Obagi Medical Devices: Short-Term Huge Gainer On Buyout, Long-Term Investment Without One

Jun.19.12 | About: Obagi Medical (OMPI)

Lately there has been a lot of buzz on a company I have been writing about called Obagi Medical Products (NASDAQ:OMPI). I was first alerted some months ago to this company as a potential buyout candidate and informed by anonymous sources that larger pharmas were interested in buying the company out. Lately, speculation of a buyout has become stronger based on the poison pill being voted down by shareholders by over a 2 to 1 margin at the recent annual shareholders meeting.

As well, Voce Capital Management, a major shareholder of Obagi publicly revealed its opposition to the poison pill implemented by the Board of Directors of Obagi. Sources continue to say that an $18-$20 "all cash" buyout of the firm may finally be close to being announced.

But what if a buyout does not occur soon? Examining this company, I have really liked what I have found. For starters, the company has a tiny market cap for its stock price of $14.45 a share, coming in at $270.68M.

Obagi's products are hot to say the least - strongly catching on with many women; Obagi Nu-Derm® Systems, Obagi Condition & Enhance® Systems, and Obagi-C® Rx Systems just to name a few. Google these products and visit the Obagi website to cross reference the rest of the company's products.

Capitalizing on the social media and networking craze, Obagi has its own Facebook page with over 64,000 'likes.'

Last quarter Obagi raked in a record revenue:

Income Statement
Revenue : 118.35M
Revenue Per Share : 6.36
Qtrly Revenue Growth (yoy): 16.00%
Gross Profit : 90.09M
Click to enlarge

Rather impressive for a company with a market cap of less than $250M which is looking at explosive market acceptance of its skin care products.

I also looked at what other authors have been saying about Obagi, and yesterday on the Yahoo news feed, I came accross an article which really upset me because the author thinks investors should be worried about one factor with Obagi. He is flat wrong and short sighted in his views; let's take a read of what he said:

A company ramping up for increased demand may increase raw materials and work-in-progress inventory at a faster rate when it expects robust future growth. As such, we might consider oversized growth in those categories to offer a clue to a brighter future, and a clue that most other investors will miss. We call it "positive inventory divergence."

On the other hand, if we see a big increase in finished goods, that often means product isn't moving as well as expected, and it's time to hunker down with the filings and conference calls to find out why.

Let's dig into the inventory specifics. On a trailing-12-month basis, finished goods inventory was the fastest-growing segment, up 48.6%. That can be a warning sign, so investors should check in with Obagi Medical Products' filings to make sure there's a good reason for packing the storeroom for this period. On a sequential-quarter basis, finished goods inventory was also the fastest-growing segment, up 33.3%. That's another warning sign.

The author above makes a general observation about Obagi's finished goods inventory on the rise, yet ignores the fact that last quarter, Obagi saw record revenue and profit, But the main factor that makes his observation on finished goods in Obagi's inventory completely null is:

Obagi recently resolved regulatory issues related to Hydroquinone with Texas and resumed selling Rx drugs within that state.

This is why finished goods were up in inventory; Obagi has just started to resume sales of its products containing hydroquinone, which include their Nu-Derm®, Obagi-C® Rx, and ELASTIderm® brands. Therefore, an increase in finished goods was to be expected as these products were finished and waiting to be shipped to Texas.

Did the author take this key factor into consideration? With Obagi seeing record revenue and market acceptance, does it make sense that inventory is on the rise because as this author implies, demand is down across the board, or does it make more sense that Obagi had extra finished inventory on hand in anticipation of the Texas ban being lifted in order to fill orders from that state?

It makes me wonder sometimes if some of these guys are paid by short sellers to write these types of articles. I know that I have been approached by many people to write articles like that for money, and I have rejected each and every offer to date. To be fair though, the author in question might also just have been a bit lazy in his due diligence and made an honest omission, or perhaps he just isn't the brightest bulb under the lamp shade.

Other developments for Obagi from its last quarter were:

  • Presented three posters at the American Academy of Dermatology meeting in April that studied the use of the Nu-Derm System with tretinoin, in the treatment of melasma and hyperpigmentation in patients with Fitzpatrick skin types III - VI (darker skin). Each study evaluated the efficacy and tolerability of the treatment on the skin as well as its effects on the patients' emotional wellbeing. All three studies reported considerable improvements in melasma and skin discoloration, in addition to high levels of patient satisfaction.
  • Introduced ELASTIderm Eye Complete Complex Serum in late January, as previously announced. The product is formulated with a proprietary bi-mineral complex and malonic acid, which in combination, has shown to improve the appearance of fine lines and wrinkles around the eye.

Concerning Obagi being bought out soon, Obagi is a perfect company for acquisition by a larger player in this field- a player that has the money to effectively market these products world wide. The right company can easily increase the above revenues 5 to 7 fold with correct capital flow committed to marketing. Personally, I think selling this company for $20 a share is way too low looking forward. I would prefer to see an infusion of investment capital to grow this company into a monster.

I have been hearing that at least 2 larger players in the beauty and skin care segment have approached shareholders in Obagi about tendering their shares. As a result, Obagi management inserted a share holders right provision, also known as a poison pill to fend off any buy out offers. It is clear to me that management was attempting to save their own cushy jobs rather than doing what the majority of shareholders want; sell the company. Now that the poison pill has been voted down by the shareholders, and according to the buzz I have been hearing from various sources, a buyout offer announcement should be forthcoming very soon between $19 and $20 a share, which could end up being a hostile offer.

Often times larger companies seek to acquire smaller ones to add greater market penetration and value to their company. In one such recent case, AstraZeneca PLC (NYSE:AZN) bought Ardea Biosciences, Inc. (NASDAQ:RDEA) for $1.3 billion ($ 32 per share at 54% premium) mainly for its gout drug Lesinurad in phase III trials.

The Ardea acquisition may be the first in a series of deals for AZN as it tries to counter growing generic competition. The company may be seeking out new products as generic competitors challenge its top-selling medicines. While AZN is not part of the beauty and skin care segment like Obagi, I list this acquisition to show how companies are looking to shore up market share via acquisitions of other companies. AZN as mentioned, is facing increasing pressure from the generic segment. The acquisition of Ardea should allow AZN to fully stock its R&D with new drugs, with the goal of obtaining a renewed patent protection profile. With the acquisition of Area, AZN receives this R&D with other phase clinical drugs such as BAY 86-9766 (RDEA119), a mitogen-activated ERK kinase (MEK) inhibitor that is in Phase II clinical trials for the treatment of cancer; and RDEA3170, an URAT1 kidney transporter inhibitor, which is in Phase I clinical trials for the treatment of gout.

Avon Products Inc. (NYSE:AVP) seems to be in a similar situation in Obagi's segment, and might have interest in acquiring Obagi according to my anonymous sources.

In my opinion, Avon would greatly benefit from acquiring Obagi as it would receive a very popular skin care line which it would be able to better utilize its $1.24B in cash, using its cash for a strong marketing campaign in order to gain greater market exposure of Obagi product lines, resulting in the company realizing substantial revenue and profit.

Avon has seen turbulent times lately, consistently underperforming for the past few years with revenues, net income, ROE, profit margins and EPS all decreasing over time.

Allergan Inc. (NYSE:AGN) may also have an interest in acquiring Obagi according to my sources. Allergan discovers, develops, and commercializes specialty pharmaceutical, biologics, medical device, and over-the-counter products for the ophthalmic, neurological, medical aesthetics, medical dermatological, breast aesthetics, obesity intervention, urological, and other specialty markets worldwide. Allergan offers a number of leading aesthetic types products, including: BOTOX® (onabotulinumtoxinA), RESTASIS® (cyclosporine ophthalmic emulsion) 0.05%, LUMIGAN® (bimatoprost ophthalmic solution) 0.01%, BOTOX® Cosmetic (onabotulinumtoxinA), the JUVÉDERM® family of dermal fillers, and the LAP-BAND® Adjustable Gastric Banding System.

Allergan may be interested in supplementing its already successful line of products with Obagi's ever growing-in-popularity products to add to its already huge market presence. Allergan has $2.64B in cash - more than enough to seamlessly acquire Obagi for $350M, or roughly $20 a share.

Whether or not Obagi gets acquired (I am virtually certain it will), we can see it is a growing company with products that are the hot buzz among many women wanting to look and feel their best on a daily basis. With a current price of $14.45, a market cap of $270.68M, sales of $119M, and Texas allowing Obagi products into its state again, the company is grossly undervalued in my strongest opinion. It is also my opinion that investors should consider doing extensive due diligence here concerning all the factors mentioned in this article, and those which might exist outside of this article.

I think those who do the due diligence will agree that Obagi is a strong buy, whether it is acquired soon or not.

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

Additional disclosure: Family members are long OMPI. I hold no shares in my account.