Friday, December 29, 2006

Will Heelys' Stock Price Skate Higher in 2007?

On December 8, 2006, “wheels-on-a-heel" footwear designer Heelys, Inc. (HLYS-$32.74) priced 6.425 million shares at $21, a 23.5% premium to its suggested IPO price of $17.00 per share. Heelys offered 3.125 million shares of common stock and certain existing stockholders sold the remaining 3.3 million shares, with Bear Stearns and Wachovia Securities acted as co-managers for the IPO.

The Company is using the net proceeds from the IPO to repay about $22.0 million in debt outstanding, upgrade its IT systems, and to fund expansion plans, including advertising (television), staff headcount (of 38 employees), and product development.

Shares “heelied” down Wall Street, as investors bid up the stock 55.2% in its first day of trading, excited about the Company’s growth prospects in domestic and international markets

Heelys sells a dual-purpose shoe that has a removable wheel, which allows the user to seamlessly change from walking or running to skating by shifting their weight to the heel. Users can also transform HEELYS-wheeled footwear into comfortable street shoes by removing the wheel.

The footwear, sold under the marketing slogan "Freedom is a wheel in your sole," is targeted to boys and girls between six and fourteen years of age, particularly those who associate themselves with youth action sports.

The wheeled shoes, which retail from $59.99 to $99.99, come in three categories—Single-Wheel, Two-Wheel, and Grind-and-Roll, and in a variety of colors—and can be found at sporting goods retailers, specialty shoe retailers, and select department stores.

Financial Analysis

In the first nine-months of this fiscal year, net sales increased 303.1% to $117.1 million, from $29.1 million for the nine months ended September 30, 2005. Unit sales of HEELYS-wheeled footwear increased by 2.9 million pairs, or 316.2%, to 3.9 million pairs for the nine months ended September 30, 2006.

For the nine months ended September 30, 2006, 85.9% of net sales were from domestic retail customers, as compared with 81.0% for the nine months ended September 30, 2005. Domestic net sales increased $77.1 million, or 327.8%, to $100.6 million for the first nine-months.

Internationally, net sales increased $11.0 million, or 198.2%, to $16.5 million. This increase was primarily the result of increased sales to distributors in Canada, the United Kingdom, Ireland and Argentina/Brazil/Chile, partially offset by decreased sales to distributors in Japan and Spain/Portugal.

As a percentage of net sales, net income increased to 15.1% for the nine months ended September 30, 2006, from 10.0% for the nine months ended September 30, 2005. Net income was $17.7 million, or share-net of $0.70, compared with $2.9 million, or 11 cents per share, last year. This impressive growth was due to higher sales and decreases in product costs (due to product mix and efficiencies related to the opening of a distribution center), partially offset by increased freight costs (primarily caused by airfreight costs to meet rush-past due orders).

For the nine months ended September 30, 2006, cash used in operating activities was $19.5 million compared to $316,000 for the nine months ended September 30, 2005. Cash used in operating activities for 2006 consisted primarily of an increase in net working capital of $37.5 million partially offset by net income of $17.7 million and non-cash items of $279,000. The increase in net working capital was primarily the result of an increase of $36.5 million in accounts receivable due to increased net sales and an increase in inventory of $11.3 million due to an increase in inventory in transit, partially offset by an increase in accrued expenses of $6.6 million and income taxes payable of $4.5 million related to increased income before income taxes.

The increase in net working capital was related to—similar to other vendors of footwear products—the seasonality of sales. There are three major buying seasons in footwear: spring/summer, back-to-school and holiday. Shipments—and the need for higher inventories—for back-to-school generally occur over the summer and shipments for the holiday season begin in October and finish in early December.

Investment Analysis

In our view, at $32.74, or 35 times estimates earnings of $0.94 per share, Heelys’ stock already discounts a strong fourth-quarter.

Heelys run out of the blocks comes on the heels of other strong specialty retailers and sportswear retailers (aimed at the youth market) IPOs in the last two years. Looking at these “lifestyle-trends” peer comparables, however, risk-reward does not favor establishing new positions in Heelys:

Heelys, Inc. (HLYS)34.8x5.7
CROCS, Inc. (CROX-$43.53)21.3x5.9
Under Armour, Inc. (UA-$50.80)52.9x6.2
Zumiez, Inc. (ZUMZ-$29.52)33.2x3.05
Volcom, Inc. (VLCM-$29.30)20.1x3.30
Note. HLYS -- PE is FY '06/ Enterprise Value/ Revenue (EV/REV) based on 2006 est. of $160.3 mill.

Action & Board sports apparel retailer Volcom illustrates what happens when yellow flags begin to fly. On May 11, 2006, one of Volcom’s largest customers (accounting for about 25% of revenue), casual apparel maker Pacific Sunwear (PSUN-$19.67) announced that same-store sales and net income were lower in its 1Q:06. From May to August, PSUN shed about 30.4% in market value—and in sympathy, Volcom’s stock price dropped about 47.2% in market value!

Heely’s current stock price could look cheap, however, if management executes on its promise to increase domestic distribution by expanding the number of stores in which its wheeled footwear is sold (by existing retail customers and by adding new retail customers). If sales double in 2007 and the Company can continue to throw off net margins of 15%, Healy’s share could increase another 50% in value.

In the coming months, a boost in Heelys’ stock price could come, too, when its underwriters Bear Stearns, Wachovia Capital Markets, JPMorgan and CIBC World Markets—in all likelihood—publish positive research comments.

[Ed. note. Due to the Company’s limited funding at its public inception, management will need to focus its marketing resources on specific regions of the country that management believes will more readily embrace wheeled sports. In our view, with growth comes the need for additional capital to fund the build-out of additional distribution facilities, staffing needs, etc. The Company will probably float a secondary offering in 2007—so who wants to be lead underwriter?]

Other Investment Risks & Considerations

In 2005 and in the nine-month period ended September 30, 2006, Heelys generated approximately 95% and 99% of its net sales, respectively, from HEELYS-wheeled footwear. Management expects to continue to depend upon this single product line for substantially all of its net sales in the foreseeable future. If consumer interest in HEELYS-wheeled footwear or wheeled sports activity products in general declines, the Company would likely experience a significant loss of sales and would be forced to liquidate excess inventories at a discount, which would have a material adverse impact on its business and operations.

Vulnerability Due to Customer Concentration. For the nine months ended September 30, 2006, Journeys and The Sports Authority accounted for 11.6% and 11.0%, respectively, of net sales. Success is contingent upon the willingness and ability of these retail customers to market and sell Heelys products to consumers.

Because Heelys outsources all of its manufacturing to a small number of independent manufacturers, the Company may face challenges in maintaining a sufficient supply of products to meet future demand for its products or experience interruptions in its supply chain.

The Company has commissioned Boss Technical Services, an independent sourcing agent, to help the Company identify and develop relationships with manufacturers of its footwear products (and provides quality inspection, testing, logistics and product development and design assistance).

Manufacturer Bu Kyung Industrial-So. Korea, (owned by one of the owners of Boss Technical Services) produced almost all of HEELYS-wheeled footwear until May 2006. Commencing in May, when demand for HEELYS-wheeled footwear products outstripped the capacity of this independent manufacturer, management used additional independent manufacturers to produce HEELYS-wheeled footwear.

The company faces risks, too, from an increasing number of counterfeit shoes being sold in the U.S. For example,
a recent lawsuit against Levy Marketing accuses the company of selling knockoffs of the Heelys to ''kiosk retail outlets in various malls'' throughout the country.

As of September 30, 2006, the Company offered its products internationally through more than 30 independent distributors, each of which has exclusive rights to a designated territory. In 2005, the largest international territories by net sales were Canada, Japan and Spain/Portugal. Since 2004, no country other than the United States has accounted for 10% or more of our net sales.

Management believes that international distribution represents a meaningful growth channel for the Company, but success in developing foreign markets depends on distributors ability to establish relationships with other distributors in new international markets.

The 10Q Detective notes that the Company is having trouble penetrating shoe markets in the Far East (surprise?). For example, a Korean firm sells a one-wheel roller shoe knockoff called “Heatys.”

To defend its patents and intellectual property in the U.S., the Company has filed more than 70 patents and holds the rights to proprietary technology with names like "High-end Grind Shoe Technology" and a wheel suspension system featuring “shock-absorbing springs” in the wheel housing.

In some Asian countries where Heelys has sought patent protection, however, third parties have challenged the validity, enforceability and scope of its patent rights. For example, the Japan Patent Office issuing an opinion in February 2006 that Heely’s Japanese patent was invalid. (The Company has filed a lawsuit with the Intellectual Property High Court in Japan, in June 2006, and plans to file a Trial for Correction in the Japan Patent Office to attempt to overturn the prior opinion).

Additionally, a third party recently commenced a proceeding to invalidate Heely’s patent on the "Roller Shoe" in Taiwan.

There is also product-liability risk. According to published reports, there are Heely bans in many public buildings, malls, school hallways and playgrounds.

In addition, the Boston group World Against Toys Causing Harm Inc.
(W.A.T.C.H.) placed Heelys on the top of its annual "10 Worst Toys" list for 2006, citing safety concerns that the wheeled-sneakers are marketed to children who are unprepared for their associated risks.

[Ed. note. On its website, the Company’s disclaimer states: “recommend that anyone who attempts to use HEELYS in any capacity should ALWAYS wear full protective gear, including: helmets, wrist, elbow, and knee pads.” Yet, in a video we watched on the site called
The Rush, the adult skater wore none of the aforementioned safety gear!]

Look for liability insurance costs to continue to rise with sales.

One rarely mentioned risk--HEELYS-wheeled footwear could become subject to import tariffs in the United States. The U.S. Customs and Border Protection currently classifies the product(s) as a skate, and as such the Company does not pay import duties to the United States. However, many in the House and Senate are calling for trade protection—especially from countries in Asia—as our
Trade Deficits balloon (the experts say these deficits are “ capital borrowing from abroad,” approaching 7 percent of GDP.)

If the classification for HEELYS-wheeled footwear changed and HEELYS-wheeled footwear became subject to an import duty (as high as 20 percent ad valorem), it might be difficult to pass these costs—to compensate for any such duty—onto the consumer.

Editor David J Phillips does not hold financial interests in any of the companies mentioned in this posting. The 10Q Detective has a Full Disclosure policy.

Tuesday, December 26, 2006

Starbucks the Victim of a Coffee Mugging by Oxfam?

Oxfam, a development charity that dates back to World War II, alleges that global coffee retailer Starbucks Corp. (SBUX-$35.38) is depriving Ethiopian coffee farmers of between $88.0 –to- $132.0 million a year, by opposing the Ethiopian government's efforts to trademark three popular varieties of its specialty coffee—Harar, Sidamo and Yirgacheffe beans.

Oxfam and its broad coalition of supporters say:
“More than a year ago, Ethiopia approached Starbucks and asked the company to lead the coffee industry by example and sign an agreement recognizing Ethiopia's legal ownership of its fine coffee names. If companies like Starbucks signed such agreements, Ethiopia would occupy a stronger negotiating position with foreign buyers, capture a larger share of the market associated with its coffee names, and better protect its brands.”

Oxfam and its activists allege that there is a huge disparity in the profit distribution to the players in the coffee industry, with Ethiopian coffee farmers often collecting no more than 10 percent of the profits from the sale of their coffees. The rest goes to the coffee industry players that can control the retail price—the international importers, distributors, and roasters like Starbucks.

Starbucks CEO Jim Donald met with Ethiopia to discuss trademark issues on November 29, 2006. Given little progress in their talks, Oxfam and its supporters organized “The Starbucks Day of Action” –in more than a dozen countries—and demonstrated outside many Starbucks stores on December 16, with activists leafleting and carrying the image of an Ethiopian coffee farmer on sandwich board fronts, with the backside reading, "For every cup of Ethiopian coffee Starbucks sells, Ethiopian farmer earn 3 cents. Tell Starbucks: Honor your commitments to coffee farmers." [Ed. note. Watch the video on YouTube now.]

Talks purportedly broke down because Starbucks favored a geographic certification model—much like Jamaican Blue Mountain Coffee, Florida Orange Juice, and French and Napa Valley Wines—which guarantees a point of origin and standard of quality; whereas, Ethiopia refused, opting for brand ownership.

We laud Oxfam’s good intentions, but question their grasp of Ethiopia’s calculus for peculations.

The rhetoric behind economic development today—especially in African countries—is such that where poverty exists, you can be sure that “corruption” won’t be far behind. Aside from widespread allegations of fraud following the May 2005 parliamentary elections, in which results showed the incumbent Ethiopian People's Revolutionary Democratic Front retaining a majority, the business environment—while not thought to be as corrupt as political life—in Ethiopia, still ranked only a 3.70 score (with 1.0 being the best & 5.0 being the worst) on an
”Index of Economic Freedom 2006” census taken by The Heritage Foundation/ Wall Street Journal: “Ethiopia's cumbersome bureaucracy deters investment…. Corruption in Ethiopia poses various problems for [the] business environment, as patronage networks are firmly entrenched and political clout is often used to gain economic prowess."

In our view, irrespective of going the certification process or the intellectual property route, in order for the coffee farmers to share in any incremental value—such as an increase in annual income—necessitates a transparent system that shows how the money is going back to the farmers.

In addition to failing to explain what type of transparent ‘checks and balances’ system need be established, nowhere in its press releases does Oxfam explain how the agency derived the incremental annual benefit to farmers of between $88.0 –to- $132.0 million.

To the contrary, since 2001, Starbucks has been inserting transparency into standard contracts. Today, the Company has
economic transparency requirements for 59 percent of all coffee purchased to provide information on the payments made to farmers. This represents 177 million lbs. (80 million kg.) of coffee.

In December 22, 2006,
Starbucks Letter to the Editor of the Seattle Post Intelligencer (regarding the Ethiopian Trademark), Dub Hay, VP-Global Coffee Procurement said, too: “While our purchases of Ethiopian coffee represent a very small percentage of the country’s total coffee exports, we pay premium prices – in 2005 our price exceeded the New York commodity market price by 23 percent -- for all of the coffee we buy in 27 countries. And, between 2002 and 2006 we increased purchases of Ethiopian coffee by more than 400 percent and are committed to growing those purchases in the years to come.”

In our view Oxfam and its supporters have not presented a cogent argument to suggest that Starbucks is acting in an unethical or socially irresponsible manner; nor has Oxfam presented any convincing evidence that Starbucks is willfully trying to maximize its own profit margins—by denying Ethiopian farmers their legitimate coffee profits.

Voir dire [Old French: “To speak the truth”] is a tool used to achieve the constitutional right to an impartial jury. Preliminary examination of Oxfam as an impartial juror would show that the aid agency is in an awkward position to comment on the social responsibility of Starbucks:
  1. Language found in a Coffee (Rescue Plan) Policy paper [2002] speaks volumes: “Despite the stagnant consumer market, the coffee companies are laughing all the way to the bank…. Until now, rich consumer countries and the huge companies based in them responded to the crises [slump in coffee prices and economic impact on coffee farmers] with inexcusable complacency. In the face of human misery, there have been many words yet little action.”
  2. In 2004, Oxfam accepted a £100,000 investment by Starbucks into a rural coffee-growing project in Ethiopia and a range of expertise-sharing programs focusing on improving trading agreements for millions of coffee farmers in developing countries.

Given the weaknesses of Oxfam’s arguments and its lapses in credibility, Starbucks comes across less as a coffee-thirsty exploiter of less-developed countries, and more the victim of a coffee mugging.

Editor David J Phillips does not hold financial interests in any of the companies mentioned in this posting. The 10Q Detective has a Full Disclosure policy.

Wednesday, December 20, 2006

Delta Air Lines + Scripophily = $1.38 per share

Delta Air Lines Inc. (DALRQ-$1.38) announced today that its Board of Directors, with the full support of the Company’s management team, formally rejected the unsolicited $8.6 billion bid by rival U.S. Airways Group (LCC-$57.50) and publicly presented its own reorganization proposal.

The Board concluded that Delta’s
stand-alone plan would provide the Company’s creditors with superior value and greater certainty on a much faster timetable.

In a valuation analysis prepared by Delta’s financial advisor, The Blackstone Group, creditors would retain consolidated equity worth between $9.4 billion to $12.0 billion. These values would result in a recovery for Delta’s unsecured creditors of about 63 cents to 80 cents of each dollar in their allowed claims (via distributions of new Delta common stock).

In addition, the Company said that the
U.S. Airways proposal was structurally flawed and could not be executed as claimed by U.S. Airways because of erroneous economic assumptions, higher debt-loads (needed to fund the merger), and, labor and antitrust issues. Insurmountable hurdles to the U.S. Airways deal include, but are not limited to the following:

  1. The flawed economic assumptions underpinning the “synergies” in the US Airways proposal would result in vastly lower value than claimed by US Airways.
  2. The combined company would have the highest total debt load in the airline industry -approximately $23 billion - seriously limiting its financial flexibility and ability to withstand the volatility of the airline industry (and would force the new entity to cut some 10,000 jobs).
  3. There are overwhelming labor issues that would preclude the combination from attaining the claimed synergies. The Delta unit of the Air Line Pilots Association, the union representing Delta’s more than 6,000 pilots, has said - and Delta agrees - that Delta’s pilot contract (which runs from June 1,2006 – December 31, 2009) would prohibit the combined company from implementing capacity reductions that US Airways asserts are the economic foundation of the proposed transaction.
  4. The transaction is not likely to receive antitrust clearance from regulators because it would result in loss of competition, thereby, negatively impacting consumers and their communities: (i) The proposed merger would eliminate or reduce competition on thousands of domestic city pairs (origin and destination cities/airports), impacting millions of passengers per year; (ii) the combined entity would operate 52% of slots and 40% of gates at major East Coast airports; (iii) there would be no competitive low cost carrier presence (> 5% passenger share) at any of the 71 U.S. cities dominated by the merger; (iv) and, the deal would substantially reduce competition at Boston-Logan, New York-LaGuardia, and Washington-Reagan National airports (share position analysis based on passenger traffic); Ergo, city pair concentration and route dominance would lead to reduced competition, fewer discounted seats, and higher passenger fare levels—subjecting the US Airways proposal to a lengthy Department of Justice review process, during which Delta would be forced to remain in bankruptcy.

As of September 30, 2006, $20.9 billion in contractual obligations subject to compromise weighed on Delta’s balance sheet. Under the priority scheme established by the Bankruptcy Code, the ultimate recovery to shareowners is the last priority to recover (what is left in assets) after all creditors are satisfied under the filed plan or of reorganization. Given that the total shareholder deficit of Delta is approximately $13.9 billion—or about $(68.90) per share—the future giveback to shareholders does not look promising.

The Company intends to emerge from Chapter 11 in the spring of 2007. The Board of Directors have suggested that when the Company emerges from bankruptcy and issues new equity for its creditors that it will cancel its outstanding common stock currently trading.

The market price of a stock reflects what buyers are willing to pay—based on their evaluation of the Company’s value, cash flows, and future prospects.
Is it rational behavior for investors to pay $1.38 per share for worthless paper?

Might common stock owners might be speculating that the Bankruptcy court and/or Creditors Committee denies the current Debtor petition?—a history of reorganizations provides evidence contrary to this position.

We broached this question once before—in our November 8, 2006, posting on
Delphi Corp.

This second go-around, we are going to introduce a new supposition:
scripophily (pronounced scri-POPH-i-ly), which is the collecting of old stock and bond certificates. Values range from a few dollars to more than $100,000 (for the rarest)., the Internet's largest buyer and seller of collectible stock and bond certificates, grew sales 31 percent during the past 12 months ending October 31, 2006, compared with the prior year. CEO and Founder Bob Kerstein: “The increase in activity is primarily due to interest in the historical significance and beauty of stock and bond certificates as well as their relative scarcity.

Physical stock and bond certificates are a permanent history of capitalism representing a cross section of the financial markets we know today. Stock certificates are becoming an artifact of the past as the world becomes more digitized."

The supply of new certificates reaching the collector market has been substantially reduced due to recent changes in State Laws and Stock Exchanges Rules. Many companies are no longer required to issue physical stock and bond certificates.

As previously mentioned, come spring 2007, the existing stock will have no redeemable value, save as a collectable.
Might investors be scooping up Delta stock in hopes of profiting from the potential value of the underlying certificates to hobby enthusiasts?

Looking through’s online inventory, extant certificates of Allegheny Airlines (in 1979 it became US Air), Air Florida Systems (folded in July 1984), American West Airlines (operated in bankruptcy from 1991 to 1994), and Braniff Airways (filed Chapter 11 bankruptcy on June 1, 1982) were recently priced for sale at $139.95, $79.95, $99.95, and $79.95, respectively.

There are many factors that determine value of a certificate including condition, age, historical significance, signatures, rarity, demand for item, aesthetics, type of company, original face value, bankers associated with issuance, transfer stamps, cancellation markings, issued or unissued, printers, and type of engraving process.

“Delta is ready when you are.” –Advertising slogan. Maybe—But we are skeptical that is ready to buy thousands of soon-to-be worthless Delta stock certificates.

Editor David J Phillips does not hold financial interests in any of the companies mentioned in this posting. The 10Q Detective has a Full Disclosure policy.

Monday, December 18, 2006

How many WorldComs in Your Future? -- Shame on You, Chris Cox!

Essayist and philosopher George Santayana knew too well the nature of men when he first wrote the now banal words, “Those who cannot remember the past are condemned to repeat it.”

Save for shareholder activists, those in academia, and the usual politicians pandering for votes—the 10Q Detective foresaw back in 2002 that the S.E.C never had the conviction to hold back the tide of the better-financed business lobbyists— Sarbanes-Oxley had a limited shelf life.

Responding to criticism that regulators had overreacted to years of corporate scandals—WorldCom, Adelphia, Enron, Tyco, to name a few—the
S.E.C. took its first steps to ease regulations on businesses.

Hidden among a flurry of deregulatory orders and proposals issued last week to “lower costs to public companies,” were proposals submitted to enfeeble the enforcement of existing disclosure and financial reporting rules. Specifically, the S.E.C. acquiesced to businesses demands by proposing that small capitalization companies be given back some control in restricting their auditors from engaging in what the executives “viewed as expensive and unnecessary audits” of financial activities that had “minimum impact on financial statements” (Section 404).

We ask our readers to indulge us—read some bullet points lifted from the recent Proxy Statement of Global ePoint (GEPT-$0.52), a manufacturer of digital surveillance and detection solutions—and, then see if you agree with S.E.C. Chairman Christopher Cox when he said last week that looser interpretation of existing auditing rules would not reduce investor protection:

Related Parties Transactions

  • Global transacts a substantial majority of its business with companies that are owned or controlled by Mr. John Pan, Chairman, President, Chief Financial Officer and largest stockholder, who beneficially owns 4.95 million shares, or almost 25 percent of the common stock. According to Global, “these transactions allow the Company to leverage sales opportunities and component and sub-system purchasing relationships of these related companies.”

Management believes that Global can achieve the benefits of economies of scale associated with shared facilities, administration, and sales, and the benefits associated with the use of the related parties’ network of global contacts, sales opportunities and purchasing power.

Facilities Leasing Arrangement

  • Global shares office and warehouse facilities in buildings owned or controlled by Mr. John Pan, which facilities are also partially occupied by another company controlled by Mr. Pan. Global also uses and pays rent to Mr. Pan for the use of its manufacturing and assembly equipment. Global recorded occupancy costs and equipment rental expenses to Mr. Pan totaling $519,000 and $492,000 for the fiscal years ended December 31, 2005 and 2004, respectively. Occupancy costs paid to Mr. Pan were based on the square footage occupied and a price per square foot verbally agreed upon.

Sale Arrangements

  • During 2005 and 2004, Global sold approximately $18.0 and $7.6 million, respectively, of products and contract manufacturing services to related parties. Included in these amounts were sales of $17.6 and $7.2 million, respectively, to Avatar Technology Inc. and $0.2 and $0.3 million, respectively, to Prophecy Technology LLC. This represented 55% and 36% of overall sales for the year ended December 31, 2005 and 2004, respectively.

Avatar provides distribution of computer components around the world, as well as consumer PCs in selected markets. In both 2005 and 2004, Avatar secured major contracts for consumer PCs with a large retail chain in Latin America and, as a result, subcontracted the manufacturing of the consumer PCs to us. Global’s contract manufacturing division generated sales of approximately $17.6 and $7.2 million in 2005 and 2004, respectively, from Avatar for consumer PCs, all of which were ultimately delivered to retail stores of Avatar’s customers throughout Latin America.

Prior to joining Global ePoint in August 2003, Mr. Pan was the founder, Chief Financial Officer, President, and a director of Avatar Technology, Inc., and he remains a consultant to that company.

Mr. Pan is also a founder, President and Chief Financial Officer of Prophecy Technology LLC, positions he has held since September 1992.

Purchases From Related Parties

  • During 2005 and 2004, Global purchased from related parties components and finished products totaling approximately $15.3 and $5.7 million, respectively. According to management, “The related parties can generally purchase components in greater quantity than Global can on its own and thereby can pass through to the Company the more favorable pricing due to its volume discounts.” Of total purchases from related parties, a majority constituted purchases of various component parts, such as memory, CPUs, hard drives and motherboards, and finished products from Avatar and Prophecy. Of the total purchases in 2005 and 2004, approximately $10.8 and $1.7 million, respectively, were from Avatar, and approximately $4.4 and $4 million, respectively, were from Prophecy. These aggregate costs represented about 53% and 35% of overall cost of goods for the year ended December 31, 2005 and 2004, respectively.

Other Related Party Transactions

  • In June 2004, Global borrowed $1.0 million from John Pan. The aggregate interest rate was 7.25% as of December 31, 2005; the outstanding loan and accrued interest totaled $1.1 million. Global is required to accrue interest payments each month until the principal balance is paid in full, which must occur no later than December 2006.
  • In addition to being the largest customer of and supplier to Global, Mr. Pan is also paid an annual wage in his role as Chairman, Chief Financial Officer and President of Global. In fiscal year 2005, his salary was increased approximately 20 percent to $245,000, plus an annual bonus of up $147,000 (based on Mr. Pan’s satisfaction of annual performance conditions to be determined by the Compensation Committee).

In our view, Global ePoint epitomizes how weakening the internal auditing control at small capitalization companies does a potential disservice to investors.

The past is history; The future is a mystery – Allan Johnson

The future for investors of small cap companies is no mystery to us—more corporate fraud.

The 10Q Detective is not alleging that Global ePoint, a provider of vending machines for the sale of instant-winner lottery tickets in a former life, was—or is—guilty of any fraud or corporate abuses.

Weakening internal control systems and lowering the bar for financial reporting standards does little to promote corporate transparency. Christopher Cox and the S.E.C.—shame on you!

Editor David J. Phillips holds no financial interest in any of the stocks mentioned in this article. The 10Q Detective has a full disclosure policy.

Friday, December 15, 2006

Early Christmas Bonuses for Ashland's Board of Directors

In the last two years, specialty chemicals distributor Ashland Inc. (ASH-$68.86) has sold two subsidiaries for an aggregate balance of about $5.0 billion.

“Capital as such is not evil; it is its wrong use that is evil. Capital in some form or other will always be needed.” – Mohandas Gandhi

Unfortunately, Ashland has displayed both fiscal prudence and exacting pretense for using the $5.0 billion to remake itself as a global player in the chemical and adhesives material markets.

On June 30, 2005, Ashland transferred its 38% interest in Marathon Ashland Petroleum LLC (MAP) to Marathon Oil Corp. for the consideration of $3.7 billion in cash and stock.

Ashland used a substantial portion of the proceeds of the MAP Transaction to strengthen its balance sheet, retiring most of its debt and certain other financial obligations. In addition to the repurchase of accounts receivable previously sold under its sale of receivables facility and the purchase of $101 million of assets that were formerly rented under operating leases, Ashland retired approximately $1.6 billion of balance sheet debt as of September 30, 2005 (incurring a loss on the early retirement of debt—repayment premium penalties and issuance fees—of $145 million).

During 2006, Ashland continued with its focus to redefine itself as more than the owner of the automotive lubricant, Valvoline, a branded motor oil (and other appearance products, including antifreeze, filters and automotive fragrances).

On August 28, 2006, Ashland sold its paving and construction business (APAC) to Old Castle Materials, Inc. for $1.3 billion. [Ed. note. Prior to the sale of APAC, the subsidiary was producing about 30 percent of the Company’s annual revenue.]

Shareholders were rewarded by this sale when the Company declared a special cash dividend of $10.20 per share, which was payable on October. 25,2006.

Even with the cash distributions to shareholders, management said that money left over from the sale of the paving business and other businesses would enable it to make more than $2 billion in purchases—including up to 7.0 million in share buybacks—without increasing debt beyond two times its earnings before taxes.

[Ed. note. For the fiscal year ended September 30, 2006, EBITDA was about $220.0 million.]

Ashland repurchased 6.7 million shares for $405 million during fiscal year 2006. Following the completion of the current share repurchase program Ashland estimates it will have purchased approximately 18% of the shares outstanding on June 30, 2005. [Ed. note. The stock repurchase actions are consistent with certain representations of intent made to the Internal Revenue Service with respect to the transfer of MAP.]

Last month, in keeping with its promise to promote growth, the Company signed an agreement to purchase Northwest Coatings, cutting-edge adhesives and coatings company that uses ultraviolet and electron beam technology, for $72 million.

Unfortunately, we did the math—followed the money trail—and could not find the $2.0 billion that the Company said was available for future purchases:

1. Saying that cash inflows to the Company were $5.0 billion would be misleading; the MAP transaction only resulted in a non-taxable gain to Ashland of about $1.29 billion and Ashland recorded an after-tax gain on the sale of APAC of $110 million in 2006.
2. $1.40 billion (revised cash inflows) - $1.60 billion (debt retirement) - $674.0 million (special cash dividends) - $405.0 million (2006 share repurchase program) - $100.0 million (additional share repurchases in 2H:05) - $101.0 million (proceeds from the MAP Transaction to purchase Construction Equipment assets) = $(1.48) billion deficit
3. OOPS! Less $72.0 million (for the Northwest Coatings acquisition) = $(1.55) billion deficit. Five Billion just doesn’t buy what it used to?

Valuation Analysis

The common stock of Ashland has climbed 21.08% in the past 52-weeks, as investors anticipate that the recent sale of the pavement and construction business represents an important strategic step in transforming the Company into a diversified chemical company, better positioned to benefit from continued global economic growth (especially in Europe and China).

[Ed. note. Now that the monies from the two subsidiaries have been spent, any future acquisitions will have to come from borrowings. Albeit we do admit that the company does sit in good financial health, with about $33.75 per share in cash and a Total-Debt/Equity ratio of only 2.6 percent.]

In our view, the rise in the price of Ashland’s stock already reflects an optimistic scenario. Long-term, we remain (fundamentally) unimpressed with a company generating a ROA and a ROE of 1.59% and 5.36%, respectively.

Corporate Governance Issues

As we demonstrated earlier, Ashland forgot to turn off the money spigot.

To further illustrate our point:

Pursuant to Ashland’s 2005 incentive plans, upon election to the Board of Directors, a new director received 1,000 restricted shares of Ashland Common Stock. Each director received, too, an annual retainer of $65,000 (for attending nine meetings of the Board of Directors).

In addition to the annual retainer, non-employee directors received $1,500 for each Board of Directors and Committee meeting attended. The Lead Independent Director also received three $5,000 quarterly installments of a $20,000 annual fee approved by the Governance Committee in January 2006. The Committee Chairs also received a $5,000 annual fee. Members of the Audit Committee, including the Chairman, also received a $1,500 fee for attendance at each quarterly Audit Committee financial review with Ashland’s management. All such fees could be paid in cash, shares of Ashland Common Stock or deferred into any investment alternative available under the Directors’ Deferral Plan.

Flush—with what they thought—were all these new billions in the Company’s coffer—the directors voted to themselves more than a 38 percent raise in their annual retainer. Effective January 26, 2007, the revised compensation program provides that non-employee directors will receive (a) an annual retainer of $90,000; (b) an additional annual retainer of $20,000 for the Lead Independent Director; (c) an additional annual retainer of $15,000 for the Chair of the Audit Committee and $7,500 for Audit Committee members; and (d) an additional annual retainer of $7,500 for other Committee Chairs.

In addition, pursuant to the revised non-employee director compensation program, effective January 26, 2007, each director will receive an annual award of deferred restricted stock units with a grant date value of $100,000! The restricted stock units will vest one year after date of grant and will be payable in stock or cash, at the director’s election upon termination of service. Under the revised director compensation program, however, annual stock option grants will no longer be made to non-employee directors.

Truth or dare—Do any investors truly believe that this new compensation package for non-employee directors will “create a stronger linkage and alignment with the long-term interests of Ashland and its shareholders?”

By contrast, CEO James J O’Brien received a base increase of only 10.8%, or $95,000, (to $983,258), during fiscal 2006. Lest we forget, however, Messer. O’Brien, was awarded a bonus of $1.16 million for fiscal 2006—and a long-term compensation payout of $1.29 million (representing fiscal years 2004 – 2006).

[Ed. note. In fiscal 2005, Ashland settled a shareholder derivative lawsuit brought in 2002. In settling the action, Ashland agreed, among other things, to solicit from its major shareholders director candidates and to nominate a qualified candidate for election to the Board of Directors.]

Certain Relationships and Transactions

Mannie L. Jackson, a director of Ashland, is Chairman of the Board and Chief Executive Officer of the Harlem Globetrotters. During fiscal 2006, Ashland paid the Harlem Globetrotters approximately $31,000 for certain promotional tie-ins.

Michael J. Ward, a director of Ashland, is Chairman of the Board and Chief Executive Officer of CSX Corporation (“CSX”). In fiscal 2006, Ashland paid CSX and its subsidiaries approximately $13.6 million for transportation services, and CSX paid Ashland approximately $114,000 for certain products and/or services.

Investment Risks and Considerations

Many of Ashland’s businesses are cyclical in nature and economic downturns or declines in demand may negatively impact the Company’s financial performance. The profitability of Ashland is susceptible to downturns in the economy, particularly in those segments related to durable goods, including the housing, construction, automotive, and marine industries. Both overall demand for Ashland's products and services and its profitability will likely change as a direct result of an economic recession, inflation, changes in hydrocarbon (and its derivatives) and other raw materials prices, or changes in governmental monetary or fiscal policies.

Ashland has been undergoing a major process initiative designed to optimize its supply chain function. By integrating the supply chain function and creating more efficient, customer responsive processes including source-to-pay, plan-to-deliver and order-to-cash, Ashland is looking to lower costs, while increasing service levels and customer satisfaction. The implementation of the Supply Chain Optimization Project carries substantial risk, including the potential for business interruption and associated adverse impacts on operating results.

Editor David J Phillips does not hold financial interests in any of the companies mentioned in this posting. The 10Q Detective has a Full Disclosure policy.

Tuesday, December 12, 2006

Blockbuster CEO Still Has 'Total Access' to Private Jets

On November 29, 2006, in-home movie rental and game entertainment provider Blockbuster (BBI-$$5.17) announced that in connection with the Company’s sale of its corporate aircraft, the Board had also entered into an addendum to its employment contract with Mr. John Antioco, its Chairman and Chief Executive Officer. Specifically, Mr. Antioco’s employment contract was modified by reference so that instead of use of the Blockbuster aircraft, he was entitled to continued use of a chartered aircraft.

According to the Company’s Proxy Statement filed with the SEC last April, during fiscal year 2005 and fiscal year 2004, Mr. Antioco (1) received a base salary of $1,250,000 and additional, deferred compensation of $383,333 and $1,045,192 in base salary and $1,000,000 in deferred compensation, respectively; (2) received a cash bonus of $5.0 million paid in 2004 (for 2003 performance); received 5.0 million restricted stock units worth $26.8 million in 2004; (3) received a car allowance of $1,100 per month for each year; and, (4) recorded expenses of $92,125 for personal use of the Company’s plane in each year.

Since early 2001, Blockbuster’s tickets to failure include an average net margin of (10.0)% per annum, more than $3.0 billion in net losses, and about a 70 percent decline in the market value of its common stock [$10K invested in Blockbuster’s stock five years ago would be worth approximately $3,100 today].

Continued declines in worldwide same-store sales, uncertainty in execution to an online subscriber business model (
Total Access), increased competition for traffic from other online channels of video distribution (Netflix), margin pressures on the sales of in-store videos from mass-merchandisers of lower-priced DVDs (such as Wal-Mart), and a leveraged balance sheet—Total Debt/Equity of 141.6 percent—which will curb marketing and limit business options (to simple decisions like closing under-performing stores)—Blockbuster has more to worry about than whether or not its CEO flies chartered or coach.

As for Mr. Antioco, in our view he is just another expression of a pampered CEO (he is still making gobs of money—albeit shareholders and the Company have made nothing). “Mr. Antioco, the peanuts they serve in coach taste just fine!”

Editor David J. Phillips holds no financial interest in any of the stocks mentioned in this article. The 10Q Detective has a full disclosure policy.

Friday, December 08, 2006

What’s Over-the-Horizon for Comtech Telecom?

Sleepwalking through most of the spring, shares of Comtech Telecommunications (CMTL-$38.71) sprang awoke in June 2006, and have jumped about 50% in value after the telecom-equipment maker raised its guidance outlook (for FY 2006).

On Monday, management raised its guidance (again) for 2007 earnings to $2.05 to $2.07 per share, up from its previous view of $1.93 to $1.95 a share.

The Company said that it expects 2007 revenue of $440 million to $450 million, up from its previous outlook of $435 million to $445 million, citing demand for its Movement Tracking System (due to deliveries on actual and anticipated new orders from the U.S. Army and Army National Guard for ongoing support of MTS program activities).

According to Reuters estimates, analysts were expecting 2007 earnings of $1.80 a share, before special items, on revenue of $439.4 million.

Comtech said in its most recent fiscal quarter ended October 31, 2006, its 1Q:07 profit fell 6 percent, hurt by higher operating expenses and lower sales in mobile data communications and RF microwave amplifiers. According to management, the decrease in net sales was due to a decision, made in fiscal 2006, to significantly de-emphasize stand-alone sales of low margin turnkey employee mobility solutions. The Company, however, still beat estimates, posting share-net of 41 cents on revenue of $97.1 million.

Consensus estimates had forecast earnings of $0.32 per share, on revenue of about $90.4 million.

In assessing the quality of its earnings, the 10Q Detective is surprised that investors and analysts alike failed to comment that almost the entire nine-cent positive EPS surprise can be traced back to a doubling of interest income for the quarter ($3.2 million as compared with $1.8 million for three months ended October 31, 2005).

Net cash used in operating activities was $3.6 million for the three months ended October 31, 2006. The loss principally reflected changes in working capital balances, most notably an increase in inventory that management currently anticipates will be delivered to its customers (primarily the U.S. government) throughout fiscal 2007, as well as the timing of payments for accounts payable and certain accrued expenses during the three months ended October 31, 2006.

Nonetheless, the Company’s balance sheet looks healthy: access to $245.6 million in unrestricted cash; $321.3 million in working capital; a total debt/total capitalization ratio of about 28 percent (which includes $119.4 million in total contractual obligations of $119.4 million—almost $105.7 million does not come due until after 2011); and, a tangible book value of $11.13 per share.

Comtech conducts its business through three business segments:
  1. The Company’s Telecommunication Transmission segment provides sophisticated products and systems (used to enhance bandwidth efficiency) for voice, video and data transmission in satellite, over-the-horizon microwave and wireless line-of-sight telecommunication systems (where terrestrial communications are unavailable, inefficient, or too expensive). This operating unit is currently Comtech’s largest business segment, representing 53.6%, or $50.9 million, in net sales for the most recent quarter (up from 47.7% last year).
  2. The Mobile Data Communications Services segment (36.7% of 1Q:07 net sales) provides its defense and commercial customers with an integrated solution—including mobile satellite transceivers and satellite network support—to enable satellite-based mobile communications when real-time, secure transmission is necessary.
  3. The RF Microwave Amplifiers segment produces solid state, high-power broadband amplifiers which are incorporated into sophisticated applications, including aircraft air-to-ground satellite communications, medical oncology systems, instrumentation and a variety of defense applications (such as cargo inspection systems for Homeland security). Net sales were $9.4 million for the three months ended October 31, 2006, a decrease of $6.9 million, or 42.3%, compared with the prior year period. The decrease in net sales was due to lower sales (as anticipated) of amplifiers that are incorporated into improvised explosive device jamming systems.

Industry Background

The Global Development of Information-Intensive Economies. Businesses, governments and consumers have become increasingly reliant upon the Internet and multimedia applications to communicate voice, video and data to their customers and employees around the world. Demand for these high-bandwidth applications should continue to grow.

Demand for Increased Communications Cost Efficiencies. Due to the significant increase in global voice, video and data communications traffic, communications service providers have been forced to increase their investments in transmission infrastructure in order to maintain the quality and availability of their services. As a result, communications service providers are continually seeking technology solutions that increase the efficiency of their networks in order to reduce overall network operating costs. In light of the relatively high cost of satellite transmission versus other transmission channels, we agree with Comtech that communications service providers will make their satellite equipment vendor selections based upon the operating efficiency and quality of the products and solutions.

The Emergence of Information-Based, Network-Centric Warfare. Militaries around the world, including the United States military, have become increasingly reliant on information and communications technology to provide critical advantages in battlefield, support and logistics operations. Situational awareness, defined by knowledge of the location and strength of friendly and unfriendly forces during battle, can increase the likelihood of success during a conflict. As evidenced in the recent Iraqi conflict, stretched battle and supply lines have used satellite-based or over-the-horizon (OTH) microwave communications solutions to span distances that normal radio communications, such as terrestrial-based systems, are unable to cover. The need for these technologies should remain high due to the lack of terrestrial-based communications infrastructure in many parts of the world where the U.S. and other militaries operate.

Growth Drivers

The Company’s Telecommunications Transmission segment provides equipment and systems used to transmit voice, video, and data between Point A and Point B, or to multiple points C. The two primary product lines—Satellite Earth Station Products and Over-the-Horizon Microwave Systems—address markets where terrestrial infrastructure is unavailable or inefficient and provide transmission capacity to satisfy increasing bandwidth demand.

In addition to video transmission and cellular backhaul equipment, the Company sees growth for its Satellite Earth Station products and in OTH capacity.

Earlier today, Comtech r
eceived an order (for up to $4.3 million) to support the fielding and training of U.S. Army Troposcatter Terminals. Irregularities in the refractive index of air causes Tropospheric scatter, which can cause harmful interference in signal transmission. Troposcatter relay facilities, however, can use this lower atmospheric phenomenon to boost long-distance point-to-point services.

Comtech is well positioned to drive top-line growth by leveraging its existing client base’s need for tropospheric scatter modem upgrades and for next-generation terminals.

Management also sees expanding opportunities for its OTH microwave systems with oil and gas companies and foreign governments.

Prospects look just as encouraging for the Company’s Mobile Data Services segment. Spending in both the government and commercial sectors is expected to remain high through the decade.

Albeit the $418.0 million contract with the United States Army for the Movement Tracking System ends in July 2007, supplemental funding is readily available for Comtech’s next generation satellite transceiver, known as the MT 2012, which offers increased speed and performance.

MTS growth is being fueled, too, by Comtech’s successful ability to land contracts with other Department of Defense branches (and U.S. allies?).

In October 2006, Comtech
received a $1.6 Million order for the Army National Guard's acquisition of Movement Tracking System equipment. The order is for the supply of installation kits to continue the deployment of MTS equipment throughout the Army National Guard.

Management believes that if current funding levels of MTS and battlefield command and control applications are maintained or increased, or if and when the Company receives additional orders from the Army National Guard, Comtech may experience additional increased operating efficiencies in fiscal 2007.

Valuation Analysis

Assuming share-net growth of (at least) 7.5% per annum, operating margins of about 17 percent, an equity risk premium of 3.0%, and a WACC of 8.3%, the intrinsic value of Comtech is about $53.00 per share.

[Ed. note. The Company is creating value for its shareholders, for ROA exceeds WACC by 200 basis points.]

Comtech offers compelling growth prospects and operates in fundamentally healthy industries, but it is selling for about 19 times forward fiscal ’07 earnings of $2.05 per share (median point of communications equipment companies). Further multiple expansions assume management can execute on all cylinders—and continue to exceed guidance.

The 10Q Detective speculates, too, that Comtech might make an attractive take-out candidate for companies looking to diversify. Call us crazy—why not a buyout by General Motors? Know any other rusty giant looking to buy its way out of a moribund industry?

CEO Fred Kornberg, 71, has been with the Company for almost 35 years. Mr. Kornberg’s existing employment agreement stipulates that if a Change in Control occurs, he is entitled to resign (at will) and would receive a lump sum of approximately $11.7 million (excluding the value of his pension(s) and 622,124 shares of common stock that he beneficially owned as of October 6, 2006).

Insider selling has been limited to share options exercised in the $3.30 - $12.00 per share range.

Investment Risks & Considerations

  • A substantial portion of sales is recognized using the percentage-of-completion method. The reason for this is that many new orders—such as Over-the-Horizon microwave systems and mobile satellite systems—are large, multi-year contracts. Ergo, operating results may prove difficult to forecast—increasing stock price volatility.
  • In recent years, Comtech has increased its dependence on U.S. government business. Sales to the U.S. government (including sales to prime contractors to the U.S. government) accounted for approximately 47.3%, 42.1% and 40.1% of consolidated net sales for the fiscal years ended July 31, 2006, 2005 and 2004, respectively. Approximately 60.4% of its backlog at July 31, 2006 consisted of orders from the U.S. government.

Sales to the U.S. government represented 56.3% of aggregate sales for the three-months ended September 30, 2006. The Company has significant commercial opportunities for many of its products—such as the oil and gas industry. In order to lessen its dependence on the U.S. government (and leverage growth opportunities in other markets such as commercial satellite-based mobile data applications), management must seek out and secure new distribution channels.

  • Comtech’s fiscal 2004 Federal income tax return is being audited by the Internal Revenue Service, other returns may be selected for audit and a resulting tax assessment or settlement could have a material adverse impact on results of operations and financial position (in addition to restating prior year filings).
  • Management also said on Monday that its independent accounting firm, KPMG International, told the company on Nov. 30 that one of its staff accountants purchased some of Comtech's common stock. In a Securities and Exchange Commission filing, the company said KPMG is assessing whether its independence has been impaired.

The company said it would file an amended quarterly report as soon as possible with the SEC. If KPMG is found not to be independent, Comtech said it would incur significant additional costs associated with changing independent accountants. [Ed. note. Translation = lowered earnings guidance.]

Editor David J. Phillips holds no financial interest in any of the stocks mentioned in this article. The 10Q Detective has a full disclosure policy.

Thursday, December 07, 2006

Is One-Million Stock Options What it Used to Be?

Many academics argue that CEO annual pay is not correlated with firm performance. We do not disagree. Our own research has uncovered hundreds of examples positing that executive compensation arrangements are often designed to benefit the executive at the shareholders’ (collective) expense.

We suggest, however, that this premise of managerial power—coupled with a servile board of directors--ignores that not all contractual power rests with the executive. We now present a case study that shows that an optimal CEO contract can be negotiated where the future wealth of the CEO is directly aligned with that of the shareholder.

In May 2001, Stephan Godevais left Dell Computer (DELL) to join rechargeable battery systems maker Valence Technology (VLNC) as its Chief Executive Officer at a salary of $500,000 per annum.

Under his employment agreement, the Company granted Mr. Godevais stock options to purchase an aggregate of 1,500,000 shares of common stock at an exercise price of $6.52 per share, vesting over a period of four years....
Read more…

Monday, December 04, 2006

Is KKR Growing Impatient with Accuride Corp?

Is commercial vehicle component maker Accuride Corp. (ACW-$11.25) about to have its wheels flattened by KKR?On November 28, 2006, Accuride Corporation entered into new Change in Control agreements with certain executive officers and other senior management employees, including CEO Terrence J. Keating, President and CFO John R. Murphy, General Counsel David K. Armstrong, Senior VP/ Human Resources Elizabeth I. Hamme, and Senior VP/ Sales & Marketing Henry L. Taylor.

In addition, each participating executive is entitled to a Change in Control severance benefit if his or her employment with the Company is terminated during the Protection Period. The change in control severance benefits for the aforementioned executives are equal to 200% -- to -- 300% of the executive’s salary at termination, plus either 200% --to—300% of the greater of the average incentive compensation award over the three years prior to termination.

The 10Q Detective has borne witness recently to instances where Change in Control agreements were [curiously?] executed only weeks—or months—before the publicly traded companies entered into terms of new management.

Accuride is one of the largest manufacturers and suppliers of commercial
vehicle components in North America, serving virtually all the heavy-duty and medium-duty OEMs and their related aftermarket channels in most major segments of the commercial vehicle market, including heavy- and medium-duty trucks, commercial trailers, light trucks, buses, as well as specialty and military vehicles (creating a significant barrier to entry).

Its products include commercial vehicle wheels, wheel-end components and assemblies, truck body and chassis parts, seating assemblies and other commercial vehicle components. The Company markets its products under some of the most recognized brand names in the industry, including Accuride, Gunite, Imperial, Bostrom, Fabco and Brillion.

Accuride principally competes in the heavy-duty, or Class 8, truck market, the medium-duty, or Class 5-7, truck market, the commercial trailer market, the light, or Class 3-4, truck market, the bus market, as well as the specialty and military vehicle markets. Heavy- and medium-duty trucks are used for local and long-haul commercial trucking and are classified by gross vehicle weight. The heavy-duty truck market is comprised of trucks with gross weight in excess of 33,000 lbs. and the medium-duty truck market is comprised of trucks with gross weight from 16,001 lbs. to 33,000 lbs.

The Company’s diversified customer base includes substantially all of the leading commercial vehicle OEMs, such as Freightliner Corporation, with its Freightliner, Sterling and Western Star brand trucks, PACCAR, Inc., with its Peterbilt and Kenworth brand trucks, International Truck and Engine Corporation, with its International brand trucks, and Volvo Truck Corporation, or Volvo/Mack, with its Volvo and Mack brand trucks.

Accuride’s core strength is that it the Company holds leading market positions—the number one or number two market position—in most of its major product categories: about an 87% market share in heavy-duty steel wheels, a 48% market share in heavy-duty aluminum wheels, a 55% market share in brake drums, and approximately a 37% market share in disc wheel hubs.

Growth in the commercial vehicle industry tends to grow in-line with the broader economy. As a result, the trucking industry generally correlates with economic indicators, including gross domestic product and industrial production indicators, such as the Industrial Production Index.

The finite lives of commercial vehicles—replacement cycle—is an industry driver, too. Most leading national freight companies replace their vehicles every three to five years. According to America's Commercial Transportation Publications, or ACT, at the end of 2003, the average age of existing heavy-duty truck fleets reached a ten-year high of 5.9 years, relative to the ten-year average of 5.5 years. Historically, vehicle demand increases as trucking fleets revert to a normal age level for their vehicles.

The commercial vehicle market continued at a robust pace during the first nine months of 2006. Freight growth, improved fleet profitability, aging equipment, high equipment utilization, and economic strength continue to drive demand for new vehicles. Current industry forecasts by analysts, including ACT Publications, predict that the North American commercial vehicle industry will continue to be strong throughout 2006, with a decline predicted in 2007 due to a change in emissions standards.

Against this industry backdrop, Accuride surprised Wall Street by
posting a 35 percent drop in its 3Q profits. The Company earned $12.4 million, or 36 cents per share, compared with $19.1 million, or 55 cents per share, for the same quarter in 2005. Accuride said that while demand for its products was strong, the company's margins continued to be hurt by higher raw material prices (such as raw steel and aluminum) and other operating costs.

Analysts polled by Thomson Financial had expected a profit of 54 cents per share.

Adjusted EBITDA was $47.9 million for the third quarter of 2006, compared to an adjusted EBITDA of $51.7 million for the same quarter in 2005.

Net sales for the three months ended September 30, 2006 grew 8.1 percent to $341.6 million from $316.1 million in the year-ago period.

The Company—although leveraged—appears to be financially stable. As of September 30, 2006, the Company had cash of $86.7 million. Total debt of $657.7 million and net debt of $571.0 million reflected a net debt reduction of $43.1 million during the quarter (an aggregate amount of $275.0 million in principal amount of 8.5% senior subordinated notes do not mature until 2015).

Accuride is trading on the equity at a gain, with (TTM) ROE of 31.61% outpacing (TTM) ROA of 7.85 percent.

For the third quarter of 2006, cash from operating activities was $50.1 million and capital expenditures totaled $9.5 million, resulting in free cash flow of $40.6 million. Book value stood at about $7.04 per share.

The stock price has fallen about 15.3% in the last year, signaling to us that more than shrinking margins are bothering investors. Accuride is dependent on sales to a small number of major customers: Freightliner, PACCAR, International and Volvo/Mack constituted approximately 52 percent of trailing twelve-month sales. We suggest that replacement demand for heavy-duty trucks—which influences the demand for component sales—is nearing the later stages of a cyclical upturn.

A contracting P/E multiple, too, reveals the deteriorating forward fundamentals of the Company. Consensus estimates for fiscal year ending December 2007 call for share-net of 93 cents (down from EPS of $1.39 just sixty days ago) on sales of 1.10 billion, compared with current year 2006 estimates of $1.82 per share on sales of $1.39 billion.

The stock, with an enterprise value of $959.9 million, is selling at a forward multiple of about 12.10 times 2007 EPS. Comparables are difficult, for example, South African-based Hayes Lemmerz International, Inc. (HAYZ-$2.55), a leading global supplier of automotive, powertrain, suspension, structural and other lightweight components, with an enterprise value of 756.7 million, is projected to lose $2.07 per share (January 2008); whereas, auto-parts maker ArvinMeritor (ARM-$17.32), with an enterprise value of about 2.11 billion, is selling for ONLY 10.8 times forward (September 2008) earnings of $1.67 per share (a 50 cent jump over 2007 EPS).

Back to our original supposition—might a Change in Events be forthcoming at Accuride Corporation?

On April 26, 2005, Accuride completed an initial public offering of its common stock and commenced trading on the New York Stock Exchange. Net proceeds from the initial public offering were $89.6 million (11.0 million shares priced at $9.00 per share).

One of the biggest stakeholders in the Company is one of the world's oldest and most experienced private equity firms specializing in management buyouts—Kohlberg Kravis Roberts & Co? KKR beneficially owns approximately 23% of Accuride’s outstanding shares of common stock and has two partners on the Company’s board of directors. [Full Disclosure -- Pursuant to a management services agreement, KKR renders “management, consulting and financial services” to the Company for an annual fee of $665,000.]

Trimaran Capital Partners, a private asset management firm headquartered in New York (dedicated to leveraged buyouts), with assets under management in excess of $3.8 billion, owns about an 11.4% stake through several entities, too. [Full Disclosure -- Trimaran Fund Management renders “management, consulting and financial services” to the Company for an annual fee of $335,000.]

Avoid being impatient. Remember time brings roses – (Unknown).

KKR, Trimaran Partners, and other institutional investors just might not wait for the roses to bloom come spring.

Editor David J. Phillips holds no financial interest in any of the stocks mentioned in this article. The 10Q Detective has a full disclosure policy.