Ceapro Inc. Report

Ceapro Inc.

We have only a few years of data for this relatively early stage company and so should not read too much into it. Results have turned sharply downwards in the past three to four quarters after a period of rapidly increasing revenues and especially earnings per share from 2013 to 2016.

Ceapro Inc. (CZO, Venture)
RESEARCH SUMMARY
Report Author(s):  InvestorsFriend Inc. Analyst(s)
Author(s)’ disclosure of share ownership:  The Author(s) hold no shares
Based on financials from: Dec ’16 Y.E. +Q2 ’17
Last updated: 21-Aug-17
Share Price At Date of Last Update: $0.65
Currency: $ Canadian
Generic Rating (This rating does not consider the circumstances of any individual investor and is therefore not specific advice for any individual): Speculative Weak Buy / Hold at   $0.65
SUMMARY AND RATING:   The graph for the past four years shows rapid growth from a very low starting point but then a notable decline in the past few quarters. Overall, the Value Ratios would appear to suggest a Sell rating. Management quality appears  strong but we have deep concerns about the lack of much disclosure of the reasons for the recent revenue decline. The insider trading signal is non-existent and therefore neutral. Executive compensation is reasonable. The outlook seems weak for the next quarter or two. In Q4 they will begin to lap the poor revenue quarters and so could start to show an increase. We consider this to be a high risk investment based on the nature of  its operations and also based on the low share price (It is a penny stock range where stock prices are usually quite volatile). The stock could be a good investment if some of its products under research and development pan out. The company does have sufficient cash and so we would not expect it to run into any financial difficulties at least through 2018. Overall we would  rate this as a Speculative Weak Buy / Hold. We would not risk a large exposure to this tiny company.
DESCRIPTION OF BUSINESS: Ceapro Inc. is “growth stage biotechnology company”. Through scientific research, it develops products or extracts from plants (currently mostly oats). It currently produces several products on a commercial scale.  Ceapro has developed (and/or purchased the rights to) certain proprietary and in some cases patented extraction and production technologies  They sell through a distributor network and not by direct sales. The current products are used in the cosmetics and include an active ingredient in anti-aging skin creams. Brand names that contain Ceapro’s products include Neutrogena, Lubriderm, Aveeno, Jergens, Dove and others – We suspect Ceapro’s product is in one or a few but certainly not all or most of the products under these brand names. Current products also include ingredients used in products for animals including a shampoo, an ear cleanser and a skin conditioner sold to veterinarians in Japan and Asia. These veterinary products appear to account for very little of the company’s revenue.  Products under development include certain health products (some related the heart health) that would be ingested by people and a meal product that would test for diabetes. Geographically, sales are 63% in the U.S., 33% in Germany, 3 % in China and 1% elsewhere and with essentially no sales in Canada.
ECONOMICS OF THE BUSINESS: The economics of the business is uncertain given the recent sharp earnings decline. The business is also quite risky in terms of the need to spend on research which may never materialise as commercial products. To some degree, this company is something of a lottery ticket.
RISKS: We suspect that the larger risks would relate to risk of spending money on developing products and processes that might never achieve regulatory approvals or commercial success. There may also be risks due to product liability in spite of some insurance coverage. There may also be significant risks related to competition or to a reliance on just two distributors and possibly on key end-use customers.
INSIDER TRADING / INSIDER HOLDING: Checking from September 1, 2016 to August 20, 2017:  There has been no insider trading in that period, therefore the  insider trading signal is non existent (neutral).
WARREN BUFFETT’s CRITERIA: Buffett indicates that all investments must pass four key tests: the business is  simple to understand and predict (Fail, because most investors would have no familiarity with the company’s products or its risks), has favorable long-term economics due to cost advantages or superior brand power (pass due to reasonably high profit levels and apparent lack of competing products), apparently able and trustworthy management (marginal pass at best given some concerns about disclosure despite the credentials of management and the Board), a sensible price – below its intrinsic value (marginal pass as it is difficult to know), Other criteria that have been attributed to Buffett include: a low  debt ratio (pass), good recent profit history (pass) little chance of permanent loss of the investors capital (marginal pass given profits but the high multiple to book value) a low level of maintenance type capital spending required to maintain existing operations excluding growth (marginal pass at best given recent spending)
MOST RECENT EARNINGS AND SALES TREND: Revenues per share in the last four quarters, beginning with the most recent, which was Q2, 2017 were down 35%, down 35%, down 40% and down 3%. In the same quarters adjusted earnings were share were down 88%, down 92%, down 88% and down 33%. For the year 2016, revenues per share were up 23% and adjusted earnings per share were up 11%. Overall, the recent trend is extremely negative.
COMPARABLE STORE SALES  OR INDUSTRY SPECIFIC STATISTICS: Not applicable
Earnings Growth Scenario and Justifiable P/E: This is not a company that should be judged primarily by its current P/E ratio but the current P/E ratio based on adjusted earnings is pricing in substantial growth.
VALUE RATIOS: Analysed at a share price of $0.65. As a relatively early-stage and research oriented company, value ratios may provide little guidance. Nevertheless, here are the numbers. The price to book value ratio is not excessive at 2.1. The equity market value is $50 million while the book value of the equity is $24 million. There is no dividend. The price to earnings ratios (with earnings adjusted downward for a tax break and upward for some unusual expenses) is unattractive at 35. The adjusted return on equity is not very good at 8% and has declined in the past few quarters. Overall these value ratios would appear to suggest a rating of Sell.
SUPPORTING RESEARCH AND ANALYSIS  
Symbol and Exchange: CZO.V, Toronto Venture
Currency: $ Canadian
Contact: jenene@jenenethomascommunications.com
Web-site: www.ceapro.com
INCOME AND PRICE / EARNINGS RATIO ANALYSIS  
Latest four quarters annual sales $ millions: $11.8
Latest four quarters annual earnings $ millions: $1.2
P/E ratio based on latest four quarters earnings: 41.6
Latest four quarters annual earnings, adjusted, $ millions: $1.4
BASIS OR SOURCE OF ADJUSTED EARNINGS: Added back 75% (assumes 25% income tax) of other operating expenses which were mainly plant relocations costs and foreign exchange losses or gains also deducted a large research tax credit here. Deducted a large income tax recovery in Q4 of 2015.
Quality of Earnings Measurement and Persistence: The adjusted earnings appear to be of reasonably high quality in that they result from selling products with a high profit margin. Earnings may be under-stated due to the expensing of research and development. Non-refundable government grants are in some ways equivalent to earnings but are mostly accounted for as a reduction of capital costs or research expenses. Certain staff expenses are currently being capitalized to new equipment which is not yet being amortised. This could mean that earnings are over-stated.
P/E ratio based on latest four quarters earnings, adjusted 34.9
Latest fiscal year annual earnings: $3.6
P/E ratio based on latest fiscal year earnings: 13.3
Fiscal earnings adjusted: $4.1
P/E ratio for fiscal earnings adjusted: 11.8
Latest four quarters profit as percent of sales 11.7%
Dividend Yield: 0.0%
Price / Sales Ratio 4.09
BALANCE SHEET ITEMS  
Price to (diluted) book value ratio:                                         2.11
Balance Sheet: (as of Q2 2017) Assets are composed as follows: 58% is property and equipment (of which 53% is leasehold improvements and 47% is equipment) , 26% cash, 11% receivables and inventory, and 5% other including prepaid expenses and an investment tax credit receivables. The company currently has a relatively large cash position due to a recent issuance of additional shares. The assets are financed as follows: 88% by equity (of which 17% is retained earnings and 83% is equity raised by selling shares), 8% by debt and 7% by accounts payable and deferred income taxes. This is a relatively strong balance sheet with modest debt  which meets that the company is very unlikely to be in any financial difficulty in the foreseeable future.
Quality of Net Assets (Book Equity Value) Even with the company trading at only 2.1 times book value (as of August 21, 2017) the quality of the assets or their realizable value would not provide support to the share price if earnings were to evaporate. While the company has ample cash, most of the assets are in leasehold improvements and equipment that likely has very little resale value.
Number of Diluted common shares in millions:                                  76.8
Controlling Shareholder: No person or company owns as much as 10% of the shares and therefore the company is likely effectively controlled by management.
Market Equity Capitalization (Value) $ millions: $49.9
Percentage of assets supported by common equity: (remainder is debt or other liabilities) 88.5%
Interest-bearing debt as a percentage of common equity 9%
Current assets / current liabilities: 4.7
Liquidity and capital structure: The company has a strong balance sheet and liquidity.
RETURN ON EQUITY AND ON MARKET VALUE  
Latest four quarters adjusted (if applicable) net income return on average equity: 8.0%
Latest fiscal year adjusted (if applicable) net income return on average equity: 27.1%
Adjusted (if applicable) latest four quarters return on market capitalization: 2.8%
GROWTH RATIOS, OUTLOOK and CALCULATED INTRINSIC VALUE PER SHARE  
X years compounded growth in sales/share not available
Volatility of sales growth per share:  $                                  –
X Years compounded growth in earnings/share not available
X years compounded growth in adjusted earnings per share not available
Volatility of earnings growth:  $                                  –
Projected current year earnings $millions: not available
Management projected price to earnings ratio: not available
Over the last ten years, has this been a truly excellent company exhibiting strong and steady growth in revenues per share and in earnings per share? Not Yet
Expected growth in EPS based on adjusted fiscal Return on equity times percent of earnings retained: 27.1%
More conservative estimate of compounded growth in earnings per share over the forecast period: not available
More optimistic estimate of compounded growth in earnings per share over the forecast period: No prediction
OUTLOOK FOR BUSINESS: Profits could continue to be very low and far lower than 2016 in Q3 and Q4 2017 due to the expenses associated with recent large investments in new manufacturing and processing facilities that will add to expenses but may not immediately add to revenues.  In addition there was a drop in revenue in Q4 2016 and Q1 2017 and Q2 2017 that could continue. By Q4 2017 the company will begin to lap the quarters with lower revenues and could start to show an increase. In the medium term the company may benefit from new products under development but this would not likely begin before 2018.
LONG TERM PREDICTABILITY: There is potential for Ceapro to grow relatively rapidly. But given the technologies and development risks involved, we would not judge this to be a very predictable company.
Estimated present value per share: As this is an early-stage growth company it does not seem appropriate to attempt to forecast earnings even though the company has reported profits for the past seven consecutive quarters.
ADDITIONAL COMMENTS  
INDUSTRY ATTRACTIVENESS: (These comments reflect the industry and the company’s particular incumbent position within that industry segment.) Michael Porter of Harvard argues that an attractive industry is one where firms are somewhat protected from competition based on the following four tests. Barriers to entry (pass due to the science required) No issues with powerful suppliers (pass). No issues with dependence on powerful customers (marginal pass at best as they are reliant on key distributors as well as key customers), No potential for substitute products (marginal pass) No tendency to compete ruinously on price (pass). Overall this industry appears to be attractive to an incumbent in the industry.
COMPETITIVE ADVANTAGE: Ceapro has certain proprietary processes and intellectual property, some or all of which are protected by patents. We understand that in some of its products it is the sole commercial provider.
COMPETITIVE POSITION: We did not see any information or discussion regarding its competitors or its market share.
RECENT EVENTS: In July of 2016 the company raised a net of $8 million dollars by issuing shares in a private placement mostly to institutional investors (the shares included also a half warrant with an exercise price of $1.50) at $1.06. The shares had been trading at about $1.20. The share price then soon spiked to $2.30 and it’s not at all clear why the price rose so rapidly as it occurred well before the second quarter earnings were released. The average diluted share count increased by 9% in 2016. In the fourth quarter the company converted a convertible debenture to shares adding an additional 2% to the share count. The $1.50 warrants as well as outstanding and future options could also add perhaps 10% to the share count in the next year or two. As of the end of Q2, 2017 the company had completed a major expansion of its facilities but was still in the process of commissioning the new facilities. When those new facilities are commissioned the company’s expense for depreciation will increase significantly.
ACCOUNTING AND DISCLOSURE ISSUES: Due to accounting rules and the nature of the business there are some complexities in the accounting which make the net earnings a less reliable figure than usual. Earnings may be under-stated due to the expensing of research and development that is intended to benefit future earnings (it arguably creates an asset). Offsetting that, certain expenses are now being capitalised and this could over-state earnings if the associated assets do not produce the expected profits. We were impressed with the candid disclosure of government funding. However this government funding  causes the asset values to be lower than their true cost and in our view lowers the book equity and increases the reported ROE.  It is very disappointing that the reasons for substantial revenue declines in the past year have not been explained. Also we did not see any discussion regarding the competition that the company faces. There was also no discussion of product liability risks or even efficacy risks. Overall, at this time, we consider the disclosure to be very poor.
COMMON SHARE STRUCTURE USED: Normal, one vote per share.
MANAGEMENT QUALITY: The company has grown rapidly and is profitable.  However, we are quite disturbed by what we viewed as a lack of adequate discussion of the reasons for a drop in revenue in each of the past four quarters.
Capital Allocation Skills: In 2016 the company produced a return on book value of equity of 27% which would indicate that capital has been deployed wisely.  But in part this is due to government funding.  Recently the company has invested heavily in equipment and leasehold improvements and the incremental return on that capital remains to be seen. The ROE has recently declined to just 8% which could indicate poor capital allocation choices.
EXECUTIVE COMPENSATION: (Based on 2016 figures released in May of 2017) Compensation is reasonable with the two named officers earning from $189,000 to $402,000. Most of the compensation is in the form of salary with relatively modest option awards and quite modest bonus amounts. However, it appears that compensation has increased in 2017 in spite of the lower earnings.
BOARD OF DIRECTORS: Warren Buffett has suggested that ideal Board members be owner-oriented, business-savvy, interested and financially independent. (Based on the Spring 2017 circular)  The six directors appear to be highly educated including relevant technical education as well as financial education and knowledge. Three of the four longer-standing directors own about one million shares each and a fourth owns 1.8 million shares. Overall this appears to be a strong Board of directors. The cash compensation of the directors in 2016 ranged from $25,000 to $37,000 which is not excessive. In 2016 the directors did not receive options but they did in prior years.
Basis and Limitations of Analysis: The following applies to all the companies rated. Conclusions are based largely on achieved earnings, balance sheet strength, earnings growth trend and industry attractiveness. We undertake a relatively detailed  analysis of the published financial statements including growth per share trends and our general view of the industry attractiveness and the company’s growth prospects. Despite this diligence our analysis is subject to limitations including the following examples. We have not met with management or discussed the long term earnings growth prospects with management. We have not reviewed all press releases. We typically have no special expertise or knowledge of the industry.
DISCLAIMER: All stock ratings presented are “generic” in nature and do not take into account the unique circumstances and risk tolerance and risk capacity of any individual. The information presented is not a recommendation for any individual to buy or sell any security. The authors are not registered investment advisors and the information presented is not to be considered investment advice to any individual. The reader should consult a registered investment advisor or registered dealer prior to making any investment decision. For ease of writing style the newsletter and articles are often written in the first person. But, legally speaking, all information and opinions are provided by InvestorsFriend Inc. and not by the authors as individuals. The author(s) of this report may have a position, as disclosed in each report. The authors’ positions may subsequently change without notice.
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