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Furiex Pharmaceuticals

Furiex (FURX) is an interesting place to start looking for an investment opportunity. Joel Greenblatt writes in his book, You can be a Stock Market Genius too, that spin-offs of small companies from much larger companies can often create great value situations. This is because often the original shareholders are not interested in owning this business outside their area of interest or due to the fact that many ETFs and mutual funds are limited by their prospecti to invest only in companies of a certain size. Furiex is much smaller than its parent (Market cap of 110 million vs. 3 billion) and is also in a different industry, or at least investor class. As I will talk about later its entire revenue stream is from future prospects vs. the stable cash flows of PPD inc. the parent company.

Furiex is a recent spin-off from PPD inc. the drug manufacturer. FURX was a small internal division which assisted drug development by speeding up the time it takes to get drugs to market. Basically FURX would partner up with a large drug manufacturer like Janssen and would run many trials simultaneously (such as state I and stage II trials, assuming stage I success to speed up the process). This would help companies like Janssen get their new drugs to market much faster than they could have done on their own. In exchange for this help, FURX would get paid based on advancement down the drug pipeline phase, called milestone payments. These could be trigged when a drug goes from stage I to stage II, when it is approved for marketing in a new country or is sold in a new market. They also get royalties, which are a percentage of total sales (normally 10-20% depending on volume) of any drug they helped develop that is successfully brought to market.

Currently FURX only has 1 drug it has developed in any actual market, and that is Priligy in the European market. Priligy is a drug designed to help men with premature ejaculation (side note: it’s always fun to research premature ejaculation drugs when your roommate is walking by). It has been in development since 1998 and management first tried to bring Priligy to market in 2004. The FDA did not approve the drug and the testers, including FURX, went back to the drawing board. It is currently in stage III trials again and will hopefully be brought to the NA market soon. Priligy is selling in Europe however and thus is bringing in small amounts ($230,000 in Q1) of revenue due to royalty sales.

FURX also has a few other drugs in the pipeline that they are entitled to milestone and royalty revenue for, including a type II diabetes drug that in the marketing application stage in the US and was recently approved for marketing in Japan. Here is a link to an image from FURX that shows the different drugs FURX helped develop and where each is in the different stages of worldwide development Drug Development Stages

So basically what all this means is that FURX currently has almost zero current income but a lot of future potential. The interesting part is the valuation. There are approximately 10 million total shares of FURX floating around at a price of 11.60 for a valuation of 116 million. The company has about 7 million in total liabilities, and as part of their spin-off agreement from PPD, 100 million in cash. So their net cash value alone is 93 million, putting the value of all their royalty and milestone claims at only 23 million. This seems quite cheap for a company that can possibly hit a homerun with a large drug and be entitled to hundreds of millions in royalty revenues.

However there is a catch. Extrapolating Q1 numbers, FURX burns through about 32 million a year in research and development costs. This is used for the development and trial of new drugs, the income streams of which might not be realized for many years, if ever. So it is possible FURX begins to burn through their 93 million net cash position. Because of this I feel more comfortable waiting 2 weeks until they report their Q2 numbers, to see if perhaps the sales of Priligy have increased in Europe, to see if maybe they can give a bit more color on the success of the stage III trials at the FDA and to see when they expect their diabetes treatment to reach the Japanese market. This is an intriguing story and one I intend to keep my eye on.

Side note: According to Greenblatt, another important thing to examine in these types of plays is if new management is taking a stake in the new company. This is another positive as upper management (although FURX only has 25 employees total) are each getting stock options for about 1%-2% of the entire company. While dilutive, this aligns their incentives with those of investors.

Yesterday WDC came out with their Q4 and year end 2010 numbers. Overall it was a disappointing quarter with revenue coming in light due to a lower average selling price of $49 per drive down from $53 in the march quarter. For the year the ASP was $50 per drive which is in line with historical numbers of $51 per drive. Yet WDC increased the number of units sold to 194 million for the year, a new record. Management guided that they expect total unit sales to grow between 10-15% yearly with revenues to grow at 5.0% to 7.5%. This is in line with my model in which I predicted 6% revenue growth for 2011 through 2013.

I did make a few small changes to my model. Management provided guidance on their expected margins in the short and long term. The range they gave was 18-23% which is consistent with my long term expectations (and the historical avg of the past 5 years) of 20%. However due to inventory buildup from the previous quarter back to the historical average of 2.5 weeks, the coming 6 months should see somewhat reduced margins. As well, due to the acquisition of Hoya, long term margins should increase by 50bps once integration is complete in a years time. Therefore I am decreasing the coming years gross margin to 19% and increasing normal continuing margin to 20.25%. My forecasted EBIT margins of 10-12% are also within management’s long term guidance of 8-14%.

In the end while this wasn’t a stellar quarter, the small amount of oversupply in the industry should work itself out in the next quarter or two and doesn’t change the long term story of WDC, namely, an undervalued company that generates high levels of free cash flow and is gaining market share year after year. Therefore I am leaving my price target unchanged with a true worth of about 15 billion.

Oshkosh:

Oshkosh is a designer and manufacturer of specialty vehicles and equipment for industrial and military use. The company operates in 4 segments. The following is from the company’s latest Q10 with my comments added in parentheses.

Defense — heavy- and medium-payload tactical trucks and supply parts and services sold to the U.S. military and to other militaries around the world. (Formerly about 25% of sales, now 50% of sales as they have a big contract to make mine resistant ATVs for the Afghanistan mission).

Access equipment — aerial work platforms and telehandlers ( basically a forklift/crane combination) used in a wide variety of construction, industrial, institutional and general maintenance applications to position workers and materials at elevated heights. Access equipment customers include equipment rental companies, construction contractors, manufacturing companies, home improvement centers and the U.S. military.

Fire & emergency — custom and commercial firefighting vehicles and equipment, aircraft rescue and firefighting vehicles, snow removal vehicles, ambulances, wreckers, carriers and other emergency vehicles primarily sold to fire departments, airports, other governmental units and towing companies in the U.S. and abroad, mobile medical trailers sold to hospitals and third-party medical service providers in the U.S. and Europe and broadcast vehicles sold to broadcasters and television stations in North America and abroad.

Commercial — concrete mixers, refuse collection vehicles, portable and stationary concrete batch plants and vehicle components sold to ready-mix companies and commercial and municipal waste haulers in North America and other international markets and field service vehicles and truck-mounted cranes sold to mining, construction and other companies in the U.S. and abroad.

As you can see, 3 out of their 4 business segments are dependent on healthy state and municipal budgets or construction spending. I am of the opinion that we are going to have ongoing problems with the general economy for some time and these businesses will suffer. Housing and construction is still contending with a supply overhang, therefore there will be little demand for their commercial products. As well, state and municipal budgets are stretched thin with tax revenues having decreased in the past 2 years. I believe that these local governments will have to cut costs further and thus will not have money in their budgets for new firetrucks, ambulances or snow removal. Therefore I am very pessimistic about much of Oshkosh’s business units.

Their one business unit that is doing well is defense. They are more than half-way done completing a large Department of Defense (DoD) contract for M-ATVs, or mine resistant ATVs for Afghanistan. This lucrative contract is responsible for the company’s record second quarter earnings and their inflated TTM earnings. The company is currently trading at a P/E ratio of only 4.6 and in the first 6 months of this calendar year generated Free cash flow to the firm of 800 million. 800 million of cash flow on an enterprise value of 3.56 billion is quite impressive and normally an instant buy for me. But I’m not convinced how high these cash flows will be after this contract runs out.

According to the company’s latest Q10 filing, in the latest quarter the company delivered 2900 M-ATVs to the DoD so total units shipped to date is now up to 5465. The DoD ordered 8,079 units in total. The company expects to deliver all the remaining M-ATVs by the end of September, 2010. After this there is no guarantee that OSK will get more orders or business in a different product from the DoD. Although they did recently win an 800 million contract for a different product (currently being contested by the losing bidders) this will only go a small way to replace the lost revenue once the main contract runs out.

One positive of OSK is that they have greatly reduced their debt. During the recession the company almost folded as a large acquisition of JLG in 2007 left the company saddled with an additional 3.1 billion in debt at the worst possible time. However, the company has used a large portion of available FCFF to repay that debt, reducing its total long term debt load from 3.1 billion in 2007 to 1.6 billion today. This level is much more manageable and should reduce interest payments from 210 million a year to 120 million a year assuming they maintain 1.6 billion in debt going forward (they may reduce it further). This reduction in debt should also reduce the cost of equity to the firm, as their beta using historical data is 2.8 yet using the unlevered beta of their competitors and releveraging for OSK’s new D/E ratio their beta is reduced to 1.42.

Trying to determine what they make going forward I looked at their free cash flow from 2007 and 2008 of 450 million. Taking out the interest payments of 120 million they should generate FCFE of about 330 million going forward. However I think the next few years might be leaner than 2007 and 2008, when municipalities and states already had orders in place before the recession crippled their budgets. Therefore I feel the company will not make those numbers in 2011 and 2012. I will keep my eye on OSK but given my macro outlook I don’t believe it is the right time to invest in this company. Should the story change in the future I will do a more comprehensive analysis and post it here.

China Education Alliance (CEU):

China Education Alliance, founded in 2004, operates in the online and on site education industry in China. The primary users are elementary and high school students (aged 6 to 18) who wish to receive addition prep and test materials. The company’s website offers a comprehensive database of practice materials written by teachers and purchased by CEU. Students access this information by paying via charge cards sold by the company. Last year CEU sold 3 million charge cards with the average balance being 50 yuan. The company employs over 200 traveling salespeople to promote this business by offering on site demonstrations.

As well, the company offers onsite training to its students as a separate business. Most students sign up for one or two classes at a time in particular subjects, such as math or English. These classes are only offered on weekends. Because of the different amount of classes taken by each student it is difficult to examine tuition paid per student, as management does not report total enrollment. However information can still be gleaned on the health of this business segment by examining the overall sales from this division as well as the gross margin.

Recently the company expanded into offering vocational training which is designed to help students who want a real world education and experience for an immediate job. This expansion has been successful as total training center revenues have increased from 21% of sales in 2007 to 33% of sales in 2009. This growth continued in the first quarter of 2010.

Finally the company earns revenue from online advertising on its main site. This is managed completely out of house by an ad agency with CEU keeping half of the revenue. This segment has not shown any growth in the past few years and thus has become an increasingly less important part of the company.

Industry Analysis:

It is estimated that the online education market in china saw total sales of 1.36 billion USD in 2009. This number is expected to grow between 25-30% over the next 3 years. The vocational market, of which CEU is increasingly involved in, is expected to hit 2.8 billion USD in sales by 2012. The industry is extremely fragmented with many companies yet no big player dominating. Consolidation should continue in the next few years with CEU themselves saying in the last conference call that they are always looking for deals, with 2 potential deals currently in the pipeline. Margins in the industry should continue to be high for the near future along with high rates of return on capital for new investments in online education and onsite vocational education. This can be seen by CEU’s 80% gross margin of the past 2 years and 40% NIM.

Management Analysis:

Corporate governance practices at CEU are weak. The CEO Mr. Xiqun Yu, is also the Chairman of the board. He has worked at the company since its inception and his background is technology based. The CFO received his CPA and MBA from Universities in the United States and began working at CEU in the summer of 2009. There are 3 independent board members who, in addition to the CFO and CEO, comprise the entire board. The same 3 independent members comprise the audit, compensation and nominating committees. This poses obvious problems, one of which can be seen in the total number of new share issuances and stock option grants over the past few years. However for the year ended 2009 and the first quarter of 2010 the company did not grant any new warrants to its employees and appox. 100,000 warrants remained outstanding (out of 31 million shares issued). The company also granted 442k options to employees last year which will vest over 3 years. The average price of around 3.11$ per share is below the current price. The company accounts for the cost of the options issuance using the black scholes model on their income statement in the year of issuance, yet these dilutive actions are still cause for concern. In regards to further dilution, in Q1 of this year the company issued no options and promised not to issue new shares for the year in response to a question about funding acquisitions.

In conference calls management does not always give reasonable answers to questions. They tend to stick by their original forecasts and promise they will achieve growth numbers without providing ways to accomplish this. In a recent conference call when asked about the 5% y-o-y sales growth in Q1, which was below the management supplied growth forecast, they replied it was due to seasonality of Chinese holidays. Obviously these holidays would have affected the comparable quarter of 2009.

Balance sheet:

CEU has an immaculate balance sheet. The company has 69.5 million in cash and equivalents along with 2.7 million in prepaid cash (charge cards) comprising current assets and only 1.7 million in total liabilities. Along with 9 million in long term assets the company has shareholders equity of 79.3 million and net cash of about 68 million. This net cash represents about half of the market value of the company and acts as a nice cushion for an absolute bottom. Since this cash position is so large it is probably worth discussing what the company intends to do with the cash.

Uses of cash:

In the most recent conference call, management explained that they have no current plans to issue a dividend or begin a share buyback program in the near future. Instead the CFO explained that they intend to use the cash in the following rough breakdown. 25% for sales expansion (which I assume is marketing and hiring of new salespeople), 25% for new acquisitions, 25% for fixed assets (which I assume is to buy more test material and expand and build new learning centers) and the final 25% to remain as working capital. Management also stated that they currently have a few deals in the works, but note that they will not go past their target of a PE ratio of 7 when buying a new company. This upper limit on the multiple has been restrictive in the past year but with the current correction in the Chinese market management may find more opportunities.

Valuation:

Sales growth rate: Management was very adamant during the Q1 conference call that despite Q1 sales being only 5% higher y-o-y, they will still achieve sales growth and net income growth of 30% in 2010 over 2009. This, coupled with the fact that the entire industry is expected to grow at a rate of 26-30% over the next 3 years led me to use the company’s guidance of 30% for this year and the following 2 years for the education center and 25% for the next 3 years for the online portion of the business. This would continue a trend that has seen the education center become a larger and larger part of total sales over the past 3 years, rising from 21% in 2007 to 33% in 2009. After that I used a growth rate of 15% for 2 years before using a terminal growth rate of 4%, which I consider to be China’s long term GDP growth rate. The previous numbers were used both for the online education and on site education portion of CEU’s business. Advertising revenues were held steady at the same level as 2009. This is because the company has no control over these revenues and they seem to have stabilized from 2008 to 2009.

Gross margin: Gross margin for the past 3 years has been steady around 80% rising from 79.56% in 2007 to 80.08% in 2009. Q1 2010 saw a gross margin of 79.3% and management explained that this number should rise during the year. Therefore I will forecast growth margin to be 80% going forward and for it to continue at this number for the next 5 years.

Administrative costs: These costs have fluctuated greatly in the past 3 years. The main reason for this is the varying degree of expenses due to options granted in the past 3 years. I have used the average cost of 13.3% of sales over the past 3 years as the rate expected to continue into the future.

Selling expenditures: Selling expenditures relate to advertising and salaries of the salesmen who go around promoting the online products of the company along with the salaries of the teachers at CEU’s education center. Therefore this is where much of the organic growth is generated. Management has forecast selling expenditures to be 25-30 % of sales for 2010. I used the high end of the range since it makes sense for selling expenditures growth to be proportional to future sales growth. Therefore 30% of sales is the estimated cost going forward.

Tax rates: The tax rate is a weighted average of 15% on the internet portion of the business and 0% on the education center which is tax exempt. This should continue indefinitely.

Depreciation and Amortization: This number is expected to be constant as a % of sales going forward since the company intends to grow both through organic growth and acquisitions which will require more PPE spending on items such as test papers and opening of new education centers. Last year’s number contained amortization of intangibles but with further acquisitions coming, this should occur again for the foreseeable future. Therefore I have used the average rate as a percent of sales over the past 3 years of 3%.

Other income: Other income is not addressed in the annual reports or by management during conference calls and has decreased significantly over the past 3 years. Thus I will assume after 2009 that it will not reoccur. Interest income is forecast to be 4 times the amount earned in Q1 2010 and then is assumed to not reoccur as management has earmarked this money for expansion and investment in CapEx.

Discount rate: Using 5% as the equity risk premium, 1.88 as the beta and 3% as the risk free rate, the cost of equity is 12.4%. This is in line with findings that the Chinese stock markets in general have equity risk premia of 8-9% so 1.88 x 5% = 9.4% which is within normal. Since this company has no debt financing the cost of equity is the same as the cost of capital. Due to my discomfort with management and their predictions of future sales and net income, I also used a higher discount rate of 15% on net income to come up with a calculation of the PV of the cash flows. Using the discount rate of 12.4% along with the terminal growth rate of 4% we get a PV of 228 million. Using the higher discount rate of 15% we get a PV of 207 million. Both of these estimates are well above the current market cap of 128 million.

Some issues and final thoughts:

There are some reasons why I passed on this company the first time I analyzed it. The company has been pretty liberal in the issuance of new shares in the past. They have used share issuance as a method of paying for their legal work, to acquire new companies, and to pay management. Total shares outstanding grew from 21.9 million at the end of 2008 to 31.6 million at the end of Q1 2010. Finally this quarter management made it clear that they will not be issuing any more shares or options for the rest of this year. I will see if they hold true to this promise and if they break this vow it might be an early warning sign to bigger problems down the road, such as making unrealistic sales and NI growth projections.
This investment is not for the faint of heart. It is unlikely that we will see any sort of distribution of excess cash to shareholders in the near future, so all of the income from this investment will have to come from share appreciation. As well there is no foreseeable catalyst other than increasing earning, but this may be enough to attract investor attention and increase the share price. I ended up buying shares around 4.30 because it seemed cheap enough with enough cash on hand and high growth prospects that I couldn’t pass. But I did use a 15% discount rate due to the above factors. Therefore I will use the more conservative market cap target of 208 million as a price target.