Recommendation: Speculative Buy

Recommendation and Summary

Since our initial HESG report dated February 12, 2002, there have been a number of important and positive corporate developments. They are:

1. The Company has rescinded the stock purchase agreement to acquire a 24.3% position in Biofarm, S.A. The 1.7 million shares of HESG stock previously issued have been recovered.
   
   
2. The Company has executed a Letter of Intent to acquire Quality Botanical Ingredients, Inc., a bulk supplier of dietary supplement products to nutraceutical product manufacturers.
   
   
3. Certain agreements with consultants have been rescinded. Shares previously issued have been recovered. Shares that were to be issued will not be issued.
   
   
4. A third party valuation of the Bioselect Innovations, Inc. patent-pending intellectual property resulted in the enhancement of the HESG’s consolidated balance sheet by $4 million.
   
   
5. In our opinion, the market has not fully digested the facts and their implications that surround the abortment of the Biofarm transaction and the recovery of two million shares of common stock. The per share price is down 11% from our initial report. In theory, the stock should have increased in an approximate proportion to the contraction in the number of shares. The public’s stake in the Company has increased from 30% to 50%. On balance, again in our opinion, the Company is far better off having the recovered shares for future acquisitions than having it tied up in a minority position of a marginal Romanian business. When the facts sink in, we believe the market will agree with our assessment.
   

Recent Developments

The following paragraphs discuss recent developments that will have an important impact on the long-term value of Health Science Group.

The Biofarm Transaction - In June of 2001, the Company began a complex two-phased acquisition of 74% or more of the outstanding stock of Biofarm, S A, a Romanian based producer of pharmaceutical and nutraceutical products. Phase one called for the exchange of 1.7 million HESG shares for 24.3% of the outstanding stock of Biofarm. In phase two, which was structured as a tender offer, 400,000 HESG shares were to be exchanged for 50% of the outstanding shares of Biofarm. Phase one, was completed on October 18, 2001. Subsequent to the share exchange of phase one, the indirect owner of the Biofarm shares, Mr. Harry Branch, became the largest shareholder and the Chairman of HESG. The consummation of phase two required the approval of RASDAQ, the Romanian stock exchange. There were months of delays in completing the transaction. The protractions were caused by circumstances that go far beyond the scope of this update report. The HESG management determined that the appeal of Biofarm as a portfolio company faded in the context of a strategic plan that would focus on North American businesses. On April 26, management entered into a rescission agreement with Branch. The 1.7 million HESG shares were returned to the Company and Mr. Branch resigned as chairman and director of the Company. HESG has no further interest in Biofarm.

We regard the unwinding of the Biofarm deal as being very positive for the Company and the stock. Biofarm is after-all a marginal player in an underdeveloped third world country. Romania is regarded as one of the poorest countries in Central and Eastern Europe with an obsolete industrial base and a pattern of output unsuited to the country’s needs. Unemployment is over 11%, inflation 46% and 44% of the population lives below the poverty line.¹ The presence of the Romanian component in the HESG earnings mix would undoubtedly be a drag on the valuation. The risks associated with inflation, currency, and politics would be reflected in the market's collective opinion and valuation of Health Science Group. Management has stated that it will focus exclusively on North American acquisition candidates in the future.

The most important benefit of aborting the Biofarm transaction is the recovery of the 1.7 million shares. Today the shares have a market value of over $5 million. The same number of shares was valued at approximately $750,000 or $0.44 per share six months ago when phase one of the Biofarm deal was transacted. The second phase called for the issuance of 400,000 additional shares. Consider that the Company’s common stock is its only currency for effecting acquisitions. With the unwinding of Biofarm deal, the Company now has a second chance to deploy these shares more productively. At the current market valuation, the Company can acquire the equivalent of two XCELs compared to what was paid in stock for the 24.3% minority stock of Biofarm.

The Pending Quality Botanical Ingredients (QBI) Acquisition - On March 21, the Company announced that it had executed a Letter of Intent to purchase QBI, a producer and supplier of raw bulk material that is sold primarily to manufacturers of dietary supplement products. The dietary supplements market at the retail level is estimated at $17 billion with herbs and botanicals representing about one fourth of the total.² The market at the QBI supply chain tier is roughly $500 million, which is shared by about 300 companies. The acquisition is expected to close before the end of the second quarter. QBI had sales of $12.3 million in calendar year 2001. More detailed historical operating results have not been disclosed. Consequently, a thorough evaluation of the deal’s merits will not be available until after the closing. The QBI acquisition will provide a degree of vertical integration to the Company. The ingredient components of the new line of proprietary products to be introduced by BioSelect Innovations under the brand name COCARE® will be supplied by QBI. The terms of the QBI transaction will include stock, cash and performance incentives for those selling shareholders who remain as managers of the subsidiary.

Modified or Terminated Consultant’s Agreements - During the summer and fall of 2001, the Company was essentially in a conceptual mode. A business strategy was unfolding but had not yet crystallized. During these months, the co-founders were retaining consultants to provide professional assistance in the formulation and implementation of a business plan. Having no cash, the Company issued shares and/or stock options as compensation for these services. Also, certain of the agreements called for the issuance of shares in the future. In hindsight, it can be argued that the agreements were too generous and lacked specific performance criteria. Management has taken the necessary steps to recover many of the previously issued shares and to cease the issuance of shares earmarked for distribution in exchange for professional and investor relations services. There were 7,203,000 shares outstanding at the date we published our initial report. We had the expectation that an additional 1,532,000 shares would be issued for consulting services. Also, consummation of Biofarm phase two would add 400,000 shares for a total number of actual and potential shares outstanding of 8,735,000. This number does not include any shares to be issued for an acquisition(s) or for an equity financing. By rescinding the Biofarm deal and by revoking or terminating consultant agreements, the HESG management has reduced by 40% the shares issued or to be issued. (An additional 180,000 options or stock were issued to consultants in March and April). We are not of the opinion that the Biofarm deal had no merit or that the consultants did not make a contribution. However, we are making the judgment that a more productive use of the shares in question was then and is now for capital generation and for acquisitions. At current market prices, the recovered shares represent a currency valued at $10 million. The following table summarizes the changes in the share capitalization.

Table I: Restructured Share Capitalization

The BioSelect Innovations Proprietary Products - BioSelect, the research and development affiliate of XCEL, has filed for patents on a number of product formulations that fall into a new category called integrative medicine. The BioSelect formulas call for the bundling of generic synthetic pharmaceuticals with natural ingredients such as herbs, botanicals and vitamins. The condition specific formulations would be targeted to relieve common ailments such as urinary infection, cold, flu and cough, arthritis, cardiac problems and migraine. Combining and marketing OTC drugs and natural supplements in the same formulation has not been done commercially. This is not because of a technological constraint. There are regulatory and marketing issues that will have to be addressed. FDA approval at some level will most likely be required. Also, expensive consumer education is a prerequisite for the acceptance of a new category of products. Consequently, BioSelect will not proceed to exploit its formulations without the financial and marketing support of an industry partner. The Company is pursuing such a relationship with several candidates.

An arms length valuation of BioSelect’s intangible assets was performed by a professional appraiser in connection with the allocation of the purchase price. The values assigned to the patents and formulas were $3.3 million and $.689 million, respectively. (The patents were carried at $188,000 at year end 2000.) The net effect was to cause an increase in the HESG consolidated shareholder’s equity from a negative of roughly $300,000 to a positive of $4,000,000.

The XCEL audited financial statements for the years ending December 31, 2000, and 2001, were released after our publication of the HESG initial report. Based on preliminary unaudited information, we reported that XCEL’s sales in the year 2000 were $2.950 million. The final audited sales figure for that year was $2.481 million. Also, there was a loss of $210,000, not a $200,000 profit in 2000. The audited 2001 sales were $3.710 million up by 8% over the estimated sales shown in our report. However, the audited result for net income for the year 2001 was a loss of $38,153 compared to our earlier estimate of a $360,000 profit. These revisions related to the recognition of revenues and the treatment of research and development costs. Sales of XCEL in the first quarter were $1.2 million or an annual rate of $4.8 million, which is 6.7% above our earlier projection of $4.5 million.

Financial Considerations

While the net worth of HESG has been greatly enhanced as a result of the consolidation of BioSelect and the appraised value of its intellectual property, there is still a serious need for liquidity. The Company has come a long way without an infusion of cash from a stock offering. A recent source of cash has been $170,000 of loans made by the co-founders. They are also deferring their salaries to conserve cash. The exercise of consultant’s options in March and April raised an additional $95,000. However, a primary stock offering either public or private is a priority goal.

The Company is in an early stage of a Reg. D offering. The agreement calls for privately placed financing of $2 million to $3 million of equity or its equivalent. If such an offering is consummated, the financial risk now facing HESG will be reduced considerably.

Conclusion

We continue to recommend HESG on the basis that the underlying concept is sound. The growth of many privately held small businesses with promising prospects is inhibited by their inability to attract capital. HESG, as a public company, has the opportunity to grow by acquisition on attractive terms. Assuming the consummation of the QBI deal, in a relatively short time frame, HESG will have demonstrated an ability and the agility to assemble a portfolio of health product companies that can provide, on an annual basis, close to $20 million in sales. This performance should accelerate following an infusion of equity capital.

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¹ Central Intelligence Agency, The World Factbook (http://www.cia.gov)
² Nutrition Business Journal, Vol. VI, No. 11, November 2001

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, 1129 Manning Drive, Suite 310, El Dorado Hills, CA 95762 Phone (916) 941-4985, Fax (978) 418-6422 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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