Female Health Company: A Stock That Just Turned Into An Option

| About: The Female (FHCO)

Summary

Female Health Company just announced a merger with another private biotech company.

On the surface, the shareholders of FHCO still own 55% of the stake in the merged company, but the economics show that the primary business has completely changed.

Given the significant insider ownership, the deal might not be destroying value. However, it changes the type of business completely, and therefore there could be some short-term selling pressure.

The Merger Announcement

Female Health Company (NASDAQ:FHCO) just announced a merger with another private biotech company: Aspen Park Pharmaceuticals.

The announcement says there is a very attractive $30 billion "potentially addressable" market, and a long list of pipeline drugs.

More sophisticated investors would look at the 8-K filing too, since it contains more information. There, you would find that FHCO shareholders would get 55% of the merged company, and Aspen Park shareholders will get 45%. So on the surface, FHCO shareholders will be the majority shareholders.

However, the 8-K filing also shows that the company is expected to need $110 million capital to fund its pipeline research in the next 4-5 years. In my calculation, FHCO had about $3.5 million average pre-tax income per year. So its own resource is only enough to fund 15% of the needed capital. Even adding the existing cash or receivables on the balance sheet, it still won't be able to fund more than 25% of the required capital. Apparently, most of the capital has to be raised from a follow-up IPO after educating "a sufficient group of institutional investors."

Therefore, it is apparent that the biotech part will be the majority part of the business, potentially well above 75%.

The Business of Female Condom

I have been following FHCO for quite some time now. It was once attractive several years ago and its price went up to $10 at one point. Certainly, I don't think $10 was justified even at that time.

However, to understand potentials of stocks, we need to understand why it could achieve such a market price. I believe it was due to the following reasons:

1. The only player in a niche market.

FHCO was the only player in the female condom market 3 years ago. This market is quite small and it takes a lot of investment to get FDA approval. That is why not many companies are interested in this market.

2. Big "potential" market.

Because female condoms can provide many benefits to women, especially in some developing countries such as African countries and Brazil, one can argue that it has a big potential market. Also, many charity foundations are also interested in pushing its popularity ahead.

Experienced investors would of course question the follow-ups: if the market really gets big enough, wouldn't another player join the game? After all, FHCO doesn't have some unique advantage on the technology. (The only significant advantage is being the first mover, and years of education for its customers on how to use its product).

3. Large temporary orders from Brazil.

The FHCO's revenue usually highly fluctuates, largely because the orders from countries such as Brazil are not stable. In 2012 and 2013, there was a large temporary tender offer from Brazil that boosted earnings.

4. Artifacts of tax accounting.

FHCO had a big operating loss many years ago. The tax accounting treatment generated a lot of temporary non-cash earnings in 2013.

As a result of the 4 factors above, inexperienced investors don't look into the details of the accounting and fundamentals, and believed that not only the recorded earnings are real and long term, the growth trend is also real, with a huge potential ahead.

The Reality

The reality after 2013 is disastrous for shareholders who bought at high prices. Not only the growth trend and the tax accounting effect disappeared, a new competitor (Cupid Limited) also appeared in India.

Normally, a small niche market with a predominant player wouldn't invite another new entrant to enter this market. However, as the cost is low in India, this new competitor still managed to acquire a significant market share. In fact, it secured more tender offers from South Africa than FHCO in the last two years.

Because of this new competitor, not only FHCO's market share got impacted, so did its profit margin.

In the meantime, it is still difficult to make female condoms more popular among consumers. Female condoms are harder to use and non-traditional. For a small company like FHCO, it is hard to do any meaningful marketing as well.

As a result of these factors, a stock that once traded at $10 dropped to a low of $1.16 recently.

The Future

The company has been seeking an acquisition target for many years. Many shareholders were thinking that it might find another similar company, but with a more retail channel presence (this might achieve the best synergy). I think most of them would be surprised of the current merger.

As a result of the current merger, a company with a leadership position in a niche market and continuous positive earnings suddenly changed into a much more risky biotech company, which needs a lot of additional capital to fund its future growth.

In the past, the earnings, despite being highly fluctuating, still provided a good foundation for its valuation. Now, it all depends on the potential of those pipeline drugs. The potential is much greater, but so is the risk. Therefore, it almost seems like it is a stock that has been turned into an option.

With this dramatic transfer of business, I expect there will be a lot of selling pressure in the short term (after all, the new company became much harder to value, especially to the existing shareholders). In the long term though, it is hard to say whether this deal is not a good thing for long-term shareholders. Since the insiders own 24% of the shares, it is hard to imagine that they would do something to destroy value.

On the other hand, maybe only the insiders knew the true value of FHCO before the merger. So it is possible that the intrinsic value was well below $2, and that alone made this merger attractive to its insiders.

Conclusion

While dramas are being played on the stock market every day, it is important for investors to reflect on the dramatic movement of the stock prices.

In the case of FHCO, a lot of money could be gained or lost. To summarize, I think there are at least three lessons to be learned here:

The first lesson is to not get too excited on the uptrend, and price in too much "potential" into the share price.

The second lesson is that leadership in a small niche market is not always a safe competitive position. A careful study on its competitive strength is needed. If a new competitor really enters and gets a foothold, the effects to the original niche player could be devastating. The combined effects of reduced volume, declining gross margin, and loss of scale benefit could dramatically reduce the value of the business (much beyond regular investors' imagination).

The third lesson: with some minor exceptions, most businesses have their intrinsic value in a very wide range. The uncertainty can be high and it depends on many unknown factors and future development. In some sense, luck (random factors) plays an important role here, on top of any careful research and study of the business and industry.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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