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Epiq

EPIQ Systems
Hidden Gem by Bill Mann

Risk-Level Rating: Medium

• A classic "boring business," the company specializes in bankruptcy and class action case management.

• Inside ownership is high, with the Olofson family controlling 25% of shares.

• Recent acquisitions have muddied results, presenting a spectacular buying opportunity.

Nasdaq: EPIQ
501 Kansas Ave.
Kansas City, KS 66105
Ph: 913-621-9500
www.epiqsystems.com
(Except price, amounts in millions)
Recent share price:$16.66
Market Cap:$298.1
Cash/Debt:$8.5/$71.0
Owner Earnings Run Rate:$24.4

Buy-Around Price: $17.20So far in Hidden Gems, we've recommended several companies that deal in misery: fire insurance (United Fire), terrorism insurance (Montpelier Re), death (Alderwoods), and collections (Portfolio Recovery). With this pick, we sidle a little closer to the grave dancers, seeking this time to profit from bankruptcy and class action lawsuits.

It may make some uneasy to even think about benefiting from tragedies like bankruptcy. However, I consider it an integral and beneficial part of the capital cycle. Japan, for example, remains in a 15-year recession because the government props up unprofitable companies rather than let them reorganize or die. It is not a pleasant process, least of all for the debtors. But we're not talking about becoming vulture investors by scavenging scraps from the downtrodden. We are investing in a company whose products help manage the process.

The Business
EPIQ Systems (Nasdaq: EPIQ), based in Kansas City, Kan., is a technology and software company that helps clients manage the complex processes of personal and corporate bankruptcy cases, class action suits, and other mass litigation. Its customers include bankruptcy trustees, law firms, corporations, and government agencies.

EPIQ's services automate many administrative tasks required during the bankruptcy and lawsuit management processes, including document and financial record management, filing, and asset and creditor tracking. Its proprietary software-driven system ensures timely and accurate administration of documents associated with complex bankruptcies and lawsuits. CEO Tom Olofson acquired the company soon after its founding in 1988 and holds more than 17% of shares. His family owns nearly 25%.

EPIQ's products are aimed at three types of bankruptcy: Chapters 7, 11, and 13. Chapter 7 (total liquidation) is most common, making up 71% of about 1.6 million bankruptcies in 2004. Chapters 9 and 11 are municipality and business reorganizations and account for 1% of all filings, while Chapter 13 is a reorganization format for individuals and represents 28% of total filings.

For Chapter 11 reorganizations, the "debtor in possession" (or the company itself) uses EPIQ. For liquidations, EPIQ is not paid by the companies or people in bankruptcy. Its clients are the managers of the bankruptcy process: trustees, law firms, and administrators. In these cases, EPIQ is paid a percentage of the asset proceeds. The trustee that elects to use EPIQ incurs no direct charge for using its services. EPIQ maintains marketing agreements with banks, which provide the trustee with the company's products in conjunction with deposit-related banking services. Until April 2004, EPIQ had an exclusive agreement with Bank of America (NYSE: BAC), but has since signed with other banks. Consulting firm Towers Perrin estimates that administration costs for class action suits exceeded $50 billion in 2004.

Also in 2004, EPIQ acquired Poorman-Douglass for $116 million in cash. Poorman-Douglass' services include notice printing, call centers management, and claims processing for large, complex class action suits that can take years to resolve. While other businesses offer bankruptcy administration services, they offer EPIQ's core case management suite little competition.

The Financials
Unfortunately, two factors make EPIQ's financial situation a bit convoluted: multiple acquisition and divestiture of assets and complex financial transactions. It's not as complicated as it seems, but beware making easy comparisons. For example, though top-line revenues grew 87% in 2004, net profits were stagnant. Remember, however, that EPIQ acquired Poorman-Douglass in January 2004 and disposed of its infrastructure software business that April. Attendant in that purchase are substantial revenues from reimbursed expenses, which are earnings neutral to EPIQ. In 2004, revenues totaled $125 million. Backing out reimbursements, EPIQ made $105 million in sales, $43 million (69%) higher than in 2003. Earnings were $0.52, versus $0.48 for 2003.

Also that year, EPIQ took on a $50 million convertible debt issue for the acquisition, which caused a spike in diluted shares outstanding, from 18 million up to 21 million. This is an accounting rule, and does not mean that share count has suddenly spiked. EPIQ is experiencing rapid growth, and has taken on a little debt in its acquisition of complementary companies.

The Valuation
Cash flow is where EPIQ shines. For 2004, it made more than $34 million in free cash flow (adjusted for some one-time events related to various corporate transactions). Its cash-generating capabilities clearly eclipse its less exciting earnings power. Not to overstate its one-year performance — as its results on a year-to-year basis vary greatly — but I believe this company is undervalued on current operations by 10% to 40%. As long as the market for its products remains as fertile as it appears it might, EPIQ's growth potential becomes, well, epic.

And just as we focus on cash generation, so does its management. In the most recent conference call, Olofson noted that cash from operations is its main performance metric. Even with additional debt, EPIQ currently trades at an enterprise value-to-free cash flow multiple of about 12. If every conversion warrant were exercised, EPIQ would still only trade at a multiple to free cash flow of 15. I'd expect these valuations from low-margin, low-growth behemoths in debt, not one with considerable growth prospects in a high-margin business. I can only assume that the market regards the reduction in margins and earnings as signs of a weakening business, not those of a changed one.

The Risks
People mistakenly confuse government laws with natural law. The rules could change, as they did when President Bush signed into law the Bankruptcy Abuse Prevention and Consumer Protection Act this year, and every time EPIQ may be adversely (or positively) affected. At a minimum, each time laws change, the company must adjust its offerings accordingly. And the laws will continue to change. I've picked EPIQ to serve as a countercyclical. It may well suffer if the economy picks up steam and corporate and personal bankruptcies drop. However, today's debt levels are an almost foolproof indicator of future bankruptcy filings. According to the Federal Reserve, individual and corporate debt has risen from already-high levels in 2004.

Another risk is EPIQ's number of acquisitions. While these businesses seem perfectly suited for one another, a company that grows through acquisition may still blow it. EPIQ took on debt to finance its operations after it bought Poorman-Douglass, a transaction that fundamentally changed EPIQ's business mix.

Conclusion
Bankruptcy and class action cases won't be going away, and they've only become more complicated. Investors like us can make money on the process of getting people and companies back on their feet or liquidating their assets. Why not? I'm certain EPIQ is going to.

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Previous recommendation Updates

These are updates from previous recommendations. I don't own FormFactor as they are a supplier that I manage and I personally don't like the way they do business.

Tragically, outside shareholders lost yesterday when the Shire-Transkaryotic merger barely passed, backed by just 52.6% of the vote. Absent the votes of two board members representing the limited interests of Warburg Pincus, this would continue as a live recommendation. Instead, prepare to receive $37 per share in cash. The position is now fully closed out on the scorecard.

***
Stanley Furniture (Nasdaq: STLY) went a long way with its earnings report to prove it has turned the corner on the inventory problems that have been dogging the furniture sector all year and most recently hounding Hooker Furniture (Nasdaq: HOFT). Stanley reported fantastic earnings for the second quarter, with sales growing 16% and profits growing just a notch slower at 10% for the quarter and 14% year to date. Free cash flow production doubled year over year. All in all, it was a great earnings report that the market did not expect.

***
QLT (Nasdaq: QLTI) announced on July 14 that Visudyne sales in the second quarter totaled $129 million, up slightly from the $124 million in the first quarter. While it is encouraging that modest growth continues, you should be very cautious about the drug's long-term future given mounting competitive pressures.

A week earlier, QLT's acne drug Aczone was approved by the Food and Drug Administration. That normally would be great news, but this drug is now in limbo. Two days prior to its approval, Aczone was dropped by former partner Astellas over concerns that the drug's restrictive label would make it difficult to market.

QLT is conducting its own market research with leading dermatologists to determine if that is indeed the case. If it is, that's a big blow to the company, because it won't promote the product until it completes the clinical studies necessary to get a more favorable label. That means the company may not generate sales from Aczone for two years.

***
Deckers Outdoor (Nasdaq: DECK) reported per-share quarterly earnings of $0.21, a nickel per share better than analyst expectations. Keep in mind that those expectations had been previously lowered twice during the quarter. Sales came in at $40.3 million, down a hair year over year, and management boosted the low end of its full-year earnings-per-share target by $0.03 and reaffirmed its sales estimate, so all in all it was a positive release.

Inventory growth surged by 240%, which doesn't make us happy, particularly since Deckers' products are sensitive to fashion trends. If this inventory is discounted, it will ultimately hurt margins.

Chairman Doug Otto called the past six months a "wake-up call." That's a good start, but it doesn't eliminate the uncertainty facing this company. New CEO Angel Martinez has a big job ahead of him as he repositions Teva as a performance, not a sandal, brand — a task that will take a few years. New product lines aren't expected to take off until 2006 and 2007, so this won't be a quick turnaround.

Because the earnings report signaled a slowdown in the bloodletting at Deckers, the market reacted positively. With the stock now significantly cheaper than it was, I think the spring's misfires have been fully priced in, and I expect good performance ahead.

***
FormFactor (Nasdaq: FORM), the leading manufacturer of advanced test probe cards, reported that year-over-year profits dropped 26% to $5 million this quarter. While revenues ($52.3 million) and bookings ($58 million, a 14% increase) both hit record highs, the company is not operating nearly as efficiently as we would like to see. There's also been a management change, with the resignation of COO Jens Meyerhoff, whose responsibilities will now be performed by CEO Igor Khandros and President Joseph Bronson.

On its conference call, management said that, despite its new manufacturing facility, FormFactor is still constrained by capacity and is undergoing a "debugging" process of new equipment. Its new facility, though still on target, is producing at only about 15% of its capacity. That means it is still relying on its old factory, which had significant problems last year that knocked the stock down, to produce the bulk of its product. As a result, it can't take on new projects to meet future customer demand.

While the earnings news was not good, we think the company is still poised to reap the benefits of the coming shift to smaller chips, which will translate into greater demand for probe cards. FormFactor's market is not drying up, its customers are not going away, and though the transition to the new facility has been more difficult than expected, we think the company is in solid shape.

***
New York & Co. (NYSE: NWY) announced that it has acquired Boston-based Jasmine. Jasmine's founders, who have been running the company for the past 35 years, will be coming along as part of the deal.

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Tiny Gems

I personally like the tiny gems. I don't think they make these formal recommendations anymore because they were surprised at how their picks effect the market when released on stocks that are such small caps

Tom's Tiny Gem
My Tiny Gem this month is Wireless Xcessories Group (AMEX: XWG) on the obscure American Stock Exchange, previous home of Marine Products before its recent move to the New York Stock Exchange. Wireless Xcessories has been an incredible 16-bagger over the past year, from a valuation below $3 million to its still micro-cap status today at about $40 million.

The company provides accessories for wireless handhelds such as rechargeable batteries and hands-free sets, selling through 2,500 dealers. The CEO owns more than 25% of the business, the balance sheet is strengthening with more than $2 million in cash on hand, and its long-term debt is completely paid off. Its run rate on owner earnings is above $2 million, which means the stock is trading at about 20 times owner earnings.

I see this as an excellent long-term consumer trend, with the primary threat being mass production from Asian competitors. That said, I think there's enough opportunity for innovation and differentiation to make this a fine wave to surf and a solid company to own.
Buy below $13.

Bill's Tiny Gem
Houston-based Omega Protein (NYSE: OME) is a fish oil and fish meal processing company. Its main product is derived from menhaden, an abundant inedible fish that the Menhaden Resource Council (MRC) at www.menhaden.org calls "a remarkable citizen of the sea." It also says that fishing for menhaden is "probably America's oldest business," having been established by Native Americans and taught to the first colonists.

We like old, stodgy businesses here, so the MRC's attempts to give prominence to its dues-paying fish work for us. Omega Protein's products are used for health-food applications — science suggests that the omega-3 fatty acid found in menhaden contains benefits for cardiovascular health, cancer, and arthritis. Who knows, perhaps someday it will help Tom regrow some hair.

Omega Protein's products come in the form of nutraceuticals, as well as in a food additive. The stock has been beaten up as weather patterns in 2004 caused a disruption in the menhaden catch, hammering Omega Protein's operations. I expect that 2005 will be much better for the company, and am pretty sure the menhaden, in keeping with its august history, isn't going anywhere. As such, this stock offers a compelling value.
Buy below $7.50.

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Investing lesson from last issue

Investing Lesson: Building a Superstar Small-Cap PortfolioSmall caps as a group have been on a tear over the past two years, with the Russell 2000 up 19% per year over the past 24 months. We've outperformed the Russell 2000 since inception, and we hope you're enjoying the positive results. You may be wondering, though, whether to take some money off the table now, given the stellar general performance of small companies.

The answer to questions like this will always depend on a variety of factors, including your age, risk tolerance, investing time horizon, near-term spending needs, and emotional temperament. There's no one-size-fits-all answer to the question of what percentage of your money you should have in stocks generally, or small caps specifically. That said, if you want to be comfortable with what you own, here are a few tips.

Don't Chase Past Performance
One thing you don't want to do is to look at what's been happening in the very recent past and extrapolate that into the distant future. It's particularly true if doing so has you heavily overweighting toward what's been hot! That's a bad idea, whether we're talking about any of our individual recommendations or the overall performance of small-cap stocks.

The temptation to buy what is on fire simply because it is en fuego is unwise. That thinking got a lot of investors in trouble at the turn of the century. For evidence, you need only look at the 1997 to 2000 rise of Lucent Technologies (NYSE: LU) from $15 to $100 per share. Today, the stock trades below $3.

Resist the temptation to blindly chase individual stocks higher; instead, pay close attention to my buy-around prices, which are tied to the present performance of the business and its prospects. Sometimes we will buy more of a stock that's doubled (Middleby at $47). Other times we won't (Marine Products at $21). Sometimes we'll sell a loser (Pegasystems at $7). Other times we'll buy more (Flamel today).

The core factors are a company's operational performance and the price tag on the business. Don't blindly buy because a stock has risen. And don't feel like you need to heavily weight your portfolio with small caps simply because they've been on a tear.

Build a Properly Diversified Portfolio
There's a lively debate about diversification in our Hidden Gems community and beyond. On the one hand, you've got the extreme position advocated by Philip Fisher and Hidden Gems interviewee David Nierenberg. They believe you need no more than five or six stocks in your portfolio. But these master investors operate at levels of expertise beyond that of most members. This is and has been their full-time job for many years.

Unless you've been investing successfully for 15 years, my advice continues to be that you lean toward being diversified into 30 to 40 small caps. If that sounds extreme, remember the examples of Shelby Davis, Peter Lynch, and Joel Tillinghast, who held more than 1,000 companies and absolutely smashed the market's average return.

Shelby Davis continues to stand as one of my investing heroes. His approach entailed buying and virtually never selling. He built a portfolio of more than 1,000 stocks in his personal portfolio and earned annualized returns of more than 23% for decades, turning $50,000 into nearly $900 million. For Shelby Davis, the time to buy stocks was when you had the cash; the time to sell them was when you needed the cash. Otherwise, you just held, letting your big winners erase the effects of your losers.

Today in Hidden Gems, we're at approximately 35 companies, a number that can protect you from violent price volatility on a day-to-day or week-to-week basis. That's a primary reason for diversification: to take emotion out of the sport of investing. In my opinion, you aren't sufficiently diversified if you ever get emotional about your investments. And I mean ever ... in good markets and bad, after good earnings reports and bad.

We'll continue to increase the number of companies recommended here, bringing you more superior investment ideas and encouraging you to diversify your way out of the realm of emotional investing. Forty years from now, you should expect to see an even balder advisor on the masthead, overseeing more than 250 small-cap recommendations, aided by a staff of experts. Remember that the promise we make is to keep track of your Hidden Gems investments until we close out the positions.

Always Add New Money
Finally, this newsletter imposes a discipline upon me as your advisor. Every fourth Thursday, my guest analyst and I are tasked with providing you a pair of formal recommendations, a Watch List, and some Tiny Gems. Some of those recommendations will be repeats, just as this month's is. Most will be new.

With this approach, we are attempting to impose a discipline upon you, too. We want to motivate you to live the life of a net saver. If we can inspire you to set aside regular amounts of money each month for the thrill of investing it in something small and promising, we can move to eliminate money as a limiting factor in the adventure of your life.

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September Hidden Gem picks

Blue Nile
Hidden Gem by Tom Gardner

Risk-Level Rating: Medium

• Pristine balance sheet and growing earnings.

• Loyal customer base with repeat purchasing growing twice as fast as the rest of the business.

• Prototypical use of Internet platform to sell established and desired product without the high cost of retail store operations.

Nasdaq: NILE
705 Fifth Ave. S., Ste. 900
Seattle, WA 98104
Ph: 206-336-6700
www.bluenile.com
(Except price, amounts in millions)
Recent Share Price: $31.45
Market Cap: $550
Cash/Debt: $81.3/0
Owner Earnings Run Rate:$13.5

Buy-Around Price: $32.00


Otter Tail Corp.Hidden Gem by Bill Mann

Risk-Level Rating: Very Low

• Matches a core cash-generating business with a strategy of acquiring undervalued companies.

• Has generated market-beating gains despite low growth at its utility subsidiary.

• There's promise in its wind tower construction and waterfront equipment businesses.

Nasdaq: OTTR
215 S. Cascade St., Box 496
Fergus Falls, MN 56538-0496
Ph: 866-410-8780
www.ottertail.com
(Except price, amounts in millions)
Recent Share Price: $28.01
Market Cap: $816.1
Cash/Debt: $16.1/$259.6
Owner Earnings Run Rate: $54.7

Buy-Around Price: $29.25