Thursday, August 30, 2007

HepaLife Technologies: Death by Liver Failure?

HepaLife Technologies (HPLF-$1.00), which is focused on the identification and development of cell-based technologies and products, demonstrates the endemic weakness of one shareholder—in this case, one with no scientific credentials—substantially influencing virtually all business strategies requisite to shepherding a medical device through the FDA marketing maze.

Mr. Harmel S. Rayat, 46, is the largest shareholder, beneficially owning 44.21 million shares, constituting about 60 percent of the common stock outstanding, worth an estimated $44.21 million.

[Ed. note. During the past five years, Mr. Rayat has been a busy bio-entrepreneur, serving at various times, as a director, executive officer, and majority stockholder of a number of publicly traded companies. Future postings will unclothe his holdings/influence in these other companies, too.]

In October 2006, Mr. Rayat resigned his positions as president and chief executive officer, but retained the Company’s chief financial officer and principal accounting officer.

Artificial Liver Device

HepaLife’s lead product in development is a
cell-supported artificial liver device. The Company is working towards optimizing the hepatic (liver) functionality of a porcine cell line, and subclones thereof, referred to as the “PICM-19 Cell Line.”

The HepaLife Bioartificial Liver device consists of three basic components: (1) a plasma filter, separating the patients blood into blood plasma and blood cells; (2) the bioreactor, a unit filled with PICM-19 cells which biologically mimic the liver’s function; and (3), the HepaDrive, a perfusion system for pumping the patient's plasma through the bioreactor while controlling gas supply and temperature for best possible performance of the cells.

According to US-based, Global Industry Analysts, Inc., one of the world’s largest market research companies, global demand for artificial liver systems is expected to rise to $2.795 billion in 2010, second only to artificial kidney support and more than double the expected $1.31 billion artificial heart market. (July 2007; Artificial Organs - A Global Strategic Business Report)

In early tests, HepaLife’s patented PICM-19 cell line, bioreactor, and HepaDrive perfusion system have demonstrated early success as an integrated system, successfully replicating the liver’s key function – removal of toxic ammonia and synthesis of urea.

Recent Financial Activity

Despite a promising commercial outlook, the ability of HepaLife to obtain additional funding will determine its ability to continue as a going concern, according to the Company’s independent auditors.

The Company has yet to establish any history of profitable operations. HepaLife has had no revenues during the last five fiscal years and does not expect to generate revenues from operations for the foreseeable future. At March 31, 2007, HepaLife had an accumulated deficit of $(11.95) million and a working capital deficit of $(1.19) million.

On May 11, 2007, HepaLife entered into a Securities Purchase Agreement pursuant to which, among other things, the Company issued a Convertible Note to GCA Strategic; the aggregate proceeds of $2,125,000 (85% of the principal amount of the Convertible Note) will be used for working capital and the further development of the Company’s proprietary bioreactor system, the main mechanical component of HepaLife’s patented bioartificial liver device.

This funding will satisfy existing contractual commitments through December 31, 2007; albeit management does not currently have sufficient cash on hand to sustain planned operating activities through the end of 2008.

The dark side to this offering, however, was a
death-spiral convert. The conversion price for the common stock to be issued to GCA Strategic pursuant to the conversion provisions of the Convertible Note will fluctuate based on the price of HepaLife’s common stock. Because the price at which the Convertible Note may be converted is variable, the lower HepaLife’s stock price is, the more shares of common stock will have to be issued upon conversion of the Convertible Note.

There is no limit to the number of shares that HepaLife may be required to issue upon conversion of the Convertible Note—as it is dependent upon the share price, which varies from day to day. This could cause significant downward pressure on the price of HepaLife’s common stock. For example, if the share price were to fall to 84 cents, 56 cents, or 28 cents, respectively, the Company would have to issue 2.96 million, 4.44 million, or 8.89 million additional shares, respectively.

To date, most of its operating losses were due to expenses related to HepaLife’s advertising and investor relations program rather than to sponsored research and development programs!

From inception through March 31, 2007, expenditures for advertising and investor relations aggregated $3.25 million or approximately 27% of total expenditures as compared to total R&D expenses during the same period of $878,376 or approximately 7% of total expenditures.

What majority shareholder benefited handsomely from this disproportionate—and irresponsible—use of capital spending? Harmel S. Rayat.

Prior thereto his Named Executive positions, Mr. Rayat served as the president of several companies that provided financial consulting services to a wide range of emerging growth corporations, including HepaLife. In this lifetime, however, Rayat ran afoul of federal securities laws (regarding unrestricted stock).

SEC Cease-and-Desist Decree

In recent years, many small publicly held companies have hired stock promoters to promote them on stock-picking websites and through mass-mailed e-mail messages. The promoter is often compensated in the form of purportedly unrestricted shares of the company's common stock, which the promoter sells after its promotional activities have attracted investor interest in the company.

Under federal securities laws, a public company cannot distribute unrestricted stock to public investors without first registering the offering with the Commission or having a valid exemption from registration for the transaction. Registration requires a company to provide important information about its finances and business to potential investors, and allows the Commission to review the company's disclosures.

In an attempt to circumvent those registration requirements, certain issuers have sought alternate sources of purportedly "free trading" company stock in order to compensate the stock promoters. In such arrangements, the issuers and promoters are nonetheless participating in an unregistered offering of securities to the public in violation of the federal securities laws, as described below.

In 2003, Rayat,, Inc. and Innotech Corporation (public relation firms collectively owned by Rayat)—the respondents—
were found to have violated the aforementioned federal securities laws.

Without admitting or denying any of the findings and/or allegations of the U.S. Securities & Exchange Commission the respondents agreed, on October 23, 2003 to cease and desist, among other things, from committing or causing any violations and any future violations.

In addition, Respondents Innotech Corporation and, Inc. were ordered to pay disgorgement of $171,370 plus prejudgment interest; but that payment in excess of $31,555.14 was waived because “the Respondents submitted a sworn Statement of Financial Condition dated March 31, 2003, and other evidence, asserting their inability to pay full disgorgement plus prejudgment interest.” [HA! HA!]

If you can do a half-assed job of anything, you're a one-eyed man in a kingdom of the blind. ~ American writer Kurt Vonnegut, Jr. (1922 – 2007)

On April 26, 2002, the 10Q Detective unearthed that HepaLife issued 2.16 million of common shares at a price of $0.05 per share in exchange for the satisfaction of debt owed to Harmel S. Rayat. The debt was for a total of $108,000 due for the forequoted management and consulting (PR) fees.

In March 2007, Rayat disposed of 2.25 million shares at 64 cents per share.

Related Party Transaction(s)

The Company’s administrative office is located in Vancouver, British Columbia, Canada—in a building owned by a private corporation controlled by Mr. Rayat. Ergo, as long as the Company sustains operations, Rayat will receive a monthly rent check of C$3,200 from HepaLife (among other concerns that Rayat has a controlling interest, too).

Working hard to get my fill
Everybody wants a thrill
Paying anything to roll the dice
Just one more time

As of June 8, 2007, HepaLife owed an aggregate of $877,800 to Rayat, pursuant to a prior $1.60 million loan commitment. The loans bear interest at the rate of 8.50% per annum (and are due upon the receipt of the written demand from Mr. Rayat). HepaLife does not currently have sufficient capital on hand to repay these loans. (The Company may not use any of the proceeds from the issuance of the Convertible Note to GCA Strategic to repay these loans.)

Some will win,
some will lose
Some were born to sing the blues
Oh the movie never ends
It goes on and on and on and on
~ Artist: Journey (Don’t Stop Believin’, 1981)

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

Tuesday, August 28, 2007

CEO of Hi-Shear Technology Whistles: "Back at Home There's Nothin' to Do."

George W. Trahan, 59, Chief Executive Officer and Chairman of the Board (since April 2000) of Hi-Shear Technology Corp. (HSR-$9.59), manufacturer of electronic firing devices and fail-safe pyrotechnic initiation and separation products for the aerospace industry, has a two-year employment agreement, which provides for 12-weeks paid vacation each year—three months of each year!

Can't seem to get my mind off of you
Back here at home there's nothin' to do
Now that I'm away
I wish I'd stayed
Tomorrow's a day of mine
That you won't be in

Who is there to tell Trahan to get his mind off of Hi-Shear and stay away for a few days? Trahan, who beneficially owns 38.3% of the common stock outstanding, can pretty much dictate the terms of his employment.

When you looked at me
I should've run
But I thought it was just for fun
I see I was wrong
And I'm not so strong
I should've known all along
That time would tell

As of May 31, 2007, the total cumulative vacation hours earned by, but unpaid to, Mr. Trahan was $594,000.

A week without you
Thought I'd forget
Two weeks without you and I
Still haven't gotten over you yet

The Agreement also provides that Trahan’s base salary shall be increased from $484,000 in fiscal 2007 to $532,000 as of February 28, 2008. Ergo, if he elects not to ‘take holiday,’ he could cumulate an additional $123,000 in fiscal 2008.

All I ever wanted
Had to get away
Meant to be spent alone

Ironically—given the industry that Hi-Shear services—the Company does not provide to Trahan a corporate jet; but, his employment contract stipulates that he is to fly in ‘first class.’

All I ever wanted
Had to get away
Meant to be spent alone
~ The Go-Go’s (
Vacation –audio clip, 1982)

In recognition of the requirements for business travel, the Company provides Mr. Trahan with the use of a Cadillac Seville (or other automobile of equivalent cost of Executive's choice). The automobile may be purchased by Mr. Trahan at the end of the lease or renewal of a new lease for just $1.00.

Beyond raised eyebrows, the 10Q Detective noted, too, that—irrespective of his past performance—if Mr. Trahan's employment with the Company is terminated for any reason other than death, permanent disability, or ‘for cause,’ Trahan shall continue to receive compensation for 48 months—or four times his annual salary! [Typically, exit packages involve a cash severance of two or three times salary plus bonus.]

Thomas R. Mooney, 70, the Co-chairman of the Board, performs consulting services for the Company, for which he received $230,000 during fiscal year 2007, which included a discretionary bonus of $36,000 earned in fiscal year 2006, pursuant to his consulting agreement with the Company (under its Executive Bonus Plan).

The Consulting Agreement provides that Mr. Mooney “will work on projects as assigned by the Company.” Curiously, his agreement does not include a requisite minimum of hours that Messer. Mooney has to work each month.

Mr. Mooney retired from active employment and as Chief Executive Officer in February 2000. Mr. Mooney served as Chief Executive Officer and Chairman of the Board from June 1994 until February 2000.

Oh—Mooney is also the other major stockholder, beneficially owning 30.6% of the common stock outstanding.

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

Friday, August 24, 2007

J.L. Halsey -- The Biggest Story Never Told!

In July 2001, J.L. Halsey (JLHY-$1.05) was just a shell of a public company, with nothing much to offer potential investors, save for about $135 million in net operating loss carryforwards. However, anyone drunk enough—oh! prescient enough—to have bought just $100 worth of this penny stock would have witnessed their investment grow to more than $35,000 by June 2006!

Halsey is the successor to NovaCare, which was a national leader in physical rehabilitation services, orthotics and prosthetics and employee services. The changes to Medicare reimbursement in the late 1990’s (due to the Balanced Budget Act of 1997) had deleterious effects on NovaCare and its competitors and customers. The prior operating business most affected by the Medicare changes was the long-term care services segment in which NovaCare provided therapists to skilled nursing facilities.

This business was disposed of in fiscal 1999 with the shutdown of certain of NovaCare’s operations in the Western United States during the third fiscal quarter and the sale of the remaining operations on June 1, 1999.

Subsequently, NovaCare sold off its other segments, and on June 18, 2002, the shell merged with and into Halsey, its remaining wholly owned subsidiary.

Shares rocketed in price after Halsey acquired four Emarketing software companies during the past two years:
Lyris Technologies (March 2005, Email marketing software & Hosting services), EmailLabs (October 2005, Email marketing software), ClickTracks (August 2006, Web Site Analysis Tools), and Hot Banana (August 2006, Web Content Management Software Suite).

In July 2007, Ziff Davis Media's IT publication, Baseline Magazine, ranked the company No. 1 on its list of the fastest-growing, publicly-traded software companies with sales of less than $150 million. J.L. Halsey landed at the top with 1003 percent 2006 sales growth to $24.4 million in sales, from $2.2 million in 2005.

More than 80% of Halsey’s revenue comes from the email marketing market — from the licensing of software, the sale of support and maintenance contracts related to its software, and from the sale of hosted services. The remainder of its revenue, with the acquisitions of ClickTracks and Hot Banana, comes from Web analytics (the ability to monitor and understand visitor behavior, funnel paths, track conversions and optimize pay-per-click (PPC) programs) and content management.

In our view, despite its torrid sales growth, the current valuation of Halsey discounts the price performance potential over the next 12-months. Granted, the Company is focused on high-growth technologies—and management’s ability to execute on successfully completing the integration of its acquisitions could drive sales and earnings higher. However, our confidence in Halsey forward earnings’ visibility dissipated after a quantitative look at growth, profitability, and capital strength metrics.


Total revenue was $28.2 million for the nine months ended March 31, 2007, compared to $16.7 million for the prior year. Lyris’ hosted revenue increased to approximately $6.8 million for the nine months ended March 31, 2007, from approximately $4.7 million for the nine months ended March 31, 2006. In addition, the acquisitions of EmailLabs and ClickTracks kicked in incremental sales of $5.5 million and $2.5 million, respectively.

Halsey reported a net loss of $(430,000), or $0.00 per share, for the nine months ended March 31, 2007, compared to net income of $2.2 million, or share-net of $0.03, last year. The primary reasons for the decrease of approximately $2.6 million were increases in research and development of $1.2 million and interest expense of $576,000.

“Some people find fault as if it were buried treasure.”

Doing what we do best, the 10Q dug into Halsey’s Income statement and found some interred accounting gems. To wit:

  • Discontinued Operations – Management is boosting its bottom line by annual changes to discontinued adjustments ($374.1 million loss on disposal of operations, which were originally recorded in fiscal year 2000).

The Company maintains allowances for the collection of its receivables remaining from its erstwhile healthcare operations. These allowances resulted from the purported inability or unwillingness of many of the Company’s former healthcare customers to make payments and Medicare related indemnification receivables. At March 31, 2007, the Company believed that “the probability of collecting the $563,000 in receivables was low” and accordingly, has fully reserved these receivables to reduce their net realizable value to zero. However, if any of these receivables are collected, the Company will record a gain in the period of collection.

Halsey also maintains $1.54 million (down from $2.31 million in 2006) in accrued expenses (still remaining from the 2000 discontinued operations, primarily consisting of liabilities that arose prior to or as a result of the disposed transactions). These liabilities include costs for litigation (necessary to defend itself against legal claims related to its discontinued operations), workers’ compensation claims, professional liability claims and other liabilities.

Management claims that the actual collections of assets or actual costs of liabilities are difficult to estimate because of the high variability of possible outcomes: “As a result, the actual costs could differ significantly from [prior] estimates.”

Of interest, management has consistently erred on its estimates (to the Company’s benefit) of its legacy assets and liabilities. For the nine-months ended March 31, 2007, management reversed a previously booked loss of $560,000. As such, the nine-month loss shrank by $0.01 per share. And, in the same period for fiscal 2006, there was a reversal of $448,000, boosting share-net by one-cent.

  • Income Tax Provision – Halsey continues to utilize its net operating loss carryforwards to lower taxable income. For federal income tax purposes, 90% of the Company’s consolidated year to date income was offset by prior cumulative NOLs. For state income tax purposes, the company pays at the statutory rate of 8.84 percent (the statutory rate in California).

For the nine-months ended March 31, 2007, Halsey’s effective income tax rate was 23.5 percent, compared to 24.3% in the prior year. In 2006, the U.S. average statutory rate was 39.3 percent.

  • Contingent acquisition payments – The Company spent about $54 million in payments for the four most recent acquisitions. In addition, each of the four foregoing acquisitions requires Halsey to make additional earn-out payments to the sellers of the businesses if certain conditions are met (specified revenue targets) totaling $13.7 million. A principle use of cash in the future will be the payment of these earn-outs (and the pay down of debt). C

Cash on hand, cash flow, and borrowing capacity under its credit facility currently are insufficient to pay these earn outs. As of March 31, 2007, the Company had only $346,000 in cash.

In addition, the Company has a current account deficit of about $(208.4) million.

  1. Lyris achieved its specified revenue targets, and was owed $6.6 million in May 2007. Halsey extended the maturity date, with interest accruing at 10% per annum, to November 12, 2008. [est. total due—with interest--$7.2 million]
  2. EmailLabs achieved its specific revenue targets, too, and is owed $1.72 million (due on October 11, 2007).
  3. Additional payments totaling approximately $4.0 million may be made in the event ClickTracks achieves future revenue targets. Halsey does not believe it is probable that ClickTracks will achieve the specified targets and accordingly has not recorded a liability as of (March 31, 2007).
  4. Halsey believes it is probable that Hot Banana’s performance will result in contingent payments for revenue targets and the second installment of a technology integration target to the sellers of Hot Banana and, as a result, the Company has accrued $882,488 in liabilities (as of March 31, 2007).

Halsey carries a market capitalization of only $103.3 million, which belies an air of ‘undervaluation.’ In our view, the trailing twelve-month ROA and ROE of 2.24% and (1.61)%, respectively, speak more to the problematic growth prospects ahead.

Investors ought note, too, that the existing capital structure can no longer support new acquisitions: intangible assets (e.g. customer relations, developed technology) and goodwill of $23.3 million and $35.8 million, collectively represented approximately 84% of total assets; and, the Company has revolving line of with Comerca Bank with some
restrictive financial covenants, including fixed charge coverage ratio and senior debt to EBITDA.

J.L. Halsey said that it will seek stockholder approval
to change its name to Lyris Solutions, Inc., at the company's annual stockholder meeting, which is expected to take place on September 12, 2007.

Editor David J. Phillips does not hold a financial position in J.L. Halsey. The 10Q Detective has a Full Disclosure Policy.

Wednesday, August 22, 2007

Advanced Environmental Recycling Tech: Quality Decking -- Lousy Stock

You should not buy a stock because it's cheap but because you know a lot about it. ~ Peter Lynch (Former Fidelity Magellan Fund Manager and Author)

If that were true—would we not all be millionaires? The 10Q Detective believes that this advice—taken out of context—has probably lost more monies for investors than it has made for them.

Advanced Environmental Recycling Technologies (AERT-$1.43) manufactures a line of low-maintenance composite building products, which are used as a non-wood alternative building material for the homebuilding market, including decking, door and window components, and exterior trim.

A read of online message boards is swimming with glowing testimonials from owners of AERT’s product(s). How many—we wonder—are from the approximately 1,600 holders of record of the Class A common stock?

The Company’s proprietary
MoistureShield decking is formulated from a mixture of recycled wood fiber and plastic for long lasting beauty and low lifecycle cost. Unlike traditional wooden decking, composite decking material does not need staining, painting or sealing to maintain its natural look. The deep wood grain texture has the appearance and texture of real wood, and its water/termite resistant composition shields the wood fiber from moisture and rot damage.

The Company’s revenues are derived principally from a number of regional and national door and window manufacturers, regional building materials dealers and Weyerhaeuser, the Company’s primary decking customer.

AERT’s recycling and manufacturing facilities make Decking board, handrails, and stair applications for Weyerhaeuser under the
ChoiceDek brand (carried exclusively at 1,300 (+) Lowes Home Improvement stores).

You shouldn't just pick a stock - you should do your homework. In our view, this is sager counsel from the Fidelity stock-picking legend.


Net sales for the second quarter ended June 30, 2007, fell 9.8% to $25.3 million compared with the prior year. Despite a strategic plan to diversify its distribution channel, which includes leading national companies such as the Weyerhaeuser Company, Lowe’s Companies, Inc. and Therma-Tru Corporation, sales to Weyerhaeuser still comprise about 80% of total gross sales.
MoistureShield decking sales were up 75% year-over-year (and comprise about 10% of aggregate sales), but ChoiceDek decking sales were lower by 15.6 percent. Ergo, overall decking sales were down 7.5% versus second quarter 2006.

Sales of OEM parts like door rails (to Therma-Tru Corporation) and windowsills (to Stock Building Supply Co.) were down significantly (41%) from the prior year because of the slowdown in new home construction.

In 2Q:07, gross, operating, and net margins fell 14.5%, 13.2%, and 7.6%, respectively. Year-over-year, raw material costs increased 680 basis points, due to the increased use of colorants and additives and increased use of higher grades of polyethylene. In addition, the slowdown in the building products industry translated into lower unit volume sales by cabinet and hardwood flooring manufacturers—meaning less scrap wood fiber available for purchase by AERT (acting to raise the cost of wood raw materials).

In addition, slower sales left the Company with some under-used manufacturing and administrative capacity, which increased overhead costs relative to sales and reduced profit margins.

The net loss for the 2Q:07 was $(383,919), or $(0.01) per share, compared with net income for the 2Q:06 of approximately $1.72 million, or 4 cents per share.

Liquidity and Capital Resources

At June 30, 2007, AERT had a working capital surplus of $365,604 compared to a working capital deficit of $(3.5) million at December 31, 2006, due primarily to a $5 million financing from Allstate investments in June 2007. Loan proceeds were used to reduce accounts payable and pay down a working capital line of credit, among other uses.

Hold the applause—the balance sheet is weaker than management makes it out to be: back out $16.3 million and $1.8 million of inventories and prepaid expenses, respectively, and AERT is running a working capital deficit of about $(10.2) million.

Operating cash flow for the six-months ended June 30, 2007, was $(4.73) million.

AERT’s capital improvement budget for 2007 is currently estimated at $4 million (excluding a proposed new waste recycling facility in Oklahoma, which is designed for less desirable, but low cost, forms of waste polyethylene and additional sources of waste wood fiber), most of which will be funded from either cash flow or a long-term lease.

The 10Q Detective applauds AERT’s management for looking to lower its cost of goods structure, but moving forward with the initiative will require monies not in the Company’s strongbox—yet. For example, just the first phase of the Oklahoma project will require $15.0 million in financing.

AERT is looking to the Adair County Oklahoma Economic Development Authority to finance the construction of the proposed new waste recycling facility through the issuance of tax-exempt industrial development bonds. Although the Company recently received initial regulatory environmental approval, there is no assurance that the anticipated funding will materialize. Without funding, AERT would have to pay for a large portion of the project costs from cash flow, ensuring the project would be delayed.

Approximately $3.5 million was available to borrow on an existing $15.0 million line of credit at June 30, 2007.

Long-term debt currently gobbles up 77 cents of each dollar in shareholder equity.

AERT will find it difficult to tap the credit markets, for AERT is currently in violation of two covenants from a 2003 bond agreement with Allstate Insurance Company: (i) accounts payable (not more than 10% of a/c payable in excess of 75 days past invoice date / June 2007: 11.1%) and (ii) debt service covenants (long-term debt service coverage ratio for last four quarters of at least 2.00 – 1.00 / Jun 2007: -0.03).

Corporate Governance

Irrespective of the Company’s cyclical financial and stock performance, AERT has been kind to the Brooks family.

Matriarch Marjorie S. Brooks, who beneficially owns 30.1% of the total voting stock, is the secretary, Treasurer and a director. Her sons, Joe G. Brooks, Stephen W. Brooks, and J. Douglas Brooks are the Chairman and co-Chief Executive Officer, co-CEO and director, and senior VP-sales and marketing, respectively.

In the second quarter of 2007, the Company purchased approximately $894,000 of certain of its raw materials through Brooks Investment Company, which is controlled by Marjorie S. Brooks. Additionally, the Company was charged interest costs by Brooks Investment Company of approximately $6,000 related to those purchases!

Mrs. Brooks is paid a ‘credit enhancement fee’ for providing a personal guarantee on the balance outstanding on the Company’s $15 million bank line of credit. This fee is intended to compensate Mrs. Brooks for her $4 million personal guarantee on the Company’s industrial revenue bonds. For the three and six months ended June 30, 2007, the Company recorded fees of $68,284 and $132,681, respectively, related to this arrangement.

On May 29, CEO Joe Brooks disposed of 247,000 shares (at $1.41) that he exercised at 46 cents to 56 cents per share.

The prior month, brother Stephen sold 500,000 shares (at $1.52) that he acquired via previously awarded stock options at strike prices between 38 cents – 56 cents per share.

Time has not been as equitable to long-suffering Class A stockholders—unless they were good market timers: The price spiked from $1.70 in January 2006 to an intra-day high of $3.71 on June 15, 2006. Save for that anomaly, the share price has quietly tiptoed around the $1.50 level for the last five years.

Investment Thesis

Despite weak conditions in the building materials industry, AERT believes that sales can rebound in the 2H:07. Management’s growth and profit strategy is focused on (1) increasing sales, (2) increasing gross margins, (3) lowering overhead costs, and (4) reducing debt-servicing payments.

Granted, AERT has a contract with Weyerhaeuser requiring the integrated forest products company to purchase a minimum number of truckloads of ChoiceDek Premium decking and accessories, which amount was set by Weyerhaeuser each year subject to a minimum annual quantity of 1,850 truckloads—irrespective of inventory levels. Nonetheless, in a summary of its 2Q business performance on August 3, Weyerhaeuser told investors: “weak demand in housing continues to affect” the wood products segment (which does not bode well for growth in 3Q decking sales at AERT).

AERT is looking capture customer sales by expanding its wood composite footprint in the $5.1 billion outdoor decking (deck boards and handrail systems) market. Wood/plastic composite products total only about 19% of this market, but an independent, industry group estimated that annual unit sales of wood/plastic composite decking products grew about 25% per year from 2000 to 2005 and are expected to continue double-digit annual growth for the foreseeable future. Most end-user sales are for remodeling jobs.

AERT is introducing three new ChoiceDek products (and a minimum of two colors stocked) in all stores and expanding its MoistureShield decking product line into nationwide distribution by the end of the first quarter of 2008.

Although the 10Q Detective agrees that AERT’s core competency is extracting value from turning recycled plastics into new products, management has yet to demonstrate that it can successfully launch a non-deck product. For example, the Company is behind schedule in launching its new outdoor fencing product (LifeCycle).

In addition, even though the new Springdale South factory is finally operational, we believe margins will continue to be adversely affected by continued management inefficiencies (less than expected demand for expanded product offerings) and rising raw material costs. The onus is on management to show that it can execute on streamlining logistics and increasing automation to improve yield and lower labor costs.

Given the uncertainties as to when and at what pace existing business segments will recover, the 10Q Detective is avoiding purchase of AERT shares.

You have to research the company before you put your money into it. ~ Peter Lynch.

After doing our due diligence on AERT, we do not beg to differ on this advice.

Investment Risks & Considerations

The loss of one or more key customers could cause a substantial reduction in revenues and profits. As previously mentioned, AERT’s principal customer for its decking material is Weyerhaeuser, which accounts for about 80% sales. In addition, Therma-Tru and Stock Building Supply each purchase a large portion of the Company’s industrial products.

AERT’s products are used primarily in home improvement and new home construction. The home improvement and housing construction industries are currently subject to a cyclical downturn caused by general economic conditions. In particular, the present credit crisis has lead to reduced homebuilding and/or home improvement activity. A sustained reduction in such activity would have an adverse effect on the demand for AERT’s products.

Future sales of shares could be dilutive and impair AERT’s ability to raise capital. The conversion of a significant number of existing outstanding derivative securities into Class A common stock could adversely affect the market price of the stock. At December 31, 2006, there were “in-the-money” warrants outstanding for 4,606,132 shares of Class A common stock at an average exercise price of $1.21, and options outstanding for 2,872,130 shares of Class A common stock at an average exercise price of $1.09. The exercise or conversion of a material amount of such securities would result in a 16% dilution in interest for other security holders.

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

Monday, August 20, 2007

At Roberts Realty -- 'Charity Begins at Home'

Roberts Realty Investors (RPI-$7.40) owns and operates multifamily residential and other properties as a self-administered, self-managed equity real estate investment trust (REIT).

At June 30, 2007, Roberts Realty owned one multi-family apartment community, four neighborhood retail centers, a 37,864 square foot commercial office building (part of which serves as the Company’s headquarters, 104 acres of undeveloped land, and a 44-acre tract of land being held for investment.

Roberts Realty has elected to be taxed as a REIT under the Internal Revenue Code of 1986. In order to qualify as a REIT—and not be subject to federal and state income taxation at the corporate level—companies must pay at least 90 percent of their taxable income in the form of shareholder dividends.

Now that U.S. real estate stocks have followed the residential housing market into the gutter as mortgage woes continue to spread, it is more important than ever to do one’s due diligence when looking at REIT stocks for investment purposes. In evaluating REIT securities, consider the dividend yield, long-term dividend growth rate, and FFO (funds from operation) growth.

When examining the regulatory filings of Roberts Realty, however, we needed only to look at the egregious compensation being paid to CEO Charles S. Roberts to realize that this REIT offers no value to potential investors.

And the lies theyve been spinnin
And the smiles theyve been grinnin
There sure has been some sinnin
But nobodys winnin

Unlike other REITs that pay regular monthly or quarterly dividends, Robert Realty has not paid regular quarterly dividends since the third quarter of 2001, and the Company presently has no plans to resume paying regular quarterly dividends.

When the walls start to crumblin
You feel like youre stumblin
And nobody wants you when youre down

The Company has reported accumulated losses from continuing operations (before any gains on sale of real estate assets) of $(12.57) million for the last five-years (fiscal ended December 31, 2006).

They took the boy from the city
But they cant take the city from the
Boys lookin pretty
Now hes lookin like a pity

Since 2001, Roberts Realty has paid dividends only out of the proceeds of property sales. On June 18, 2004, the Company paid a special distribution of $4.50 per share to shareholders funded from profits generated by the sale of five apartment communities to Colonial Properties Trust.

Cut the flesh down to the bone
But you cant get
You cant get blood from a stone
You cant get blood from a stone
~ Cinderella [Blood From A Stone]

You can’t get blood from a stone—of course you can. To wit: CEO Roberts, who beneficially owns 38.2% of the common stock outstanding, has not had to sacrifice like the ‘common stockholder’ at Roberts Realty.

Roberts Realty enters into contractual commitments in the normal course of business with Roberts Properties, Inc. and Roberts Properties Construction, Inc., which are affiliates of Roberts Realty that are wholly owned by Mr. Charles S. Roberts, the President, Chief Executive Officer, and Chairman of the Board of Roberts Realty.

Roberts Realty has paid substantial fees to the Roberts Companies for various types of services and will continue to do so in the future. In addition, the REIT has purchased property from Roberts Properties, and is obligated to use Roberts Properties for development services and Roberts Construction for construction services for some of its undeveloped properties. These various arrangements are summarized below:

  • Northridge Community. On June 28, 2001, the REIT purchased 10.9 acres of undeveloped land from Roberts Properties. The Company intends to develop a 220-unit apartment community on this site, located on Northridge Parkway in Atlanta adjacent to its Northridge office building. The Company retained Roberts Properties to complete the design and development work for a fee of $2,500 per unit, or $550,000. The REIT also entered into a cost plus 10% contract with Roberts Construction to build the 220 apartment units.
  • Northridge Office Building. On June 28, 2001, the REIT purchased a partially constructed office building and approximately 3.9 acres of land from Roberts Properties. The three-story, 37,864 square foot building serves as the Company’s corporate headquarters. The REIT occupies a portion of one floor in the building and leases the remaining space on that floor to Roberts Properties and Roberts Construction.
  • Peachtree Parkway Land. The REIT purchased an undivided interest in a 23.5-acre portion of the undeveloped land from Peachtree Parkway (owned by Mr. Roberts) for a cash purchase price of about $10.2 million. The land is zoned for 292 apartment units and is located across Peachtree Parkway from the upscale Forum Shopping Center.

In acquiring the Peachtree Parkway property, the Company assumed and became bound by a restrictive covenant recorded in those records in favor of Roberts Properties and Roberts Construction that provides that if the then-owner of the property develops it for residential use:

  1. Roberts Properties, or any entity designated by Mr. Roberts, will be engaged as the development company for the project and will be paid a development fee in an amount equal to $5,000 per residential unit multiplied by the number of residential units that are developed on the property, with such fee to be paid in equal monthly amounts over the contemplated development period; and
  2. Roberts Construction, or any other entity designated by Mr. Roberts, will be engaged as the general contractor for the project on a cost plus basis and will be paid the cost of constructing the project plus 10% (5% profit and 5% overhead) with such payments to be paid commencing with the start of construction.
  • Development Fees. The REIT pays Roberts Properties fees for various development services that include market studies, business plans, design, finish selection, interior design and construction administration. During 2005 and 2006, the Company entered into development and design agreements with Roberts Properties on four projects, totaling $5.06 million in associated fees.
  • Construction Contracts. The REIT enters into contracts in the normal course of business with Roberts Construction. During 2005, the Company entered into contracts with Roberts Construction on four projects. The total cost, including contractor fees, is estimated to be approximately $206 million!

2006 Summary Compensation. In addition to the aforementioned millions being paid to Charles Roberts and/or entities controlled by him, on February 28, 2007, the Board granted a $25,000 salary increase to Charles S. Roberts [raising his annual salary to $224,000] “for his performance as Chief Executive Officer.”

What performance?

REI = Dow Jones REIT Composite Index

According to Lipper—prior to the 1H:07 real-estate meltdown—the average real-estate fund yielded a 5-year total return of 207% (through January 2007), including an average dividend of almost 7% (June 2002) to about 4.6% (January 2007).

As previously mentioned, Roberts Realty has made only irregular dividend payments—with a dividend payout ratio of nil during the last 12 quarters. And has rewarded stockholders with a historical price chart that looks more like a patient in asystole—a flatlined electrocardiogram!

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

Thursday, August 16, 2007

More Fish Tales at Northfield Labs

In its recent proxy statement, Northfield Laboratories (NFLD-$1.16), which is developing a hemoglobin-based oxygen-carrying red blood cell substitute (PolyHeme) for the treatment of urgent, large volume blood loss in trauma, revealed that its Chief Executive Officer, Steven A. Gould, M.D., received $365,000 in base salary and was awarded a $100,000 cash bonus.

The 10Q Detective chose not to ignore the remuneration—no matter how small the actual payment—for it epitomizes the disconnect between pay and performance goals.

The Compensation Committee said, “2007 bonuses were paid based on the achievement of board approved performance goals in the areas of clinical, regulatory, manufacturing and administration.”

In fiscal 2007, shares in Northfield stumbled more than 94 percent in value, as its red blood cell substitute,
PolyHeme, failed to meet the primary goals of mortality and safety in a pivotal Phase III study.

The 10Q Detective recognizes that because patient enrollment was conducted primarily in urban settings (urban Level I trauma centers have the patient volume, resources and sophistication to conduct a clinical trial of this complexity), transit times in the ambulance would be briefer than in rural or ‘conflict’ areas (war). As patients in the control group reached the hospital quickly, they had early access to blood, in relatively short periods of time.

Suspicion became fact, for the observed outcome in the trial did not demonstrate the expected survival benefit that might have occurred if the trial were being conducted in the rural setting.

Irrespective of the clinical setting, however, Northfield could not ‘explain away’ why the incidence of cardiac adverse events were higher in the PolyHeme group than the control group (who received crystalloid solution in the field), at 35% (123 patients) compared to 29% (105 patients), respectively (p>0.05). And, the overall incidence of MI in the study as reported by investigators was 2%: eleven PolyHeme patients and three control patients (p £ 0.05). Three PolyHeme patients and one control patient died.

Northfield rewarded Messer. Gould cash bonuses of $140,000 and $100,000 in fiscal 2006 and fiscal 2005, respectively, despite the expiration in 2006 of five key United States patents and a pending patent expiry of the broadest issued United States patent come 2008.

Whatever you say, say it with conviction. ~~ Humorist Mark Twain (1835 – 1910)

The Committee also said that during its 2007 fiscal year, the amount of Dr. Gould’s compensation (salary) was determined “based principally on compensation levels applicable to the chief executive officers of similar or competitive companies."

Northfield has two public competitors in the race to bring to market a blood substitute (oxygen-transport) product: (1) Biopure Corporation (BPUR-$0.92), which is developing a bovine hemoglobin-based oxygen carrier product,
Hemopure; and (2) Synthetic Blood International (SYBD-$0.10), which is developing a perfluorocarbon-based oxygen carrier product, Oxycyte.

Biopure previously withdrew a proposed BLA in the United States for Hemopure in Level 1 trauma centers (hospital setting) due to safety concerns. However, the company has submitted a final study report to the FDA for the first trial in its cardiovascular ischemia program (COR-001).

CEO Zafiris G. Zafirelis received a salary of $253,016 and $250,016 from Biopure in fiscal 2006 and fiscal 2005, respectively. The Company, however, did not award Messer. Zafirelis a bonus in either of the last two years.

After receiving clearance from the FDA, Synthetic Blood conducted a Phase I clinical study on Oxycyte, which was completed in December 2003. Phase II clinical trials are expected to continue through the end of 2007 and into 2008 (pending receipt of requisite R&D monies).

President Robert Nicora earned a salary of $173, 250, $189,000, and $189,000 in fiscal 2007, fiscal 2006, and fiscal 2005, respectively. Synthetic Blood did not reward any cash bonuses in any of the aforementioned years to Messer. Nicora.

To the contrary, in determining compensation policies and the composition and levels of compensation for its executive officers, the Compensation Committee at Northfield is blatantly not reviewing “publicly available information regarding the compensation paid by similar companies.

Liar, liar
Your pants on fire
Your hair's sticking up
Like a telephone wire
Editor David J. Phillips does not hold a financial interest in Northfield Labs. The 10Q Detective has a Full Disclosure Policy.

Tuesday, August 14, 2007

Too Early to Jump Back on Ralph Lauren's Horse

Shares of Polo Ralph Lauren (RL-$81.71) climbed 4.3% today on news that the premium clothing and home furnishings maker had set a $250 million stock buyback.

The 10Q Detective is puzzled as to why investors reacted so positively to this news, for repurchased shares at Ralph Lauren—though accounted for as treasury stock at cost and held in treasury—go through a revolving door, back out to Named Executive Officers.

For example, during the three-months ended June 30, 2007, 1.7 million shares of Class A common stock were repurchased at a cost of $170 million under an existing $250 million program; however, 6.01 million stock options and 836,000 performance-based (and non-vested) Restricted Stock Units were outstanding and due to Named Executive Officers.

Pursuant to his existing executive employment agreements, founder and CEO Ralph Lauren is entitled to annual grants of options to purchase 150,000 shares of the Company’s Class A Common Stock and annual issuances of 100,000 restricted stock.

Last week, shares in Polo Ralph Lauren stumbled 16.5% as the Company
missed analyst expectations for the first-quarter for fiscal 2008 ended on June 30, 2007, and more importantly for the Street, cut its yearly guidance.

Ironically, less than one-month prior, the Board lauded Messer. Lauren for the Company’s 2007 financial performance by rewarding him with restricted stock, options, and a cash incentive bonus of $5.5 million, $2.7 million, and $16.5 million (representing his maximum bonus opportunity), respectively.

Contrary to prior guidance of a Fiscal 2008 effective tax rate of 38 percent, management is now estimating a FY 2008 effective tax rate to be approximately 39 percent, due to the impact of the company's adoption of FIN 48 (which clarifies the accounting for uncertainty in income tax positions). The higher tax rate will shave approximately 6 cents in share-net. As a result, the Company now expects FY 2008 diluted earning per share to be in the range of $3.64 to $3.74 compared to prior expectation of $3.70 to $3.80, incorporating the effect of the tax rate change.

In our view, a change in tax rates is not what rattled the Street. In terms of earnings’ cadence for fiscal 2008, a slower payoff from new business initiatives, such as
``American Living'' (where Polo will be offering an exclusive lifestyle brand for JC Penny) and the Polo Ralph Lauren Watch and Jewelry Company, is what unnerved analysts.

In addition, management had formerly intimated that accessories, denim, and retail would show progress in providing incremental growth opportunities. However, in the recent quarter, operating income in retail and licensing fell 1.7% and 17.0%, respectively.

CFO Tracey T. Travis said the Company does not expect to see “the first signs of revenue related to some of those investments beginning [until] the fourth quarter and continuing into fiscal 2009. This will result in suppressed earnings in the first three quarters of the year with full earnings growth disproportionately weighted to the fourth quarter.”

Description of Businesses

Polo Ralph Lauren’s business is affected by seasonal trends, with higher levels of wholesale sales in the second and fourth quarters and higher retail sales in the second and third quarters. These trends result primarily from the timing of seasonal wholesale shipments and key vacation travel, back-to-school and holiday periods in the Retail segment.

The wholesale segment, which represented 54% of Fiscal 2007 net revenues, consists of products sold principally to leading upscale and certain mid-tier department stores, specialty stores and golf and pro shops.

The retail business (representing 41% of Fiscal 2007 net revenues) consists of retail-channel sales directly to consumers through 147 full-price and 145 factory retail stores and through a retail Internet site located at (formerly known as In Fiscal 2007, the website averaged 2.3 million unique visitors a month and had 1.1 million customers.

Approximately 22% of licensing revenue is derived from two product licensing partners: Impact 21, a former sub-licensee for Japan, and WestPoint Home, Inc, which accounted for 14 percent and 8 percent, respectively, of licensing revenue in Fiscal 2007.

WestPoint Home, Inc. offers a basic stock replenishment program that includes bath and bedding products and accounted for approximately 77% of the net sales of Ralph Lauren Home products in Fiscal 2007. Given the existing housing slump, on the recent earnings call management did not even bother to talk up organic growth prospects in this segment.

First revenue shipments for most of the lifestyle brands being developed for specialty and department stores will not be seen until Spring 2008—missing two critical selling periods: back-to-school and holiday periods.

Operating Results

The Company reported a share-net increase of 8 cents, or 10.8%, to 82 cents, driven primarily by a 12.2% gain in sales (to $1.07 billion). This revenue growth was partially offset by a decline in gross profit percentage of 40 basis points to 55.3%, primarily due to the effect of purchase accounting associated with recent acquisitions (Japanese business transactions and a small leather goods acquisition), and an increase in SG&A expenses, primarily related to recent expansions and the overall growth in the business.

Analysts had forecasted a profit of 85 cents per share on sales of $1.1 billion.

Of note, interest income of $8.2 million contributed about 5 cents (after-tax) to net income.

Financial Condition and Liquidity

The Company’s cash flow remained robust. Net cash provided by operating activities increased $48.2 million (year-over-year) to $280.8 million during the three months ended June 30, 2007. This net increase in operating cash flow was driven primarily by a net decrease in working capital needs, principally due to a decrease in accounts receivable days sales outstanding as a result of improved cash collections in the Company’s Wholesale segment.

Current assets of 2.17 times current liabilities, however, is slightly misleading, for less $604.7 million and $99.2 million in inventories and prepaid expenses, respectively, working capital drops to $209.6 million.

Nonetheless, the quick acid ratio of 1.26 means the Company still has enough in liquid assets to cover an unexpected drawdown of liabilities.

Albeit the Company generated free cash flow of $236.1 million in the last quarter, the just-announced $250 million stock buyback might not be the best use of funds.

Goodwill and other Intangible Assets (consisting principally of re-acquired licensed trademarks and customer relationships/lists) of $922.5 million and $373.9 million, respectively, account for 32.4% of total assets.

The 10Q Detective noted, too, that ‘charges against revenue to increase reserves’ (including estimated end-of-season markdown allowances, costs associated with potential returns of products, and operational charge-backs) increased $26.5 million to $94.3 million year-over-year. This increase was likely the result of retail customers being aggressive about clearing inventories in general through the spring/ summer season(s).

Investment Thesis

Current expectations call for a high single-digit revenue growth in the 2Q:08 to be followed by a mid-teen rise in revenue by the 4Q:08 leading to share-net of $3.64 to $3.74 for fiscal 2008.

In our view, although Polo Ralph Lauren is trading at a slight discount to other players in the space—a current P/E multiple of 22 times fiscal 2008 EPS and a TTM multiple of 24.97 times, respectively—we believe the stock price fairly values the expected earnings growth.

Successful execution of brand building (new merchandising lines), proving that acquisitions will be accretive to earnings, and a strengthening of its global competitive position are necessary catalysts for expansion of Polo Ralph Lauren’s earning’s multiple.

Margin expansion will be difficult to achieve in quarters two and three, for planned investment costs will continue to weigh on the Company for the duration of 2007.

In addition, delays in bringing in-house recent key acquisitions, including its leather goods, media (through which the Company operates its e-commerce initiatives), and Japanese businesses (that were formerly conducted under licensed arrangements) could adversely impact margins, too, leading to higher than anticipated integration costs (currently estimated at 27 cents per share).

Investment Risks and Considerations

The success of Polo Ralph Lauren’s business depends on its ability to respond to constantly changing fashion trends and consumer demands. At present, a big chunk of the Company’s sales comes from the men’s channel. Management is looking to jumpstart growth in the women’s room as the new American brand label unveils a new dress division through JC Penney.

In the wholesale business, the Company has two key department-store customers that generate significant sales volumes. For Fiscal 2007, Federated Department Stores and Dillard Department Stores represented approximately 29 percent and 14 percent of all wholesale revenues.

Approximately 80% of net sales are earned in the U.S. and Canadian markets. Ergo, Polo Ralph Lauren is gambling on accelerated operating profit growth at a time when most economists are expecting a material slowing in discretionary consumer spending.

Editor David J. Phillips does not hold a financial position in Polo Ralph Lauren. The 10Q Detective has a Full Disclosure Policy.

Wednesday, August 08, 2007

Sharper Image & Richard Thalheimer: Clash of Egos

The competitive landscape for Sharper Image (SHRP-$7.16), the troubled San Francisco-based retailer of specialty technology products, recently intensified when founder and former CEO Richard J. Thalheimer launched his own E-commerce gadget site,

Although Sharper Image is a multi-channel specialty retailer, online operations are important to the Company’s profitability, generating about 16 percent of total sales in each of the prior two fiscal years (with 187 retail stores and catalog purchases contributing about 60 percent and 14 percent, respectively).

Case Study of Merchandising Failure

Historically, the sales of Air Purifiers constituted a significant portion of revenues and net income. Beginning in 2005, sales of the line of indoor air purification products declined significantly, due to competitive pressures and litigation claims made with respect to the performance and effectiveness of the Ionic Breeze branded product line. Contrary to the Company’s claims, independent third-parties, including Consumer Reports, found the air purifiers did not remove dust and smoke from the air and may, in fact, release high levels of ozone instead.

In fiscal 2006, 2005 and 2004, the air-purification line of products generated 23.4%, 27.7% and 40.0% of total revenues, respectively.

Returns and allowances for fiscal 2006 were $61.8 million or 10.8% of sales, as compared to $74.2 million or 10.2% for fiscal 2005.

Due to the foregoing dependency on air purification products, and product returns, the Company lost $(59.9) million, or $(4.00) per share, $(16.1) million, a share-net loss of $(1.01), respectively, in the fiscal year(s) ended January 31, 2007 and 2006, on declining annual sales of $525.3 million and $669.0 million, respectively.

All three sales channels showed attrition, too, year-over-year: the average revenue per transaction for stores, catalog, and Internet fell 30 percent to $98, 25 percent to $151, and 11 percent to $136, respectively.

Adding to the Company’s troubles, on September 6, 2006, the Board announced that it had launched an independent review of the company's historical stock-option practices and related accounting matters (dating back to 2003). And, on Sept. 18, the company said it would restate results for three fiscal years and two quarters due to options.

In late September 2006, with the share price down more than 76 percent from its February 6, 2004, closing high of $39.88, Thalheimer was ousted as CEO.

Clash of Egos

Sharper Image entered into a Separation Agreement with Mr. Thalheimer in December 2006, payable April 1, 2007. Pursuant to the terms of the Settlement Agreement, Thalheimer received the following amounts: (i) severance in the amount of $2.04 million, which included severance, interest, and ‘paid time-off’; (ii) continued health coverage for himself and his dependents until his death (or in the case of his dependents, until the later of Mr. Thalheimer’s death or September 30, 2016), estimated at $110,874; (iii) payment of a nonqualified retirement benefit of $3,900,000; (iv) an office allowance of $300,000 “to assist him in renting office space and in securing secretarial assistance for three years”; (v) reimbursement of attorney fees and expenses incurred by him in connection with the negotiation of the Settlement Agreement, up to $80,000.

Ironically, too, Thalheimer retained his 50% discount on all goods sold by Sharper Image, up to $50,000 per year (lifetime benefit). Perchance he could resell the Sharper Image purchases on his new web site at a profitable mark-up?

The Board shaved $3.0 million from his severance payment to offset “certain amounts Mr. Thalheimer previously received upon the exercise of options to purchase common stock of the Company that had been granted to him at exercise prices that were below the fair market value.” The 10Q Detective notes, however, that Thalheimer made $4.56 million by exercising a total of 183,500 stock options during Sharper Image's fiscal 2004 and 2005, according to company disclosures for those years.

Thalheimer further distanced himself from Sharper Image when he sold almost all of his company stock to key investors, including the Knightspoint Group and Sun Capital Partners Inc., for an aggregate purchase price of about $25 million, or $9.25 per share, leaving him with a reported 1 percent stake (down from 19.7% on May 8).

What's New is Old

Sharper Image is looking to turn the Company around by clearing inventory to make way for new-to-market branded products, high-quality private label products, and improved proprietary products, particularly in its air-purification product line.

For example, the retailer just licensed its brand to a company that makes luggage; announced it has a deal with Las Vegas-based Zero Gravity Corp to start selling flights with periods of weightlessness on a NASA airplane for $3,500 per person; and, partnered with Donald Trump to offer its customers a line of Trump-signature Steaks Classic Collection, featuring USDA Prime Certified Angus Beef Brand steaks.

Your eyes are yours to close
Never let go Sleep is wrong
When I grow up I'm never gonna sleep
When I grow up I'm never gonna cry
When I go out I'm never coming home
When I grow up I'm never gonna die
~~ Artist, Sleepytime Gorilla Museum – (Sleep Is Wrong Lyrics)

In a recent interview with BusinessWeek (August 13, 2007), Thalheimer said, “there's a lot of humble pie in being asked to leave." But when it came to his new venture, the motivation was simply: "my favorite quest in life is to find that one product and market it hard. I just love it."

Unfortunately, Thalheimer will continue to be the irritant in Sharper Image’s air purification filters—a distraction the new merchandising team does not need. In our view, despite his statements to the contrary, Thalheimer’s ego will not let him—to paraphrase the Welsh poet, Dylan Thomas: “ go gentle into that good night.”

Thalheimer says that his new work “isn’t a dig at Sharper Image,” but there are definite commonalities between the Internet operations. To wit: The graphics on both sites feature the company name encased in white lettering within a black-colored header. In addition, Thalheimer’s site sells similar goods: air purifiers, interesting gadgets (such as InfoScan Pens and Night Vision goggles), and Archos video units. In our view, however, the presentation on Thalheimer’s site is “cheesier” and the product-designs/offerings seem inferior.

Notice the name of Thalheimer’s website, too: Richard Solo—a not too subtle reference to Thalheimer making all of the merchandising decisions.

Curiously, the Company never had Thalheimer sign a non-compete agreement. Ergo, each customer that Sharper Image fails to attract to its Internet operations—and a sale that might instead find its way to—will adversely affect the Company’s business and future operating results.

Sharper Image did, however, include a Confidential Information clause in Thalheimer’s Settlement Agreement: I agree that in the course of my employment with the Company I have had access to confidential and proprietary information relating to the Company, its subsidiaries, and affiliates, and their respective businesses, clients, finances, operations, strategic or other plans, employees, trade practices, trade secrets, know how, or other matters that are not publicly known outside the Company and that are integral to the operations and success of the Company (Confidential Information), and that such Confidential Information has been disclosed to me in confidence and only for the use of the Company. I agree that (a) I will keep such Confidential Information confidential at all times, (b) I will not make use of such Confidential Information on my own behalf, or on behalf of any third party….

Does not merchandising decisions, which are integral to the future profitability and success of Sharper Image, constitute Confidential Information? As such, if the website becomes too successful, Sharper Image’s attorneys may just come knocking on Thalheimer’s door looking for a payment of their own.

The 10Q Detective doubts, however, that in its current format, with little advertising too support his new brand, poses much of a competitive threat to Sharper Image.

According to, the recent three-month traffic rankings for the websites of Sharper Image and were 17,225 and 1,021,529, respectively. In terms of reach (page views and users), Sharper Image is currently winning this clash of egos – it’s called branding!

Investment Thesis: Avoid

Even with Thalheimer out of the way, the gadget retailer is still in shambles. For the quarter ended April 30, the loss was $(16.8) million, or $(1.12) per share, up from $(12.7) million or 85 cents per share, in the same period a year ago.

Revenue fell to $67.6 million from $106.8 million in the prior year, due primarily to a decrease in the sales of proprietary designed and Sharper Image branded products, in particular the air purification product line and massage chairs.

Sharper Image’s business is highly seasonal, reflecting the general pattern of peak sales and earnings for the retail industry during the holiday shopping season. In recent past years, a substantial portion of total revenues (about 39%) and all or most of net earnings, if any, has occurred in the fourth fiscal quarter ending January 31.

The share price has fallen an additional 23 percent since Thalheimer sold his holdings back in May.

Until new management can demonstrate their merchandising acumen in judging customers’ purchasing habits, however, we would avoid making investment purchases in the stock of Sharper Image.

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

Monday, August 06, 2007

Mattel Quarantines Big Bird and Elmo

Mattel Inc. ($22.72) is recalling 1.5 million Chinese-made toys, which resulted in a charge of about $28.8 million for the second-quarter ended June 30, 2007. A contract manufacturer in China, using a non-approved paint pigment containing lead, made the toys for Mattel's Fisher-Price unit, which included popular characters like Elmo and Big Bird.

In a
regulatory filing, the Company said: “[it] believes that it has some of the most rigorous quality and safety testing procedures in the toy industry.”

Jim Walter, Mattel’s senior vice president of Worldwide Quality Assurance, said: “We require our manufacturing partners to use paint from approved and certified suppliers and have procedures in place to test and verify, but in this particular case our procedures were not followed.”

Mattel is also conducting a review of the procedures followed with respect to all its products manufactured by vendors at its 50 plants in China. If any similar problem is discovered, Mattel “will take prompt, responsible remedial actions.”

For the six months ended June 30,2007, Mattel Girls & Boys Brands (including Barbie fashion dolls and accessories, Polly Pocket!, Hot Wheels, and, Matchbox); Fisher-Price Brands (including Sesame Street, Dora the Explorer, and Go-Diego-Go!); and, American Girl Brands (Just Like You, the historical collection and Bitty Baby) contributed $472.2 million (43.6%), 491.7 million (45.4%), and $118.7 million (10.9%), respectively, of total domestic sales.

Given that most of the foregoing toys are made utilizing third-party manufacturers throughout Asia, primarily in China, Indonesia, Malaysia and Thailand, the 10Q Detective questions just how fearful suppliers are to threats of ‘remedial action’ promulgated by Mattel.

In addition, gross profit is driven by squeezing every last penny in cost efficiency from its supply chain: as a percentage of net sales, gross margin improved 70 basis points to 44.2% in the second quarter of 2007, driven by favorable exchange rates and “made in china” savings, partially offset by the impact of the Product Recalls (which had the effect of decreasing gross profit as a percentage of net sales by 190 basis points).

In a November 2006 cover story, BusinessWeek commented on how American companies continually
demanded lower prices from their Chinese suppliers. Ergo, U.S. price pressures created a powerful incentive to cheat, whether it be labor conditions or toy paint.

American importers counter that they have increased inspections of labor conditions and product safety and quality control inspections at the factories run by their Chinese suppliers. Unfortunately, many Chinese manufacturers have just gotten better at concealing abuses.

In terms of scale and scope of product quality—China's export of counterfeit drugs, tainted pet food ingredients, and toothpaste—cheating is far more pervasive at Chinese export manufacturers than Mattel will ever publicly admit. And, no amount of audits will catch third-party suppliers devoted—like Mattel—to the almighty dollar.

For example, a boss pays $10,000 for a ton of plastic materials and his employee goes and pays $8,000 for something else. The $2,000 is eaten up and
you end up with a cheaper material that has toxic substances in it.

Mattel awarded CEO Robert A. Eckert, President Neil B. Friedman, and Thomas A. Debrowski, Exec. VP-Worldwide Operations, cash bonuses of $2.5 million, $1.2 million, and $639,000 for service performance(s) in fiscal 2006. Perchance aligning cash incentive compensation to quality assurance will serve as a needed incentive to manufacture non-toxic toys.

A lasting solution would be to bring manufacturing jobs back to the shores of the United States. Doing so, however, would mean passing on higher costs to the consumers buying the “Made in U.S.A.” Barbies and Big Birds. A worker earns around $132 a week for toiling 11 hours per day, six-days per week, in a Chinese toy factory.

Next time your kid is nibbling toxic lead paint from a “made in china” doll, remember, too, that because as a consumer you wanted a ‘bargain price,’ the health of your child is not just the responsibility of Mattel.

Editor David J. Phillips does not hold a financial interest in Mattel Inc. The 10Q Detective has a Full Disclosure policy.