Saturday, July 29, 2006

"Sorry, Wrong Number." The New 'Pump & Dump' Stock Scheme.

The "Nigerian" 419 Letters, faxes, and e-mails (and text messages to mobile phones) looking for assistance in freeing up “millions of dollars” in foreign lands; International Lottery Scams asking for bank account details to facilitate revenue sharing of big winnings; Phishing e-mails spams and VoIP 'vishing’ sent by identity thieves intent on fraudulently capturing your personal information (credit card numbers, bank account information, Social Security number, passwords, or other sensitive information); and, Purchase scam services (offshore corporation lacking a U.S. address or bank account and in need of someone to take goods sent to their address and reship them overseas for a split percentage}—the common denominator in all of these schemes is to get the unsuspecting to part with their savings.

In August 2004, the Securities and Exchange Commission (SEC) first issued an investor alert warning about a new twist on the "pump and dump" stock-fraud scam– answering machine “wrong number” stock tips. We are not referring to the 1948 film, Sorry, Wrong Number, starring Barbara Stanwyck as a bedridden millionaire's daughter who overhears a plot for murder. The SEC became aware that messages were being left on answering machines (throughout the United States) saying that the price of a small, thinly traded company’s stock would shoot up soon. The caller makes it appear they believe they are leaving a message for a friend and do not realize they have dialed the “wrong number.” The message is designed to sound as if the speaker didn't realize that he or she was leaving the hot tip on the wrong machine:

  • "Hey Tracy, it's Debbie. I couldn't find your old number and Tammy says this is the new one. I hope it's the right one. Anyway, remember Eva, that hot stock exchange guy that I'm dating? He gave my father that stock tip on WLSF and it went from under a buck to like three bucks in two weeks and you were mad I didn't call you? Well I'm calling you now. This new company is supposed to be like the next Tommy Bahama and they’re making some big news announcement this week. The stock symbol is ... He says it’s cheap now. It's at like 50 cents—Sorry I’m eating but I’m starving—and it's going up to like 5 or 6 bucks this week so get as much as you can. Call me on my cell—I’m still in Orlando. It’s 407-XXX-XXXX. My Dad and I are buying a bunch tomorrow and I already called Kelly and Ron too. Anyway I miss you, give me a call. Bye."

    [Listen to one of the "wrong number" voicemails here.]

Regulators have since uncovered direct evidence implicating stock promoters and related parties who are being paid to leave these messages on hundreds, if not thousands, of answering machines in the hope that people will buy the stock and drive the price up. The people behind the scam own the stock and will then be able to sell it a profit after which the stock will fall when the calls stop.

These scams have also migrated to email and faxes. The SEC has also released ‘Investor Alert’ bulletins warning of similar cozenages that start out like this:

  • “ …Hey you!
    PLEASE don't tell anyone about this email, because if the SEC finds out, I could get in big trouble for passing on this information, maybe even go to jail.
    This is super important! I hope I have the right email for you. Your messages keep bouncing back because your mailbox is full, and I seem to remember this is your other account. I tried calling but you're not home…. arghh! OK here's the news.”

On May 3, 2005, The SEC filed two complaints in the United States District Court of the District of Columbia charging two voicemail broadcasters and associated individuals with the nationwide broadcasting of hundreds of thousands of fraudulent "wrong number" stock tip messages.

Michael O'Grady and two affiliated Augusta, Ga.-based telemarketing companies, Telephone Broadcast Company, LLC and Telephony Leasing Corporation, LLC, were charged with broadcasting "wrong number" touts of at least six microcap stocks. The complaint alleged that the messages were part of a larger scheme enabling Houston-based stock promoters to sell approximately $4.5 million of one of the touted stocks through a Tampa, Fla.-based broker-dealer. Authorities say the scheme drove up the price of each of the touted stocks, temporarily inflating their combined market capitalization (in just 26 days) by approximately $179 million.

According to the SEC, O'Grady himself profited from trading in three of the stocks. For example, on or about July 28, 2004, O’Grady purchased 10,000 shares of [despite its misleading name] a developmental stage company involved in adult stem cell technology, Maui General Store, Inc. (MAUG.OB-$0.043) at $0.68 per share and sold the shares on or about July 29, 2004, as the price spiked to $0.98 per share, realizing a $3,001 profit.

Without admitting or denying the allegations made by the Commission, O'Grady consented to a final judgment ordering him to pay $50,786 in disgorgement and prejudgment interest and a $25,000 penalty. The SEC's action against O'Grady was brought contemporaneously with a related action by the U. S. Attorney's Office for the District of Columbia in which O'Grady pled guilty to one count of criminal information charging him with obstruction of justice.

The scheme allegedly spawned a copycat scam involving thousands of similar phony voicemail messages promoting the shares of two small, thinly traded companies: Triton American Energy Corp. (TRAE.PK-$0.185), a small, Houston-based oil company, and Yap International, Inc. (YIPL), a provider of a wide range of wireless and communications solutions, now known as iPackets Int’l (IPKL.PK-$0.0017).

In this latter case, the SEC filed charges against David E. Whittemore of Dallas, his company Whittemore Management Inc (WMI), Peter S. Cahill of Houston and his company Clearlake Venture Group.

The complaint alleges that in July 2004, Cahill, who had acquired a material number of the outstanding shares of TRAE, contacted Whittemore to engage WMI’s services to broadcast voicemail messages touting the stock of TRAE.. Whittemore and WMI, who are in the business of using auto-dialing computers to broadcast prerecorded messages via telephone, agreed to broadcast messages for Cahill and his company Clearlake Venture Group.

On or about August 12, 2004, Cahill paid Whittemore 594,000 shares of TRAE stock in advance for his services. Whittemore later returned the TRAE shares to Cahill, who then paid Whittemore $142,000 in lieu of the returned stock.

On or about August 17, 18, 19, 31 and September 14, 2004 and other dates unknown, in furtherance of the scheme to defraud, Whittemore and WMI broadcast a series of false and misleading messages touting TRAE, leaving the following or a substantially similar message on telephone answering machines across the country:

  • “Hey David, it’s Kathy. Listen, honey, Jim wanted me to give you a call. I just put him on a plane and he didn't have time to call you himself, uh, but he wanted you to know…remember those guys that do those stock promos? They’re getting ready to start another one this week. Uhm, they just did, uh, shoot. Hang on there a minute, let me look here and see. Okay, the first one was CNDD, the other one was PWRM, and he said that the next one you can get in on was TRAE. Let me look here, uhm, yeah, TRAE. It’s an oil company. And, anyway, he said he thought that it’s gonna be their best stock promotion this year. It’s at 75 cents right now and I think it’s going to go up to like five or six bucks, or something like that. He said you needed to get in in the morning before the price starts going up ‘cause you definitely want in on this one. Give him a call later tonight, sweetheart, and, um, I think that’s it. I'll talk to you soon. Bye.”

Studies have shown that stock tips posted online, or 'inadvertently' left on voicemail, or sent over email, can have a significant effect on the stock market.

In the case of Kathy, David, and Jim--The messages had their intended effect, increasing the trading volume and share price of TRAE stock. During the voicemail scheme to defraud, the price of TRAE’s common stock, which had last traded at $.32 per share on August 6, 2004 with a trading volume of 10,000 shares, tripled to a high of $.97 per share with a trading volume of 756,000 shares on August 19, 2004, an increase in market capitalization of approximately $12 million.

Cahill profited by selling TRAE shares while the voicemails were being broadcast. Between approximately August 23 and September 14, 2004, Cahill sold 680,800 TRAE shares, generating proceeds of $508,056.

Similar fraudulent messages were left in late August and early September 2004 about the stock of YPIL. Between approximately August 19 and August 27, 2004, WMI sold 45,014 of these YPIL shares generating proceeds of approximately $37,070.

The messages had their intended effect, increasing the trading volume and share price of YPIL’s common stock. During the voicemail scheme to defraud, the price and trading volume the stock of YPIL, which had traded at $.68 per share with a trading volume of 7,380 shares on August 27, 2004, spiked to a high of $1.00 per share with a trading volume of 302,814 shares on September 1, 2004, an increase in market capitalization of approximately $10 million.

The Commission's complaint against Whittemore, WMI, Cahill and Clearlake seeks civil penalties, disgorgement of all ill-gotten gains plus prejudgment interest, and permanent injunctions barring future violations of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder against all four defendants. This complaint is pending in federal court.

The SEC, like the FBI, “always gets their man”—or in this case, their woman. On July 27, 2006, the Commission filed charges against a Florida woman, Anna Boling (the alleged “Debbie” in the aforementioned fraudulent "wrong number" stock tip messages), her then husband, Roderic Boling, and stock promoter, Jeffrey Mills of Longwood, Florida and his company, Direct Results of Sweetwater, LLC, for the broadcasting of hundreds of thousands of Misleading Stock Tip Voicemail Messages.

In its action, the Commission seeks permanent injunctive relief, disgorgement of illegal profits with prejudgment interest, and civil monetary penalties based on each of the defendants' alleged violations of the antifraud provisions of the federal securities laws, specifically Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, and Anna Boling’s alleged aiding and abetting of those violations.

To avoid being the victim of the Pump and Dump, keep in mind the following tips from the online watchdog, The Fraud Bureau, which monitors Internet fraud and/or deceptive business practices:

  1. Beware of unsolicited email or telephone calls. Only deal with people you know. If you have any questions about a penny stock, call your broker who can assist you in learning more about a stock.
  2. Don't make hasty decisions after speaking with a promoter or after hearing a tip.
  3. Don't believe any promise of great profits at no risk. No investment can deliver guaranteed profits at nominal risk.
  4. Don't believe in claims of inside information.
  5. Do your own research. Look at any recent press releases of the company and take the company at face value.

If after reading this article, you still find yourself the patsy to your own greed, look on the bright side: “Never cry over spilt milk. It could've been whiskey." [Maverick-the classic TV Western shown on ABC in the late 1950s, starring James Garner]

Thursday, July 27, 2006's Profitability--"Much Ado about Everything"

’T is all men’s office to speak patience
To those that wring under the load of sorrow,
But no man’s virtue nor sufficiency
To be so moral when he shall endure
The like himself.
[Much Ado about Nothing. Act v. Sc. 1- William Skakespeare]

Weak results from Inc. (AMZN-$26.26) weighed heavily on trading Wednesday, as those investors of very melancholy disposition marched en masse to the exits, sending the shares down 21.82%, or $7.33 per share. The shares of the online retailer plummeted to a three-year low after the Company reported a 58% drop in second-quarter earnings and guided its full-year operating profits lower.

For the three months ended June 30, the Company reported a profit of $22 million, or 5 cents per share, compared with earnings of $52 million, or 12 cents per share in the prior year period, as higher operating costs offset a 22% rise in sales (to $2.14 billion).

Analysts polled by Thomson Financial were expecting second-quarter earnings of 7 cents per share on revenue of $2.1 billion.

Management cut its full-year operating income estimates to a range between $310 million and $440 million, down from a previous forecast of $390 million to $520 million.

In a conference call, management said operating income was hurt—and going forward into the 2H:06—margins will continue to be materially impacted, by the termination of the contract with Toys R Us Inc., the impact of free shipping promotions (for Amazon Prime club members), lower product prices, higher technology expenses, and the launch of new content (such as an online grocery store, toy store, and sporting goods store).

Piper Jaffray analyst, Safa Rashtchy, downgraded Amazon to under perform from market perform, saying that “while reduction of operating income guidance was expected, scope was larger than previously expected; it also takes Amazon further away from its goal of double-digit margins.” He cut his 66 cents 2006 EPS estimate to share-net of $0.55 and his 2007 EPS estimate from $0.96 to 86 cents. He also lowered his $38 stock price target to $25.00 per share.

Deutsche Bank analyst Jeetil Patel wrote in a note that while "overall investor sentiment surrounding the company (and its prospects) still appears to be acutely negative, we are nevertheless encouraged by some of the key trends in the 2Q results and momentum in the business."

Dan Geiman, an analyst at Seattle brokerage
McAdams Wright Regan, noted that gross margins dropped 187 basis points to 23.8% from a year ago, cutting quarterly operating margins by more than half, to 2.2% from 5.9% in the second quarter of 2005. In a research note published Wednesday, he called margin pressures and earnings erosion "both worrisome trends" but took a wait-and-see stance, saying: "We expect that the stock may move sideways for the next quarter or two, but further expect that there is modest upside in the near to intermediate term if — and it's still a big if — AMZN can stem the tide and start to generate some earnings momentum.”

Perhaps Bear Stearns’ consumer Internet analysts said it best: The ultimate question has been and remains, “when will the necessary investing subside and when will the model begin to demonstrate the leverage that many believe can be achieved? While we believe investors will ultimately see these investments pay off, the waiting is the hardest part….”

Bear Stearns is reducing its 2006 Year-End Target Price from $47 to $40 per share, but is maintaining its ‘Outperform Rating.’

The confluence of events that conspired to drive down Amazon’s Common Stock price has inspired little confidence in the Company’s management—unfortunate to the credibility of the Wall Street analysts that are lowering their ratings & target price (after the stock has already plunged), and for the stockholders who will now have to wait even longer to see this investment “pay off.”

[Ed. note. “Even a dead cat will bounce if dropped from high enough!" To our readers expecting to trade off a potential bottom in Amazon, it is our view that any bullish rally will be short-lived, for the Common Stock still sells at a princely 30 times forward 2007 consensus EPS estimates.]

Wednesday, July 26, 2006

"Stupid is as Stupid does."

After spending this weekend past shucking 10-Q filings to uncover some undiscovered pearls in which to invest, we admit that we came up short. Nevertheless, the 10Q Detective did uncover several instances of corporate newspeak—lending credence to con man Joseph ("Paper Collar" Joe) Bessimer famous quote: "There's a sucker born every minute...and two to take 'em.” [Ed. note. Before readers rush off to correct us, the evidence strongly suggests that P.T. Barnum never uttered those famous words.]

After many quarters of steady growth, during the second quarter of 2006, homebuilder Lennar Corp. (LEN-$45.22) experienced slower sales, higher cancellation rates and greater need for incentives and discounting. These factors contributed to lower backlog year-over-year and margin erosion, which will be realized in future quarters [i.e. declines in future profitability]. The Company said that its homebuilding activities in the second quarter were affected by a combination of factors found in many of its largest markets across the country, primarily:

· weakened demand due to changing homebuyer sentiment stemming from a view that now is not the best time to purchase a home;
· weakened demand due to the speculative real estate investor exiting the market;
· increased supply and pricing pressures due to speculative investors now selling previously purchased homes at reduced prices; and,
· increased supply due to purchasers of primary residences and speculative investors canceling existing contracts.

Despite these conditions, and the factors contributing to them, management “believes the fundamentals driving the homebuilding business remain strong and suggest a healthy long-term prognosis for the industry.”

Contrary to what management would have its shareholders believe, evidence continues to accumulate that the housing market is softening and it appears that the inventory of homes for sale may be starting to adversely impact housing prices.

The National Association of Realtors said today that existing-home sales were down 1.3% in June to a seasonally adjusted annual rate of 6.62 million units from 6.71 million in May. June's rate was down 8.9 percent from the 7.27-million-unit pace set a year earlier.

Additionally, inventories of unsold homes at the end of June swelled 3.8 percent to a record 3.73 million, representing 6.8 months of supply -- the largest since July 1997 -- from 6.4 months at the end of May.

“Stupid is as Stupid does.” [Forrest Gump]

Citing a weak sales environment for residential furniture, home furnishings’ maker, Stanley Furniture Company (STLY-$23.67) said that its sales in the second quarter ended July 1, 2006, fell 7.4 percent to $77.5 million and the Company’s net income came to $3.9 million, or 32 cents a share, down from $5.8 million, or share-net of 44 cents, a year earlier.

The Company also cut its profit outlook for the year, guiding Wall Street to a profit range of $1.52 to $1.61 a share and a sales range of between $323.5 million and $331 million. Analysts currently expect profit of $1.58 a share for this year on full-year sales of $324.7 million, according to Reuters estimates.

In the Company’s second quarter 10-Q filing with the SEC on July 18, management also cited a surge in low cost imported products, primarily from China, as a reason for declining sales and profitability.

“Imports have grown dramatically in the past few years and according to industry sources it is estimated that imports now account for over half of all residential wood furniture sold in the United States.”

In response to this trend, Stanley developed a blended strategy of combining its domestic manufacturing capabilities with an offshore sourcing program that incorporates selected imported component parts and finished items in its product line to lower aggregate production costs. According to management, sourced product represented approximately 34% of sales during the first six months of 2006 compared to 31% in 2005.

This integration was also “meant to provide design flexibility and to offer a better value to customers.” After admitting that the Company faced competitive pressure from Asian imports, management then goes on to state in the 10-Q that to offset unit volume declines, average selling prices were increased on its product offerings. [Ed. note. How does raising prices offer “better value to customers?”]

On July 17, 2006, management announced, too, that the Board of Directors increased its stock repurchase authorization to $50 million. From April 1, 2006 – July 1, 2006, Stanley had already repurchased 587,345 shares of Common Stock at an average price of $25.41 per share.

If this announcement is supposed to signal to investors that Stanley Furniture Company’s stock is cheap at its current price, our confidence was quickly dashed when we read that the Company has a great excuse hidden up its sleeve to explain away any future profit shortfalls:

“An outbreak of avian flu or similar epidemic in Asia or elsewhere may lower our sales and earnings by disrupting our supply chain in the countries impacted.” [10-K Annual Report]

"And that's all I have to say about that." [Forrest Gump]

Saturday, July 22, 2006

Cell Therapeutics: Cytotoxic to Shareholders?

A number of readers wrote to us after perusing our review on Abraxis Biosciences and queried us with a common concern—if Seattle-based biopharmaceutical company, Cell Therapeutics obtains regulatory approval for XYTOTAX (pronounced “Zi-o-taks”), will this pose direct competition to ABRAXANE?

A clinical and commercial assessment of late-stage cytotoxic agents (like XYTOTAX) for metastatic breast cancer and non-small cell lung cancer (NSCLC), in our opinion, would not prove to be direct competitive threats to ABRAXANE, but, to the contrary, would serve to facilitate physician (and insurance companies) acceptance of alternatives to existing treatment paradigms (and expand the commercial market for targeted therapies like ABRAXANE).

Separately, XYTOTAX would not be a direct competitor to ABRAXANE because the former is seeking its first FDA indication for NSCLC and the latter’s only approved indication (to date) is to treat metastatic breast cancer after a combination of chemotherapy fails or within six months of a relapse.

XYTOTAX is Cell Therapeutics (CTIC-$1.21) chief drug in development.

XYOTAX (paclitaxel poliglumex) is a biologically enhanced chemotherapeutic that links paclitaxel, the active ingredient in Taxol, to a biodegradable polyglutamate polymer, which results in a new chemical entity. When bound to the polymer, the chemotherapy is rendered inactive, potentially sparing normal tissue's exposure to high levels of unbound, active chemotherapy and its associated toxicities. Blood vessels in tumor tissue, unlike blood vessels in normal tissue, are porous to molecules like polyglutamate. Once inside the tumor cell, enzymes metabolize the protein polymer, releasing the paclitaxel chemotherapy.

Initially, the future looked promising for XYTOTAX. However, at the 2006 Annual Meeting of the American Society of Clinical Oncology (ASCO), a composite analysis of phase 3 STELLAR trials of XYOTAX in patients with NSCLC was presented. The outcome data (survival-days) indicated that if XYTOTAX were to reach the market, its patient population would be limited by gender (pre-menopausal female NSCLC patients, since estrogen appears to be the catalyst that makes the drug more effective) and performance status (“PS2”--women who have poor performance status). Unfortunate, for NSCLC patients and the Company, given that more than 50% of the NSCLC population is aged 65 or older.

Nonetheless, the Company is moving forward with the development of XYTOTAX. [Ed. note. In order to justify the generous salaries that the Company pays to its key executives—does the Company have any other alternative?]

After a meeting held with the FDA last month, management announced that the Company and the FDA agreed on a new drug application (NDA) route for XYOTAX for women with lung cancer. The FDA agreed to review an NDA submission based on interim results of the PIONEER trial (designed to test whether single agent XYOTAX provides improved overall survival compared to paclitaxel in chemotherapy-naïve women with NSCLC who are PS2, chemotherapy-naive women with advanced stage NSCLC) with the results of the STELLAR 3 and 4 trials to support the filing. Based on this feedback, if the PIONEER trial meets its pre-specified interim endpoint. The Company plans to submit an NDA in the first half of 2007 and would request a priority (six month) review based on the fast track designation, instead of the standard ten-to-twelve-months.

Nevertheless, our confidence in the agent’s commercial potential is not bolstered after reading that European regulators will allow the biotech drug maker to lower performance endpoints for XYOTAX in order to seek EU marketing approval. The Company said the European Medicines Agency's Scientific Advice Working Party "agreed in principle" that Cell Therapeutics can use a clinical trial where XYOTAX is shown to be not-inferior to other cancer drugs for approval, rather than being superior as originally planned.

Even with FDA approval, Cell Therapeutics may find its “restricted” NSCLC market difficult to penetrate, given tough competition from better-capitalized company’s like Sanofi-Aventis’ TAXOTERE (docetaxel) and Eli Lilly’s GEMZAR (gemcitabine). TAXOTERE is used to treat non-small cell lung carcinoma alone, or like GEMZAR, in combination such as cisplatin.

Additionally, drug-treatment paradigms are difficult to change. For example, despite limitations like adverse-events and poor outcomes, chemo-drugs like cisplatin and vincristine have been used to treat cancer for more than 30 years—and remain at the forefront of treatment. In particular for NSCLC, the last decade has borne witness to expanded drug options, including the introduction of adjuvant and neoadjuvant chemotherapy. Still, suitable therapeutics remain elusive, with five-year survival rates failing to improve—despite advances in drug development.

There are over a dozen NSCLC candidates in late- stage development, with almost half of the pipeline candidates molecular targeted therapies (MTT):

1. Genentech’s TARCEVA (erlotinib) is a small molecule tyrosine kinase inhibitor which works intracellularly to disrupt EGFR function, and has been shown to increase survival in lung cancer patients. The FDA for the second-line treatment of advanced non-small cell lung cancer recently approved TARCEVA.
2. Amgen's novel agent, ABX-EGF (panitumumab), is a human monoclonal antibody directed extracellularly against the epidermal growth factor receptor (EGFr). Phase II data shows outstanding toxicity profiles both for first-and-second line NSCLC. When approved, pricing is thought to be critical to panitumumab’s market success against other MTTs. [Ed. note. EGFR inhibitors show a predictive response best in those cancer patients present with the EGFR mutation—overexpression of EGFR.)
3. Genentech/Roche's AVASTIN (bevacizumab) is an anti-angiogenesis drug that works by blocking the signal protein vascular endothelial growth factor (VEGF) and is gaining prominence as an important tool in the treatment of cancer. The FDA first approved AVASTIN (in combination with intravenous 5-fluorouracil-based chemotherapy) for use in colon cancer in 2004. Early results from a large randomized clinical trial for patients with previously untreated advanced non-squamous, non-small cell lung cancer show that those patients who received AVASTIN in combination with standard chemotherapy lived longer than patients who received the same chemotherapy without AVASTIN.
4. Other MTT in NSCLC mid-to-late-stage development include AstraZeneca's ZACTIMA (vandetanib/ Phase 2 trials); NEXAVAR is the first oral multi-kinase inhibitor that targets both the tumor cell and tumor vasculature, and is currently in the (900) patient enrollment stage of a pivotal Phase 3 trial sponsored by Onyx Pharmaceuticals & AG Bayer designed to compare length of survival in NEXAVAR when co-administered with two chemotherapeutic agents - carboplatin and paclitaxel - versus carboplatin and paclitaxel alone; and, a multi-center phase 2 randomized trial presented at ASCO 2006 has demonstrated that Millennium Pharmaceuticals/Johnson & Johnson's VELCADE (bortezomib), the first in a new class of anticancer agents known as proteasome inhibitors, has significant activity as a single agent or in combination with Taxotere (docetaxel) in patients with non-small cell lung cancer (NSCLC) who have failed at least one prior regimen (toxicity issues are a concern).

Non-small cell lung cancer comprises over 75% of all lung cancers. In 2006, more than 338,000 cases of the disease will be diagnosed. Despite three decades of extensive R&D and chemotherapy use, the overall survival of NSCLC patients still remains below 12 months. The NSCLC death rate now exceeds that of breast, prostate and colon cancers combined.

Given that the unmet needs in NSCLC are so significant, the 10Q Detective argues that treatment paradigms will have to shift—and that multi-modal therapies will gain wider acceptance as first-line treatments. The corollary to our supposition is that there is a built-in market for all proven, next-generation cancer treatment agent—XYOTAX (lower toxicity and potentially increased effectiveness), too.

As best we know, Cell Therapeutics has no direct competitors that focus on the same core competencies (developing a protein based polymer drug like XYOTAX)

Our readers would also like to know the following: With a market capitalization just shy of $125 million, is the Common Stock of Cell Therapeutics an attractive buy at its current price of $1.21 per share?

Investment Risks and Considerations:

Credibility of Management Team. James A. Bianco, MD, a principal founder, President and CEO, his brother, Louis A. Bianco, Exec. V.P.-Finance & Administration, and the entire executive team have a reputation for being long on hype but short on results. Three years ago, James Bianco confidently predicted that XYOTAX would be on the market by 2005. Chastised [but not humbled], he is now calling for an FDA review—optimistically—in the 1Q:07.

Balance Sheet Weaknesses Limit Financial Flexibility. TRISENOX was, prior to its divestiture to Cephalon in July 2005, the Company’s only commercial product approved by the FDA, EMEA, and the Japanese Ministry of Health to treat patients with relapsed or refractory acute promyelocytic leukemia, or APL. As a result of the divestiture, there were no product sales for the three months ended March 31, 2006.

As of March 31, 2006, Cell Therapeutics had incurred aggregate net losses of approximately $(878.5) million since inception. Corporate expects to continue to incur additional operating losses for at least the next several years. Until XYTOTAX receives FDA marketing clearance, the Company has no material source of recurring revenue.

Without revenue generated from commercial sales, management anticipates that funding to support ongoing research, development and general operations will primarily come from public or private debt or equity financings, collaborations, milestones and licensing opportunities from current or future collaborators.

As of April 2006, the Company had approximately $83.5 million in cash and cash equivalents. However, contractual obligations (convertible notes, interest on notes, operating leases, and long-term debt) totaled $232.6 million.

Additionally, the Company still owes milestone payments [which management may be required to pay pursuant to the amended agreement with PG-TXL Company L.P] of $14.9 million, $5.4 million of which may be triggered in 2007 if XYOTAX is successful with current plans for registrations with the FDA and EMEA.

On June 21, 2006, the Company announced that it had signed a "step-up equity financing agreement" with the French bank, Societe Generale, in which the bank agreed to buy up to $72 million of new common shares of Cell Therapeutics and sell them on the Italian market.

For a Company in such a weakened financial condition, the 10Q Detective questions the dedication of management in shepherding XYOTAX through the FDA approval process. The aforementioned clinical disappointments and regulatory delays have done nothing to temper senior management’s avarice or willingness to enrich themselves at the expense of other shareholders.

James A. Bianco, MD and his brother, Louis Bianco, each earned $1.0 million, $932,647 and $439,030, $426,127 in FY 2005, FY 2004, respectively, in salaries, bonuses, and “other annual compensation.” These payments excluded restricted stock awards of $2.12 million and $1.0 million to each brother, respectively, in FY 2005.

Additionally, in the last three fiscal years—with the Company bleeding red ink—the Board of Directors saw it fit to approve perquisites for Dr. Bianco of $224,628 for travel and entertainment expenses, including the personal use of the corporate jet ((the aircraft was finally disposed of in November 2005—several months after corporate layoffs); and protective services provided for Dr. Bianco and his family as part of the Company’s corporate security program which totaled approximately $216,000, $1,242,201 and $939,537 for 2005, 2004 and 2003, respectively. The corporate security program was cancelled in August 2005.

This should aggravate shareholders, too: The compensation paid to Dr. Bianco during fiscal 2005 that was not performance-based under Section 162(m) exceeded the $1 million dollar limit per officer by approximately $485,000. The Company will not be able to take a federal income tax deduction for this excess amount. [Ed. note. Not that the Company had any profit to worry about!]

As mentioned, in late 2005, the Company sold the corporate plane, eliminated the security program, and gave pink slips to 75 employees. Doing so, the Company is hoping to cut its cash burn rate to approximately $8.0 million per month. In the 1Q:06, the cash burn rate was approximately $8.8 million [Ed. note. Perchance if the Board froze executive salaries, the Company might be able to lower its burn rate to the desired target.]

The Company faces direct and intense competition from better-capitalized competitors in the biotechnology and pharmaceutical industries, and must deal, too, with managed health-care and related-cost containment issues. Aside from the aforementioned therapeutic modalilities with clinically proven outcomes data, Cell Therapeutics will have to negotiate with managed care organizations predisposed to using generic (cheaper) alternatives, including the taxanes—generic paclitaxel (introduced in the U.S. in December 2004) and TAXOTERE (docetaxel), which goes off-patent in 2008.

Pipeline and Portfolio Risks. In addition to XYTOTAX, the Company is also developing pixantrone (pick-san-troan), a novel anthracycline derivative, for the treatment of non-Hodgkin’s lymphoma, or NHL. Preclinical data and clinical studies in more than 175 patients indicate that pixantrone is easy to administer, may exhibit significantly lower potential for cardiac toxicity, and may have more potent anti-tumor activity than marketed anthracyclines (like doxorubicin).

Anthracyclines have been shown to be very active clinically in a number of tumor types. However, they are usually associated with cumulative heart damage that prevents them from being used in a large proportion of patients. Pixantrone has been designed (by altering chemical groups thought to be associated for free radical production) to reduce the potential for these severe cardiotoxicities, as well as to potentially increase activity and simplified administration compared to the currently marketed anthracyclines

Management is targeting an interim analysis from its ongoing phase III study of pixantrone in the 3Q:06, and depending on the results of this analysis, a second interim analysis may be performed in the first half of 2007.

Additionally, Cell Therapeutics is working on CT-2106, a polyglutamate camptothecin conjugate, which is in the phase II component of a phase I/II trial in combination with 5FU/LV for the treatment of colorectal cancer relapsing following FOLFOX therapy and in a phase II trial in ovarian cancer.

Preliminary data of the phase I study of CT-2106 for patients with advanced solid tumor malignancies were presented at ASCO 2006 and successfully showed that the novel conjugate appeared to be well tolerated, with reduced bladder toxicities that characterize the parent camptothecin molecule.

Investor attention is focused on XYTOTAX—and rightly so. Given that the three STELLAR phase III clinical trials for the treatment of NSCLC did not meet their primary endpoint, without a successful PIONEER trial or positive interim results from the PIONEER trial, the 10Q Detective does not expect a favorable regulatory review from the FDA.

We remain concerned, too, with the regulatory strategy presented before the European Union: the aforementioned agreement “in principle" that Cell Therapeutics can use a clinical trial where XYOTAX is shown to be not-inferior to other cancer drugs for approval, rather than being superior as originally planned. At minimum, in our view, such an approach will pose future commercial risk to XYOTAX, for the Company is sacrificing potential sales to secure EU approval. [i.e. Competitors will position XYOTAX as a drug ‘of last resort.’]

Valuation Thesis.

We believe that there is significant risk to owning Cell Therapeutics, and its ability to continue as a going concern is dependent on the ultimate success/failure of XYTOTAX. That said, we have calculated a sum of the parts valuation of Cell Therapeutics’ intrinsic worth (with our expectations calibrated to reflect XYTOTAX’s regulatory approval and risk-adjusted for the potential maximum revenue, costs, time to approval, and probability of approval for the two drugs in the pipeline).

Our sum-of-the-parts valuation assigns an enterprise value of $0.74 per share. Assets include $1.30 for XYTOTAX, $0.47 for pixantrone, and $0.42 for CT-2106—which are offset by a negative cash position of $1.45 per share.

Like we said, the only stakeholders being enriched at Cell Therapeutics are Bianco & Company. They remind us of deer ticks, who will just keep sucking the life blood until they become so engorged, they just fall off their victims—still and all, plump and satiated.

As for shareholders on the outside looking in, look up the oncology term cachexia—for, in our view, that is what is what the future holds in store for shareholders' valuations.

Monday, July 17, 2006

Abraxis BioScience: A SPARC for Explosive Growth?

Abraxis BioScience, Inc. (ABBI-$21.45) provides a unique opportunity for investment in a biopharmaceutical company revolutionizing cancer therapy with its proprietary nanotechnology platform. Abaxis’ nanoparticle albumin-bound, or nab technology, exploits the natural properties of a human protein, albumin, for drug delivery. For example, by wrapping albumin around active drug and creating particles of approximately 130 nanometers, the Company has found a way to eliminate the need for solvents and deliver higher concentrations of (tumor-targeting) chemotherapy without the solvent-related toxicities compared with solvent-based taxanes.

Angiogenesis inhibitors (drugs that prevent the growth of new blood vessels), antisense therapy (genetic code blockers that turn off oncogenes), and tyrosine kinase enzyme inhibitors (inhibiting or slowing the division of targeted cancer cells)—three in a number of promising cancer therapies. Tumors, however, have adapted several mechanisms to meet their increasing need for nutrients.

Tumors are known to naturally "feed" by taking in and retaining albumin-bound nutrients. It has recently been discovered that tumors secrete a specialized protein called SPARC (Secreted Protein Acidic and Rich in Cysteine) into the tumor's interstitium that acts as a highly charged receptor. The SPARC protein specifically binds albumin-bound nutrients and concentrates them within the tumor's interstitium to prevent nutrients from diffusing outside the tumor cell.

Abraxis’ nanoparticle drug therapy exploits tumor vascular biology by delivering (concentrated) albumin-bound cytotoxic drugs preferentially to all tumors (secreting the SPARC protein) as a nutrient.

In January 2005, Abraxis received approval to market a first-in-class "protein-bound particle" drug. ABRAXANE, consisting only of albumin-bound paclitaxel nanoparticles (and free of toxic solvents), is indicated for the treatment of breast cancer after failure of combination chemotherapy for metastatic disease or relapse within 6 months of adjuvant chemotherapy.

Paclitaxel (originally derived from the bark of the Pacific Yew tree in the early 1960s) is known for its ability to produce hypersensitivity reactions, and these may occur in 20%-to-40% of patients. The drug has limited aqueous solubility and is commercially available as TAXOL as a non-aqueous concentrate containing the solvent, Cremophor EL (itself a mixture of hydrogenated castor oils) and ethanol as a co-solvent. Cremophor EL is believed to be responsible for producing much of the hypersensitivity reactions.

Toxicities associated with taxane-based chemotherapy include nausea and vomiting, severe myelosuppression, prolonged peripheral neuropathy, myalgias, and severe edema.

ABRAXANE is an important therapeutic breakthrough, since it addresses the toxicities associated with solvents in taxane-based chemotherapy. Additionally, since severe anaphylactic reactions are rare, pre-treatment with corticosteroids and antihistamines can be minimized.

Permitting more frequent dosing improves rapid and higher bioavailability of paclitaxel compared to Cremophor-paclitaxel (Taxol) formulations, this next-generation taxane is able to deliver 50% more drug to the tumor site.

As of December 31, 2005, Abraxis had active patient enrollment in ten clinical studies with ABRAXANE for breast cancer, including monotherapy in first-line metastatic breast cancer, in combination with Herceptin in HER 2 positive patients; in combination with Roche Labs’ Xeloda (Capecitabine) or with with Navelbin in first-line metastatic breast cancer; and, in weekly dosing in neoadjuvant breast cancer.

The Company has embarked upon an aggressive and comprehensive clinical development plan (investigator-initiated studies) to maximize the commercial potential of ABRAXANE. As of December 31, 2005, the drug is undergoing numerous other clinical studies in various stages of testing and development to determine its effectiveness against other cancers, including ovarian (6); prostate (5); G.I., pancreatic, head and neck, and cervical (15), and (12) non-small cell lung cancer (the most common form of lung cancer, accounting for approximately 87 percent of all lung cancer cases).

In addition to further investigation with ABRAXANE, the Company has developed an extensive pipeline that includes other promising drug candidates in oncology (thirteen compounds in phase 1 or 2 clinical trials) and a cardiovascular portfolio.

Approximately 800,000 procedures of coronary artery stenting are performed in the United States alone every year. Prospective studies of Interventional procedures have been plagued by Restenosis (in up to 50% of patients) due to the formation of endothelial tissue overgrowth at the lesion site. As opposed to bare metal, drug-eluting stents that are covered with a medicine that is slowly dispersed [were initially hailed by the medical community] as the curative in suppressing the restenosis reaction. (Sirolimus and paclitaxel are the two drugs used in coatings which are currently FDA approved in the United States). However, attention has been recently focused on—sometimes fatal—late thrombotic complications related to drug eluting stents that are being reported in increasing numbers (after discontinuation of concomitant oral platelet therapy).

Abraxis is developing the technology for potential use in cardiology where nab paclitaxel has been shown to significantly reduce coronary artery restenosis. According to corporate, the Company has initiated phase 2 clinical trials in patients with coronary artery disease with single dose therapy (COROXANE) following balloon angioplasty and stenting and is hopeful that clinical findings will corroborate the positive preclinical data.

Peripheral artery disease of the lower extremities is common in older adults with significant morbidity. Similar to coronary artery disease, this disorder is typically caused by thickening of the blood vessel wall that limits blood flow to the legs, particularly due to narrowing or closure of the superficial femoral artery. Currently the standard treatment is angioplasty alone. Surgical placement of bare metal stents or tubes within the blood vessel has had limited success, most often due to the tube breaking. Phase 2 studies are focusing on the use of COROXANE along with angioplasty of the affected blood vessel.

Abraxis also has numerous discovery product candidates for various indications such as anesthesia, oncology and transplantation. The Company believes the application of its nab technology will serve as the platform for the development of numerous drugs for the treatment of life-threatening diseases.

Drug delivery remains a challenge in the management of cancer. Until recently, approaches focused on technologies such as liposomes to overcome the poor solubility of cytotoxics and monoclonal antibodies to target cytotoxic agents to cancer cells. In our opinion, Abraxis’ approach of facilitating the desired cellular entry by harnessing protein transduction domains (PTDs), heralds an exciting new approach in drug delivery technology.

According to analysts, the market value of worldwide cancer drug delivery technologies has been estimated at $7.5 billion rising to $18.4 billion by the year 2010 and $38.5 billion by the year 2015 (albeit the market value of drug delivery technologies and the anticancer drugs are difficult to separate).

Additionally, driven by this explosion in novel therapeutic options, the chemotherapy market (valued around US$42 billion) is currently the fastest growing in the pharmaceutical industry.

Taxanes are one of the most widely used chemotherapy agents, with an estimated current use by approximately 325,000 patients in the United States alone and an estimated current worldwide market size approaching $2.0 billion.

ABRAXANE is well positioned to capture a large slice of the chemo pie. Other than in Japan, Abraxis owns the global rights to ABRAXANE.

Launched in February 2005 (by a novice sales force with no published FDA-approved data at the time of launch & a confusing new insurance re-imbursement environment), ABRAXANE still achieved 2005 net sales of $133.7 million in the 11 months following its launch for its initial indication in the treatment of metastatic breast cancer.

On April 26, 2006, the Company entered into a Co-Promotion Agreement with AstraZeneca. Under the Agreement, both companies will co-promote ABRAXANE in the United States for a term of five and one-half years beginning July 1, 2006. AstraZeneca will provide sales representatives to support Abraxane and will fund half of the promotional and advertising program

Abraxis management forecasts that net sales of ABRAXANE will be in excess of $200 million in FY 2006—and could rise to $500 million within three years (just for the breast cancer indication)! [Ed. note. internal reports show that 68 out of 75 or 91% of physicians surveyed anticipate increasing their ABRAXANE usage in the coming months.]

In our opinion, the nab tumor targeting technology has been validated by the successful launch of ABRAXANE and the drug represents the future of Abraxis. This product has all the hallmarks of a blockbuster and could drive the Company’s topline growth for years to come.

Abraxis believes it can apply its nab tumor targeting technology to numerous chemotherapy agents. By exploiting the abnormal vascular growth (angiogenesis) and the overexpression of albumin-binding proteins (gp60 and SPARC) in advanced tumor cells and by overcoming water insolubility of many active chemotherapy agents, corporate believes that its technology may revolutionize the delivery of chemotherapy agents to cancer patients.

Next up for clinical investigation, the 10Q Detective sees Sanofi-Aventis Pharmaceutical’s dominant chemotherapy agent, Taxotere (docetaxel).
At the June 2006, American Society of Clinical Oncology (ASCO) meeting, the Company presented a pre-clinical study (Poster #5438; Title: Enhanced efficacy and safety of nanoparticle albumin-bound nab-docetaxel versus Taxotere) applied nab technology to docetaxel and in pre-clinical models of colon cancer compared nab-docetaxel with Taxotere (docetaxel injection). The study suggested that nab-docetaxel showed significantly greater antitumor activity against colon tumor versus Taxotere stents used to treat obstructed coronary arteries, as it is believed that sirolimus-eluting stents (marketed by Cordis as the Cypher stent) are less likely to cause restonosis, too. The anti-thrombin inhibitor rapamycin is currently under review by Abraxis—as nab rapamycin.

In addition to its oncology line (ABRAXANE & injectibles), Abraxis also profitably markets a line of generic anti-infectives and critical care products, which contributed $52.8 million and $45.3 million, respectively, to total net sales of $143.7 million for the first quarter ended March 31, 2006.

Together with a number of anti-infective (injectibles) with ANDAs In the FDA product pipeline are generic Arixtra (an anticoagulant called Fondaparinux—derived from heparin—that is given subcutaneously daily) and Lovenox (Enoxaparin, which is a low molecular weight heparin)—both of which are have big commercial opportunities for preventing blood clots and of deep vein thrombosis.

The Company, however, is not without its share of controversies. On November 27, 2005, the Company was borne out of a merger between privately held American BioScience (ABI), a drug-delivery development company, and publicly-traded American Pharmaceutical Partners (APP), a specialty pharmaceutical company that manufactured and sold injectable pharmaceutical products.

Based on American Pharmaceutical's Nov. 28 closing price of $39.25 per share, the combined entities’ share price has fallen 45.35%, with the primary concerns being (1) the dilutive effect that the transaction will have on minority shareholders and (ii) the fact that the merger is expected to be dilutive to EPS over the next five years, too.

Approximately 134.1 million shares of APP were issued to ABI shareholders in connection with the merger, substantially diluting the percentage ownership interests of current APP stockholders.

Dr. Soon-Shiong, CEO and Executive Chairman, of APP, was also the President, CEO, and a Director of ABI (and the controlling stockholder of APP with approximately 98.9% of the outstanding shares of ABI). Following the merger, Dr. Soon-Shiong and his affiliated entities beneficially owned 83.3% of the outstanding shares of Abraxis.

What also concerns, the 10Q Detective, is that Dr. Soon-Shiong has a “Martha Stewart” complex. For example, despite knocking down more than $825,000 in salary & bonus last year, the Company provided Dr. Soon-Shiong with the use of a car and a trained security driver, security systems for his residences, and 24 hour personal and family protection services at his office and residences and on other appropriate occasions. The aggregate costs to Abraxis (stockholders) for providing these systems and services in 2005 was $355,151—more than nine-fold the cost that $85.1 billion titan, Genentech (DNA-$80.75) spent on protective services for its CEO and Chairman, Arthur D. Levinson, Ph.D. [Ed. note. Perchance Dr. Soon-Shiong is fearful that the People’s Republic of China is looking to kidnap him for his Company’s nab technology!]

Nonetheless, the Common Stock price of Abraxis is such a screaming BUY—we do not mind looking askance at this piggish display.

Goldman Sachs calculated the enterprise value of Abraxis based on indications of net present value of free cash flow from the beginning of December 2005 through the end of 2030 (plus indications of net present value of terminal values for Abraxis). Indications of net present value of free cash flows used discount rates of 14 percent Terminal values in the year 2030 were based on perpetuity growth rates ranging from 0% to 4%. These terminal values were then discounted to calculate implied indications of present values using discount rates at 14 percent. Just for existing ABRANE indications (worldwide), milestone payments based on existing agreements, and the Company’s existing (injectible) Generic business’ (less corporate expenses & R&D), Abraxis’ total enterprise value was calculated to be $9.93 billion—or $62.53 per share!

In the opinion of the 10Q Detective, Goldman Sachs’ analysis though accurate—discounts the remarkable (global) growth potential of Abraxis’ deep product development pipeline that leverages the revolutionary technology built-on the company's nab platform. Additionally, we believe that the Company is well positioned to fund the R&D necessary to fuel this long-term value by capitalizing on the strong financial position of its hospital-based portfolio of injectables business. BUY.

Investment Risks:

Entities affiliated with Dr. Soon-Shiong own a significant percentage of Abraxis’ Common Stock and could exercise significant influence over matters requiring stockholder approval, regardless of the wishes of other stockholders. As of May 8, 2006, entities affiliated with the chief executive officer owned approximately 84.2% of Abraxis’ Common Stock. Accordingly, they have the ability to significantly influence all matters requiring stockholder approval, including the election and removal of directors and approval of significant corporate transactions such as mergers, consolidations and sales of assets. Additionally, this significant concentration of stock ownership may adversely affect the market for and trading price of the Company’s Common Stock if investors perceive that conflicts of interest may exist or arise.

The success of ABRAXANE in the Phase III trial for metastatic breast cancer may not be representative of the future clinical trial results for ABRAXANE with respect to other clinical indications. The results from clinical, pre-clinical studies and early clinical trials conducted to date may not be predictive of results to be obtained in later clinical trials, including those ongoing at present. Further, the commencement and completion of clinical trials may be delayed by many factors that are beyond our control, including slower than anticipated patient enrollment and unforeseen adverse events.

Clinical and regulatory risks—if Abraxis is unable to develop and commercialize new products, the Company’s financial condition will deteriorate. Profit margins for a pharmaceutical product generally decline as new competitors enter the market. As a result, future corporate success will depend on the Company’s ability to commercialize the product candidates currently in development (as well as developing new products in a timely and cost-effective manner). Additionally, failure to receive the necessary regulatory approvals of ABRAXANE in Europe and other global markets would have a similar deleterious effect on the Company’s future financial condition (and the calculated enterprise value).

Technological obsolescence--given recent advances in combinatorial chemistry, high throughput screening approaches being used are identifying potential Cremophor EL-free paclitaxel formulations that replace Cremophor with other excipients or excipient combinations (while retaining ethanol as a co-solvent). The Company anticipates that future net sales of ABRAXANE will represent a higher percentage of aggregate sales ($30.1 million in sales in the 1Q:06, represented approximately 20.9% of total net sales) in coming years. However, a number of pharmaceutical companies are working to develop alternative formulations of paclitaxel and other cancer drugs and therapies, any of which may compete directly or indirectly with ABRAXANE and which might adversely affect the commercial success of ABRAXANE.

Friday, July 14, 2006

American Woodmark: Executives Win our First Golden Fleece Award.

One of the greatest of the England’s Romantic poets, a man of letters, and addicted to opium for most of his adult life, Samuel Taylor Coleridge (1772 – 1834) wrote: “Let us have a little less of "hands across the sea," and a little more of that elemental distrust that is the security of nations. War loves to come like a thief in the night; professions of eternal amity provide the night.

In the Middle East, distrust breeds more distrust—which spawns endless conflicts. The military wing of Hezbollah (Islamic: “Party of God”) infiltrated Israel's northern border July 12, killing three soldiers and capturing two. The Hezbollah raid mirrored one carried out by Hamas, the Palestinian group that abducted an Israeli soldier June 25.

In response, Israel's stated diplomatic position is that it is looking to completely remove any Hezbollah presence in southern Lebanon. Israeli army chief warned, “nothing is safe” in Lebanon.

Israel jets are pounding Hezbollah strongholds in Southern Lebanon, a highway linking the Lebanese capital to Damascus, and Beirut's international airport for the third time in 24 hours. The Israeli Defense Force has also placed a blockade on Lebanese air, land and sea routes.

The Syrian-backed Lebanese Hezbollah militia has fired about 140 rockets into northern Israel in the past 48 hours, including one that reached Haifa (Israel’s third-largest city and 45 kilometers from the Lebanese border) for the first-time late yesterday. This sends an ominous signal to Israeli military intelligence. Hezbollah has long pledged that its overall mission is the complete destruction of Israel (and to drive the Jews into the Sea).

And the three-day conflict is escalating—ah…let’s call it what it is—WAR!

It has long been known that Iran (with its own anti-Semitic issues and Nuclear ambitions) has provided financial aid to terrorist groups like Hezbollah and Hamas. Military intelligence (knew two years ago) confirms, too, that Iran has supplied Hezbollah with solid-fuel, Zelzal-2 missiles with a 200-km range. The rockets are not very accurate, for they do not have a self-guidance system. Noneless, packed with explosive warheads weighing up to 600 kilograms, the Zelzal-2 missiles are intended to strike broad targets such as communities and cities—and to inflict as many casualties and property damage as possible. Iran’s role darkerns further, too, as rumors circulate that the two recently captured Israeli soldiers are being moved to Tehran.

If history is any guide, do not expect a settlement of this “conflict” to play out on the World Stage: (i) The only resolution from the United Nations Security Council demanded that Israel end its “disproportionate use of force;” (ii) The European Union stated that Israel has no justification for its air and sea blockade on Lebanon. The EU presidency added, “Actions, which are contrary to international humanitarian law, can only aggravate the vicious circle of violence and retribution;” and, (iii) Russia, Italy and France have all agreed with the EU, calling Israel’s actions against Lebanon “disproportionate.”

The good news, despite the potential for the fighting in Lebanon to threaten a broader conflict in the Middle East—Syria & Golan Heights dispute—the U.S. backed Arab regimes like Egypt and Jordan are sitting on the sidelines, professing that they would like to see a peaceful settlement.

Intensifying conflict in the Middle East (sectarian strife in Iraq, too) and concerns about Nigeria oil supplies being cut by the country's rebels recent activities are raising concerns of possible supply disruptions. Light sweet crude for August delivery was as high as $78.40 a barrel in trading on the New York Mercantile Exchange. By midmorning in Europe, however, the price was $77.45, up 75 cents from Thursday's record settlement of $76.70 a barrel.

On Wall Street, stock market futures on Friday were pointing to a modest rebound following two days of heavy losses in the markets, with traders to focus on General Electric earnings and retail-sales data. Nonetheless, we suspect as trading dries up later in the day, the major stock indices will dip south towards the close.

Here at home in the Northeast, with the weather expected to soar into the 90’s this weekend, the Wall Street elite have more pressing problemswhat time should they retreat from their offices—to beat the mass exodus and inclined traffic—and hit the roadways to their summer homes?

The Hamptons (pristine beaches and sophisticated nightlife), Fire Island (the “don’t ask – don’t tell” crowd), and, Martha’s Vineyard and Nantucket, the bucolic Massachusetts vacation areas frequented by as many high-profile celebrities, politicians as business executives. [Sorry—according to our sources, luxury properties (with high-speed Internet access) renting for $150,000 a month on Martha's Vineyard were gone by January.]

Given the gravitas of many of our recent articles, the 10Q Detective thought it might be fun to inject some levity in today’s entry. Our method is to look back at the pages and pages of SEC filings that we have read this past week, and then to offer up to our readers notice of whom is the winner of our first Golden Fleece award. (First established in 1975, by the late Senator from Wisconsin, William Proxmire, the Golden Fleece was awarded to those public officials he judged to be wasting public monies.)

The first 10Q Detective Golden Fleece award is presented to the executives of cabinet maker American Woodmark Corp. (AMWD-$32.34). The summary Compensation (Salary + Cash Bonus + Other Annual Compensation + LT Option Awards/Current Value) earned/awarded to James J. Gosa, Chairman & CEO (in FY 2004), Ian J. Sole, former Senior Vice President, Sales and Marketing (in FY 2004), and, Jonathan H. Wolk, CFO (in FY 2006) totaled $1.6 million, $691,359.00, $545,067.00, respectively. Despite the gobs of monies earned by these executives, they still felt it necessary to ask for—and of course, receive—discounts on cabinet purchases made by each executive.

1. Mr. Gosa received a $6,144 discount on cabinet purchases made for the FY ended April 30, 2004;
2. Mr. Sole received a $2,762 discount on cabinet purchases made for the FY ended April 30, 2004; and,
3. Mr. Wolk received a $4,885 discount on cabinet purchases made for the FY ended April 30, 2006.

Not disclosed is if each man also received a tax-gross-up adjustment for the 5.0% sales tax paid for the cabinets?
The 10Q Detective welcomes nominations for future Golden Fleece awards from our readers.

Wednesday, July 12, 2006

British Petroleum: skandale,скандал,escándalo,醜聞, 醜聞, (الاسم) فضيحه‏ , A Scandal in Any Language!

"Far from trying to hide the facts, my effort throughout has been to discover the facts—and to lay those facts before the appropriate law enforcement authorities so that justice could be done and the guilty dealt with." Richard Milhous Nixon, the 37th President of the United States (1969 – 1974), quoted prior to his resignation in the face of imminent impeachment related to the Watergate first break-in and the subsequent Watergate scandal....

Last month, the U.S. Commodity Futures Trading Commission (CFTC) called into question the reputation of the proprietary trading business of the London-based energy giant, BP plc (BP-$71.37). On June 28, 2006, the CFTC filed a Civil Complaint in a Chicago federal court against BP Products North America, Inc., a wholly owned subsidiary of BP. The CFTC alleged that BP traders “with the knowledge, advice, and consent of senior management,” among other things, manipulated the price of February 2004 TET physical propane by illegally cornering up to an estimated 88% of the U.S. propane market by late February 2004. [Ed note. Entering February, BP owned nearly 50% of available physical propane at the TET location.]

The company made $2.97 billion in profit last year from its trading operations, about 13 percent of its 2005 net income of $22.34 billion.

Sold compressed in cylinders of various sizes, propane is a popular fuel used primarily to heat rural homes and businesses. During the winter months, much of the demand for propane is concentrated in the Northeast and the Great Lakes regions of the upper Midwest, in rural areas absent natural-gas distribution networks. This market is served by the Texas Eastern Products Pipeline Co., a pipeline and storage network that runs from Mont Belvieu, Texas, through Ohio and into New York, Pennsylvania and Illinois. Traders call propane running along this line "TET propane."

BP is the leading supplier of natural gas liquids, including propane, in the USA, generating $5 billion in annual sales, according to the company.

Internal BP documents obtained by the CFTC show that a team of BP Houston-based traders sought to establish a long February propane position, withhold a portion of that propane from the market, and artificially drive up the price of propane.

BP’s scheme to corner the market allegedly caused the price of TET propane to become artificially high. By cornering the market, the clandestine trading operation was able to dictate prices to short-sellers seeking to cover their open positions. The CFTC asserts that on or about February 27, 2004, BP’s actions had successfully pushed up the price of propane (briefly) to 94 cents a gallon— a fifty percent price hike that would not otherwise have been reached under the normal pressures of supply and demand.

The CFTC complaint further alleges that by cornering the TET propane market, BP employees sought to generate a profit for BP of at least $20 million “with potential for upside from there.”

Internal BP reports show that the traders calculated odds of a loss from the strategy at 20% and put the potential return anywhere from a $5 million loss to a $15 million gain, the internal report shows.

Ironically, BP lost money when rising prices and trading volumes exceeded smaller trading partners' credit limits, leaving the company with large, expensive stockpiles that plummeted in value at month's end, when that month's futures contracts expired.

Adding to BP's disappointment, the CFTC says, another unidentified propane trader unexpectedly dumped large supplies on the market at month's end, enabling it to collect BP's anticipated profits.

Court documents also reveal recordings of phone conversations between BP traders that show their intent while planning and carrying out the alleged scheme. On phone conversations in early February, for example, Dennis Abbott, one of the Houston-based traders, and Mark Radley, trading manager of BP's natural gas liquids business, discussed their getting others in management to approve of the plan.

Of course, BP denies that it ever rigged propane prices or engaged in illegal trading schemes.

"Market manipulation did not occur," BP spokesman Ronnie Chappell said. "We are prepared to make and prove that case in the courts ... In this situation we investigated the trades in question and cooperated fully with the CFTC investigation. We will assist the Department of Justice in its ongoing investigation," he added.

[Ed. note. Based on its own internal findings, BP published a confidential manual for its traders on how BP could profit in the future from the February 2004 propane debacle, fittingly called, NGL Trade Lessons Learned.]

BP's own investigation resulted in the dismissal of three employees [Abbott, too] for “failure to follow its trading policies,” but the company declined to provide details, saying only that they have since taken steps to strengthen supervision of their trading activities.

Do any of our readers buy into Ronnie Chappell’s transparent insincerity?

Court documents show that BP has been about as cooperative as (“I am not a crook”) President Richard M. Nixon during the Watergate hearings.

As far as Chappell’s veracity—about as believable as Nixon’s secretary, , Rose Mary Woods, when asked why there was a crucial, 18½ minute gap on one of the subpoenaed tapes given in evidence to Watergate investigators, saying “she had accidentally erased the tape by pushing the wrong foot pedal on her tape player while answering the phone.”

The 10Q Detective, traditionally the chronicler of the brackish behavior and pecuniary offenses sired in the boardrooms of Corporate America, thought that our readers (who are paying $3.00 a gallon for gasoline at the pump) might find some glee in this tale of greed gone amiss on the Houston trading floor of energy giant BP (ironically, the home of Enron).

[Ed. note. Speaking of Enron--We caught the following headline on the death of the Enron founder: "Kenneth Lay Dead at age 64." The verb lie means to be in a horizontal position; whereas, the verb lay means to put (something) in esp. a flat or horizontal position. Ergo, when Kenneth died, the proper headline should have read: "Kenneth Lies Dead at Age 64!"]

Abbott, 34, admitted his participation in the manipulation scheme, and on June 29, 2006, entered his guilty plea to a previously filed conspiracy charge in U.S. District Court for the District of Columbia. Under the terms of a plea agreement, Abbott could face up to five years in prison, a fine of $250,000, and supervised release following any incarceration. Additionally, Abbott has agreed to cooperate with law enforcement officials in the ongoing civil investigation against BP.

Monday, July 10, 2006

Ebay: Hype over G-Checkout or Is It Hype Over Skype?

The Common Stock of online auctioneer, eBay Inc. (EBAY-$26.62) closed at a new 52-week low on Friday as Wall Street analysts suggested in published research reports that Google Inc.’s (GOOG-$420.45) new online payment service, Google Checkout, could prove to be a legitimate long-term threat to PayPal, currently the Internet’s leading payment service.

Dubbed the ‘PayPal Killer’ in the press, Google Checkout does offer two advantages over PayPal. Speed of checkout is faster for consumers and the service charges merchants 2.0% plus $.20 per transaction, which is less than PayPal’s processing fees (which range between 1.9 percent and 2.9 percent of the purchase amount plus 30 cents per transaction).

Traditional payment methods such as checks, money orders and credit cards processed through merchant accounts, all present various obstacles to the online commerce experience, including lengthy processing time, inconvenience and high costs. PayPal’s Value Proposition is that the proprietary global payments platform offered by PayPal enables any individual or businesses with an email address to securely, easily and quickly send and receive payments online.

PayPal’s account-based system is available to users in 55 markets, including the United States. As of December 31, 2005, PayPal had approximately 96 million total accounts, comprising approximately 19 million business accounts and 77 million personal accounts.

In a report issued last Thursday, Citigroup analyst Mark Mahaney cut his long-term earnings growth forecast for eBay from 22 percent a year, on average, to 20 percent a year. Citing competition from Google Checkout as his main reason for cutting his projected growth rates, Mahoney slashed his target price for eBay to $40 from $51 per share, too.

There is some merit to Mahoney’s investment thesis; for the three-months ended March 31, 2006, PayPal contributed 23.6%, or $328.15 million, of eBay’s $1.39 billion in total net revenue (up from 22.0% in the prior year period).

In an ever-changing competitive technological landscape, G-Checkout is not the first e-commerce competitor that has threatened PayPal’s dominance. PayPal competes with existing online and off-line payment methods, including, among others:

  • Credit card merchant processors that offer their services to online merchants, including Cardservice International, Chase Paymentech, First Data, iPayment and Wells Fargo; and payment gateways, including CyberSource and;
  • Money remitters such as MoneyGram and Western Union, a subsidiary of First Data;
    Bill payment services, including CheckFree;
  • Processors that provide online merchants the ability to offer their customers the option of paying for purchases from their bank account, including Certegy, PayByTouch and TeleCheck, a subsidiary of First Data, or to pay on credit, including Bill Me Later; and,
  • Issuers of stored value targeted at online payments, including VisaBuxx, NetSpend and Next Estate.

When Google first released its Checkout offering last week, eBay made statements to the effect that it was not worried about Checkout, reassuring investors that it was not a PayPal competitor, for Checkout was targeting a different market. [For example, G-Checkout cannot be used to make payments from person to person.]

eBay’s recent actions proved the contrary. Citing Checkout as a new service “without a substantial historical track record of providing safe and reliable financial and/or banking related online transactions,” the Company has banned Checkout as a payment method for Ebay users.

We do applaud Ebay, however, for being innovative in leveraging its core advantage in e-commerce. On May 25, 2006, Ebay strengthened its dominance in e-commerce when it formed an alliance (with the Internet's most trafficked Web site) Yahoo Inc. that will make PayPal the preferred third-party provider of its online wallet.

The 10Q Detective does question, however, Wall Street’s trepidation over Google’s (purported) growing dominance of the Internet? An analysis reveals that its non-research products grab more headlines than market share:

  • Google Talk. The ten-month-old instant-messaging system ranks No.10 in the world, with just two percent as many users as market leader MSN.
  • Google Maps. Although it ranks No.2 worldwide, viewership is 20% less than market leader MapQuest.
  • Blog Search. This nine-month old web log service was expected to bury market-leading Technorati. It gets less than one-fifth as many users.
  • Google Finance. Three-months after its launch, the site ranks No.40 in the U.S.—despite strong initial buzz. Yahoo! Finance remains No. one.
  • Orkut. The social-networking site gets less than one percent as many U.S. visitors as [Source: BusinessWeek, July 10, 2006, “So Much Fanfare, So Few Hits.”]

On a valuation basis, the Common Stock price of eBay looks attractive, selling for only 20.9 times forward 2007 earnings of $1.27 per share (PEG of 1.01x). Competitors Google and Amazon (AMZN-$36.11) sell for forward 2007 EPS estimates of 33.3 times (PEG 1.48x) and 43.0 times (PEG 3.19x), respectively.

Before running out on Monday morning to BUY eBay stock, however, our readers should note that the 10Q Detective has unearthed some accounting concerns, that may cause analysts to rethink their earnings’ models—and appropriate valuations of eBay.

The 10Q Detective believes that analysts need to revisit the acquisition of eBay’s communications business. On October 14, 2005, the Company completed its purchase of Skype Technologies S.A., a Luxembourg-based global Internet firm that was established in 2003. Skype provides software that, among other things, enables free VoIP calls between Skype users online. Skype’s premium offerings, which are currently Skype’s primary source of revenue, provide Skype’s users with low-cost connectivity to traditional fixed-line and mobile telephones. Skype currently offers its software in 23 different languages.

We applaud the rationale for the purchaseenabling eBay to create new potential channels to monetize e-commerce activity. Communication via Skype allows buyers and sellers in highly involved, expensive or complex categories of goods or services, to benefit from being able to communicate directly with each other in an instantaneous and private environs.

Additionally, corporate continues to leverage synergies between Skype and its other businesses. On its 1Q:06 conference call, management noted that the Company now regularly promotes Skype across all of its eBay and PayPal sites. Tapping into Skype fee-based offerings, users can utilize PayPal, which allows for efficient online payments and increased growth in users for PayPal as well.

Nonetheless, given the total purchase price of approximately $2.6 billion (which included cash of $1.3 billion and 32.8 million shares of Common Stock valued at $1.3 billion)—we believe that eBay overpaid for Skype—the purchase price could actually reach approximately $4.1 billion if potential earn-out payments are met.

As of March 31, 2006, Skype had 95 million members in 225 countries and territories. Skype is considered a market leader in VoIP offerings in virtually all countries in which it does business.

For the three-months ended March 31, 2006, Skype’s telephony services contributed $35.2 million to top-line sales in the first quarter of 2006. [Prior to the buyout, Skype reported revenue of $3.3 million for the FY ended December 31, 2004.]

Goodwill of $6.1 million and intangible assets (net) of $823.2 million represent approximately 58.7% of the $11.79 in total assets on the balance sheet. Skype contributed approximately $2.3 billion and $280.3 million in goodwill and intangible assets (net), respectively, to this total.

Ebay has allocated a preliminary estimate of $280.3 million to amortizable intangible assets (consisting of registered user base, access and termination agreements, existing technology and trade names with useful lives not exceeding five years).

Applying a fair-value based impairment test for assets, based on the Company’s last impairment test as of August 31, 2005, corporate determined there was no impairment. Additionally, there were no events or circumstances from that date through March 31, 2006, indicating that no further assessment was necessary.

FASB Statement 142 does a nice job in answering the question—When is Goodwill Impaired? “Financial statement preparers will compare the fair value of goodwill to its carrying amount. If the fair value is less than its carrying amount, goodwill is considered impaired and the company must recognize a loss on the balance sheet.”

The VoIP market climate has changed considerably since eBay did its Skype deal. First, the market is far more competitive now. As such, Skype is facing pricing pressures from cable companies that can offer multiple services such as cable television, voice and broadband Internet service. Additionally, these competitors are offering VoIP or other voice services as part of a bundle, in which they offer voice services at a lower price than Skype can for new subscribers.

Aside from cable, Skype must now contend, too, with legacy telephone carriers (like Verizon's VoiceWing consumer VoIP service and AT&T Callvantage), other VoIP providers (like Vonage, Net2Phone, and 8x8), and the Instant Messenger (IM) platform offerings of AOL, Google, Yahoo! and, Microsoft (which bought Internet start-up Teleo).

The Internet Service Providers are not sitting idle. For example, last December Yahoo! extended its VoIP services beyond PC-to-PC applications with the launch of two fee-based Internet telephony services (called Phone Out & Phone In). And in April, AOL answered the VoIP call with its own service, called AIMphone.

In a more crowded market, eBay’s revenue projections for its Skype communications segment seem more undoable with each passing quarter.

According to documents filed with the SEC in September 2005, EBay anticipated that Skype would generate an estimated $60 million in revenues in 2005 and more than $200 million in 2006. Skype posted $24.8 million in sales in the 4Q:05—well below initial estimates; and, as previously mentioned, the goal of $200 million in forecasted communication revenue for FY ’06 is looking like a stretch, too.

Nonetheless, management at eBay continues to put on their happy faces. To quote their CFO, Bob Swan:

“Skype continues to expand its community of registered users at a phenomenal pace. We ended Q1 with nearly 95 million registered users, representing a nearly 200% increase from a year ago and sequential increase of 27%. To put this in context, in Q1 Skype acquired over 220,000 new users per day. The rapid acquisition of new users, along with the expansion of the Skype ecosystem, is enabling increased activity, which resulted in 6.9 billion Skype-to-Skype minutes served in Q1, a sequential increase of 31%. We are extremely happy about Skype’s Q1 performance, and we are on track to achieve our full year revenue guidance of approximately $200 million for Skype.”

Market conditions have changed, too, which has affected valuations:

1. In January 2005, Net2Phone was acquired by IDT for an aggregate consideration payment of $155.8 million. [2006 EV/ Revenue: 1.56 times]
2. In October 2005, Skype was acquired by eBay for an aggregate consideration payment of $4.1 billion. [2006 EV/Revenue: 20.5 times – which excludes any cross-selling potential]
3. On May 24, 2005, the Vonage IPO priced at $17.00 per share. Recent price: $7.67 per share. [Trailing 12-month EV/ Revenue: 3.74 times]
4. Internet Telephony Service Provider, 8 x 8, Inc. (EGHT-$1.01]. [March 2007 EV/ Revenue: 0.65 times]

In conclusion, the current Common Stock price of eBay has already discounted continued market share erosion in the Far East (spec. South Korea & China), sluggish auction growth in the core U.S. and U.K. markets, and the perceived threat posed by G-Checkout.

In our opinion, however, future earnings could be adversely affected if—and when—the Company is forced to write down the value of its Skype investment.

Wednesday, July 05, 2006

G&K Services: Freezes Pension--What About That Gold Watch?

G&K Services Inc. (GKSR-$34.65), one of the nation’s biggest uniform-rental companies, announced last Friday that it would freeze the defined benefit pension plan for its 6,300 employees, effective December 31, 2006. The Company joins a growing list—IBM, Verizon, and Circuit City Stores—of financially healthy firms that have moved to freeze pension obligations as they seek to shift the burden of retirement savings to employees.

According to the Employee Benefit Research Institute, the number of active, private-sector workers covered by defined-benefit plans has been on the decline for some time. The number of PBGC-insured plans peaked at more than 114,000 in 1985, declining to 31,238 in 2004.

“The burden of funding defined benefit plan obligations is a hurdle that challenges even financially secure companies like G&K in strengthening their market position," said Richard Marcantonio, Chairman and CEO.

In G&K’s press release last Friday, CEO Marcantonio, noted that in recent years, financial and legislative pressures on defined benefit plans have mounted and the funding costs have become increasingly volatile and unpredictable. On the former comment, the 10Q Detective and Mr. Marcantonio can agree— long-term, comprehensive reforms are needed to strengthen corporate America’s Defined-Benefit Pension System(s).

In the last two years, Congressional subcommittees have held hearings on how to better protect employee benefits in Corporate America. Areas of reform under discussion include making permanent changes to the interest rate companies use to calculate their pension liabilities, improving transparency by enhancing disclosure for participants, and reforming pension funding rules (e.g. raising funding limits).

In "The Critique of the Gotha Program” Karl Marx elucidated his much repeated bromide: “to each according to his labor contribution.” Just as in communist countries, however, history has shown that the burden of change always seems to more adversely affect those not making the decisions.

The changes at G&K will not affect the $13.9 million in projected benefit obligations owed to past—and present senior management members—under the Supplemental Executive Retirement Plan (SERP). Nor will the burden of funding this ancillary executive retirement plan go away. As of FY ending July 2, 2005, the Company’s SERP was under-funded by approximately $14.0 million.

Karl Marx would assert that only when society moves beyond “the sphere of bourgeois right altogether”—and ascends to a higher phase of communist society—only then will society operate according to the moral norm, “from each according to his ability, to each according to his needs.”

Has anyone ever seen a member of the Politburo of the People’s Republic of China riding a bicycle to a Committee meeting? The day that happens is the day that society moves beyond the sphere of bourgeois—and will be the day that management at G&K (and all companies) actually makes a fiduciary decision that adversely impacts their own perquisites and retirement benefits, too!

Pension fund freezes are a transparent ploy to cut costs and strengthen balance sheets (by limiting accrual of payment obligations). G&K did not disclose the expected savings that will result because of their maneuver; nonetheless, a review of G&K’s financial statements might provide a useful guide in assaying whether or not there is a value proposition to flash freezing future pension obligations?

[Ed. note. Readers concerned about spotting worrisome signs that their own pensions might be in trouble—perchance—can also pick up some identifying patterns from our review of G&K. The 10Q Detective also suggests linking to a recent online BusinessWeek article: Is Your Pension Plan Retiring Before You?]

G&K’s rental operations business is largely based on written service agreements whereby the Company agrees to collect, to launder and to deliver uniforms and other related products. The service agreements provide for weekly billing upon completion of the laundering process and delivery to the customer. Accordingly, revenue from rental operations is recognized in the period in which the services are provided. Revenue from rental operations also includes billings to customers for lost or abused merchandise.

Direct sale revenue is recognized in the period in which the product is shipped.

G&K Services, Inc., founded in 1902 and headquartered in Minnetonka, Minnesota, is a market leader in providing branded identity apparel and facility services programs that enhance image and safety in the workplace. The Company serves a wide variety of North American industrial, service and high-technology companies providing them with rented uniforms and facility services products such as floor mats, dust mops, wiping towels, restroom supplies and selected linen items. G&K also sell uniforms and other apparel items to customers through a direct sale programs. The North American rental market is approximately $6.5-$7.0 billion, while the portion of the direct sale market targeted by the Company is approximately $4.5-$5.0 billion in size.

Through internal growth and acquisitions, G&K has steadily expanded its operations into additional geographic markets. The Company operates over 140 locations in North America. These locations service customers in 86 of the top 100 markets, including all 30 of the top 100 markets in the United States and Canada.

In fiscal 2005, revenue grew to $788.8 million, up 7.5% over the prior year. Excluding the impact of a 53 rd week in fiscal 2004, full year revenues were up 9.5%. According to management, revenue growth was negatively impacted by lost uniform wearers due to reduced employment levels within the Company’s existing customer base, offset by an improved pricing environment and new account sales.

Rental revenue, which represented 93.9% of total net revenue, was up $32.0 million in fiscal 2005, a 4.5% increase over fiscal 2004 (96.6% of total net revenue). Rental revenue increased 6.4% when excluding the impact of an extra week recorded in fiscal 2004. This growth rate was impressive, considering that the organic industrial rental growth rate was approximately 0.5% (an improvement from negative 2.0% in the prior year period). According to management, improvements in customer retention and a better pricing environment were slightly offset by lost uniform wearers (due to reduced employment levels within its existing customer base).

Direct sale revenue was $48.1 million (6.1% of net revenue) in fiscal 2005, a 94.3% increase over $24.7 million (3.4% of net revenue) in fiscal 2004, largely due to the impact of the Lion Uniform Group. The organic direct sale growth rate was approximately 29.5%. The increase in the organic direct sale growth rate was largely due to garment sales through G&K’s rental operation including its annual outerwear promotion and large shipments at the direct sale unit to one customer.

Gross Margins fell 110 basis points in the past two years (to 35.9 percent). The decrease in gross margins was principally due to higher energy and acquisition integration costs in the current year, largely offset by the benefit of numerous operational initiatives focused on lower merchandise and production costs.

According to management, significant increases in energy costs, specifically natural gas and gasoline, can materially affect operating results. As of July 2005, energy costs represented approximately 4% of total revenue. The retail price of gasoline on July 4, 2005, was $2.46 per gallon (87-octane).

Operating margins have remained relatively stable, falling only 20 basis points in the last two years (to 9.6% of operations).

Selling and administrative expenses increased 7.3% to $165.8 million in fiscal 2005 from $154.5 million in fiscal 2003. As a percentage of total revenues, however, SG&A decreased to 21.0% in fiscal 2005 from 21.9% in fiscal 2003. The improvement as a percent of revenue was due to continued leverage on incremental revenue growth and investments in growth initiatives.

Selling and administrative costs include costs related to the Company's sales and marketing functions as well as general and administrative costs associated with the Company's corporate offices and operating locations including information systems, engineering, materials management, manufacturing planning, finance, budgeting, and human resources.

G&K’s SG&A expenses are competitive with other major North American providers of corporate identity uniforms, including UniFirst Corp. (UNF-$34.54) and Cintas Corp. (CTAS-$39.55), with SG&A of 21.4% (for the thirty-nine weeks ended May 28, 2005) and 26.4% (for the year ended May 31, 2005), respectively.

[Ed. note. Executive Compensation (Annual Compensation + Long-Term Compensation Awards + All Other Compensation) for the top five decision-makers at G&K contributed approximately $4.3 million for FY ’05, or 2.6%, of the reported $165.8 million in SG&A expenses in 2005. The Company paid out approximately $2.3 million in Executive Compensation in FY 2004, which contributed 1.4% to the $158.0 million expensed as SG&A that year. Do any of our readers see any fat in SG&A that could be cut from the budget to yield additional cost-savings?]

Of interest, despite net income rising thirty basis points in the last two years to 5.1%, net cash provided by operating activities has been falling—$63.5 million in fiscal 2005, compared to $96.3 million in fiscal 2004 and $96.9 million in fiscal 2003. Rising net income, but falling cash flow is a red flag. The Company attributes the decline partially to an $11.2 million growth in new inventories “in connection with the expansion of its manufacturing operations”—despite prior initiatives that focused on controlling the usage of ‘in-service’ inventory. Accounts payable and other accrued expenses also rose $16.3 million and cash was also negatively affected by the timing of tax payments.

G&K’s inventories consist of new goods and rental merchandise in service. For the FY ended July 2, 2005, year-over-year inventories grew $26.6 million to $121.1 million, the result of a $22.6 million increase in new goods (in connection with corporate expansion of its manufacturing operations).

The 10Q Detective is putting the spotlight on G&K’s inventory levels, for industry experience dictates that the useful life of uniforms is only eighteen months. Ergo, taking on additional “stocking costs” are just as relevant as incurring “stockout costs” (of too little inventory on hand).

G&K’s goods turned-over every 77.8 days, compared to 74.5 days in the prior year period. Management would attribute the slight rise in days outstanding to its ‘in-service’ initiative.

By comparison, Cintas, North America's leading provider of corporate identity uniforms through rental and sales programs, turned its inventory over every 47.2 days.

As previously mentioned, in its sale of customized uniforms, G&K competes on a national basis with other uniform suppliers and manufacturers, like Cintas and UniFirst. Additionally, G&K vies with a multitude of regional and local competitors that vary by market. Given an anemic sales environment (with single-digit top line growth), the 10Q Detective has spotlighted corporate initiatives focusing on the importance of reducing cycle times and operating costs (to leverage profitability). As such, G&K must look to supplement its internal growth with strategic acquisitions and the cultivation of new businesses.

Management’s goal is to build a national footprint and, accordingly, it is placing strategic value on acquisitions, which expand the Company’s geographic presence. And this takes money.

The 10Q Detective has unearthed ‘soft spots’ on G&K’s balance sheet that call in to question the Company’s financial integrity.

1. In August 2004, G&K acquired Keefer Laundry Ltd., a textile laundry company serving the Vancouver and Whistler areas of British Columbia. The acquisition extends the Company’s uniform and textile rental service area to Western Canada.
2. Nettoyeur Shefford Inc., a uniform and textile service company serving Granby and Montreal, Quebec was purchased in October 2004. This acquisition enhances the market position, serving customers in the province of Quebec.
3. Also in October 2004, G&K purchased certain industrial rental assets and customers of Marathon Linen, Inc., a uniform and textile service entity serving the Detroit metro area. This acquisition expands the geographic coverage to a major North American market.
4. In December 2004, the Company acquired the direct sale uniform group and related assets from Lion Apparel, Inc., a Dayton, Ohio based designer, marketer and distributor of customized uniform programs. This acquisition expands the direct sale business and positions G&K to pursue greater direct sale growth.
5. Custom Linen Systems, Ltd. was acquired in February 2005. Custom Linen Systems is a textile laundry company serving Calgary and Edmonton, Alberta. This acquisition expands the Company’s uniform and textile rental service footprint in western Canada.
6. In March 2005, G&K acquired certain assets from Coyne Textile Services. The Company acquired two processing facilities serving customers in Connecticut, New York, Pennsylvania and New Jersey, and also acquired certain customer assets in Maryland and Florida. This purchase expands and enhances the uniform and textile rental business in North America.

The total purchase consideration, including related acquisition costs of these transactions, was $86.8 million, $24.9 million and $88.7 million in fiscal 2005, 2004 and 2003, respectively. The fiscal 2005 purchase consideration includes $11.9 million of debt issued.

Working capital at April 1, 2006 was $142.4 million, up 37.2% from $103.8 million at July 2, 2005. However, subtracting inventories and pre-paid expenses of $137.2 million and $14.6 million, respectively, and current working assets shrink to $(9.4) million.

Adding to G&K’s potential liquidity problem is the sluggishness the Company has in converting its expenditures back into cash. G&K’s Cash Conversion Cycle is approximately 97 days.

At April 1, 2006, G&K had available cash on hand of $22.0 million and approximately $234 million of available capacity under its revolving credit facility when considering current outstanding borrowings and letters of credit. Corporate anticipates that it will generate sufficient cash flows from operations to satisfy its cash commitments and capital requirements for fiscal 2006 (and to reduce the amounts outstanding under the revolving credit facility); however, the Company has $140.5 million in fixed cash obligations (payments due on long-term debt, including capital leases) coming due in the next three years.

The 10Q Detective calculates that G&K’s defensive-interval ratio—which measures the time span a firm can operate on present liquid assets without mortgaging future revenues—was approximately 58 days. Ergo, we doubt that G&K will be able to simultaneously seek out new acquisitions, pay its daily expenses—and meet estimated capital expenditures in FY ’06 of $30 million to $35 million—without slashing costs somewhere on its books.

U.S. Film Director, Billy Wilder, was credited with saying: “Hindsight is always twenty-twenty.” Looking retrospectively at the financial statements of G&K Services, the red flags bringing attention to possible cash drains at the Company were easier to spot—as was an “I Told You So” percipiency that a flash freeze of its defined benefit plan was imminent.

G&K’s pension plan is a financial drain on the Company: G&K recognized expense for its defined benefit pension plan of $4.9 million, $6.1 million and $3.1 million in fiscal 2005, 2004 and 2003, respectively.

G&K shelled out $1.34 million to cover post-retirement employee benefits (PREB) for FY ‘05, an 8.4% increase over the prior year. In five-years (based on expected number of employees & aggregate years of future service), retirement plan payout benefits were expected to grow approximately 700 percent—to more than $10.3 million per annum.

[Ed. note. Pension liability and future pension expense increases as the discount rate is reduced. Corporate discounted future pension obligations using a rate of 5.50% at July 2, 2005. (The discount rate is determined based on the current rates earned on high quality long-term bonds.) Decreasing the discount rate by 0.5% (from 5.50% to 5.00%) would increase G&K’s accumulated benefit obligation at July 2, 2005, by approximately $4.1 million and increase the estimated fiscal 2006 pension expense by approximately $1.1 million.]

Some readers might ask—Would these cost-savings be eliminated by additional corporate contributions to G&K’s 401 (k)? All full-time nonunion employees are eligible to participate in the 401(k) plan. The Company matches a portion of the employee’s salary reduction contributions and provides investment choices for the employee. The matching contributions under the 401(k) plan, which vest over a five-year employment period, were $$1.81 million in fiscal 2005. The answer is no. Matching contributions are made in G&K stock—which is a non-cash entry to the Company

Additionally, the Company paid out $307,000 in SERP benefits to retired executives, a 15.8% increase over the prior year. In five-years, SERP benefit plan payouts are expected to rise 742.9% to $2.57 million per annum. [Ed. note. We do not expect the Company to freeze this ancillary executive perquisite.]

As of FY ended July 2, 2005, G&K’s pension liabilities were twice as much as its assets. In fact, the plan was under-funded by $(30.23) million. [That is the gap between the $(59.29) million obligation and the $29.06 in plan valued assets.]

Why the shortfall? Given that companies generally do not get tax benefits for contributing to the plans (and the gains are taxable), historically it did not make sense for G&K to close the deficit.

What impact did the plan have on FY ’05 net income? First, there was the $3.79 million in service cost (which was the present value of the future benefits earned by current employees during the year); then there was the $2.72 million in interest costs (on the projected benefit obligation).

An offset to the aforementioned costs is the Company ‘expected long-term rate of return’ of 8.0% (on plan assets), which lowered the expense by $2.17 million. [Ed. note. The expected long-term rate of return on plan assets at July 2, 2005 was based on an allocation of U.S. equities and U.S. fixed income securities. Decreasing the expected long-term rate of return by 0.5% (from 8.0% to 7.5%) would increase the Company’s estimated 2006 pension expense by approximately $0.1 million.] Hopefully our readers picked up on this ‘soft spot’—for the actual return on plan assets was a gain of a less-than-expected $1.89 million.

In the mix the Company also stirred $55,000 in prior service cost and a loss (unexplained in footnotes) of $514,000 and the 2005 period benefit cost totaled a previously mentioned $4.9 million!

In our opinion, because of pecuniary offenses endemic to G&K Services (and already discussed in this blog), freezing its pension plan will not give the Company any singular, competitive advantage over UniFirst or Cintas.

The 10Q Detective also believes that Cintas will flash-freeze its defined-benefit pension, too. The Company continues to be the target of a corporate unionization campaign by UNITE HERE and the Teamsters unions. In our opinion, should workers eventually say yes to union representation—look for the Company to say no to its pension plan.

As the economy has strengthened and employment rates have improved, the outlook for fiscal 2006 and FY ‘07 remains guardedly optimistic for all three uniform-rental firms. In our opinion, upward price changes in oil and fuel costs will continue to pressure gross margins; In the marketplace, internal growth rates will depend foremost on which of the three companies can recognize appropriate opportunities as they arise—and supplement their internal growth with strategic acquisitions.

On a forward enterprise-to- FY ’07 revenue multiple, all three companies are fairly valued: G&K Services, UniFirst, and Cintas sell for 1.0X, 0.98X, and 1.82X, respectively. [Ed. note. Might Cintas’ inviolable premium have something to do with (a) more analysts follow the stock than the other two companies in the aggregate and (b) its (trailing twelve-month) Return-on-Assets and Return-on-Equity of 10.28% and 14.92%, respectively, best its rivals significantly?]

Ironically, many economists consider the demand for uniform rentals & sales to be surprisingly accurate indicators of future economic health. That said, given that the three aforementioned stocks are trading slightly off their 52-week lows—might the stock prices be signaling a slowing job growth market? Therefore, now may not be the time to be a contrarian—at least when it comes to uniform-rental providers.