Four Promising Small Caps

It's a high-percentage bet when you invest in companies that make cash, have cash, and are priced at a low multiple to their cash earnings power. Today, in part three of this four-part series, we look at four more companies that meet our criteria. The companies include a small grocery chain, an apparel retailer, a convenience service to the wireless telecom industry, and an automobile component supplier.

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By Matt Richey (TMF Matt)
October 22, 2002

One principle that guides my investing is: Few bad things can happen when you buy a company that 1) consistently generates cash, 2) has more cash than debt, and 3) is priced at a low multiple to its cash earnings power. It's a simple, unoriginal formula that works time and again.

With that formula in mind, today we continue our search for promising small caps. If you're just joining us, we're in part three of a four-part series covering companies on my small-cap value radar. Each segment of this series includes a brief look at four companies that meet our criteria. To review, those criteria are:

  • A valuation of no more than 10 times free cash flow or earnings
  • A balance sheet with more cash than debt
  • A three-year track record of consistently positive cash flow from operations
  • A stock price above $5

Why these criteria? Lots of reasons, but most important is this: Companies with these characteristics are well-equipped to reward shareholders with stock buybacks and dividend payments, both of which can bring about a higher stock price. In addition, such companies, with solid financials and low valuations, will occasionally become acquisition targets.

Such was the case yesterday with the announcement that King Pharmaceuticals (NYSE: KG) will acquire Meridian Medical Technology (Nasdaq: MTEC) for $44.50 in cash. Meridian is a company originally highlighted by Zeke Ashton in the April edition of The Motley Fool Select, our monthly newsletter of best stock ideas. Regular readers will also recall that I wrote about the company last month, noting that Meridian had excess cash, solid earnings, and a low multiple to its free cash flow. For the record, I sold my Meridian shares yesterday on the strength of this good news.

There are other Meridians out there to be found, which is what this series is all about. Here are four more companies that meet the criteria laid out above.

Arden Group (Nasdaq: ARDNA)
Arden Group operates 18 grocery stores in Southern California under the Gelson's and Mayfair store names. The first Gelson's Market opened in Burbank in 1951, advertising itself as "the best quality products and services that a store could provide." To this day, the company prides itself in offering superior produce, highest quality meat/seafood/deli, an extensive selection of wine and liquor, and exceptional service.

The company's grocery business has shown nice growth over the years. Since 1995, annual sales have increased from $243 million to $392 million, or 8.3% annually. Also, management has diligently used its cash flow to repurchase shares almost every year, resulting in a decline in average shares outstanding from 5.2 million in 1995 to 3.4 million in 2001. As such, sales per share have actually grown at a 16.3% pace, or almost twice as fast as overall sales. Also impressive is the company's return on invested capital of around 25%.

At a current price of $55.60, the stock is priced at 9.9 times free cash flow and 13.2 times earnings. In addition, the company has $14.48 in net cash per share. When you back out the cash, the business is priced at only 7.4 times free cash flow.

Deb Shops (Nasdaq: DEBS)
Deb Shops is a primarily mall-based apparel retailer with 322 stores in 41 states. The company's apparel targets the fashion-conscious, budget-constrained teenage female (i.e., all teenage girls). One of Deb's distinguishing attributes is that it makes its fashions available to the "plus size" shopper, with over 30% of the company's stores stocking merchandise in larger sizes.

After going public in 1983 with 106 stores, the company grew rapidly, reaching almost 400 stores by the early '90s. But the pursuit of growth went too far and led the company to losses from 1994 to 1996. Profitability returned in 1997, however, as the company retrenched with a reduced store count. Since 1997, the company has gradually resumed its growth, expanding from 269 stores in January 1998 to 309 stores in January 2002, representing 3% annual store growth.

The growth may be low, but the company's profits are impressive. The net profit margin over the past three years has averaged 8.4%, while the free cash flow margin has averaged a similar 8.3%. The strong free cash flows have resulted in an enormous cash balance of $141.4 million, or $10.33 per share. Subtracting this cash from the current stock price of $21.55 yields an enterprise value (EV) per share of $11.22. With trailing annual free cash flow (FCF) per share of $2.15, the stock trades at an EV-to-FCF ratio of only 5.2. At this valuation, management ought to be buying back stock like it's going out of style.

Metro One Telecommunications (Nasdaq: MTON)
Don't let the telecom stigma scare you away; this one's pretty interesting. Metro One is the nation's leading provider of "enhanced directory assistance." The service is offered primarily to wireless carriers who contract for Metro One's service as a value add to its wireless subscribers.

Metro One has over 6,000 operators available 24/7 to offer a wide variety of information content, including directory assistance, turn-by-turn driving directions, restaurant and hotel reservations, and movie listings. Through the first half of 2002, Metro One handled approximately 270 million requests for information, on pace to grow nicely from last year's 472 million requests. The company was recently ranked No. 23 on Forbes' annual list of the "200 Best Small Companies in America."

At a current price of $9.54, the stock trades for 15.6 times free cash flow and 8.4 times earnings. According to the company's posted financial guidance for the remainder of the year, earnings should come in at $1.10 to $1.20 per share, comparable to last year's $1.15. Also noteworthy, the company expects this year's gross margin to come in at 44% to 45%, up a notch from last year's 43.5%. Achieving even a slight boost in gross margin would be an admirable accomplishment for a company whose customers (wireless carriers) are facing such a tumultuous environment.

Strattec Security (Nasdaq: STRT)
Strattec's "security business" is the old-fashioned variety: locks and keys, specifically for the automobile market. Strattec has a 61% market share in North America for mechanical and electro-mechanical automobile locks. In fiscal 2002 (ended in June), the company supplied locks and keys for nearly 84% of General Motors' production, over 62% of Ford's, 97% of DaimlerChrysler's, and 100% of Mitsubishi's.

Strattec has been in the auto security business for 85 years, although only in 1995 did the company begin its life as a public company. In February 1995, Strattec was spun off from Briggs & Stratton (NYSE: BGG) at a price of $13.25. As is the case with many spin-offs, the focus brought by a dedicated management team allowed Strattec's value to blossom. At a current price of around $49, Strattec shares have compounded at a 19% annual rate since the spin-off.

Most of this value creation is a result of judicious stock buybacks, not out-and-out business growth. Strattec's sales over the past seven years have compounded at 6.8%, including lower sales over the past two years versus peak sales achieved in fiscal 2000. This is a cyclical business, and it may prove especially cyclical in the aftermath of the current 0% financing wave that's padding today's sales at the expense of tomorrow's demand.

Given the sketchy outlook for the auto market, this company may be fairly valued at 8.7 times free cash flow and 12.6 times earnings. Nevertheless, the company is one to watch. If the auto market declines, Strattec is well-positioned to ride out the difficult times with a cash cushion of $8.48 per share and no debt.

Worth a closer look�
All of these companies are worth a closer look. If I had to pick a favorite based on what I've seen so far, Arden seems especially attractive, given its low valuation and stable business.

Next Tuesday, I'll finish the series with a look at four more companies. As always, if you have any insights on the companies we've been studying, please send me your feedback.

Matt Richey is a senior investment analyst for The Motley Fool. At the time of publication, he had no position in any of the companies mentioned in this article. Matt's personal portfolio is available for view in his profile. For Matt's best Foolish stock ideas and analysis that you won't find anywhere else each month, check out our unparalleled newsletter, The Motley Fool Select. The Motley Fool is investors writing for investors.