Awful Market, Great Tech Stock

I'm a believer in growth stocks. As an analyst for our Motley Fool Rule Breakers service, I think you should be a believer, too. But some growth stories are inevitably better than others. Hence this regular series. My goal? Out the Fakers, elevate the Breakers, and examine the growth stories stuck in between.

Next up: NetGear (Nasdaq: NTGR  ) . Is this maker of data networking equipment for small businesses growing sustainably enough for your portfolio? Let's get right to the numbers.

Foolish facts

Metric

NetGear

CAPS stars (5 max) ****
Total ratings 2,385
Percent bulls 96.8%
Percent bears 3.2%
Bullish pitches 332 out of 345
Highest rated peers ShoreTel, Digi International, Spirent Communications

Data current as of March 21.

NetGear just isn't my type of stock. Not only is it a slower grower than most of tech names I invest in, but the company also faces tough competitors in the business of personal networking. Cisco's (Nasdaq: CSCO  ) Linksys, for example. Without a clear competitive edge, I don't see a reason to buy shares.

But that also doesn't mean I'm right. NetGear has been a winning pick for David Gardner's side of the Motley Fool Stock Advisor scorecard since March 2007, and that's including a 10% haircut suffered in February when the company came in $0.03 under fourth-quarter earnings estimates.

All the other indicators looked great. Management raised guidance for the first quarter, confident that a flood of new connectivity and home theater products -- 20 in all -- would lift revenues. Most of them made an appearance at January's Consumer Electronics Show in Las Vegas.

Volume has two purposes here. First, a lot of gear requires a lot of shelf space. The more shelf space, the more likely it is browsing consumers will think of NetGear when they need equipment for linking computers and home electronics to the Web.

Second, because the Web has become a medium for work (i.e., cloud computing) and play (i.e., online gaming, video streaming), the need for high-powered networking equipment has never been greater. ABI Research estimates that fixed broadband service revenue will reach $186 billion by the end of this year.

The elements of growth

Metric

2010

2009

2008

Normalized net income growth 156.2% (28.6%) (38.1%)
Revenue growth 31.4% (7.6%) 2.1%
Gross margin 33.2% 29.8% 32.5%
Receivables growth 39.2% 17.8% (12.4%)
Shares outstanding (million) 36.2 34.7 34.3

Source: Capital IQ, a division of Standard & Poor's.

Judging from the patterns shown in the table above, NetGear is capitalizing on increasing demand for online access. Let's review.

  • Growth investors like me love straight-line accelerating revenue growth leading to accelerating profit growth. We mostly have that here. Revenue dipped some in 2009 after a slight uptick the year prior. The good news? Both revenue and profits soared last year.
  • Pricing power is also something we like to see. Or, in lieu of that, excellent cost management leading to higher margins. NetGear hasn't been consistent here either, but the trend looks good. Gross margin is up 70 basis points from 2008.
  • We also like businesses that collect quickly. Businesses that do this well grow revenue faster than receivables, leading to higher cash flows from operations (CFO). NetGear didn't enjoy either last year. Receivables outpaced revenue growth by about 8 percentage points, while CFO fell 45% to $26.4 million.
  • Finally, dilution looks modest for a tech company. Shares outstanding are up 5.5% over the past two years, mostly likely driven by exercised stock options.

Competitor and peer checkup

Company

Normalized Net Income Growth (3 yrs.)

Apple (Nasdaq: AAPL  ) 54.6%
Cisco (4.2%)
Hewlett-Packard (NYSE: HPQ  ) 9.6%
NetGear 4.3%

Source: Capital IQ. Data current as of March 21.

NetGear isn't the fastest grower on the list. Nevertheless, it's interesting to see the upstart outperforming its closest peer: Cisco. By focusing on a niche and attacking it with a wide array of products, NetGear has carved out an ample slice of the market for itself.

Grade: Sustainable
Long-term investors should take comfort in that. NetGear is cash-flow positive and has produced double-digit returns on capital in four of the past six years despite being chased by some of the richest companies in tech, in a market well-known for commodity products. There's no reason to believe management won't continue to outperform.

Do you agree? Disagree? Let us know what you think about NetGear's products, strategy, and valuation using the comments box below. You can also ask me to evaluate a favorite growth story by sending me an email, or replying to me on Twitter.

And in the meantime, keep tabs on NetGear by adding the stock to your watchlist for free, personalized stock tracking.

Apple and NetGear are Motley Fool Stock Advisor selections. Motley Fool Alpha LLC owns shares of Cisco. Motley Fool Options has recommended members open a bull call spread position in Apple. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Tim Beyers is a member of the Motley Fool Rule Breakers stock-picking team. He owned shares of Apple at the time of publication. Check out Tim's portfolio holdings and Foolish writings, or connect with him on Twitter as @milehighfool. You can also get his insights delivered directly to your RSS reader. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool owns shares of Apple and has created a bull call spread position in Cisco Systems and written Apple puts. The Fool is also on Twitter as @TheMotleyFool. Its disclosure policy thinks Monty Python is sustainably funny.


Read/Post Comments (2) | Recommend This Article (3)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 26, 2011, at 6:50 PM, FoolSolo wrote:

    I've been in NTGR since 2008, mostly on TMF SA recommendation. I don't see much being discussed about NTGR in the SA forums, which concerns me. I'm currently sitting on a paper gain of about 193%, and I've watched NTGR hit a high of $37, only to retreat to $30, and pop up again to $33.

    Your summary is pretty much right on, I think NTGR is in a highly competitive, relatively low margin market, which makes it very difficult to grow in leaps and bounds. However, from my personal experience, I have found NTGR products to be very reasonable and good quality, and usually superior to many of the competitors, including Linksys.

    NTGR seems sensitive to foreign exchange rates, and with US currency declines it might be able to stay on the positive side. I am hopeful they can maintain a steady growth rate, but I'm not counting on it.

  • Report this Comment On March 26, 2011, at 10:16 PM, Mary953 wrote:

    A question for those who know more than I do. Japan's recent tsunami took out large portions of its industrial base. What impact, if any, does this have on this niche player? Are any of its competitors going to run into supply problems? If so, NetGear might be an especially good choice short term. Is NetGear going to run into difficulties with its supply chain? If it is and if they are running on a 'just in time' delivery schedule, then NetGear might be looking at a supply problem of its own.

    Does anyone have any insight on this short-term effect?

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