Wednesday, August 30, 2006

Force Protection--A Cult Following

Charles Bradlaugh (1833 – 1891), a colorful freethinker and political activist in England, said: “Without free speech no search for truth is possible... no discovery of truth is useful.”

When I posted the commentary on Force Protection yesterday, I did not know that I was stepping on a landmine—planted by the ‘longs’ in the Common Stock! According to, the days to cover the open short interest in Force Protection (FRPT) is only 1.2 days (779,931 shares shorted). Looking at the comments left on my blog, however, the BULLS believe that my posting is part of some concerted ‘SHORT’ conspiracy to test their faith:

  • “I think if you had a son over in Iraq you would be begging for him to be in a Cougar. Your little write-up about FRPT seems suspicious at best. You sound more like a short.”

[Ed. reply: You are correct—if I had a son in Iraq, I would want him to travel in a blast-protected military vehicle like the Cougar. It is the policy of the 10Q Detective to fully disclose whether or not I or any of my staff has a position—long or short—in any stock that is posted on this blog. To be honest, I wish that I established a long position in the Common Stock of Force Protection—nine months ago when the share price was still trading at the $1.00 per share level. That said—I’m sorry, but the current valuation—given MY ASSUMPTIONS—is ahead of the fundamentals.]

  • “Please!....U are missing the big picture of FRPT....I suggest U continue to do greater DD [sic. Due Diligence] via contacting Marc Robbins at Catalyst Financial(its obvious U didn't!), and read the FRPT Ragingbull message board(there is some really great info there).”

[Ed. reply: I spent more than fifteen hours—yes, 15 hours, doing the necessary due diligence sufficient to write a ‘balanced’ report.]

[Ed. Response: And speaking of Full Disclosure: Force Protection is paying Catalyst Financial Resources $6,000 per month for 12 months for services rendered.]

  • “FRPT pps [sic. Price per Share] will be north of $20+ next year (conservatively)....why?? The demand for FRPT's products are staggering World-wide….”

[Ed. Reply: Even if the demand is outstripping supply, where do you come out with a $20.00 valuation? The Company’s (factory) capacity utilization cannot put out enough Cougars on a monthly basis to justify such an exorbitant P/S ratio. And remember-the DoD can cancel any contract at any time. If a Democrat—like H. Clinton is elected in 2008—watch out saith the Republicans]


[Ed. reply: You are correct. As long as man has the capacity and the free will to kill—he will. War is not going away. Read my recent posting on Halliburton Corp. WAR—What is it good for? P-R-O-F-I-T-S!]

  • "…you were remiss by failing to mention the Force Protection / BAE alliance which is supplying Cougars for the Iraqi police (over 1,000 vehicles).”

[Ed. Reply: Force Protection is the subcontractor on a BAE Systems agreement to supply (up to) 1,050 Light Armored Vehicles to the Iraqi army. The Iraqi Light Armored Vehicles are similar to the Cougar armored vehicles and will include Force Protection's V-shaped hull designed to deflect the force of explosions away from passengers inside the armored hull.]

  • “I would like to know in all of your analysys [sic. Spelling] why there is no mention of the contract with the U.K. This in itself shows that the companies [sic.] future is looking much brighter and has not only the need to expand but is gaining the capitol [sic.] to expand. If you decide to revise your review you might want to add that part in.”

[Ed. note. This contract announcement was mentioned in the posting: [See Investment Risks & Considerations. Force Protection markets its products to a limited customer base…. As previously mentioned, the Company did just receive a contract with the British government for 85 Cougar armored vehicles.]

  • Are you part of Al Qaeda? Only Al Qaeda has a beef with Force Protection….Be sure and tell Osama those IED's aren't working on the Cougar's and Buffalo's. Maybe you should ride in one of those Humvee's over an IED and you might have a different prospective on FRPT. Better yet, interview a young soilder [sic] sitting in a hospital missing an arm or leg because he wasn't provided a Cougar. You should be ashamed Mr. Phillips!
  • “Dude, this analysis isn't even on a 3rd grade level. Did you actually recommend paying a defense lobyist? Right...great idea…..”
  • “I just would like to remind everyone what a schmuck and bad stock picker Cramer is. THIS GUY ONE OF HIS BITCHES.”

[Ed. note. Yup. Ad hominem argument wins me over every time! Who is the research analyst/firm making $72,000 for coming out with a bullish report on Force Protection? The 10Q Detective does not receive remuneration for any posting—good news or bad.]

A famous line from an ode by Horace goes—"Dulce et decorum est / Pro patria mori," (meaning "It is sweet and proper to die for the fatherland")—I guess the same goes for a cult.

As I said in my original posting: (For the BULLS)—A turnaround at Force Protection is well underway…(Now one for the BEARS)—but lingering concerns on future contract wins will likely put a ceiling on further multiple expansion….(And, now one for the BULLS)—A step-up in new product flow coupled with new contract wins—especially Humvee replacement orders—are the necessary positive catalysts for additional short-term trading gains in the price of the Common Stock….And, now to Duck and Cover—The 10Q Detective, however, prefers to stay on the sidelines….

Monday, August 28, 2006

Force Protection--Explosive Turnaround Story.

Have you ever gazed at a stock that fundamentally looked like all the stars were in alignment for probable share price gains, but something nagged at you not to push the BUY button?

Sales at Force Protection (FRPT.OB-$6.41), a Ladson, S.C.—based maker of ballistic and blast-protected military vehicles, rocketed to $90.8 million for the six-months ended June 30, 2006, up from $1.2 million for the full FY ended December 31, 2001.

The Company, which bled red ink for five years, went from a ‘Going Concern’ being issued by its accountants in April 2006, to finally achieving profitability, recording a net profit of $568,382, or share-net of $0.01, for the 1H:06, the result of a sharp
increase in demand for the Company’s armored vehicles in Afghanistan and Iraq.

In February 2005, the Company affected a 12:1 reverse split of its Common Stock. The Company, however, has finally rewarded its long-suffering shareholders, with the stock price climbing 305.7% in the last year.

Roadside bombs, which the military calls improvised explosive devices (IEDs), are the cause of most of the combat deaths and injuries in Iraq.

According to a recent military report, insurgents planted a record number of roadside bombs last month. Approximately 2,625 bombs exploded or were discovered before they could detonate in July, up from 1,454 in January. And as the ‘conflict’ [Ed. note: O.K. CIVIL WAR!] widens in Iraq between Shiite and Sunni insurgents, more U.S. troops will find themselves in harm’s way.

Force Protection produces two series of armored vehicles—the
Buffalo and Cougar—to detect IEDs and landmines. These protective vehicles are designed with advanced V-shaped hulls to help deflect the blasts of the bombs away from the passengers within, too, and can travel at speeds up to 70 miles per hour.

The Buffalo is the heavier of the two products—weighing 22 tons—and is designed principally for route clearing activities. It integrates a blast resistant capsule with an American-made truck engine and drive train.

The Cougar—at about 14 tons—is lighter than the Buffalo—but is built to offer a similar level of blast protection. It is designed to withstand a 30-pound blast of TNT to either the front or rear axles as well as a 15-pound blast to the center portion of the vehicle. A 4-by-4 Cougar is equipped with tires that will run even when flat.

The Cougar can be configured to complete a wide variety of mission requirements. The newer, Hardened Engineered Vehicle (HEV) can serve as a mine-proof troop transport vehicle, a law enforcement special response vehicle, a weapons platform, or an escort protection vehicle.

Current backlogs indicate substantial growth in sales over the next several quarters (but are already reflected in recent stock price gains). The Company forecasts 2H:06 delivery of 164 armored vehicles, as compared to actual delivery of 37 vehicles in the 2H:05. Revenue is primarily recognized at the time goods are delivered and accepted by the customer.

The world market for mine-protected vehicles is growing rapidly. Landmines and IEDs are the weapons of choice for terrorists and insurgent groups because they are highly effective yet relatively low cost. With increasing world tensions, we agree with management that there is a need for vehicles that can provide a level of protection against these threats during a variety of missions. Such missions include troop transport in and around unexploded ordnance or mine threat areas as well as route clearance and humanitarian de-mining—which require entrance into known mine fields.

Most of these missions require operating in areas of known terrorist activities and have traditionally been accomplished using light weight wheeled utility vehicles, including, for example, the High Mobility Multi Wheeled Vehicle (better known as the “Humvee”). However, Humvees were never designed to sustain high—powered explosive blasts and these un-armored utility vehicles are vulnerable to enemy fire and offer a prime target for attack.

Additionally, trying to better the armor and blast protection of the Humvee by retrofitting heavy armor into its hull, has not worked and has increased the mechanical wear caused by the added weight, too.

Conventional armored vehicles such as the Bradley and the Abrams tank do offer some protection from ballistic and blast threats. However, even these are too often no equals for the latest batch of powerful IEDs. Further, these vehicles are expensive, and require substantial resources to maintain. They are large and difficult to maneuver in crowded urban environments.

Force Protection is working on a blast-protective vehicle capable of carrying cargo and troops. This prototype, the Mine-protected Utility Vehicle/Rapid Deployable, or MUV-R (dubbed the Mover), is a potential replacement of the Humvees used by the military.

There are an estimated 150,000 Humvees in active service in the U.S. military. The government is expected to put out a request for replacement proposals in November (with production expected to start in 2008). A contract win by Force Protection could be a future footprint of success for the Company and its stock price.

To date, the Company has experienced no fatalities in any of its vehicles.

In our view, as the U.S. military increases its focus on protecting our troops—and expands [NOT contracts] its ‘peace-keeping’ efforts in Iraq, Force Protection should witness an increasing market demand for its products.

During 2005, Force Protection depended on two principal customers, the United States Army and the United States Marine Corps. Albeit there is risk with such a limited customer base, the Company recently announced it has been awarded a contract by the British Ministry of Defense for more than 85 Cougar Explosive Ordnance Disposal (EOD) vehicles.

As evident in the Common Stock price gain this year, investors have jumped onboard Force Protection due to the clear signs of a turnaround in the Company’s fortunes. Given growth shows no sign of slowing—why the apprehension in buying shares for our portfolio?

Financial Considerations

In the 1H:06, gross margins improved 400 basis points to 18.5%, which management attributes to increased vehicle production and increased operating efficiencies.

Many government contracts are fixed-price and maybe subject to termination or renegotiation at the convenience of the government. And, large portions of the Company’s factory expenses are fixed. Ergo, management would be unable to reduce expenses significantly in the short-term to compensate for any unexpected delay or decrease in anticipated revenues. As a result, expected profits could become realized net losses.

For the six month period ended June 30, 2006, after years of bleeding red ink, Force Protection generated positive cash flows from operations (CFFO) of 4.0 million. However, the 10Q Detective notes that if you back out the $7.2 million increase in accounts payable, CFFO flips back into the red--$(3.2) million.

The Company has (historically) depended on the capital markets to stay afloat and fund continuing operations. For example, on July 24, 2006, corporate realized net proceeds of $39.2 million through the sale of 8.25 million shares of its Common Stock (at $5.00 per share) in a private placement to institutional investors, including John Hancock and Cortina Asset Management.

As of August 14, 2006 Force Protection had approximately 51.1 million shares of common stock issued and outstanding, up from 21.7 million at FY ended December 31, 2003.

The accumulated deficit (as of June 30, 2006) was $(48.9) million. The book value was $0.08 per share.

Management is optimistic that infrastructure expenses previously incurred in connection with the production ramp-up will begin to level off or decline and that the Company will continue to experience increased levels of positive cash flows from operations as the Company increases the volume of vehicle production. Management also expects that such positive cash flows will allow the Company to pay down all or a portion of its short term debt and reduce the level of its accounts payable ($21.9 million).

In addition to growth acceleration, there is also the possibility of a growing recurring revenue stream from the sale of spare parts and other support services. During the FY ended December 31, 2005, spare parts contributed 10.9% to total sales of $44.8 million

As of June 30, 2006, the Company had $3.4 million in cash, the Total Debt was about 30.3% of Total Equity, and for the 1H:06, the interest coverage ratio finally swung positive—albeit a less than stellar 1.35 times operating income.

Corporate Governance Issues

Effective April 18, 2005, Gordon McGilton was promoted from Chief Quality Officer to CEO. Along with the usual salary [$420,000] and bonus-option incentives, the Company also agreed to pay Mr. McGilton "in kind" compensation in the amount of $20,000 (in the form of a Vortex jet boat). This "in kind" compensation was for work performed by Mr. McGilton as an independent contractor during 2001 and 2002—three years earlier?

And, it is not like McGilton could not afford to buy a NEW boat, for he received options to purchase 1,000,000 shares of Common Stock at an exercise price of $0.72 per share (which vest on January 1, 2007)—now worth an estimated $6.4 million.

In addition to his duties as CEO, McGilton is a principle of APT Leadership, a consulting firm the Company hired to provide various “business consulting services, training seminars and certain business software.” Through the period ended June 30, 2006, APT Leadership billed Force Protection a total of $563,120 for such services, training and software. In addition, Force Protection entered into an agreement with APT Leadership pursuant to which the Company purchased a non-exclusive right and license to use the “diagrams, methods, concepts and business operating system functionality” contained in APT Leadership software and presented in APT Leadership's training seminars. Force Protection also paid a one-time license fee of $60,000 and agreed to pay an annual license fee thereafter of $50,000 under the terms of the said agreement.

The 10Q Detective would like to know—why the need for this leadership training? According
to the APT Leadership website, the consulting firm provides motivational services designed to get employees “working together towards the organization’s goal.” The Company is selling armored vehicles—not burgers. Would not the monies be better spent on defense lobbyists? Or, given the highly politicized nature of weapons procurement programs, perhaps the monies ought be channeled as PAC money to the re-election campaign of embattled Congressman Henry Brown (R-SC), a big advocate for Force Protection on Capitol Hill.

Investment Risks & Considerations

Force Protection markets its products to a limited customer base and if the Company does not find acceptance of its products within that customer base, or if the Department of Defense (because of budget issues) cancels contracts, its business may fail. As previously mentioned, the Company did just receive a contract with the British government for 85 Cougar armored vehicles.

The Company is subject to significant competition from companies that market products that perform similar functions. This competition could harm the Company’s ability to win business and increase the price pressure on its products. The firms that Force Protection competes against include large, multinational vehicle, defense and aerospace firms such as BAE Land Systems, Iveco DVD (Italy), Textron, Stewart & Stevens, Australian Defense Industries, Oto Melara (Finmeccanica-Italy), and General Dynamics.

On June 16, 2006, Force Protection significantly improved its competitive position when it signed an intellectual property agreement to develop and market patented Blast Manipulation Technology (applicable to wheeled and tracked vehicles) with South Africa’s Council for Scientific and Industrial Research (CSIR), a world leader in (blast-resistant) lightweight composite research. Still, it troubles us that corporate—perhaps to raise EPS visibility—is spending less than four cents of every sales dollar on R&D. Ought the Company be spending more on technology and research to exploit their competitive advantage?

With relatively short production runs and high fixed factory costs, contrary to what management would lead us to believe, sustainability of future profitability is difficult to predict. Force Protection is benefiting from the U.S. military’s need to and ramp-up of combat-ready protective vehicles for service in Iraq and Afghanistan. There is no guarantee that the Company will be awarded procurement contracts in the future for the replacement of legacy systems (such as Humvees); and, to date, the Company has had limited success in diversifying into other markets.

Valuation Analysis

After an extended period of downsizing, followed by mergers (to consolidate excess capacity), the Land Combat Systems (LCS) industry appears to be in the midst of a robust growth period—both domestically and globally. For example, given the expanding demand for protected vehicles for military applications in Iraq and Afghanistan, and the move toward transforming legacy systems in both the U.S. Army and the U.S. Marine Corp., industry pundits predict that more than $2.0 billion per annum over the next twenty years could be infused into the domestic LCS industry.

The impact of globalization is also leaving its footprint on the U.S. LCS industry.

In our view, the trend of mergers and acquisitions are likely to continue, and Force Protection could find itself on the front-end of a merger by a foreign concern (probably a U.S.-NATO ally) looking to build a presence, competitive advantage, and an increased access to U.S. markets.

Is the Common Stock of Force Protection worthy of new investments?

Manufacturing needs of the U.S Military will keep sales (and profits) trending higher through at least the 2008 timeframe. However, we believe that the market has already discounted this timeframe (witness the 305.7% price gain in the past 52-week period). After 2008, all bets are off—new faces in the White House, compounded by rising deficits and Social Security payments, could spell cutbacks in Department of Defense spending.

In our opinion, Force Protection’s management does not have the know-how to be profitable as a ‘low-volume’ producer—with only two product lines, the Company is highly dependent on ramping up production for sustainable profitability. And management has yet to demonstrate its ability to leverage its core-competence by exporting its blast-resistant technology.

Is Force Protection attractive as an acquisition candidate? In our view, this is a probable outcome, for the Company would be an attractive purchase for a (NATO-ally) European defense contractor looking to establish a U.S. footprint to improve their likelihood of winning Pentagon contracts. FY 2005 LCS transactions sold at an average EV/sales multiple of 1.65 times.

The current enterprise value of Force Protection is $331.24 million. Assuming the Company sequentially grows sales in the 2H:06, and exists the year (optimistically) with $240 million in full-year 2006 sales, that places an EV/sales multiple of 1.38 times on the price of the Common Stock. EV/sales of 1.65 times puts the Common Stock of Force Protection
at $7.75 per share--a 20.9% premium above its current share price.

In June 2005, Britian’s largest defense contractor, BAE Systems, completed the acquisition of Arlington, VA. —based United Defense Systems (UDI), a dominant player in domestic LCS (like the M2 Bradley Infantry Fighting Vehicle) and a global leader in ground combat vehicles and precision munitions. The transaction for UDI was valued at $3.97 billion, or 1.73 times trailing twelve-month sales of $2.29 billion.

In the summer of 2004, BAE Systems outbid General Dynamics (by $100 million) for Alvis Vickers, the UK's principal land systems business. BAE paid almost $651 million, or 1.03 times Alvis’ trailing twelve-month sales.

At a current price of $6.41 per share, the Common Stock of Force Protection is valued at a P/S of 1.36 times FY 2006 exit sales of $240 million.

A turnaround at Force Protection is well underway, but lingering concerns on future contract wins will likely put a ceiling on further multiple expansion. A step-up in new product flow coupled with new contract wins—especially Humvee replacement orders—are the necessary positive catalysts for additional short-term trading gains in the price of the Common Stock.

Sales growth acceleration beyond FY 2008 is cloudier. However, industry consolidation trends bode well for shareholders in Force Protection.

The 10Q Detective, however, prefers to stay on the sidelines—at least for now.

Thursday, August 24, 2006

AOL's New Business Plan: Digging for Gold

Jim Cramer told viewers of his “Mad Money” television show yesterday that media giant Time Warner (TWX-$16.54) is "so bad that the Company should be called "Time Goner." The stock is not going anywhere unless the company's CEO Richard Parsons starts playing the right game…. The cable business is all about the triple play (cable, telephone and Internet) right now. Parsons needs to realize that his ace is his cable business and that he needs to throw everything else out. This move would make Time Warner jump to $26 a share.”

Cramer has a valid point, for in the last two years, the stock price of TWX has traded in a narrow-band [$16.00 - $19.90]—and in the last year, the stock has lost 5.75% in value (vs. a 52-week change of 6.89% in the S&P 500 Index).

We beg to differ, however, when he said on his recap that,
“The Company’s AOL business "is worthless," and Time Warner should sell it immediately….”

Although concerns do exist on whether or not AOL can execute on its recently announced
‘free’ web-portal strategy, the double-play of (1) continued growth in advertising revenue [growth exceeded 30% across all advertising product categories in the 2Q:06] and (2) cost-cutting measures [such as marketing scalebacks] are expected to more than offset subscription revenue losses (and the Company has targeted a goal of $1.0 billion in cash flow savings by the FY end of 2007).

Despite an increase in (dial-up) churn—AOL members declined 976,000 in the 2Q:06—the footprint of this Internet & Content Provider still stands at an impressive 17.7 million members. Monthly ARPU for the total membership base rose to $19.42 in the current quarter.

On August 3, AOL expanded content with the launch of 45 video-on-demand sites (free—but with commercials). In our view, this is part of the new strategy to grow traffic—and advertising revenues.

There may be unrecognized incremental value in AOL’s recent sojourn to mining for precious metals, too. What? Say, you….

Tuesday, AOL announced that it intended to
dig up the yard belonging to the grandparents of Davis Wolfgang Hawke—in pursuit of (alleged) buried gold and platinum.

Mr. Hawke disappeared after losing a $12.8 million judgment to AOL in federal court in Virginia under the
Can-Spam Act.

Last year,
AOL confiscated a Hummer and $100,000 in gold bars and cash from another spammer in Massachusetts.

Perhaps if AOL makes this a permanent part of their new business model—going after more spammers’ hard assets—the Common Stock of its parent company might start tracking the trading gains of the CBOE Gold Index (and related gold mining stocks)?

GOTCHA' Journalism

Does anyone need to consult a psychic to have advance knowledge of the foretold outcomes described in the following press clippings?

U.S. says Iran proposal falls short

Tuesday, August 22, 2006

Biomet--Catching a Break?

Companies in the besieged orthopedic device maker space, like Biomet (BMET-$32.68), Stryker Corp. (SYK-$47.38), and Zimmer Holdings (ZMH-$67.83), the largest (independent) orthopedic player, whose stock prices have slumped 12.5%, 11.1%, and 17.51%, respectively, in the past year, recently caught a break. After initially signaling to manufacturers that reimbursements would stay flat next year, on August 1, 2006, the Centers for Medicare and Medicaid Services (CMS) announced its decision to raise payments for joint-replacement surgeries by 4%-to-5% in FY 2007. According to industry analysts, this rate relief should give the companies more pricing flexibility with their product mixes.

Nonetheless, after reviewing recent SEC filings, the 10Q Detective believes that Biomet will under perform its peers. Simply, despite changes in senior management and other restructuring moves, the Company’s financial performance in recent quarters has failed to show any meaningful improvement in margin gains—and is probably months away from materializing (if at all).
Hip and knee and extremity joint replacements account for more than 95% of all orthopedic implants and Biomet holds about 12% of this market, which accounted for 68% of the company's net sales in FY 2006.

Biomet, with operations in 60 locations and distributions in more than 100 countries, operates in three other musculoskeletal market segments, too. (1) Fixation devices, which represented 12% of the Company's net sales for fiscal year 2006, include internal (products such as nails, plates, screws, pins and wires designed to stabilize traumatic bone injuries) and external fixation devices (utilized for stabilization of fractures when alternative methods of fixation are not suitable), craniomaxillofacial fixation systems and electrical stimulation devices that do not address the spine. (2) Spinal products, which represented 11% of the Company's net sales for fiscal year 2006, include electrical stimulation devices addressing the spine, spinal fixation systems and orthobiologics. (3) The other product sales category, which represented 9% of the Company's net sales for fiscal year 2006, includes arthroscopy products, softgoods and bracing products, casting materials, general surgical instruments, operating room supplies and other surgical products.

Net sales increased 8% during the current fiscal year ended May 31, 2006, to $2.02 billion from $1.87 billion in 2005.

In the reconstructive device space, worldwide sales increased 10% to $1.38 billion in fiscal 2006. Factors contributing to this increase included: 14% sales increase in dental reconstructive products, a 9% increase in
hip replacement sales, offset by bone cement and accessory sales decreases of 5 percent. Bone cement and accessory sales were negatively impacted by the loss of the Company's primary bone cement supplier during the year. The Company introduced its own bone cement during the year and anticipates recapturing some of its lost market share.

knee replacement market saw healthy growth, too, with sales increasing 12% worldwide. These percentages were partially achieved by continued acceptance of Biomet’s Vanguard Complete Knee System and the domestic Oxford Unicompartmental Knee System, the only free-floating meniscal unicompartmental knee system available in the United States.

The aforementioned CMS price allowance for FY 2007 is of material significance, for worldwide product volume growth in the hip & knee reconstructive market is expected to be approximately 7% -to- 9% per annum in the coming years—which means Biomet can only show double-digit growth by product/volume mix increases (new product rollouts and/or price increases of legacy products) and/or by cannibalizing market share from other (formidable) competitors.

Fixation sales increased 2% during fiscal 2006 to $251.36 million.

Craniomaxillofacial products, including bone substitutes, increased 12%; internal fixation devices increased 6%, offset by sales declines in electrical stimulation devices.

Favorable pricing and incremental volume/product mix increases of spinal hardware, including orthobiologics (like the Osteoprogenitor-Bone Marrow Aspiration Kit & the Demineralized Bone Matrix), offset by spinal stimulation product sales declines, lead to a 4% increase in spinal sales to $221.9 million in FY 2006.

Sales of the Company's other products increased 5% to approximately $173.0 million in fiscal 2006. Favorable pricing and incremental volume/product mix increases of arthroscopy products and general surgical instrumentation goods contributed to these gains.

Net Income grew to $496.14 million for FY 2006 from $351.62 million in 2005. However, this result was magnified by a 250 basis point decrease in the Company’s effective tax rate and a reduction in the shares used in the computation of earnings per share (through a share repurchase program), which resulted in an 18% increase in basic earnings per share for 2006 to $1.64 compared to $1.39 in 2005.

Management admits to unresolved problems endemic to the Company that could shadow future financial performance. The fourth quarter had a 5% decrease in net profit, in part because SG&A expenses increased 1% to $190.5 million, representing 35.3% of sales (management turnover and related severance packages) and continued sales shortfalls—despite a reorganization—of its spinal and fixation market(s) subsidiary, EBI.

To improve EPS visibility going forward, corporate announced several ongoing initiatives on its fourth quarter sales call:

  • Reduce COGS. The Company is looking to identify and reduce excess capacity by consolidating its worldwide manufacturing operations (e.g. Biomet has initiated a program to bring all of its spinal manufacturing in house). Additionally, management has announced plans to no longer outsource production of bone-cement (its former dependency on one outside supplier led to lower profit margins on bone-cement products when the Company [Heraeus Kulzer GmbH] raised its prices at the end of FY 2005).
  • Reduce SG&A. Given a plethora of acquisitions over its twenty-seven year history, decentralization formerly had served the Company well in fermenting an entrepreneurial spirit. However, with SG&A eating up more than 35 cents in every dollar of sales in the fourth quarter, management intends to become more centrally focused in key operational areas such as accounting, IT, human resources, regulatory and clinical affairs plans. [Ed note. Look for headcount reductions.]
  • Corrective actions taken at EBI include the announced resignation of, Bart Doedens, M.D., less than one year after being promoted to the position. [Ed. note: Dr. Dane Miller, co-founder and former CEO said about Doedens on June 30, 2005: “We are confident that Dr. Doedens will provide the leadership capabilities necessary to position EBI as a leader in the spinal and fixation market places."]
  • New Product Rollouts. In the past six fiscal years, Biomet has introduced more than 700 new products to the market. Continuing this product launch streak, the Company is hoping that the following systems will be big revenue drivers in the coming quarters:
  1. Vanguard Complete Knee System is designed to provide precise fit for all patients regardless of gender, race, stature or any other variables contributing to anatomical differences. According to corporate, the Vanguard is the most comprehensive total knee system on the market today, offering full interchangeability of the system’s components, and providing greater bone preservation than competitive high flex systems. In FY ’06, the Company continued the development efforts to complete the rotating platform and revision options of its Knee System, rolling out the Vanguard Interior Stabilized Bearings during the 4Q:06, and the Company also received regulatory clearance for the Vanguard Pop Top Tibia.
  2. Oxford Unicompartmental Knee System is the only free-floating meniscal-bearing Unit available in the U.S. According to Biomet, more than 100 U.S. surgeons completed Oxford training in the 4Q:06.
  3. Hip Systems. Biomet continues to explore the development of innovative articulation technologies and materials. The Company received FDA clearance during the fourth quarter for Acetabular cups manufactured with Biomet's Regenerex core titanium construct. Titanium has become a clinically proven material in the orthopedic market, resulting in optimal biological fixation. Management believes the long-term success of Biomet's titanium implants will translate into strong demand for Regenerex as the material of choice for porous metal constructs (and complement the Company’s best-selling M2a-Magnum Acetabular systems). Corporate is scheduled to initiate the launch of Regenerex cups and augments during the second quarter of fiscal 2007.
  4. In Europe, the Recap Total Resurfacing System is experiencing strong market acceptance. The Recap is a bone conserving resurfacing system indicated for patients in the early stages of degenerative joint disease. During the fourth quarter, the Company introduced the Recap Ha, Hydroxy Appetite Coated Shell to the European market. In the U.S., Biomet continues to enroll patients in its IDE study for the Recap Total Resurfacing System, which currently has approximately 50 patients enrolled.
  5. On the spine side, the Polaris Synergy System is expected be a big driver as Biomet progresses through fiscal 2007. Internal fixation products like locking plates and [inaudible] screws are viewed as critical to a sales ‘turnaround' at EBI in FY ’07.
  6. Extremity Systems. The recently introduced ExploR Radial Head Replacement continues to receive excellent market acceptance. The ExploR, a two-piece hemi-elbow, modular device, includes a tapered stem and a head designed to articulate with the patient’s natural bone.
  7. Maestro Wrist, which was also introduced recently, can be used as a total wrist device or a hemi arthroplasty for carpal replacement.
  8. Biomet is looking to ‘stimulate’ growth' at its troubled EBI unit with the introduction of several new electrical stimulating bone growth products.

As a percent of sales, research and development expenses were 4.2% in fiscal 2006 and 2005.

Demographics support future growth trends in the musculoskeletal market space. According to U.S. Census Bureau projections, the 55 –to- 75 year-old U.S. population is expected to almost double in the coming decade (from 39.6 million in 2006 to 68.0 million in 2016). And this healthier, aging boomer generation is demanding top quality care to stay active.

Today’s surgeons are driving trends as well, since they are more willing to grant surgery with the knowledge that newer technology is bringing with it pain relief and longer-lasting materials.

The Company believes it has firmly positioned itself as a surgeon advocate and has worked to promote the right of the surgeon to prescribe the medical treatment best suited to the needs of the individual patient.

Biomet was the first company to introduce (muscle sparing) microplasty minimally invasive totally knee replacement system. In the last three years, more than 1,350 surgeons completed instrument training. During FY ’06, the Company continued its expansion of the Microplasty Minimally Invasive Instrument Platform to include less invasive posterior referencing, anterior referencing and image-guided options.

Valuation Analysis

As mentioned earlier, CMS announced the revised reimbursement rates that will go into effect October 1, 2006. Biomet believes (as do we) that this action reflects a positive pricing environment for the majority of the Company’s products. The new reimbursement rates for Major Joint Replacement and Hip or Knee Replacement will reflect an increase of 4.2% and 5.0%, respectively. As a group, the new reimbursement rates for spinal and trauma procedures are estimated to increase an average of 7.0 percent—all fundamental positives for the Company.

Biomet is in the midst of several major product launches and management anticipates that the Company will continue to be rolling out instruments at least early into fiscal 2007.

Looking ahead, Biomet said it remains "comfortable" with analysts' sales and earnings estimates of $513 million to $530 million and 43 cents to 45 cents per share for the first quarter of fiscal 2007, and $2.15 billion to $2.22 billion and $1.85 to $1.95 per share for fiscal 2007.

The Company’s valuation looks attractive. The Common Stock’s valuations are priced at multi-year lows. For example, BMET’s P/E is only 17.5 times forward May 2007 consensus estimates of $1.87 per share [low end]. This is a 38.5% discount to its trailing five-year mean multiple of 28.5 times earnings. And with an estimated forward five-year EPS growth rate of 15.0%, the Company’s PEG multiple is an attractive 1.2 times [in line with its peer group multiple, which includes Stryker Corp., Zimmer Holdings, and Smith & Nephew].

Value investors might also note the predictable 30% operating margins, and the 20.4% return on capital (compared to its cost of capital of 5.8%).

Tempering these valuations, however, is the boring—in your face—thesis that there are few catalysts on the event horizon to expand valuation multiples (such as a turnaround in its EBI operations or margin improvement gains).

Patient investors with a longer-term view might consider the current price as an entry point, but (with a dividend yield of 0.90%) we prefer to put our dollars to work elsewhere.

In April 2006, the Company confirmed that it hired investment banker Morgan Stanley to help explore future strategies, including a possible move to put itself up for sale. Analysts have cited Medtronic and Smith & Nephew as potential buyers. The asking price for Biomet, should it decide to sell, could be more than $10 billion—or approximately $44.40 per share.

Investment Risks & Considerations

Litigation. Biomet is not without obstacles on the road to sustainable profitability. In June, the US Justice Department, which is investigating various companies for
possible antitrust violations, subpoenaed the Company.

Additionally, in March 2005, the U.S. Attorney’s Office subpoenaed Biomet for documents related to consulting and other agreements with surgeons (using or considering the use of Biomet’s hip or knee implants).

Foreign Currency Exposure. During fiscal year 2006, sales of the Company’s products in foreign markets approximated $700.6 million, or 35%, of total revenues. Ergo, significant increases in the value of the U.S. dollar relative to foreign currencies could have an adverse effect on the Company’s results of operations.

Corporate Governance Issues

On July 12, 2006, Biomet announced the resignation of Bart J. Doedens, M.D., the erstwhile President of EBI, who left “to pursue other interests.” In our view, Doedens—who headed up EBI for only one-year—did not leave voluntarily; he was “fired.” Articulating such language, however, might have jeopardized the $720,000 bonus previously paid to Mr. Doedens for relocation expenses [when he was promoted in 2005].

On May 8, 2006, the Company entered into a Separation, Release and Consultancy Agreement with Dane A. Miller, PhD, 60, a cofounder and former CEO of Biomet. Dr. Miller will receive $9 million in connection with the separation package. Pursuant to the terms of the Separation Agreement, Dr. Miller will receive $4,000,000 on October 1, 2006, $500,000 on November 30, 2006 and $500,000 on the last day of each quarter thereafter through the first quarter of fiscal year 2010, as compensation for “consulting services” to be provided in accordance with the terms of the Separation Agreement.

The 10Q Detective shucked these other pearls from Dr. Miller’s Consultancy Agreement, too:

In the event of Miller’s incapacity or death, his estate or heirs shall receive from the Company the balance due on the contract. [Ed note. How can one do consulting if they are dead?]

Biomet shall also reimburse Miller up to $100,000, paid monthly, per fiscal year, for the out-of-pocket fees and expenses of the services of a secretary and the provision of an office (not in the Company's facilities).

On behalf of the Company in his capacity as a consultant, his foregoing duties shall not exceed forty hours per month (or twenty hours per week).

After the Termination Date, Miller shall be compensated by the Company at the rate of $500 per hour plus expenses for additional ‘consulting duties.’

And, yes, he gets to keep his laptop and company car.

Dane Miller beneficially owns 6.02 million shares, or 2.5%, of the Common Stock of Biomet, worth an estimated $196 million.

Dr. Miller is also the majority shareholder in a corporation, AirWarsaw, Inc., which provided the use of an aircraft to Biomet on an as-needed basis through May 31, 2006. Biomet paid a flat monthly fee of $39,750, plus sales tax, to AirWarsaw for the use of the aircraft. During the last fiscal year, Biomet made payments to AirWarsaw of approximately $505,620 in rental fees. This lease was terminated effective May 31, 2006. The Company does not expect to make any payments to AirWarsaw during fiscal year 2007.

In addition, during fiscal year 2006, Biomet purchased a motor home, at a cost of $349,381 to be used to transport people for tours and other Company business. This motor home was purchased from ForeTravel Motorcoach, a company in which Dr. Miller was a minority shareholder and a member of the board of directors.

On August 15, 2006, management filed their annual Proxy Statement with the SEC. Buried in one of the back pages we found this gem: “The Committee believes that the executive compensation programs and practices described above are conservative and fair to Biomet’s shareholders. The Committee further believes that these programs and practices serve the best interests of Biomet and its shareholders.”

“The more things change, the more they remain…insane.” --Michael Fry & T. Lewis (Over the Hedge comic strip)

Friday, August 18, 2006

FARO Technologies: Measurable Success Ahead?

The specialty measurements and inspection systems maker, Faro Technologies (FARO-$17.82) leases its headquarters in Lake Mary, Florida from Xenon Research, Inc., all of the issued and outstanding capital stock of which is owned by Simon Raab, the Company's co-founder, and Diana Raab, his spouse. The fixed rent under the lease is $302,750.00 per annum payable monthly, increasing on an annual basis by three percent over the fixed rent for the preceding year (until the lease expires in July 2011). The lease is a “net lease,” meaning that the Company also is responsible for real estate taxes and insurance expenses covering the leased premises.

The term of the lease commenced as of July 1, 2006 (about the time that Raab started to feel the impact of a 50% reduction in his base pay because he went into ‘semi-retirement’). Pursuant to his employment agreement, Raab transitioned from Chief Executive Officer to Co-Chief Executive Officer during 2005 and altered his full-time commitment to no more than 80 hours per month. Dr. Raab, who holds a Ph.D. in Mechanical Engineering from McGill University, saw his salary slashed to $200,000 per annum.

Rabb is the beneficial owner of 1.25 million, or 8.6%, of the Common Stock of Faro, worth an estimated $22.3 million (which also includes an exercisable option to purchase 90,000 shares at $2.23 per share).

Raab’s reverse-engineering into semi-retirement could not have been better timed—for him. Back in March 2006, the Company, as a result of an internal review that it conducted, announced that it had “recently learned of suspicious payments in connection with foreign sales activities in China.” Specifically, an investigation—still ongoing—is underway to verify allegations that its salespeople operating in China and the Asia/Pacific region paid kickbacks to government officials (in possible violation of the anti-bribery, books and records and internal controls provisions of the Foreign Corrupt Practices Act).

The measure of success is not whether you have a tough problem to deal with, but whether it is the same problem you had last year. - John Foster Dulles, American statesman (1888 – 1959)

If this Co-Chief Executive appointment goes sour, Rabb, 53, can still measure his success in real estate management.
As an investment, the Common Stock of FARO looks compelling to us, for the Company appears to be moving beyond its bribery scandal. On August 3, corporate reported net income for the second quarter ended July 1, 2006 of approximately $900,000, or share-net of $0.06, compared with net income of $1.9 million, or $0.13 per share. Second quarter 2006 results included pre-tax expenses of approximately $3.4 million for legal and professional fees, of which $2.2 million was related to the Company's Foreign Corrupt Practices Act (FCPA) internal investigation.
Sales for the second quarter of 2006 were approximately $38.0 million, an increase of $7.1 million, or 23.0% from $30.9 million in the second quarter of 2005.
The Company outperformed consensus estimates of $0.04 per share on sales of $35.4 million.
Management said that the Company continues to show strength in the CAM2 (computer-aided manufacturing measurement) market, and therefore they are maintaining the original full-year 2006 sales guidance of $150-$157 million (and estimate gross margin to remain between 57-59%).
The Common Stock sells for 18.5 times forward December '07 consensus estimates of $0.96 per share. [A 50% discount to its average 3-year trailing P/E multiple.]
The catalyst(s) for an upward move in the stock price would be (i) a firming of gross margins in coming quarters [dependent on product mix] and/or (ii) resolution of the FCPA investigation.

Wednesday, August 16, 2006

Limited Brands: "Who Has a Secret?"

4:16PM – August 15, 2006

The specialty retail operator of Victoria's Secret, Limited Express and Bath & Body Works stores, Limited Brands, Ltd. (LTD-$26.81) announced the retirement of its Chief Financial Officer, Ken Stevens.

Mr. Stevens, 54, is leaving before the Company’s exciting “Semi-Annual Volcanic sale event toward the end of the season.” Stepping down after only two months in the post, he said he was retiring “to spend more time with his family.”

Stevens had been with Limited for five years in various roles. Most recently he served as CEO of Limited Brands’ Express subsidiary and earlier was president of its Bath & Body Works chain.

Stevens’ employment agreement (effective June 12, 2006) provided for an initial base salary of $900,000. [Ed. note. I love my family, too, but it’s hard to walk away from—including potential bonus’—one million (+) per annum.]

In our view, “Victoria is not the only one with a Secret.” There is more to this announcement than the bromidic press release—“personal reasons.” We recommend to our readers a reading of Limited Brands’
Q1:06 Conference Call Transcript. Paul Rapp (President of Express) quickly answered a question directed to Stevens on trading margins and he [Stevens] fumbled a second question on the number count in change of store leases.

Stevens does not depart empty-handed. There is a rider in his agreement that articulates that “if he terminates his employment for good reason, he will continue to receive his base salary for one year after the termination date.” All told, provided that he agrees to “execute a general release of the Company,” he will collect—in aggregate--$1.8 million in salary continuation (payable over twenty-four months). Additionally, he has the
earn-out potential to receive $1.98 million in incentive compensation.

Unclear is whether or not he will have to return 15,000 shares committed for purchase to him by the Company for his fleeting promotion to CFO.

Limited Brands has an active group of Loss Prevention Professionals dedicated to reducing shrinkage (inventory shortages)—ranging from tackling organized crime through ‘panty-raids’ of online auction houses to Info-Sharing with other retailers. In the case of this ephemeral CFO, in our view, the Company could have used one of these professionals in working out this departure deal.

Monday, August 14, 2006

Bristol-Myers Squibb--'Excedrin Headache No. 99.'

In the last two weeks, shares of Bristol-Myers Squibb (BMT-$20.24) have plummeted 22% on investor concerns that the introduction of generic competition to its blockbuster growth-driver, PLAVIX, would jeopardize the drug-makers’ earnings and dividend.

On August 8, 2006, after a patent dispute resolution failed to receive required antitrust clearance from New York state attorneys general, Canadian drug maker Apotex launched a generic copy of the blood-thinning treatment,
clopidogrel (PLAVIX), even though it's being sued for patent infringement by Bristol-Myers, which holds the U.S. marketing rights to the Sanofi-Aventis (SNY-$43.17) drug.

Bristol’s original patent suit claimed that Apotex infringed on a second patent (US. 4,847,265) covering a
chiral compound, that purports to show that the “pharmacologically superior and less toxic” (+) enantiomer of clopidogrel is necessary for the efficacy/safety profile of PLAVIX [and this patent does not expire until 2011].

In February 2002, Apotex filed an Abbreviated New Drug Application (ANDA) with the FDA challenging two of Sanofi’s US patents relating to PLAVIX. Specifically, the company asserted that the original patent [covering both (+)/(-) anantiomers] of clopidogrel, which expired in July 2003, contained the active ingredient sufficient to proceed with the manufacturing of the non-brand name drug. In other words, Apotex argued that the 2011 patent offers no new information and is invalid because the active molecule of PLAVIX is already described in the expired patent. [Generic manufacturers need only show in vivo
bioequivalence –no comparative efficacy/outcomes data is needed to bring before the FDA to receive marketing approval.]

Bristol-Myers is going to court this week seeking an injunction to enjoin Apotex Corp. from selling its generic version of the platelet aggregation inhibitor.
Citing prior
settlement concessions, including the recently file document with the SEC that Bristol-Myers had waived its right to seek treble damages [had Apotex gone ahead with its intended launch while litigation was ongoing], analysts think that the drug-maker has less than a 50% chance of being granted the desired temporary restraining order. [Ed. note. Legal experts opine that by reducing the potential penalty “to 40% to 50% of Apotex's net sales,” Bristol-Myers management ‘lowered the bar’ and did not believe that Apotex’s actions posed any material threat to the brand-name franchise!]

Time is money for generic manufacturers. The US FDA offers a
180 day exclusivity period to generic drug makers in specific cases. During this period only one (or sometimes a few) generic manufacturers can produce the generic version of a drug. The bulk of a generic company's profit on a product comes during the 180-day exclusivity period because the lack of competition means it doesn't have to slash prices deeply. Often, they only price at a 25 percent discount to the brand. That discount can fall to 80 percent –to- 90 percent once numerous competitors enter a market.

Prior to the collapse of the trade agreement with Apotex, Bristol management had been in negotiations for a similar settlement with the Indian generic drug firm Dr. Reddy's Laboratories (RDY-$31.00), which has been challenging the PLAVIX patent since April 2002. If Bristol-Myers loses its day in court this week, in 180 days—or sooner—Dr. Reddy’s hopes of selling a cheaper copy of PLAVIX in the United States may bear fruition.

Teva Pharmaceutical Industries (TEVA-$34.51), Watson Pharmaceuticals ($24.28), and Cobalt Pharmaceuticals have filed ANDAs to market copycat versions, too.

In the second quarter ended June 30, 2006, primarily due to increased demand, sales of PLAVIX increased 18% (over the prior year) to $1.14 billion, and contributed 29.3% to total worldwide pharmaceutical sales of $3.9 billion. In FY ’05, PLAVIX accounted for $3.8 billion of Bristol's sales, or 20% of the total.
Ranked by net sales, PLAVIX is currently the largest product sold by Bristol-Myers. In 2005, with $5.9 billion in worldwide sales, PLAVIX was the second-best selling drug after Pfizer Inc.'s (PFE- $25.82) cholesterol lowering drug, LIPITOR.

Generic drugs—because their average wholesale costs are only a fraction of their name brand counterparts—offer higher-margins and are more profitable all the way up the food chain, from pharmacy benefit managers Caremark RX (CMX-$55.91), to health insurer titan UnitedHealth Group (UNH-$47.57), to the nation’s largest drugstore chain CVS Corp. (CVS-$33.90), and to the largest for-profit hospital operator HCA Inc ($48.90).

Even if Bristol-Myers is successful in getting a temporary restraining order, Apotex has brought the drug giant maker to its knees. In a research note, Morgan Stanley's Jami Rubin, said “channel checks suggest some wholesalers and pharmaceuticals benefit managers have up to 6 months worth of generic PLAVIX in their channels.”

Last Wednesday, Medco (the largest U.S. pharmacy benefits manager by revenue), which serves some 65 million members, said it would start shipping the blood thinner to patients who fill the prescription through its mail- order services. According to a company spokeswoman, “Medco members accounted for 24% of PLAVIX's U.S. market share, and more than half of Medco's PLAVIX prescriptions are filled through the company's mail-order pharmacies.”

A quick check of online pharmacies by the 10Q Detective found that pharmacists had received initial supplies. The generic drug retails at an average of $51 for sixty – 75mg. Pills, or $0.85 per pill, compared with an average $203 for 56 tablets of PLAVIX made by Bristol-Myers.

Standard & Poor's Ratings Services placed Bristol-Myers’s ‘A+' long-term corporate credit and 'A-1' short-term rating, on CreditWatch (with negative implications), citing the material importance of PLAVIX revenue to the drug manufacturer’s financial health.

PLAVIX contributed approximately $0.40, or 28%, to share-net of $1.43 in FY 2005.

Management is still piloting the drug-maker through the troubled wake of substantial revenue losses (in the last few years) due to the expiration of market exclusivity protection for certain of its products. For 2006, the company estimates reductions of net sales in the range of $1.4 billion to $1.5 billion [excluding PLAVIX] from the 2005 levels for products that have lost or will lose exclusivity protection in 2004, 2005 or 2006, primarily:

  • PRAVACHOL (patent expired in April 2006), the cholesterol drug, whose patent expired in April 2006, witnesses a year-to-year sales decline of 48% to $323 million in the second quarter ended June 30, 2005;

  • Sales of CEFZIL, an antibiotic for the treatment of mild to moderately severe bacterial infections, decreased 57%, to $23 million in 2006 from $54 million in 2005, primarily due to generic competition in the U.S. Market exclusivity for CEFZIL expired in December 2005 in the U.S. and is expected to expire between 2007 and 2009 in countries in the EU; and,

  • Sales of TAXOL (paclitaxel), an anti-cancer agent sold almost exclusively in non-U.S. markets, decreased 20%, to $149 million in the second quarter of 2006 from $186 million in the same period in 2005, primarily due to increased generic competition in Europe. Market exclusivity for TAXOL expired in 2000 in the U.S., and in 2003 in countries in the EU. Two generic paclitaxel products have received regulatory approval in Japan, and one generic product has entered the market.

Revised consensus estimates call for 2006 and 2007 earnings-per-share estimate to be $1.05 and $0.75, respectively, from $1.17 and $1.22.

Paying out $1.12 in cash dividends, Bristol-Myers’ Common Stock yields 5.50 percent—which has been propping up the stock shares above the $20 support level. We warn our readers, however, not to be tempted to rush out to buy Bristol-Myers Common Stock, for its attractive yield is not secure.

The expected slowdown in growth prospects means that the Dividend Payout Ratio will jump from a prior estimate of 91.8% to 149.3% in FY 2007. A dividend cut is imminent. The trailing five-year average payout ratio in dividends is 85.8%. We are comfortable with this payout ratio—which translates into $0.65 per share.

Articulating the dividend cut thesis in financial jargon--in the last several years the Company's 'sustainable growth' [2.6% in 2005] has been lagging 'actual growth' [ROA - 10.2% in 2005] measures. Ergo, corporate cannot sustain growth prospects without "funding" that growth. Either management needs to kick up the profit [margin improvement gains alone will not do the job] or corporate will need to "fund" growth prospects [recently launched products & late-stage drugs in pipeline] from other sources. To ratchet up growth, the Company will likely pull from dividends.

The 10Q Detective suspects that management may target its underfunded defined benefit plan as a future “unnecessary” expense. The Company shelled out $459.0 million for retiree benefits in 2005 [flat compared to 2004], but the plan(s) remain underfunded by approximately $(1.3) billion.

A big offset to these costs that remains suspect is the Company’s expected long-term rate of return on its U.S. pension plan assets of 8.75 percent. Given that the target asset allocation is 70% equities—this return might be somewhat optimistic (especially when the legendary Bill Miller, long-term manager of Legg Mason’s Value Trust Fund, admits to having a tough year).

Until earnings accelerate, the dividend yield—was/is the principle valuation driver. If management cuts the dividend by half—the stock price could drop to $14.00 per share.

Valuation Analysis.

A share price in the teens would make Bristol-Myers an attractive BUY:

  1. The Company has been divesting itself of low-margin, distracting businesses, such as (1) the 2005 sale of Oncology Therapeutic Network (OTN) for cash proceeds of $197 million. OTN generated net sales of approximately $1.0 billion for the first six months of FY 2005, but its contribution to the bottom line for the corresponding period was a loss, net of taxes, of $(5.0) million; and (2) the 3Q:05 non-core divestment of its U.S. and Canadian consumer medicines business to Novartis AG. Bristol-Myers Squibb's primary consumer medicine brands in the U.S. and Canada, including EXCEDRIN, KERI lotion, and COMTREX sales accounted for 1% of the Company’s sales in 2005.

  2. The positive is that the PLAVIX exclusivity loss is a known variable and analysts are already reworking their valuations to price this into the Common Stock. In the coming quarters, corporate growth should start to reflect a healthy mix of new and existing products, including:

Total revenue for ABILIFY (aripiprazole), an antipsychotic agent for the treatment of schizophrenia, acute bipolar mania and bipolar disorder, increased 35% to $324 million in the second quarter of 2006 from $240 million in the same period in 2005;

Sales of ERBITUX (cetuximab), which is sold by the Company almost exclusively in the U.S., increased 76% to $172 million in the second quarter of 2006 from $98 million in the same period in 2005, driven by usage in the treatment of head and neck cancer, an indication that was approved by the FDA in March 2006, augmented by the continued growth for the treatment of colorectal cancer;

ORENCIA (abatacept), a fusion protein indicated for adult patients with moderate to severe rheumatoid arthritis who have had an inadequate response to one or more currently available treatments, such as methotrexate or anti-tumor necrosis factor (TNF) therapy, was launched in the U.S. in February 2006. Sales for the second quarter of 2006 were $18 million;

SPRYCEL (dasatinib), an oral inhibitor of multiple tyrosine kinases, received accelerated approval by the FDA on June 28, 2006, for the treatment of adults with chronic, accelerated, or myeloid or lymphoid blast phase chronic myeloid leukemia (CML) with resistance or intolerance to prior therapy, including GLEEVEC (imatinib mesylate); and,

ATRIPLA for the treatment of human immunodeficiency virus (HIV) infection in adults was approved on July 12. ATRIPLA is the first-ever once-daily single tablet three drug regimen for HIV intended as a stand-alone therapy in treatment-naïve patients or in combination with other antiretroviral ‘cocktails.’ This triple co-formulation could drive interest/use of the product—lower prescription co-payments and improved dosing compliance (convenience). At an estimated $14,000 per annum per patient for therapy, we believe that this drug could drive top-line growth—assuming drug resistance occurs later rather than sooner]. The product combines SUSTIVA (efavirenz), manufactured by Bristol-Myers Squibb, and TRUVADA (emtricitabine and tenofovir disoproxil fumarate), manufactured by Gilead Sciences (GILD-$62.05).

Bristol-Myers Squibb has more than 50 compounds in its pharmaceutical development pipeline. Ten promising compounds are currently in late-stage Full Development. Investors who buy on pullbacks could be well rewarded (as should existing—read patient—shareholders).

Corporate Governance

An analyst friend, Debra Fiakas, recently posted an excellent expose on “Executive Chicanery” in the Executive Boardroom at Bristol Myers on her blog,
Small Cap Copy. We urge our readers to link to Debra’s article, for she does an excellent job in raising questions about the leadership abilities of Bristol-Myers Chief Executive Peter Dolan, who has been at the helm of the company during a major accounting scandal and the current PLAVIX mess.

There is also the problematic investment (overpayment concerns) in biotech company ImClone Systems Inc. (IMCL-$28.11). In the past five years, Bristol-Myers has invested almost $2 billion in ImClone (September 2001 BMY bought 14.4 million shares @ $70/share—cash plus $900 million in milestone payments in the last 5 years) to share revenue from one of the biotech company's promising cancer medicines, Erbitux (cetuximab).

This monoclonal antibody is believed to work by targeting a natural protein called "epidermal growth factor receptor" (EGFR) on the surface of cancer cells, interfering with their growth.

The drug is particularly effective in patients with tumors that express EGFR.

Erbitux was approved in 2004 for use in combination with the anti-neoplastic chemo-agent irinotecan in the treatment of patients with EGFR-expressing, metastatic colorectal cancer who are refractory to irinotecan-based chemotherapy, or alone if patients cannot tolerate irinotecan.

In March 2006, the FDA also approved ERBITUX for use in combination with radiation therapy for the treatment of locally or regionally advanced squamous cell carcinoma of the head and neck.

Although a “promising” treatment for other types of solid tumors that express EGFR, too, sales—to date—have been disappointing for its approved labeling. Additionally, Amgen (AMGN-$66.40) is expected to enter the market for colorectal cancer with its own EGFR targeting drug, Vectibix.

Today, Bristol-Myers 14,392,003 shares of Imclone are worth an estimated $404.6 million—an 80.3% loss in value (excluding $900 million in milestone payments).

Like their famous television ads of the 1960s & 1970s--just another "Excedrin headache" for Bristol-Myers Squibb shareholders.

Friday, August 11, 2006

An EPIC Fraud?

On August 1, the SEC (Commission) charged Nicholas A. Czuczko, age 34, with civil securities fraud. Mr. Czuczko, the operator of a stock picking website, allegedly made more than $2.7 million in profits by secretly selling the stocks that he recommended as "mega bonus buys” on his site,

The Commission's complaint alleges that Czuczko, of Beverly Hills, Calif., routinely recommended obscure, thinly-traded penny stocks on his website while he personally planned to sell the stock into the rising price spurred by the recommendation(s).

Between mid-December 2005 and the end of March 2006, the Commission alleges that Czuczko paid approximately $1.15 million to Internet search companies and other web advertisers to drive traffic to the Stockster website. Ads for the Stockster site would appear on Google and Yahoo! in response to Internet searches for terms like "stocks" and "investment advice," and on popular financial websites like,, and The Wall Street Journal Online.

Czuczko, who holds a Bachelor's Degree in Business Administration from the University of La Verne in La Verne, Calif., must have forgotten to take a ‘business ethics’ course while at college. His alleged “pump-and dump” scam was to buy shares of the recommended stocks shortly before posting the selection on the Stockster website. When unsuspecting Internet visitors, seduced by the enchanting sirens of greed, bought the recommended stocks and drove up the price of the shares, Czuczko sold his holdings for substantial profits (without disclosing his own sales on the Stockster site).

Czuczko is the Chairman of the Board, CEO & CFO of Epic Media, Inc. (EPMI.PK-$0.60), a multimedia company that (purportedly) packages information into marketable print and digital products. He is the majority shareholder, too, beneficially owning approximately 13.2 million shares, or 58%, of the Common Stock. [His dad, Nicholas Czuczko, Sr., beneficially owns 5.0 million shares, or 22.0%, of the Common Stock.]

The Company has changed its business model in as many years; has no established source of revenue (and no operations); and its auditors have expressed doubt as to its ability to continue as a going concern.

John Yeung, Secretary of the Board, Director, and COO since 1996, is also a graduate of the University of La Verne.

Noted alumni of the
University of La Verne [which is dedicated to “sound, people-centered, values-oriented education”] include pro skateboarder, Phil Esbenshade; former Kansas City Royals-Major League Baseball pitcher, Dan Quisenberry; and Sunny Han, part of the Han twins murder conspiracy.

On Feb 15, 2004, the Company purchased assets consisting of two magazines named EVERYTHING for Men and EVERYTHING for Women from Czuczko. In return, the Company forgave a note receivable from Mr. Czuczko dated Nov 30, 1998, for the purchase of 1,000,000 Shares of Common Stock in the amount of $5,000,000 ($5.00 per Share). The Magazines had a historical book value of $44,101. Additional Paid in Capital decreased by $4,955,899, as the use of goodwill is not allowed in related party transactions as per GAAP.

In its 10-QSB filing with the SEC on July 17, 2006, the management of Epic Media disclosed its decision to discontinue the operations of the proposed magazine business, citing their belief that the “proposed magazines no longer represented a profitable venture for the Company based on the proposed budgets, the inability to hire effective talent in the Los Angeles area, along with many other factors.”

Czuczko and Yeung do not presently receive a salary for their services. They are, however, reimbursed for any “out-of-pocket expenses” incurred on the Companies behalf. In the six-months ended May 31, 2006, the Company incurred out-of-pocket expenses (General & Administrative, Consulting, and Professional Fees) of $313,776.

In a related scheme, regulators allege that in early December 2005, Czuczko recommended the purchase of Epic Media stock on a website that was the predecessor to the Stockster site. After the price of Epic Media stock spiked, Czuczko sold his shares for a small profit.

Additionally, Czuczko did not publicly disclose those trades, among others, in stock ownership forms that he was required to file with the Commission under federal securities laws.

"A fool and his money are soon parted, but seldom by another fool."

Wednesday, August 09, 2006

Casey's General Stores: "A Convenience Store and a Whole Lot More?"

Casey's General Stores, Inc. (CASY-$22.17) is a little-known convenience store chain that operates 1,413 stores in nine Midwestern states, primarily within Iowa, Illinois, and Missouri. The Company traditionally has located its stores in small towns (as not served by national-chain convenience stores). The stores carry a broad selection of food including freshly prepared foods such as pizza, donuts, and sandwiches; beverages; tobacco products; health and beauty aids; automotive products and other non-food items. The stores also offer gasoline for sale on a self-service basis.

The chain—from a page lifted out of Sam Walton’s playbook—markets itself toward smaller communities, for management believes that a Casey’s General Store provides a service not otherwise available in small towns and that a convenience store in an area with limited population (as few as 500) can be profitable if it stresses sales volume and competitive prices. The Company’s store site selection criteria emphasize the population of the immediate area and daily highway traffic volume.

In the year ended April 30, 2006, Casey earned a record $60.5 million, or $1.19 per share, compared with $36.8 million, or 73 cents per share, for the prior year.
Sales rose 25.4 percent to $3.5 billion from $2.8 billion.

Gasoline sales are an important part of the Company’s revenue and earnings. Over the past three fiscal years, gasoline revenue accounted for approximately 67% of total revenues [71% in FY '06] and the gasoline gross profit accounted for approximately 24% of total gross profit.

Tobacco Products have averaged approximately 10% of total revenue over the past three fiscal years, and the tobacco gross profit accounted for approximately 12.8% of total gross profit for the same period.

Grocery & Other Merchandise — sales continued to be strong. Net sales for the year were up 9.4% to $779.3 million. Same-store sales [for stores open more than twelve months] were up 5.7%, well above the internal goal of 3 percent, with an average margin of 31.9% for the year (up 100 basis points from the prior year). The annual goal was to increase same-store sales 3% with an average margin of 31.5 percent. The Company outperformed the sales and margin goal for the year by capitalizing on increased store traffic brought in by the introduction of the lottery and enhancing its point-of-sale technology (POS).

Commissions on lottery sales were nearly $4 million in fiscal 2006.

Prepared Food & Fountain —The annual goal was to increase same-store sales 5.5% with an average margin of 60.5%. The Company increased same-store sales 7.4% for the year and achieved an average margin of 63 percent. Net sales for the year increased 12.3% to $229 million. Corporate credited the introduction of profitable new products and leveraging POS data to align menu items with customer demand (and to manage inventory) for the excellent results.

Liquidity and Capital Resources

Casey’s balance sheet continues to be very strong. At April 30, cash and cash equivalents were $75.4 million and shareholders’ equity rose to $523.2 million, up over $54 million. Long-term debt net of current maturities was down $16.6 million to $106.5 million. At the end of the year, long-term debt to total capital ratio was 24 percent.

[Ed. note. In our view, the balance sheet is stronger than that construed by ratio analysis. The Company owns its Corporate Headquarters and Distribution Center operations on a 45-acre site in Ankeny, Iowa. Additionally, Casey’s owns the land at 1,317 locations—$211.9 million is listed at cost on the balance sheet—and the buildings at 1,329 locations]

In the year ended April 30, 2006, net cash provided by operations increased $18,078 (13.9%) to $147.8 million primarily because of an increase in net earnings and a large increase in accounts payable ($45.5 million). This result was partially offset by an increase in inventories ($23.3 million).

The Company generated free cash flow of approximately $47.8 million. On the year-end conference call, CapEx was broken down as follows: “2006 was about $100 million………As far as new stores, it was about $15 million. Replacements —replacements of stores are about $12 million. Maintenance and remodeling, about another $10 million or so…. Transportation, about $5 million. Information system, about $10 million. The warehouse addition that we talked about earlier is about $10 million. And then the remainder, which I think is about $40 million, is for acquisition activity.”

Going forward into fiscal 2007, management expects CapEx (depending on acquisition activity) to be somewhere in the neighborhood of $115 million –to- $120 million.

Reasons to Invest

Also on the call, management talked about a balanced focus on operational improvements (e.g. POS) and revenue growth, citing the following Fiscal 2007 goals:

  • Increase same-store gasoline gallons sold 2% with an average margin of 10.8 cents per gallon;
  • Increase same-store grocery & other merchandise sales 3.9% with an average margin of 32.2 percent;
  • Increase same-store prepared food & fountain sales 7.9% with an average margin of 63.4 percent;
  • Hold the percentage increase in operating expenses to less than the percentage increase in gross profit; and,
  • Acquire 50 stores and build 10 new stores.

Looking forward, predictable growth remains the critical investor concern. Aside from acquisition-driven growth, corporate ability to fully integrate best practices throughout its store portfolio—if properly executed—should lead to strong growth and higher margin opportunities in the coming years:

  • Rollout of higher margin products, such as bottled water, sports drinks and energy drinks;
  • Product expansion of its fountain program to include offerings such as Pepsi, Mountain Dew and Dr. Pepper;
  • The Company began marketing made-from-scratch pizza in 1984, expanding its availability to 1,310 Corporate Stores (94%) as of April 30, 2006. Management believes pizza is the Company’s most popular prepared food product. The Company continues to expand its prepared food product line, which now includes ham and cheese sandwiches, pork and chicken fritters, sausage sandwiches, chicken tenders, popcorn chicken, sub sandwiches, pizza bites, breakfast croissants and biscuits, donuts, breakfast pizza, hash browns, quarter-pound hamburgers and cheeseburgers, hot dogs, and potato cheese bites.

We applaud management’s initiatives, for although retail sales of non-gasoline items during the last three fiscal years have generated approximately 33% of the Company’s retail sales, such sales resulted in approximately 76% of the Company’s gross profits from retail sales.

Gross profit margins for prepared food items, which have averaged approximately 61% during the last three fiscal years, are significantly higher than the gross profit margin for retail sales of gasoline, which has averaged approximately 6% during the same period.

The Company’s portfolio-enrichment strategy to increase same-store sales, coupled with cost-containment initiatives (such as POS technology and the addition of 98,000 square feet to the Distribution Center), should serve as a platform for predictable organic growth.

Valuation Analysis

On a forward 12-month P/E basis, the Common Stock is reasonably priced at 14 times April 2008 consensus estimates of $1.58 per share. We look for multiple expansion once management demonstrates its ability to execute on its growth strategy.

The intrinsic value of Casey’s Common Stock is $47.00 per share. [growth rate of 14.5%--excludes growth potential of a large merger—more than 50 stores—within a 500-mile radius of its Ankeny, Iowa Distribution Center, operating margin of 3.4%, equity risk premium of 3%]

Albeit the stock will tread water until management can deliver consistent operational and financial performance.

Investment Risks

The convenience store industry is highly competitive. Food, including prepared foods, and nonfood items similar or identical to those sold by the Company are generally available from various competitors in the communities served by Casey’s General Stores. Convenience store chains competing in the larger towns served by Casey’s General Stores include 7-Eleven, Quik Trip, Kwik Trip, and regional chains.

Approximately 62% of all Casey’s General Stores are located in areas with populations of fewer than 5,000 persons, while approximately 12% of all stores are located in communities with populations exceeding 20,000 persons—effectively limiting the competition.

Casey's advantage can be attributed to the fact, too, that it has a good track record of buying up smaller chains in its core territories and either strengthening its presence or closing stores “across the street” from existing locations (Casey closed 10 of the Gas ‘N Shop stores purchased in the past eighteen months because they were in direct competition with existing Casey’s stores in the same market areas.)

The volatility of wholesale petroleum costs could adversely affect operating results. In the past three fiscal years, gasoline revenue accounted for approximately 67% of total revenues and the gasoline gross profit accounted for approximately 24% of total gross profit. As we all know, crude oil and domestic wholesale petroleum markets are marked by significant volatility in price The Company attempts to pass along wholesale gasoline cost changes to its customers through retail price changes; however, this is not always possible, for the timing of any related increase or decrease in retail prices is affected by competitive conditions.

If management is unable to identify, acquire, and integrate new stores, this could adversely affect the Company’s ability to grow its business. From May 1, 2005 through April 30, 2006 the Company acquired 67 convenience stores. Every acquisition growth strategy involves integration risks, including post-deal financial underperformance, loss of key managers, and a failure of due diligence (discovering new liabilities of companies or businesses acquired).

Corporate Governance

Oliver Cromwell, Lord Protector of England from1653 until his death in 1658 (a less-than-handsome man) purportedly instructed Sir Peter Lely, paint “all these roughnesses, pimples, warts, and everything as you see me, otherwise I will never pay a farthing for it (portrait).”

Warts and all—the 10Q Detective felt it prudent to sketch for our readers a pimply disclosure found in Casey’s recently filed Proxy Statement with the SEC.

Ronald M. Lamb, who had been CEO since 1996, when he replaced founding chairman Donald Lamberti, recently stepped down. Apropos, he will retain his annual base salary of $700,00—all for being the Chairman of the Executive Committee.

Messer. Lamb gets to keep his present office. His duties, as outlined in an amendment to his Restated Employment Agreement (an 8-K filed with the SEC on July 12, 2006), state that “ Lamb shall act as liaison between the Chief Executive Officer of the Company and the Board of Directors to assure that all matters for consideration are communicated to members on a timely basis. At times when neither the Board of Directors nor the Executive Committee are in session, Lamb shall be available to receive the report of the Chief Executive Officer on their behalf.” Including bonus, Lamb will make $1.0 million per annum.

“And like the Old Soldier of that ballad, I now close my military career and just fade away, an old soldier who tried to do his duty as God gave him the light to see that duty. Good-by.”
And so said a retiring General Macarthur.

Unfortunately, in the United States, old CEOs do not fade away—they become titular Chief Executives—just like Ronald Lamb.

But the self-enrichment (at the expense of shareholders) does not stop there. In addition to his pension, upon his retirement from the Company, Mr. Lamb will be entitled [he owns approximately $18 million in Company stock] to receive benefits from the Supplemental Executive Retirement Plan (SERP) to receive an annual retirement benefit equal to one-half of his then-current salary (i.e. $350,000).

Additionally, should Mr. Lamb, age 70, die—before retiring—the Company is obligated to pay his surviving spouse Mr. Lamb’s $700,000 salary for two years (after which his wife would receive monthly benefits equal to one-half of his retirement benefits for a period of 20 years or until her death whichever occurs first). [Ed. note. Is this a shareholder-funded insurance plan?]

“A convenience store and a whole lot more!”—Definitely for insiders…maybe for investors?