Rating: Buy

Basis for Rating:

Touchstone Applied Sciences (OTCBB:TASA) has just announced impressive financial results for the third quarter of fiscal 2002, which meet the aggressive revenue and net income projections for the quarter laid out in the J.M. Dutton Research Report published on July 24, 2002.

Nevertheless, this stock continues to be badly undervalued. As of its closing price of $0.55 on September 20, TASA is trading at a price-earnings multiple of 2.9, which clearly does not reflect its current or potential growth, or the quality of its earnings.

• The U.S. is currently in the midst of a federally mandated major upgrade of its primary and secondary school public education system.
  
  
• Touchstone is very well positioned to benefit from this initiative, as it already offers products that specifically meet each of this program's objectives, and which are also widely respected within the education community.
  
  
• The Company is in the process of divesting itself of its money-losing Educational Delivery Division. As a result, its management will be able to focus on its strongest business segments - its Assessment Products and Instructional Products Divisions - which have been the source of the Company's growth and profits over the last several years. In addition, it eliminates the probability of losses from this subsidiary in future quarters and it makes the Company's financial history much cleaner by moving this subsidiary's losses down to the "discontinued operations" line.
  
  
• As noted above, the Company has just reported strong financial results for its most recent quarter. This leaves open the possibility that it could have generated even stronger results for the quarter had management's focus not been at least partly diverted by the Educational Delivery Division divestiture.

Currently, Touchstone's stock trades at five times its trailing 12 months earnings per share from continuing operations. Based on the Company's most recent financial results, we believe that TASA can currently justify a market price of at least $4.00 per share.

Company Background:

Touchstone Applied Science Associates (OTCBB:TASA) provides a package of teaching and assessment (testing) tools for the U.S. education industry. After completion of the Mildred Elley divestiture, the Company will be made up of two remaining divisions:

• Assessment Products -- providing reading tests based on its proprietary Degrees of Reading Power (DRP) technology, which is widely respected among educators, and also consulting and test design services through its BETA subsidiary.
  
  
• Instructional Products -- creating, publishing and distributing "consumable" student materials for grades K-5, primarily focusing on the basics of reading and writing, through its Modern Learning Press subsidiary.

Although TASA's business is providing educational products and services, these two divisions focus on different, but interrelated segments of the education industry. Each uses a different mix of resources and technologies to develop unique product lines, which in turn are marketed to differing customer segments, and address differing sets of service needs.

J.M. Dutton's initial Research Report on the Company, dated March 20, 2002, includes in-depth analyses of the education reform programs that are currently being implemented in the U.S., and also provides more detail about the Company's divisions and their individual product lines.

Mildred Elley Divestiture:

The acquisition, subsequent history, and recently-announced planned divestiture of the Mildred Elley School was discussed in depth in the analysis update published by J.M. Dutton & Associates on July 26, 2002.

Plans for this divestiture were first discussed at TASA's annual stockholders meeting in March, while a letter of intent was announced on May 20, with the conclusion of the transaction scheduled to take place by the end of August 2002. However, it now appears that this transaction will not be completed until the end of October 2002, with the additional time needed for the purchaser to finalize the necessary financing.

Since the Company has entered into a plan to dispose of the School, it is reporting Elley's financial results as discontinued operations. During this last quarter, Elley incurred an additional $203,000 in losses.

As shown in subsequent sections of this report, the divestiture of Mildred Elley will benefit the Company in a number of ways. First, it will enable the Company to focus on its strongest business segments -- its Assessment Products and Instructional Products Divisions, which have been the sources of the Company's growth and profits over the last several years. In addition, it eliminates the probability of losses from this subsidiary in future quarters and it makes the Company's financial history much cleaner by moving this subsidiary's losses down to the "discontinued operations" line.

Continuing Operations:

As a result of the upcoming Elley divestiture, the Company's "Continuing Operations" are comprised of its Assessment Products and Instructional Products divisions. These two divisions are each currently benefiting from major changes taking place in the markets that they each serve.

These major changes are the result of recently enacted Federal legislation. The initial research report on this Company, published by J.M. Dutton & Associates on March 20, 2002, contains a detailed review of the recent changes in the domestic U.S. educational system, often referred to as the 'No Child Left Behind Act.' This broad educational initiative is a cornerstone in the current administration's domestic policy programs, and can be expected to generate change for at least the next decade.

Under this program, states and school districts are not only mandated to upgrade their public education systems, they are also required to more aggressively assess student performance. Focusing on several historical problem areas, this program is designed to:

• Improve the performance of educationally disadvantaged children so that they can achieve the same standards as their peers.
  
  
• Ensure that every school child can read by the third grade, through an intensive "Reading First" program.
  
  
• Upgrade bilingual and "English as a second language" programs so as to allow children with limited proficiency in the English language to become fully integrated into regular classrooms within three years in the U.S. school system.
  
  
• Ensure that these educational standards are met through annual assessments of every child's reading and math skills.

Touchstone Applied Sciences is very well positioned to benefit from this initiative, as it already offers products that specifically meet each of the program's objectives, and which are also widely respected within the education community.

• Its Assessment Products division offers a number of educational testing tools, including its "Degrees of Reading Power" reading assessment product, its MAC II test for use in "English as a Second Language" programs, and Signposts, its early literacy assessment program designed for use with children in the third grade and below.
  
  
• Its Instructional Products division currently publishes a number of "consumable" student workbooks for kindergarten through grade 6, to support the teaching of phonics, English-as-a-Second-Language, reading comprehension and vocabulary development, including workbooks, closely linked with TASA's DRP technology and materials which can be integrated with the Signposts Early Literacy Assessment System.

In its most recent press release, Andrew L. Simon, the Company's president and chief executive officer, explains, "We continue to benefit from the U.S. 'No Child Left Behind Act,' which mandates that states upgrade their education efforts and assess their progress."

Financial Review of Continuing Operations:

Business Seasonality: because it serves the education marketplace, each of TASA's continuing business units have seasonal revenue fluctuations that are not widely understood by investors. These fluctuations occur because TASA serves the educational marketplace. As a the result of this seasonality, it is anticipated that the Company's financial performance will be weakest in the first fiscal quarter and will strengthen as the year continues, as shown by Table 1.

Recent Financial Performance:

As shown in Table 2, during the third quarter TASA's continuing operations generated a 5.2% increase in revenues. Although both divisions contributed to this increase, the major portion of it was due to gains made by the Instructional Division. Year-to-date revenues rose 11.6%, with the Assessment Division as the major contributor.

Although gross profits did decline during 2002, this was largely due to an upward bias in fiscal 2001 resulting from the mix of consulting assignments carried out by BETA during that time, and not to any long-term weakness in the Company's business.

The apparent shortfall in net income and earnings per share was accurately anticipated in the updated research report published by J.M. Dutton on July 24. At that time, third quarter revenues were projected to be $3,516,000 versus the actual results shown above. Net income from continuing operations was projected to be $404,000; the $3,000 shortfall versus actual results is essentially insignificant.

A review of the Company's balance sheet and cash flow statements does not show any noteworthy changes in position, as Touchstone remained operating cash flow positive during the quarter in spite of a seasonal build-up in accounts receivable. The Company's working capital and current ratio continued to strengthen.

Financial Projections:

As shown on Table 3, we are maintaining the financial projections that were developed for our second quarter update, as we have not seen any information on which to justify any changes.

In its most recent earnings release the Company stated "We expect substantial increased sales in assessment products and services in the fourth quarter, as well as going forward when other provisions of the act are phased in." However, these increases have already been factored into our earlier estimates.

These projections are more completely documented in the Income Model, to be found on Page 6 of this report.

Analysis of Current Market Valuation:

There are several ways to develop a market price justification for the Company's stock. One of these is to look at the intrinsic value of the stock itself, in light of one of several economic perspectives. Another is to compare it to its peers -- similar public companies in its industry or in similar industries.

Possibly one of the most commonly used and widely accepted equity valuation tools is the "Intrinsic Value" method that was initially described by Dr. Benjamin Graham in his book, "The Intelligent Investor," as this takes into account both the stock's projected earnings and its projected rate of growth. Table 4 gives a range of valuations that supports a target price of $4.00 per share.

Another "economic valuation" method is the Net Present Value of Projected Cash Flows which projects the current value of the cash flows that a company is expected to generate in future years. Since this valuation tool reflects the Company's strong operating cash flows, it supports a valuation around $5.50 per share.

Developing an industry benchmark against which to compare TASA is quite difficult as discussed in our March 20 research report, and it has become even less meaningful as several peer group members have recently reported losses. As a result, the "segment PE ratio" is based on results from one single peer -- Renaissance Learning (NASDAQ:RLRN).

Net-net, Touchstone's stock is clearly undervalued at its closing price of $0.55 per share on September 20, a situation that supports our continued Buy recommendation.

Click to view Table 5 - Income Model for Fiscal 2002.

Analyst:
Robert M. Davis
Mr. Davis has 15 years of experience as the Chief Financial Officer of two different NASDAQ companies, and for the last five years has been the editor of the highly regarded Napeague Letter, and is currently co-editor of The Securities Sleuth. Forbes magazine has named both of these E-zines to its 'Best of the Web' list. From 1987 to 1995, he was the Chief Financial Officer of Total Research Corporation (NASDAQ:TOTL), a marketing research and consulting firm in Princeton, NJ. Prior to this he was the was the Corporate Controller for Waverly Press Inc. (NASDAQ:WAVR), a medical and scientific printing and publishing company, and then co-founder, CFO and divisional general manager of a privately-held company in the transportation services industry. He received a BA degree from Rutgers University and an MBA from the Harvard Business School. Mr. Davis is applying for membership in the Philadelphia Society of Security Analysts, and the AIMR.

Contact:
Touchstone Applied Science Associates, P.O Box 382, 4 Hardscrabble Heights, Brewster, NY (845) 277-8100. Andrew L Simon, President and Chief Executive Officer www.tasa.com

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 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 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 costs US $25,000 prepaid for one-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.

© Copyright, 2002, by J.M. Dutton & Associates, LLC.