The Next Telecom Double?

In my last column, The Next Home Run Stock, I promised to explain how I dug up the recommendation that launched my Motley Fool Hidden Gems newsletter service. That company is Talk America (Nasdaq: TALK  ) , a national provider of bundled long distance and local telephony for residential and small-business customers.

I recommended Talk America to my Hidden Gems members back in July at $10.57. It trades today at $13.50, and I think it has plenty of room to run.

It might surprise you that I've plunged into the treacherous waters of telecommunications. You're right to be worried. Over the past five years, this industry has destroyed shareholder wealth like few others, while executives have enjoyed lavish perks and multimillion-dollar salaries.

But now, consider the possibility that years of disastrous overexpansion by major telecoms -- which led to massive debt, accounting fraud, and bankruptcy -- also created some compelling niche opportunities for enterprising small competitors.

Telecom's hidden gem
Little Talk America competes directly with debt-laden behemoths -- companies like SBC (NYSE: SBC  ) , Verizon (NYSE: VZ  ) , and AT&T (NYSE: T  ) . All have lost a measure of monopoly power over the past few years, as the government has invited competition onto a communications infrastructure it subsidized.

Today, Talk America benefits from an FCC ruling requiring the regional Bells to open access to their government-funded infrastructure at wholesale costs. The regional Bells are frantically appealing the ruling, but the extended appeals process will give Talk America plenty of time to build its business. Ultimately I believe there's too much momentum behind fostering consumer choice and lowering phone bills to derail the ruling.

Talk America pays a wholesale toll to, say, SBC in Michigan. It then packages deep discounts relative to the high prices SBC charged as a monopoly. Talk America also offers first-rate customer service, which is antithetical to monopoly rule. Its members get: (a) real-time billing updates online at www.talk.com, (b) free member-to-member long distance, and (c) cost savings on calls over an extended local area.

In our Hidden Gems interview with Talk America CEO Gabriel Battista, he emphasized that the large telecommunications companies are stuck fighting a defensive war. They can't drop their prices aggressively, lest they alert millions of their own customers that the same service is available at lower prices. Meanwhile, Talk America gets to take the offensive.

Winning the war
In its earnings guidance this week, the company pre-announced accelerated customer growth to 495,000 bundled lines. That beat expectations, but it's nothing compared to the 140 million residential and small-business lines in America. Clearly, there's plenty of room for a financially strong small company like Talk America to win market share.

All of which is reflected in accelerating top-line growth. Over the past three quarters, Talk America's annualized sales growth has climbed above 20%. The company has a run rate of more than $50 million in structural free cash flow, and over the past three quarters, has paid debt down from $140 million to just $47 million. On top of that, it has repurchased 6% of its outstanding shares over the past year.

And yet, at $13.50 per share and a market capitalization of $350 million, Talk America is valued at just 6 times its run rate of free cash flow.

Last week, a Needham & Co. analyst posted a $20 one-year target for the stock, which would mark a near double for Hidden Gems members. I like to run valuations based on a minimum holding period of two to three years (among other benefits, we prefer that long-term capital gains tax rate). My long-term valuation is closer to a triple for our members, with the stock nearer $30 than $20. Even though Talk America has already risen more than 25% since I recommended it, I believe it is a compelling investment here at $13.50.

How did I find it?
I love to dig right into those beaten-down industries discarded by tag-along institutional investors. I've found that, if you can shield your eyes from the corporate tragedies, you're bound to locate one or two standout companies. They're often priced at tremendous discounts, since investors are forever tuning their attention to the hot industries.

And what's less attractive than telecommunications?

Telecom brought us the disastrous roll-up at WorldCom. It delivered us Global Crossing. It spawned tens of billions of AT&T debt. This industry is about as attractive to an institutional investor as fresh manure to a city slicker. The prudent advice is to hold your nose, furrow your brow, and step away. But buried deep in the sloppy muck of telecom are a few gems for the taking. As I waded through this and other beaten-down groups this summer, I searched for:

  • Companies trading below 10 times normalized earnings and free cash flow

  • Top-line growth in excess of 12%

  • Double-digit rates of return on equity and assets

  • Companies paying down debt

  • Companies repurchasing shares

  • Limited insider selling

  • Proven management and a compelling story

In Hidden Gems, we apply these criteria, among many others, to our search for companies with strengthening asset bases and top-line growth -- specifically, those that are deeply undervalued. When the time came to kick off the service back in July, Talk America emerged as the star among hundreds of hopefuls.

Today, I'm as convinced as ever that Talk America has the market opportunity, depth of management, strength of assets, and the financial discipline needed to substantially outperform the market from here.

If you'd like to read my Hidden Gems report on Talk America and my three recommendations since, sign up for a 30-day FREE trial with no obligation to subscribe, by clicking here.

Continued good luck with your investments.

Tom Gardner is co-founder of The Motley Fool. He owns none of the companies mentioned above. The Motley Fool is investors writing for investors.


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