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Archive for January, 2007

Websense (WBSN) Earnings Miss Expectations

January 30th, 2007 by Yehuda Fruchter   |   No Comments

After the close today, Websense (WBSN), reported fourth quarter earnings that missed Wall Street expectations. The company blamed the shortfall on various new accounting policies, but The Market will probably care little for this excuse.

The bottom-line is that the company’s core business has matured and new initiatives have yet to produce meaningful results. If you are long WBSN, like us, this simply means that the upside in the stock will be capped, until the company can show some evidence of renewed double-digit growth. We had thought that this quarter would finally show some accelerated growth, but we were clearly wrong.

At the same time, we still believe that the downside in the stock is minimal at current prices. The company is generating in excess of $85 million a year in cash-flow and sitting on about $230 million in cash with no debt (after the Port Authority acquisition). With M&A activity in the security software sector at high levels, it’s difficult to see how the stock could trade for an any extended period at lower than 10X EV/Free Cash-Flow or about $1.1 billion. This valuation would equate to about $22 to $23 per share.

Admittingly, our call on this stock has been wrong thus far and our entry point was ill-timed. However, given the above financial risk analysis, we plan to have some patience here for at least a few more quarters.

Disclosure: We hold shares in WBSN, and recommended them to subscribers at a price of $25.50. In addition, this report includes market analysis. All ideas, opinions, and/or forecasts, expressed or implied herein, are for informational purposes only and should not be construed as a recommendation to invest, trade, and/or speculate in the markets or in any particular stock. Any investments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are committed at your own risk, financial or otherwise. We maintain no legal responsibility to update this report or his holdings in the stock mentioned in this report.

Extreme Networks (EXTR): Moving in the Right Direction

January 28th, 2007 by Yehuda Fruchter   |   No Comments

Late last week, Extreme Networks (EXTR) reported quarterly results, which continue to support our investment thesis, that EXTR has limited downside risk at current prices, and substantial upside potential, assuming new management continues to drive positive change at the company.

The most important positives from the quarterly results were:

Balance Sheet Remains Pristine Limiting Downside Risk

During the quarter, Extreme Networks (EXTR), paid down all of its debt and exited the quarter with nearly $205 million in cash. This large cash cushion implies that there is little to no financial risk at the company and investors can remain comfortable holding the shares as the turnaround progresses.

Book-To-Bill Signals Healthy Business Growth

During the conference call, management of Extreme highlighted that the company’s Book-to-Bill ratio was greater than one, due to higher than anticipated demand for the new Summit X450 stackable switch. The book-to-bill ration is the ratio of business “booked” (orders taken) to business “billed” (products shipped and bills sent). A book-to-bill ratio higher than one (1) is encouraging.

On the negative side:

US Sales Remain Disappointing

The most glaring negative of the quarter was the continued weakness in the company’s US sales. Management indicated, though, that they continue to restructure and re-train the US salesforce, and they expect to see positive results from these efforts in the coming quarters.

Options Investigation Still An Issue

In addition, Extreme, like many other high-tech companies, is still undergoing investigation related to past option practices. While we don’t view this investigation as important from a business perspective, it’s probably the case that this may limit demand for the shares in the interim, as some investors will shy away from the stock until the company files updated financials.

Valuation Remains Depressed and Already Reflects All the Negatives

Despite evidence of improving results, Extreme’s stock price remains depressed as evidenced by an Enterprise Value (EV) to Revenue ratio of less than 1, with competitors such as Foundry Networks (FDRY) sporting EV/Sales ratios of 3X+. The discounted valuation reflects years of underperformance by the company from both a business and shareholder perspective.

Underperformance Indicates Substantial Upside Opportunity

However, despite past underperformance, the company appears to be undergoing significant changes under a new management team and as current results suggest there is ample room for continued upside surprises in the year ahead.

In general, in these types of turnaround situations, most analysts on Wall Street prefer to wait for several quarters of improving results until they become more positive on the company. In fact, out of the eight analyst reports we have read on EXTR, only two analysts are positive on the company, and only moderately so. Clearly, in the case of EXTR, the negatives are already well understood and priced in by the Market.

Our view, howver, is that since EXTR’s share price pretty much already reflects worst case scenarios, and there is ample evidence to suggest that substantial positive business changes will be coming in the next year, you have no need to wait here. In sum, at current prices, there is little to lose and much to gain, the perfect investment combination.

We would note, in the case of EXTR, that if the company continues to report improving financial results and US sales begin picking up, there is absolutely no reason why the company should trade at a substantial valuation discount to its peers. In fact, a valuation more in line with industry comps, would suggest a potential target price of $8 to $10 in the coming year, if results continue to improve.

Please Note: We first recommended Extreme Networks (EXTR) at $4.22, and still hold a position in the stock. All ideas, opinions, and/or forecasts, expressed or implied herein, are for informational purposes only and should not be construed as a recommendation to invest, trade, and/or speculate in the markets. Any investments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are committed at your own risk, financial or otherwise.

Phoenix Technologies (PTEC): Turnaround On Track

January 26th, 2007 by Yehuda Fruchter   |   2 Comments

Bottom Is Definitely In

Yesterday, Phoenix Technologies (PTEC) reported Q1 results which significantly exceeded expectations and provided solid evidence that the company’s turnaround is in on track. With revenue increasing by 17% over the prior quarter and the company’s loss reduced, it seems clear that a bottom has already been reached in the business and results will only continue to improve as the year progresses.

Market Rejects Ramius Capital

Importantly, the market reacted favorably to the company’s earnings report, pushing PTEC stock up nearly 10%, and leaving the share price nicely above Ramius Capital’s recent takeout offer of $5.25 per share.

Interestingly, Ramius Capital had suggested that Phoenix’s turnaround would be a, “difficult and risky operational turnaround.” However, these results seem to show that this prediction was merely a scare tactic, designed to try to acquire the company on the cheap. It appears obvious, at this juncture, given these solid results, that Ramius’s offer will be rescinded. Hopefully, with the ultimate judge, the Market, now providing its opinion, Ramius will allow Phoenix management to get on with their obviously successful turnaround plan, and cease burdening them with unproductive proxy battles.

Outlook Appears Solid

Going forward, Phoenix management remains very confident that sales will continue to increase throughout the year, with significant increases expected in the second half of 2007. Currently, management forecasts $50 million in sales this year, and breakeven during the early part of the fourth quarter, a bit earlier than the original forecast.

This improved outlook, which suggests a $60 million+ revenue run rate by mid-2007, reflects the success of the company’s new sales and pricing initiatives. As mentioned in our initial write-up of Phoenix Technologies (PTEC), the company has fully eliminated the use of fully paid up licenses in the BIOS software business in favor of a more royalty-based pricing model. With these new pricing plans now in place, management has a much easier ability to forecast revenue over the coming 12 months, suggesting that current projections are accurate. Moreover, with Microsoft’s Vista still in the very early stages of its rollout, is seems to us that current estimates may even be slightly conservative.

Stock, While No Longer A Steal, Is Still Attractive

Overall, we still remain very positive on PTEC’s stock, even though the share price has now moved up nearly 20% since the beginning of the year. While the stock is no longer “obviously” cheap, with the price now above Ramius’s takeout offer, we still think the company has significant upside from present levels.

If current forecasts are met, and the company gets back to more normalized revenue levels of $60 million, it’s conceivable, given the very high gross margins of the BIOS business, that PTEC would valued at 3X Enterprise Value to Sales. That would imply a valuation of about $8.50 per share.

However, we expect that once management fully stabilizes the BIOS business, they will seek complementary acquisitions, to beef up the company. This process may take a few years to play out, but given management’s incredible success in other similar endeavors, the odds of a positive outcome seem high and could lead to substantially greater upside than presently suggested by the BIOS business alone.

Please Note: We first recommended Phoenix Technologies (PTEC) at $4.55, and still hold a position in the stock. All ideas, opinions, and/or forecasts, expressed or implied herein, are for informational purposes only and should not be construed as a recommendation to invest, trade, and/or speculate in the markets. Any investments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are committed at your own risk, financial or otherwise.

S1 Corporation (SONE): Banking on a Sale

January 24th, 2007 by Yehuda Fruchter   |   No Comments

Disclosure Note: The price of S1 Corp. (SONE) as of this report was: $5.60. Neither Envoy Global, Inc. nor any of its affiliates currently own shares in SONE. We, or our affiliates, may purchase shares at any time. Please be sure to read our disclaimer at the top of this post.

Introduction
For those of you following the torrid pace of M&A in the past year, you may be aware that software has been a hot sector, especially for those very busy private equity shops. In fact, Bill Burnham over at Burnham’s Beat, counted 32 software acquisitions in 2006, with Private Equity firms accounting for 25% of them. This is up strongly from 11% of the deals in 2005. In this post, we’ll cover S1 Corporation (Nasdaq: SONE), a company that operates within a software sub-sector experiencing intense M&A activity: banking and payment software solutions.

There have been a lot of deals in the financial software space, which provide some convenient comps for evaluating the potential upside and downside in this sector laggard. In addition, the company’s underperformance relative to its peers, in conjunction with some attractive business features, has drawn in an activist hedge fund, Ramius Capital, which has been exerting significant pressure to unlock shareholder value. Some of you may already be familiar with Ramius via one of our top member picks, Phoenix Technologies (PTEC).

Interestingly, Ramius’s pressure has already yielded some positive results, such as a modified Dutch auction and some shake-ups in management and in the structure of the organization. So let’s dig into S1 Corporation (SONE) and see if there’s more value here that has yet to be realized.

Business Summary
What does S1 do? The business description in the company’s SEC filings is now somewhat obsolete, because as of last week, the organization has been reorganized into three distinct operating units. A high-level summary of the business is available right here on the company’s new website.

Basically, the company’s Postilion unit offers software for self-service banking to financial service providers. The Postilion division also includes offerings based on payment processing, which include gift-card processing.

Meanwhile, the S1 Enterprise division (about $110 million in revenue), is focused on providing front-end banking solutions to larger banks. Products include treasury management tools for larger corporate clients of banks, cash management tools for smaller corporate clients of banks, online personal banking tools, teller systems, and call center platforms. The division will also try to sell to insurance companies. State Farm is the only insurance client of S1 at this time, but management feels it can build upon its success with State Farm to attract smaller insurance clients.

Finally, FSB Solutions, a newer unit, is focused on teller and branch solutions and possibly lending software aimed at the branch.

In all, S1 has over 3,000 financial institution customers, the majority of which are located in the United States.

Basic Capitalization Statistics
Following a recent Dutch auction in which SONE bought back nearly 15% of its float for $55M (at $5.25 per share), there are about 60.6M shares outstanding. The balance sheet is clean with adjusted cash of approximately $85 million and zero outstanding debt. At current prices, SONE’s enterprise value is about $260 million.


Financial and Comp Summary
Historically, SONE has not been a profitable company on an accounting basis, primarily due to large depreciation and amortization charges. However, the company has generated positive operating cash flow in the past. Notably in 2002 and 2003, the company reported about $20 million in operating cash flow. Offsetting this cash flow is about $7 million in cap-ex. So overall, the company is currently trading at about 20X EV/Depressed Cash Flow levels.

To really understand the value of this company, though, one needs to recognize that at the core lies a large base of recurring maintenance and service revenue at decent margins. Managed correctly, this type of revenue stream, as opposed to lumpy license revenue, can throw off a large amount of cash on a predictable basis. In fact, it is this mostly stable, and potentially very profitable, revenue stream that attracts private equity to software companies. In the case of S1, the company had about $160 million of this type of revenue in 2005 and for 2006 the numbers look basically the same. Total revenue in fiscal 2006 is expected to come in at about $190 million. So the stock is currently trading at about 1.3X EV/Revenue.

To put these numbers into context, there are two recent deals that occurred in this competitive space. First, The Carlyle Group and Providence Equity Partners bought Open Solutions for $38/share in October 2006. Factoring in the ability of bondholders to convert to stock puts the valuation at about 3x EV/TTM revenue and 10x EV/2007E EBITDA. Then, on Nov. 30, Intuit bought Digital Insight for $1.35B, valuing the company at about 5x EV/TTM revenue and over 15X EV/EBITDA.

These companies had been great performers, and were assigned generous multiples accordingly. Therefore, aside from the fact that the businesses are somewhat different, one can’t immediately apply these multiples to SONE to arrive at a fair value estimate. However, as you can see, growing and profitable companies in the space command a significantly higher multiple than S1 currently sports, leading us to believe there is a lot of room for multiple expansion for SONE in the case of a sale or turnaround of the company.

The People: New Top Entrepreneurial Executive
It has been a bit of a revolving door at S1. James “Chip” Mahan served as Chairman for the better part of the last 8 years, and as CEO from 1995 to 2000. Jaime Ellertson took the helm until his termination in July 2005. Chairman Mahan reassumed the CEO role until his retirement from the company in October 2006. Ramius had been pressing hard for a separation of the CEO and Chairman roles, and they got it: John Spiegel is now Chairman and Johann Dreyer has been appointed CEO as of November 2006. We are enthusiastic about the appointment of Mr. Dreyer as CEO. Mr. Dreyer is a proven entrepreneur and co-founded Mosaic, a company SONE acquired in 2004 for nearly $40m.

Here is Mr. Dreyer’s bio as listed on the IR section of the S1 website:

Johann has 19 years’ experience in the banking technology and electronic funds transfer field and is a founding Director of Mosaic Software, an ATM/POS company that S1 acquired in 2004. Prior to joining S1, Johann started his own company, Software Collage, in 1992, specializing in EFT systems for banking. In 1994, Software Collage merged with Jigsaw Software to form Mosaic Software. In 1999, Johann was appointed Executive Chairman of the Board of Mosaic Software and moved to the U.S. to take up the challenge of establishing the company in the global market. In early 2002, Johann became Group CEO of Mosaic Software. He completed a BCom Honours (cum laude) in Computer Science at the University of Stellenbosch, South Africa.

Upon his appointment as CEO of S1, Mr. Dreyer was offered options for about 450,000 shares at $4.86 per share.

We generally like to invest alongside entrepreneurs who are working with a clean balance sheet and strong options incentives. We are therefore optimistic that Mr. Dreyer can turn things around at S1, or sell the company.

What Went Wrong?
Acquisitions and Bad Execution amidst a Strong Industry Environment
S1 is basically a software acquisition story gone wrong. A good summary of the company’s additional problems was provided by Ramius in various SEC filings, so there is not much reason for us to rehash it.

Let us quote from their proxy:

The Ramius Group believes the Company is substantially underperforming its peers due to a series of operational missteps, poor capital allocation decisions and a failure to capitalize on a range of growth opportunities in the Company’s legacy and Enterprise product suites.

Despite its large installed customer base and the high margin recurring revenue stream that such a customer base provides, the Company has faced significant challenges operating as a stand-alone entity. S1′s share price has declined by approximately 77% from January 2, 2002 to March 20, 2006 (decreasing from $18.00 to $4.10) and S1′s revenues have declined approximately 13.8% from January 1, 2002 to December 31, 2005 (decreasing from approximately $236.7 million to approximately $204.1 million).

The Ramius Group believes management did not allocate appropriate research and development resources necessary to support legacy products, and as a result missed out on growth opportunities in the core community banking sector. In addition, the Ramius Group believes that repeated execution issues on the Enterprise side of the business have resulted in missed growth opportunities in the large financial institution sector, a cost structure that we feel may not be appropriate for the potential revenue opportunity of the Enterprise product family and damage to the Company’s credibility with customers, stockholders and the research analyst community.

What Has Changed?
New Management Initiates a Corporate Reorganization

With its ugly performance in 2005, S1 drew the attention of Ramius Capital, a hedge fund that initiated a position in December of that year but really started loading up in March 2006, around the time that it met with management to discuss the company.
Ramius has been publicly urging S1 to put itself up for sale since that time. The company replied that it would not be prudent to sell the company, and a proxy battle immediately began to take shape as Ramius announced that it would be seeking board representation, board expansion, and reinstatement of the ability for any 10% shareholder to call a special meeting.

The two parties settled in advance of the annual meeting, with the result being one Ramius member gaining a board seat and reinstatement of the 10% rule. Additionally, the company agreed to hire investment bank Friedman Billings Ramsey to explore strategic alternatives. That latter move led to the tender offer, and apparently the retirement of “Chip” Mahan and the hiring of Johann Dreyer as CEO.

In Mr. Dreyer’s short time as CEO he has already consolidated and reorganized the company into three distinctly branded units: Enterprise, Postillion, and FSB Solutions. In addition to helping focus the business, this reorg could certainly facilitate a piecemeal sale of the company’s remaining operations. Investors should get a sense as to the financial impact of this reorganization in coming quarters. We suspect that recent moves will allow the company to both improve profitability and position it for increased sales.

Risk Analysis: Strong Balance Sheet, but Customer Concentration
We view the long-term risk in SONE shares as extremely limited because of the attractiveness of the company’s stable revenue base and clean balance sheet. Specifically, the company has no need to raise money and could operate quite profitably under the right scenario. In addition, the stock is currently trading at a significant discount to M&A multiples in the industry, suggesting that a fair amount of pessimism is already reflected in the shares.

It is also important to note, though, that SONE does have some degree of customer concentration risk. Currently, State Farm Mutual Automobile Insurance, in the Enterprise segment, contributed 25% of total revenues (or about $35m) during the nine months ended September 30, 2006. One clearly needs to take this large revenue stream into consideration when valuing the company.

Return Analysis: Successful Turnaround or Sale

If the company’s efforts to bring down operating costs, rebrand its units and roll out the new Enterprise offering are moderately successful, we believe that S1 will achieve profitability and renewed top-line growth. In this scenario, the shares will trade up to an expanded multiple, more in line with its profitable peers. Short of this success, we view a near term buyout as quite likely, and this would value the company at a premium to the market price.

Conclusion: Downside and Upside Scenarios and Our Position

We note that Ramius bought most of their shares in the low-$4 range, and new CEO Dreyer’s options are at $4.86 per share. Therefore, on the downside we don’t see much risk of the shares going for less than 1x EV/Sales, or about $4.50 per share. In addition, the prospects of a near-term buyout should help to keep a strong floor on the stock price.

On the upside we have two scenarios: a near-term buyout or a turnaround under present management. A buyout in the near term, assuming mediocre results from present initiatives, would likely value the company at a little over 2x EV/Sales, or around $8 per share. The turnaround, for which we will assume zero revenue growth, could bring the company into the 2.5-3x multiple range of its profitable peers; that works out to roughly $10/share.

Assigning each of the three scenarios equal weight gives us an expected value of about $7.50/share, a 30%+ premium over the present share price.

Overall, while we don’t expect any fireworks here, we seem to have a reasonable investment gamble at present prices and a very attractive play at sub-$5 prices. This is surely one stock to keep on your watch list. Our reason for our not aggressively purchasing shares at current levels reflects our desire to buy stocks at near or below key executive option prices. In addition, in situations where there is a re-focusing with a prospect of a sale, one needs to be extremely careful to purchase shares at a substantial discount to worst-case M&A values in order to reap the maximum upside.

Special thanks to Toby Shute for contributing to this post.

Network Engines (NENG) Expands Partnership with Microsoft

January 23rd, 2007 by Yehuda Fruchter   |   No Comments

Back in August 2006, we alerted subscribers to the potential of an expanded Network Engines/Microsoft partnership, following Microsoft’s acquisition of Whale Communications. Today, much to our delight, but not surprise, Network Engines (NENG), released an important PR that actually details an expanded business partnership between the two companies.

According to Microsoft:

“Our expanded relationship with Network Engines ensures that our current IAG customer base will have solid support and service as well as a resource for purchasing and upgrading the IAG-based solutions,” said Mike Schutz, group product manager of the security and access products group for Microsoft. “Network Engines has an established track record of providing appliance solutions and support for Microsoft applications, that when coupled with their advanced manufacturing facilities, Network Engines emerges as a strong choice to support current and future IAG customers.”

We view this news as extremely positive for NENG and we hope to get further clarity on the exact financial impact of this deal when NENG announces quarterly earnings on February 1st. Nevertheless, given NENG’s still depressed valuation, we would still expect the stock to react very favorably to this important new strategic partnership with Microsoft, especially since it provides further evidence on how Network Engine’s (NENG) is slowly, but successfully, growing the Non-EMC business. As we have stated in the past, NENG’s stock should receive a valuation in line with industry-wide multiples, once investors feel comfortable that the company has a more diversified revenue stream. We expect that throughout 2007, the company will establish this broader, and profitable, revenue stream.

Please Note: We first recommended Network Engines (NENG) at $1.88, and still hold a position in the stock. All ideas, opinions, and/or forecasts, expressed or implied herein, are for informational purposes only and should not be construed as a recommendation to invest, trade, and/or speculate in the markets. Any investments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are committed at your own risk, financial or otherwise.

Reviewing the Internap (INAP) Situation

January 19th, 2007 by Yehuda Fruchter   |   1 Comment

The situation at Internap (INAP) is fairly simple: The company is undergoing a major transformation in 2007 due to the acquisition of VitalStream.

Putting aside all the various business justifications for the purchase as detailed in Internap’s S-4 filing, the primary reason for the acquisition, as we have stated in the past, is that Internap and VitalStream management are attempting to provide Wall Street with an alternative to Akamai.

And who can blame them? With Akamai trading at approximately 35X+ Enterprise Value (EV) to 2007 EBITDA and over 15X EV to 2007 Sales, a successful competitor could seemingly see a significant appreciation in its share price.

In the case of Internap, post the VitalStream purchase, the company is looking to have about 50 million shares outstanding, $240 million in 2007 revenue, $35 million in EBITDA, and about $100 million in net cash. Putting that all together and applying an Akamai-like valuation to the business (ex low-margin revenue streams), implies a potential upside target to Internap (INAP) of between $25 – $30 per share.

The question, of course, is whether Akamai’s, seemingly obscene, valuation is at all sustainable? Unfortunately, nobody has an answer to that question, which is why we caution that investors in Internap prepare themselves for continued volatility in Internap’s (INAP) stock price over the next year.

As for us, we’re holding onto our INAP shares, primarily because we’re optimistic on the IP Services/Managed Hosting sector over the coming years, and we see little reason for a sustained collapse in share prices. We also suspect that INAP’s numbers in 2007 could exceed the above estimates, given management’s propensity for conservative financial guidance. At the same time, the high valuations throughout the sector (i.e. AKAM, EQIX etc.), suggest that share gains in 2007 maybe more subdued than in past years.

Please Note: We first recommended Internap (IIP) at $4.00 per share, and still hold a position in the stock. All ideas, opinions, and/or forecasts, expressed or implied herein, are for informational purposes only and should not be construed
as a recommendation to invest, trade, and/or speculate in the markets. Any investments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are committed at your own risk, financial or otherwise.

A Buyout Battle Looms at Phoenix Technologies (PTEC)

January 17th, 2007 by Yehuda Fruchter   |   5 Comments

If you’ve been following Phoenix Technologies (PTEC), one of our top software turnaround picks, we’re sure you noticed that yesterday Ramius Capital offered to purchase PTEC for $5.25 per share, a 15% premium to our purchase price for the shares back in November 2006.

Today, Phoenix management soundly rejected the Ramius offer. What we found interesting about the refusal of the buyout proposal was that Ramius actually considered offering a slightly higher price for the company.

As PTEC management says:

“We have reiterated to you on several occasions our Board’s confidence in the Company’s potential to yield significantly more value to stockholders than your proposed offers, including your revised offer of $5.30 per share made verbally last week and the $5.25 per share offer made today. “

The implication is that Ramius has been pretty active with regards to PTEC and they are not finished here yet. Shareholders can look forward to an interesting hedge fund vs. management battle in the year ahead.

As for us, we’re holding onto our shares of PTEC and we would be buyers on any dip. We are not surprised that management has refused to accept the Ramius offer. New CEO Woody Hobbs has only come to PTEC recently and has clearly not had enough time to make much of an impact, even though he has already implemented several significant restructuring actions.

Given that the vast majority of Mr. Hobbs incentive options are at about $5 per share, we hardly think that the 5% return will be enough to appease this proven software executive. We remind investors that the last company Mr. Hobbs took over, subsequently rose by nearly 500% after he turned it around and sold it to Nokia. And while we’re not expecting that type of return in the case of PTEC, we surely think the company could be worth far more that $5.25 per share when BIOS revenue begins to recover over the next 12 to 18 months.

Please Note: We first recommended Phoenix (PTEC) at $4.55 per share, and still hold a position in the stock. All ideas, opinions, and/or forecasts, expressed or implied herein, are for informational purposes only and should not be construed as a recommendation to invest, trade, and/or speculate in the markets. Any investments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are committed at your own risk, financial or otherwise.

Isolagen (ILE) Update

January 16th, 2007 by Yehuda Fruchter   |   No Comments

Our timing into Isolagen (ILE) has sure been bad and the stock remains one of our worst performers. However, we still remain optimistic about this biotech over a 3-year time horizon, even if the prospects of additional financing actions may put pressure on the stock for some time. In this post, we’ll update you on some of the more important events related to the Isolagen (ILE) situation.

The UK Experience
Soon after our write-up of the Annual Meeting, ILE announced the closure of its UK facility to focus exclusively on the US market. We view this development as very positive, because the UK operation was draining cash from the company and there were serious execution issues. A recent article in the UK tabloid Daily Express perhaps best summarizes the UK failure. Sure, this was a hatchet job, but we think it gets to the core of the business failure:

“Richard Arnott, Isolagen’s UK sales director, said the company had sustained massive losses because the process of growing and storing cells was expensive. The success of the treatment, he said, depended on the skill of the doctor who administered it.”

The rest of the article is not really worth quoting, but you can follow this link for more juicy details.

Our take: Failure is at times a prerequisite for success. We believe that ILE management has learned many valuable lessons from the UK debacle, which they will use to increase the odds of ILE’s success in the US Market. Notably, in advance of any FDA rulings, ILE has already hired experienced manufacturing executives to help lower the company’s costs of production and storage.

JPM Presentation and What To Look For in 2007
Surely enough, both cost of goods and physician training are issues cited by Isolagen itself in the CEO’s recent presentation at JPMorgan’s Healthcare Conference. This is our second notable event. If you are just joining the story, the JPM Presentation is a good way to get yourself up to speed on the state of the company (in combination with our previous write-ups). A PDF of the presentation is available by clicking here.

Of particular note, the key near-term milestones, which may drive the stock price over the next year or so, are identified on slide 32:

Clinical Milestones
•US “wrinkle study” fully enrolled—all subjects receive all injections—move program into data collection phase.
•Seek protocol acceptance/ initiate full face aesthetics study
•Negotiate best outcome with FDA so to start burn & acne scar clinical programs
•Finalize dental program strategy

Operating/Business Milestones
•Launch Agera® Business successfully
•Continue to improve cost efficiency and quality in manufacturing process
•Finalize UK closure
•Sell Swiss facility
•Complete capital structuring plan
•Make decisions on potential acquisitions/collaborations/partnerships

These bullet points give us the best outline of what developments to anticipate in 2007. We think that aside from positive clinical trial results, potential near-term upside is hidden in both the Agera roll-out and in acquisitions/partnerships which, judging from the language used in the slide, are in process but not yet finalized.

We should note that the company’s estimates for the potential of Agera are well beneath our assumptions, and as such we have tempered our enthusiasm for this product line. It’s difficult to understand the rationale for Agera, unless one assumes that ILE will make other acquisitions in the non-FDA approved product area.

Implications of the Recent Financing
As you may already know, a shelf registration is in the works for ILE and the company announced that it will be looking to raise up to $50M after it files its form 10-K in March. With a present market cap of $80M, current shareholders can expect some serious dilution. The funds are ostensibly being raised “for working capital and general corporate purposes,” but we take that to mean acquisitions. We view this financing as a painful, but necessary step in the company’s turnaround.

The Valuation
We are no closer to nailing down a specific valuation of this stock, and we would note that valuing biotechs tends to range from extremely difficult to nearly impossible. Subscribers should also note that in our original writeup we cautioned that in the worst case ILE could easily go to $0.

However, we would also point out that when Mr. Teti, the new CEO and Chairman, was brought in to turn ILE around he received options with a $1.88 strike price. We view this as a floor for the stock price because we still think it is doubtful that someone of Teti’s stature would have joined this tiny company without expectations of significant upside. Therefore the closer we get to his option price level, the more bullish we will feel about these shares, provided that no serious setbacks occur in the interim.

On the upside, we would note that biotechs can be sold for seemingly astronomical sums, even when there are negligible historical sales. The reason for this is that if trials prove successful there is no need per se for a biotech company to actually generate any sales as a potential buyer could generate significant revenue for new products via existing sales channels. With the potential for three late stage, i.e. Phase III, products, representing very large market opportunities, in ILE’s portfolio by year-end 2007, the company seemingly has enough in the pipeline to generate significant interest from larger pharmaceutical companies and at the same time cushion the impact of unfavorable results in one particular product line.

In sum, we still view ILE as a very interesting opportunity for those willing to hold on for the ride over the next 2-3 years as ILE brings its pipeline of therapies to market. The short-term bumps can be difficult to stomach, for sure. This situation once again reinforces our contention that a well-diversified portfolio is the only way to go when dealing in volatile microcap stocks.

Special thanks to Toby Shute for contributing to this write-up.

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