On the surface Female Health Company's (FHCO) fourth quarter loss might cause alarm and has sent shares back down to where they were prior to the announcement of the Brazilian tender. After digging through the 10K filing, we continue to believe that the market is overreacting, yet again, and is selling first and asking questions later. We will look at the reported loss for Q4 and explain its bloated nature due to a non-recurring item as well as do our best to explain why the company is now reporting taxes on their income statement while there continues to be deferred tax assets. Looking to the future, and accounting only for the Brazilian tender and nothing else, FHCO's shares are again trading at a highly attractive valuation.
Unprofitable Quarter Due to Non-recurring Item
Female Health Company has been profitable for years even as government orders fluctuated. There are only two other quarters since 2005 - when they reached profitability - that FHCO has reported a loss. Below are our quick notes related to the unprofitable quarters. Note that in each instance, they were caused by non-recurring events.
- ($226k) Loss
- Negatively impacted by product mix, with a significant number of units sold at a low-margin contract price
- Increased unit sales
- Higher direct material cost, labor, and production
- Operating inefficiencies
- Remember FC1 was the condom sold
- ($700k) Loss
- Restructuring costs $1.9MM
- A result of the transition from FC1 production to FC2 production
- Charge was taken for exiting the previous lease for the UK manufacturing facility
This quarter FHCO's operating expenses grew from half a million dollars in Q4 2013 to $3.37 million this quarter. The spike is largely related to the reversal of the incentive compensation that happened in Q4 2013. The company had not achieved its target and forced itself to take a ~$1.42 million charge.
As a long-term shareholder I commend management for making the reversal achieving results. The point of incentive compensation is to reward the employees for performing. Too often do we see incentive structures where management and company employees are rewarded for merely treading water. Many other managements, of questionable character, in the same position might have massaged the income statement in a way where the incentive compensation would not have been reversed and the company would show profitability.
If we take out this non-recurring charge, FHCO would have achieved pre-tax income of approximately $1.44 million instead of the loss of $566k.
The other part of the increase in operating expenses is a result of ramping up operations to meet the demand of the Brazilian tender for 2014 as well as the programming in 2012. ~$0.932 million were related to this and we would expect this and the other operating expenses to continue as the company both executes on its new strategy and pays for costs associated with the Brazilian tender.
We highlighted in this article the Brazilian tender of up to 50 million units is not being accounted for by the market currently. That order is now likely to be what is showing up in the company's filings via a huge increase in the back-log.
A >3 times increase in back-log is significant. A nearly $10 million back-log is even more significant. The company does not report back-logged orders in the Q statements, however, looking back at all the annual reports, November 30, 2012 was the last time the company reported >$10 million in back-log. At that time they had $11.38 million of unfilled product orders. If FHCO is able to get most of the 50 million units sold to Brazil, that alone would be equal to the revenues the company achieved all of 2014.
Another cause of concern that others might have is that FHCO's income statement is now showing a tax payment. Female Health continues to have net operating losses, so some might question why the company is booking taxes, however, a basic understanding of taxation can help us understand why this is occurring. Keep in mind we are not a tax professional.
It is our understanding that when a company believes that there is a >50% chance that some or all of the deferred tax asset will not be realized, a valuation allowance needs to be established. Female Health in the past had set up a valuation allowance because the objective data indicated that there was a >50% possibility that some or all of their deferred tax asset would not be realized. In other words they did not have solid proof, past performance of net losses, that they would be able to use those tax assets at all or fully. Objective data is weighted heavier than subjective evidence as subjective evidence can be based on hopes and be wildly wrong.
Per FHCO's recent 10K "These assumptions require significant judgment regarding the forecasts of the future taxable income in each tax jurisdiction, and are consistent with the forecasts used to manage the Company's business." The key here is that if the net weighted evidence is positive, a valuation allowance is generally considered unnecessary, as long as there are no clear negative circumstances that lie ahead. Female Health has been readjusting the allowance downward as the net weighted evidence has shown that they would be able to realize more of their deferred asset.
Although there still is a $2.5 million valuation allowance, in our view FHCO's decision to start reporting income tax expense on the P&L could indicate that management believes that there is compelling evidence that the company has a >50% possibility of realizing some or all of their deferred tax asset. The valuation allowance might be reduced totally soon.
The lower P&L now, which now includes booked taxes, will shrink EPS while the company actually pays little in cash taxes. A smaller EPS now is almost universally taken negatively by the market, so there must be benefits to doing this in the long haul. Like with the reversal of incentive payment described above, a management team of questionable nature could probably find a way to report taxes where it does not impact EPS in the short-term with fancy accounting. FHCO's management is definitely not looking to appease the market's short-term interests and in our view is a good indication that management is operating with the eyes far down the road, not two inches in front of their feet.
In our previous article we have described that a good way to value Female Health Company is on a pre-tax basis. Although they are starting to book taxes in the income statement, they are not truly paying out that much in taxes as seen in the cash flow statement. We continue to believe that our previous projection of FHCO achieving ~$11 million in pre-tax profits in FY 2015 looks highly probable with the Brazil tender, the potential for a piece of the South African tender, ongoing purchases for other countries as well as the potential growth in US consumer demand. Keep in mind that during 2012, which was the previous record year in unit sales, the company achieved ~$11 million in pre-tax income and the Brazilian tender of up to 50 million units is likely to drive units sold much higher than 2012.
With $5.8 million in cash now, the company's enterprise value is ~$100 million indicating that shares trade at below a 10x multiple and at cash yield over 10%. Such a price is attractive as our numbers are likely to be conservative, the underlying economics of the company are well above average and the opportunities for growth smoothed out quarter-to-quarter on a trailing twelve-month basis is likely to be higher than the market anticipates.
The market continues to overreact to Female Health Company's future prospects and is overlooking a fairly decent quarter which needed a little explaining. The loss reported for Q4 was largely a result of a one-time expense and the company's decision to book taxes is nothing to worry about. Management's decisions indicate that they are taking the long view and are not in it to paint a rosy picture to appease the market's short-term needs. The large $10 million back-log indicates that Q1 sales are going to be strong and we continue to believe the share price is attractive.
Disclosure: The author is long FHCO.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article is meant for instructional purposes and not meant as a recommendation to buy or sell. We are human and can be wrong, especially with our forecasts, so it is extremely important to do your own homework. The only kind of intelligent investing is through your own due diligence.