol is facing imminent generic intrusion, the 10Q Detective believes the franchise still has room for life-cycle management, such as the dosing convenience of switching Coreg to Coreg CR.

Bears may conclude that the Coreg CR numbers miss suggests a repudiation of the commercial appeal of Flamel’s drug-delivery potential. We beg to differ, for strengthening Rx trends and managed-healthcare wins should set the stage for a stronger third quarter.

In addition,
the long-term buy thesis for Flamel remains intact, including the Company’s visibility as a potential acquisition by big pharma.

The risk to our bullish argument is that the replacement power of Flamel’s pipeline, should Coreg CR come up short, is still several years away from commercial viability.

Editor David J. Phillips holds a long position in Flamel Technologies. The 10Q Detective has a Full Disclosure Policy.

Wednesday, July 25, 2007

Transcend Services: Does Price Decline Portend Unpleasant Earnings Guidance?

Shares in Transcend Services (TRCR-$17.20) stumbled in trading on Monday and Tuesday, falling $7.43, or 31.4% in price, on more than 2.5 times average daily volume (three-month) of 170,158.

Asked to comment on the volatility in the stock trading, Lance Cornell, Chief Financial Officer of the Atlanta-based provider of transcription and editing services, said: “we are not aware of any particular rumors, leaks, or news—local or national—that would have been driving it, or any information on particular sellers that would have been causing it—the price decline—over the last few days…. I know that’s not much, but I hope that this helps.”

The Company will release second quarter earnings before the market opens on Thursday, July 26, 2007. Stockholders will know soon enough if anybody traded on material non-public information.

Tuesday, July 24, 2007

Mentor's Compensation Committee Treats Shareholders Like 'Boobs.'

Nary a whisper of complaint would probably be heard from testosterone- infused males or Hollywood starlets (looking “to leave an impression” on some producers) about breast implant maker Mentor Corp.’s (MNT-$41.00) executive pay practices.
The average woman would rather have beauty than brains, because the average man can see better than he can think. ~Author Unknown

CEO Joshua H. Levine earned an impressive $4.1 million in fiscal 2007 ended March 31, 2007, consisting of salary, cash bonuses, and stock and option awards of $500,000, $950,000, and $2.6 million, respectively.

Aesthetics of breast augmentation aside, the compensation package awarded to Levine illustrates—once again—two problems with executive pay practices: (i) linking pay to performance is often undermined when Boards set benchmarks that are too subjective and weaken the link between CEO pay and corporate performance; (ii) an imbalance still exists between company stock performance and CEO pay.

For fiscal year 2007, the Compensation Committee at Mentor adopted a performance-based annual incentive bonus plan (“AIB”), which provided the Committee with the flexibility to design a cash-based incentive compensation program to motivate and reward performance for the year for its executive officers.

The benchmark used to determine minimum, target and maximum levels was founded upon Mentor’s achievement of specified results with respect to corporate operating income, or COI, for that fiscal year. The 10Q Detective noted, however that the Committee was granted the oversight “to modify” those bonus target levels:

In making the determination of minimum, target and maximum levels, the Committee retains wide discretion to interpret the terms of the AIB plan and to interpret and determine whether COI objectives or an individual’s performance objectives have been met in any particular fiscal year. The Committee also retains the right to exclude extraordinary charges or other special circumstances in determining whether our COI objectives were met during any particular fiscal year.

In addition, the target level with respect to COI has been based on confidential internal performance goals. In other words, the Committee does not have to clarify what they consider best practices to outside shareholders!

Fiscal 2007 was a notable roller coaster of a ride for common stockholders. , Following the November 17, 2006, announcement that the FDA approved for sale the Company’s
MemoryGel silicone gel-filled breast implants, the share price peaked on November 21, at an intra-day high of $53.95, up almost 23% year-to-date. This news was material, for implants account for 87% of product sales.

On April 20, 2007, however, shares fell 17% to $40 per share on word from the medical products company that it
would report lower-than expected fiscal year 2007 and 2008 sales and operating income.

In fiscal 2007, net sales increased 13% to $302.0 million from $268.3 million in the prior year. Net sales of breast implant products for plastic and reconstructive surgery increased 13% to $262.6 million from $233.2 million in the prior year. However, the Company saw (only) overall growth in unit sales of breast implant products of approximately 6 percent.

Corporate operating income for the 12-months ended March 31, 2007, fell 5% to $65.6 million, due to higher SG&A, R&D, and asset impairment and restructuring charges.

Nonetheless, the Board saw fit to pay CEO Levine a cash performance bonus of $500,000—or 100% of target levels attainable in fiscal 2007. Again, as COI target bonuses were based on confidential internal performance goals—and not reported operating income—the Board had free reign to unlink pay to performance!

The Board may also approve cash bonuses outside of the AIB plan. For example, the Committee may approve bonus awards in connection with an executive officer’s efforts and accomplishments with respect “to strategic initiatives and milestones, and such bonus awards may overlap with or be in addition to bonus awards under the AIB plan.”

In fiscal year 2007, the Committee approved two special cash bonus awards to Mr. Levine in the aggregate of $450,000: a payment of $200,000 to compensate him “for his contributions to the sale of a urology division” and $250,000 for “his leadership in multi-year efforts to obtain FDA approval of the silicone gel-filled breast implants.”

Are we missing something—or do not the foregoing fall under expected JOB DESCRIPTION?

The Board rewards Named Executive Officers with annual grants of stock options, shares of restricted stock, and Performance Stock Units (PSUs), the size of which took into consideration a number of performance metrics with respect to annual rewards, including cash flow, revenue and share-net. The objective was to align employee interests with those of other stockholders.

In fiscal 2007, cash flow from operations fell 30% to $68.9 million (from the prior year) and % Return on Assets and % Return on Equity fell 10 basis points and 670 basis points to 9.2% and 17.4%, respectively.

Irrespective of these non-performing metrics, the Board still saw fit to reward Mr. Levine with $1.93 million and $702,318 in stock grants and stock options, respectively.

Investors initially bid up the share price of Mentor on expectations that the Company’s ability to sell (higher-margin) silicone-gel implants in the U.S. for women who wanted breast augmentation would yield healthy revenue and share-net gains for Mentor. As that promise proved premature, the stock fell.

Despite the hasty retreat in market valuation, CEO Levine is still sitting in the catbird seat. At fiscal year-end March 31, 2007, he held exercisable options for 171,250 shares at exercise prices ranging from $19.01 to $37.70 per share. In addition, in fiscal 2007, Mr. Levine exercised 100,000 shares with an unrealized gain of $3.32 million (not reported in 2007 compensation).

In its 2007 Proxy Statement, the Board reiterated that the ultimate objective of its compensation program was to improve shareholder value. In the last year, the stock lost $515.0 million in value, and currently has a market capitalization of $1.63 billion. Looks like the Board failed at that objective, too.

The 10Q Detective believes that Mentor (which formerly sold penile implants!) has an attractive, aesthetic implant business model, especially if it can execute on selling more of the silicone implants. The silicone-gel implants, which supposedly feel more like natural tissue, sell for about $600 (twice as much as the saline-filled aesthetic devices). Unfortunately, management has yet to demonstrate its ability to reign in costs and sell in a competitive market.

Editor David J. Phillips does not hold a financial interest in Mentor Corp. The 10Q Detective has a Full Disclosure Policy.

Friday, July 20, 2007

Can Flamel Technologies Deliver?

Flamel Technologies S.A. (FLML-$21.72) is a drug delivery company with expertise in polymer chemistry. In our view, recent price weakness is temporary, and affords investors an inflective buying point.

Industry Overview

Against a background of soaring R&D costs, the onslaught of patent expiries, and increasing consumer—and FDA—demand for improved medications, pharmaceutical companies are relying more heavily on novel ‘Lifecycle Management’ strategies—including Over-the-counter (OTC) switching, combination products, patent litigation, or
advanced drug delivery technologies, to help sustain and extend products' profitable commercial value.

Once the proprietary product patent expires, generic erosion is inevitable, for generic manufacturers usually price their products at a discount to the brand, which encourages switching from the branded product to the cheaper generic.

Once patent protection and periods of marketing exclusivity expire for a branded drug, the price typically plunges about 40 percent during the first six months, followed by another 40% to 50 percent plunge after more authorized generic(s) join the competition. And, a branded product can expect to concede 70% of its market share to generics in a mere four-to-eight weeks.

Prozac, an antidepressant drug with strong product recognition, lost its patent in August 2001. Generics stole 73% of the drug's new prescription volume (Rx) within two weeks, and two years later, Eli Lilly lost more that $ 2.0 billion in annual sales, making just $182 million in U.S. sales of Prozac, less than a third of its generic equivalent, fluoxetine.

Trying to match the price of the generic often is a failed strategy, too. When Merck’s $4.4 billion cholesterol drug Zocor’s patent expired in June 2006, the company sold the pill below the price of the first generic. Nevertheless, data from health care informatics provider Verispan showed a 70 percent reduction in Zocor’s sales in the first full month of generic competition.

Research from Datamonitor, a leading provider of data, analytic and forecasting platforms for key manufacturing sectors, shows the speed and impact of brand erosion can fluctuate, depending on factors such as country-specific prescription, pricing and reimbursement (P&R) regulations, product formulation (e.g., if a product has a short half-life and needs to be administered two or more times daily, reformulating this as an extended-release product will improves odds against generic erosion), success of the targeted brand (e.g., highly prescribed and administered on a chronic basis), and the implementation of lifecycle management (LCM) strategies.

Drugs worth nearly $140 billion in sales are
coming off patent coming off patent by 2016. And, the percentage of prescriptions that are generic is expected to increase to 75% in 2011 from 56% now.

Manufacturers need to develop novel drugs in order to maintain franchise and portfolio revenues in the face of generic intrusion.

Nevertheless, according to a Reuters Business Insights report (2005), Generic Defense Strategies, a high percentage of reformulations fail, due to poor timing, inadequate promotional support, lack of competitive differentiation, or no clinical advantages (such as better efficacy or improved compliance).

This abbreviated assessment of current and future opportunities and threats facing branded drugs should translate into a commercial bonanza for drug delivery companies offering proprietary technology platforms that complement drug makers own internal research activities aimed at stifling generic competition and extending branded life-cycles.

Technologies & Products

Flamel’s drug delivery platforms,
Medusa for therapeutic proteins and peptides, and Micropump for small molecules, have been developed “to improve the therapeutic characteristics, safety profile and ease of use of wide variety of drugs,” (and extend the drugs’ life-spans beyond patent expiry of the active substances).

The design of the Micropump microparticles allows an extended transit time in the small intestine with a plasma mean residence time extended up to 24 hours, which is especially suitable for short-lived drugs known to be absorbed only in the small intestine. The current research pipeline includes the extension of the release of four small molecule drugs, known to be only absorbed in the upper part of the small intestine:
  • Proton pump inhibitors for the treatment of gastroesophageal conditions, including heartburn and other symptoms of gastroesophageal reflux disease (GERD);
  • Genvir, long-acting acyclovir for the treatment of Acute Genital Herpes (positive results in Phase III);
  • Metformin XL, an anti-diabetic for the treatment of type II diabetes (positive results in Phase I);
  • An undisclosed ACE inhibitor co-developed with Servier Monde (confidential); and,
  • Augmentin SR, an antibiotic (confidential).

The 10Q Detective believes the current share price also discounts the commercial viability of the Medusa delivery platform, a versatile nanotechnology that can accommodate the physico-chemical specifications and the delivery therapeutic-requirements of a wide variety of protein drugs. Medusa nano-carrier is also suitable for the efficient delivery of insoluble (i.e., hydrophobic) small molecule drugs and could be applied to peptides.

Using its Medusa nanoparticles, Flamel is developing second-generation formulations of native protein drugs with better performance (i.e. long time of action, high bioavailability and efficacy, reduced side effects and improved compliance) compared with first-generation proteins. The reduced side-effect profile should allow for increased dosage of some proteins, thus extending their efficacy and potential applications.

Flamel's most advanced products are Basulin, a second-generation formulation of long-acting native insulin—however, in September 2004, Bristol-Myers pulled out of its partnership for this drug; IFN alpha-2b XL is a long-acting native interferon alpha-2b for the treatment of Hepatitis B and C and some cancers; and IL-2 XL, a second-generation long-acting interleukin-2.

Business Strategy

The Company’s business model is to leverage its proprietary technology platforms through
partnership agreements. Flamel applies this strategy to its own drug candidates as well as to the re-formulation of already marketed drugs and the development of new chemical entities with partner companies.

Recent Developments

The share price of Flamel is trading near an eight-month low, on investors’ worries that the Company’s near-term fortunes remain too dependent on the ultimate scale and market acceptance of GlaxoSmithKline’s (GSK-$52.97)
COREG CR, launched on March 22nd.

For the first quarter of 2007, Flamel reported total revenues of $9.6 million, with COREG CR sales accounting for 67 percent: $5.4 million in microparticle shipments to GSK and $1.0 million in GSK milestone payments.

GSK chose to defend its $1.4 billion COREG (carvedilol) franchise by partnering with Flamel. COREG CR utilizes Flamel's proprietary Micropump technology, which controls the delivery of carvedilol helping to maintain appropriate amounts of medicine in the body over a 24-hour span. This technology allows COREG CR to be dosed once daily, in contrast to immediate-release COREG tablets, which patients must take twice daily.

Buy Thesis

In our view, the controlled-release formulation will be a success, for the once-daily formulation of COREG CR offers key advantages to patients. According to Stephen H. Willard, Flamel's Chief Executive Officer, “Physicians understand that once-daily medications lead to greater patient compliance; non-compliance is one of the leading causes of hospitalization in heart failure patients. COREG CR delivers substantially the same peak and trough levels of carvedilol as the twice-a-day drug, but with a smoother release profile. Moreover, COREG CR has been observed to result in 24% fewer adverse events than immediate release Coreg in a crossover study conducted in hypertension.

COREG CR is approved to treat the same conditions as twice-a-day COREG, which has established a significant role in the treatment of heart disease (the only beta-blocker agent approved by the FDA to improve survival in mild-to-severe heart failure).

Moreover, the growth driver behind twice-a-day COREG was its CHF labeling. The reformulation of COREG opens new marketing opportunities, including patients with high-blood pressure or post-MI patients where beta-blocker therapy is appropriate.

Another catalyst for growth is combination therapy. For example, clinical trials are being conducted to examine the benefits of combining COREG CR with lisinopril, an ACE Inhibitor, for the treatment of hypertension.

Determining COREG CR’s intrinsic potential for share retention—and (other approved labeling) growth—is critical to Flamel’s share valuation.

Referencing the foregoing growth drivers, we believe that the Company can easily hit the consensus 2008 share-net target of $1.40.

A short ratio of 13.9 days and a forward 12-month P/E of 15.5 times, in our view, justify the current price as a good inflection point for growth-oriented investors.

The loss of patent protection for key products is increasingly significant in assessing the future performance of major pharmaceutical companies, including GSK.
In our opinion, the successful identification and exploitation of the opportunities afforded by patent expirations provides a major growth driver for drug delivery companies, such as Flamel, who focus their business on extending the life cycle of branded products.

Given an enterprise value of only $471.8 million, the commercial success of COREG CR might make Flamel an attractive acquisition for big pharma and/or biotech companies facing the loss of blockbuster drugs in coming years. Three logical buyers would be (1) GSK (shingles & genital herpes medicines, Augmentin, and COREG CR); (2) AstraZeneca (first patent for Nexium expires March 1, 2008); and, (3) Bristol-Myers Squibb (diabetes franchise).

Investment Risks and Considerations

Flamel remains highly dependent on the commercial success of COREG CR. The Company has no new products coming through its pipeline over the next few years. If sales of COREG CR are not successful or delayed, it would have a material impact on revenue, results of operations, and financial condition. Conversely, we believe the successful launch of COREG CR will validate the Micropump drug delivery platform.

Despite trailing-twelve-month operating cash flow of $(26.89) million, finances remain healthy, with total debt/equity under 5 percent and a current ratio of 3.45 times.

Since May 2007, technical indicators for Flamel have been in a weak downward trend, with the share price breaking below resistance of $23.91 and the 50 day moving average of $23.64.

Editor David J. Phillips is long Flamel Technologies. The 10Q Detective has a Full Disclosure Policy.

Tuesday, July 17, 2007

USANA Announces Record Q2 Sales and EPS, Buries News of Auditors Departure

USANA Health Sciences, Inc. (USNA-$50.10), which makes nutritional and personal care products, on Monday issued preliminary second-quarter results above previous guidance and current Wall Street predictions.

"We are pleased to give investors a preview of our strong financial results in advance of tomorrow's earnings announcement," said Gilbert A. Fuller, the Company's executive vice president and chief financial officer. "We believe these sales and earnings results demonstrate the fundamental strength of our business and are the direct result of the hard work and commitment of our Associates to our high quality products.”

USANA said it expects to post a quarterly profit of 66 cents per share on $109.4 million in revenue. The company previously predicted a profit of 63 cents to 65 cents per share on $103 million to $105 million in revenue.

Analysts polled by Thomson Financial expected a profit of 63 cents per share on $104.2 million in revenue.

Oh—the Company announced, too, the departure of Grant Thornton LLP (GT) as the Company's independent registered public accounting firm.

Even though GT resigned on July 10, 2007, management did not file a
Form 8-K with the SEC until after the close of trading on July 16. As if to minimize any material implications hereof, USANA noted that there “were no disagreements between the Company and Grant Thornton on any accounting principles or practices.”

“Fraud and falsehood only dread examination. Truth invites it.” Samuel Johnson (English writer, 1709 -1784)

The last audited report of Grant Thornton for the Company was for the fiscal year ended December 30, 2006. No certifying accountant means that investors need to “rely on management’s representations” for the financial statements of the first quarter and second quarter ended March 31 and June 30, 2007, respectively.

In its filing, management was quick to note “GT has not advised the Company that information has come to its attention that it has concluded materially impacts the fairness or reliability of either: (i) a previously issued audit report or the underlying financial statements, or (ii) the financial statements issued or to be issued covering the fiscal periods subsequent to the last audited financial statements.”

Given recent controversies circling the Company--including a just filed lawsuit by independent distributors accusing the Company of fraud and deception,
credibility issues about its network marketing business model, and a series of flaps involving the credentials of top executives and sales associates—maybe Grant Thornton had the prescience to quietly slip away.

“Better slip with foot than tongue.” Benjamin Franklin (American Statesman, 1706 – 1790)

The price of USANA climbed $1.22 per share, or 2.44% in after hours trading, partly driven by short interest of 106.50% relative to its public float.

USANA Health Sciences


Aug-07 PUTS

Profit: $5,043.86

Editor David J. Phillips is long put options in USANA Health Sciences, Inc. The 10Q Detective has a Full Disclosure Policy.

Thursday, July 12, 2007

CEO Edward Zander's Bye-Bye Handshake with Motorola Is Worth $30 Million

Searching leading public prediction market platforms, the 10Q Detective could not find any trading exchanges willing to offer contract odds on the departure/resignation (forced or voluntary) for one Edward J. Zander, the embattled CEO of Motorola, Inc. (MOT-$17.95).

We doubt that there is any odds-maker out there who would offer less than 1:5 that Zander will last out the summer. Yesterday, the struggling cell-phone maker warned investors of a second-quarter loss and said it no longer expected its mobile phone business to be profitable this year, blaming weak sales in Asia and Europe.

Despite what Carl Icahn and long-suffering shareholders might wish to the contrary, a review of the
employment agreement between Motorola and Zander suggests the CEO is going to depart from the Company a wealthy man.

In his contract—short of any malfeasance, dishonesty or fraud—it is near impossible to terminate Zander ‘for cause.’ How can he be fired for insufficient performance—when it is written in his agreement that in “no event will his annual target bonus be less than 135% of his annual base salary”?

To rub salt in the wound: “the Company [paid] directly to the Executive [Zander] all reasonable legal fees and expenses reasonably incurred by the Executive in connection with the negotiation and preparation of [his] Agreement, subject to a maximum of $50,000.”

Mr. Zander’s reward for driving Motorola down an embankment? The
2007 Annual Proxy filed in March reveals that Mr. Zander is entitled to severance, stock options (unvested and accelerated), Restricted Stock Units (unvested and accelerated), health and welfare benefits of $7.05 million, $11.89 million, $10.83 million, and $40,652, respectively. Add in the $178,630 (present value) of accumulated pension benefits, and Messer. Zander will walk away with about $30 million!

"Ask not what your country can do for you - ask what you can do for your country." ~ John F. Kennedy

His resignation a certainty, an indeterminate future still to be decided—who will pay for Zander’s MOTORAZR phone plan?

Editor David J. Phillips does not hold a financial interest in Motorola. The 10Q Detective has a Full Disclosure Policy.

Tuesday, July 10, 2007

Transcribing Profits with Transcend Services

Transcend Services (TRCR-$23.00) provides medical transcription services to the health care industry. After trading in a sideways pattern between $2.00 and $2.50 per share for most of 2006, the stock price exploded in October and has entered a strong uptrend. Driven by a turnaround in profitability and momentum traders scrambling onboard this thinly-traded stock—insiders beneficially own 32% of the outstanding stock—Transcend has gained more than 1,000 percent in the past ten months!

Industry Overview

The market for
medical transcription services is sizable. The total annual market potential for outsourced medical transcription services is estimated to be approximately $6 billion. While competition is significant, with perhaps 1,500 transcription services companies nationally, and few barriers to entry, Transcend is one of only a handful of companies that operate on a single, Internet-based technology.

HIPAA compliance has saddled healthcare providers with increasingly complex documentation requirements, resulting in an increase in the need for dictation and transcription of medical encounters.

In addition, demand for medical transcription services is growing as the demand for healthcare services increases. Macro-economic trends such as the aging of the baby boomer generation are projected to have a major impact on the demand for healthcare services in general and should lead to a corresponding increase in the demand for medical transcription services, which analysts forecast to grow 16 percent a year.


Transcend provides two primary medical transcription options to the healthcare industry: (i) transcription support services for customers with their own transcription systems and (ii) its
BeyondTXT Platform, which leverages advances in speech recognition technology, enabling an end-to-end digital voice-to-text transcription solution using the Internet.

Business Strategy

Transcend is planning to gradually increase the percentage of voice files processed through BeyondTXT, from approximately 20% of its total volume of transcriptions at the end of 2006 to approximately 25% by the end of 2007. Longer term, the percentage of volume that is edited using speech recognition technology will depend on such factors as the mix of volume that is processed on Transcend’s proprietary platform vs. customer platforms, the percentage of dictators for which Transcend is able to build high quality voice profiles, and the Company’s ability to hire, train, and retain talented medical language specialists (MLS) and editors.

In our view, management’s success in leveraging demand for BeyondTXT will directly impact gross margins. The rollout of the Company’s speech recognition-enabled BeyondTXT platform will result in additional cost savings as fixed infrastructure costs are spread out among a higher user base.

Management is also looking to contain costs by moving business offshore. Indian contractors transcribe approximately 7% of the transcription volume processed by the Company. Transcend expects this number to increase in 2007. However, significant portions of existing and potential customers do require that transcription services be performed domestically.

We believe that the Company is well positioned to increase market share by taking advantage of uneven service delivery by some of the smaller medical transcription firms, which also lack the requisite technology and capacity to compete on a ‘value proposition.’

Transcend also intends to increase market share through acquisitions.


Transcend reported first-quarter net income of $1.3 million, or 15 cents a share, up from $150,000, or 2 cents a share, in the year-ago period. Revenue rose 30% to $10.4 million from $8.01 million in the comparable period last year.

Impressive share-net gains and investors’ share trading, notwithstanding, the 10Q Detective has some concerns about the ‘quality of earnings’ reported for the three-months ended March 31, 2007.

Management reported that of the $2.41 million increase in revenue, 79 percent, or $1.90 million consisted of sales from new customers. This is misleading, for a more detailed review by the 10Q Detective uncovered that this growth was not organic, but was purchased through recent acquisitions: Medical Dictation, Inc., a Florida-based medical transcription services company, and OTP Technologies, Inc., a Chicago area medical transcription company.

In its
10-Q regulatory filing, management said “no single customer accounted for greater than 10% of total revenue for the quarter ended March 31, 2007.”

However, revenue attributable to one contract with Providence Health System - Washington (for four hospitals) accounted for 9.2% of total revenue for fiscal 2006.

In addition, “the Company provided medical transcription services for the three months ended March 31, 2007, to individual customers that are members of a group of hospitals. Revenue attributable to members of this group comprised 22% of the Company’s total revenue for the three months ended March 31, 2007.” These ‘individual customers’ number approximately 40 customers who are members of Health Management Associates, Inc., a single healthcare enterprise.

At March 31, 2007, the Company had net operating loss carry-forwards of approximately $16.4 million, which is being used to reduce income taxes. As a result, the Company paid no current federal income taxes due for the first quarter.

Growth Opportunities

The clinical documentation outsourcing industry is highly fragmented, with less than ten firms in the industry accounting for less than 10% of the total outsourcing market. There are currently two large national transcription competitors, one of which is Spheris and the other of which is MedQuist (MEDQ-$11.15), several mid-sized service providers with annual revenues between $10.0 million and $40.0 million, including Spi Technologies (a wholly owned subsidiary of Philippine Long Distance Telephone Co.), and hundreds of smaller, independent businesses. Ergo, the field is ripe for consolidation.

Historically, the Company has financed acquisitions either through debt or equity or a combination thereof. At present, there is only $1.5 million available on a term loan from Healthcare Finance Group, which management believes is insufficient to complete larger transactions [medical transcription firms with more than $5.0 million in annual sales].

The Company has engaged investment banker, Morgan Keegan, to help locate potential acquisition candidates and financing for these.

In our view, Transcend’s ability to execute its acquisition strategy is less dependent on its ability to secure financing than in the past (when the share price was less than $3 per share). At $23 per share, and with only 8.15 million shares outstanding, the Company can use its common stock as currency.

However, the balance sheet is looking anemic. As of March 31, 2007, Transcend had goodwill and intangible assets at carrying amounts of $4.5 million and $601,000, respectively. The total of $5.1 million represented approximately 41% of total assets, up from 38% of total assets as of December 31, 2006.

The Company has contractual obligations--leases for the rental of office space and operating leases related to the purchase of computer and other equipment-- totaling $849,000 due in 2007—more than the cash and cash equivalents of $653,000 on the balance sheet at the close of the first quarter.

Other Investment Risks & Considerations

Transcend’s reliance on key third party software could affect its ability to operate competitively.
MultiModal Technologies, Inc., an enabler and provider of conversational speech solutions, provides integral parts of the BeyondTXT technology under a non-exclusive, third party vendor agreement, renewable for up to four successive one-year periods.

Management’s inability to maintain the relationship with MultiModal, or find a suitable replacement for the technology, would adversely affect the Company’s ability to operate competitively and to meet the workload demands of its existing customer base.

We question management’s commitment to sustaining technological leadership and innovation. Transcend invests only about one-percent of its annual sales in R&D to improve its Internet-based platform/ infrastructure to yield faster turnaround times, better workflow management and increased productivity.

Insiders collectively own approximately 32% of the outstanding common stock. Consequently, together they continue to be able to exert significant influence over the ‘independence’ of directors and the outcome of most corporate actions requiring shareholder approval and business.

Nonetheless, the 10Q Detective is impressed with who sits on the Board, including Joseph P. Clayton, the Chairman and former CEO of Sirius Satellite Radio, and Walter S. Huff, Jr., the founder of HBO & Company (and a personal friend of Transcend’s Chairman and CEO Larry G. Gerdes, who held various executive positions with HBO prior to 1991).

Gerdes and Huff beneficially own 13.55% and 12.13%, respectively, of the outstanding stock of Transcend Services.

On June 4, 2007, Mr.Gerdes entered into a selling plan pursuant to Rule 10b5-1, pursuant to which he may sell up to 200,000 shares of the Company’s common stock on a periodic basis through June 30, 2008.

This is the rare case where a CEO cashing in some stock “to diversify” does not trouble us.

In recent years, more than 40% of Gerde’s annual compensation has been in company stock. For example, on December 15, 2006, Gerdes—and other Named Executives—were each granted 50,000 shares at an option price of $3.40 per share!

In addition, as of December 31, 2006, Gerdes owns (exercisable) options underlying 100,000 shares at an option price of $4.15 per share.

Ralph: “For the last time, Alice, I'm telling you, I'm going for the $99,000 question.”
Alice: “For the last time, Ralph, I'll be very happy if you win the 600 bucks.”
Ralph: “$600? Peanuts, peanuts! What am I gonna do with peanuts?”
Alice: “Eat 'em, like any other elephant.” ~~ [The Honeymooners, 1955]

In our view, bullish sentiment remains intact, and additional momentum buying on the back of a solid second quarter could send the stock price bouncing along to newer highs.

In addition, companies which provide services complementary to medical transcription, such as electronic medical records, coding and billing, may expand the services they provide to include medical transcription, and therefore, may consider Transcend—with an enterprise value of only $178.8 million—an attractive purchase.

Momentum buying in a bull market—even Ralph Kramden might get lucky owning this stock.

“Yessir, this is the time I'm gonna’ get my pot of gold.” ~~ Ralph Kramden.

Editor David J. Phillips does not hold a financial interest in Transcend Services. The 10Q Detective has a Full Disclosure Policy.

Monday, July 02, 2007

'Hide and Go Seek' at Blue Nile

“One-Mississippi, two-Mississippi, three-Mississippi, four-Mississippi . . ."

Blue Nile Inc. (
NILE-$63.35) on Friday named Scott Devitt as chief financial officer, effective July 23.

Previously, Devitt served as managing director and senior analyst for the Internet Consumer Services division at financial services company Stifel Nicolaus & Co.

Pursuant to Mr. Devitt's offer letter, Mr. Devitt will receive a sign-on bonus of $200,000, an annual base salary of $200,000 and is eligible to receive a pro-rated target annual incentive bonus of $100,000 for fiscal year 2007.

"Ready or not, here I come!"

Devitt will now report to Diane Irvine, who previously served as Blue Nile's CFO since 1999.

Funny thing – Blue Nile was one of the e-Commerce companies covered by Devitt during his recent stint at Stifel Nicholas. On May 7, Devitt participated in the online jewelry retailer’s
first-quarter earnings call, asking President Diane Irvine pointed questions about product-mix and capital expenditures.

Are we the only ones who are thinking Devitt should have recused himself from the conference call because of a conflict of interest?

"Alley, alley, oxen free!"

Curious why investors—and research clients—of Stifel Nicolaus—do not seem to care how long the ‘bullish’ analyst was in negotiations with Blue Nile for the CFO position. A rising stock price hides all sins. Unless you are short the stock—like the 10Q Detective.