Description

We continue to find the current equity market environment extremely challenging, to put it mildly, for the traditional value investor. Purchasing individual equities with the current market valuations, requires special situations which have an unambiguous cause for a company’s market undervaluation and a clear cogent argument that investors have misinterpreted recent developments, the company’s prospects or the valuation of the company’s assets. We believe we have found such an opportunity in The Female Health Company (FHCO).

FHCO is not the traditional undiscovered “diamond in the ruff “, that we as value investors love, but a well-known Company that has been thrown in the trash heap because of sales volatility and a change in strategy, that included the elimination of  its dividend. Investors first began to punish the shares when FHCO had weak March quarterly sales and then completely destroyed the shares in July when they announced, as part of a change in strategy, the elimination of their quarterly dividend. Ending the dividend immediately panicked the income investors, who represented a significant portion of the Company’s investor base, and they sold with abandon. The share price was chopped about 50%.

We have been carefully watching FHCO for many years, intrigued by the Company’s success and product, but hesitant to purchase the shares given their valuation. When we stepped back from recent events and analyzed the Company’s business we quickly realized that there has not been a significant change in the Company’s prospects. We concluded that the elimination of the dividend did not reflect poor prospects for the Company, but simply a decision to use cash flow differently in the future. It was simply an opportunity to buy a good business at a 50% discount to the recent share price.

The Business

FHCO manufactures and sells the FC2 Female Condom (“FC2”). FC2 is the only currently available female controlled product, approved by the U.S. Food and Drug Administration (FDA) and cleared by the World Health Organization (“WHO”) for purchase by U.N. agencies, that provides protection against both unintended pregnancy and sexually transmitted infections (STIs"), including HIV/AIDS. The Company’s first generation product was the FC1 Female Condom, a Class III medical device approved by the FDA in 1993. The Company’s second generation product, FC2, has been available globally since 2007, and in the U.S. since 2009 after it was approved by the FDA as a Class III medical device.

Because FC2’s primary usages are for disease prevention and family planning, the public health sector is the Company’s main market. Within the public health sector, various organizations supply critical products such as FC2, at no cost or low cost, to those who need but cannot afford to buy such products for themselves. The Company has a relatively small customer base, who generally purchase in large quantities. Over the past few years, significant customers have included large global agencies, such as the United Nations Population Fund (“UNFPA”), the United States Agency for International Development (“USAID”), through its facilitator, John Snow, Inc., and Sekunjalo Investments Corporation (PTY) Ltd (“Sekunjalo”), the Company’s distributor in the Republic of South Africa (“RSA”).  Other customers include ministries of health or other governmental agencies, which either purchase directly or via in-country distributors, and non-governmental organizations (“NGOs”). FC2 is currently available in 143 countries. The Company's three largest customers currently are UNFPA, USAID and Sekunjalo. UNFPA accounted for 62 percent of unit sales in fiscal 2013, 40 percent of unit sales in fiscal 2012, and 25 percent of unit sales in fiscal 2011. USAID accounted for less than 10 percent of unit sales in fiscal 2013, 25 percent of unit sales in fiscal 2012, and 26 percent of unit sales in fiscal 2011. Sekunjalo accounted for less than 10 percent of unit sales in fiscal 2013, 20 percent of unit sales in 2012 and less than 10 percent of unit sales in fiscal 2011.

Volatility in sales simply comes with the territory and is certainly not a new development for the Company. A significant number of countries with the highest demand potential are in the developing world. The incidence of HIV/AIDS, other STIs and unwanted pregnancy in these countries represents great potential for significant sales. However, conditions in these countries can be volatile and can result in unpredictable delays in program development, tender applications and processing orders. Purchasing patterns vary significantly from one customer to another, and may reflect factors other than simple demand. For example, some governmental agencies purchase through a formal procurement or bidding process. Bids are subjected to an evaluation process which may take many months to complete. Administrative issues, politics, bureaucracy, processing errors, changes in leadership, funding priorities and/or other events may delay or curtail the process and affect the purchasing patterns of public sector customers. As a result, the Company may experience significant quarter-to-quarter sales variations due to the timing and shipment of large orders.

In the past few years, the Company’s business model, which includes high gross margins, modest capital expenditures and low expense requirements compared to production volumes, has allowed the Company to sustain profitable operations without debt and maintain dividend payments during periods of delayed orders. 

The Product

The Company’s first generation product, FC1, was produced from a costly raw material, polyurethane, in a labor intensive manufacturing process in London, England. To expand women’s access to the female condom, increase sales volume, reduce costs, and significantly increase gross margin, the Company developed its second generation product, FC2. The second generation product is made from a less costly raw material, a nitrile polymer. FC2’s production process is more efficient and less labor and capital intensive than that of FC1, making it less costly to produce. Its price is now approximately 30 percent less than FC1. FC2 is currently being produced at the Company’s facility in Selangor D.E., Malaysia and in Kochi, India. The

Company made its first substantial sales of FC2 in fiscal 2007. Since October 2009, all of the Company’s unit sales have been FC2. Production in London was discontinued with the final shipment of FC1 in October 2009. As a result of the successful development of FC2, the Company was able to both reduce the price to the public health sector and increase its gross margin.

Since the product’s primary market is currently the public health sector, the Company incurs minimal sales and marketing expense. Thus, as the demand for FC2 continues to grow in the public health sector, the Company’s operating expenses may grow at a much lower rate than that of volume.

Currently, there are only two FDA approved and marketed products that prevent the transmission of HIV/AIDS through sexual intercourse: the male condom and FC2. FC2 is currently the only FDA approved and marketed female-controlled product that prevents STIs and unintended pregnancy. FC2 does not compete with the male condom; it provides an alternative to either unprotected sex or male condom usage. An economic analysis of the cost effectiveness of an FC2 HIV/AIDS prevention program conducted by Dr. David Holtgrave, the chairman of the

Department of Health Behavior and Society at the Johns Hopkins Bloomberg School of Public Health was featured in the March 26, 2012 issue of AIDS and Behavior. The study showed that the Washington, D.C. FC2 prevention program, a public-private partnership to provide and promote FC2, prevented enough HIV infections in the first year alone to save over $8 million in avoided future medical care costs (in addition to the cost of approximately $445,000 for the program). This means that for every dollar spent on the program, there was a cost savings of nearly $20. In the article Dr. Holtgrave concluded, “These results clearly indicate that delivery of, and education about, Female Condoms is an effective HIV prevention intervention and an outstanding public health investment.” Washington, D.C. began its program in 2010 to fight a disease that is at epidemic levels. At least 3 percent of Washington, D.C. residents have HIV or AIDS, a prevalence rate that is the highest of any U.S. city.

Numerous clinical and behavioral studies have been conducted regarding use of the female condom. Studies show that in many cultures, the female condom is found acceptable by women and their partners. Importantly, studies also show that when the female condom is made available as an option along with male condoms there is a significant increase in protected sex acts with a concurrent decrease in STIs. The increase in protected sex acts varies by country and averages between 10 percent and 35 percent.  FC2 consists of a soft, loose fitting sheath and two rings: an external ring of rolled nitrile and a loose internal ring, made of flexible polyurethane, FC2’s soft sheath lines the vagina, preventing skin-to-skin contact during intercourse. Its external ring remains outside the vagina, partially covering the external genitalia. The internal ring is used for insertion and helps keep the device in place during use. FC2’s primary raw material, a nitrile polymer, offers a number of benefits over natural rubber latex, the raw material most commonly used in male condoms. FC2’s nitrile polymer is stronger than latex, reducing the probability that the female condom sheath will tear during use. Unlike latex, FC2’s nitrile polymer quickly transfers heat. FC2 warms to body temperature immediately upon insertion which may enhance the user’s sensation and pleasure. Unlike the male condom, FC2 may be inserted in advance of arousal, eliminating disruption during sexual intimacy. FC2 is also an alternative to latex sensitive users (7 percent to 20 percent of the population) who are unable to use male condoms without irritation. To the Company's knowledge, there is no reported allergy to the nitrile polymer. FC2 is pre-lubricated, disposable and recommended for use during a single sex act. FC2 is not reusable.

Financial Results

After poor results in the second quarter, in the third quarter ending June 30, 2014 the Company sold 13.7 million FC2 Female Condoms, generating $7.9 million in net revenues, representing a 9 percent increase in unit sales and net revenues when compared with the third quarter of the previous year.  The Company’s operating profit margin was 26 percent of net revenues in the third quarter, compared with 15 percent of net revenues in the prior year quarter. The Company’s net income increased to $1.16 million from $.73 million last year.

During the first nine months of Fiscal 2014, the Company sold 32.8 million FC2 Female Condoms, generating $18.9 million in net revenues, which represents a 29% decrease in unit sales compare to last year. The Company’s operating profit margin was 23 percent of net revenues and $1.5 million in positive cash flow from operations was generated, during the nine months ended June 30, 2014. "The Company’s overall financial performance for the third quarter was solid," commented Company CEO Karen King. "Although nine month earnings trailed prior year levels, the Company once again maintained profitability, generated positive cash flow from operations, and remained debt-free. While we are very pleased to report a strong third quarter, the market we serve continues to be subject to quarterly volatility in purchase patterns of the global public health sector."

The New Strategy

On July 14, 2014 the Company announced a major new strategic direction and a suspension of its quarterly cash dividend. The Company stated that the first priority of this strategy is to accelerate and grow global demand for FC2 by devoting greater resources to sales and marketing activities. FHCO appointed a new Executive Vice President of New Business Development to further advance opportunities and the markets for FC2.  The Company firmly believes that the worldwide need for the female condom far exceeds the current utilization. HIV/AIDS continues to be the leading cause of death globally for women in the 15-44 year age group, and in the U.S. alone, non-HIV sexually transmitted infections occur at a rate of 20 million new cases per year, half of which involve young people aged 15-24. The new EVP will be building a small team of sales professionals to implement the FC2 growth strategy.

By suspending the dividend the Company will have additional cash flow to implement its growth strategy. The strategy will include not only additional FC2 marketing efforts, but possible diversification into a complimentary product. The Company has been a one product company since inception. It seems reasonable to explore the possibility of adding some complementary products. In addition, the Company will look for opportunities to buy-back its shares, which it now considers undervalued. Between August 4 and August 6, 2014, for example, the Company bought back 130,000 shares, with 800,000 shares remaining in its buyback authorization.

Competition

Competition does exist, but no competitor has the FDA approval, experience, track record and extensive patents of FHCO. One company in India, Cupid, did secure part of a recent South African order but they are not FDA approved. There are also two Chinese Companies marketing female condoms. The Company has not experienced any pricing pressure due to competition.

The Company is closely monitoring possible competition, but believes it will maintain its competitive advantage. In addition, the market is large enough to support additional manufacturers.

Valuation

The current year’s earnings will be depressed due to the weak second quarter, but the Company generated $.40 per share in earnings in both fiscal 2013 and 2012. Even assuming no growth from its strategic efforts the Company should be able to easily again generate $.40 eps in the coming years. With the current share price of $3.70, the shares trade at about 9.3 times earnings. Obviously, the current valuation assumes the Company has lost its market or that the market is in a secular decline. Obviously, this absolutely not the case! On the contrary, the need for the Company’s FC2 condom is growing rapidly. This valuation provides an option on the Company’s growth for free. If the Company has even minimal success with its strategy the current valuation will prove to be extremely attractive.

The balance sheet is solid with no debt and $4.1 million in cash. In addition, the Company has over $19 million in US and over $60 million in UK tax loss carry forwards that will keep it from paying taxes for a long time.

Recently Company insiders have become buyers of the shares at the current level.

Summary

The case for FHCO is straight forward. We have a Company that totally dominates its market with a product that is desperately needed throughout the world selling for less than ten times earnings. The shares are down because it has changed its focus from cash flow distribution to shareholders in the form of dividends to growth. The strategy change has dislodged the income-oriented shareholders, leaving a great opportunity for value and growth investors.

Concerns

1)      Competition may accelerate over the coming years as the market opportunity is recognized by other companies. FHCO does have a twenty year    lead on any potential competitor with an outstanding track record of quality which should secure future market domination.

2)      The Company’s growth strategy maybe poorly implemented with the largest risk being making an unattractive purchase of another product line.

3)      The Company's three largest customers currently are UNFPA, USAID and Sekunjalo. UNFPA accounted for 62 percent of unit sales in fiscal 2013, 40 percent of unit sales in fiscal 2012, and 25 percent of unit sales in fiscal 2011. Obviously, it is critical that the Company maintain good relationships with these agencies.

4)      The shares have limited liquidity. Management holds over 24% of the shares outstanding, which might be considered a positive.

Catalyst

1)      Several quarters of good earnings demonstrating that the second quarter was an anomaly.

2)      The Company’s growth strategy gains traction and demonstrates revenue growth.

3)      The market simply recognizes that the shares are cheap.

4)      Continued Company share buy-backs and insider buying.