10 Small Caps to Rule Them All

Small-cap companies are absolutely one of my favorite areas to research because you can often uncover hidden gems that analysts have neglected or simply not discovered yet. They can offer the ultimate risk-vs.-reward ratio, but are also not for the faint of heart.

This 10-week series is dedicated to finding the 10 small caps to rule them all. Here are the previous two choices:

• Golden Star Resources
• Buffalo Wild Wings

This week I want to highlight fabless semiconductor company Integrated Silicon Solution (Nasdaq: ISSI).

What it does
Integrated Silicon Solution provides specialty memory products to the networking, automotive, telecom, industrial, and consumer sectors. The company derives roughly 33% of its revenue from its SRAM products, with another nearly 60% coming from its DRAM line.

How it stacks up
The biggest challenge a company like Integrated Silicon faces is the cyclical nature of its highly competitive sector. The company is always going to be susceptible to economic peaks and troughs. Even more so, SRAM and DRAM memory prices are crucial to Integrated Silicon's profitability, and any major changes in those prices can drastically alter the company's outlook.

That being said, the company's current outlook is bright. What softening the company did report last quarter has given way to renewed optimism for the remainder of the year. Although a completely different type of memory, NAND flash memory prices have been rising. This is typically a bullish sign for SRAM and DRAM prices as most specialized memory products tend to move in tandem with regards to price as drivers like PC demand or natural disasters can affect the entire memory industry. The specialty memory sector looks ripe to capitalize on these strong prices, but none looks more compelling than Integrated Silicon.

Source: Yahoo! Finance.

As you can see, most of these specialized memory chip companies trade at very reasonable valuations. All of them maintain strong cash positions, but none have more of their current valuation tied up in their cash value than Integrated Silicon. With nearly 30% of its current market value derived from cash currently on its balance sheet, the company should have limited downside potential if demand for specialized memory chips weakens.

Focusing on growth, SanDisk does have a higher projected five-year growth rate, but appears to be more expensive on a forward earnings and PEG basis than Integrated Silicon. Cypress and Integrated Device Technology also have double-digit growth rates, but look downright overpriced if you place their forward P/E or current PEG ratios side-by-side with Integrated Silicon. On paper, Integrated Silicon looks like a smart play, now let's see if it makes for a practical buy.

How it could make you money
Controlling costs is the most important aspect to specialized memory chip producers. SRAM and DRAM prices will always vacillate, so the only true way these companies have to control costs is either to trim the fat from within, or consider merging with each other to obtain cost advantages. No company looks more primed for a takeover than Integrated Silicon.

The company has a market cap of only $248 million, but has $74.5 million in cash and, according to consensus estimates, should produce $40 million in earnings next year. It wouldn't be difficult for a company like Micron to incorporate Integrated Silicon's technology into its product line since their products are already extremely similar. Micron, and really all of the above-mentioned companies, has the cash necessary to pull off such a deal. It simply remains to be seen whether Integrated Silicon will continue to grow on its own or whether a larger rival will step up and purchase it in order to take advantage of the cost synergies associated with less competition.

Integrated Silicon has historically been very conservative with its cash usage, but its recent purchase of Si En Integration Holdings for $20 million in cash has me excited. Si En is a China-based producer of analog and mixed signal integrated circuits and represents a completely new product line for Integrated Silicon. The purchase will be immediately accretive to earnings, and more importantly, Si En's 42.5% gross margins will provide a boost to Integrated's margins, which have recently ranged from 33% to 38%. The point is that Integrated Silicon is not just expanding its product line because it has an overabundance of cash; it's utilizing its cash wisely and taking advantage of obvious opportunities.

Integrated Silicon has shown its ability to grow organically and it has also shown recently that despite its small size it can grow through acquisitions. I feel it's only a matter of time before the market recognizes this undervalued small cap as truly a chip off the old block.

What's your take on Integrated Silicon Solution? Share your thoughts in the comments section below. Also consider making your life less complicated by tracking your own personalized portfolio of stocks, including Integrated Silicon Solutions, with My Watchlist.