Recommendation: Speculative Buy

Recommendation and Summary:

Health Sciences Group, Inc. has a very ambitious business plan that calls for the acquisition of primarily privately held pharmaceutical, nutraceutical and biotechnology companies that are profitable but lack access to growth capital. If the plan continues to be successfully implemented, shareholder value will be considerably enhanced. Supporting our conclusion are the following developments.

• Health Sciences Group has demonstrated the validity of the concept in its initial transactions, the purchase of Biofarm shares and the XCEL Healthcare, Inc. acquisition. The combined revenue of these two acquisitions is estimated to be $15 million in the current year. It is probable that two or more additional acquisitions, in the revenue range of $5 to $15 million, will be completed during the year.
  
  
• The Buy recommendation of Health Sciences Group shares is qualified as Speculative until the Company completes a near-term equity financing of several million dollars. To date, the Company has not raised serious equity, which it needs for working capital and for obligations pursuant to past and future acquisitions.
  
  
• The management team has the financial experience to perform due diligence to negotiate terms and to supervise on-going performance of the acquired businesses. Presumably, the abundance of consulting and advisory talent, compensated with stock options, will stimulate a heavy deal flow enabling Health Sciences Group to meet its goals in terms of frequency and size of future acquisitions.
  
  
• The acquisition of XCEL Healthcare, Inc. provides the Company with a portfolio of proprietary over-the-counter (OTC) pharmaceutical and nutraceutical products that address very large consumer markets. These products, when further developed, will be marketed by joint venture partners or licensees.
  
  
• Aggressive accounts that are not adverse to early stage company risks may find it advantageous to establish a partial position at the current price. More aggressive accumulation is advised when the fundamentals unfold over the next two quarters.
  

Introduction

Health Sciences Group, Inc. (HESG) has developed and is implementing a business model that is designed to identify, acquire and provide guidance and capital primarily to privately owned companies in health-related businesses. In the Company's words, the goal is to 'acquire and integrate into a collaborative network, companies operating in the fields of pharmaceuticals, nutraceuticals and biotechnology.' The value added by Health Sciences Group in this undertaking is (a) its status as a publicly traded company with access to capital and (b) its ability to provide strategic guidance and operational support by a team composed of executive management, consultants and advisory board members. Collectively, the Health Sciences Group team has the relevant skills and experience that are generally not available to emerging companies. Management believes that, with the assistance of consultants and advisors, it will regularly make acquisitions at favorable prices, typically for stock. The business plan is an ambitious one. Management has set for itself a five-year financial goal of $590 million in revenues and more than $90 million in net income.

Management

There are three executives at the corporate level of Health Sciences Group. They are the co-founders Fred E. Tannous and William Glaser, and Controller David Johnson, CPA. Tannous and Glaser have experience in investment banking and corporate finance. The board chairman, Harry Branch, is a UK-based consultant in corporate structuring and finance. The Company has retained the consulting services of three others experienced in the areas of mergers, acquisitions and investor relations. Health Sciences Group is in the process of assembling an advisory board consisting of people skilled and experienced in investment banking and the healthcare industry.

Initial Acquisitions

In the few months since the Company began to execute its current business plan, there have been two acquisitions. The first was the purchase of a minority stock position in the Romanian pharmaceutical company, Biofarm, S. A. During the second quarter of 2002, we anticipate the completion of an additional block purchase and tender offer that will bring the Company's ownership of Biofarm to 87%.

The second transaction was the purchase of 100% of the stock of XCEL Healthcare, Inc. and its affiliated company, BioSelect Innovations, Inc., both Los Angeles-based companies. XCEL's core business is a pharmacy that provides prescription drugs and other goods and services to patients suffering from catastrophic illness. Also, through its BioSelect affiliate, XCEL produces a line of cosmetic base material that is sold to other pharmacies for compounding into topical skin care products. Most importantly, the BioSelect affiliate has developed a number of proprietary OTC products, a number of which are patent-able. Also, BioSelect has been engaged in preliminary work on several biotechnology projects in partnership with the University of California at Los Angeles (UCLA).

Biofarm, S.A.
The Company's initial acquisition is a work in progress. To date, the Company has purchased a minority common stock position in Biofarm, an old-line Romanian-based manufacturer of pharmaceutical and nutraceutical products. The acquired block of stock represents 24.3% of Biofarm's outstanding shares. The seller in this transaction was International Pharmaceutical Group, a Nevada company owned by H. S. Branch. The purchase price was $750,161 in the form of $55,000 of cash and 1.7 million shares of Health Sciences Group common stock. Branch sold the stock to the Company at his cost. Subsequently, Branch was elected chairman of the board of Health Sciences Group.

The initial stock purchase was in two steps, as shown in the table below. The Company has entered into a letter of intent (LOI), which provides for Health Sciences Group to acquire additional stock of Biofarm equal to 50% of the outstanding shares. The sellers are a trust consisting of H. Branch, the board chairman of Health Sciences Group, and Robert Ferran, general manager of Biofarm. The terms of purchase of the 50% block are 400,000 shares of Health Sciences Group stock. The transaction is subject to the Romanian stock exchange approval, which is expected in the second quarter. The Company anticipates owning 87% of Biofarm at the completion of the transaction.

Table I: Biofarm Transaction

Source: SEC filing-10Q 9/30/01

The Business of Biofarm
Biofarm has roots that reach back to 1924. Its most relevant history began in 1995, when the company was privatized after five decades of ownership by the state of Romania. In 1997, H. Branch, through his private investment company, International Pharmaceuticals Group, acquired a 40% stock position in Biofarm from the Romanian State Ownership Fund. Additional shares were acquired by Branch by way of a capital infusion. Branch sold a portion of his interest to Robert Ferran, the company's general manager since 1998.

Biofarm is in the business of manufacturing and distributing approximately 60 pharmaceutical products, primarily in its domestic market. The management of Biofarm believes they have less than a 2% share of a highly fragmented $400 million Romanian domestic market. (Sicomed, the leading company, states it has only a 10% share). Romania has about 200 drug manufacturers, yet 60% of industry product sales are imported. The market has been relatively flat in overall unit volume. Total product value is growing, however, reflecting an easing in price controls and an increase in the generic drug segment.

Biofarm's core business is the manufacture and sale of mature but profitable natural drugs that are derived from plant extracts. These products represented about 75%, or $6.5 million, of its 2001 total revenues of $8.7 million. The balance and future growth will come from (a) its generic lines and (b) a line of branded natural products that have a high growth potential. It is anticipated that these two categories, currently generating aggregate revenues of $2.2 million, will provide 53%, or $7.3 million, of 2004 sales. A summary of past and projected Biofarm operating results provided by Health Sciences Group is displayed in Table II.

Table II: Biofarm Operating Results and Projections
(Years Ended December 31; US$M)

* From 2002 forward, approximately a 13% minority interest to be deducted from Health Sciences Group total pre-tax income.
Source: Health Sciences Group Management

As of October 31, 2001 Biofarm's net worth, according to Health Sciences Group, was $5.7 million. The debt-free company had at this date a working capital position of $2.7 million and a current ratio of 3.5.to 1. The deemed value of the Health Sciences Group stock to be issued for the 87% interest represents a 51% discount from this book value per share.

XCEL Healthcare, Inc.
On December 17, 2001, Health Sciences Group acquired XCEL Healthcare, Inc., a California corporation, and its affiliate company, BioSelect Innovations, Inc. Health Sciences Group exchanged 855,000 shares of stock (valued at $2.45 million or $2.82 per share) for 100% of the shares of the two entities. The terms also include a binding commitment by Health Sciences Group to invest cash of $615,000 over the next six months. Last calendar year, XCEL's revenue and net income were $3.45 million and $360K, respectively.

XCEL was founded in 1996 by two pharmacists and a pharmacy technician. The company has two business segments 'XCEL Healthcare and BioSelect Innovations. Healthcare, a fully licensed pharmacy, provides prescription drugs and other supplies and services to patients with catastrophic illness that include quadriplegia, cystic fibrosis, muscular dystrophy, cancer and organ transplantees. The prescriptions are prepared either by using manufactured drugs purchased in bulk from pharmaceutical manufacturers or by compounding . Revenues from compounded prescriptions are currently about 40% of XCEL Healthcare's $3 million revenue. Margins on compounded prescriptions are above the corporate average profit margin. Currently, the company's geographic market is the State of California. Ninety-nine percent of the company's billing is to MediCal, MediCare or other third party payers. The company operates in niche illness segments that are generally insulated from the competition of the national discount pharmacy chains and large independent pharmacies. Growth in the core business is estimated at 30% per annum.

XCEL's second business segment, BioSelect Innovations, contributed revenues of $450,000 in 2001, primarily from the sale of a line of topical bases for skin-care products that are produced and marketed by other pharmacies. As an outgrowth of its expertise and experience in compounding prescriptions, the Company has developed a number of proprietary formulations that have considerable potential. Patents have been applied for several of these. The basis of claiming the intellectual property rights is the unique integration of selective traditional over-the-counter generic drugs with complementary alternative medications such as vitamins, herbs and other natural nutraceutical supplements. XCEL considers itself to be a pioneer in what is a new field of integrative medicine. This family of products carries the Cocare® trademark. Examples of the BioSelect formulations are shown in Table III. The Company has a total of 11 formulations in various stages of securing a patent and another 7 where patent potential is being explored. The development of prototypes of these products will require capital. The primary motivation of the XCEL principals in selling to Health Sciences Group was the latter's access to the capital necessary to exploit the considerable potential of these proprietary OTC formulations.

Table III: OTC Proprietary Products in Development.

Sources: BioSelect management interview; SEC filing on Stock Purchase and Share Exchange Agreement, schedule 3.18 (b) (i)

Over time, the potentially faster growth in the non-prescription, proprietary products of BioSelect should cause accelerated growth and an overall enhancement of operating margins. Unlike the Healthcare segment of prescription fulfillment, proprietary products are not labor intensive. There are no selling price constraints other then competitive forces in the market. (Third-party payers establish price ceilings on prescription drugs). OTC drug products are typically marketing-intensive. However, XCEL expects to avoid the high capital cost of both manufacturing and branding by entering into arrangements with drug manufacturers and wholesale distributors who will have responsibility for production and market penetration. Another alternative is the outright licensing of the proprietary formulations.

It should be mentioned that the Company is developing relationships with respected research institutions. For example, XCEL is collaborating with UCLA on a biotechnology project that employs antibody-antigen infusion proteins for the delivery of oncological agents to the brain. Other UCLA joint projects are the development of antibody-antigen technology for the eradication of Staph A and Staph B resistant organisms.

XCEL has been profitable since inception. Revenues have grown from $533,000 in 1997, the company's first full year, to $3.45 million in 2001. Health Sciences Group management believes XCEL can maintain a compound annual growth rate in revenues of 30% for the core specialty prescription business, and a higher growth rate for BioSelect proprietary products that are building from a lower base. The Company's recent past results and projections of future operating results are shown in Table IV below.

Table IV: XCEL Past and Potential Operating Results
($ Millions)

Source: Estimates provided by Health Sciences Group management.

Financial Considerations

The immediate challenge facing the Health Sciences Group management team is capital generation. To date, very little cash has been raised to implement an ambitious business plan. The Company is currently discussing an equity financing with several investment banking firms. Since its inception, the Company has raised approximately $500,000 through private placements, a small IPO and by the exercise of stock options.

A summary of the shares issued and to be issued is displayed in Table V.

Table V: Actual and Potential Share Issuances

Source: SEC filings and JM Dutton & Associates
* Obligations pursuant to contracts; ** Future shares to be sold for cash;
***Assumption of two acquisitions in 2002 with assumed total revenues of $20 million and net income of $2 million.

Conclusion

Our rating of Health Sciences Group common stock at current price levels is a Speculative Buy. Our reasoning is as follows:

We believe the stock is a Buy because its business plan has validity. We concur in the expectation that private or thinly traded healthcare businesses can be purchased at attractive valuation levels by public companies using marketable stock as currency. Health Sciences Group has demonstrated the validity of the concept in the initial transactions--the purchase of Biofarm's shares and the XCEL acquisition.

The full-time management team has the financial experience to perform due diligence, to negotiate terms and to monitor ongoing performance. Presumably, the abundance of consulting and advisory talent will stimulate heavy deal flow and the Company will meet its goals in terms of frequency and size of future acquisitions.

One or two transactions during the current year could make today's stock price undervalued. Consequently, a Buy recommendation, albeit qualified, is warranted for aggressive accounts. We qualify the buy recommendation as being 'Speculative' for one reason:

The Company has not, to date, raised serious equity for working capital and for obligations pursuant to past and future acquisitions. It may be that this shortcoming will be resolved soon, as the Company is in discussions with investment bankers with the capacity to privately place equity in the area of several million dollars.

Once this occurs, we will re-evaluate our Speculative Buy recommendation on Health Sciences Group, Inc.

Analyst:
Gerald F. LaKarnafeaux, CFA

During the past 40 years, Mr. LaKarnafeaux has held senior positions in international and regional investment banking firms as a securities analyst, portfolio manager and director of corporate finance. Mr. LaKarnafeaux is currently providing consulting services to early stage private and public companies in the areas of corporate valuation and capital formation. He has been an active member and officer of regional chapters of The Financial Analyst Society, The Corporate Finance Council and The American Society of Appraisers.

Contact:
Health Sciences Group, Inc. 6080 Center Drive, 6th Floor, Los Angeles, CA 90045 (310) 242-6700 Fred E. Tannous, CEO.
American Financial Communications, Inc. 655 Redwood Highway, #255, Mill Valley, CA 94941 (415) 389-4670 Terry McGovern, Partner.

J.M.Dutton & Associates, LLC. John M. Dutton, President and Supervisory Analyst, 801 S. Figueroa, Suite 1120, Los Angeles, CA 90017 Phone (213) 929-2616, Fax (213) 896 0457 Email: [email protected] Web site: www.JMDutton.com

Information, opinions or recommendations contained in this research report or research note are submitted solely for advisory and information purposes. The information used and statements of fact made have been obtained from sources considered reliable but we neither guarantee nor represent the completeness or accuracy. Such information and the opinions expressed are subject to change without notice. This research report or note is not intended as an offering or a solicitation of an offer to buy or sell the securities mentioned or discussed. Neither the Firm, its principals, nor the assigned analysts own or trade shares of any company covered. The Firm does not accept any equity compensation. Anyone may enroll a company for research coverage, which currently costs US $25,000 prepaid for one-year. Dutton & Associates received $20,000 from the Company for coverage for the year. Reports are performed on behalf of the public, and are not a service to any company. The analysts are responsible only to the public, and are paid in advance to eliminate pecuniary interests and insure independence. Please read full disclosure and other reports and notes on the Company at www.JMDutton.com..

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