Monday, January 7, 2013

Computer Modelling Group ( Toronto - CMG ) -- Momentum Continues

Computer Modelling Group ( $21.50) appears on track to report excellent on target Q3 (December) results.  The company is the leading provider of simulation software used to model energy reservoirs so that production is maximized.  Demand is rising because new deposits have become increasingly difficult to exploit.  A wide range of enhanced recovery technologies have reached the market in recent years, making it more cost effective to extract those reserves.  Complexity has grown, as well, requiring more computer horsepower to analyze the best route to take.  Competition is provided by Schlumberger and Halliburton.  Those companies offer less robust products that originally were built in the "black oil" days, when drilling required simpler techniques.  Schlumberger is continuing to offer its own product line, often without charge, to try to retain marketing control of its accounts.  Many customers are gravitating to Computer Modelling's superior technology, nonetheless.  Halliburton now licenses the company's key products for its consulting group.  That provides a direct revenue contribution.  End users often buy Computer Modelling licenses once Halliburton's consulting efforts finish, giving the company access to a larger customer base.

Existing customers are purchasing additional licenses, too.  Demand is vibrant in all geographic markets.  Volume is responding to the combination of steady selling prices for oil and declining production costs.  Enhanced recovery techniques traditionally were expensive and unreliable.  Computer Modelling's software has played a role in driving costs down, and production up.  Companies that deliver those enhanced recovery and fracking methods have boosted price performance dramatically, moreover.  Difficult to recover reserves like tar sands, shale, and heavy oil are becoming increasingly economical to produce.

The renewal rate remains in the 95%-98% range.  Occasionally a license is not renewed after a project ends.  But most customers retain the technology and just move the expertise to a new target.  Computer Modelling has been transitioning its customer base from perpetual to annual licenses for several years.  Some still prefer the perpetual format, though.  Those deals cause quarterly results to fluctuate, due to the higher dollar amounts involved.  The underlying trend in annuity revenue continues to advance at a 15%-25% rate.  Profitability exceeds 50% pretax.  A large portion of income is paid out as cash dividends.  Our estimates are unchanged.

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3-S Bio ( Nasdaq - SSRX ) - Mexican Standoff

3-S Bio (SSRX $13.50) remains subject to a $15.00 per share buyout offer.  A China based private equity firm launched the all cash offer in September.  That group is believed to report to the Central Government, which provides some or all of its funding.  3-S Bio's chief executive officer is part of the buyout group, as well.  One purpose for the transaction is to leave the U.S. stock market.  Several Chinese companies have been pursued by short selling groups.  Even the Securities and Exchange Commission has given greater scrutiny to Chinese accounting practices.  Many of those challenges have proven correct.  But valuations of China based companies have declined across the board.  There's no evidence 3-S Bio is involved with any shady practices.  Yet its shares trade at an unusually low valuation due to the cloud cast over Chinese stocks in general.

A two thirds majority of shareholders is required to accept the offer.  Several funds that own the stock have been reluctant to agree to the $15.00 a share price.  The bone of contention is that 3-S Bio would be worth $25-$30 a share under normal circumstances.  The company holds $7.00 a share in cash.  It earns about $1.00 a share.  It has a leading position in a high growth industry, suggesting a P/E multiple of 18x-25x plus the cash value.

That valuation might be too high considering 3-S Bio is subject to price controls.  The Chinese government sets the price 3-S Bio can sell its products at.  Those prices have been regularly lowered in the past.  And another round of cuts is slated for 2013.  3-S Bio already prices its products well below the legal maximum.  So it won't have to go down as much percentage wise as the new rules suggest.  But there will be some pressure on margins over the next few quarters.  3-S Bio expanded capacity 200% a few years ago.  So margins are likely to rebound in the future as volume expands.  Income growth may moderate in 2013 but the long term outlook remains positive.

3-S Bio also is engaged in a joint venture with U.S. based Davita, the world's leading dialysis provider.  3-S Bio will deliver some of the drugs used by Davita in China.  The U.S. company is creating a national network of dialysis centers.  While the Central Government could harass 3-S Bio if it turns down the buyout offer, doing so might raise concerns at Davita.  That might be especially true if the government singled out 3-S Bio for special treatment.

The chief executive officer is in an awkward position.  Right now he is part of the buyout group.  But he still has a fiduciary responsibility to his existing shareholders.  How everything plays out remains to be seen.  Our guess is that the share price will hold up even if the deal falls through. 

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Foraco International ( Toronto - FAR ) -- Outlook Improves

Foraco ( $2.50) appears on track to report relatively poor Q4 results.  The company is the leading provider of high end drilling services used by mining companies to delineate potential targets.  Since the reserves haven't been exploited yet, drilling usually occurs in remote areas that require special expertise and original thinking.  Rates generally are elevated.  And demand tends to remain steady despite fluctuations in spot market commodity prices.  Mining companies normally expand their reserve base in a regular fashion.  Approximately 75% of Foraco's sales are provided by major mining companies.  So-called junior operators are more likely to cancel projects due to their reduced access to capital.  Foraco's performance nosedived during the second half of 2012 despite its relative strengths.  Worldwide demand for minerals skidded as third world economic growth stalled.  Foraco additionally suffered from management mistakes at its Chile subsidiary.  Those factors likely impacted December period results, as well.  A negative comparison is likely in the quarter.

New contracts are being signed at a solid clip.  A large portion of Foraco's contracts come up for renewal in the fourth quarter.  It appears the company has been successful in arranging work for most of its fleet of drilling rigs.  Prices probably are lower due to the industry's persistent weakness.  But a solid showing appears attainable in 2013, nonetheless.  Results will be reinforced by a series of acquisitions Forcao completed last year.  Those transactions took place after the industry declined, enabling Foraco to sign the deals at attractive prices.  Organic growth is likely to fall 10%-20% in 2013.  But overall sales are poised to increase 10% due to the acquisitions.  Income could advance 33%, bolstered by a return to profitability at the Chile subsidiary.

The long term outlook is uncertain.  If the world economy keeps struggling for several years the demand for commodities is certain to remain muted.  Even so, these shares could rise in value as Foraco's market share expands and free cash flow is invested in more accretive acquisitions.  If the "New Abnormal" winds down a more vigorous showing is possible.  Our projections assume a modest performance in 2013 as the U.S. and Europe endure an adjustment process to their government finances.  Once that foundation is established growth could re-accelerate.  In 2-3 years sales could reach $500-$600 million to support income of $.50-$.60 a share.  Applying a P/E multiple of 15x to the low end of the range suggests a target price of $7.50 a share, potential appreciation of 200% from the current quote.

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