Saturday, September 30, 2006

3Q:06 -- 10Q Detective Portfolio




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Information has been obtained from sources believed to be reliable, but its accuracy or completeness is not guaranteed. We advise readers to recognize that they should not assume that present or future recommendations will be profitable or will equal the performance of securities listed or recommended here in the past. Readers should be aware, too, that the purchase of securities, particularly in the case of low-priced shares, involves substantial risk of capital. The 10Q Detective is published by Blue Sky Enterprises, LLC. Blue Sky Enterprises, LLC. is not a registered investment advisor and therefore cannot give individual investment advice. The opinions expressed herein are subject to change without notice. Neither the information nor any opinion expressed herein constitutes a solicitation by us of the purchase or sale of any securities.

Friday, September 29, 2006

Sara Lee--No Brownie Points for the Committee

GSPC = S&P 500 Index


Last week, food & consumer products maker Sara Lee (SLE-$16.03) filed its Proxy Statement with the SEC. Of interest, the 10Q Detective noted that for the FY ended July 1, 2006, the top five executives earned (on average) $1.0 million in performance-based cash bonuses.

Brenda Barnes, Chairman & CEO, took home more than $2.1 million in salary and bonus, 950,000 stock options, and $1.7 million in restricted stock awards. In 2005, she received $1,308,725 in salary and bonus, 250,000 options, and restricted stock awards valued at $5,065,038.

The price of the Common Stock of Sara Lee has slumped 15.05% in the last 52-weeks, (reflecting investor skepticism with inconsistent quarterly growth and profits and uncertainty regarding the timing of a “promised” turnaround due to restructuring efforts by management). In the comparable period, the S&P 500 Index gained 9.06% in value.

The American Federation of State, County and Municipal Employees, a large labor union which beneficially controls 8,424 Sara Lee shares, has submitted a proposal (to be voted on by shareholders at the Annual Meeting on Thursday, October 26, 2006), asking the Board of Directors to adopt a policy that would allow stockholders to express their opinion about senior executive compensation practices by establishing an annual referendum process.

The union believes that the results of such a vote would provide Sara Lee with useful information about whether stockholders view the company’s compensation practices, as reported each year in the Compensation Discussion and Analysis, to be in stockholders’ best interests:
“We believe that the current rules governing senior executive compensation do not give stockholders enough influence over pay practices… Stockholders do not have any mechanism for providing ongoing input on the application of standards to individual pay packages.”

Would it surprise any of our readers to hear that the Company has recommended to stockholders to vote against the union proposal, countering that Sara Lee already has an efficient and meaningful method for stockholders to communicate their concerns with the Board. [Ed. note. They can write letters!]

Management has been divesting non-core operations, such as luxury goods (Coach leather goods—April 2001), European meats division (Summer—2006), and branded U.S apparel units (e.g. Hanesbrands Inc. IPO—September 2006).

Additionally, in August 2006, the Company cut the annual dividend almost 50% (from 79 cents to 40 cents per annum).

For all these efforts, consensus estimates call for share-net to come in around $0.81 cents and $0.85 cents, respectively, in FY 2007 and FY 2008—well below 2005 EPS of 92 cents.

According to Sara Lee’s Committee, the executive compensation program is designed to
“retain key executives” and to support the practice of appropriately rewarding key executives for positive results (i.e. profitable growth and increased stockholder value).

In this case, recompense as a loyalty incentive is not necessary—the 10Q Detective says let the “key executives” walk out the door. As for excuse number two—rewarding the key executives for performance—the empirical evidence suggests that the Committee is doing a disservice to all stakeholders—
what performance?

The 10Q Detective does not wish to be a
doubting Thomas, but we would not bet the farm on Proposal No. Four getting a yeah vote.

Editor David J Phillips does not own any of the stock mentioned in this article. You can see his portfolio holdings in the sidebar. The 10Q Detective has a full disclosure policy.

Wednesday, September 27, 2006

China Natural Gas--Showing Investors the "Green."

A recent sentiment survey of commodity traders found only 17.0% were bullish on natural gas. This suggests to us that a bottom is forming. Welcome to our Common Stock idea of the day:

China Natural Gas, Inc. (CHNG-$3.15) is the first People’s Republic of China (PRC) based natural gas firm publicly traded in the United States. The Company is principally involved in the end user delivery of natural gas services to homes and businesses (2.6% of sales); the sale of compressed natural gas (CNG) as a hybrid vehicular fuel (natural gas/gasoline) at company-owned filling stations (62.5% of sales) and to third party natural gas filling station operators (2.2% of sales); and, the construction of pipelines that supply end users with natural gas (32.7% of sales).

End User Delivery of Natural Gas

China Natural Gas is the only private company to own and operate a (120 kilometer long) high-pressure natural gas pipeline in China's Shaanxi Province (home to China's second largest natural gas reserve). The Company is the sole authorized provider of natural gas to residential customers in certain parts of the Xi’An area, including Lantian County and the Baqiao District. Additionally, the Company has proprietary access to more than 63,000 Xi'An households through its network of pipeline.

The city of Xi'An is centrally located in China. Xi'An, supported by a population of 8 million, is the fastest growing city in China's western regions, and is considered to be the "gateway" to China's developing western regions, for it is within easy access to China's more developed regions in the East and South.

Management is seeking to expand supply services to the Shangluo and Ankang areas of Shaanxi province. Upon approval from the government, the Company would have the exclusive right to provide natural gas to residential and commercial end users in those areas, too. In order to obtain such approval, the Company was required to submit a project proposal for the feasibility of supplying gas to each area. The approval process takes approximately four to six months and is pending.

Wholesale to Filling Stations

China Natural Gas sells CNG to filling stations on a wholesale basis. The stations, in turn, sell natural gas to taxis and buses in Xi’An that operate on
compressed natural gas (CNG) technology. Government statistics indicate that there are currently 5,000 buses and 20,000 taxis using natural gas in Xi’An. Each bus uses an average of 70 cubic meters of CNG per day and taxis use an average of 30 cubic meters of CNG per day. The municipal government estimates that by 2010 the city will have over 46,000 CNG vehicles.

In July 2005, China Natural Gas purchased a Compressor Station that is operated in proximity to its pipeline and which allows the Company to compress and transport natural gas via truck to retail gas stations.

Retail Filling Stations

In our opinion, growing demand for CNG as a vehicular fuel offers the Company the greatest opportunity for profit and growth.

China's "Eleventh Five-Year Plan" (2006 - 2010) promotes alternative energy sources including compressed natural gas (CNG) fueled vehicles. The Chinese government is supporting the use of natural gas due to its environmental friendliness and its cost effectiveness.

Hybrid fueled vehicles emit 87% less nitrogen oxide, 70% less carbon monoxide, and 25% less carbon dioxide than gasoline. It is estimated, too, that the hybrid CNG fuel saves about 60% on a price per mile basis compared to regular gasoline.

The Company is rapidly expanding its network of compressed natural gas filling stations to satisfy the tremendous demand for CNG. As of September 25, 2006, China Natural Gas operated eleven company-owned retail filling stations. By the end of 2006, the Company’s targeted goal is to be operating approximately twenty-one company-owned natural gas filling stations. [Ed. note. This might be a reach, for the construction time for each filling station is 45-60 days at a cost of approximately US$600,000.]

We do agree with management, however, that China Natural Gas’ vertically integrated operation should allow the Company to be able to surpass the average sales volume of competing stations, estimated at 12,000 cubic meters per day, based on its proprietary supply of CNG from its own pipeline.


For the second quarter ended June 30, 2006, China Natural Gas recorded net income of $927,269 (share-net of $0.04) on revenues of $3,724,183, compared to net income of $388,442 (share-net of $0.02) on revenues of $1,078,712 for the three months ended June 30, 2005. The increase in revenues was primarily due to substantially increased sales of natural gas revenues, which grew 488% (to $2.5 million) from the same period last year.

China Natural Gas began operating an additional 4 new natural gas retail filling stations during the three months ended June 30, 2006, bringing to a total of 7 CNG filling stations in operation at the end of the second quarter.

The balance sheet is healthy. As of June 30, 2006, the Company owed no long-term debt, had $6.6 million in working capital (net advances to suppliers and other prepaid expenses), and was worth $0.84 in book value per share.

Valuation Analysis

Aside from the (known) speculative risk of owning a small-cap company, China Natural Gas, with a market capitalization of only $74.1 million, is an inventive way to leverage a single investment into two sectors—the red-hot Chinese economy and the depressed natural gas market (the price of the Common Stock is down about 44.0 percent—from its $5.68 per share intra-day high hit in February 2006).

The Company is selling for only 7.9 times estimated 2007 share-net of $0.39 on revenue of about $43.6 million. The future looks “green” for China Natural Gas. The current distribution infrastructure in Xi’An supports less than 40% of the current estimated market need for more than one million cubic meters of vehicular CNG per day (which is expected to continue to increase with China’s “Clean Energy Policy.”

Leveraging its existing pipeline, China Natural Gas should easily be able to double its number of company-owned CNG filling stations, too.

Going forward, China Natural Gas is looking to expand its footprint to the neighboring province of Henan, which is the most populous province in China with a growing population of approximately 100 million people.

China Natural Gas just signed a natural gas supply contract with Zhengzhou Zhongyou Oil & Gas Co., Ltd., a subsidiary of Sinochem, China's largest chemical company to supply 350,000 cubic meters of compressed natural gas per day to the Company's planned new stations in China's Henan Province. The 5-year natural gas supply agreement should ensure an uninterrupted and reliable gas supply to the new stations in the Henan region.

Management also has plans to develop a liquefied form of natural gas (LNG) that can be transported over longer distances by gas tanker truck and which could expand the Company’s geographical sales. The Company is currently conducting a feasibility study with regard to LNG production.

Investment Risks and Considerations

#1. China Natural Gas depends on a single source for its supply of natural gas and an interruption to this service may harm its business.

Currently, China Natural Gas has only one natural gas supplier, the Shaanxi Natural Gas Co., Ltd., a government owned enterprise. In the past, contracts were renewed on an annual basis. However, as the volume of usage has increased, Shaanxi Natural Gas has revised their policies, and contract terms are now six months and subject to review prior to renewal. Management, however, reports that it does not expect any issues or difficulty in continuing to renew the supply contracts going forward. Price points for natural gas are strictly controlled by the government and have remained stable over the past 3 years.

#2. The revenue of China Natural Gas’ pipeline business is generated under contracts that must be renewed periodically. In particular, management’s ability to extend and replace contracts could be adversely affected by variable factors, including competition by state-owned natural gas pipeline companies; the proposed construction by other companies of additional pipeline capacity; or changes in state regulation of local distribution companies.

The three largest state-owned energy companies, CNPC (China National Petroleum Corp.)Group, SINOPEC, and CNOOC are principally engaged in the upstream supply of energy and are major players in exploration and transportation of oil and gas. They build much of the country's high-pressure pipeline infrastructure. Natural gas is distributed to smaller regional firms that redistribute the gas to the end user, either through lower pressure pipeline networks, or via tankers in the form of liquid natural gas.

China Natural Gas is aware of two privately owned companies in China which may be considered to be its direct competitors: Xinjiang Guanghui LNG Development Corporation Ltd and Xin'Ao Gas Field Ltd. Xinjiang Guanghui LNG Development Corporation Ltd is primarily involved in the transportation of LNG via tanker truck to storage facilities from natural gas wells. Xin'Ao Gas Field Ltd. is a publicly owned company traded on the Hong Kong Exchange, distributing natural gas via pipeline, doing business in 13 provinces and municipalities that have a combined population of 31 million. Neither Xinjiang Guanghui nor Xin'Ao is approved to supply natural gas to any area in which Xilan is currently operating.

Additionally, in order to meet the growth in natural gas demand, the PRC government has encouraged private companies to invest in and build the natural gas infrastructure. On December 27, 2002, the Ministry of Construction issued a memorandum stating that regulation of the public utility industry (including gas distribution) should be liberalized and foreign and private investment participation should be encouraged and welcomed. The memorandum encouraged private investment in the sector and provided a legal framework for private urban natural gas distribution.

#3. China Natural Gas may not be able to build and/or acquire, and successfully integrate identified retail CNG filling stations as planned, which would adversely affect corporate’s ability to grow its business.

Currently, there are approximately 31 filling stations in Xi’An City. Thirteen of these stations are state owned enterprises. The other 18 stations are privately owned with the majority of these being single station operators. Management believes that it can effectively compete with the stations based upon its organization, experience and financial resources.

Editor David J Phillips owns stock in China Natural Gas. The 10Q Detective has a full disclosure policy.

Monday, September 25, 2006

Hi-Tech Pharmacol--Be Wary of its Name.

Hi-Tech Pharmacal Co.'s (HITK-$13.60), corporate name belies its actual operations. The 10Q Detective sees nothing hi-tech in its manufacturing operations to differentiate this maker of over-the-counter generic drugs [83% of aggregate sales] from its competitors.

Bernard Seltzer and his son, David S. Seltzer, serve as Chairman of the Board Emeritus and as Chairman of the Board, President, Chief Executive Officer, CEO, Secretary and Treasurer, respectively, of the Company.

Bernard Seltzer, who beneficially owns 4.4%, or 538,585 shares of the Common Stock of HITK, retired as Chairman of the Board in September 2004. As Chairman Emeritus (an honorary title that in Latin means “to earn for service”) receives an annual base salary of about $285,000. [Ed. note. Was there ever a time that ex-CEO’s took their retirement packages—including stock options, pension, SERP—and to quote General Douglas MacArthur—“just faded away?”] Mr. Bernard Seltzer may also receive a bonus in the discretion of the Board of Directors.

David S. Seltzer, who beneficially owns 15.4%, or about 2.0 million shares of the Common Stock, has served as President and Chief Executive Officer effective May 1, 1998 (succeeding his father). David Seltzer’s employment agreement provides that his annual base salary is $382,000 for the fiscal year commencing May 1, 2005 through April 30, 2007. David Seltzer earned a cash bonus of $277,000 and $227,000 in FY 2006 and FY 2005, respectively.

Corporate Governance Issues

HITK uses the services of Mr. Reuben Seltzer, an attorney and Director, and the son of the Company’s Chairman Emeritus and brother of the President. He provided “legal and new business development services” throughout the year. For each of the fiscal years 2006, 2005 and 2004, he received fees, auto allowance and health insurance benefits totaling $236,000, $248,000 and $199,000, respectively. He is also the beneficial owner of 9.2%, or about 1.2 million shares of Common Stock of HITK.

In addition, in each of FY 2002 and 2001 the Company granted Mr. Reuben Seltzer an option to purchase 37,500 shares of the Company’s common stock at an exercise price of $5.76 and $2.67, respectively, which have vested and are now exercisable through 2006 and 2005, respectively. During the years ended April 30, 2006 and 2005 the Company valued this option at $237,000 and $130,000, respectively, which was charged to operations.

What a great gig if you can get it? In our view, Mr. Reuben Seltzer is getting paid by HITK to ‘consult them’ on the Company’s investment in Neuro Hi-Tech (NHI) of which Reuben Seltzer is Chief Executive Officer (and receives $165,000 in annual salary).

Neuro-Hitech (NHPI-$6.00) is a biotech start-up focusing on the commercialization of next-generation therapies against proven targets for neurodegenerative diseases. The company's signature offering, Huperzine A, is being tested for efficacy in the treatment of Alzheimer's disease and the company has plans to study other degenerative disorders such as vascular dementia, mild cognitive impairment and myasthenia gravis (as funding permits). Neuro-Hitech is currently developing Huperzine A in both oral and transdermal form.

Huperzine A is a Cholinesterase Inhibitor (AchE inhibitors) that Neuro-HiiTech believes may be effective in the treatment of
Alzheimer disease (AD) and Mild Cognitive Impairment (MCI), although, to date, its efforts have been focused upon huperzine A’s effectiveness in AD.

At April 30, 2006, HITK had a 12 percent interest, or beneficially owned 1.13 million shares, in Neuro-Hitech, Inc. In addition, the Company has 15,000 warrants at an exercise price of $5.00 per share.

HITK’s stake in Neuro was profitable to the Company last year. The Neuro-HiTech shares available for sale over the next twelve months at April 30, 2006 totaled 94,115, valued at $744,000 and resulted in an unrealized gain of $439,000, net of deferred tax of $292,000 being included in accumulated other income as of such date (share-net of 3 cents). The restricted shares aggregating 1,031,495 are carried at cost of 13 cents per share!

Additionally, HITK and Reuben Seltzer have a 17.7% and 17.7% interest, respectively, in Marco Hi-Tech JV LLC, a New York limited liability company which markets raw materials for nutraceutical products (principally huperzine). To generate revenue, Marco has imported and sold inventories of natural huperzine (from China) and other dietary supplement ingredients to vitamin and supplement suppliers to generate revenues. [Ed. note. Undisclosed is whether or not HITK buys any raw materials from Marco.]

Two pre-clinical studies suggest that Huperzine A's potential advantages over other AChE inhibitors include higher blood-brain-barrier penetration, better tolerability and multiple mechanisms of action, including both AChE and
NMDA receptor antagonism.

The drug is currently in the enrollment stage of a planned multicenter, double-blind, placebo-controlled therapeutic Phase II trial to determine whether treatment with huperzine A 200µg twice a day improves cognitive function in individuals with AD.

We applaud the genuine efforts of NHI in expending the necessary resources in bringing to market neuroprotective agents for cognitive diseases (in a field littered with bankrupt biotech failures).

NHI aside, we are troubled with the corporate governance at Hi-Tech. How can Reuben Seltzer make a material contribution to Hi-Tech when he more than has his hands full running day-day operations and R&D complexities at NHI? And why is Hi-Tech giving him a car allowance and health insurance, too?

Should the Seltzers be feeding self-indulgencies when HITK’s fundamentals are weakening? The Common Stock has tumbled more than 50% in price in the last six months, after the specialty pharmaceutical company posted a share-net loss (8 cents) in the first quarter of 2007 ended July 31, 2006, compared with a profit (of 11 cents) a year ago.

In a conference call with analysts, the company said it faced both new competitors in its existing product lines and stronger pricing competition from existing competitors. Management cited lower demand for its higher margin cough and cold products due to a mild and short-lived cold season as the reason for a decline in unit sales of generic sales to $8.4 million from $13.9 million last year.

Valuation Analysis

In our view, the Company’s Health Care Products, which markets branded products, is positioned for attractive growth. In the 1Q:07, net sales for this division were $1,790,000, an increase of $555,000 or 45%, compared to $1,235,000 reported for the same period last year, fueled by growth in the (arthritic pain relief)
Zostrix and the Diabetic Tussin line of products.

A full pipeline is critical for a generic drug company’s success. Management has identified more than $4 billion of brand name drugs in the liquid, sterile, and semi-solid dosage forms that will lose patent protection over the next five years. The Company is currently developing drugs with total branded sales of over $2 billion.

In FY 2006, HITK received Abbreviated New Drug Application for only one drug, Acyclovir Oral (equivalent to GlaxoSmithKline’s Zovirax Suspension) indicated for the treatment of Herpes Zoster Infections, Genital Herpes and Chicken Pox.

Generic companies have pricing power for only six-months, so its all about pipeline and volume (sold units). The US FDA offers a 180-day exclusivity period to generic drug manufacturers. During this period only one (or sometimes a few generic manufacturers) can produce the generic version of a drug. Ergo, It’s deliver—or die—for when competitors enter the market with their own
bioequivalent generics, supply goes up, and price (and margin) goes down.

According to management, the Company has 12 products submitted to the FDA and pending approval, and approximately 20 products in various stages of development.

Additionally, HITK should benefit from the new Medicare prescription drug plan.

However, we see no catalyst to jumpstart HITK’s growth engine right now. For FY 2007, Hi-Tech is selling for 23 times analyst estimates of $0.58. Analysts do expect a rebound in FY 2008 and look for EPS growth of 31% to $0.76 per share.

Follow the insiders? In the last six-months, there have been no insider purchases.

Additionally, the growth in short interest implies that investors expect the stock to trend lower, too. From June through August 2006, days to cover have increased from 5.01 to 7.89 days.

The Company does, however, have an attractive balance sheet. Working capital of $62.43 million (less pre-paid taxes), almost $4.00 per share in cash, a book value of $7.23 per share, and no long-term debt.

In our view, management should look to purchase growth instead of wasting money on family enterprises (years away from a pay-off). Hopefully, in complex litigation involving patent disputes, the Company does not use the services of Reuben Seltzer (given his other responsibilities).

The catalyst for a turnaround lies in first-to-market advantage with a blockbuster drug losing patent protection (like the cholesterol drug Zocor or Bristol-Myers’ anti-platelet Plavix).

Unfortunately, in HITK, we just do do not see any hi-tech "sizzle."

Editor David J Phillips does not own any of the stocks mentioned in this article. You can see his portfolio holdings in the sidebar. The 10Q Detective has a full disclosure policy.

Saturday, September 23, 2006

Thursday, September 21, 2006

Imclone Systems-- Benefiting from a Dose of Carl Icahn?

On Wednesday morning, prior to being elected to the Board of Directors at Imclone Systems, Inc. (IMCL-$29.50), billionaire investor Carl Icahn said in an open letter delivered to Chairman David Kies that he expected Kies to make good on a promise to give up his job at the biotechnology company:

Dear David:

When you offered me a directorship at ImClone in August, we discussed and I thought you indicated that you would not continue to be the Chairman of the Board of the Company. I also told you that it would be a mistake to give the Interim CEO a long-term contract, given that he has little or no expertise in biotech companies. I asked that you at least allow the new Board to make this decision. Nevertheless, without warning, ImClone entered into a multi-million dollar contract with the Interim CEO. You have also indicated that you will not be willing to give up your chairmanship at today's meeting.

On January 24, 2006, Joseph L. Fischer, 56, was named Interim Chief Executive Officer of the Company. Icahn is correct in his first assertion that this interim CEO “has little or no expertise in biotech companies.” In his thirty-year career, Mr. Fischer has served in a variety of senior management positions, most notably with the personal care division of Johnson & Johnson and Dial Corp’s global Consumer Products group. Mr. Fischer became a CPA in New York. In 1972, he graduated with a Bachelor of Science in Accounting at Penn State University.

The Company entered into an employment agreement with Mr. Fischer on August 23, 2006. Effective immediately, Fischer will receive $45,000 per month in base salary while he serves as Interim CEO. If Mr. Fischer is still employed by Imclone on the date that bonuses for fiscal 2006 are paid, he will receive a bonus of no less than $500,000 and, if the Company employs him on December 31, 2007, he will receive a $500,000 retention bonus.

If the Company without cause terminates Fischer’s employment, or in the event he terminates his employment with good reason following a change in control of the Company, Mr. Fischer will be entitled to a lump sum cash severance payment of not less than $500,000. [Ed. note. This is on the cheap as compared to many CEO resignations that we have commented on in the past.]

The Compensation Committee also (unanimously) granted Mr. Fischer stock to purchase 100,000 shares of the Company's Common Stock at an exercise price equal to the closing price of the on the date of grant (i.e., February 28, 2006). Contrary to Icahn’s noted umbrage, the exercise price for Fischer is $38.30 per share—almost nine dollars higher than the current share price of the Common Stock.

Now that I am becoming a director of ImClone, I am asking you again for the good of ImClone and its stockholders to give up your position as Chairman of the Board. Given what I consider the sorry record of the Company under your watch, it is time for you to step aside and allow someone else to be elected. You have even admitted to me that the board has done a bad job. ImClone has been without effective leadership for almost three years.

During your tenure, ImClone has suffered as a result of its inability to attain the leadership position it should enjoy as an important biotechnology company. Most importantly, a great disservice has been done not only to stockholders, but, potentially, to cancer patients as well, by ImClone's apparent passivity in pushing to start appropriate trials in first-line colon cancer and other indications.

Erbitux is Imclone’s only product on the market (in two tumor types—colorectal cancer and head & neck tumors). For the six-months ended June 30, 2006, the drug generated total sales of approximately $395.0 million, as compared to $178.1 million in the prior year period.

During your tenure, I believe that commercialization has suffered, trials have not been sufficiently pursued…. the Company has not provided its stockholders the performance that they deserve. Rumors abound about employee dissatisfaction and probable defections.

A Phase III clinical trial is underway for the first-line treatment of advanced stage pancreatic cancer. Trial results will probably be available in the 1H:07. Additional Phase 3 trials are underway for first-line and second-line use in advanced non-small cell lung cancer (NSCLC).

Unfortunately, disappointing results for the first-line use of Erbitux with chemotherapy in colorectal cancer patients were released in June 2006, for survival results did not differ significantly between the two patient groups.

When Icahn talks “Sorry Record and performance that stockholders deserve,” in our view he is referencing Icahn Group’s dismal total return on its investment in Imclone. Look at the 52-week drop in the price of the Common Stock, and you will see one angry man sliding downhill with the Company’s share-net price.

As of the time of the Board meeting, the Icahn Group beneficially owned approximately 11.7 million shares, or 13.8% of the outstanding shares, at an aggregate cost of $390.5 million (including commissions)—or $33.38 per share.

During your tenure, ImClone hired a President and CEO who was totally the wrong person for the position and it took you many many months to recognize this and replace him. His replacement lasted only a few months. Now, ImClone has another interim CEO and his permanent replacement is nowhere on the scene. To make matters worse, you even rewarded him with a favorable contract increasing his compensation and making it more expensive to replace him. This has all occurred during the most critical period in the history of the Company in which its ability to exploit its lead in cancer treatment was being tested. Your regime has failed the test.

Daniel S. Lynch, 48, was the aforementioned “wrong person for the position.” He joined the Company in April 2001 as its Vice President, Finance and CFO. In February 2004, he was promoted from interim CEO to CEO, and continued to serve in this capacity (and as a Director) until his employment was terminated with the Company (effective as of November 10, 2005). Imclone paid Mr. Lynch a salary (and bonus) of $486,000 and $903,477 in FY 2005 and 2004, respectively. As part of his severance agreement, the Company made cash payment of approximately $2.8 million to Mr. Lynch.

Upon the departure of Mr. Lynch, Philip Frost, M.D., Ph.D., then Executive Vice President, Chief Scientific Officer of the Company, assumed the additional position of Interim CEO. Dr. Frost served in those dual positions until January 23, 2006, when Joseph L. Fischer was appointed to the position of Interim CEO. Dr. Frost remains with the Company in his previous position as Executive Vice President and Chief Scientific Officer. In addition to the compensation for his service as Executive Vice President and Chief Scientific Officer, Dr. Frost received $16,818 in base salary in his capacity as Interim CEO (in addition to his salary/bonus of $510,077).

During your tenure, ImClone's meaningful lead relative to potential competitors has shrunk considerably and ImClone has suffered reversals such as the loss of the patent suit in the past week. I cannot believe that there were not a number of opportunities to achieve a favorable settlement of the patent suit under your leadership. Now the suit has been lost.

While Chairman Vies fiddled, Imclone’s first-to-market advantage with its
epidermal growth factor receptor (EGFR) inhibitor, Erbitux (Cetuximab), burned to the ground. Biotech giant Amgen (AMGN-$70.98) is awaiting word from the FDA to bring to market its own candidate for EGFR-expressing metastatic colorectal cancer, called Vectibix (Clinical Drug: Panitumumab).

After three years, on September 18, 2006, the U.S. District Court in NYC ruled that scientists associated with Yeda Research and Development were the sole owners of a patent (involving the method of using a monoclonal antibody in combination with chemotherapy) that ImClone Systems licenses from Sanofi-Aventis SA (SNY-$43.91).

Aside from appealing the court’s decision, one tactic Imclone could employ would be to negotiate an exclusive license for Erbitux with antineoplastic agents covered by the patent.
Outmaneuvered! Securing potential uses for its own EGFR-inhibitor, Amgen has already announced that it has secured licensing rights from Yeda Research.

The Company is facing additional intellectual property litigation, too, dealing with the production (manufacturing) of Erbitux in commercial quantities. On July 28, 2006, the Company’s motion for summary judgment seeking to dismiss all claims on the basis that the patent rights at issue were exhausted as a matter of law was denied by the courts. The plaintiffs, MIT and
Repligen Corp. (RGEN-$3.08), will now take their case to trial.

[Ed. note. As management does not believe the patent litigation will have a material impact on its operations, no reserve has been established in the financial statements for any of the Yeda or MIT and Repligen actions]

You should recognize that your leadership of ImClone should come to an immediate end. The time has come for you to peacefully pass the baton to a successor who will be able to bring strong leadership back to ImClone. If you fail to do so, you will have thrown down the gauntlet and we will have to react accordingly.

Very truly yours,
Carl C. Icahn.

On January 24, 2006, the Company announced that the Board of Directors had engaged the investment bank Lazard to conduct, in conjunction with management, a full review of the Company’s strategic alternatives to maximize shareholder value—including a sale of the Company.

David M. Kies, 62, a Director of the Company since June 1996, was named Chairman in February 2004. Mr. Kies is a Partner of the New York-based law firm Sullivan & Cromwel, specializing in mergers and acquisitions.

Ironically, Mr. Kies’ and Icahn are on the same side of the street, for Kies’ stake in Imclone is underwater, too. In 2005, the Chairman of the Board was granted options to purchase 45,000 shares of Common Stock at an exercise price of $46.12 per share; with respect to 2006 service, he has been granted option to purchase 30,000 shares of Common Stock at $34.14 per share.

The time, however, may have come for Kies to “peacefully pass the baton.” After eight months of review, the Company announced its decision to remain independent, citing that the alternatives available, including bids received for the acquisition of the Company were too low, and did not match the Company’s intrinsic value (potential).

What is the value potential in owning Imclone Common Stock? The Company has a broad spectrum of innovative product candidates with potential application in multiple tumor types: (i) growth factor blockers for solid tumors and (ii)
tumor angiogenesis blocker called vascular endothelial growth factor receptors (VEGFR). However, these biologics are still in preclinical or Phase 1 stages of development.
At present, Imclone is a one-trick pony—named Erbitux. The Company is like McDonald’s when all it had on its menu was burgers, fries, and shakes. The difference is that McDonalds had a visionary leader, Ray Kroc.

Imclone has a CEO with no background in biotech. After yesterday—Imclone does have Carl Icahn, an activist stakeholder known for aggressively pushing for corporate changes to enhance stock value. Launching proxy fights is like getting dressed in the morning for financier Icahn. Recently, investors who followed Icahn into the maker of the hit Grand Theft Auto video-game series Take-Two Interactive (TTWO-$15.01) and Symantec (SYMC-$20.95), the No. 1 anti-virus software maker, were rewarded by gains of 27% and 18% in the price of the stocks, respectively, in just a few months.

Imclone has approximately $964 million, or $11.44 per share, in cash. Net the $844.2 million in total contractual cash obligations (mostly LT Debt, Interest Expense, and Operating Leases), or $(10.01), leaves a less-than-impressive $1.43 per share in cash. (However, the LT Debt does not come due—aside from designated events—until May 2009, 2014, or 2019.)

Despite the patent setback, the Company will probably reach a settlement and end up paying royalties (estimated at two –to – three percent of sales) to Yeda Research.

In our view, the bigger worry is Amgen’s Vectibix and Genentech’s (DNA-$79.17) VEGF-blocker, Avastin, which received FDA approval (in combination with chemotherapy) for Second-Line Metastatic Colorectal Cancer Patients in late June 2006.

Icahn is correct, current management is not up to the task of taking on this Sisyphean task.

If, however, Icahn can pull off a coup de`tat, and milk the cash cow (Erbitux), investors could be handsomely rewarded in the end. BUY and wait for the ‘Icahn Effect.’
Editor David J Phillips does not own any of the stock mentioned in this article. You can see his portfolio holdings in the sidebar. The 10Q Detective has a full disclosure policy.

Tuesday, September 19, 2006

Power Outage at American Power Conversion Corp?

Matrix Asset Advisors Inc., in a letter dated September 11, urged the Board of electrical systems maker American Power Conversion Corp. (APCC-$20.73) to sell the Company, on the grounds that its stock price did not reflect the company's "intrinsic value."

According to regulatory filings, Matrix, a $1.6 billion large-cap value fund, beneficially owns 2.38 million American Power shares, or about 1.25 percent of the outstanding stock.

The Common Stock of American Power has lost 20.7% in market value in the last year, as compared to a 7.3% gain in the S&P 500 in the same period.

American Power markets power protection equipment and related software and accessories for computer, communications, and related equipment. The Company has three operating segments:

*The Small Systems segment provides both surge and back-up power protection for PC and home electronics, UPS (
uninterruptible power supply) and management products for the PC, server and networking markets (both local area and wide area).

American Power is benefiting from the increasing digitalization of the economy and the subsequent need for uninterruptible power supplies. The Small Systems segment posted healthy results for the second quarter ending June 30, 2006, increasing 12 percent year-over-year to $399.6 million. Demand for American Powers’ online single-phase Smart-UPS solution, the Smart-UPS RT, and summer demand for Back-UPS desktop UPSs were top drivers of growth in the segment during the quarter.

Second quarter 2006 gross margins, however, for the Small Systems segment of 41.5% declined 370 basis points from the comparable period in 2005. The Company attributes the year-over-year margin decline to higher freight and logistics costs, and pricing and mix shifts.

*The Large Systems segment provides systems, products and services that primarily provide back-up power, power distribution and precision cooling equipment for data centers, facilities, and communications equipment for both commercial and industrial applications. This on-demand architecture for network-critical physical infrastructure (NCPI) is dubbed

American Power is looking to capitalize on its brand image and dominance in the small systems market to drive commercial awareness and subsequent adoption of its Large Systems product offerings by data centers. For the second quarter 2006, revenue in American Power’s Large Systems segment, consisting primarily of 3-phase uninterruptible power supplies (UPSs), APC Global Services, precision cooling and ancillary products for data centers, facilities and communication applications, increased 33 percent year-over-year to $139.5 million.

The problem—as articulated in Matrix Asset Advisor’s letter to management--is reflected in the Common Stock share price. Investors are wondering how management is expecting to jumpstart growth on lower margin offerings? Second quarter 2006 gross margin for the Large Systems segment was 18.5%, an increase of 20 basis points from the comparable period in 2005.

Irritating investors, too, was that on the Company’s 2Q:06 conference call, management refused to give a timeline when it expected a return to renewed profit growth. Instead, American Power steered shareholders to its continued need to spend dollars on sales & marketing initiatives, both
“essential to branding the data center and establishing American Power as a leader in the NCPI market.”

The Company said, too, that margins will continue to be pressured in coming quarters because of capital spending needs dedicated to expanding future capacity (to meet expected future demand for Large Segment offerings) and lowering overhead in existing production facilities.

Net sales for products in the Other segment, consisting principally of mobile accessories and replacement batteries, decreased in the second quarter of 2006 by 4.7% (over the 2Q:05) to $15.6 million, due to a decrease in demand.

Second quarter 2006 gross margins for the Other segment of 55.2% decreased 130 basis points from the comparable period in 2005. Pricing and material costs negatively impacted this segment’s gross margins.

Net revenue for the second quarter 2006 was $560.0 million, up 17 percent from $480.6 million in the second quarter 2005. Net income for the second quarter 2006 was $24.7 million or $0.13 per share, down 41 percent from $41.9 million or $0.21 per diluted share in the second quarter 2005.

Corporate Governance Issues

On August 15, 2006, American Power said Rodger Dowdell, Jr. was retiring as President and Chief Executive Officer, effective immediately (collecting $2.0 million in severance). Although Dowdell will continue to serve on the board as non-executive Chairman, the board named Rob Johnson as President and CEO on an interim basis.

Johnson’s promotion serves his family well—unlike a sale of the Company.

Dug out from an 8K-A (filed on August 22, 2006):

“Mr. Johnson joined the Company in 1997 when it acquired Systems Enhancement Corporation, a family-owned and operated power management software firm, where he held the position of President. When Systems Enhancement Corporation was acquired by the Company, other members of Mr. Johnson’s immediate family were, and continue to be, employees of System Enhancement Corporation, which is currently a wholly owned subsidiary of the Company. These members of Mr. Johnson’s immediate family are: Richard Johnson, a brother; Patrick Johnson, a brother; James Johnson, a brother; and James Rigman, a brother-in-law. As employees of Systems Enhancement Corporation, these members of Mr. Johnson’s immediate family are paid an annual salary (which salaries range from $108,000 to $165,000) and are eligible for annual cash bonuses.

In addition, the father of Mr. Johnson, Rollie Johnson, provides consulting services to Systems Enhancement Corporation on an hourly basis. Systems Enhancement Corporation paid Rollie Johnson $139,400 for consulting services provided in 2005 and he has been paid $112,500 for consulting services provided in 2006 through the date of this report.”

Valuation Analysis

American Power is selling for 23.8 times forward December 2007 consensus estimates of $0.87 per share (slightly lower than its trailing five-year median of 24.9 times earnings). The Company’s trailing twelve-month operating margin and ROE were 6.3% and 6.8%, respectively.

Industrial equipment maker and competitor Emerson Electric (EMR-$82.65) sells for 16.5 times December 2007 consensus estimates of $5.02 per share. On a trailing-twelve-month basis, EMR sports an operating margin and ROE of 15.3% and 22.6%, respectively.

In our view, we cannot see any visible catalysts to drive American Power’s stock price significantly higher (save for buyout speculation).

Investment Risks & Considerations

On a trailing twelve-month basis, the Company’s free cash flow was $(59.1) million. Nevertheless, the Company carries no long-term debt and has almost
$3.00 per share in cash.

Efficiency ratios. In the last two years: Days-of sales outstanding have held steady at about 64 days; Days inventory dropped (trailing twelve-months) to 140 days compared to 146 and 156 in 2005 and 2004, respectively; Cash conversion cycle has improved 11 days to 166 days (2004 to TTM).

Gross margin variability could continue to adversely affect financial performance. Overall gross margins may be negatively impacted by increased operational costs, price reductions, and a continued shift in product mix toward the faster-growing, but lower-margin, Large Systems products (increased operational costs, including freight and warehousing, associated with the re-architecture of our supply chain). Additionally, the Company’s move into the Larger Systems market could cause competitors like EMR to respond with aggressive price-cutting to retain market share.

In our view, as the Company becomes more dependent on the Larger System segment for top-line growth, its business will become more cyclical in nature, too, due to a growing dependence on corporate IT spending needs.

Friday, September 15, 2006

Southwestern Medical--Anatomy of a Penny Stock Hype.

Southwestern Medical Solutions, Inc. (SWNM.PK-$0.08) is a distributor of in-vitro diagnostic tests for the detection of infectious diseases in humans.

Readers will note on the stock chart four peaks in the price of the Common Stock of Southwestern (one in January, two in April, and one in August) all trended by spikes in volume, too. [The exaggerated one-day spike—to the upside in February and to the downside in April did not happen—charting errors.]

To understand this tale of the tape, our readers should follow the unfolding narrative:

On May 9, 2005, Southwestern (with the price of its Common Stock stalled at 15 cents per share—down from 40 cents per share in January 2005) announced that it had acquired the worldwide rights to the LABGUARD Accucheck Collection System, a
"technologically advanced device that is expected to significantly ease the task of on-site collection and testing, thus providing the highest level of safety and quickest possible results for the large and growing on-site diagnostic testing/screening market.”

On November 28, 2005, with the price of its stock trading at 5 cents per share, the Company announced that it had completed its “extensive clinical trials of the Company’s proprietary
LABGUARD on-site collection & diagnostic testing technology and was poised to bring this product to market through its many distributor alliances including international markets and OEM license of the product to two of the largest laboratory distributors in the U.S.”

“Having met FDA guidelines and requirements for a Medical Device license
,” the Company said (on December 7, 2005), “the final engineering & design for packaging/ assembly and quality control of its initial LABGUARD system commenced with a large California-based medical supplier.”

[Ed note. In the month of December, the stock price of Southwestern traded between 5 cents and 7 cents per share, on average daily volume of approximately 250,000 shares per day.]

On Tuesday, January 17, 2006, SouthWestern announced that it was “applying for, and expected to receive, CLIA (Clinical Laboratory Improvement Amendments) “Waived Status" concerning its proprietary LABGUARD testing & diagnostics device." The objective of the
CLIA program is to ensure quality laboratory testing. Management reiterated, too, that it was poised to bring this product to market through its many distributor alliances including international markets and OEM license of the product to two of the largest laboratory distributors in the U.S.”

[Ed. note. One week earlier, on volume of 110,000 shares, the common stock closed at 6 cents per share. On Thursday, January 12 the common stock closed at 7 cents per share on volume of 1.5 million. On Monday, the day prior to the ‘big’ announcement, the stock price surged to 13 cents per share, on volume of 1.5 million; and on the day of the announcement, on volume of approximately 4.6 million shares, the stock closed at 16 cents per share, after hitting a 52-week high of 20 cents per share.]

March 24, 2006, one of many “third-party” spamming e-mails (allegedly in progress for more than twelve-months) promoting
SWNM: Southwestern Medical Solutions (Stock Spam) is revealed:

  • “Investigative studies for its patent protected Labguard systems, Southwestern Medica Solutions continues to develop exciting advancements in products for the healthcare community. SWNM is poised to gain a strong market presence and build a healthy portfolio of high demand products…. Please Watch this One Trade Friday! Go SWNM!”

[Ed note. At the close of the market on Friday, March 24, Southwestern closed up one cent, at 11 cents, on trading volume of 495,000 shares. On Tuesday, March 28, 2006, the stock of Southwestern closes at 15 cents per share, on trading of approximately 1.6 million shares.]

On April 24, 2006, Southwestern ($0.15), announced that had received “confirmation that a major U.S. distributor of medical related products wished to become the exclusive distributor of LABGUARD.”

[Ed note. Did not the Company say—many times prior—that it already lined up “many distributor alliances.” Trading volume in the three trading days prior to the announcement saw trading jump to approximately 3.1 million shares per day, with an intra-day price variance of 7 cents -to- 17 cents per share, as compared to average daily trading volume of approximately 255,000 shares in the prior two weeks, with an intra-day price variance of 12 cents- to – 14 cents per share.]

On July 11, 2006, with the stock price down some 47% (to 8 cents per share) Southwestern stated that the Company was “working closely with governmental agencies [U.S. Food & Drug Administration—FDA] to commence its OTC clinical trials in order to offer the product as an over-the-counter device” (which would eliminate the need for professionals to conduct the diagnostic analysis of the LABGUARD systems).

On August 16, 2006, management said that the Company was “evaluating inclusion of a medical software program to license to hospitals and medical professionals that could literally change the physician-to-patient communication and education process as well as offer in depth analysis in real-time to the specific diagnosis.”

[Ed. note. See graph for corresponding price-volume changes.]

The Company says that its product portfolio includes Western Blot confirmatory tests for the Human Immunodeficiency virus (HIV), Human T-cell Leukemia virus (HTLV), and Helicobacter pylori; ELISA tests for Hepatitis E virus (HEV) and HTLV; Rapid screening tests for Hepatitis B virus, Helicobacter pylori, Malaria and sexually transmitted diseases.

A stock does not have to sell for less than one dollar per share to be a “penny stock.” It may sound oxymoronic, but Rule 3a51-1, promulgated under the Securities Exchange Act of 1934, defines an issuer’s stock, common or preferred, to be a “penny stock” if the stock does not maintain a minimum bid price of $4 per share.

Definition controversies aside--Southwestern is a penny stock. The Company is a non-reporting issuer, too, meaning that it does not have to file public reports or financial statements with the SEC [it trades on the
pink sheets].

"Without faith, hope and trust, there is no promise for the future." -- Adlin Sinclair

Southwestern may just have run out of faith and trust.

Last Monday, September 11, 2006, the SEC "temporarily suspended trading (terminating at 11:59 EST on Sept. 22,2006) in the securities of Southwestern (last trade was 8 cents per share) because of questions that have been raised about the accuracy and adequacy of publicly disseminated information concerning, among other things, the existence of applications for U.S. Food and Drug Administration approvals for its Labguard product, the existence of a patent and trademark, and the receipt of an order for the sale of several thousand units of Labguard."

Editor David J Phillips does not own any of the stock mentioned in this article. You can see his portfolio holdings in the sidebar. The 10Q Detective has a full disclosure policy.

Wednesday, September 13, 2006

SmartVideo--Dumbing Down its Proxy Statement?

MSU = Russell 2000 // IXIC = Nasdaq Stock Market


On September 8, SmartVideo Technologies, Inc. (SMVD.OB-$1.28), a provider of video content distribution services, filed its Annual Proxy Statement with the SEC. After a read though, we agree with Yogi Berra, when he said: “ nickel ain't worth a dime anymore.”

In its press releases, corporate says that its core competence centers around a proprietary technology platform that is optimal “for the efficient utilization of Internet bandwidth in conjunction with—high quality picture and sound—streaming video. Management believes that the Company is able to deliver to its customers one of the widest selections of programming available today.”

If one were to just look at the 37-month (cumulative) Total Return chart [provided by management] that compares the Common Stock performance to small-cap indexes one would see that $100 invested on November 26, 2002 in Smart Video stock would have grown to $469.14 on December 31, 2005, compared to $166.96 and $187.39 (including reinvestment of dividends) for a $100 investment in the Nasdaq Stock Market and the Russell 2000, respectively.

Stock Performance Graph

The following graph compares the changes over the last five years in the value of $100 invested in (i) the Common Stock, (ii) the Nasdaq Stock Market, (iii) the Russell 2000, (iv) the Russell Microcap, (v) the Nasdaq Telecommunications, and (vi) the RDG Internet Composite indicies. The year-end values of each investment are based on share price appreciation and the reinvestment of all dividends.

Historical stock price performance shown on the performance graph is not necessarily indicative of future stock price performance.

* $100 invested on 11/26/02 in stock or on 10/31/02 in index-including reinvestment of dividends.

Fiscal year ending December 31
November 26December 31December 31December 31December 31
Smart Video$100$136.46$453.97$445.95$469.14
Nasdaq Stock Market100100.73150.07163.19166.96
Russell 2000100102.86151.46179.23187.39
Russell Microcap100105.28175.15199.92205.05
Nasdaq Telecommunications100112.13186.54199.07187.88
RDG Internet Composite100102.41145.19160.51157.64

DateOpenHighLowCloseVolumeAdj. Close
Smart Video Technologies 6-Jan-031:3 Stock Split

To remind our readers—the Proxy was filed on September 8, 2006. The Common Stock traded at 52-week intra-day high on December 5, 2005, when it hit $7.60 per share. Since peaking on December 5, the stock has lost more than 86.2% of its market value (as of August 31, 2006).

In fact, as August 31, 2006, contrary to management’s ‘cut & paste’ job, adjusted for the reverse 1:3 stock split, an investor who put $100 in the Common Stock of SmartVideo on November 26,2002, would have witnessed his (approximate) 270 shares reduced to 90 shares; and, as of September 1, 2006, the investor’s holdings would be worth $94.50—quite a difference than the $469.14 value that management bragged about on December 31, 2005!

Ivana Trump, on finishing her first novel, remarked, “Fiction writing is great, you can make up almost anything."

A review of the Company’s quarterly filings with the SEC paints a different picture than the company shown in the aforementioned graph. SmartVideo is a company in distress. As of June 30, 2006, SmartVideo had an accumulated deficit of approximately $49.6 million.

SmartVideo is also a company with a less-than-certain future. As of June 30, 2006, the Company reported a working capital deficiency of approximately $2.6 million.

Mmanagement anticipates, “based on its proposed plans and assumptions relating to operations that the net proceeds from the closing of its most recent financing in July 2006, together with revenues generated from operations, will not be sufficient to meet the cash requirements for working capital and capital expenditures beyond June 2007…. if adequate funds are not available or not available on acceptable terms, SmartVideo will be unable to continue as a going concern.”

For the year ended December 31, 2005, SmartVideo lost $19.7 million on revenue of $197,257.

The income statement shows that SG&A contributed close to 48% of this net loss. As we could not find a comprehensive listing of Key Executives and their total compensation packages for FY 2005, this only leaves us more curious—on whom—or how—is management spending their limited capital resources?

According to management, SG&A increased approximately $1,449,000 year-over-year when compared to 2004. In their 10-K filing, the jump in expenses was associated with the executives’ “participation in numerous trade shows and the extra costs attributable to the decision to develop a prominent presence in each of these events. The Company also incurred additional travel related and marketing costs associated with specialized consultants hired to assist management in this process.”

As if the aforementioned was not troubling enough, the 10Q Detective takes issue with corporate governance at the Company. In particular, we differ with management on the ‘independence’ of certain directors who sit on the audit and compensation committees.

The Compensation Committee is responsible for reviewing and approving the executive compensation program for the Company, assessing executive performance, making grants of salary and annual incentive compensation and approving certain employment agreements. According to the Company, each member of the Compensation Committee is an “independent” director; as such term is defined by the applicable listing standards of the Nasdaq Stock Market.

The Compensation Committee is comprised of Glenn Singer, Justin Stanley and Michael Criden, who beneficially own 8.6%, 1.4%, and 6.4% of the Common Stock outstanding, respectively. Nasdaq has stated that ownership of company stock by itself does not preclude the Board from concluding that such shareholder(s)/director(s) is grounds for compromised independent judgment.

The primary duties of the Audit Committee are to are to serve as an independent and objective party to monitor the Company’s financial process and the internal control system, to review and appraise the audit effort of the Company’s independent accountants and to provide an open avenue of communication among the independent accountants, financial and senior management of the Company and the Board of Directors. The Audit Committee is comprised of Michael Criden, Glenn Singer, and Justin Stanley.

The Board of Directors determined that each of the Audit Committee members is an “independent” director within the meaning of such listing standards of the Nasdaq Stock market.

Among other definitions, Nasdaq consider persons who are not independent to be “a director who is a partner in, or controlling shareholder or executive officer of, any organization to which…the company received payments that exceed the greater of 5% of the company’s consolidated gross revenues for that full year, or $200,000, whichever is greater, in the current fiscal year, or any of the past three years.”

On July 18, 2005, Justin A. Stanley was appointed a member of the Board of Directors of the Company. On August 12, 2005, the Company borrowed $225,000 from Mr. Stanley. [Full Disclosure: The principal amount of this note was repaid to Mr. Stanley on November 22, 2005.]

On November 21, 2005, Michael Criden and Glenn Singer were appointed as member of the Board of Directors of the Company. On September 26 and October 19, 2005, Michael E. Criden and Glenn H. Singer and GHS Holdings Limited Partnership, a company controlled by both men, loaned the Company a total of $600,000. In exchange for the loans, the Company issued convertible promissory notes and warrants to each of Messrs. Criden and Singer and GHS Holdings Limited Partnership.

"I get to go to lots of overseas places, like Canada." - Britney Spears, Pop Singer.

No interference with independent judgment? A rising stock price (with an outdated stock chart)—to signal all is well at the Company? Foxes watching the hen-house? And who is watching the foxes? SmartVideo must think it has dumb shareholders.

Editor David J Phillips does not own any of the stocks mentioned in this article. You can see his portfolio holdings in the sidebar. The 10Q Detective has a full disclosure policy.

Monday, September 11, 2006

News Corp., Old World Executives--New World Bonuses

News Corporation (NWS-$19.54) is one of the world’s largest media and entertainment conglomerates with assets that include Fox Broadcasting Company and the 20th Century Fox film studios, the interactive social networking website MySpace, and the Internet entertainment portal IGN Entertainment. It also owns a number of newspapers, including the Times of London, the New York Post, and the pulp tabloid National Star.

The Company’s pan-continental empire includes equity interests in such recognizable brands as the National Geographic cable channel, Gemstar-TV Guide, DirecTV, a satellite television network British Sky Broadcasting Group, and (50%) of the
National Rugby League.

On Friday, the largest shareholder of News Corp., CEO Rupert Murdoch (who beneficially owns 31.7% of the Common Stock), saw his name splashed across the business pages when it was reported in the Company’s Annual Proxy Statement filed with the SEC that he was paid $25.7 million in the fiscal year ended in June, including salary and a $21-million bonus. Additionally, in May the Company started paying $50,000 a month for a NYC apartment leased in his name.

The excesses do not start and stop with Murdoch. News Corp. also paid $29.3 million to Peter Chernin, its president and chief operating officer, including salary of $8.1 million and a bonus of $21.2 million. Additionally, he earned approximately $12.8 million in Restricted Stock Units (RSUs).

A reading of the Company’s Proxy Statement (analogous to reading Tolstoy’s War and Peace), said the annual performance-bonuses for senior executives were based on a computation of (adjusted) earnings-per-share growth. After a thorough reading of the Company’s 10-K filing, the 10Q Detective was left with a big headache—and a bigger concern—an uneasiness that management had (has) the capacity to massage EPS to legitimize its executive excesses?

According to the Compensation Committee, the "adjusted EPS percentage increase was 32.35%,” and therefore, they approved the aforementioned annual performance-based bonuses.

For the full year, net income from continuing operations was $2.8 billion ($0.87 per share on a diluted combined basis), an increase of $684 million or 32% from the $2.1 billion ($0.69 per share on a diluted combined basis) reported in fiscal 2005. However, on a share-net basis, income increased only 26.08%--not 32.35% as reported by the Compensation Committee. Additionally, on a share-net basis, 3 cents can be attributed to $2.5 billion spent on share buybacks year-over-year.

And, according to the $25.7 million man, Rupert Murdoch: “Recognizing that disconnect and the continued value inherent in purchasing new shares, the Board has extended our original program by an additional $3 billion to be completed over the next two years. We expect to continue to be active buyers of our shares so long as the market undervalues the Company. It's a good use of our cash.” If you are looking to enhance EPS visibility, share buybacks are a good first step.

Capitalization policies can also be a red flag on the march downfield to the end zone. We are not alleging any misdeeds at News Corp, but with millions in bonuses on the line, what entertainment costs the Company chooses to capitalize or expense ought to be closely watched. For example, in the Company’s 10-K filing, it is stated “development costs for projects not produced are written-off at the earlier of the time the decision is taken not to develop the story or after three years.” In other words, the Company has the flexibility of thirty-six months to decide whether or not to write-off production expenses involved in storyboard decisions. One does not have to be a member of the Financial Accounting Standards Board (FASB) to note that write-offs can be timed to coincide when operating income surpasses expected bonuses.

Employment Agreements.

Mr. Peter Chernin, the Company’s President and Chief Operating Officer has entered into three amended employment agreement in as many years. Chernin was paid approximately $72.8 million in salary and bonuses in the last three years (which does not even include the estimated $12.8 million in RSUs awarded to him in FY 2006). Apparently, this was not enough to satiate this COO, for commencing on August 1, 2004, a savings account with monthly Company contributions of $358,334 was set up on his behalf!

Additionally, if Chernin resigns for ‘good reason’ (is there any other kind), he is entitled to the usual perquisites (accelerated vesting of stock options and RSUs), as well as a lump sum
cash payment of $40.0 million!

The 10Q Detective believes that Chernin harbors secret Hollywood ambitions of his own. Buried deep in his employment agreement, we unearthed the following tidbit: “Within 30 days following the termination of Mr. Chernin’s employment for any reason (including for cause), except if Mr. Chernin resigns after declining to replace Mr. K.R. Murdoch as Chief Executive Officer of the Company…. Chernin may require that the Company enter into a six-year motion picture production agreement and a six-year television production agreement…. The motion picture production agreement will provide for the purchase by the Company of at least two motion pictures per year….”

Mr. Roger Ailes, Chairman and Chief Executive Officer of Fox News Channel, Chairman of Fox Television Stations and Twentieth Television, earned approximately $22.7 million in salary and bonus collectively in the last three fiscal years (which does not include the amount spent on his personal security, which equaled $77,243, $113,227 and $130,584, respectively, for the last three years). Additionally, The Company provided a car and driver to Mr. Ailes for commuting purpose at a cost of $124,020, $111,620 and $110,835 for fiscal 2006, 2005 and 2004, respectively.

Pursuant to the terms of his employment agreement, signed in August 2005, the Company agreed to pay Mr. Ailes a base salary of (at least) $5.0 million per annum. Additionally, in August 2006, a retention bonus worth an estimated $7.3 million was credited to Ailes (to be paid in cash and/or RSUs in five equal annual installments beginning on August 15, 2006)!

Retirement Bonus.

In addition to the News America Employees’ Pension and Retirement Plan and (the usual) Supplemental Executive Retirement Plan, the Company is providing enhanced compensation bonuses to coincide with the date of retirement of certain key executives. Messrs. K.R. Murdoch, Chernin, and DeVoe, will each receive, as a minimum, an annual benefit of $500,000 adjusted annually for inflation.

Director Compensation.

In October 2005, News Corporation announced that
Stanley S. Shuman resigned from the Company’s Board of Directors. Mr. Shuman, who is managing director of investment banker Allen and Company LLC, has been a director of News Corporation since 1982. He will continue his association with the Company as Director-Emeritus, attending Board meetings but not voting on resolutions.

Commenting on Mr. Shuman’s resignation, News Corporation Chairman and CEO Rupert Murdoch said:
“Stan has been an outstanding director for the past 23 years as News Corp…. His sage advice and his firm friendship have been deeply valued. We are fortunate to be able to count on Stan’s opinions in the future as he continues to contribute to our Company as Director-Emeritus. All News Corp. stockholders owe Stan a debt of gratitude for the great work he has done for our Company over the years.”

[Ed. note. Dissident shareholders demanded the
creation of an independent majority on the board; this change was set in place by retiring the seat held by former director Shuman (when he left on October 6, 2005). Shuman’s 'hari-kari,’ however, came with its own price. The ‘debt of gratitude’ voiced by Murdoch will be paid for by shareholders. In addition to his honorary—and non-voting—position, Mr. Shuman will receive $185,000 per annum ($85,000—annual retainer and $100,000 in annual Deferred Stock Units of the Class A voting shares). Oh—Shuman’s firm, Allen & Co., received $6.1 million and $3.9 million in fees from News Corp. for the last two years, respectively.]

In August 2005, Lachlan Keith (LK) Murdoch, age-34, Rupert’s son, resigned as the Deputy Chief Operating Officer of News Corporation. His dad, commenting on LK’s decision said,
"I am particularly saddened by my son's decision and thank him for his terrific contribution to the company. I have respected the professionalism and integrity that he has exhibited throughout his career at News Corporation."

His service at News Corp is better remembered by other shareholders for the collapse of
One.Tel Ltd., a telecommunications company that Lachlan advised News Corp in to taking an investment stake.

“You'll tell your friends about One.Tel.” This slogan was engineered to draw the connection between the One.Tel brand and personal communication. Three and one-half years after its IPO on the Australian Stock Exchange, One.Tel was declared insolvent in March 2001. One of the more notable business failures of the year—it
cost News Corp. more than $500 million in losses.

These days, the 10Q Detective doubts that L.K. Murdoch tells anyone about One.Tel.

Pursuant to the terms of his severance agreement, LK received a separation cash payment of approximately $7.8 million (equal to his salary and bonus for fiscal year ended 2005).

Like a bad joke being played on shareholders, LK continues to sit on the Board of Directors. As LK is no longer an employee of News Corp., he, too, (as a director) will be compensated $185,000 per annum.

Additionally, Mr. L.K. Murdoch will serve as an advisor to the Company [compensation unknown].


Freud Entertainment Limited, which is controlled by Matthew Freud, Rupert’s, son-in-law, provided external support to the press and publicity activities of the Company during the fiscal year 2006. The fees paid by the Company to Freud Entertainment Limited were approximately $502,860 for the fiscal year ended June 30, 2006.

Rupert Murdoch, commenting on the FY 2006 said, "Longer term, we're intently focused on developing ways not only to monetize our acquired internet assets, but also on how to exploit our vast content libraries. As regards executive pay, insiders have already figured out how to monetize and exploit corporate assets.

Friday, September 08, 2006

Frisch's--No Appetite for This Restaurant Stock.

Frisch’s Restaurants, Inc. (FRS-$24.70), is a regional company that operates 90 full service family-style restaurants under the name “Frisch’s Big Boy,” located primarily in various regions of Ohio, Kentucky and Indiana. Menus are generally standardized with a wide variety of items at moderate prices, featuring well-known signature items such as the original “Big Boy” double-deck hamburger sandwich, freshly made onion rings and hot fudge cake for dessert.

The Big Boy marketing strategy - “What’s Your Favorite Thing?” – has been in place for almost nine years. Results from ongoing market research lead the Company to believe its effectiveness has not diminished. Television commercials are broadcast on local network affiliates and local cable programming emphasizing Big Boy’s distinct and signature menu items.

The Company also operates 34 grill-buffet style family restaurants offering a wide variety of buffet items under the name “Golden Corral.” All of these eateries are fitted with charbroil grills placed directly on the buffet line. This format has allowed customers to be served grilled-to-order steaks directly from the buffet line as part of the regular buffet price. This “Great Steaks Buffet” strategy also features many other varieties of meat including fried and rotisserie chicken, meat loaf, pot roast, fish and a carving station that rotates hot roast beef, ham and turkey. The buffet also includes fresh fruits and vegetables, other hot and cold buffet foods, a salad bar, desserts, an in-store display bakery that offers made-from-scratch bakery goods every fifteen minutes, and many beverage items (none of which contain alcohol). Most of the food is prepared in full view of customers in order to emphasize its freshness and quality.

The Company’s vision is to be the “best large owner/operator of franchised, multi-location restaurant concepts within 500 miles of Cincinnati.”

If our readers were to only look at the Common Stock Price Comparative Performance Graph supplied by Frisch’s management in their recently filed
Proxy Statement, the observable conclusion reached would be that the Company was well on its way to being ‘the best.’



The graph compares the yearly percentage change in the Company’s cumulative total stockholder return on its Common Stock over the five year period ending May 30, 2006 with the Russell 2000 Index and a group of the Company’s peer issuers, selected by the Company in good faith. The graph assumes an investment of $100 in the Company’s Common Stock, in the Index and in the common stock of the peer group on June 3, 2001 and reinvestment of all dividends.

The Peer Group selected by the Company “in good faith” consisted of the following issuers: Bob Evans Farms, Inc. (BOBE), Steak n Shake Co. (SNS), CBRL Group, Inc. (CBRL), IHOP Corp. (IHP), Ryan’s Restaurant Group Inc. (RYAN), and Friendly Ice Cream Corp. (FRN).

Friendly Ice Cream Corp., the restaurant chain famous for its "Fribble" ice cream-based drink, and IHOP Corp, the franchise better known for its pancakes than its steaks, both have histories of erratic financial performance and troubled credit and debt ratings.

If the Company were to have included Applebee's International Inc. (APPB) and Red Robin Gourmet Burger (RRGB) in their Peer Group analysis, the five-year cumulative total return of Frisch’s Common Stock would not have looked as robust.

Of interest, a peer analysis of key financial metrics leads the 10Q Detective to conclude that Frisch’s “Big Boy” double-deck hamburger smells more like a turkey-burger!

Profitability Ratios:

1. Operating Margin for Past 5-Years. FRS-6.0% Industry-12.0%
2. Net Margin for Past 5-Years. FRS-4.1% Industry-7.3%

Management Effectiveness Ratios:

1. ROA for Past 5-Years. FRS-7.1% Industry-8.7%
2. ROE for Past 5-Years. FRS-13.7% Industry-14.9%

Growth Rates:

1. Sales Growth for Past 5-Years. FRS-8.9% Industry-12.9%
2. EPS Growth for Past 5-Years. FRS-6.8% Industry-15.8%

Corporate Governance

Frisch’s—as described—is a family-style restaurant chain. Management’s ignis fatuus cannot hide the fact that this is a Maier family restaurant—and the relatives are overindulging at the buffet.

Until his death on February 2, 2005, Jack C. Maier served as Chairman of the Board. Jack C. Maier was the husband of Blanche F. Maier, and upon his death, the Company began paying to his widow, Blanche F. Maier (for each of the next ten years) the amount of $214,050, adjusted annually to reflect annual percentage changes in the Consumer Price Index.

Craig F. Maier (President and Chief Executive Officer) and Karen F. Maier (Vice President – Marketing) are siblings and are the children of Blanche F. Maier.

Blanche, Craig, and Karen (combined) beneficially own 75.1% of the outstanding Common Stock of the Company.

Despite dismal financial performance (as measured by operating margin) in the FY ending May 30, 2006, the Board granted to Craig Maier 20,000 options—which represented 28% of the total options granted to ALL employees in FY 2006.

Craig Maier’s annual bonus is indexed to pre-tax earnings: total sales formula. He earned approximately $1.08 million in incentive dollars (for lackluster and erratic operational performance) in the last three fiscal years. He is also sitting on $1.9 million of unexercised (and in the money) stock options.

Members of Blanche F. Maier’s family—including Craig—are financially invested in three Big Boy franchises, too.

Scott Maier, a Construction Manager at the Company, is the son of Blanche F. Maier and the brother of Craig F. Maier and Karen F. Maier. During the fiscal year ended May 30, 2006, Scott Maier received a salary of $64,891 and an auto allowance of $5,256.

After reading Frisch’s Restaurants’ Proxy Statement in its entirety—we lost our appetite.