Last week we took a look at one of the worst-performing small cap stocks of 2001, Pinnacle Holdings (Nasdaq: BIGT), to see what lessons we might learn from its downfall. Today we'll continue our class with Professor History (I can't believe I just wrote that) and study one of the better performers of the past year.

My screen for the best small cap of 2001 is almost identical to the one we talked about last week:

  1. Market capitalization below $1 billion
  2. 2001 revenue below $500 million; and
  3. Percent price change in 2001 as high as possible.

I added one more criteria, and that was to screen out all stocks that traded below $5, reasoning we likely would have avoided such companies to begin with. That left PEC Solutions (Nasdaq: PECS) standing at the top, an interesting company that returned 363% to its shareholders in 2001.

PEC Solutions has nothing to do with Arnold Schwarzenegger flexing his pecs. Instead, this northern Virginia company just outside the D.C. Beltway helps stodgy government agencies get along in the Internet world. It provides such services as consulting, program management, system architectural design, network engineering, and applications development. In short, the company "relieve(s) our clients of the details of the application and management of technologies so they can focus on their core competencies and mission."

It's a huge industry, really. A prospective investor reading through the PECS 10-K from last year would have learned of an Electronics Industry Association study that estimates the federal government outsourced $26 billion of its total $30 billion information technology budget in 1999. The segment PECS addresses, "Internet professional technology services," was estimated to grow at a rate exceeding 50% a year and reach about $2.8 billion by 2003.

PEC Solutions' biggest customers include the likes of the Drug Enforcement Administration (DEA), the Immigration and Naturalization Service, the Veterans Benefits Administration, the Internal Revenue Service, the Bureau of Alcohol, Tobacco and Firearms and the "intelligence community." Heading into 2001, PEC Solutions' revenue and earnings had increased by an average of about 43% a year since 1996.

So, at the beginning of 2001, we had a fast-growing company serving a fast-growing industry. It had been profitable for years, was producing plenty of free cash flow, and had no debt. Certainly these are all positives that would make us want to dig deeper and consider a possible investment. What else looked promising?

Last week I asked our loyal small cap readers to post their thoughts on our Foolish Eight discussion board. As it turned out, some of the board regulars had been considering PEC Solutions throughout the year, but most thought its valuation was a little rich. That view certainly hasn't changed with the stock up over 350%.

"Government clients are good clients to have in tough economic times, because they pay their bills and don't go out of business," wrote dior29. "That's still true, and somehow PEC has been labeled as a top-notch government contractor who is benefiting from increased security and military spending in light of recent events. Good for them, but I just don't get how it supports this huge increase in valuation. I detect a bubble."

Danbobtx also believes it's overvalued, and that it would have been hard to predict its growth a year ago. But, he wrote, "One bullish note is the secondary public offering, which may have served to increase liquidity."

Finally, sleejohnson expressed concern that the days of the federal government running a budget surplus are over. "I am concerned that the economic slowdown will result in declining tax revenues that won't be fully felt until next year, and many governments that previously ran surpluses will run deficits. This could lead to cutbacks that hurt PECS sales."

When all is said and done, however, perhaps the best foreshadowing of the company's success could be found in its press releases trumpeting a fairly steady amount of new contract wins throughout the year. A $9.8 million deal with the DEA in January, for example, and a separate $1.9 million DEA contract in February. In July it landed a $7.3 million deal with the Navy, and then two multi-year contracts worth $75 million, again with the DEA.

During the first quarter, the company had to hire 119 employees to keep up with growth. PEC Solutions' rise, therefore, may have been nothing more than the market pricing in future revenue and earnings increases.

Although the stock dipped somewhat after the Sept. 11 terrorist attacks, it more than doubled thereafter as investors equated the nation's increased security and informational demands with more government spending. Indeed, PECS announced six more contract wins after Sept. 11.

All of this has been instructional, but what about now? Is PEC Solutions still worth considering despite its valuation? The company is just now appearing on the Foolish Eight list, which in and of itself is definitely not a "Buy" signal, but it does make it worthy of further research.

To my way of thinking, it all boils down to the amount of new business it can continue to pull in. Friedman, Billings, Ramsey Group (NYSE: FBR) published a report a couple of months ago predicting higher valuations for government information technology (IT) services providers, "given trends that favor continued IT outsourcing by federal, state, and local government agencies." FBR pointed to such factors as "higher government spending in the face of an economic recession, a looming government IT staffing crisis, strong demand for commercial best practices for IT services, and heightened interest in security and defense technology" to support its prediction.

It must be said that FBR, which does investment banking, shouldn't be viewed as a completely objective party here. Its reasoning seems sound, however, and valuations have indeed jumped since the report was issued.

All signs seem to point to the continued business success of PEC Solutions. But the company is trading at about 66 times 2002 estimated earnings, and it seems to me the continued success of the stock hinges on securing many more contract wins... enough to ensure 30% or more earnings growth. Any missteps along that path, and the stock could take a hit.

Rex Moore has determined that the most underrated fruit in the world is the lime. Have some in your tea today! At the time of publication, he owned no companies mentioned in this column. Here is his profile; here is The Motley Fool's disclosure policy.