Despite Challenges, Obagi Is Still A Buy

Aug.29.12 | About: Obagi Medical (OMPI)

There has been a great deal of hope and speculation that Obagi Medical Products (NASDAQ:OMPI) is an imminent target for a buyout. This hope was given a big boost when shareholders voted down a poison pill introduced by the company board and executives. It was a resounding statement that shareholders made, telling the board and CEO we want to sell. On the face of it, this makes perfect sense. Obagi, which is engaged in the discovery and marketing of facial and beauty products, including prescription grade, has an incredibly loyal customer base; just check out Obagi product reviews on (NASDAQ:AMZN). (The average rating is 4.5 with the lowest being 4 and highest 5). Obagi also has good relationships with dermatologists because its products have a strong track record for efficacy. Moreover, the company has operated ethically. As you get to know the company (and I recommend you do), you can't help but develop affection and respect for it. However despite all that it has going for itself, Obagi has been unable to achieve double digit sales growth since at least 2003.

In investor circles, Obagi is now more known for its anemic sales and marketing strategy than for its excellent track record and customer loyalty. Between 2007 and 2011, Obagi revenue increased by about 10% - not 10% compounded annually - just 10%. In 2007, total revenue was $103 million and in 2011, it was $114 million. It is on track to hit $120 million this year. Moreover during that same period, net income was stagnant at best; it fluctuated between $9 million in 2010 and $15 million in 2007. More importantly net margins have continued to decrease over this same period from about 14% to about 9%. Not only is this decline alarming, 2011's net margin was well below industry average (13.3%). So how can it be that a solid company with a great product line continues to see a decline in its net margin when everything else for the most part has remained constant and its revenue is increasing?

Obagi is currently engaged in developing an online pharmacy for its products. It has invested heavily (between $9 and $12 million) in developing its e-commerce platform. I along with many others are skeptical of the potential of such a system. First, while it may seem like a brilliant idea to sell your products online by yourself, it is a logistical hassle. Online marketing means additional staff with additional expenses, warehouse, greater inventory management, marketing department, tech support, and so on. It is not a small task or project. So, it would seem that unless Amazon, Overstock (NASDAQ:OSTK), (NASDAQ:DSCM) or the dozens of other online retailers are refusing to carry your products, you do not do it yourself. Worse yet, Obagi leaders, as far as I can tell, have no real experience in online retail. In fact, the CEO commented that an e-commerce platform was the next logical step because the term "Obagi is searched for 400,000 times per month." Seriously, he said that. This is a man who does not understand e-commerce. I'm sure the term "McDonald's" is searched 4 billion times per month, but you are unlikely to be buying Big Macs over the internet any time soon.

Despite these uninspired trends and missteps, Obagi does seem to be on a positive track. Q1 results came in better than expected. Revenue was $30.8 million - highest ever. Gross and operating margins improved. Earnings for the year were revised upwards even when accounting for the e-commerce expenses. As a result, takeover rumors resurfaced with analysts projecting a value as high as $23 per share. These rumors were again given a big boost when shareholders voted down a poison pill. By many accounts this was a company that simply needed a small dose of strong leadership, know-how, and the sky was the limit. There was even speculation that the company was "entertaining" several offers in the $20 per share range. As a result in 2012, its share price went on a bit of a tear, climbing from about $11 to $18. Then the CEO announced that the firm had not hired a bank to provide it with strategic advice (i.e. help it sell itself). Markets reacted badly and by the next trading session the company lost nearly a third of its value. It dropped to as low as $10.70 before recovering some.

Obviously, investors are not happy. It is unclear why Obagi does not have an advisor. The CEO has said that one of Obagi's board members is experienced in corporate finance and capable of providing advice on any acquisition issues. But no one is buying that. No bank means you are not serious about what your shareholders want.

The most remarkable thing is that the stock price took an Olympic style dive simply as a result of the CEO saying "we have not hired a bank." That was it. You can argue it was an overreaction; you can also argue that it was an appropriate reaction. I am among the latter. 90% of Obagi shares are owned by institutional investors. By voting down the poison pill, publicly pushing for a sale, and writing an open letter to investors and managers, they have made their position very clear - sell now. By the way if you have not read the letter, it is a good read.

I don't know how immenent the sale of Obagi is. Despite the hype that biotech companies have seen and experienced in 2012, acquisition deals have not been as frequent or as large as the hype would suggest. In fact for 2012, the overall merger and acquisition market has been in a bit of a lull, hovering around a ten year low. Furthermore the M&A market notwithstanding, a sale of Obagi may only happen if there is a change in leadership. However despite these uncertainties, I still think it is a good buy. Yes, it is a poorly managed company; Voce Capital's open letter details in grim language just how poor the management and corporate governance at Obagi is. Moreover for a long time, it has been a company that has lacked clear strategic path. From the outside, it appears as thought decisions are discussed and executed in an ad hoc manner. However, despite all of this, this is one of the very rare companies that is almost dummy proof. Its products are so good, so respected, and so wanted by its customers that even poor management with a complete lack of foresight can't mess it up - at least in the near term. This is why I like Obagi a lot - for now.

Disclosure: I am long OMPI. 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.