Description

Description
The Female Health Company (FHC) is the only approved manufacturer of female condoms in Europe, the US (FDA), and by the World Health Organization (WHO) for purchase by UN agencies. We estimate FHC currently trades at 10x its 2009 cash earnings and is materially undervalued.

Key bullets:
• Half-way into its 4th consecutive year of 25%+ revenue growth (+28% ytd). Profits and cash flow are positive and accelerating and EBIT in the recent quarter alone equaled the entire FY'07 EBIT.

• In Feb ‘07, FHC started shipping its FC2 2nd generation product manufactured in Malaysia (vs. the FC1 in the UK) at significantly reduced costs. Sells for 25% less, grosses 50% more margin – almost all of which flows directly to the bottom line as operating expenses grow at inflation and customers pay all shipping, handling, and logistics costs. Operating cash flow is > $2mm in last 2 quarters alone vs <$0.5mm in any prior year.
• India’s largest manufacturer of male condoms, HLL, began production of FC2 in 12/07 via service agreement with FHC. Total capacity is already 7.5 million units and large new orders have been recently announced. HLL is a billion dollar company and is targeting India unit sales alone at greater levels than FHC’s entire current business.
• Recent AMEX listing and newly issued guidance (recently revised upward, still low).
• EBIT margins are currently 13-14%, incremental margins on revenue growth are ~40%.
• The Company is solidly profitable (thus NOLs are relevant). NOLs are worth > 50% of current enterprise value.

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What drives revenue growth?
The bulk of sales go to third world countries as part of disease-prevention allocations made by organizations such as UNAIDS and USAIDS. Once allocations are made into organization or country budgets, they stick. Overall funding for disease-prevention and specifically for condoms has increased every year for over a decade and this trend is expected to continue as AIDS rates in several third world countries exceed 30% and continue to climb. Clinical studies have shown that when female condoms are made available with male condoms, there is a 10%-35% increase in protected sex acts, and in October 2006, a study was published indicating the incremental cost of providing female condoms is less than the cost of treating the HIV infections they prevent. FHC is in a favorable position for continued revenue growth due to 1) continued acceptance of the female condom’s efficacy, 2) the failure of competing solutions, and 3) the introduction of the lower-priced FC2 (which generates higher margins for FHC).

Training and education of the female condom is an important step as well, and the organizations which FHC works with and which fund purchase of its products spend as much on creating end-user training and product education programs as on the products themselves. Due to the success of these female condom programs and continued acceptance of the female condom’s efficacy, the female condom has received higher allocations among overall condom budget dollars, resulting in revenue growth of 24%, 33%, and 30% the past 3 years. FY 2008 has started well, with first half FY’08 (Sept YE) revenue growth greater than 28%.

Competition
The FDA categorizes female condoms as class III medical devices. This creates a sizable barrier to entry into the US market and US funded international organizations. FHC estimates it would take 4-6 years to receive FDA approval for another type of female condom. Competitors have been unable to create a product that can meet stringent regulatory standards and be manufactured cost-efficiently. The competitor with the best product, PATH, is unable to manufacture at a remotely commercial scale and the only other competitor, Dr. Reddy in India (not associated with the multi-billion Indian company) has issued and retracted false press releases regarding the status of WHO endorsement and clinical trials in the US in the past, has been passed over in his native India in favor of FHC, and is not viewed as a credible nor viable manufacturer. WHO has not cleared Dr. Reddy’s product for purchase by UN Agencies.

Substitutes
The two most promising substitutes for female condoms as an AIDS preventative device have recently suffered significant setbacks.
– AIDS vaccine research has yielded poor results in testing with one of the most favorable vaccine candidates, V520, pulled from Phase II trials in September ’07. Seven similar trials based on similar principles have been halted. “"None of the products currently in the pipeline has any reasonable chance of being effective in field trials," Ronald C. Desrosiers, a molecular geneticist at Harvard University, declared last month at an AIDS conference in Boston. "We simply do not know at the present time how to design a vaccine that will be effective against HIV." The US has spent multiple billions in total over 20 years trying to develop an effective vaccine. The current NIH annual budget for AIDS vaccine research is $497M. The following link references a Washington Post article which accurately depicts the recent Vaccine Failures: http://www.washingtonpost.com/wp-dyn/content/article/2008/03/20/AR2008032003398_pf.html .
– Microbocides have witnessed similar setbacks. At the 2006 world AIDS conference, AIDS microbicide research promised an alternative to condoms and abstinence for protection against AIDS. Several promising candidates gave hope for a successful microbicide within 2 years. Since then, 4 major microbicide trials have failed including nonoxynol-9, Ushercell, and most recently Carraguard. Nonoxynol-9 showed an increase in infection rates among users. Funded partially by the Gates Foundation, Ushercell trials began in 2005 and was terminated in January 2007 also due to higher infection rates. Carraguard, which work similarly to Ushercell, began trials in 2004 and ended in March 2008 showing no statistically significant different in infection rates between users and the placebo group. Currently, experts confirm we are a long way off from having an effective microbicide.

Operations
Management is headquartered in Chicago and FHC’s plants are located in the UK and Malaysia. The UK plant manufactures FC1 (female condom 1) at approximately $0.50/unit, with an average sales price of roughly $0.80/unit and a gross margin just under 40%. SG&A is a largely fixed at $6-6.5 million/yr due to the finite number of end customers (countries/organizations). Importantly, end customers pay for all delivery and shipment costs. SG&A has held flat between $1.3-$1.7mm/qtr for 11 of the past 12 quarters and should continue to increase at inflationary rates, as it has the past five years. Capital expenditures (CapEx) are minimal, with $1 million (mm) in spending in FY ’07 as FHC expanded manufacturing capacity for the new FC2 (discussed below), and $0.1mm and $0.3mm in the 2 prior years. Maintenance CapEx for current facilities runs $200,000-300,000 annually, with additional CapEx for FC2 expansion detailed below.

FC2
FC2 (female condom 2) began shipping in early 2007. The product utilizes a proprietary design using Nitrol instead of latex, and is manufactured in Malaysia at significantly reduced costs. The product was approved in Europe, CE mark, and was submitted for FDA approval in February. We estimate manufacturing costs for the FC2 at $0.20-0.25/unit with an average sales price of $0.60/unit. This results in 25% lower costs to the customer but generates a 50% increase in gross margin to FHC. Allocations for condoms are typically made in dollars - not units - so revenue levels will continue to grow at significantly higher gross margins with the shift from FC1 to the FC2. Currently, female condoms are 2-3% of the condom market. The higher cost of female condoms is the primary reason for its low penetrations levels, an issue which FC2 addresses and we expect will result in larger percentage allocations among the overall condom budget.
Current FC2 capacity is 30M units annually. FHC can expand FC2 capacity by 7.5M units for ~$0.5M in CapEx with 6 months lead time. 7.5M units of FC2 generates an additional $2.7M gross margin dollars/year, yielding a greater than 500% ROI on this CapEx spend. The bulk of FC1 allocations should convert to FC2 in the next 1-2 years (FC2 has the same efficacy at ¾ the price), allowing FHC to close the UK plant and eliminate significant fixed costs (at an all-in closure cost of approximately $1-2 million), resulting in company-wide gross margins approximating FC2’s 60%.

India
India represents a sizable opportunity for FHC. In 2007, FHC finalized a service agreement (expected to turn into a joint-venture) with HLL (Hindustan) industries in India. HLL currently sells over 1 billion male condoms in India (50% of the market), is partially owned by the Indian government, and an HLL board member is on India’s ministry of health. Under the agreement, HLL will handle all manufacturing spend (7.5 million units of FC2 operating capacity are already up and running), marketing, and sales of the FC2 in India. FHC will receive per-unit compensation and possibly an equity stake. HLL has aggressive estimates for female condom unit sales reaching 60M units in 2010 compared to total worldwide unit sales of 25.9M units by FHC in 2007. Although HLL has lofty targets, hitting even a fraction of these would provide significant material upside economics vs. our numbers. Nonetheless, we assume no material contributions from HLL in our numbers. The attached article provides some detail on HLL’s plans for the female condom. http://www.nerve.in/news:253500119843

PEPFAR
The President's Emergency Plan for AIDS Relief was originally enacted in 2003 for $15B over 5 years. Funding has grown from $2.3B in 2004 to an estimated $6B in 2005 representing a 29% CAGR. Of the total funds, 20% is spent on prevention programs made up of condoms and abstinence programs. The original PEPFAR contained a provision stipulating 1/3rd of funds be spent on abstinence programs. Abstinence programs have been shown to be ineffective in slowing the spread of AIDS and the provision was highly criticized. The new version of PEPFAR, passed on April 3rd 2008 by the House, increases spending to $41B over the next 5 years and removes the clause requiring 1/3 of prevention funds be spent on abstinence programs. Instead, the administration has been directed to promote “balanced funding for prevention activities”. Given that prevention funds are spent exclusively on condoms and abstinence programs, the removal of the 1/3rd requirement should increase demand for female condoms.

The U.K. Department for International Development
On June 3rd, 2008, the British Department for International Development announced the British government will spend nearly US $12 billion) over seven years to improve health services and systems in developing countries to fight HIV/AIDS. This is a significant step-up from Britain’s prior funding. Allocations for the female condom are expected to be included in this as the Dept. of Intl. Development has supported female condoms in the past – including in October, 2005, when this same British Department granted approximately $1.7mm US through the Business Linkages Challenge Fund to partially fund the collaboration between FHC and Hindustan to develop the female condom in India.

Valuation
• Despite numerous upside triggers, we conservatively estimate revenues to grow 25%, 20% and 20% the next 3 years, reaching $34mm in 2010. We expect full conversion to FC2 by 2010 (if not sooner), resulting in $20mm gross margin and $12+mm EBIT less CapEx (equal to cash earnings as FHC’s high NOL’s shield it from cash taxes for the foreseeable future). Until full conversion occurs, EBIT for ’08 and ’09 will be affected by one-time costs related to: completion of FC2 FDA approval; employee training for capacity increases in Malaysia; and the ramp-down and eventual closing of the UK plant. However, these costs will aggregate to less than $2mm in total, won’t stifle strong ’08 and ’09 earnings growth, and will be minimal by 2010.
• FHC’s organization and country allocations have low - if any - correlation to global economies or the macro-economic environment. Although trading at premium multiples, few if any healthcare companies possess as much stability in their business as FHC. We expect FHC to trade at an earnings multiple more consistent with the growth, operating leverage, and stability of its business, in the 25-35x P/E range, at a minimum.
=> At a “too-low” 25x target multiple (earnings and free cash generation are growing greater than 100%/yr) FHC is worth $300 plus roughly $25mm cash on books by YE 2010, or $11/share. Discounting back 2 years produces a FYE ‘08 $9/share price target. Ultimately we expect FHC to be acquired by a male condom manufacturer for obvious public sector and commercial market sales channel synergies.

Volume/Ownership
Although we hate this part as it falls under "technical," to some degree its real and meaningful to certain investors. As such, we offer the following: The stock is closely held, with the Board owning 35% of the Company and one institution owning just over 5% through a 4/07 tender offer. This leaves nearly 16mm shares in the float. Three month average daily volume is just over 17,000 shares but mature/ discovered companies typically trade at 1-2% of their float on a daily basis, equating to a 10-20 fold increase in volume. This type of volume increase is not at all uncommon as under-followed companies are discovered. For this to occur, investors of size will have to purchase FHC in the $2.90-3.00 range – something they have done 26 different times in the past nine months at a 3x higher avg. daily volume. In fact we began writing this after FHC’s May 14th Q2 earnings release, whereupon the stock climbed to $2.92.
Given FHC can be purchased in volume for $2.90-3.00/share (we believe it is worth $9+ and is thus a highly attractive purchase at that level), has enough float to trade at greater volumes at that price level, and has traded at greater volumes at that price level, the stock can be bought and should not be mis-categorized as a “dead money” micro-cap. On the contrary, the Company has utilized its significant free cash generation to repurchase maximum permitted number of shares every quarter for five consecutive quarters. We expect repurchases to continue and increase in line with volume increases - including at levels well above current prices - as management and the Board recognize this as a highly accretive use of cash.

Summary
FHC lost Wall Street’s interest and de-listed to the bulletin board after heavy historical losses (as it gained product approval). Although long forgotten by Wall Street, it is half-way into its fourth consecutive 25%+ growth year, has a new, lower-priced product generating significantly higher margins, and has turned the corner to ongoing and accelerating growth and profitability. The business requires minimal reinvestment of capital to grow and is thus incredibly high ROI, FHC is the sole solution in its category as alternative solutions have failed, the business gets stronger as the Company continues to grow (additional manufacturing synergies will further reduce cost/unit, FHC can offer lower prices for very large orders which will further entrench customers), and the NOLs alone are worth more than half of today’s enterprise value. There is significant insider ownership, the Company is buying back as many shares as it can despite a higher stock price vs. recent years, and the Company makes for an intuitive takeover by male product manufacturers upon further growth. As such, this is both a value and growth investment at misunderstood prices and with material upside.

Catalyst

It’s a forgotten stock after 10+ years of losses (through ’05) generating $150mm+ in NOLs. The stock was delisted and only recently re-listed with AMEX. This is a classic "waiting for this to be discovered" stock (see Labcorp, LH, in '99/ '00). There is enough stock in the float for it to trade, earnings are accelerating at a significant rate, and it is undervalued according to any metric. The Company is buying back every share it can as 1) insider ownership is significant and management knows the stock is cheap; and 2) $s required for reinvestment into the business are minimal and buybacks represent the best use of free cash. Trading volume has already increased from past levels. This is a superb, high ROIC, high growth business completely isolated from financial market risk due to its UN Aids allocation/funded customers, is the only provider of its products, and all competing products have failed. As it continues to hit institutional radar/screens and trade in greater volumes (one tender offer completed in April '07), the stock will trade at a premium multiple in-line with the stability and visibility of its revenue growth and profitability.
Lastly, management provided (and recently revised upward) guidance for the first time, yet there remain numerous upside triggers.