“The cell phone is the black hole of 21st century technology.” I’m quoting myself here, but this insight is truer today than when I first said it a few years ago, and it is making a big difference to our investments–especially one that is a Top Buy today.

What it means is that numerous functions of different kinds of electronic gear are turning into features of the cell phone. What started as a device to make mobile telephone calls quickly expanded to text messaging and then added and integrated the:

• personal digital assistant (PDA), calendar and contact list
• digital camera
• MP3 music player
• digital camcorder
• Internet browser
• GPS navigator

As these functions become standard features, the companies making the standalone devices get pushed into the smaller high-end market that will pay for higher quality or extra functionality. The companies that make the specialized semiconductors and other components for the standalone device get their profit margins squeezed as they transition from selling to dozens of device manufacturers to sitting across the table from the buyers for Samsung, Nokia and Motorola. Those folks calculate chip prices to the fourth decimal.

Cell phones will be one of the strongest markets in 2008 and 2009. In 2007, personal computer sales rose 14% to 269 million, beating my forecast of 263 million. I had one of the highest estimates around, based on the Vista upgrade and overseas strength, when others were saying PCs are old technology and a dead market. This year I think we’ll see only 5% growth, and then 2009 to 2011 will be flat if the deep recession I anticipate comes to pass.

In contrast, 2007 cell phone sales rose 16% to 1.15 billion, also beating my forecast of 1.025 billion, based on more features and flat prices. This morning, Gartner Group announced that March quarter cell phone sales hit 294.3 million phones, up 13.6% from the same quarter in 2007. But sales in Western Europe fell 16.4% from a year earlier, the first decline there ever. Sales also fell 10.1% in Japan. Still, I expect double-digit growth again this year, in the 10% area, and about 5% further growth in 2009. A deep recession should produce a flat 2010 and 2011, but I would be the first to say that if I’m wrong, I’m low.

There are about two billion cell phones activated in the world today. In Asia and some less developed countries, an Internet-enabled cell phone is seen as a much cheaper substitute for a computer. Data services are getting faster and everywhere but in the United States, usage charges are coming down. Between the most recent spectrum auction, WiMAX and a deep recession around the corner, monthly charges might even come down in the U.S. in a couple of years.

With so many phones and an infrastructure in place, companies are now looking at the cell phone with a large screen and text messaging capability as a potential platform for some exotic, small-market applications. For example, in the medical area, phones are being tested in the Bay Area to stop heart attacks, rehabilitate stroke patients, monitor internal bleeding in women who have just given birth and spot potentially cancerous tumors.

Most of these new applications treat the phone as just a data collection device, using a specialized piece of equipment that plugs into the phone’s USB port. One company designed a cheap, handheld ultrasound scanner to detect breast tumors. It collects tissue data and transmits it to a computer for analysis. The computer then sends an image back to the cell phone’s screen. Their next application is detecting internal bleeding, a common cause of death after childbirth in less developed countries.

A UC-San Francisco team has been putting cell phones in ambulances to continuously monitor heart attack patients. For the last five years, Santa Cruz County ambulances have carried a 12-lead EKG data collector that transmits over the cell phone. If the patient’s heart rhythm shows an abnormal pattern, the phone dials the emergency room, a cardiologist takes a look, and the ER team can be ready to start treatment immediately once the patient arrives. Heart muscle starts dying quickly after a heart attack, and it never comes back. So far, patients using the ambulance-based system get diagnosed one hour earlier and treated 37 minutes sooner than others. For treatment with tPA or similar drugs, that much time can make a world of difference in long-term disability or even death.

A UC-Santa Cruz research group is working on using cell phones to provide inexpensive speech therapy to stroke victims. It is based on a computer program that has an animated language tutor that carefully demonstrates how to pronounce words. Users can look inside the tutor’s mouth to see where their tongues should be placed or move. The program has been used to teach deaf and autistic children to talk. Now they will move it to large-screen cell phones and test it in Malaysia. As is the case in many less developed countries, cell phone networks reach about twice as many people as Internet service providers. Providing speech therapy over cell phones is much less expensive than doing it in person, so the health care systems will be eager to adopt a successful therapy.

Cell phones are not about to replace stethoscopes, but they are a cost-effective platform to deliver first-class medical care in less developed countries or rural locations. The application opportunities in diagnosis, treatment and rehabilitation seem endless, especially as large screens, video downloads and text messaging become commonplace. It’s a long way from just being able to dial 911.

How do we invest?

The component suppliers in cell phones or any other portable consumer device have an obvious problem. No matter which function they started providing to a standalone device, they have to plan both to take that function to the limit in higher-end devices and cope with the integration of their specialized function into a multifunction device. They can cope in the short run by licensing their intellectual property (IP) to a bigger company like Texas Instruments that is consolidating functions into features. That was the path RF Micro Devices took with their Bluetooth business after investing tens of millions of dollars in R&D to develop a very successful chip set. They milked it for a while and then sold their Bluetooth assets to Qualcomm, which introduced an integrated solution. Now RF Micro Devices has stopped investing in their transceiver products as that function is integrated into the main processing chip.

Or they can develop or in-license additional IP to transition to being a broadline supplier themselves, preferably avoiding competing with the likes of Texas Instruments head-on. That’s the transition underway at SiRF Technology (SIRF), where they are moving their world-class GPS technology into a general applications processor that will be able to handle many other functions. I think they will succeed, although I suspect acting CEO Dado Banatao might sell the company rather than continue to go it alone.

One of the most powerful ways to cope with this world of functions into features is to offer a chip solution that provides all the core functions of a consumer electronic device that also provides very easy customization so the manufacturer can introduce a whole line of products at different price points, easily upgrade to new models and even respond quickly to competitors’ moves to add new features. That’s the strategy underlying our investment in Top Buy-rated QuickLogic (QUIK). With the stock stuck under $2 due to conservative guidance on the March quarter conference call, a profits probable in 2009 versus Wall Street’s estimate for a 17 cent loss (only one analyst, though), I think this is a remarkable opportunity to take a big position in the stock.

QuickLogic started with a better way to make programmable logic devices, competing with Xilinx and Altera. They have evolved into what they call Customer Specific Standard Parts (CSSP), which is taking a standard programmable chip a step further by programming some “platform” core functions into it. The customer can then add functions to create a whole product line based on the platform functions, get into the market quickly, upgrade their products later by adding functions, or respond to competitors by shortening product cycles. Because QUIK’s technology is inherently low power, the company focuses on battery-powered devices, primarily for consumers.

QuickLogic does not produce the main processing chip, so we can expect some of their design features to be designed in to the main chip as volumes accelerate. Of course, those tend to be high volume functions or they wouldn’t be integrated in the first place. So QUIK management has to be on top of this continuing transition, introducing new functions as older ones get absorbed by the processor. But one major advantage QUIK has is that there always are new functions emerging and becoming mainstream and the device manufacturers want to be able to introduce models of their basic platform that include the new functions. So there is a strong incentive to design in the QUIK chip, even if marketing can’t exactly predict which functions will emerge as important over the next year or two.

QUIK’s CSSP chips have a tested, bulletproof interface to the processor or communications bus on one side, and a human or machine interface on the other. In between, the programmable logic and memory makes the chip adaptable to new requirements. It’s a unique approach that’s already shown solid market acceptance, and if management can continue to execute and get new design wins, QUIK should be the next great semiconductor stock. It is hard to believe it is trading at a “perpetual option” price. QUIK remains a Top Buy up to $4 (the first double) for an $8 target (the second double–and there could be a third one waiting for us).

Biotech MegaShift

CombinatoRx (CRXX) completed patient enrollment in their Phase IIb trial designed of CRx-102 for symptomatic knee osteoarthritis. The study was overenrolled, with 279 patients participating. Results will be reported in the second half of this year. CRXX is a buy up to $7 for my $16 target.

ViroPharma (VPHM) said this morning that they have completed enrollment in the Phase III study of maribavir to prevent cytomegalovirus (CMV) disease in 681 stem cell transplant patients. It was done in 90 transplant centers in the U.S., Canada, and Europe, so everyone in the field knows about it. The company said that data collection for the six month assessment will continue through November, top line results will be announced in the March quarter of 2009, and the NDA will be filed in the September quarter. VPHM remains a buy up to $12 for my $25 target.

Content on Demand

Akamai (AKAM) was downgraded by both Goldman Sachs and Citicorp in the last couple of weeks. Goldman took the stock to a “sell” based on the old competition argument, even citing AT&T as a potential near-term competitor. Goldman’s analyst wrote: “Beyond valuation, we are also concerned about intensifying competition as private entrants proliferate and selected large network operators begin to eye the space … While portions of Akamai’s customer base are likely relatively immune from competitive pressures, we believe that the majority of Akamai’s 2,700 customers will be able to put increasing pressure on the company as contracts come up for renewal this year.”

Wrong, or rather, “still wrong,” as I had discussed this red herring in my original recommendation here. Yes, there are other companies with excess capacity in their data centers that periodically announce they are in Akamai’s business, offering local Web page storage. Then they discover it is everything else AKAM offers–transcoding, content management, digital rights management (DRM) and much more–that keep its customers loyal. And the new entrant quietly folds its tent and departs. At one point, the bears went after AKAM by saying Google could enter the business at any time. Well, so could General Motors; they have lots of excess capacity now that they can’t sell giant trucks and SUVs. The only real competitor Akamai has today is Level 3, which offers less functionality for a lower price.

Goldman cites AT&T as the new threat, especially since AT&T is a big Akamai customer. Goldman thinks AT&T might build its own Content Delivery Network. But industry sources tell me that AT&T will have about 400 gigabytes of capacity by the end of the year, which isn’t enough for their own video, software and applications delivery. So even this drop-in-the-bucket-compared-to-Akamai capacity will probably mean T stays a customer of Akamai’s rather than a competitor. And if they decide to compete, there’s the little matter of Akamai’s patents on delivering Internet traffic, which have already sunk or crippled would-be competitors like Speedra and Limelight.

Goldman also cited potential future competition from peer-to-peer networks like BitTorrent as a reason to sell Akamai. There is a technology issue that Akamai must contend with in the future, although they may be able to use peer-to-peer to complement their own service. But right now, peer-to-peer is not making much of an impact on the market. Kontiki is one of the oldest peer-to-peer services, and they did only $6 million in sales last year as part of VeriSign. That’s no reason to downgrade AKAM.

Akamai will encounter more price pressure on its basic services when the market for content delivery slows. But online video is still surging, up 64% in March from last year, and now accounts for more than 50% of Web traffic. More than 100 customers spend more than $1 million a year with Akamai and that number will go up, not down, for the each of the next few years. AKAM is an excellent buy on dips under $36 for my $60 target.

Market Outlook

As I expected, first quarter GDP growth was revised up, not down. While 0.9% growth is nothing to get excited about, it’s getting very hard to believe there will be a U.S. recession if we don’t have a single down quarter. GDP was up even though builders cut spending on housing projects by 25.5% year-over-year, the most in 27 years, and consumer spending grew only 1%. The current quarter is expected to be the weakest of the year at +0.4%, yet this week’s durable goods survey showed surprising strength in everything but commercial aircraft and autos. Excluding the volatile transportation segment, orders rose 2.5%, the biggest gain in nine months. This must have been the most anticipated recession in history, so businesses did not build up inventories or go on a capital spending binge, so it’s possible there are no excesses to work off and therefore the recession will not happen. If we can muddle through the June quarter with ever-so-slowly growing GDP, the Fed cuts and tax rebates should goose growth in the September quarter well over 2.0%. Just this morning, the Fed said they will hold three note auctions in June, each for $75 billion–a whopping $225 billion total. They also auctioned more Treasury securities to investment firms this morning. They offered $25 billion in the Fat Cat Relief Program, but the brokers only took $16.4 billion. Since the brokers can put up their worst junk paper as collateral, this might be a sign that the credit crisis is effectively over. It’s hard to imagine them not taking down every cent they can on these terms.

The stock market has been stronger than I expected, as I thought the S&P 500 would go down to 1366 or 1326 before rebounding over 1395 and heading back up for another try at breaking through 1440. But the bears have not been able to find any traction, and if today’s decisive move over 1395 survives a retest, it should be the last chance to get on board for a big move up in the second half of the year. If 1390 does not hold, then a quick, scary test down to 1326 would set up the same slingshot move. Either way, I still think we are well positioned for that, especially with our Top Buys.

Last week, I discussed the most likely path for the S&P 500. On Monday, the S&P did exactly as I predicted. The index tagged 1440 right on the button and then sold off as the consolidation process began. Going forward, I expect 1440 to continue to be a barrier for two or three more rally attempts, with at least one of the failures providing the dramatic plunge I mentioned last week. Right now, I think the downside will stop at 1385, 1370 or 1366. But I would welcome a plunge to 1326 to really suck in the bears. Then we will blast past 1555 to record highs as shorts cover, put buyers scramble to unwind their positions and the $4 trillion in cash comes off the sidelines rather than miss the action in the second half of the year. So far, the market is following my script pretty closely, and I like what I’m seeing for the potential effect it will have on our stocks.

A subscriber of mine asked a good question at the Las Vegas Money Show:

Q. “If you are expecting serious economic trouble to begin next year, why won’t the market start discounting that now and just forget the rally–especially if the Democrats look likely to win the White House?”

The short, generic answer to this is that the market discounts about six months ahead, not 12 to 18 months. It is easy to over-think market strategy, especially when we fix our focus on what to expect after what we’re expecting now happens.

The longer and more interesting answer is that Wall Street is just catching on to some crucial changes in the world we live and invest in. During the subprime panic in December and January, technology stocks were slammed because conventional Street thinking is:

• The credit crisis/falling consumer confidence/high oil prices will make the economy slow
• If the economy slows, get out of cyclical stocks
• Technology is cyclical, and volatile
• Sell tech

But during the second panic in March, when most stocks set their lows for the year to date, most technology stocks held well above their January lows. I think Wall Street was starting to catch on, but they still have a long way to go. The changes I am looking at revolve around rapid growth in Brazil, Russia, India and China (the BRIC countries), where the numbers are big enough to make a significant difference, plus fast growth in dozens of other less-developed countries.

In many cases, the growth is being aided and abetted by government policies, and high on their lists is developing a technology infrastructure–networking, technical education and communications–that will give them a competitive edge in the 21st century. That means both businesses and governments outside of the United States are spending a lot of money on technology equipment, software and services, much of it sourced from U.S.-traded companies. Even non-technology multinational companies based in the U.S. are dong relatively well due to the strength in non-US demand, so they have to spend on technology to expand their global operations. I’m not looking for much from the strapped U.S. consumer, but remember that the analog television signals will be turned off on February 17, 2009. Most U.S. consumers are as addicted to TV as they are to coffee and sugar, and they’ll find a way to get a digital flat panel TV before the analog signal goes dark. It may be the only present under the Christmas tree, but it will be there.

At the same time Wall Street is realizing that worldwide technology spending will hold up even as the U.S. goes through a slow growth period, or maybe even a recession. Their fear of the credit crisis has shrunk valuations in the financial sector. As a result, technology recently replaced financials as the largest sector in the S&P 500 for the first time since mid-2001, and it is now clear which sector can lead the market up to new record levels.

But will it happen? I’ve said many times that a solid close over 1440 will “ring the bell” for the next leg up. I’ve also said it’s going to take some work to get there, and that it might not happen, so we will let the market tell us what to do. Maybe the bears are right and this was just another relief rally, like the one from mid-August to mid-October of last year.

But yesterday was a very bad day in the markets, compounding the drops Monday afternoon and Tuesday. I was on a plane on Monday, so as the S&P 500 approached 1440, I sold my call options on the S&P Depository Receipts (SPY) or Spydrs. As I mentioned last week, I was expecting a dramatic plunge back to 1395 or maybe 1350 in a late June/early July summer swoon. After hitting 1440.24–I can’t call them closer than that–the S&P dropped 14 points during the rest of the day, 13 more points on Tuesday, and 23 points yesterday to go under 1395. I doubt this was the big drop, because instead of a sharp recovery today, the S&P is consolidating just under 1395. That tells me the market wants to go lower.

But if we see a further quick drop to 1350 or even 1326, my summer swoon may be here already. This is great news. A market that consolidates by dropping rapidly back to the last support levels scares the bulls, reinvigorates the short sellers and put buyers, and quickly gains the energy needed to move much higher. It’s a much clearer picture than the typical back-and-forth or sideways consolidation that takes a few weeks to play out. It means the next bounce could clear 1440 and be the slingshot that launches the run to new all-time record highs.

I am feeling good enough about this move to recommend a new stock in the Content on Demand MegaShift. I also looked hard at Hansen Medical (HNSN), a robotic arrhythmia surgery company started by the same doctor who founded Intuitive Surgical–I used to hang out in a house on his property in Woodside. It would be a good addition to the Biotech MegaShift, and I’d like to buy it around $16. Another candidate was Stratasys (SSYS), the maker of 3D printing or rapid prototyping systems, where anything under $19 would get me to pull the trigger. But the stock I want you to buy now is Sunnyvale-based Infinera (INFN), a unique chip company that’s growing so fast, Wall Street has underestimated its earnings every quarter since they went public last June.

Shine a Light

In a fiber-optic network, a light signal is sent down the fiber cable. Before the signal attenuates to the point it can’t be seen, it is detected by an optical sensor, converted to an electrical signal, boosted in power, converted back to an optical signal, and sent on to the next processing node. The same process happens whenever the signal has to change its path–that’s why Cisco’s boxes are called “routers.” They route the optical signal in the same way a railroad opens and closes track switches to route trains.

Cisco’s routers are expensive, because it takes a lot of electronic parts to handle the optical signal. Consequently, there’s been a lot of work in the industry on improving the signal and making the optical fiber clearer so data will travel further before it has to be converted, boosted and reconverted.

Infinera was founded in 2000 to shrink that whole optical-electrical-optical process down to a single chip: the Photonic Integrated Circuit. All through the tech recession, venture capitalists poured over $300 million into the company to make the technology work. And they succeeded. One small Infinera module can replace racks of traditional routing and switching equipment. Infinera makes the process so cheap, network designers are now adding more nodes than necessary just to give them more control points to switch or monitor the traffic as it flows over the network.

And it’s fast. They produce chips with 10 gigabyte per second (Gb/s) and 40 Gb/s channels, and they can stack these. They’ll have a commercial product this year that stacks 10 of the 40 G/bs chips to provide 400 G/bs throughput. That’s the equivalent of 85 full-length movies per second. No other company has this technology, or is even close to it. An Infinera network is cheaper, easier to set up and more flexible than the Cisco-Juniper-Ciena-Nortel-Alcatel competition. For a new network, using Infinera is a no-brainer, and that’s accounted for much of their business so far. But the big opportunity is in upgrading all the 600 million miles of existing optical networks out there, as the Level 3s and Googles of the world try to cope with the explosion in video traffic.

Infinera did $58.2 million in sales in 2006 and $345.9 million in 2007. Sequential quarterly growth recently supports my forecasted annual growth rate of 25% a year, although they will have a flattish June quarter following higher than expected March results. Infinera has only 42 customers in total, and their revenues can be very lumpy. In the March quarter, Level 3 Communications accounted for 31% of sales, up from 17% in the December quarter, and INFN has three other customers that each accounted for more than 10% of sales. If we crunch the numbers, at least 61% of sales came from four customers.

But INFN’s customer-base loves its equipment, and as the company’s test sites in the United States turn into large deployments, followed by growth in international deployments, I think Infinera can keep growing their revenues at 25% or more for many years to come. Verizon estimates that global bandwidth will increase 10X every three or four years for the foreseeable future, due to the video explosion. That’s about 80% growth per year, so my 25% per year growth rate forecast is very conservative.. It’s no mystery – video is a huge bandwidth hog, and there’s a seemingly insatiable demand for more and better video applications.

The company guided for $88 million to $90 million in sales in the current quarter, below the consensus for $96 million. Although this hit the stock, looking at the March and June quarters together, they are right on target. Infinera also said they expect to report one or two cents a share in profits, but the consensus is still printed at a loss of one cent. I say “printed” because one source claims the real estimate was four cents, even though it did not show up in the estimate services. The company is in the process of switching from carrying heavy reserves on sales of a “development” product to full GAAP accounting by the March 2009 quarter, and that may be what is confusing the issue. By this time next year, they will be reporting rapid revenue growth with good profitability and cash flow, and the current confusion is just contributing to the buying opportunity.

INFN went public last June at $13, ran up, fell back, and closed today at $13.18. I expect them to announce major contract wins with new customers and beat Street estimates for each of the next four quarters. They’ll do over $400 million in sales this year–the highest Street estimate is $391.6 million–and cross the $500 million mark next year. As you know, I think we are headed for an April 2009 market top and a nasty bear market after that, but INFN is one of the stocks that can keep going up even in a down market. I want you to buy INFN up to $15 for a $30 target in 12 months, and higher levels after that.

Biotech MegaShift

After eight years of an unfriendly administration, whoever is the next president will support funding for stem-cell research. John McCain voted to expand embryonic stem cell lines and is very much in favor of amniotic fluid and adult stem cell research. Hillary Clinton and Barack Obama are even more favorably disposed towards stem cells. That will be good news for Geron (GERN), which needs something to go right.

The FDA told Geron it needs more time to review the clinical trial plans for GRNOPC1, the stem-cell based therapy for spinal cord injuries. Geron said they don’t know yet what the reason for the hold is, but as soon as they get an official letter and meet with the FDA, they will make a statement. I expected the FDA to take longer than the usual 30 days to review all of Geron’s data in their filing to begin a clinical trial, simply because the FDA has little experience with stem-cell therapies and the agency is in one of its periodic go-slow phases. But I did not expect them to put a clinical hold on the filing. This may be administration meddling, trying to keep the issue out of McCain’s campaign, but that won’t work. Geron stock isn’t likely to get any cheaper, so continue to buy GERN up to $9 for my $18 target.

Amgen (AMGN) announced new denosumab results over the weekend. Their drug outperformed Fosamax, the current standard of care for osteoporosis. The year-long Phase III trial included 504 post-menopausal women with low bone mass and “demonstrated superior results for all the primary and secondary endpoints.” Amgen said the study found that women treated with denosumab achieved about 80% better bone mineral density gains than those treated with Fosamax. They will file with the FDA for approval before the end of the year, and the drug should be on the market by the end of next summer.

On the back of that good news, the company sold $1 billion in notes on Tuesday. Even for a big biotech, that’s a lot of money and it could indicate another major acquisition is coming. Hold the Amgen January 2009 $70 LEAP call (VAMAN). Buy the Amgen January 2010 $40 LEAP (WAMAH) under $10 for a $20 target.

Dendreon (DNDN) presented some early, preclinical animal data on D-3263, their drug to treat benign prostatic hyperplasia (BPH). Treatment with D-3263 resulted in a significant 39% reduction in prostate weight compared to the control. The same drug may work against various cancers, including prostate cancer. Of course, the big payoff for DNDN will be the results of the peek at the current Phase III Provenge data in about 120 days. I’m moving DNDN back to a Top Buy under $8 as we get closer to the data release and maintaining my $40 target.

eResearch (ERES) picked Tuesday’s weak market day to announce that their Chief Financial Officer has resigned effective June 17 to move to a privately-held medical company. He was immediately replaced by the Vice President – Controller who has been there seven years, so this will be as smooth a transition as it gets. Still, the stock dropped 90 cents a share on the news. ERES is a Top Buy just under my $16 buy limit for the $30 target price.

Content on Demand MegaShift

Telkonet (TKO) won an energy management contract with Cornerstone Hotel Management as part of Wisconsin’s Focus on Energy incentive program. Cornerstone will install Telkonet’s SmartEnergy system at three of its properties to cut utility bills by eliminating unnecessary heating and cooling of unoccupied guest rooms.

SmartEnergy works very differently from the typical fixed-setback system, in which the temperature is fixed in all rooms. Telkonet’s patented Recovery Time technology, running over their Broadband over Powerline system, enables optimum energy savings without any compromise of guest comfort. Each room’s temperature is adjusted based on many factors, calculating how far it can drift from the occupant’s preferred temperature setting, while ensuring the temperature will return to the occupant’s setting within minutes upon their return. This market is just exploding as the hotel industry and many others face up to out-of-control utility bills, and TKO is moving fast to take advantage of it. TKO remains a buy all the way up to $5 for my $15 target.

UTStarcom (UTSI) reported revenues up 23.1% in the March quarter to $586 million, with a 21 cent per share profit. But they had a 40 cent per share gain from the sale of investments, including one in Infinera, so the operating losses continue. For the June quarter, they guided for $580 million to $610 million in sales (+8% to +13%) with continued poor gross margins around 14%. They’ll have another $30 million to $40 million operating loss. UTSI remains a hold for my $10 target in a better market.

New Energy Technology MegaShift

Oil rose over $135 a barrel this morning for the first time ever. I think we are close to the end of this speculative bubble and we’ll see oil back under $100 sometime soon. Look at this chart of the Bullish Percent Index for the oil sector, which measures how many stocks in a sector are in bullish patterns:

On Wednesday, about 91% of the stocks in the oil sector were moving higher. But this chart can’t go over 100%, and very rarely goes over 90% –for any sector. When everything is this bullish and the stock prices are in a parabolic upturn, a very large decline in prices is due. Look at what happened in January, or July/August 2007.

But calling the top in a parabolic market like this in advance is impossible. You have to wait for it, see the price break, watch the rally back that fails, and then go short as the price falls below the point at which the failed rally started. That could happen now or from $140 or even $150. Until you see it, keep filling up your tank every chance you get, because gasoline prices will keep rising for a few weeks even after oil breaks.

Holly Corp. (HOC) continues to be squeezed by the high price of oil, as the refinery crack spread just can’t widen when the price of raw oil is going up at this rate. But when the break comes, Holly will benefit tremendously. It’s interesting that the psychology now would label $3 a gallon gasoline as “cheap” and that price would make consumers feel better. What a difference a year makes! But that is where we are headed, and if you want to make money off the coming decline in crude, buy HOC while it is under $48 for my $70 target, probably in the next six months.

Ocean Power Technologies (OPTT) won a contract with Griffin Energy to jointly build and operate a wave-power station offshore Western Australia. They’ll start with a 10 megawatt system and then expand it to 100 megawatts, and feed the energy into Western Australia’s main power grid. It costs about 10 cents a kilowatt hour to generate electricity with oil, but only five cents with wavepower. The density and reliability of waves off the Western Australian coast means that a 250-acre area can produce 100 megawatts of power. Buy OPTT up to $20 (almost a double from current levels) for my $40 target.

Robotics MegaShift

iRobot (IRBT) will hold an Analyst Day next Wednesday that might spark some interest. I am reducing the buy limit on IRBT to $15 while maintaining my $30 target. Also kicking myself for not sticking to my informal guideline to wait until I can see at least a double in a year before recommending a stock.

Security MegaShift

Packeteer (PKTR) and Blue Coat Systems received antitrust clearance for the latter’s $7.10 bid for PKTR. It looks like there isn’t going to be another bid, so sell PKTR and redeploy the money into a Top Buy or recent recommendation that will improve your portfolio diversification.

I’ve just returned from the Las Vegas Money Show. I was startled by the number of investment advisers that are lukewarm or outright bearish towards the market. In one session I followed Joe Battapaglia, who gave a negative presentation for the first time I can ever remember. His litany of reasons the market is in trouble followed almost to a “T” my PowerPoint slide series that lists the bad news (falling home prices, continuing subprime write-offs, dazed consumers, high oil prices, hurricane season coming, geopolitical risks). The second slide in that series says the bears are probably right about all those factors, but they are wrong about one thing: The stock market is going up anyway.

The reasons, of course, start with the fact that all those negatives are known and in the market. If CitiCorp keeps writing off $10 billion a quarter for the next year, will you really be surprised? Then there’s the little matter of $4 trillion in cash on the sidelines, record short selling and record put buying. The ingredients are there for a massive bear trap, and it will have to be a big one to catch all the bears I heard in Las Vegas.

Although 1420 is putting up more resistance than I expected, today may be the breakthrough day. I still think the most likely path for the S&P 500 is to grind up to 1440, consolidate around there, give us one more dramatic plunge back to 1395 or maybe 1350 in a late June/early July “summer swoon” to get the bears short again and the bulls back on the sidelines, and then run up 20% in 21 trading days, just like in early 1991. The swoon might come from a big negative earnings preannouncement (Google? Apple?), or an Obama raise-the-capital-gains tax white paper, or something bad in Iran–who knows? The rally just depends on realizing that things will not get worse in the short run, as the Fed’s firehose of liquidity continues to run full blast even if they don’t cut interest rates again.

But, I am open-minded on this, and as always we will let the market tell us what to do. At the moment, it is lifting off the March 17 bottom in what is starting to look like a parabolic upturn, similar to tech stocks in 1999. But that can change, and if the S&P fails at 1440 and then breaks all the support levels down to 1270, I’ll be on the alert for a real bear market signal. It sure doesn’t look like that’s happening today, though.

We’ve had a few more companies reporting earnings, and I have a couple of changes I’d like to make to my recommendations, as well as some “get readies.”

Biotech MegaShift

Amgen (AMGN) spoke at a Robert Baird Health Care Conference. Discussions with the FDA are ongoing over exactly what the new Aranesp label will say. It sounded like we’ll have an answer in six to nine weeks. Denosumab data for osteoporosis in post-menopausal women will come in the September quarter, and based on the clinical results so far, that may be the event that lights up this stock.

They are now calling 2008 a “reset” year in which they will earn $4 to $4.30 a share, and then resume their double-digit growth from that new base. So why is this stock still selling for only 10X earnings? I have no idea. It is grossly mispriced, and will be one of the prime targets when that $4 trillion starts coming off the sidelines. Hold the Amgen January 2009 $70 LEAP call (VAMAN). Buy the Amgen January 2010 $40 LEAP (WAMAH) under $10 with a $20 target.

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A Note on Leaps

Thanks to the subscriber at the Las Vegas Money Show who reminded me to remind you that when the exchange introduces the January 2011 LEAP contracts, the 2010 contracts probably will take a hit–the former “furthest out” contracts always do. LEAPs trade in three cycles, and the Cycle One contracts will be listed on Tuesday, May 27 (May 26 is Memorial Day). Cycle Two lists on Monday, June 30 and Cycle Three on Monday, July 28. In next week’s issue, I will give you a specific strategy to sell the 2010 and then buy them back while minimizing the time you are out of a market moving up. Of course, if the S&P runs right up to 1440 and then starts to fall back, we may be able to accomplish this very gracefully. In that case, you’ll read my advice here or in a Flash Bulletin.

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CombinatoRx (CRXX) reported last week. They booked a net loss of $16.7 million or 48 cents a share, but that included $1.7 million of stock-based compensation, so the pro forma loss was closer to 43 cents. They used $13.6 million in cash in the quarter and have $99.0 million left, enough for seven more quarters of similar losses. But with the good news from their Phase 2a clinical trial of CRx-191 in plaque psoriasis, they are looking for a development partner that would bring a cash infusion. In addition, they have a lot of trial results coming this year:

• CRx-102 Phase 2b knee osteoarthritis clinical trial data in the second half of 2008, with Phase 2b rheumatoid arthritis data following in early 2009
• CRx-197 Phase 2a topical dermatology clinical trials for plaque psoriasis and atopic dermatitis, with data in the second half of 2008
• CRx-401 in Type-2 diabetes data expected in the second half of 2008

Good data on any of these will mean more partnering discussions and more cash in the door. R&D expenses hit $17.0 million in the quarter, up from $12.8 million last year, with the increase due mostly to the CRrx-102 and CRx- 401 trials. There will be an R&D Day on July 23 to go through the entire product pipeline in detail.

Management reconfirmed their guidance to do $15 million to $20 million in revenues this year with a pro forma loss of $49 million to $55 million, leaving them with $58 million to $64 million of cash. CRXX is a very cheap stock with a $7 buy limit and a $16 target price.

Crucell (CRXL) posted good results, with revenues up 36%, the gross profit margin up sharply from 23% to 40%, and their net operating loss cut in half. About half of the loss was from currency changes: The weak dollar and the strong Swiss franc. They reiterated full-year guidance for 20% growth in sales and positive cash flow. They are trying to reduce expenses (excluding R&D) by 15% by the end of 2009.

The travel vaccine business is good, and the real growth can be seen in their 5-in-1 childhood vaccine. As I’ve said before, I am not comfortable with this product as I think it is a terrible idea to give even single vaccines to babies under the age of six months, but the medical establishment disagrees with me so far. Crucell picked up another $150 million in government orders for 2008 and 2009 to go with the $230 million they announced last December, and I’m sure there’s a lot more coming.

The company’s rabies vaccine is on a fast development track in the Philippines, and we’ll get Phase II results for their pandemic flu vaccine this quarter. They were able to find an antibody that seems to be capable of neutralizing not just H5N1 avian flu, but all pandemic strains so far known to man, including the Spanish Flu. In animal trials, even when the vaccine was given when the animals were sick and ready to die, this antibody saved their lives. They have a number of other vaccines in trials, either with partners or on their own nickel, and one of the attractions of this stock is the very broad pipeline based on their human cell line production technology for vaccines. The stock moved up a couple of dollars after the report and went over my buy limit, so buy CRXL only on dips under $17 for my $35 target.

Content on Demand

Telkonet (TKO) reported March quarter revenue of $5.0 million, tripling last year’s results. The company has a record backlog, including contracts with more than 2,400 customers that will generate about $3.6 million in annual recurring support and Internet advertising revenue. They also have purchase orders under a major utilities energy management initiative. One contract is for $600,000 now, with committed future sales of $4.5 million for products and services through March 2010. They recently partnered with another energy efficiency program in Wisconsin that will grow to 5,000 rooms. Yet another $3.8 million contract with a national hotel chain covers energy management devices in 16,000 rooms. The current order backlog for this contract alone will generate $2.5 million in revenue in the June and September quarters.

On the conference call, management said market researchers peg the energy management market alone at $25 billion by 2011, thanks to high energy prices. There are increasing federal and state pressures on utilities to provide rebates and incentives to customers installing energy-efficient products. Telkonet’s new CEO has refocused the company on this opportunity and the sales force is meeting with utilities to help them develop programs for their service areas. Telkonet also works with large commercial customers and franchisers to set up corporate programs directly with utilities.

The company continues to do well in the hospitality industry and government, and has some recent wins providing broadband over power-line systems to schools. TKO is back on track, and expects to be cash flow positive this year. Even though the stock is selling for less than 50 cents a share and about a $32 million market capitalization, I still think their opportunity is gigantic. I am maintaining my $5 buy limit and $15 target price in the expectation this will be a billion dollar market capitalization company at some point in the next few years.

New Energy Technology MegaShift

Eugene, a subscriber, asked a timely question regarding solar power stocks.

Q. “How do you rate solar stocks such as (STP) and SunPower (SPWR)?”

Below about $100 a barrel for oil, solar economics don’t make sense unless someone is messing with the free market and subsidizing solar systems. That’s a shame, because all the way down at $40 oil, some alternatives make sense: onshore windpower, wavepower and geothermal. At $50 to $60 oil, Canadian tar sands, Rocky Mountain shale oil and coal to oil make sense. But solar has a great lobby, both here and in Europe, and has captured most of the alternative energy subsidy dollars.

One factor people rarely discuss is the quality and longevity of the solar panel. The gold standards are Kyocera, Sharp and BP panels; they’ve been in the business for years. Solar installers tell me those panels might go for 25 years, while some of the newer entrants might only last 10 years. A builder wanting to advertise solar homes might go for the cheaper panels–they don’t care what happens in 10 years, and the customers don’t know the difference. I’ve heard solar installers justify using the cheaper panels because in 10 years panels will be so much better that they ought to be replaced. Well, maybe.

I am actively looking for another solar investment to back up Energy Conversion Devices (ENER), which not only jumped 40% in one day last week, but has gone on to hit my $55 target price. I think we can squeeze a little more out of ENER, so I recommend holding for another $5 or $10. I hope to have another solid solar recommendation shortly to switch into.

Connacher Oil & Gas (CLL.TO) reported knockout results. The great news is that the steam-assisted gravity drainage (SAGD) technology we bought this company for is working better than expected. In only two months, with 14 of the 15 well pairs fully converted to SAGD, daily production is running 7,000 to 8,500 barrels a day, on its way to better than the 10,000 barrels a day design target.

Steam is made by burning natural gas, and the company produces more gas than it needs from its own wells. The bitumen is then sent to the refinery they own in Montana, which they bought from Holly Corp. (HOC). Every refinery’s business has been squeezed by the rapidly increasing price of crude oil, so Connacher is delaying some capital spending on the refinery until margins improve. I still expect that to happen during the summer driving season–that’s why I recently recommended buying Holly. Connacher is increasing their overall capital spending budget, in part to drill more conventional gas wells and in part to buy long-lead-time items for Pod Two.

Management said if their March cash flow was annualized, it would exceed $125 million, and they expect cash flow to grow with production. They now plan to be profitable for 2008. Although the stock went up some in response to the news, it is still very undervalued as the low-cost, environmentally-preferred producer of bitumen from Canadian tar sands. Their integrated approach to the business, burning their own natural gas to run the SAGD process and then refining their own bitumen, was costly to establish, but is starting to pay off big time. The stock is right on the edge of my $4.50 buy limit, and the $9 target looks more and more realistic.

Energy Focus (EFOI) reported $4.8 million in sales for the first quarter, a drop of 3% from last year’s $5 million. However, this was a good quarter because the declining swimming pool product sales (related to the housing crunch) were almost completely offset by a $1 million increase in EFO sales. (EFO is their new high-efficiency LED/optical fiber product, with immediate applications in cold storage and freezer displays.) The year-over-year revenue decline in the December quarter was 24% due to swimming pool products, so this was a good showing. They lost 28 cents a share compared to 23 cents last year, and have $14.8 million in cash, including a $9.4 million financing in March. They have committed to burn less than $5 million of that in 2008.

The new CEO from Johnson Controls, who came from sales and marketing, said they still expect to double EFO sales in 2008 to $14 million, and get those products up to 50% of total revenues this year. Traditional products will continue to decline at a 15% rate this year. My model has them showing year-over-year revenue growth beginning in the September quarter for sure, and possibly a bit ahead in the current June quarter. Their backlog of orders is double what it was last year.

They have a test installation of the EFO-ICE products in a freezer case at a U.S. Commissary facility, and the government is a natural market for them for the next several years.

Larry, another loyal subscriber, asked:

Q. “Why is EFOI not enjoying a rally along with other “solar/energy efficient” stocks? Is it time to ‘turn off’ this company’s lights?”

Companies are just waking up to how much their utility bills are rising, and I think by the end of the year most of us will be shocked at the office and at home by electric bills that are 50% higher than today. Although it took them a while to pay attention, cutting utility bills by using EFOI LED products or Telkonet energy management system gives such a fast return of investment that business should be great for years to come. EFOI is quite small and I wouldn’t expect it to be one of the first movers, but ultimately I think it will be one of the biggest movers in the energy efficiency group. EFOI is a Top Buy up to $6 for my $15 target as they turn a technology-based company into a marketing-driven company.

Infinity Energy Resources (IFNY) reported March quarter sales of $1.2 million, down from $2.1 million last year due to the sale of assets to Forest Oil. The operating loss was $796,000, much better than last year’s $2.2 million loss (that included some unusual items). They are in a second forbearance period with Amegy Bank that has a May 31 deadline to pay off $7.1 million of the bank line. Amegy will probably grant an extension, but they could require IFNY to sell their Texas properties.

Forest Oil has started drilling under the joint venture agreement, and Infinity can cut costs and muddle along for a long time with oil prices this high. But that’s no reason to own the stock. The reason to own the stock is that they have a total market capitalization of less than $8 million, yet they have a 1.6 million acre leasehold concession in the Caribbean Sea off the coast of Nicaragua that probably contains one to five billion barrel oil fields. On the conference call, they said a neighboring leasehold has jumped through all the hoops and is about to start drilling, so Infinity is ever more comfortable that they will get permission to push ahead.

If Amegy Bank wants to play hardball, they can bankrupt Infinity at anytime. But I don’t think they will, and as they get paid off (earning gluttonous fees along the way) Infinity will review the seismic data on their leasehold and look for partners to exploit it. The people now running the company are level-headed and well connected, and I would buy IFNY all the way up to $2 for a $7 first target based on the ultimate value of their Nicaragua concession.

Rentech (RTK) reported $28.5 million in sales for their March second quarter, up 68.6% from last year thanks to continued strong demand for fertilizer to grow corn for ethanol. Still, their loss grew to $22.8 million or 14 cents a share as they increased selling, general and administrative expenses by 50% and doubled R&D, where they are expensing the costs of building their pilot plant in Commerce City, Colorado. That project remains on schedule, and their first commercial production facility near Natchez just qualified for a $175 million tax-exempt project-financed bond issue.

They have $31.2 million in cash left and are quietly downsizing the company to take corporate spending to a level that can be supported by the free cash flow from their REMC fertilizer plant. As it turns out, buying this plant to convert to coal-to-liquids was a mistake, because they never could figure out what to do with the carbon dioxide the Fischer-Tropf process produces. But they lucked out as fertilizer prices boomed thanks to the ethanol scam, and they might be able to sell the plant for what they have invested in. I would tell them to do it, rather than count on these high fertilizer prices to last for many years. On the other hand, reducing costs is always a good idea as long as they don’t cut muscle, and what they need to do now is get the pilot plant going and then partner and build as many production plants as possible.

Yesterday, they said the pilot plant is mechanically complete and will be producing synthetic petroleum liquids–jet fuel, ultra-clean diesel and chemicals–by the end of June. It eventually will produce 420 gallons of liquids a day, at first from natural gas and later, when their gasification equipment is turned on, from coal, biomass and a variety of feedstocks.

On the conference call, management said that rather than sell stock at these low levels, they will borrow the money to complete the Colorado pilot plant and buy the land for the Natchez operation. That land is over 400 acres, and it has lots of buildings and other infrastructure that they can use or sell.

An announcement around the end of June that they are producing liquids from the only synthetic petroleum facility in the country should move the stock. It also will let RTK sign a series of contracts to evaluate and test the liquids in various applications, and they’ll announce all of those. It’s been a longer wait than I thought, with a major misstep at the fertilizer facility where good luck has counted for more than good planning, but we are finally on the edge of cashing in. Buy RTK all the way up to $4 for my $8 target as they move towards commercial production in Natchez.

Nanotechnology & Materials MegaShift

Subscriber Robert from Fremont had a great question about IPG Photonics.

Q. “In December of last year IPG Photonics (IPGP) released some interesting news on their newest products and claimed ‘Heavy industry applications, such as shipbuilding, pipelines, gas tanks, aerospace, and construction, can now weld thick metals outdoors or very large pieces at the highest power levels with the flexible beam delivery of IPG’s lasers.’ Is IPGP the type of company that will outperform for the New World Investor?”

The quick answer is yes. I’ve been working on a package recommendation of IPGP and Rofin-Sinar Technologies (RSTI). IPGP is the dominant company in second-generation fiber lasers, while RSTI is the leading producer of traditional lasers. But the slowdown in business capital spending, a lagging indicator that will probably be soft for a whole year, is creating a headwind for these industrial companies. RSTI is at 19X earnings and their business probably will be hit harder than IPG’s, but IPGP is at 28X earnings. So I decided to wait for what seems like an inevitable earnings miss, and then just recommend IPGP at lower levels and a lower valuation.

New World Economy MegaShift

I sent you the following earlier today in a Flash Alert:

Cnet Networks (CNET) will be acquired by CBS for $1.75 billion, or $11.50 a share. That’s well below my $17 target price, which I expected to see after Cnet showed better monetization of their traffic, and it’s a great deal for CBS. As I say on the website: “This could turn into a multi-year hold, or it could be bought out at any time.” Even though we are booking a 8.6% profit in eight months during a tough overall market, I am sorry to see the company sold so cheaply. But this is a done deal, unless Jana Partners, the dissident shareholders that led a proxy fight, won’t go along and look for a higher bid. Hold CNET for now until we see if there is another bidder. We’ll sell the stock in a few weeks if the CBS is the buyer and $11.50 is the price.

Security MegaShift

American Science & Engineering (ASEI) missed their revenue target due to a 62% drop in sales of Z Backscatter vans. They also announced a $9.2 million order for these vans from a Latin American country, an order they could not book in time for the March results. So they did $42 million in sales, down 8.5% year-over-year, while Wall Street was looking for $46.4 million. In addition to the shortfall and product mix impact on profit margins, they had sharply higher R&D expenses that hurt the bottom line. Earnings dropped 52% from last year to 42 cents a share before a 12 cent bad debt write-off. The consensus was looking for 65 cents.

ASEI always has unpredictable quarterly results, which is why they don’t give quarterly guidance. Their orders are huge and lumpy, but it is still a great, dominant business in the security area. The stock fell on this news, and ASEI is a Top Buy at these levels and all the way up to my $59 buy limit for an unchanged target price of $93.

WiMAX MegaShift

Airspan (AIRN) reported earlier, and I reviewed the numbers last week. My conclusion was to keep buying the stock up to $3 for an $8 target after they turn profitable. AIRN makes very high quality hardware, especially for mobile WiMAX, and it always tests out right near the top in competitive analyses. But I learned something new this week: Their software is pretty bad, to the point that it is hard for their own engineers to make the hardware work well in a system application. This seems to be the real reason the company doesn’t convert as many trials to orders as they should.

Software problems can be fixed, but it takes a while and this small company simply may not have the talent to do an adequate, let alone superior, rewrite of their software system. From these prices, I am willing to give them more time to get things straightened out, in part because there are a number of companies that would buy them just to get the hardware designs.

As I said last week, they have enough cash to survive, and the stock is selling for about four months’ revenues, or around $25 million for the whole product portfolio after you adjust for the cash. That still doesn’t make any sense. But bad software will cap the stock at a lower target price than I’ve been thinking, so I am moving AIRN to a hold for a reduced $5 target in a buyout or after they turn profitable.

Cnet Networks (CNET) will be acquired by CBS for $1.75 billion, or $11.50 a share. That’s well below my $17 target price, which I expected to see after Cnet showed better monetization of their traffic, and it’s a great deal for CBS. As I say on the website: “This could turn into a multi-year hold, or it could be bought out at any time.” Even though we are booking an 8.6% profit in eight months during a tough overall market, I am sorry to see the company sold so cheaply. But this is a done deal, unless Jana Partners, the dissident shareholders that led a proxy fight, won’t go along and look for a higher bid. Hold CNET for now until we see if there is another bidder. We’ll sell the stock in a few weeks if the CBS is the buyer and $11.50 is the price.

The market continues to grind its way higher towards the big test at 1440 on the S&P 500, pausing frequently to dip back to support levels like 1395 to build up energy for the next step up. I still like what I’m seeing and I still think the most likely path leads through 1440 to the old highs at 1555, and then much higher into next April. But we won’t really know until we close solidly over 1440 if this was just a one-year correction in an ongoing bull market or the first wave down in a big bear market. So we’ll watch and wait.

The Fed continues to pour liquidity into the financial system. The $40 billion per month Term Auction Facility program for emergency reserves that started late last year was expanded to $60 billion earlier this year, and then to $100 billion in April. The Fed just bumped that up to $150 billion for May. This is new money created out of thin air and the program now is coordinated with the European Central Bank and the Swiss National Bank. The European Central bank boosted their auctions to $25 billion every two weeks, from the $10 billion to $15 billion level with no set schedule. The Swiss chimed in for $6 billion every two weeks.

The Fed also expanded the kinds of (junk) assets that investment bankers can pledge as collateral. Now that the Fed is loaning to these private businesses for the first time since the Depression, it should be very clear that they are going to keep the fire hose of liquidity on full blast until the credit crisis is over. As usual, a lot of the dollars get parked in financial assets first (stocks, bonds, commodity futures) before working their way into the real economy, accelerating GDP growth. That is a major reason why the stock market is a leading indicator, moving ahead of the consumer economy (a coincident indicator), to be followed by capital spending, consumer confidence, employment, and spending surveys–all lagging indicators.

I’m reading quite a bit of outrage from the bears that all the lagging indicators are getting worse, yet the market is going up. That makes me feel that it’s business as usual, since this is always what happens when the Fed steps in. But, as the poet/philosopher George Santayana said: “Those who cannot remember the past are condemned to repeat it.”

Once the S&P clears 1440 for good, there probably will not be another easy entry point for a while. Those expecting to buy the dip will be disappointed, as the bear trap is sprung. We saw this as recently as the July 2006 bottom, which was another difficult, complex bottom with much thrashing around. But then the S&P marched higher for seven straight months to the February 2007 Shanghai market shock, regrouped and added another five months of advance to the July 2007 top. That one-year advance should be exceeded by the April 2008-April 2009 advance.

I would not be surprised to see a couple of months of consolidation in May and June around the 1440 level, to build up enough energy and bearish sentiment to drive the next leg up.

With the Presidential candidates most likely settled by then, the way will be cleared for a rally like Desert Storm in January 1991, when the S&P gained 20% in only 21 trading days. There is plenty of cash on the sidelines or sitting in put positions and short sales to drive a move like that.

In these big moves, there is a scramble to put money to work in areas that are showing good revenue growth and good earnings, yet stocks are cheap. That pretty much defines technology stocks these days and this week I want to review the outlook for what has to be one of the hottest sectors of all: Video.

On the Edge of a Worldwide Video Revolution

I don’t think “revolution” overstates the situation. Consider these facts:

• Analog television broadcasts end on February 17, 2009
• Digital TV can be broadcast over the air, but also is very appropriate for optical fiber or copper cable transmissions
• Video already accounts for half of the traffic on the Internet
• Video is becoming common on ecommerce websites
• YouTube came out of nowhere to be one of the most popular websites
• Cellphones are moving from including digital cameras to digital camcorders just as the ability to transmit and receive video is improving
• iTunes just announced they will distribute movies digitally the same day they become available on DVD
• The DVD format war is over: Blu-ray won, although digital distribution over the Internet may have passed it by
• Telephone companies are committed to upgrading to fiber optic networks to replace relatively slow DSL over copper lines and be able to cope with video
• Cable companies are committed to rolling out an even faster data transmission standard, DOCSIS 3.0, which will provide a large, rapidly-growing equipment market for many years.

As a result of the confluence of these forces and events, video is one of the hottest areas in all of tech-land. Comcast, for example, said on their conference call that they are reducing capital spending from 20% of revenues last year to 18% this year. Since revenues will grow 10%, capital spending dollars will be about flat. But they are tilting their spending towards high-speed Internet connectivity, in large part to handle video. Cable modem users share the cable coming into their houses, and if everyone is downloading lots of video, service can be slow. Comcast is rolling out a new, faster standard called DOCSIS 3.0, intending to upgrade about 20% of its user base this year and continue the program for several years. On one of their slides, they said they would focus their capital spending on:

1. Reclaiming bandwidth by completing the conversion from analog to digital video across its network. In order to do this, they need to deploy many more digital encoders, as supplied by Harmonic (HLIT).
2. Beginning the switched digital video rollout, which simply means instead of sending 500 channels to every subscriber’s house and letting them switch among them, they only send one or two channels and let the switch happen at the Comcast facility (known as the head-end). This is a much more efficient use of the existing bandwidth, and easily supports video on demand that always has to be switched at the head-end.. Harmonic makes a device called an EDGE QAM that supports DOCSIS 3.0 for cable modem Internet access, switched digital video and video on demand.
3. Video on demand is another growing area that helps maintain customers, lowering the churn rate, and signing up new subscribers who want unlimited access to the Comcast library. Harmonic acquired Rhozet, a company that had transcoding technology to insert targeted ads into video. HLIT also acquired Entone, a maker of video servers. Comcast is not a customer for these two companies today, but Harmonic could win a share of the much larger future orders for this sort of equipment.
4. The DOCSIS 3.0 rollout will dramatically increase data speeds, especially when combined with reclaiming analog bandwidth. Comcast has historically bought this type of equipment from Arris (ARRS), but now Harmonic is sharing the business. On the Arris conference call, they said it will take several years for all the cable companies to complete their roll-outs, which matches my expectation that we are looking at strong growth for many years in this area.
5. Business services are a huge opportunity for Comcast and other cable companies. Historically, their cables have bypassed office complexes to get television to the residential areas. Now that they offer high-speed Internet access and telephone service, they can go back and sell to all those offices, with very little extra equipment required. The specific equipment is Coarse Wave Division Multiplexing, which Comcast buys from Harmonic.
6. Comcast sees interactive advertising, which combines the ability to target ads to particular users, as a revenue opportunity with Google-like attributes. Harmonic offers real time ad insertion via its Rhozet products, and recently introduced a new Gator user interface to manage this process.

When Harmonic announced its results, they gave conservative guidance in part because they did not know what Comcast would say about its capital spending plans. Comcast was a $50 million customer for HLIT in 2007. What Comcast does, the rest of the cable industry will do, and what the cable industry does, the telephone companies must respond to.

Comcast added almost half a million new broadband subscribers in the March quarter, with over two-thirds of them coming from competitors selling DSL over copper wires. Comcast and the other cable companies know that the telephone companies will move as fast as they can to upgrade to fiber, and therefore the cable companies have to up the ante. DOCSIS 3.0 allows broadband speeds up to 100 megabits per second, about 150X as fast as most DSL and over 3X faster than the fastest FIOS package advertised on Verizon’s website.

So why did Harmonic’s stock go down after they reported their excellent quarter? I think there are two reasons and neither one should bother us. The first is the company’s guidance, which after the Comcast call they now admit was conservative.

One of our subscribers, Elie, asked about the second issue:

Q. “I was wondering if you could comment on why Harmonic has not really taken off. Harmonic has outperformed analysts’ expectations from all aspects. You once mentioned, and I have read, that analysts may be keeping the stock down because Harmonic’s tax rate could go up significantly in 2009 to 38% versus its current cash tax rate of only 5% to 7%. Should we be concerned about this tax rate change (i.e. will the tax rate change really take a chunk out of HLIT’s profit?)”

Elie, the Board has decided the company is likely to maintain and grow its profitability, so later this year they will take an extraordinary gain for their tax asset as required by accounting conventions, and then report fully taxed numbers in 2009. Although it does not affect the company’s cash flow since they will net future stated taxes against past realized net operating losses, there may be some confusion in the reported numbers. I expect Harmonic to provide apples-to-apples comparisons adjusted for the tax rate for 2009 quarters, but the news readers on CNBC may report the unadjusted numbers and scare some investors with a negative comparison. I think the reported tax rate will be around 30%.

As I titled this section, I believe we are on the edge of a worldwide video revolution. Since Motorola (MOT) bought General Instrument, Cisco bought Scientific-Atlanta, and Ericsson bought Tandberg, Harmonic is one of the few major independents left. HLIT’s future is very bright and the stock is at a ridiculously low price, less than 12X this year’s earnings estimate. HLIT is a Top Buy up to $12 for my $18 target.

Biotech MegaShift

BioCryst Pharmaceuticals (BCRX) reported earnings this morning, and fell very short of the consensus. They lost 34 cents a share compared to the 18-cent loss estimate, on $10.8 million in revenues compared to the expected $19.8 million. Revenues, however, were up 17.4% from last year. They have $81.2 million in cash and expect to burn $25 million to $50 million in 2008, depending on the timing of reimbursements from the Department of Health and Human Services.

I am most interested in the intravenous (I.V.) version of peramivir for patients hospitalized with the flu, especially avian flu. Management said later this summer they are expecting an update from a trial run by their partner, Shionogi. For Biocryst’s own trial in hospitalized patients, they will provide an update by the end of the year. I still expect this to work and be better than Gilead/Roche’s Tamiflu.

BCRX stock is certainly down in the dumps, but good news from Shionogi followed by good news from their own trial will make for a very different picture by the end of the year. Although my buy limit and target price are far above the current stock price, those are still the right numbers if I.V. peramivir works as I expect. Buy BCRX up to $8 for my $30 target after permavir is approved for purchase for government antiviral stockpiles.

eResearch (ERES) reported a really excellent quarter, as their rapidly-growing order flow from last year turns into a rapidly-growing revenue flow this year. They did $33.7 million in sales, an all-time record and up 59.7% from last year. Earnings hit 11 cents a share, up 175% from last year’s four cents. The gross profit margin increased to 52.5% from 47.6% in the December quarter.

Best of all, they did $50.1 million in new orders, and all-time record that tells us growth will continue at a blistering pace for at least another 12 to 18 months. The backlog of signed contracts increased to a record $151.4 million, up $11.2 million in three months. To top it off, they increased their June quarter guidance to revenues of $34 million to $36 million and 10 cents to 12 cents a share. They increased 2008 guidance to revenues between $133 million and $140 million with 44 cents to 49 cents a share, up about $3 million in revenues and two to three cents a share.

The stock moved up about $2.50 on heavy volume, but ERES remains a Top Buy while it is (barely) under my $16 buy limit, and I am even more confident about the $30 target price.

New Energy Technology MegaShift

Energy Conversion Devices (ENER) reported this morning and rose over 40% to $14.44 a share today in a spectacular burst of short covering. My advice to give the new management a chance to perform was solid, as the company reported 25 cents a share in pro forma profits versus the consensus expectation for a six cent loss. Sales rose 155.5% from last year to $70 million, well above the $66.7 million consensus. The company gave above-consensus guidance for the June fourth quarter, looking for $73 million to $78 million in sales, compared to the $73.1 million consensus.

Business at United Solar is so good that the company has been able to get take-or-pay contracts with its customers. They will expand and add 120 megawatts of additional capacity to their Greenville facilities, funding the expansion from cash flow. This will get them to approximately 300 megawatts of capacity by the end of fiscal year 2010.

They said they are pursuing a sale of Cobasys and I think the buyer most likely will be Toyota.

One of my subscribers, Dana, asked a good question:

Q. “What is the business model of the relationship with Intel on phase-change memory? Please give us detail on income model basis on just how much revenue and income is to be expected from various assumptions of market success of phase change memories.”

The phase change technology is in a separate company, Ovonyx, which is a joint venture between ENER and Intel. So we won’t see the revenues and earnings on ENER’s income statement, which is one of the company’s goals–they are trying to insulate themselves from erratic quarters. However, the value will build in the company as phase change moves into the marketplace and then anything could happen from Intel buying the whole company to an IPO to a sale to another company. Ovonyx is the icing on the United Solar cake, and solar is where I am focused.

Another subscriber, Eugene, asked a question about solar stocks.

Q. “How do you rate solar stocks such as STP and SPWR?”

We are not in these stocks right now for two reasons. First, their sales depend on government subsidies, and it is always possible that the government will come to its senses and put the money into coal-to-liquids or wave power, that make economic sense today. It’s not a likely scenario, I know, but it is possible.

Second, there is a major quality issue in this industry in that some manufacturers’ solar panels, like Sharp and Kyocera, last a long time, while others’ panels do not. In a subsidized world that doesn’t matter, but the solar installers know about the differences and eventually I think prices will match quality. I don’t have good comparisons right now and they are difficult to get, but in my view this is a major question to be answered before we should invest. I do know that ENER’s United Solar products have a terrific reputation and a big form factor advantage for replacement and new roofs on industrial buildings, and that’s why I’m happy to participate in solar through ENER right now.

Today’s stock price jump put ENER well over my $30 buy limit, so I am moving it to a Hold for my $55 target.

Gasco Energy (GSX) reported a four cent loss after losing five cents a share on a derivatives hedge, but they also had record oil and gas sales as the Rocky Mountain pipeline situation opened up, and record cash flow from operations. They are producing at record daily rates. The futures markets for natural gas suggest a $1 to $1.50 increase in the near term to around $8.50 per million BTU. By early next year, natural gas should be around $11, and a winter natural gas crunch is looking more likely due to very low imports of liquid natural gas (LNG). A recent Goldman Sachs report said we are already two months into the summer refill season when producers normally stock up on cheap gas to sell in the winter, yet the storage facilities are empty as they take advantage of high prices now.

In New Jersey, an energy auction in February resulted in power prices based on natural gas costs of about $8.50 per million BTU, said Ralph Izzo, chief executive of utility company Public Service Enterprise Group Inc. But natural gas prices projected for early next year are about 30% higher, or roughly $11 a unit, showing more increases could lie ahead. This bodes very well for Gasco, and you should buy GSX up to $4.50 for my $9 target next winter.

Plug Power (PLUG) posted a 42% increase in March quarter revenues to $3.7 million, but lost 24 cents a share compared to 13 cents last year. Three cents of the loss came from a write-down of auction rate securities, which means their CFO made a major mistake. Another five to eight cents came from their new operations in Canada. GenDrive, their fuel cell forklift truck, is in deployment at Wal-Mart and got follow-on orders from Bridgestone Firestone, plus initial deployments at SYSCO Foods and Ace Hardware.

The company shipped 61 backup power systems in the March quarter, received 54 new orders, and has a 298 unit backlog. PLUG remains a buy up to $5 for my $10 target.

WiMAX MegaShift

Craig McCaw’s Clearwire will combine with Sprint’s wireless broadband unit to form a new $14.5 billion mobile WiMAX service company. About 22% of the company will be owned by Intel ($1 billion), Google ($500 million), Comcast ($1.05 billion), Time Warner Cable ($550 million) and Bright House Networks, a regional cable provider ($100 million). Sprint Nextel will own 51% and current Clearwire shareholders about 27%, but the company will adopt the Clearwire name, service the existing 400,000 Clearwire subscribers and be managed mostly by Clearwire. The new company expects to cover 120 million to 140 million people in the United States by the end of 2010.

This partnership is targeting both consumer “last mile” technology to compete with DSL, cable modem and satellite data services, and fourth generation (4G) cellphones and smartphones that will connect to the Internet. Where Wi-Fi has a range of 100 to 300 feed and can transfer data at about one megabyte per second, WiMAX has an effective range of four to six miles and transmits at up to five megabytes. For comparison, current 3G cellular broadband transmits at up to 1.4 megabytes. The cable companies need to offer wireless connectivity as part of their VVD (voice, video, data) packages, and this lets them offer a technically superior product years before their telephone company competitors can respond.

This is mobile WiMAX and the immediate impacts on our portfolio are on Alvarion (ALVR) and Airspan (AIRN) as potential equipment suppliers, which clearly is good news. There also is an indirect impact on Towerstream (TWER) for WiMAX service, and again it is good news. Towerstream wants to move from fixed WiMAX equipment to mobile even though their business service is targeted at fixed locations. Mobile WiMAX equipment will be cheaper due to the high volumes of production, and also can be installed by the user without a truck roll from a professional installer. Equipment and installation costs are a big chunk of Towerstream’s up-front costs to bring on a new customer, so these savings matter.

At the same time, the new Clearwire is not going to target the business market using wireline T1 connections, which is what Towerstream targets. Winning in that business requires getting the right rooftops for Towerstream’s antennas and they have done a superb job of locking up these locations in the major cities. Clearwire, like any consumer DSL or cable company, sells a “best efforts” product to consumers. Towerstream sells a service level agreement, specifying speed and uptimes, to businesses. It is a different market and a different sales call.

Towerstream reported March quarter results yesterday and there was both good news and surprising news. The good news was that year-over-year sales growth continues to accelerate, with the March quarter up 31.7% to $2.1 million. Guidance for the current June quarter is up 47% and it looks like the March 2009 quarter will be the peak growth, up 70%. The company lost 10 cents a share, a bit worse than the consensus for an eight cent loss. The churn rate dropped back to 1.35%, as management predicted. The average sale per trained salesperson also dropped as I expected. Towerstream has been in a rapid sales-force expansion phase, and it is to be expected that average sales will fall until their average experience grows. The stock was murdered last quarter by this factor, but it didn’t hurt today. Perhaps Wall Street is finally understanding what is going on.

During the quarter the company opened their ninth market, Dallas/Ft. Worth. The surprising good news is that management looked at the stock price and competitive situation and decided to slow down their expansion to increase profitability. If the stock was where it belongs – between $5 and $10 – I doubt they would do this. But there isn’t any other company close to them so they can slow their sales-force expansion, stick with their current nine markets for a while and drive up revenues until they are profitable. Then they can turn the expansion back on because during this time they can continue to lease rooftops in new cities and hold onto them until they are needed.

They expect to be EBITDA positive by the end of the March 2009 quarter by holding the sales team to the current 110 to 120 people. This “pause” (while revenue growth accelerates from 31.7% to 70%) will give them time to tighten operations and improve productivity. Even if the business economy continues to slow, TWER sells a solution that is faster and cheaper than the telephone company competitors and should benefit from corporate cost-cutting.

Here’s a YouTube video that is pretty elementary due to the interviewer’s confusion over what business TWER is in, but still worth watching. And for laughs, don’t miss this one kidding Nextel. TWER is a Top Buy up to $6 for my $16 target.

Airspan (AIRN) reported another quarter marred by a sharp decline in their legacy business, while their mobile WiMAX products made progress. Overall, revenues fell 35.6% to $17.2 million and the company lost 17 cents a share. WiMAX is up to 78% of their revenues and I expect one more quarter of the decline in legacy products will mark the end of that dynamic. They guided for $21 million in sales in the current June quarter.

The company burned $2.7 million in cash in the quarter and still has $34.0 million on their balance sheet. They are reducing expenses another 15% by the September quarter. There’s no question that they have good, competitive mobile WiMAX products–they had 20 new customers during the quarter and 90 total WiMAX customers. They have the cash to survive. But there is a question about how fast carriers will deploy mobile WiMAX. At today’s close, the whole company had a market capitalization of only $50 million plus $9.2 million in debt. If we subtract the cash, the market is valuing their product portfolio and business at about $25 million–less than four months’ revenue. That doesn’t make any sense. AIRN remains a buy all the way up to $3 for an $8 target after they turn profitable.

Death of the Dollar

I saw an interesting forecast that if the dollar continues to lose purchasing power at its current clip, within about 10 years China and India will be buying all the food in the world and Americans will have to grow gardens to eat. It sounds like wild speculation, except Sam’s Club is now limiting the amount of rice customers are allowed to buy. India and Vietnam have banned rice exports to try to avoid the food riots that have now hit around 12 countries with another 30 or so on the edge. Of course, this government meddling will cause lower rice prices, followed by lower planting, less supply, and higher prices anyway.

The United States is still sending too many dollars all over the world, and Helicopter Ben is accelerating the printing presses. Our dollars cause inflation in other countries, rising food prices, and…riots. Converting corn to ethanol – a dumb idea that benefits only Archer-Daniels-Midland, Monsanto and fertilizer producers like Rentech – is already driving up tortilla prices in Mexico. With the dollar slumping to record lows, steel prices are at record highs even though construction and automobiles are in major slumps. With metals prices high, plastics prices rising due to the cost of petroleum feed-stocks, and oil for transportation at record levels, the absolutely inevitable destructive inflationary results of Bernanke’s policies are bubbling up. I expect the April 2009 turn date will be driven by some event precipitated by a renewed decline in the dollar and the whole 2010-2011 deep recession to mark the end of the dollar as the world’s reserve currency. But for the next year or so, the dollar should stabilize around current levels, giving the stock market a chance to catch up with commodity and precious metals prices.

May Day! May Day! On Monday, Warren Buffet said: “My general feeling is that the recession will be longer and deeper than most people think. This will not be short and shallow.”

Wednesday morning, the Commerce Department gave the advance estimate for March quarter real GDP: +0.6%. That follows an identical +0.6% in the December quarter. The build-up in inventories that helped March quarter GDP will be a drag on the June quarter, but the tax rebates will help, and GDP could be either slightly positive or slightly negative.

It’s hard to have any recession, much less a long and deep one, if GDP won’t go down for even one quarter. Almost as hard as having a bear market, like the one so many pundits say we are in, when the indices refuse to go down 20%. For the record, from the highest close to the lowest close the Dow Jones Industrial Average fell 16.1% and the S&P 500 fell 17.8%.

The bears get to barely claim the NASDAQ Composite for their case since it dropped 20.2% thanks to its 2169.54 low close on March 10. Unless things go to hell in a hand-basket pretty quickly, it will be obvious to one and all that we’re experiencing a correction in the bull market, not a bear market. And rather than a long and deep or even a short and shallow recession, we are in a slow growth period. Still, it’s more fun for pundits to talk about recessions and bear markets than corrections and slow growth. So you can expect to hear more jabber for the next six months or so. Then lagging consumer confidence will switch gears and everyone will say it’s safe to buy stocks again — 20% higher than where they are today.

That is the most likely scenario, by far. The alternative is that the S&P 500 fails at 1440 and the rally since mid-March turns out to be a mere retracement in a real bear market that eventually takes the S&P 500 down to 1180 or so. That’s a low probability, given the huge amount of liquidity the Fed and other central banks worldwide have pumped into the global economy, but I can’t take it off the table until we see a solid close over 1440.

After that, with over $4 Trillion-with-a-capital-T in cash on the sidelines, the old highs at 1555 on the S&P 500 and 14000 on the Dow are going to collapse like mobile homes in a Florida hurricane. In addition to the sideline cash, NYSE short interest is over 16 billion shares, an all-time record. These are the folks betting on a recession and a bear market, and it’s starting to look like they might be wrong. A rising short interest in a market that won’t go down is a potentially explosive scenario. A close over 1440 is going to hurt them, but the close over 1555 is the killer. Bear markets don’t set new highs, and when bull markets resume, they drive short sellers out by forcing them to cover at higher and higher prices. Sideline cash plus heavy put buying and high short interest are just as few of the drivers for a parabolic upturn during the next 10 months.

The Fed Is Done, Now It’s Up To The Stock Market

The Fed came through yesterday with another quarter-point Fed funds rate cut to 2.0%, and I think that should mark the end. All the Fed does is follow the two-year Treasury rate, and that jumped from 1.24% at the panic low on March 17 up to 2.38% yesterday. The free market is already saying the worst is over, and the negative yield curve you heard so much about last fall as a recession predictor is now positive. Funny how the recession crowd doesn’t mention the shape of the yield curve anymore.

As you know, my new market forecasting tools pretty much nailed the March turn date. The next big downturn should start around April 19, 2009, from much higher levels. I know it sounds ridiculous to pinpoint the date so far in advance, but these tools are working and I want to share the exact forecast with you. The S&P 500 will be around 1900 by then, and maybe up to 2200 if we get another parabolic finish like 1999 to this bull market. Our current stocks will do extremely well in that environment, and some will do well even during the two- or three-year real bear market due to start next April. I call them Winners No Matter What, and for new recommendations, I am looking only for these kinds of stocks that can go considerably higher in a market that could be cut in half. Typically, I find them in cost-saving capital spending, the Internet, alternative energy, biotech and medical technology. Today’s Winner No Matter What recommendation is a potential 10-bagger and comes from the medtech area.

Shine a Light

Mick Jagger, Keith Richards, Charlie Watts and Martin Scorsese all have at least two things in common. One is their involvement in the new documentary on the Rolling Stones’ career, Shine A Light. The other is that they are all in the age bracket most susceptible to skin cancer and its precursors. As a card-carrying member of the Slow Irish Skin group, I have a great interest in this topic myself. (We blue-eyed, blond Slow Irish are descended from Irish women too slow to escape the Viking invaders, which I always say accounts for my abominable 100-yard dash times.)

Skin problems range from actinic keratosis, the small red spots that develop with age, to basal cell cancers, Bowen’s disease, squamous cell cancers and then the biggie, melanoma. Thanks to my lifelong love of convertibles, I’ve personally experienced each of the first four, but don’t ever expect to get the Big M. That’s because scientists in Australia, where one out of every two adults gets some form of skin cancer, have learned that while sun exposure increases actinic keratosis, basal and squamous cell cancers, it actually is protective against melanoma. This comes as a shock to a lot of people, including some American dermatologists who have not kept up with the research.

Melanomas are cancers of the cells that produce melanin, which is the pigment that colors our skin, hair and eyes. It is a somewhat unique cancer because it grows very rapidly, yet one’s prognosis is very closely tied to the stage at which it is discovered. The depth of a lesion’s penetration is an indicator of its severity. Melanoma caught and treated at Stage 1, where the lesion is less than one millimeter deep and therefore confined to the outer layer of skin, has a 95% five-year survival rate. But melanomas that are diagnosed at a later stage, after the melanocytes have grown through the skin and its underlying fat and traveled to sites beyond, are deadly. Stage 4 has about a 15% five-year survival rate. Even though the majority of skin cancers are basal cell and squamous cell (both serious but far less fatal), melanoma causes 79% of skin cancer deaths, according to the American Cancer Society. There will be about 54,000 new cases of melanoma this year, a number that has grown 50% in the last 35 years.

Source: Electro-Optical Sciences

Dermatologists are trained to find oddly-shaped or colored spots, and then decide whether or not to biopsy them. They do pretty well, too. But as the above chart suggests, missing small spots early on can be a disaster for the patient, and of course the smallest ones are the hardest to see. Experts can identify about 85% of all melanoma lesions, but even they find only 70% of the smallest ones. Yet identifying the small ones, those less than six millimeters wide, is crucial for better patient outcomes.

False positives — thinking something is a melanoma that is not — subject the patient to an unnecessary biopsy. Dermatologists perform about 40 unnecessary biopsies for every melanoma found. False negatives put the patient at great risk. Here are some admittedly extreme examples:

Source: Electro-Optical Sciences

So, what is “MelaFind?” MelaFind is a noninvasive melanoma diagnostic device based on an optical reader that uses 10 different wavelengths of light to “see” about 2.5 millimeters into the skin. It then uses image processing software to identify the characteristics of the lesion, and analyzes the characteristics using expert system rules to classify the lesion as either a probable melanoma that should be biopsied, or probably not melanoma. The reader is hand-held, with a touch-sensitive screen to make it easy to use. It takes three minutes to “read” a suspect area. The information on each patient is stored on a proprietary media card for later reference and comparison. Instead of getting results in five to seven days from a lab, the patient gets the diagnosis in 10 seconds in the dermatologist’s office. The doctor can print out the results and immediately counsel the patient.

The first devices in the field of dermoscopy, also called epiluminescence microscopy because it lights and magnifies features on the skin’s surface, simply combined good lighting with a modest magnifying lens in a handheld device to allow dermatologists to better view and evaluate features like mole shape and color.

The next generation uses a high-quality camera to record images of a patient’s moles, so the dermatologist can track and evaluate changes over time. The leading product is MoleMax II, an Austrian device priced low enough to use in individual practitioners’ clinics.

The latest development are third generation devices like MelaFind that use image analysis through computerized border selection and lesion color detection, compared to established diagnostic criteria to predict whether observed spots are cancerous. The first of these was SolarScan from an Australian startup, Polartechnics, which is approved in Australia. SolarScan established their diagnostic criteria by observing and questioning dermatologists, which is a traditional way to create a rules-based expert system. MelaFind shines their 10 wavelengths of light, each of which penetrates to a slightly different depth, on a spot to look for the chaotic or disorganized cell structure that is typical of a cancerous tumor. Disorder in how its cells are assembled is a consistent sign of the out-of-control growth that characterizes cancer. MelaFind moves beyond human understanding of order and disorder, using statistics to calculate if and how a region of cells is in disarray. It is a more advanced and efficient system than SolarScan, and I believe will prove to give a more accurate diagnosis.

Some form of dermascopy already is the standard of care in many other countries, but oddly enough not in the United States. That is about to change, and already some U.S. doctors are using first and second generation dermascopy, with excellent results.

Electro-Optical Sciences (MELA) invented MelaFind, took it through two Phase II trials, and is now wrapping up Phase III. In the first Phase II trial, 28 of 352 lesions were melanomas and MelaFind identified all 28. In the second Phase II trial of 562 lesions, MelaFind identified 53 of 54 melanomas. In both studies, MelaFind did approximately twice as well as dermatologists without the equipment. I cannot recall another Phase II medical device trial that showed 98.8% accuracy.

The Phase III pivotal trials are being held at seven centers in Florida and the Southeast, San Diego, Chicago and Pittsburgh. They have diagnosed 765 patients with 1,052 lesions, and found 80 melanomas. The trial endpoints include identifying 92 of 93 biopsy-confirmed melanomas, with an improvement compared to the study dermatologists of p=.05 (less than a 5% chance that the improvement is merely random). The Phase II trials had p values under .0001, so the Phase III study is easily powered for approval at this level of patients.

Market research showed that most dermatologists see an average of 150 patients a week, and would be expected to use the MelaFind 33 times a week. “High biopsiers” said they would use it 44 times a week on average. Interestingly, their nurses predicted MelaFind would be used 70 times a week. That is probably because dermatologists think a biopsy just takes a couple of minutes, not remembering that a nurse spends about an hour per patient setting up the room and equipment, cleaning up afterward, and counseling the patient on wound care and expectations.

Electro-Optical Scientific expects to sell MelaFind on the basis of saving the doctor time to do other, more lucrative procedures. Their numbers show a dermatology practice can net an additional $150,000 a year per dermatologist, after the expenses associated with MelaFind. The device itself will sell at a fairly low price, because the real money is in the media cards, which provide HIPPA-compliant patient data storage in an easy-to-print form.

The company became public in November 2005, raising $21 million at $5 a share. They did a private placement in November 2006 to raise $13 million at $5.70. A second private placement in August 2007 raised another $11.5 million at $5.75. They still have about $20.9 million in the bank or over $1 per fully diluted share.

They have been granted expedited review by the FDA and have a Special Protocol Assessment, where if they hit their endpoints they get approval. I expect them to conclude the clinical trial shortly and file for approval for MelaFind by midyear. That will move the stock up. But I have been involved with these camera-and-film model medical device companies before, and typically the stock comes back down during the early device shipment phase. The company wants to put 400 devices in the field the first year, using a sales force of 10 to 12 people. They then want to ship 800 in the second year and 1,200 in the third. But due to the length of time it takes to convince doctors to give it a try and then train them, someone on Wall Street will always be disappointed. The devices also carry a low profit margin, because the company doesn’t want the price of the device to be an issue when the profits are in the “film,” in this case the media card. So that’s another knock on the stock.

Plus, they have to convince the payers — Medicare and the health insurance companies — to reimburse doctors for the cost of the MelaFind procedure. That shouldn’t be too hard. The U.S. spends about $1.5 billion a year treating skin cancer, and hundreds of millions of dollars of that are for biopsies that don’t successfully identify melanoma. MelaFind can save close to one million biopsies a year, and that should make Medicare and the insurance companies happy to reimburse for the MelaFind scan.

After that the company hits the point where a lot of devices are installed, dermatologists are telling each other that they work and make money for the practice, “film” sales are accelerating and profit margins are increasing. That’s when Wall Street gets really excited.

For a company like MELA, that can mean this kind of pattern: Today the stock is around $6. When they file for approval, the stock will trade to $8 to $9. After FDA approval, it will trade to the $10 to $12 area, maybe a little higher. But then it will go quiet and drift off during the initial shipment phase, perhaps back down to $8, maybe all the way back to $6 if a negative Street report comes out. From there the big move will begin, slowly at first, that can carry it up to a billion dollar market capitalization — $60 a share — over a couple of years.

What drives such a big gain? There are over 11,000 dermatology practices in the United States. Electro-Optical is targeting one MelaFind in just over 10% of those practices by the end of the second year of shipping. Assuming the device is used on just 50 patients a week — not the 70 patients the nurses are predicting — revenues will be about $200 million a year in two years. In five years, MelaFind should be in at least 30% of all dermatology practices (I would not be surprised if patients demand it), generating $600 million a year in sales. After-tax margins should hit 7% at the two-year mark and max out at 15% at the five-year mark. Assuming some modest further stock sales, that translates to 78 cents a share in two years and $5.00 a share in five years. Although medical device stocks at similar stages of development often sell for 50X earnings, I am using a 30X multiple on 78 cents to get to a $23 target price. At the five-year mark, a terminal multiple of a modest 20X would give us a $100 stock.

The way I like to invest in these is to have a core position and a trading position. The core position should be whatever you would be comfortable holding through the whole up-and-down process that can eventually lead to a 10-bagger or more. Then establish an additional trading position, which might be from 50% to 100% of the size of your core position. Buy both positions now, and then sell the trading position after they file for approval. Buy it back when and if the stock drifts off, and sell it again after approval. Buy it back after the initial disappointment with the sales growth hits, and then hold both positions for the 10-bagger.

Electro-Optical Sciences is a “Winner No Matter What” recommendation because aging baby boomers are developing more melanomas, dermatologists need help to catch them at an early stage and to make the biopsy decision, and the company’s sales and earnings are not sensitive to the economy, interest rates, the falling dollar, consumer spending weakness or any of the other current or foreseeable negatives. The company has a tiny market capitalization, under $100 million, and was almost unknown before they presented at the Cowen HealthCare Conference on March18. Insiders own 19.7% of the stock and have bought over 230,000 shares in eight separate transactions during the last six month. I want you to buy MELA up to $7, with a $12 first target after FDA approval, and a $60 long-term target.

Biotech MegaShift

Affymetrix (AFFX) reported the poor quarter they pre-announced last Thursday, and I said I wanted to review the conference call before taking the stock off Hold. Of the $8 million revenue shortfall in product sales, about two-thirds came from pharma customers cutting budgets for traditional gene expression products. But genotyping products continue to grow rapidly, as do diagnostic products and reagents. Overall, the company expects to grow this year while they introduce their new expression products, and then have a stellar 2009. They continue to trim costs to protect the bottom line during the product transition.

There is no doubt that AFFX stumbled in the last couple of years and was late in a key technology cycle against Illumina. But they are in several high growth markets like diagnostics and genetics, with new technology and a leaner company. They have a big customer base that thinks highly of the company’s products and customer service. New products will be in customers’ hands in the second half of this year, and they have $600 million in cash to develop and market new products. Given the low current valuation of the stock, this is a real turnaround opportunity — low risk, high reward. I’m moving AFFX back to a buy, with a $15 buy limit to reflect the current trading range, and an unchanged $35 target by April 2009.

Amgen (AMGN) also reported last Thursday, with results just above the consensus, and reaffirmed its 2008 revenue guidance range of $14.2 billion to $14.6 billion, with pro forma earnings from $4.00 to $4.30. On the conference call, they said they are working with the FDA on the label changes for Aranesp and Epogen that came out of the March 13 meeting. The advisory committee showed strong support for Aranesp in chemotherapy-induced anemia, and thought that this option should be made available. There was a lot of commentary at the meeting about the need to have physician discretion, so I don’t expect the label to have strict limits on when and when not to use Aranesp. It is more likely to have advisory language. They also said Enbrel sales growth is offsetting some of the decline in Aranesp and Epogen, as is international sales growth of most of their other products. It was a good, solid call. They’ve postponed the June 6 business update meeting until they have the final label information and also some clinical trial data for denosumab, their postmenopausal osteoporosis drug that looks like a big winner.

At 10X this year’s earnings, Amgen is incredibly cheap. Buy the Amgen January 2010 $40 LEAP (WAMAH) under $10 with a $20 target.

QLT (QLTI) reported $11.9 million in sales and a four cent per share pro forma loss. I was looking for $26 million in sales and a couple of pennies positive on the bottom line, but the shortfall is not what it seems. The company has decided to sell all its QLT USA operations — Eligard for prostate cancer, Aczone for the treatment of acne vulgaris, and the Atrigel drug delivery system — and now lists them as discontinued operations. Visudyne sales grew 10.6% in North America, where the competitive situation has stabilized, but fell 48.5% in Europe as Lucentis builds the same kind of market share it got in the U.S. more than a year ago. These negative comparisons should come to an end later this year.

In the meantime, QLTI has reduced headcount 45%, and in addition to selling the three USA products the company is selling their headquarters in Vancouver. They had $120.0 million in unrestricted cash at the end of March, plus another $122.4 million restricted that is posted as a bond in their patent lawsuit appeal. They have $172.5 million in convertible notes that can be put back to them in September 2008, and they are getting ready to handle that. Their strategy is to stick with Visudyne, wait for the combination studies to come out and show that Visudyne plus Lucentis (or any of the other anti-epithelial growth factor drugs like Macugen) are the right way to treat age-related macular degeneration. Then they will ride the sales curve back up and go back into a growth mode. This is the right strategy, and I don’t want to sell QLTI here. The company is forecasting Visudyne sales of $145 million to $160 million this year, with a 20% share of the profits to QLTI. Buy QLTI up to $6 for my $12 target.

Rochester Medical (ROCM) reported record sales of $9.2 million and pro forma earnings of four cents a share. That is deliberately lower than last year’s eight cents, as Rochester builds up its sales and marketing operations to take advantage of the coming October change in Medicare reimbursement for hospital-caused infections. Medicare will no longer reimburse, and 40% of these infections are in the urinary tract, related to catheterization. Rochester’s drug-eluting catheter slashes infection rates.

The company got a nice bluebird when Medicare changed their reimbursement policy on April q to permit an intermittent catheter user a maximum of 200 catheters per month instead of four. Hospitals had to reuse catheters before the change, but now they can just buy new ones from Rochester. On the conference call, management estimated a complete changeover from reusing catheters to always using a new, sterile one (as is the practice in Europe) would add $4 million to $5 million to the top line just from current customers.

Branded sales are growing 25% or more, while private label grows around 18%. “Rochester” branded products are up to 66% of revenues, and that is where the company is spending its sales and marketing dollars. Sales and marketing expense is up 67% year to date versus last year, pursuing opportunities in both the U.S. and Britain. Although R&D is not up much, they’ll have new products across the product line towards the end of 2008, into 2009.

The next court date in the litigation against Covidien and Novation won’t happen until December. Of course, the defendants could (and should) settle anytime. ROCM remains a Top Buy all the way up to $20 for my $40 target after the October 1 Medicare reimbursement rules kick in.

Sequenom (SQNM) reported first quarter revenues of $10.6 million, up 7% from last year. As previously announced, sales of MassARRAY systems in the U.S. were on the weak side, probably due to the same factors that impacted Affymetrix: Delays in the funding cycle and economic uncertainty. Several high probability U.S. system sales were delayed in the last couple of weeks of the quarter, and only 12 system sales were booked. They lost 19 cents a share compared to 11 cents last year. But they also announced a Central and South America distribution deal with Invitrogen, including their first sale of a MassARRAY system into Brazil for use in developing biofuel from sugarcane.

The non-invasive prenatal genetic tests program is moving along well. They can do a direct genetic assessment for Down syndrome, and some preliminary performance data on an internally developed test showed the ability to detect with 95% sensitivity (Down syndrome is present) and 99% specificity (Down syndrome is not present).

Management reaffirmed 2008 guidance for revenues between $50 million and $53 million, up about 30% from 2007. They’ll have a net loss of $30 million to $33 million, and burn $26 million to $28 million in cash. On the conference call, they said several of the delayed sales have closed and the rest will — none was lost to competition.

Management will be presenting at the Rodman & Renshaw Fifth Annual Global Healthcare Conference on May 19, and also do a European investor relations road-show. They’ll also hold two analyst days focused on the noninvasive prenatal diagnostic assays. One will be on June 3 at the 14th Annual International Conference on Prenatal Diagnostics and Therapy in Vancouver. The second will be held in September in New York.

I think SQNM will bounce back quickly from the first quarter U.S. revenue disappointment, so I am moving the stock back to a buy under $7 while maintaining the $12 target.

ViroPharma (VPHM) reported Vancocin sales up 3.9% year-over-year to $50.9 million, but earnings fell to 22 cents a share from 31 cents last year as they grew the sales force and spent development money on Camvia, their stem-cell-transplant prophylactic treatment formerly known as maribavir. The company expects Phase III patient enrollment to end this month, with Camvia data leading to a filing for approval in 2009. They expect Vancocin sales of $210 million to $235 million this year.

VPHM has a total market capitalization of $636 million, and $599 million in cash. So Wall Street is saying (1) Vancocin is worth only $37 million, (2) Camvia is worthless and (3) ViroPharma maangement can’t be trusted to do an intelligent acquisition or in-licensing deal that will create a future for the company after generic Vancocin finally hits the market. All three of those assumptions are wrong, which gives you an outstanding opportunity to buy VPHM up to $12 for my $25 target.

Content on Demand MegaShift

Akamai (AKAM) reported pro forma earnings hit 41 cents a share, up 49% and ahead of the 39 cent consensus. They now have 2,672 customers, up 8% year over year, so they clearly are booking a lot more business per customer. That’s a reflection of the growth of the Internet and, especially, video over the Net.

On the conference call, management said they saw robust year-over-year growth across all their key vertical markets, with solid growth even in an uncertain macroeconomic environment. They think the year will remain strong for them, and I wholeheartedly agree. On their last earnings call they guided for revenue growth between 26% and 30% for 2008, to between $800 million and $825 million. Based on the March quarter, they now say they are tracking toward the mid- to high-end of that range.

On the last call they also guided for pro forma earnings of $1.65 to $1.70 per share. They now say they’re tracking to the high end of that range or slightly above, so they raised their earnings guidance to $1.68 to $1.71. That implies net income growth of 29% to 32% for the year — in a stalled economy! Buy AKAM up to $36.

QuickLogic (QUIK) reported after last Thursday’s close, and I got the numbers into last week’s Radar Report. On the conference call, they said they are booking revenues and getting design wins in new smartphones. They are working not only with handset manufacturers, but with the cellular service providers that often dictate what features they want in a new phone. QUIK made a timely shift into what they call the “prosumer” market for high end electronic products that come in a variety of flavors, all based on one basic design. They really are in the right place at the right time and, unlike SiRF Technology (SIRF) with a similar strategy, QUIK is executing well. QUIK remains one of my favorite stocks and a Top Buy up to $4 for my $8 target.

New Economy MegaShift

Cnet Networks (CNET) also reported after the close last Thursday, booking $91.4 million in sales and a three cent pro forma loss. On the conference call they said they have made good progress on their business model change and are getting good traffic growth. They are still having trouble monetizing it, and that was one reason for the Yahoo deal. They expect an additional $100 million over the next three years from the Yahoo relationship. Management guided for 6% to 10% revenue growth in the June quarter to $100 million to $104 million, on which they can breakeven. The consensus already was looking for $103.3 million and a one cent profit, so their guidance was in-line. For the year, they said they would do $440 million to $460 million and three or four cents a share. I would say if they can’t stay on that track, the Board will sell the company. CNET still has great Web properties and a low valuation, so the risks are low and the potential if they can turn it around or sell it for a fair price is high. Buy CNET up to $9 for my $17 target.

Security MegaShift

Packeteer (PKTR) remains a hold for another week or two to see if we get a higher offer than Blue Coat’s (BCSI) $7.10 a share. PKTR is a hold with a $10 target to leave room for a higher offer.

SiRF Technology (SIRF) reported after the close last Thursday. The conference call with Dado Banato as interim CEO certainly was an improvement. The Chief Financial Officer also is resigning, effective May 8. Dado said the June quarter will be another weak one, and it is possible the second half won’t show the usual seasonal strength in personal navigation devices. He is setting the bar way low, as I would expect him to do. The stock should be bottoming right here. Buy SIRF up to $8 for my $20 target after Dado brings in a great CEO to straighten out the company.