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Printer FriendlyCNS, Inc.(CNXS) - $4.60 on Oct 14, 2001 bybibicif87

Price: $4.60 EarningsPerShare:

Shares Outstanding (in M): N/M P/E:

Market Cap (in $M): 65 P/FCF:

Net Debt (in $M): N/M EBIT (in $M):

TEV (in $M): N/M TEV/EBIT:

CNS, Inc., is a consumer products company selling for less than half of its value

as an acquisition. There is good reason to believe that it will be sold within a

year or so. In addition, it has a cash heavy, debt-free balance sheet, and sells

at less than ten times the coming years estimated earnings, thus providing some

nice upside potential while awaiting a takeover.

PRODUCT: CNXSs primary product is an odd one, the Breathe Right Nasal Strip

(BRNS), that Band-Aid looking thing seen on the noses of many football players.

It is a strip of plastic or fabric which sticks to the nostrils and pulls themout and open. To get an idea of its effect, first breathe through your nose,

then try it again using your fingers to lift your nostrils away from your face.

Youll probably notice a big difference in air intake.

The BRNS line is one of the best selling products in the cough/cold product

category in the US, and it has recently been reintroduced abroad after a several

year hiatus. Each BRNS strip can only be used once. It is primarily sold in

boxes of 12 and 30, and the retail price works out to about a half buck or so

per strip. In addition to theoriginal tan colored strips, there are clear

plastic ones, tan ones impregnated with VicksVap-o-Rub, and a line of kids

strips with Vicks, or with decorative designs. The adult strips come in two

sizes to handle most nose sizes.

While a good source of publicity, the football player market is minuscule, and

athletic use in the aggregate is probably not more than 10% of sales. The

primary buyers are people who use BRNS while sleeping, either because they have a

cold, or to prevent snoring, or because they have a deviated septum or other

physical abnormality that prevents a comfortable nights sleep. Nasal sprays and

decongestant pills can accomplish some of the same goals, but they can have

unwanted side effects, especially the sprays, while BRNS, other than the benign

Vicks version, is drug free.

Many people find that BRNS has a dramatic effect on their ability to sleep, and

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use one nearly every night. This group of highly loyal users (one might even

consider them addicts) represents a major part of BRNS sales. It makes BRNS

relatively unique as a consumer package goods product, in that addicts do not

require much, or possibly any, advertising to get them to keep buying the

product.

Although many people, because of the shape of their nose or other reasons, wont

use the product, the market is still relatively untapped. Even if loyal users

(Ill define them as those using 300+ strips per year) accounted for 100% of BRNS

sales, that still comes to well under 1 million people, a tiny percent of peoplewho snore, have colds, or other difficulties where BRNS might help considerably.

Only some poorly designed private label nasal strips, that cant use CNXSs

patents, stand in the way of CNXS having 100% market share of the nasal strip

category, and those competitors account for well under 10% of the market.

Contrast that position with a typical brand of soap, deodorant, shampoo, hand

cream, or toothpaste, where the markets are saturated, the competitive products

are similar, and the consumer is fickle, requiring constant heavy advertising for

a competitor to maintain market share. While CNXS has in fact been advertising

very heavily (excessively so, IMO) in the last few years in order to build up its

base of loyal users, were it to stop all advertising completely, sales would holdquite stable, and profits would explode.

In other words, much of the red ink in the last few years was, in a sense,

voluntary, with current profits being sacrificed by heavy advertising in order to

grow the brand. As a result, the BRNS line has finally grown enough that,

despite continued heavy advertising, the company is turning nicely profitable.

With 65% gross margins and a loyal customer base that mostly doesnt need

reminder advertising, CNXS could show massive earnings any time it wants to, once

it is willing to start milking the brand rather than grow it.

VALUE AS AN INDEPENDENT COMPANY: Numbers for Q3 2001 will be out October 18.

CNXS recently announced that EPS would be in the $0.32-.37 range untaxed onclose to $19MM in sales, up from the $0.25-.30 projection for Q3 made when Q2

numbers were released. (CNXS has no analyst coverage, so therefore no

consensus.) Given the sales weakness for the quarter reported by retailer CVS and

other customers and companies in the health and beauty products area, this

suggests that the loyal user base has grown nicely, allowing CNXS to buck the

trend.

Note that Q3s earnings are often the highest, even though BRNS sales are much

stronger during the winter cold season, because there is minimal advertising over

the summer. CNXSs advertising is always a short term loser, although if it

creates enough loyal users, it will pay over the long run.

Just looking at the near term financials, CNXS is cheap. Company guidance for

next year, made with the Q2 earnings release and now looking conservative in view

of recent trends, is for sales of $90-100MM and operating profits of $9-12MM,

which works out to diluted EPS in the range of about $0.67-.87 untaxed, or

$0.44-.57 as if taxed. With over $20MM in cash, no debt, and negligible capital

needs, its EV of $45MM is modest at about one half sales.

Given the untapped growth potential, both in the US and overseas, a P/E of 15

times next years taxed EPS could have the stock in the $6.60-8.60 range, an

adequate enough return, if nothing else happens. If the stock continues to lag,

the company, which has reduced its shares outstanding from 19MM to 14MM in the

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last few years, could keep buying back stock.

VALUE AS AN ACQUISITION: CNXS should not exist as an independent company. It is

nothing more than one major brand (BRNS) and one minor brand (FiberChoice fiber

supplement), disguised as a company. If another health and beauty products

company (think P&G as an example) were to acquire CNXS, the buyer could eliminate

all of CNXSs executives, its marketing staff, and the R&D people. The buyer

could lower the advertising expense per ad because of superior purchasing power,

and push the product into other channels, such as convenience stores, where

CNXSs marketing is weak.

The BRNS brand calls for a brand manager, not a complete company. Cost reduction

that could be achieved by an industry buyer would probably be on the order of

$8MM per year, and sales could be an extra $10MM per year higher, adding another

$6.5MM to gross margin. So whatever CNXS is worth as a going concern, its

EBITDA, were it part of another company, would be substantially higher. The

logic of CNXS being bought out is compelling.

Fortunately for our analysis, branded package goods lines change hands often

enough for one to get a sense of value. Negotiations normally take place in

terms of price to sales, since the buyer, integrating the brands into its own

organization, might have a considerably different cost structure than the seller.The most recent transaction, announced last week, is Smucker (SJM) buying Jif

and Crisco from P&G at 1.7 times sales.

Ive kept track of other transactions in the last few years, and they tend to go

for between 1.5 and 2.5 times sales. (My guess is that the SJM/PG transaction was

at the low end because this will double SJMs size, implying SJM will need a lot

more staff to handle it, and cant cut costs as much as a larger buyer might.)

Brands with a high gross margin and low continuing need for advertising, like

BRNS, are potentially much more profitable and therefore tend to trade on the

high end. Even some weak brands in competitive areas can fetch some surprisingly

high prices to the right buyer, such as the sale a year ago of the declining BAN

deodorant brand for 2 times sales.

At a lowly 1.5 times sales, CNXS would be worth about $10 per share, adding in

its cash and receivables, subtracting all liabilities, and assuming all stock

options get exercised. At 2 times sales, it comes to $13. Ill take either.

Will CNXS be sold, or will management cling to its jobs at the expense of

shareholders? One never knows. The fact that management has a lot of stock and

options, but not so much as to fend off an unfriendly raid, suggests it will do

the right thing.

I sense that management has been awaiting substantial and sustainable black ink

before putting the company up for sale, to strengthen its stock price andnegotiating position first. With the strong Q3 numbers, the clock is starting to

tick.

ADDITIONAL INFO: Topics I can discuss in follow up notes if anyone cares, rather

than further lengthen this post, include: Why did sales plummet so much between

1996-99? Why the weird swings in quarterly numbers in recent years? What about

international markets? Do CNXSs minor products (FiberChoice and Flair) have any

value or potential? How strong and/or important is the patent protection for

BRNS? What can go wrong?

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Private Expand All

Collapse All

1. Strong chance of CNXS being acquired by another consumer products company,

with a value, based on comparable transactions and the huge consolidation savings

available to the buyer, of more than $10.

2. P/E of under ten on rapidly growing earnings, from a company with about $1.50

per share of cash, no debt, and minimal capital spending needs.

# Author Date Subject

12 bibicif87 04/12/02 11:49 AMSpray andstrips

I'm certainly no otolaryngologist, but from what I understand CNXS's newanti-snoring throat spray attacks a different cause of snoring than its stripsdo.

From a medical website: "The noisy sounds of snoring occur when there is anobstruction to the free flow of air through the passages at the back of the

mouth and nose. This area is the collapsible part of the airway where thetongue and upper throat meet the soft palate and uvula. Snoring occurswhen these structures strike each other and vibrate during breathing."

Nasal strips attack the problem by keeping the nasal passageways open;when they are closed, one breathes through the mouth only, and thatcauses the tongue to s lide back and set up the vibration mentioned above.For many people, that will solve the problem.

But for many other people, it makes no difference how clear the nasalpassages are, their tongue will slide back anyway. The new spray attackssnoring by containing both an astringent, which stiffens the tissues thatmight otherwise vibrate, and a lubricant, so the back of the tongue will slidearound more and not force air through a narrow passage, causing the tissuevibration.

So the spray should work for some people for whom the strips won't, viceversa, and some people should probably use both.

One difference is that the strips in many cases give the user a better night'ssleep, because one is less likely to wake up because of a dry mouth frommouth-only breathing. That is why I use the strips, and use them even whenthere is no one by my side to be disturbed by snoring. The spray can onlyaffect snoring, and not quality of sleep.

At my request the company sent me a sample bottle of the spray, and from avery limited test so far it seems to be working. I find the flavor of it mild and

acceptable, but that is obviously and literally a matter of taste.

From a business point of view, I consider this new product to be a verypositive development for a variety of reasons.

The anti-snoring market is potentially huge, with the number of people whoregularly snore measured in the many tens of millions (the number of regularnasal strip users is only a few hundred thousand.) Breathe Right is probablythe only well known brand name in that field. With this new product CNXShas an opportunity to build on its established reputation and extend itsdominance in the field, where it already has 90+% of the nasal stripbusiness.

Anti-snoring is a great market to attack because it is something people do

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every day of the year, as opposed to the use of nasal strips by those withcolds or flu, or involved in athletic events. The cold remedy market is verycompetitive, requiring heavy advertising to maintain share. An anti snoringproduct, taken nightly, easily becomes a habit that results in repeatpurchases without constant advertising reminders. Also, there will be obviouscross marketing opportunities, with free nasal strips in the box containing thespray bottle, and coupons for the spray in the nasal strip boxes.

The company has indicated that gross margins on the spray should be atleast as good as with the strips, and it will be priced similarly in terms of costper night, so if there is some small amount of cannibalization, it won't hurt.Marketing money spent on the new product, because it is going out underthe Breathe Right name, should have some positive effect on the nasal stripsas well, unlike the heavy advertising spending that CNXS did for itsFiberChoice product.

Another advantage from this product is increased shelf space at the majorretailers. There is a limit as to how much real estate retailers will give tonasal strips, and by expanding its SKU's in the last year to include the Vixvapors infused strips, to some extent CNXS was cannibalizing itself.

Other anti-snoring sprays have come out in the last couple of years, but thebig retailers have shunned them because their makers were no-name outfitsthat couldn't afford national advertising other than of the 800 number late

night TV type. Breathe Right is the established brand name in the field, andCNXS will spend millions (diverted from the nasal strip advertising budget) tosupport the spray, so it looks like it should be getting the shelf space itneeds to make the product a success.

Overall, this strikes me as an excellent brand line extension. The risk is low,because even if people don't buy the spray, the advertising for the BreatheRight brand may help the strips. The upside potential of another product with~70% gross margins and potential sales in the tens of millions, without amajor expansion of the advertising budget, seems worth the risk.

11 andrew14 04/08/02 11:07 AMwho makesvicks?

a natural acquiror of cnxs??

10 andrew14 04/08/02 11:03 AM@bibi- newthroat sprayproduc

What's your take on this product and the new ad $ that have to be putbehind it.?

In some respects this cannabalizes the snoring market strips are targeted at.However, it may prove more effective for some snorers than others vs. strips.

Are the margins per usage anywhere near those of strip? I highly doubt it.

9 bibicif87 03/06/02 10:57 AM

CNXS Q4,

and avaluationcompa

Andrew14: CNXS's Q4 was nothing to get excited about, but neither it northe s lightly reduced guidance changes the bullish case.

Earnings in Q4 were actually a bit above the company's previous prediction,but that was mostly because advertising spending was a little less thanexpected. Sales were OK at best, and the main factor, which affected theentire cough/flu category, was the decrease in the number of people who selfmedicated with OTC medications, and increase those using prescriptionremedies, relative to the number of people known to have been ill.

No one knows why this is the case. One theory is that in Q4 people were

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nervous about anthrax and went to doctors who gave them prescriptions. Ifso, then people should revert to their previous normal behavior over time. Orperhaps there is some fundamental change in "normal" behavior. Since CNXSdidn't know why consumers' behavior has changed, it lowered its projectionssomewhat going forward, just to play it safe.

Bear in mind that the snoring market is both bigger and much more profitablefor CNXS, since people who buy the strips for that reason use them everynight, and require little advertising since there is no really competitiveproduct out there. Nevertheless, CNXS has gone aggressively after thecold/flu users in the last two years, to introduce the product to a new group.That has worked, but at the literal expense of heavy advertising, and theadded uncertainty that comes from having a big chunk of one's businessdependent on things that are unpredictable, like how many people will get acold, and how they might choose to treat it. The company has indicated that,now that BRNS is better known amongst potential cold/flu users, it will putmore effort back into growing the snoring prevention market.

Despite the poor performance of its category, BRNS sales were still relativelystrong. Sales overseas were up substantially, and are still in very earlystages of lift off in various countries. With its high gross margins, the extrasales are having a big impact on profits. And one advantage of the loweredprojection was that the stock sold off a bit, enabling the company to buy backa half million shares at around the $5 level.

In current news, there was a transaction yesterday that backs up my 1.5 to2.5 times sales estimated value for CNXS's brands. Chattem (CHTT $18)bought Selsun Blue medicated shampoo from Abbott Labs for about 1.9 timessales. Remember, one uses "times sales" rather than an earnings basedmeasure because the cost structure that the buyer imposes on the brand isprobably different than what the seller had; this is especially true when theseller is a small public company such as CNXS in which one brand has tosupport the entire corporate infrastructure.

Selsun is a good product, but with many similar competitors there is noreason to think that it has margins or growth prospects any better thanBreathe Right. At that valuation level, and adding in net liquid assets, CNXS isworth more than $13.

8 andrew14 03/04/02 01:53 PM

anythoughtsfrom mostrecent

was curious as to your take-away from most recent earnings report/conf calland somewhat reduced guidance.

7 bibicif87 11/09/01 01:41 PMPresentationonline

On November 6 CNXS gave a presentation to some analysts in NYC, and putthe presentation online on its website at http://www.cns.com

It lasts about 40 minutes, with both audio and a slide show, including a Q&Aat the end. If you have any interest in the stock, it is worth listening to.

6 bibicif87 10/18/01 03:38 PM

Colds,prices,milking, sidee

"Do people with colds really use these? Personally, if I had a cold I wouldn'twant to put a plastic strap on my nose (when I am blowing my nose all thetime)"

I never wear nasal strips during the day, cold or no cold. The fact is, they looksilly. But I do put one on almost every night just before sleeping, since I get a

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much better night's sleep and my wife says I snore much less. I suspect mostusers, even the ones who use them only when they have colds, wear themjust for sleeping.

"Do you have unit volume history. Any idea of how much sales increase isfrom volume increase vs. price increase"?

The company hasn't given out volume figures, although one can make crudeguesses by dividing sales by some approximate retail price per strip. I don'tbelieve that CNXS has changed the suggested retail price, and presumablythe wholesale price, for years.

Interestingly, many retailers, like CVS and Walgreen's, charge a good bitmore than suggested list price. A 30 count box of clear strips, the ones I buy,that have a list of $11.99, are usually sold for $13.49 at those stores. EvenWal-Mart wants $10.49 for them, an unusually small discount for it. Thatsuggests to me that retailers know that BRNS users are very loyal, and willpay up to get the product. This is why BRNS is a much more valuablefranchise than the price of CNXS might imply.

This also suggests that BRNS is a very high margin product line for retailers,which is why they have been giving it more shelf space, and why they didn'tgo out of their way to help Schering Plough when it came out with acompetitive product a few years ago.

"What is your assumption of normalized FCF assuming mgmt. does decide to"milk" the business."

That depends on how low advertising can go without having a negativeeffect on sales. I think quite low, but management disagrees with me. Andyou can't really drop it to zero, or retailers would think that the company isn'thelping them, and might turn over some shelf space to other products.

Q3 numbers, due to be released less than an hour from when I am writingthis, will give you an idea of what a quarter would look like with very littleadvertising. CNXS preannounced that sa les would be $18-19MM and eps inthe $0.32-.37 range, untaxed. Q4 should typically be a few million better interms of sales, because of winter colds, and gross margins are in the 65%

range, so the numbers could easily be a dime or more higher in Q4, if CNXSwanted to go the "milk the cow" route. But I am sure it will still spendsignificant amounts on advertising in Q4 to grow the brand. The importantthing is that it appears that BRNS has enough base users that the companyas a whole is becoming decently profitable, despite that.

"Also curious about the side affects from the other products."

I'm no doctor, but I know that many nasal sprays have a "rebound effect",where you need more and more every night to get ithem to work. Cold pillsmake some people groggy the next morning, while other people find theymake them jittery. Most of what I know on the matter comes from readingthe warnings that come w ith the literature in the various products' boxes.

5 blue320 10/18/01 02:05 PMVery wellwritten idea.Seems

Very well written idea. Seems like an interesting name. Do people with coldsreally use these? Persona lly, if I had a cold I wouldn't want to put a plasticstrap on my nose (when I am blowing my nose all the time). Do you have unitvolume history. Any idea of how much sales increase is from volume increasevs. price increase. What is your assumption of normalized FCF assumingmgmt. does decide to "milk" the business. Also curious about the side affectsfrom the other products. Thanks.

4 bibicif87 10/16/01 03:22 AMre: CashFlow

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I don't have the numbers in front of me at the moment, but the big drop incash in Q1 is very explainable. In Q4 2000 CNXS was still doing a high level ofads introducing the FiberChoice product, and Q4 is part of the cough/coldseason during which time Breathe Right Nasal Strips is heavily advertised aswell. A lot of this advertising took place in the month of December, leaving abig accounts payable on the books on 12/31/00. The bills were paid in Q1,hence the drop in cash.

I'll add that cash flow pretty much tracks profits at CNXS, with the occasionalone quarter lag as I just described. Depreciation and other non-cash charges

are low, and so is capital spending, because this is not a capital intensivebusiness. Manufacturing is all outsourced.

Now that the losses from the introduction of FiberChoice are behind it, andsales of Breathe Right have gotten to the point that the company can showdecent profits despite heavy ad spending to grow the brand, we should seecash rising rapidly over the next year. I expect updated guidance with the Q3release this Thursday, but expect cash to rise by about the level of expectedprofits, which will be untaxed for a while, due to a large tax losscarryforward.

3 wrt233 10/15/01 11:02 PM Cash flow

A good idea, well presented.

Cash flow was aw ful in Q1 01 vs. the previous year (the Q2 comparison wasslightly favorable), triggering a $12M drop in cash from $31.3 to $19.3 (it's at$19.7 as of Q2 01). Any idea what happened?

2 bibicif87 10/14/01 07:34 PMhistory,management,patents

"Why the w ide swing in profits over past few years"?

Let me give you the long term history of CNXS: The company was founded in1982 by two doctors to build specialty medical devices, and went public in1987. It blobbed along, not accomplishing much commercially, until it licensedand started selling Breathe Right Nasal Strips ("BRNS") in the early 1990's.Football star Jerry Rice started wearing them in 1994, and radio commentatorRush Limbaugh started touting BRNS in 1995, and the product took off.

In 1995, 3M was took a license from CNXS to market the product outside theUS, and a combination of the publicity from football and Limbaugh, plusenormous purchases by 3M for pipeline filling, caused sales to explode in1995 and 1996. In two years, CNXS had gone from sales of about $3MM to$86MM.

Then everything fell apart. At the time CNXS lacked management with anyconsumer products background, and was unable to sustain the brand whenthe initial consumer fad was over. Orders from 3M dwindled from $25.8MM in1996, to $6.4MM in 1997, to $1.8MM in 1998. 3M had overstocked the

product initially and then, due to a change in focus away from a group ofhealth products of which BRNS was a part, stopped advertising and just satthere, slowly working off inventory and not ordering much more from CNXS.

In 1999, CNXS bought back the foreign marketing rights to BRNS from 3M, soit could aggress ively develop the bus iness overseas. In Q3 1999, CNXS tooka $6.35MM writedown for the cost of the repurchased license and 3M'sremaining inventory. The switchover was effective on 7/1/00; one reasonwhy sa les in Q3 2000 jumped so much (and make this year's Q3 sales growthlook so anemic by comparison) was CNXS's initial pipeline filling deliveries tosome new ly appointed foreign distributors.

A second item that has had a positive effect on sales and a negative one onearnings in the last four quarters has been the introduction in Q2 2000 of

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CNXS's only significant product other than BRNS, FiberChoice chewable bulkfiber tablets. This is a product that competes with Metamucil, FiberCon, etc.Its advantage is that it is a tasty (to me, anyway) chewable tablet that canbe eaten without water. Competitive products in this segment a ll require theuser to drink lots of water, or the product itself is a powder that must bemixed with water, forming an unappetizing sludge. The lack of water is a plusfor older users, and others who want to avoid frequent urination.

There were pipeline filling shipments of FiberChoice in Q2 and Q3 last year.Also, CNXS spent heavily on advertising to introduce the product, much morethan could be justified by the initial sales. This accounted for a big part of thered ink in 2000 and early 2001.

In June of this year CNXS announced a restructuring. It laid off about 25% ofits staff, took an $0.08 per share write down, and decided to cut way back onFiberChoice advertising. Essentially, FiberChoice's sales seemed unaffectedby the level of advertising, so why bother?

To summarize, various corporate developments have caused some bigswings in quarterly sales and earnings, but the big picture is this:

1. CNXS is mainly about the BRNS product.2. Sales exploded into 1996, dropped off through 1999, and are now on theway back up, aided by both domestic growth and international markets.

3. Other than write downs in Q3 1999 and Q2 2001, losses have beencaused by heavy advertising to build the brands.4. Advertising as a percent of sales should be dropping steadily goingforward, which is why the company expects substantial black ink in 2002.

"have you talked with mangement - would they really sell? Are their interestsaligned w ith ours?"

They say all the right things, but you never know. Their salaries plus bonusesare too high, IMO, given the company's performance in recent years. On theother hand, they own lots of stock, including options for over 1MM shares, yetnot so much that they could fight off a raider with a premium bid. I think thattheir interests lie in fattening up the profits and stock price, and selling it outfor the low to mid teens, as I explained in my original post on this stock,

rather than take a chance that someone unexpected could come along andbid $8, and kick them out.

Management is well aware that CNXS is worth much more dead (i.e., as partof another company) than alive (as an independent company). The Q2 layoffsand the slowing of advertising expenses, the items that helped make Q3'snumbers (to be released this Thursday) so good, are very positive signs thatthe "fattening up for sale" process has begun.

"How do I get I handle on how proprietary this technology really is?"

There are patents. And, as a lways, where there are patents, there arecomplex patent lawsuits. Beats me as to who will ultimately win, however

many years from now that may be.

In any event, I am not so sure that patents are all that important. BRNS isthe dominant brand of nasal strip, with more than 90% of the market. A fewyears ago, a potentially formidable competitor, Schering Plough, under itsestablished "Afrin" brand, introduced a competitive product, and spentheavily on advertising. It went nowhere, and that product is now gone. Thatexperience won't encourage others, I don't think.

Here is a link to the 10-K, with much more info:http://www.sec.gov/Archives/edgar/data/814258/000089710101500081/cns01

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1 bedrock346 10/14/01 04:32 PM Profits,Management,patents

Why the w ide swing in profits over past few years, have you talked withmangement - would they really sell? Are their interests aligned with ours?

How do I get I handle on how proprietary this technology really is?

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