Recommendation: Buy

Basis for Recommendation:

Touchstone Applied Science Associates (OTCBB: TASA) provides a package of teaching and assessment (testing) tools for the U.S. education industry. Included among these tools are reading tests based on its widely respected proprietary Degrees of Reading Power (DRP) technology, and consulting and test design services offered through its BETA subsidiary. In addition, its Modern Learning Press subsidiary creates, publishes and distributes "consumable" student materials for grades K-5, primarily focusing on the basics of reading and writing. The Company also owns several post-secondary proprietary schools in the Northeast.

During the last year, TASA's revenue and net income growth has accelerated, almost entirely as the result of three factors:

• A major, positive change in the Company's business environment. The recent implementation of significant nationwide education reform legislation in the U.S. has drastically increased demand for the Company's products and services.
  
  
• Ideal positioning to benefit from these changes. The Company has a strong product line specifically designed to address the new market needs, which has already been validated by its use in Texas, the "prototype" for the nationwide education reform program.
  
  
• Exploiting internal synergies. Several of the Company's businesses -- its Assessment Products, BETA Consulting and Instructional Products divisions -- interrelate in a variety of ways, creating potentially strong synergies which have begun to favorably impact the Company's business.
  

As a result, the Company has already seen over the last year a dramatic increase in demand for its core products and services, an increase that can be expected to continue for the next three to five years.

Currently, the stock trades at a multiple of only seven times its trailing 12 months earnings per share; its market valuation does not reflect the Company's recent earnings gains and has not taken into consideration its future growth potential. Based on the Company's most recent financial results, we believe that TASA can currently justify a market price between $3.50 and $4.00 per share. And, assuming that it meets our projections for fiscal 2002 and 2003, it could command a price in excess of $6.00 a share.

Key Changes in Business Environment:

The United States has always placed a lot of emphasis on education - and it has never been satisfied with the results it achieves in this area. This dissatisfaction periodically leads to educational reform movements, at both the state and federal levels.

George W. Bush, while Governor of Texas, led a very successful initiative to overhaul that state's primary and secondary school system by returning its focus to basic math and reading skills, and by making school administrators accountable for their results.

In 1998, as these educational reforms were taking effect, the Texas Education Agency began to make extensive use of TASA's educational testing capabilities, first for measurement of its "English as a Second Language" programs, and later for state-wide reading tests. As a result, many of TASA's Assessment products became key elements in the Texas educational testing programs.

When Governor Bush became President of the United States, he brought with him a commitment to similar educational upgrades on a national level, modeled on the successful Texas program. As a result, the new Administration initiated major education reform legislation, the No Child Left Behind Act (H.R. 1), a complete overhaul of the 1965 Elementary and Secondary Education Act. Enacted into law at the beginning of 2002, this upgrade program will be generating basic changes in U.S. education for the next 3 to 5 years.

However, there have been numerous demands for improvements in our public education system here in the U.S. As a result, this is not just a "Bush initiative" but also one that has strong bipartisan support. As evidence of this, in many cases Congress actually appropriated more funding for certain of these programs than was initially requested by the Administration.

• The largest single funding item in this legislation was for the Title I program - $10.35 billion, or $1.6 billion more than the President's budget request, was provided to aid states and school districts to help educationally disadvantaged children achieve the same high state academic performance standards as all other students.
  
  
• Another was the "Reading First" Initiative, a new program to ensure that every child can read by the third grade, which was funded at the requested level of $975 million. This program will enable states to eliminate "the reading deficit" through scientific research-based reading programs, focusing on students from kindergarten through grade 3.
  
  
• This legislation also mandates annual state assessments of student's reading and math skills for every child in grades 3 through 8, and provides $387 million, $67 million more than the budget request, to cover the cost of developing annual state assessments of student's reading and math skills. States will be responsible for selecting and designing their own assessments and will have three years in which to do so. Federal funds will cover the cost of developing these assessments.
  
  
• Bilingual and Immigrant Education programs have been dramatically reformed to focus on teaching English to limited English proficient children and expediting their transition into regular classrooms. The budget requested $460 million for this purpose; however, this bill provides $665 million in recognition of the growing number of limited English proficient children. States and school districts will have more flexibility in using bilingual funds, but in exchange they must show annual increases in English proficiency, and they will be required to teach children in English after three consecutive years of being in school.
  
  
• The use of technology in education will be expanded under this legislation. Various funding programs will be consolidated, and technology strategies will target the specific needs of individual schools.
  

This upgrade program sets nationwide educational objectives, modeled after those implemented in the State of Texas, and provides federal funding for programs to meet these objectives. Although selection of specific programs and their implementation will remain the responsibility of state and local school administrators, it appears likely to us that a significant percentage of those states that do not already have such programs in place will turn to proven sources, such as TASA, especially since these national objectives must be met within a relatively short three year time period.

And TASA appears to be such a "proven source." As a result of its successful work with the Texas Education Agency, TASA has developed a number of assessment and educational tools specifically designed to support these new Federal programs.

Company Background:

Touchstone Applied Science Associates is made up of the following three 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.
  
  
• Education Delivery--post-secondary, proprietary schools through its Mildred Elley Schools subsidiary.
  

Although TASA's business is providing educational products and services, its three divisions focus on widely differing 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.

Assessment Products and Services Division:

The Assessment Products and Services Division provides a growing range of testing materials and services for use by educational institutions. It is also the home of BETA, a strong and widely respected educational consulting group.

Degrees of Reading Power (DRP), the Division's "core" product, is a highly regarded line of reading tests based on its "proprietary Degrees of Reading Power (DRP) assessment methodology."

DRP tests measure how well a student reads under real-life conditions, both in and out of school, and also allows tracking of an individual student's reading skills over time. From discussions with various educators and reviews of other information sources, we have confirmed that this proprietary methodology is well respected and is seen by many as being "state of the art."

Very simply, DRP tests determine how well a student reads, both in and out of school, by measuring how well they understand the meaning of a selected text. To quote the Company's latest 10-K Report:

DRP tests consist of nonfiction paragraphs and/or passages on a variety of topics, each written, edited, and calibrated by the Company. The individual test passages are stored in the Company's "Test Passage Bank," and each test is created by selecting the appropriate test passages from the Test Passage Bank to satisfy the criteria set for a particular test. Each passage undergoes a two-year process of development and calibration and has an estimated useful life of 11 years.

The Company has designed its DRP tests for use with different age and education levels, and produces DRP tests in a variety of different forms. The more common type is the "shelf" versions that are listed in TASA's catalogs and are licensed to schools for an indefinite period of time. The alternative type is a "secure" version composed of test passages that have never before been used, and are used only once in a "secure" test. These are primarily used by the states of Connecticut, New York, and Virginia.

Since 1998, the Company's DRP tests have been included in the Primary Reading Inventory used in the State of Texas. As a result, it is a likely alternative to be selected by a State needing to implement a reading assessment program for every child in grades 3 through 8.

English as a Second Language: As frequently reported by the news media, the United States continues to be a nation of immigrants, whose native languages are today as diverse as Spanish, Urdu, Serbo-Croatian and Chinese. Only now, our educational system is making a stronger effort to serve the needs of those students for whom English is a second language. One key element in this effort is determining how well each of these students understands English. As a result, there has been a substantial increase in demand for testing tools in this area.

Several years ago, the Company acquired the Maculaitis Assessment of Competencies test, which was developed for use in various "English as a Second Language" programs in U.S. schools. Almost immediately, TASA made a number of revisions to this technology, including the development of national norms, to make it easier to use and more readily marketable. In its reading segments, the new Maculaitis test makes extensive use of the DRP methodology, and the results can be quantified using DRP scores.

The new Maculaitis test, known as MAC II, was launched nationally in July 2001 with an extensive marketing effort. On July 27th, a Company press release stated that the initial response was "extremely encouraging" and that "we expect the MAC II to be one of our most significant proprietary products in terms of sales and customer interest."

By the end of 2001, the MAC II test had passed the review process and was on the state lists of approved tests in the States of Florida and Illinois, in addition to New Jersey, and had been adopted as the single state test in Rhode Island. With the new federal education program calling for annual increases in English proficiency, it appears likely that such testing will increase, and that states will turn to proven sources for such testing.

TASA has subsequently announced plans to develop an "adult" version of the MAC II that would be a useful tool for placement of older English language learners.

Signposts - Early Literacy Assessment Program: Realizing that there was a need for a reading assessment tool for grades K-3 that was linked to the DRP assessment process, the Company developed Signposts to monitor the important literacy skills in the primary grades. Quoting the Company's most recent 10-K Report:

Signposts is a comprehensive system designed to provide a unique set of assessments and integrated instructional activities for students in grades K-3. Signposts spans a range of literacy strands--reading, writing, listening, and speaking--and includes a pre-DRP reading test and measurement scale for emergent readers.

Signposts has already seen acceptance at the statewide level in Michigan, and is currently part of a pilot program in the Indianapolis School District.

Test Scoring & Reporting: A school testing program that covers an entire state, or even a major school district, can be a logistical nightmare. To help its clients deal with these problems, the Company offers scanning, scoring, and reporting services for all of its tests. In addition, TASA has licensed its proprietary scanning and scoring software to third-party firms, state agencies, and large school systems that provide scanning and scoring services to schools.

Software: Quantifying a student's reading level is important since it can be used to measure their progress over time. However, this knowledge becomes really valuable if a teacher can use this reading level score to actively help that student improve their reading skills. The Company's "DRP-->Booklink" product allows a teacher to do this quickly and effectively.

"Take the time and the guesswork out of selecting books for your students' reading assignments. Order DRP-->Booklink today."

The DRP-->Booklink CD contains a database of 17,500 books, each of which has been scored in terms of its text difficulty, or DRP readability, as well as the areas of interest that it covers. The CD also contains user-friendly software that allows a teacher to create a variety of booklists, for individual students or for an entire class on a particular subject. As a result, DRPáBooklink enables teachers to find appropriate books for each student based on the interests and the reading ability of that individual student. This database of books is growing yearly and modifications to the software each year have made it progressively more user friendly. According to the Company, DRP-->Booklink has received wide acceptance over the past 24 months.

Custom Test Products -- BETA:

The Company's subsidiary, Beck Evaluation & Testing Associates (BETA), provides custom test development and consulting services to states, schools and textbook publishers. Over the past several years, this subsidiary has been the fastest growing segment in TASA's business.

But BETA is also important to TASA for other reasons. For instance, BETA allows TASA to offer a broader range of educational testing alternatives, while still fully exploiting its proprietary DRP technology. In a December 1997 press release, Michael Beck, the president of BETA is quoted as saying "BETA's activities in test assessment and design provide TASA with a much broader participation in the state educational markets. While the DRP test is highly regarded by those who use it, and TASA continues to spread the word on the DRP test, there are other test philosophies that may be more appropriate in certain situations."

BETA also provides the Company with an entry-point for new statewide relationships:

• Michigan: While its initial project for Michigan was announced at the end of 1997, by 2001 it is clear that BETA's relationship with its Department of Education had become stronger. In January 2001, BETA received a $1.5 million contract to develop "MI-Access," an assessment process for use with special-education students, which also made use of "TASA's test production and test scoring and reporting capabilities." In July, Michigan awarded TASA a five-year extension of this contract.
  
  
• Texas: In May 1998, shortly after TASA' s acquisition of the Maculaitis test, BETA received a contract is for the development of a statewide testing program in Texas for Limited English Proficiency (LEP) students grades 3 through 8. Shortly thereafter, the Company's DRP test was approved by the state of Texas as one of the several reading tests on its approved list, and in March 1999, BETA joined up with Harcourt Brace for the development of test materials for a state-level assessment for special education students in Texas.
  
  
• Minnesota: BETA's initial consulting relationship for this state was announced at the end of 1997. In May of 2000 this initial contract was expanded "to provide reading, writing and mathematics assessment items for Minnesota in Grades 3, 5, and 8."
  

Since its acquisition by TASA in January 1997, BETA has concentrated on increasing its test assessment and design services to states. This effort has been successful, and BETA now provides its test design and psychometric services to state customers in Delaware, Connecticut, Indiana, Massachusetts, Michigan, Minnesota, North Carolina, Ohio, Texas, and Virginia.

In Fiscal 2000 and 2001, BETA also gained significant non-state assessment business from agreements with publishers, such as Princeton Review, Harcourt, Macmillan/McGraw-Hill, and the Core Knowledge Foundation.

BETA's growth strategy was summed up in a May 2000 press release; "We believe that the key to growing BETA's business is to get a toehold in a state, excel in the performance of the required task, and build new business from old.''

The Assessment Products Market:

The market for test design and consulting services is very fragmented -- many different entities provide some or all of these services, and the customers for these services are equally diverse.

• A number of for-profit and non-profit organizations provide test design, production and consulting services to states and school districts. In addition, many states and school districts have their own testing departments, which handle some or all of the individual steps involved in designing, implementing and scoring large-scale testing programs.
  
  However, there are several major companies who hold dominant positions in the testing market, including NCS Pearson, Harcourt Brace Measurement, Macmillan/McGraw-Hill, and Riverside Publishing, the testing division of Houghton Mifflin. TASA, through its BETA subsidiary, has working relationships with each of them, and has served as a subcontractor on their projects.
  
  
• The Assessment Products Division serves an equally broad mix of customers, ranging from state education departments to individual elementary and secondary schools and colleges.
  
  
• This market is further complexed by a variety of alliances and subcontracts, under which a test provider may work directly with a state or school district on one project and as a subcontractor on another project for that same state or school district. Similarly, these same providers may work for a third organization that is sponsoring a test even though it lacks the necessary technical capabilities to produce it.
  

According to Education Week's Quality Counts 2001 survey, 16 states test all elementary school students in at least six out of grades one through eight. Another 14 more test in four to five of those grades, but 18 states test in three or fewer grades.

As a result of this fragmentation, determining the size of this market is difficult. According to an April 2001 report from The National Board on Educational Testing and Public Policy, "It is difficult to obtain exact figures on the size of the testing marketplace, partly because so many different agencies and people administer tests that it is impossible to track all of them down. Moreover, the testing industry itself is somewhat secretive." This report goes on to estimate that test sales were in excess of $263 million in 1997, having grown from less than $7 million in 1955.

Instructional Products Division -- Modern Learning Press:

As its primary product line, Modern Learning Press publishes "consumable" student workbooks for kindergarten through grade 6, to support the teaching of phonics, penmanship, English-as-a-Second-Language, and reading comprehension to vocabulary development and workbooks that help students write about social studies topics, as well as supporting materials for elementary school teachers and parents.

The Modern Learning Press catalog includes a number of materials that are synergistic with its Assessment Products:

• At the end of 1998, MLP introduced a new series of "consumable" workbooks, closely linked with TASA's DRP technology, and appropriately entitled "Developing Reading Power." To quote the Company's press release of October 26, 1998, "Each Developing Reading Power workbook consists of high- interest stories grouped by reading difficulty, as measured in TASA's Degrees of Reading Power (DRP) units, as well as by children's interests."
  
  
• In the spring of 2000, MLP introduced new, consumable Signposts instructional materials which can be integrated with the Signposts Early Literacy Assessment System published by TASA's Assessment Products Division.

Traditionally, the Company marketed its instructional products almost exclusively through direct mail programs. In late 1999, it determined that its products could also be sold through independent sales representatives, and it began using this approach. MLP also began using the Internet to present and sell its products, both through its own web site, at http://www.modlearn.com and though third parties
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So as to generate the volume of sales needed to support a stronger sales and marketing effort, in mid-2000 MLP signed sales agreements with three other publishers - Boyds Mills Press, Troll School and Library, and Richard Owens Publishers. Their catalogs of products complement MLP's instructional line and broaden its scope into the middle school market, and they tend to increase the average price of individual sales.

According to the Company's latest 10-K Report, "The market served by MLP consists of an estimated 16 million total students in grades K-4, establishing an approximate market size of $30-$35 million for each workbook series" and goes on to note that "The elementary school market for the consumable books published by MLP is both huge and highly competitive, with every major publisher and numerous smaller publishers providing material."

Clearly, MLP's close relationship with the Assessment Division and BETA provide it with a variety of new opportunities. In addition, the Company feels it can compete very effectively due to the speed with which it can react to opportunities and introduce new products. It also feels that its cost structure allows it to sell at lower prices than its competitors, a significant benefit given the "the growing pressure for cost-effective purchasing by school districts."

Educational Delivery Division -- Mildred Elley:

The Company acquired the Albany, NY-based Mildred Elley School in November of 1998. Offering programs in business, paralegal, travel, information technology and health fields, this two-year, New York State degree-granting post-secondary school, had been in operation for over 80 years, and had an additional branch in Pittsfield, Massachusetts. Its largely female student body tends to have lower income levels and needs additional skills in order to maintain or improve their current employment situation.

It would be an understatement to describe the post-secondary proprietary school industry as highly regulated. A variety of governmental and quasi-governmental authorities at both the state and federal levels impose a variety of controls over accreditation, degree-granting authority, expansion and curriculum, and government funding issues. Although Mildred Elley has generally been able to work within this structure, it was excluded from the Federal Guaranteed Student Loan program until the beginning of 2001 due to regulatory issues regarding its loan default rates and reaccredidation.

In addition to its previous inability to offer Guaranteed Student Loans, Elley has also faced a shortage of potential students. Due to the strength of the Albany, NY economy, relatively fewer individuals were inclined to upgrade their skill base. However, the recent economic downturn, combined with its new access to Guaranteed Student Loans, appears to be solving this problem.

Elley has also entered into an agreement with a division of the State University of New York, under which Mildred Elley credits will be accepted toward various Bachelors degrees at its campus. Management expects that this "will enable Mildred Elley to attract a more balanced student body, including an increased number of traditional students," and "may pave the way for involvement with other schools in the SUNY system."

The Company had originally intended to grow the Educational Delivery Division through additional acquisitions. In 1998 and again in 2000, the Company entered into letters of intent to acquire two other post-secondary proprietary schools. However, after the normal pre-acquisition "due diligence," the Company withdrew from both of these situations, due to legal and regulatory issues uncovered during its review. At last years Annual Stockholders Meeting, management announced that the Company was not planning to explore new acquisition opportunities, but instead would focus on "maximizing the potential of our existing schools."

One legal issue remains to be resolved. In August 2000, the former owner of the Mildred Elley School, who is its current president and chief executive officer, initiated suit "alleging defaults in the payment of certain amounts under the asset purchase agreement between the Company and Mildred Elley School, Inc. and the accompanying promissory notes." The complaint also alleges certain defaults by the Company in this individual's employment agreement.

It appears that this legal action is unlikely to develop into a major issue, but instead will continue to wind its way through the court system. In the interim, it is clear to us that all parties in this suit continue to work together amicably.

Financial Review:

Business Seasonality:

Before reviewing the Company's financial history, it is important to understand that there are seasonal fluctuations in its financial performance. Because the Company serves the educational marketplace, the revenues and profits of each of TASA's business units have seasonal fluctuations that are not widely understood by investors. As the result of this seasonality, it is anticipated that TASA's financial performance will be weakest in the first fiscal quarter and strengthen as the year continues, and reach its strongest level in the fourth fiscal quarter. The following chart will help to explain this seasonality:

Assessment has been the primary generator of this revenue increase. As shown opposite, this Divisions revenue grew 35% in fiscal 2001, and jumped another 33% in the first quarter of fiscal 2002. And it is this increase that has fueled its improved bottom line.

This chart shows TASA's price range for each month since January 2001 as a series of "candlesticks", showing the opening, closing and trading range during the month.

The blue line on the chart gives the modeled price at which this stock would have traded had the market priced TASA at its "Economic Value," assuming a 20.0% projected growth rate.

As this chart shows, even though TASA's improved financial performance first became visible last fall, the market has only lately begun to recognize and react positively. The red arrow on the right-hand side of the chart shows the extent to which this stock is currently undervalued.

Table 5. Touchstone Applied Science Associates Income Model
Click here to view Table 5.

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 10509. Phone: (845) 277-8100. Andrew L Simon, President and Chief Executive Officer. Web site: 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 $22,000 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.