3S Bio ( Nasdaq - SSRX ) - Follow-up Report

3S Bio (SSRX $14.50) is on track to produce excellent on target Q4 results.  The Chinese government issued a revised set of reimbursement prices for certain drugs this week.  That's part of the national health care law that went into effect in 2009.  3S Bio's two main products were not affected by the change.  The drugs that were impacted suffered an approximate 20% price reduction.  The government insurance program accounts for most of the Chinese market.  Coincident with the government's updated price list was a plan to expand health care spending by 25% next year, to boost the number of people covered and provide more comprehensive treatment.  3S Bio remains vulnerable to future government price mandates, although the company's bargaining position is pretty strong in that its lead product (TPAIO) does not face any direct competition.  Use of that product currently is restricted to "work related injuries," even though its primary application is in chemotherapy.  The company presently serves only 5%-10% of the potential market.  And that potential market is thought to be just a third or less of what it might be, since a large number of prospective patients are never treated.  It's possible that labeling could change for the better if a lower pricing schedule is handed down.

Another new product recently was added to the R&D pipeline.  That licensed drug treats gout, a fairly common affliction in China, and currently is in Phase II clinical trials.  More international partnerships could emerge.  We continue to estimate 2010 earnings will finish around $.65 a share.  Next year $.75 a share remains a realistic target.

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3S Bio ( Nasdaq - SSRX )

3S Bio (SSRX $16.00) is a leading Chinese provider of genetically engineered pharmaceuticals.  The company's two lead products were developed internally and currently hold the largest share of their respective markets.  EPIAO is an injectible version of EPO, the drug that put Amgen on the map in the 1990s.  It's used to stimulate red blood cell production to treat anemia, primarily in post surgical and cancer applications.  That line accounts for 60% of sales and has a 42% share of the Chinese market.  TPIAO treats chemotherapy induced platelet deficiencies and represents 30% of sales with a dominant market share.  Foreign compeition was blocked out of China while TPAIO went through the evaluation stage, but those restrictions were lifted earlier in 2010.  3S Bio also markets three older products through its direct sales force.  Two additional products have been licensed from foreign drug companies.  Those drugs are in clinical trials and probably won't be introduced for 2-3 years, assuming approval is obtained.

Demand is growing at a fast pace.  China implemented a comprehensive health care reform law in 2009, which expanded coverage to most of the country's population.  Economic stimulus funding has generated further impetus.  Proliferation of advanced medical technology is increasing the number of procedures performed.  And the basic need for treatment is rising due to the rapidly aging Chinese population.  The entire medical industry is expanding at a 10%-15% annual rate.  3S Bio is growing even more quickly, in the 25%-30% area, due to its focus on the high end of the market and a superior sales force.

We estimate 2010 sales will rise 25%-30% to $58-$60 million.  Earnings are likely to end relatively flat with those of the prior year at $.65-$.70 a share due to a higher tax rate and greater R&D spending.  Next year sales could reach $75 million as 3S Bio's two lead products retain their leading positions in China's fast growing pharmaceutical industry.  Income could attain $.75-$.80 a share, depending on how well margins hold up.  3S Bio recently doubled production capacity, which will cause unit costs to increase until volume catches up.  Further hikes in R&D spending are possible, too.

The long term outlook is bright.  3S Bio is managed by American trained scientists who enjoy a stellar reputation among foreign executives.  Its proven track record could lead to increasingly large joint venture relationships.  Finances are robust, with $109 million in the bank and no debt.  New products already in the pipeline have the potential to amplify performance dramatically.  In 2-3 years the current line-up could yield sales of $125 million, and earnings of $1.40 a share.  New products and joint ventures could generate substantial leverage beyond that.   Applying a P/E multiple of 25x suggests a target price of $35 a share, potential appreciation of 120% from the current quote.  3S Bio represents a high potential acquisition candidate, moreover, so a higher valuation is possible.

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Computer Modelling Group ( CMG - Toronto Exchange ) - Follow-up Report

Computer Modelling (CMG $21.00 Canadian) reported excellent on target Q2 (September) results.  Sales advanced 47% to $13.3 million.  Earnings climbed 73% to $.26 a share, excluding non cash stock option expense.  The company sells its reservoir modelling software to the energy industry both as a perpetual license and on a recurring year to year basis.  Up front revenue is greater on perpetual sales.  That format does generate some recurring revenue in the form of annual maintenace contracts, however, ensuring customers they receive technology upgrades when they become available.  New unit sales typically are tied to new development projects.  Computer Modelling doesn't break out unit volume but it appears activity picked up sequentially in Q2, bolstered by stronger petroleum prices and improving access to capital.  Results also benefitted from a modest pick-up in perpetual license sales, especially compared to the first quarter when they were practically zero.  Year to year renewals still account for a majority of the business.

The next generation DRMS ("Dynamic Resource Management System") went into service in Q2.  The initial applications will be at sites being developed by Computer Modelling's software partners (Shell and Petrobas).  Those energy giants are each paying one third of the product development costs, although Computer Modelling will retain 100% rights to the technology.  The partners get first crack at the system, though, and that lock-up probably will extend for awhile.  Commercial sales to outside customers are likely to provide a major boost to results through the decade.  But that contribution is likely to modest over the next year or two as Shell and Petrobas fine tune the software and reap the initial benefits for themselves.

The core operation remains in a high growth mode.  New oil discoveries are being made, but they have become increasingly complicated to exploit.  Most of Computer Modelling's sales continue to come from North America.  Interest is building in the Middle East, Asia, and Africa, however.  Those markets promise to keep results marching higher well into the future.  We estimate fiscal 2011 (March) income will reach $1.10-$1.30 a share (Canadian) on sales of $55-$60 million.  Further improvement is likely next year, especially if inflationary pressure increases in the energy complex.  By then the DRMS line should start making a substantial contribution.  Note - Computer Modelling's stock also trades in the U.S. under the ticker symbol CMDXF.  Trading is more liquid in Toronto.

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Central European Distribution ( CEDC - Nasdaq ) - Follow-up Report

Central European Distribution (CEDC $26.75) reported Q3 results that were below our expectation.  We had anticipated a down period.  Results came in even lower due to a summer heat wave in Eastern Europe, which encouraged drinkers to switch from vodka to beer (which the company doesn't manufacture).  Fires in Russia contributed added pressure.  And Central European spent a lot of time and effort selling off its Polish distribution business and restructuring its Russian operations.  Earnings slid 75% to $.12 a share.  Sales 16% to $157.8 million.  Central European predicts a better showing in Q4, which is its strongest selling season due to the holidays.  Still, full year earnings are likely to finish in the $1.50-$1.70 a share range, somewhat below our previous $1.75 a share estimate.

Things could pick up in 2011.  Pricing has improved in Russia, bolstered by government measures aimed at cutting into the black market.  Untaxed sales represent approximately 50% of the entire market at present.  Greater enforcement could divert more business to legal producers, as well, lending Central European a further boost.  How much of the black market the company will ultimately get its hands on remains to be seen.  Much of the illegal output is made at otherwise legal facilities, just on an extra shift.  And police and government officials are believed to benefit from various profit sharing arrangements with black market operators.  New entities may crop up if those enterprises convert to a legal format, blocking Central European from simply scooping up the extra business.

Competition is more intense now that it was in early 2000s, when the company originally entered the Polish vodka market.  Back then the Americans who ran Central European exerted superior management know-how and stronger finances to zoom past its competition and garner 30%-40% of the industry.  The company already holds about 20% of the Russian market.  Expansion from there are likely to be grudging, in the neighborhood of 1%-2% a year if everything goes great.

Outsize earnings gains may be difficult to achieve in the future.  Income could climb back to the $3.00 a share level over the coming 2-3 years, but a lengthier time horizon may be required.  Downside risk is limited by Central European's appeal as a potential takeover candidate.  Value investors may want to hang on and see some more cards.  Due to the company's uncertain earnings prospects, however, aggressive investors are advised to close out positions and reinvest the proceeds in a stock with more clear cut appreciation potential.

Central European Dist. ( CEDC - Nasdaq )

Central European Distribution (CEDC $23.75) is the leading producer of vodka in Poland and Russia.  The company holds about 25% of the legal market in Poland, and 20% in Russia.  Early in the decade the black market accounted for an estimated 40% of total Polish consumption.  The Government knocked that down to 5%-10% with a series of measures, mainly excise tax cuts and greater policing.  Today, black market sales still account for 50% of Russian unit volume.  The Kremlin recently implemented a minimum price statute designed to curtail black market activity.  Enforcement is increasing, as well.  So the legal market in Russia could expand significantly over the coming years, improving Central European's potential reach.  Meantime, the company is bouncing back from a decline in business caused by the recession.  Efforts are underway to boost market share in both countries, shore up finances, and restore profit margins to previous levels.  Central European faces direct competition in both markets, so progress is unlikely to come as quickly as did when the company first arrived in Eastern Europe a decade ago.  (Management is American.)  It does appear that financial results are poised to turn the corner, though, setting the stage for better days to come.

Earnings probably will decline for a second straight year in 2010.  Last year they fell 19% to $2.37 a share.  A 26% drop to $1.75 a share appears to be in the cards for the current year.  Most of the shortfall in 2010 was caused by the sale of the company's liquor distribution operation in Poland.  That unit formerly contributed $.40 a share.  Central European entered Poland with that business ten years ago, but performance began to fade as competitors followed its example.  The company now primarily is a vodka manufacturer, although it also imports a range of products for resale in both Poland and Russia.  Vodka sales didn't rebound in 2010 because of continued weakness in consumer spending, more intense competition, and tight budgeting that constrained growth while a series of borrowings were restructured.  Most principal payments now come due in 2016.  Sale of the distribution business generated further flexibility.

A pick-up in 2011 is achievable.  Marketing efforts have been beefed up.  New products are in the pipeline.  Plenty of spare production capacity is available.  Cash flow is positive and expanding again.  And the Russian government may enact additional price floor increases in November.  That would enhance profitability directly.  It also would expose or eliminate a large part of the black market.  We estimate income will climb 29% to $2.25 a share.  In 2-3 years income could make it back to $3.00 a share.  Finances should continue to strengthen over that period, allowing Central European to pay down debt.  Applying a P/E multiple of 13x suggests a target price of $36 a share, potential appreciation of 50% from the current quote.  A higher valuation could result if Central European becomes a takeover candidate, or the Polish and Russian economies develop more rapidly.  If the black market in Russia is reduced to the 5%-10% level, and Central European maintains or expands its market share, earnings might advance far beyond our projection.  Under the right circumstances income could reach $4.50 a share or more.

Computer Modelling ( CMG - Toronto Stock Exchange )

Computer Modelling Group (CMG $18.00 Canadian) is the leading provider of simulation software used by energy companies to model underground reservoirs.  Customers rely on the technology to test a range of possible production strategies so that the most efficient method is identified.  The process continues for as long as the field remains productive.  Conditions change over time as reserves are brought to the surface, causing new approaches to become better solutions.  Schlumberger and Halliburton, the two leading oilfield services companies the world, dominated the industry since its inception in the mid-1980s.  The advent of supercomputers made by Silicon Graphics and Cray Computer made it feasible to perform the analysis on computers.  Schlumberger and Halliburton focused on so-called "black oil" reservoirs, which involved relatively straightforward drilling programs.  Computer Modelling entered the fray a decade later with an emphasis on hard to produce reserves, among them heavy oil and tar sand projects.  The company has continued to invest aggressively in the technology, leveraged by third party funding relationships that leave Computer Modelling with 100% ownership of the intellectual property. 

Growth is accelerating as new oil discoveries become increasingly complex.  Computer Modelling is gaining market share as exploration moves towards reserves that are more difficult to drill.  Software sales tend to be made on a project by project basis, and the programs tend to stick with each project until the field is completely exploited.  Since most of the easy to produce oil already has been discovered, new business is gravitating towards more complicated fields.  Computer Modelling's large competitors still control a number of major oil company accounts (especially the national ones), so despite its superior technology the company still holds a minority share of the market.  But that percentage has been rising over the past decade as more geophysicists familiarize themselves with the software, and a growing number of top tier energy companies sign on as customers.

A new product line offers additional leverage.  Computer Modelling has been developing a more comprehensive system in combination with Shell and Petrobas over the past four years.  The technology encompasses all of a project's above ground facilities in addition to reservoir modelling, and appears to be ideally suited for deep offshore drilling.  Petrobas plans to put the software to the test on an unnamed project starting this week.  The company recently raised $75 billion to develop the world's largest offshore oil discovery in Brazil.  That might be it.  Shell is starting a project of its own.  If the software performs as expected further expansion in those two companies is likely.  Commercial sales to other oil companies probably would follow in future years.

Earnings are rebounding following a temporary decline in fiscal 2009 (March '10).  Energy companies around the world delayed projects last year due to the recession and the uncertainty that created about the future of energy prices.  Now that crude has stabilized in the $70-$80 per barrel range, and interest rates remain low, many of those projects have gotten underway again.  Computer Modelling netted $.85 a share (Canadian) last year, down from $.99 a share the year before.  (Please refer to our "Accounting Notes" section.)  In the current fiscal year, ending next March, we estimate income will rebound to $1.10-$1.30 a share.  The company sells licenses on an annual basis, and as perpetuals that customers own forever.  Annuals sell at about 40% of the perpetual price.  Perpetual licenses generate annual maintenance fees equal to 20% of the selling price, entitling the owner to software updates as they come available.  Either way, the company creates a long term recurring revenue stream.  Perpetual sales generate more income right away, though.  So this year's exact income figure will hinge on how the license sales are split up.

We estimate total revenues will rise 21%-33% to $55-$60 million.  In the first quarter (June), earnings advanced 50% to $.24 a share on an 18% revenue increase ($12.1 million).  In 2-3 years earnings could reach $1.75 a share on sales of $70 million.  Applying a P/E multiple of 25x suggests a target price of $45 a share, potential appreciation of 150% from the current quote.  Note - The stock also trades in the United States on the Pink Sheet exchange under the ticker symbol CMDXF.