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Full Analyst Report............CS First Boston......is now associated with GUMM
Gum Tech International (Nasdaq: GUMM)
January 2001
Gum Tech is getting ready to move into Phase II of its business plan, or from a development company to a profitable enterprise that builds on the foundation and credibility they have established over the last five years. A company can't go from an unknown producer of one product to making gum for billion dollar firms over night, and Gum Tech has spent the last few years establishing itself in the marketplace. So the issue is when and if Gum Tech will generate positive cash flow in their operations. The income statement includes sales, cost of sales, operating expenses, R&D expenses, net interest (income - expense), taxes, and the payment to Biodelivery Technologies. Let's look at these one by one.
Sales: Gum revenue increased sequentially and year to year every quarter in 1998 and into Q1 1999. Year to year sales were higher in Q2 99, but sequentially lower than Q1 99. Year to year and sequential sales began falling in Q3 99, and have fallen every quarter since. The decline in sales has been solely responsible for declining margins on the gum side, but this issue will be remedied once sales of gum increase. The increase will come from sales of dental gum to the major consumer products company and sales of nicotine gum to the joint venture with Swedish Match.
Cost of sales: Gum Tech’s cost of sales include a variable component and a fixed component. In my estimation, the fixed component is approximately $500,000 quarterly, and includes things such as quality assurance personnel, first line supervisory labor, direct labor to make and package gum, labor overhead such as medical and life insurance, leave, and holidays, and other costs of production that don’t vary with the quantity of output. While labor could be considered a variable cost, my discussions with Gum Tech management lead me to believe that they can produce at least $15 million quarterly in gum before a measurable amount of additional labor would be required. Since their production is way below that, I think it is fair to include the cost of labor as a fixed cost. Variable costs include things such as the cost of raw materials, electricity to run the production equipment, etc, and in my estimation are approximately 45% to 50% of sales. Let’s assume for a moment that sales of gum increase to $5 million quarterly. The fixed costs would remain at about $500,000 and variable costs would rise to about $2.5 million, for total cost of sales of about $3 million. Under this scenario, their gross profit would be $2 million, or 40% of sales. I believe that this is a reasonable expectation, and also believe that they will sell a minimum of $5 million quarterly when they start producing dental gum for the large consumer products company. Actually I believe that their gross margin will rise to 45% to 55% with the higher level of production, but to be conservative, let’s leave it at 40%.
Operating expenses, also called general and administrative expenses, include things such as salaries for officers, salaries for administrative personnel, rent, utilities for office space, and perhaps the cost to purchase and maintain machinery, etc. With few exceptions, these expenses have been in the $500k to $700k range quarterly, and I don’t think they will increase much even if sales increase to $15 million quarterly. The reason is that they already have plenty of excess capacity, but for the purposes of this estimate, let’s assume that operating expenses rise to $1 million if sales increase to $5 million.
R&D expenses have varied between $100k to $200k quarterly, and I don’t see a big change coming here either. In fact, the joint venture with Swedish Match will reimburse Gum Tech for the R&D that went into creating nicotine gum.
Net interest is favorable to Gum Tech since they paid off their debt earlier this year. They will save about $500k quarterly or about 6 cents per share.
The deduction for Biodelivery Technologies only comes into play if Gel Tech has an accumulated profit, so they would only have a deduction for this if Gel Tech contributes positive cash flow to Gum Tech.
Net profit: Based on $5 million in quarterly gum sales and my other assumptions, the gum business would generate a net profit of about $1 million, or about 12 cents per share quarterly. Sales of existing gum products will be accretive to earnings once they get over the break-even point, which I estimate to be about $2 million quarterly. I believe that sales of existing gum products will add about 3 cents per share to earnings, for total earnings from the gum business of about 15 cents quarterly. This analysis doesn’t even include the value of the joint venture with Swedish Match. While sales to the joint venture won’t immediately generate profits to Gum Tech, the value of the asset that they own with Swedish Match will increase as the joint venture’s sales increase and profits accrue. This will add value to Gum Tech even if a profit doesn’t show up on the income statement. The value of the joint venture will show up on the balance sheet instead. Depending on how much the joint venture pays for nicotine gum, Gum Tech’s profit could be higher than I have estimated here. For example, if the joint venture pays a portion of Gum Tech’s operating expenses and fixed cost of sales, more profit will make it to the bottom line. I believe that some of these costs will be included in the price of nicotine gum to the joint venture because they are part of the costs of making nicotine gum and fall into the category of “full cost”. To err on the side of conservatism, I have not included this in my estimate.
Zicam: ANNUAL analysis. Based on $10 million in advertising, $4 million in other operating expenses, $1 million in R&D, and 72% gross margin, Gel Tech would contribute the following profit to Gum Tech at various sales levels:
Sales (million)-------------Profit (per share)
$21.5----------------------- break-even
$25.0-----------------------$0.23
$30.0-----------------------$0.51
$35.0-----------------------$0.78
$40.0-----------------------$1.06
Every $5.0 million in sales adds $0.28 per share to earnings.
You can use your own judgement on how much they will sell annually. Despite the delay, I still think that they will sell Zicam outside the US.
I don’t think it is unreasonable to expect Gel Tech to sell $25 million to $35 million in Zicam in 2001. If you assume $30 million, the profit to Gum Tech would be 51 cents per share. If you add in 60 cents per share from the gum business, total profits in 2001 would be $1.11 per share. Based on a forward PE of 30, the stock would be worth $33 one year forward. If you add in even only $5 per share for the value of the joint venture with Swedish Match, the one year forward value is $38. If you discount that value back one year at a rate even as high as 25%, the stock would be worth $30 today. The reason it isn’t trading there is due to a combination of factors including a lousy market, rising short interest, uncertainty regarding sales of Zicam, uncertainty regarding the timing of and magnitude of dental gum sales to the large consumer products company, and uncertainty regarding sales of nicotine gum. If any reputable analyst other than Gunn Allen, put out an estimate such as mine, the stock would trade much higher than it is now. By the time you see two consecutive quarters of positive cash flow, I think that the stock will trade two to three times today’s price.
This Analyst Report was issued by Dan Zimmermann M.B.A. who has followed Gum Tech for several years.
Institutional analysts can contact him at makemilns@yahoo.com for further assistance.
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