eSpeed (Nasdaq: ESPD)
trading at $9.59 as of 10/26/04
Talk about a trick! Back in March, the Fool's Hidden Gems newsletter recommended that investors reach into the plastic pumpkin bucket and pull out a handful of eSpeed -- one of two firms that dominate the world market for electronic bond-trading. The stock slowly decomposed over the next few months, then look what happened in July! In short, eSpeed has been a disaster for us, down more than 50% in seven months. And that's a good thing.
As Scooby used to exclaim when sighting a ghost: "Wuh?!" But yes, it sounds so nice, I'll say it twice: Thanks to its fall, eSpeed has evolved into a mouthwatering, no-carb, low-cal treat. At its current, frighteningly cheap price, this company passes my 7 Step test for finding small-cap gems and gets my Foolish vote for "Hidden Gems pick with the most room to run." Here's why:
Enterprise value-to-free cash flow (FCF)
Over the past 12 months, including the July that so spooked the Street, eSpeed collected $48.2 million in free cash flow. Compare that to its ultra-low $295 enterprise value, and you've got a company with an EV/FCF of just 6 -- a veritable skeleton compared to such debt-bloated monsters as General Electric (NYSE: GE) or U.S. Steel (NYSE: X).
Historical and projected earnings growth
Ordinarily, I like to choose the lower of a company's five-year historical or projected earnings growth rate to more conservatively estimate the next number, EV/FCF/Growth. In eSpeed's case, though, the historical numbers were disrupted when the company was all but destroyed during the World Trade Center attacks on Sept. 11, 2001. Using just the future projections, then, we see that the six analysts currently following eSpeed collectively think the company can post 17% gains in profits per annum over the next five years.
EV/FCF/G
Divide the EV/FCF of 6 by the growth rate of 17, and eSpeed is clearly a small-cap value candidate. Its ratio of 0.35 is well under my targeted threshold of 1.0, giving this investment a wide margin of safety -- and as for why you want that, remember the lesson learned last July: Disasters can happen. You wouldn't go into a graveyard after dark without your garlic and holy water, would you? Likewise, don't venture onto Wall Street without a large margin of safety.
Return on equity
Stock analysts are only human. In projecting future growth, they're bound to make mistakes. So I like to test my EV/FCF/G assumptions, by ensuring that the growth rate I use is backed up by a similar return on equity number. In eSpeed's case, return on equity scores a solid 14.2% -- close enough to my 17% growth number to allay my concerns.
Insider ownership
Management has a huge stake in eSpeed's long-term success: They own well more than 60% of the company themselves, so if the company fails, they take a huge hit. Similarly, don't expect them to run the business for short-term profit, to fudge their revenue numbers to "make estimates" or engage in similar shenanigans. They know that if eSpeed's stock price goes up for a quarter through mere accounting flim-flammery, the SEC could drive a stake through the company's heart. They'll work hard to keep that from happening in order to protect their own investments -- so their interests align with yours, the outside investor's.
Share dilution
Referring to eSpeed's most recent 10-K reveals that over the past two years, share dilution has been kept in check at just under 3% per annum.
Conclusion
With a compelling valuation, strong projected growth and current return on equity, minimal share dilution and inside owners whose interests align strictly with the shareholders', Hidden Gems pick eSpeed offers a treat to savor long after Halloween has faded into a sugar-laden dream.
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Fool contributor Rich Smith owns shares of eSpeed but of no other stocks mentioned in this article.
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