Obagi Puts Its Problems Behind It

By Will Ashworth | May 25, 2012 AAA
A year has passed since I wrote about the trials and tribulations of Obagi Medical Products (Nasdaq:OMPI) and the effect they were having on its stock price. I suggested its losses in Texas presented an opportunity for investors willing to take a risk. Since then its stock is up 39%, its Texas problems behind it, and a future that's brighter than ever. With larger cosmetic companies rumored to be interested in its proprietary skin care systems, another 39% move over the next 12 months is a reasonable expectation.

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Texas Troubles
Obagi's problems go all the way back to November 2009 when the Texas Department of State Health Services sent the company a letter suggesting it was shipping products containing unapproved new drugs in the state of Texas. Eventually, Obagi voluntarily ceased shipping any products containing 4% hydroquinone (HQ) from April 2011 through Feb. 29, 2012, at which time the Attorney General of Texas closed its investigation, rendering no penalties against the company. Obagi reintroduced its HQ products into the Texas market in May. The entire ordeal cost the company $3.9 million in sales returns and inventory in 2011.

At the same time the Texas government was dropping the matter, the state of California was just getting started. In February 2012, the California Attorney General's (CAG) office subpoenaed Obagi seeking to determine whether its business practices regarding its HQ products were reasonable. Clearly, this is politically motivated because Texas just finished investigating the matter for 27 months and found no evidence of any wrongdoing. Why the CAG feels the need to get involved at this point is a bit of a mystery, and while Obagi should prevail in California's inquiry, it is a time consuming and unnecessary distraction.

First Quarter Results
They were solid. Revenues increased 16% in Q1 to $30.8 million, its best quarter ever. In terms of operating profits, if you add back the $7.2 million in pre-tax litigation and settlement costs with founder Zein Obagi, they increased roughly 48% year-over-year to $4.9 million. Gross margins improved 30 basis points to 79.7% and operating margins 340 basis points to around 16%. Nu-Derm, its largest product in terms of sales, which accounts for slightly more than 50% of revenue, increased 18% year-over-year to nearly $15.6 million. Included in its operating expenses was a $1.5 million investment for the creation of an e-commerce platform and online pharmacy.

In total, it plans to spend between $9 million and $12 million getting it up and running in 2012, and expects it will recoup its investment within 12 months and another $2- 3 million to keep it running every year. The initiative will reduce its 2012 earnings by at least 29 cents per share. Revenues in 2012 should be around $119 to $124 million, with earnings per share of between 58 cents and 62 cents, which includes the e-commerce expenses mentioned previously. The future looks promising, especially if the e-commerce platform gains traction.

SEE: Earnings Forecasts: A Primer

Takeover Target
In early March, rumors surfaced that Obagi was a takeover candidate because it introduced a rights plan to treat all shareholders equally should a third party attempt to obtain part or all of the company. The rumors died down, but now seems to have resurfaced. Analysts at Cantor Fitzgerald, Canaccord Genuity and Roth Capital all have "buy" ratings on its stock and word is the company is entertaining several offers including a $20-plus offer from a major cosmetics company.

Cantor Fitzgerald analyst Irina Rivkind believes a possible candidate is Medicis Pharmaceutical (NYSE:MRX), which recently announced that $450 million in new financing that will be used for M&A activity. Other potential candidates include L'Oreal (OTCBB:LRLCY), Valeant Pharmaceuticals (NYSE:VRX) and Allergan (NYSE:AGN). Recently, Fougera was sold for 3.55 times sales, suggesting an offer could be as high as $23 a share should one appear.

SEE: Mergers & Acquisitions: An Avenue For Profitable Trades

The Bottom Line
Obagi is the perfect tuck-in acquisition for any of the names mentioned above. I'd be shocked if an offer didn't appear by the end of the summer. At $23, you're looking at a 77% return in just three months. The downside risk appears minimal at the moment, while the upside is huge. Swing away.

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At the time of writing, Will Ashworth did not own shares in any of the companies mentioned in this article.

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