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About a year ago, I was screening the market for small cap stocks that had a good net profit margin and a strong return on equity. Among the results was The Female Health Company (NASDAQ:FHCO).

At first I was cautious, as to be honest the name put me off, however, after doing a little research on the company, its strengths rapidly won me over and I have been following the stock, waiting for a good entry point ever since.

So what does The Female Health Company do and why do I believe it is worth investing in?

Well, The Female Health Company manufactures and sells the FC2 female condom, currently the only women's condom that is approved by the U.S. Food and Drug Administration. The condom provides dual control against unintended pregnancy and sexually transmitted infections, including but not limited to HIV/AIDs.

The FC2 is not just sold in the US, The Female Health Company owns certain worldwide rights to the product, the product is sold in 130 countries around the world and the product is patented in many of the company's main markets. In addition, the World Health Organization (WHO) has cleared the FC2 for purchase by U.N. agencies opening up a huge market.

The market & customers

According to the Female Health Company's annual report:

The Condom Market:

The global male condom market (public and private sector) is estimated to be $3 billion annually. The global public health sector market for male condoms is estimated to be greater than 10 billion units annually. UNAIDS estimates that the annual public health sector demand for condoms, both male and female, will reach 19 billion units by 2015.

The size of the market where the FHCO operates is large, to say the least. Moreover, the majority of the market is government sponsored and funded, e.g. government agencies buying in condoms to distribute to the population for free. This gives the company almost a defensive nature as governments are already under almost constant pressure to improve sexual health around the world.

For example, after the Summit on Family Planning held in London last July, the UK allocated funding specifically for 17 million female condoms in accordance with goals and targets established at the summit. 17 million FC2's equate to roughly 17% of The Female Health Company's manufacturing capacity in a year.

The company also sells its products through distribution networks to suppliers in different countries, allowing the firm to pocket a higher margin and avoid high distribution and selling costs that come with selling the product on the ground. The company has distribution agreements with commercial partners in 16 countries including two of the biggest potential markets in the world, India and Brazil.

In addition to these distribution partners, as I have written above, the company's largest customers are large global agencies, non-government organizations, ministries of health and other government agencies, which purchase and distribute FC2 for use in HIV/AIDS prevention and family planning programs. In the United States, FC2 is sold to city and state public health clinics as well as not-for-profit organizations such as Planned Parenthood. FC2 is being distributed as part of New York City's Female Condom Education and Distribution Project.

The competition

While The Female Health Company does have competitors, which manufacture the same type of product, there are only two products in the world that have FDA approval and recognition for preventing the spread and transmission of HIV/AIDS.

The first product is the male condom and the second it the FC2, which means that The Female Health company is the go-to company for the manufacture and supply of completely effective female condoms.

So how's business going?

The market for the FC2 product is huge and has lots of potential. Backed by government programs the Female Health Company should have no problem selling its product but how is business and is the company fulfilling its potential?

Well, in 2009 the company transferred from its first trial product, the FC1 to its current product the FC2 and then shifted to full production. In its first year of full production, (2010) 38.9 million FC2's were sold and after a shaky year in 2011, the company's sales have since taken off.

Year

Units Sold

Revenues

2010

38.9

$22.2

2011

32.9

$18.6

2012

61.6

$35

Half-Year 2013

33.8

$19.4

FY 2013 Est.

67.6

$38.8

Figures in $US millions

Risks

There are two significant risk factors that overhang The Female Health Company. Firstly, the company's product is manufactured in one leased factory in Malaysia. The factory has capacity to manufacture up to 100 million units a year and the company recently invested a significant amount of cash to bring production up to this level. Fire, building collapse, deterioration of the political environment or other risk factors could shut off the company's production ability removing several years of investment and leaving the company with nothing to sell until the rebuild is complete.

The second risk is the fact that the company only has one product in the market at the moment. Although the FC2 is a relatively defensive product, the company is still exposed to competitors and attacks from regulators, which could dent, or even worse, stop sales.

So that's an overview of the company's background but how do its finances stack up?

Income statement

The company had a slow year during 2011 but managed to regain its momentum during 2012. Having said that, even a poor year for the Female Health Company produced a 30% return-on-equity, 28% return on assets and generated $1.3 million in free cash for the company - increasing its cash balance by 47%.

Balance sheet strength and key ratios

The Female Health Company is no start-up and the company's cash generative nature along with almost non-existent need for capital spending have led to the company's strong balance sheet and robust cash balance.

Year Ending

Sep 30, 2012

Sep 30, 2011

Sep 30, 2010

Cash And Cash Equivalents

$5,291

$4,313

$2,919

Inventory

$1,458

$2,027

$2,194

Total Current Assets

$16,826

$9,747

$11,791

Total Assets

$30,446

$19,443

$18,368

Short/Current Long Term Debt

$0

$0

$0

Total Current Liabilities

$5,860

$2,293

$1,938

Long Term Debt

$0

$0

$0

Total Liabilities

$6,228

$2,690

$2,236

Total Stockholder Equity

$24,218

$16,753

$16,132

Figures in $US thousands

Cash and equivalents have been growing steadily while the company has kept inventory low and inventory turnover high. Current liabilities have grown faster than current assets, as the company builds up a larger trail of creditors. That said, current liabilities are still well covered with current assets. Total liabilities have remained low overall during the past three years while shareholder equity has expanded 50%.

2012

2011

2010

Quick Ratio

2.62

3.37

4.95

Current Ratio

2.87

4.25

6.08

ROE

63.17%

32.23%

41.76%

ROA

50.25%

27.77%

36.68%

Although current liquidity ratios have fallen, the company still remains well-capitalized in the short term. Meanwhile, the company's return-on-equity and return-on-assets has improved rapidly apart from a slow-down in 2011 but this was soon made up in 2012.

Cash flows

Sep 30, 2012

Sep 30, 2011

Sep 30, 2010

Growth

Total Cash Flow From Operating Activities

10,356

6,968

3,992

159%

Capital Expenditures

-718

-46

-51

Total Cash Flows From Investing Activities

-654

-46

49

Dividends Paid

-6,193

-5,545

-4,124

Total Cash Flows From Financing Activities

-8,660

-5,591

-3,933

Change In Cash and Cash Equivalents

1,041

1,331

109

Figures in $US thousands

As I have already shown above, The Female Health Company is highly cash generative with a 60% gross margin and 40% net margin, most of this cash goes straight back to shareholders or the company's bank. The company's cash from operating activities has expanded 159% during the last three years and as shown above, the company is returning most of this cash to investors through dividends and a small share repurchase program (not shown above, however, discounting the sum of dividends paid away from the total cash flows from financing activities, give an idea of the buyback).

The table above shows that the company has almost no need for capital spending. The one charge that the company has taken on that account was the $718,000 charge to expand its manufacturing capacity by around 50% during 2012. This expansion was funded from the company's cash balance and should have a very short payback period.

Investing for the future

One of the overriding themes of The Female Health Company is that the company is focused not just on selling products and making money but also raising public awareness of HIV/AIDS and educating both its current and prospective customers about its product and other products that are available.

The company has been known to work with the Bill & Melinda Gates Foundation on family planning summits and is investing $14 million over the next six years in reproductive health and HIV/AIDS prevention, education and training in collaboration with global agencies. The company is also encouraging customers to increase their circulation of the product by awarding major public sector purchasers with no-cost product equal to 5 percent of their total annual purchases and issuing large discounts on bulk orders.

Conclusion

The Female Health Company is one-of-a-kind and as far as I can tell it is the only company producing such products. Some investors could be put off by the nature of the company's business but the fact remains that this is a very defensive industry with a constant demand, which is growing as awareness is raised. Furthermore, the company has government and NGO support behind it, effectively underwriting income streams.

Financially the company is strong with a good cash balance, no debt, wide profit margins and is achieving a good return on stockholder equity. The only risks that I can see for the company right now is its reliance on one manufacturing facility and its dependence on one product.

Even if The Female Health Company is not a growth company and its revenues remain constant for the next few years, its cash generation will ensure that investors continue to receive dividends and stock repurchases that should drive EPS higher.

Sources: The majority of the data in this piece is from The Female Health company's annual report and company website that detail the company's strengths, weaknesses, opportunities and threats.

Source: The Female Health Company: A Defensive Company With Plenty Of Cash