Obagi's Pitfalls Provide Investment Opportunity

By Will Ashworth | May 24, 2011 AAA

I was almost three years ago to the day (May 22) that Obagi Medical Products (Nasdaq:OMPI) was trading around $8. Over the next three years to May 5, 2011, it was up about 62% to $13, compared to 10% for the iShares Russell Microcap Index ETF (NYSE:IWC). Then uncertainty struck. After the markets closed May 5, 2011, Obagi announced a first quarter loss of 13 cents a share due to two situations that I'll explain shortly. The next day its stock dropped 24%, erasing over half its gains since I wrote good things about the company back in 2008. It's not very often that stocks go on sale, but Obagi's current pitfalls present real opportunity for investors. I'll explain why.

TUTORIAL: Fundamental Analysis: Qualitative Factors - The Industry

Litigation
The first issue involves an ongoing lawsuit between Dr. Zein Obagi, founder of Obagi, and the company. Originally filed in January 2010 in the California courts by Dr. Obagi, the lawsuit made certain claims based on the doctor's 2006 separation-agreement. The parties were unable to reach an agreement until May 2 of this year. As part of this agreement, Obagi Medical Products agreed to pay the doctor a one-time payment of $5 million. In addition, it incurred $2.2 million in litigation costs from the lawsuit . Both were included in the first quarter SG&A expenses and the company expects to have $600,000 more fees during the second quarter. Its general liability insurance carrier has agreed to cover some of the $7.2 million, although it's unknown just how much. At this time, it's safe to assume less than more. Nonetheless, the issue is put to bed and no longer a distraction for management. (Learn more in Cover Your Company With Liability Insurance.)

Texas Revenue
The second issue involves the Texas Department of State Health Services. In November 2009, the company received a letter from the state agency suggesting that products containing 4% hydroquinone, which it was selling in Texas, were unapproved new drugs. The two parties went back and forth until April of this year when the Texas Attorney General's office said it was in violation of state law and impounded its product. The company is voluntarily stopping selling its products in Texas and is accepting returns from customers for a full refund. As a result, $1.9 million for sales returns and allowances were added to "accrued liabilities" on the balance sheet, overall revenues were reduced by an equivalent amount and gross profits were reduced by $1.6 million. In 2010, Texas accounted for 8.8% of overall revenues so an ongoing battle will cost the company money in terms of lost revenue, potential penalties and litigation fees. This situation isn't over by a long shot.

Obagi Medical Products and Peers

Company EV/EBITDA - Next 12 Months
Obagi Medical Products (Nasdaq:OMPI) 7.67
Allergan (NYSE:AGN) 12.90
Johnson & Johnson (NYSE:JNJ) 8.08
Roche Holding (OTCC:RHHBY) 8.16
Medicis Pharmaceutical (NYSE:MRX) 5.74

What It Means
In its Q1 earnings release, Obagi management lays out a non-GAAP income statement that adds back the $1.9 million in lost revenue, $1.6 million in lost gross profits and $7.2 million in litigation settlement costs. An apples-to-apples comparison sees it delivering 16 cents in earnings per share in the first quarter of 2011 compared to 11 cents a year earlier. That's a 45% increase so the fundamental business is still very profitable. The real question for investors is the revenue outlook. Due to the Texas situation, its revised guidance in 2011 is $114 to $116 million, which is flat to last year. This means it expects the rest of its business to deliver approximately 8.8% revenue growth in 2011 and that's the worrisome part. Since passing the $100-million mark in sales back in 2007, if it meets guidance, it will have added just $11 million or so in revenue over a four-year period. That won't cut it. Nonetheless, its earnings per share in 2011 should be its best on record at 75 cents, a 70% increase over 2010. With the $3 haircut it got May 5, we are talking about a forward P/E of 13 for a company that up until these two pitfalls; was going to come close to doubling its EPS for the year. (Explore the controversies surrounding companies commenting on their forward-looking expectations, check out Can Earnings Guidance Accurately Predict The Future?)

Bottom Line
The more I write about stocks, the more I realize that the most successful investors are those who are jumping into the pool when the rest of us are jumping out. So, while many investors are looking for the fastest way out, it may be a fine time for you to cannonball into some OMPI's stock.

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