Wednesday, September 28, 2011

Cantel Medical Keeps Growing

Cantel Medical has been a good stock to hold so far in 2011, closing today at $21.28, up 30% from $16.38 a year ago, with a 52 week high of $28.29 and a 52 week low of $15.57. Not a bad showing in this tough market. Cantel is not a household word, so I thought I'd fill in my readers on what they do and why they might want to own a piece of this company.

Cantel Medical is a smallish company (market capitalization today ended at $366 million). Cantel specializes in infection control through sterilization and disposables. I know that infection control is more cost effective than treatment, and is becoming a much larger problem because of the evolution of multiple-antibiotic resistant bacteria. I watched Cantel for a while, then bought stock a couple of times when I thought the valuation was good.

Cantel is not a well-known name, even in hospitals, partly because it operates through named divisions. Minntech makes and markets endoscope and dialysis equipment sterilizers. Crosstex is the disposables business, working mostly in the dental market, but also moving into the general medical market. It makes face masks, sterilization patches, and other single-use items. Mar Cor makes machines to purify water, often for specialized medical needs. A smaller division is Saf-T-Pak, which produces specialty packaging for transporting specimens, and related materials.

When there are infectious disease scares Cantel gets bursts of extra revenue, so in evaluating the stock you might want to both zero-out such bursts to get a real trend line, and also figure that over time those bursts do add up.

Also, while Cantel does develop products and grows by increasing sales organically, they also grow by acquisition. If you, like me, have been burned occasionally by the poor acquisition strategies of other companies, you might not take this as a recommendation. However, for the few years I have followed Cantel they have done very well with acquisitions. They don't pay too much and they usually acquire a division of a company they want, rather than the whole company. Then they cross-sell the new products with their established sales force.

The latest acquisition was of Byrne Medical, announced August 2, 2011. Byrne manufactures products that act as replacements in gastrointestinal endoscopy procedures, eliminating the need for sterilization before reuse. The price of $100 million for a company with trailing annual revenues of $38.6 million seems high on a revenue basis, but trailing annual pre-tax profits were $8.6 million. Cantel expects to increase gross margins in the business, which has a historical growth rate of over 20%. The business is expected to be accretive over fiscal year 2012 ending July 31, 2012.

Since Cantel is already in the endoscopy business, cross-selling is a given. The combined endoscopy businesses will have 80 sales and marketing personnel. Acquiring Byrne is the largest transaction in Cantel's history. Even before the combination Cantel's recent endoscope sterilizer equipment sales had been ramping rapidly. The newer sterilization machines are called reprocessors; they do helpful things like inventory management that the aging machines can't do.

Meanwhile, the water purification business just keeps growing. Also the disposables business should ramp up when (of if) the unemployment rate tweaks down. People have been avoiding doctor and dental visits for economic reasons; when they have the dough to head back in for a checkup, the run rate will pick up again.

So, in summary, the overall anti-infection story is a good one. Cantel is a pure infection play, and it has top-notch management. Should you be cautious because the stock is up 33% y/y? My guess is that even in the short term the stock could make another run for its 52 week highs, if the overall market firms up. The trailing P/E ratio at the end of today was 18 (per NASDAQ), which is still reasonable for a company with a strong growth track record. Today's ending price seems fair to me and attractive for long-term investors looking for diversification in the healthcare space.

For more details on last quarter's results, see my Cantel Medical Q3 fiscal 2011 analyst call summary.

Disclosure: I am long Cantel, and have no plans to buy or sell in the next 2 weeks.

Thursday, September 22, 2011

Red Hat at Billion Dollar Run Rate

Red Hat (RHT) is poised to become the first open source software company with a billion dollar per year revenue run rate. Yesterday Red Hat released fiscal Q2 (ending August 31) revenue of $281 million, up 28% from the year-earlier quarter.

The alleged slowdown of the American and global economies has had little effect on Red Hat. This may partly be from the dollar store effect: Red Hat Enterprise Linux, or RHEL, is a much less expensive operating system than its main rivals, UNIX and Windows Server, yet is roughly as capable. Management, however, attributed the revenue growth to an expanded sales force and an expanded line of products to sell. The main products sold in addition to RHEL, are JBoss, their middleware product, and RHEV, their virtualization product. Also, as major customers expand their datacenters, they pay more for the number of copies of software necessary to operate the new hardware.

RHT is a great example of the power of patience, and of the importance of avoiding buying anything in a bubble. Founded in 1993, and going public in 1999, it was caught up in the Internet Bubble, almost immediately reaching a share price of over $100 (implying a market capitalization of over $20 billion) despite being unprofitable and not even generating very much revenue at the time. After the bubble burst you could buy RHT for less than $4 per share.

Despite the crazy pricing swings of the stock, the underlying company kept at its mission of providing an enterprise-quality version of Linux. As years passed revenue grew, and even profits began to accumulate. The last time you could buy RHT cheap was around November 2008, when it was around $10 per share. Today it closed at $41.52.

Right now it is a good stock to hold, but the price-to-earnings (P/E) ratio could scare off many potential investors. At a time when many technology stocks showing revenue growth are trading at P/E's under 20 or even under 15, Red Hat has a (non-GAAP) trailing P/E of 70 and 1 year forward P/E of 54. That is partially justified by the rapid rate of growth; the danger would be if the rate of growth slowed.

I believe Red Hat software offers a tremendous value proposition for enterprises. While revenues are dwarfed by Microsoft Windows Server revenues ($5.9 billion in Q1 alone), and many companies have already converted from UNIX to Linux, the fact that Red Hat has such a small portion of the $50 billion annual server operating system market leaves plenty of room for growth. RHEL also competes with free Linux distributions. Given the staffing it takes to run a free Linux at the enterprise level, TCO can be cheaper when businesses pay for RHEL and the support services that go with it.

I expect Red Hat will continue to do well as a company. Since its product is software, it has high margins and earnings tend to grow faster than revenues. For Q2, GAAP earnings grew 67% over the year-earlier quarter, but it was an exceptional quarter.

Disclaimer: I don't own Red Hat and have no intention to buy or sell it in the next 3 days.

See also:

Red Hat home page
Red Hat investor relations page
My main Red Hat page
My notes on the Red Hat Q2 analyst conference

Monday, September 19, 2011

AMD at the Earnings Crossroads

AMD (Advanced Micro Devices) has only two competitors in its niche: Intel (INTC) for CPUs (computer processing chips) that run x86 software and NVIDIA (NVDA) for GPUs (graphics processing chips). How much market share it takes in the PC chip market, and what margins it receives on the chips it does sell, determines its levels of revenue and profit or loss.

Historically, while AMD has been innovative, it has come in a far second against Intel and NVIDIA. In the last two years it has lost ground to Intel and gained ground from NVIDIA. The picture has been complicated further by the emergence of ARM architecture based processors as the preferred basis for smaller mobile devices like smartphones and tablet computers.

After years of development (usually corresponding to quarterly earnings losses) this year AMD is selling chips that combine a CPU and a GPU. Intel, also, has appended graphics to its new line of CPUs, but their chips are remarkably inferior, incapable of running the current Windows graphics standard, DirectX 11. As a result AMD has been selling all the Fusion chips it has been able to make.

Why then, the lack of excitement and lack of upward momentum in AMD stock? Today AMD closed at $6.92, well off its 52-week high of $9.58 and with an astonishingly low P/E ratio of 6.4, the kind you would expect from a declining industry stock.

For the moment the most visible cutting edge technology is in smartphones and Apple and Android based small tablets. That pretty much sums up tech investor thinking about AMD: that a tidal wave of 7 inch screens are going to replace PCs, including both notebook computers and desktops that can run 60 inch displays.

Let's say you have discovered the limits of small screen computing and think there is still life left in the larger form factors. How should AMD be priced then?

First—even if the economy lags, even if consumers are careful with their holiday electronics purchases, even if the economies of India and China don't grow quite as fast in 2011 as they did in 2010—in Q3 and more so in Q4 AMD will get a significant boost in profits from its new Bulldozer CPUs for the server market. They began shipping in quantity earlier this month, with most of the early allotment going directly into the supercomputer market, where they will replace, or fill empty slots in, the prior generations of AMD Opteron processors. Profit margins are better for server chips than for PC chips. AMD has lost a lot of market share to Intel in server chips these last five years. The new chips should help regain market share. They have a different architecture than the Intel chips, and hence are very cost effective at certain workloads. Bulldozer is not a conquer-the-world chip, but it will keep AMD in the most profitable part of the server CPU game.

On the down side, there are so many rumors about yields (% of good processors on a die) being poor for the Fusion chips, that I think it is fair we can treat the rumors as true. At the next AMD analyst conference there should be a question about that. At the Q2 conference the closest answer we got was that margins were good on the Fusion chips. If both are true, and AMD was right about 2nd half margin improvements, then what we have is upside potential. Yields usually improve over time; if margins are already good, they should be great when yields improve. The problem was doubtless forging the CPU and GPU on the same die; traditionally these chip types used different silicon technologies. Bulldozer yields are rumored to be good, but then these server chips don't have a GPU component.

For now I would take Q3 guidance as a fair range. The economy might push revenues down, but yield improvements could push margins up. Guidance was for Q3 revenue to increase 8 to 12% sequentially. Note that because of holiday demand, Q3 is typically the strongest quarter for AMD.

The numbers, when reported, give us hard data, but the technology trends rule long-term value. I think AMD (and for that matter Intel) are over-discounted. I think both will be taking market share in the tablet market in 2012 and 2013. I think the PC market will stay healthier than most pundits predict. Consumers and businesses who skipped a desktop or notebook upgrade to buy a tablet and smartphone will get back on the upgrade cycle.

The combination of full-powered GPUs and CPUs on a single chip may be more revolutionary than the smartphone. Essentially, we are introducing desktop (or even notebook) parallel supercomputing. We are just beginning to see software applications that utilize either a CPU plus separate GPU or the new Fusion chips. So watch for companies like Microsoft, Adobe, and Autodesk, as well as lesser-known companies and startups, to take advantage of this new paradigm.

Disclosure: I am long AMD.

Thursday, September 8, 2011

Dendreon Restructuring Call

Mitchell H. Gold, MD, Dendreon's CEO, led a analyst conference call to discuss restructuring plans. This follows the month-earlier announcement that Provenge sales were ramping slower than expected.

About 500 employees are being laid off, out of about 2000. Restructuring costs are estimated at $21 million, including $5 million in non-cash stock-based compensation.. Savings from restructuring are estimated at $120 million per year. Most of these employees were in training to be ready to meet the (previously expected) demand ramp. Presumably if demand accelerated again they would have to be rehired, and the savings would not accrue.

For most mid to long term investors the key question is long term demand. Revenues for August were reported at $22 million, up 16% from July, which would put July around $19 million. Given a similar $3 million ramp in September, Q3 income would be $66 million, but management stood by its refusal to guide on revenue other than to say that it expects it to ramp slowly quarter by quarter in the immediate future. $66 million is up 32% sequentially from $50 million in Q2, which would be tremendous had expectations not been raised so high earlier in the year.

Approval of Provenge in Europe was painted as a 2013 event, so no revenue help there is likely until 2014.

Analysts' questions went every which way at management's statement that $500 million in annual revenues, or $125 million per quarter, would get Dendreon to cash-flow break even (but not to GAAP profits). They also believe they have enough cash to reach that point. They had $674 million in cash at the end of next quarter, and $600 million on August 31. Cash use should decline now that the 3 Provenge facilities have been certified by the FDA.

Aside from restructuring, the major effort is in sales. The good news is that the reported time for reimbursement for Provenge has dropped to around 30 days, from prior reports of 60 days or more. That means medical organizations with cash flow issues could treat twice as many patients with the same amount of capital. Also, a concerted effort to make sure prescribers understand the Provenge label and reimbursement availability has been made and is ongoing. We will see if this all has an affect if management keeps reporting revenues on a monthly basis.

Management still believes that the $90,000 per patient price is not an obstacle, and that other prostate cancer drugs will not prevent Provenge from being prescribed within its label, since it is very safe, with almost no side effects, and the course of therapy is much quicker than for most cancer drugs.

There seems to be little fodder for short term momentum plays up or down right now. A lot of risk has been incorporated into the current stock price. A slow revenue ramp with flattening in 2012 would probably keep the price in a range. A faster ramp and better evidence that end demand really can ramp well above $500 million per year would justify a higher stock price, maybe substantially higher, but that could take several quarters to see.

Disclaimer: I have been long Dendreon since 2005, but buy and sell according to my analysis of prospects versus the market capitalization. I added Dendreon shares in August 2011 and last sold shares in April of 2010. I have no plans to buy or sell Dendreon in the near term.

See also: Dendreon Press Releases

Tuesday, September 6, 2011

HP, Dead or Just Resting?

HP, as the Hewlett Packard Company likes to be known, (NYSE: HPQ), is on its last legs, if you judge it by its stock price. It is selling for less than six times earnings. It has become a symbol of technological failure lately, mainly because of the failure of its tablet computer offering and its lack of presence in the smartphone market. Also, it announced it wanted to sell or spin off its personal computer (PC) business, but apparently no one with that kind of bucks wants to buy the division.

But suppose the pundits and investors arranging for a funeral are reading the symptoms wrong. In that case it possible this is a buying opportunity for those who get an accurate view of the situation. After all, a PE under 6 means trailing earnings are about 17% of the stock price. That strikes me, on the surface, as a much better deal than 2% annual returns on risky long term loans to the United States government.

The most solid evidence that things are not so bad are actual GAAP results from fiscal Q3 2011, as reported on August 18, 2011. True, revenue was up only 1% y/y, and while GAAP net earnings were $1.9 billion, up 9% y/y, non-GAAP net earnings were $2.3 billion, down 11.4% y/y.

A company with $1.9 billion in GAAP earnings in a quarter is not on death's doorstep. So the low stock price must be based on opinions about something more fundamental than mere profits: technology trends.

I have been around long enough to see a lot of companies go out of business, especially in the PC space. I know it can happen. Margins are brutal when differentiation from competitors is difficult. That is why IBM turned over its PC business to Lenovo. On the other hand, Lenovo has done quite well since then, so maybe IBM's strategy was not so brilliant.

The main theory is that tablets and smartphones are going to eat PCs, just like PCs ate up minicomputers back in the 1980s. To buy that argument you have to include servers in the PC category, because what PCs ate up was dumb terminals. Servers, based on technology similar to PCs, are what actually killed minicomputers.

Digging deep into history, recall that PDAs were going to replace PCs. Instead MP3 players replaced PDAs, because more people wanted to listen to music than wanted to carry around a tiny crippled business tool. HP was a leader in PDAs, and a failure in MP3 players, yet it did not die from the experience.

HP has several segments; the future does not look the same for each segment. The printer segment does not seem to be disappearing. The business hardware segment, excluding PCs, includes servers, enterprise-level storage, and other datacenter components like switches, routers, and the software needed to enable and manage racks of equipment. Because people are increasingly relying on mobile information, these datacenters, aka the cloud, continue to expand. Competition with IBM, Dell, Cisco, Oracle and many other companies is fierce, but so far HP has competed rather well. Services for enterprise computing are also a major source of revenue and profit.

So if the consumer PC division is seen as a weakness, the worst case scenario should be that it gets spun off. Stockholders get the enterprise and printer gravy in one tray and the consumer business in another.

If HP is making a mistake, it is not seeing the further possibilities of the PC business (with PC broadly defined). Every few years since the PC was born it has been declared to have all the computational power it needs. I have made that mistake myself. These days the new AMD A-series chips can run a pretty good game without the need for a discrete graphics card. They can put HD video on a big screen. The end of innovation must be near, except for smartphones. And tablets.

If you think PC innovation is coming to an end, you have not talked to the visionaries at Microsoft, or AMD, or even at Intel. Amazing things are just beginning to be computationally possible. A good example is the Kinect device for Xbox 360 games. There is no reason similar technology can't be attached to PCs running 60 inch displays. In fact, hackers are doing that already, with Microsoft even offering a software development kit (SDK) to help.

Yes, you will be able to wave your hand in the air, talk a bit, and do everything from altering an accounting spreadsheet to running a tractor to manipulating DNA from the comfort of your chair.

You are going to want the latest smartphone when you are on the road. But in your den or office, you are going to want a PC with a big screen, input devices more intuitive than touchscreens, and a hairy advanced processing unit to make it all work in real time.

If Leo Apotheker is too dull to see the potential of HP's PC division, it is still going to be profitable for the foreseeable future, even if it is just a commodity manufacturer of innovation spun elsewhere. A spin off suits me fine. Wish I would run it, wish I could own it. In addition I would get shares of the enterprise segment, a gold mine in itself.

Wait, I can own a piece of it. That is the great thing about stocks, you don't have to buy the whole company all at once.

Disclaimer: As I write this I own no HPQ, but it is on my wish list to buy. I do own AMD stock. I do occasional subcontracted work for Microsoft. I also own stock an HP competitor, SGI, that specializes in technical computing.