Fool Buys ATCT
October 17, 1996

BUYING

ATC Communications
NASDAQ: ATCT
Type: Small-Cap Highflier
Closing prices: $20 1/2 bid, $20 5/8 ask

Trailing 12-month sales: $94.3 million
Trailing 12-month earnings per share: $0.25
Last quarter reported: 4Q Fiscal '96 (June)
Next quarter reported: 1Q '97 (September), week of October 24th
Consensus EPS estimate for quarter: $0.09e
Fool Ratio: 1.03

Trade: Buying 600 shares

OVERVIEW

With free cash just sitting around after the September sale of Medicis, one month later the Fool Portfolio latches onto its newest small-cap holding, ATC Communications.

Ever since last month's Fool Portfolio sale of Medicis (Nasdaq:MDRX), we've been paring down our list of small caps searching for the next Foolish winner. American investors always have a heap of prospects to pick from, so it's the act of selecting a few jewels from acres of display cases that typically occupies most of our time. Just as we write in our book, we start by combing the Nasdaq pages of Investor's Business Daily for big earnings growers. Then we type the company names into spreadsheets, order up the financial statements, fill out the numbers using the gargantuan amount of online info available in Fooldom, and update our work every few weeks.

And then we make our decision.

ATC ("Advanced Telemarketing Corporation") Communications is an upstart headquartered in Dallas, Texas, operating successfully in a hugely burgeoning industry: telecommunications services outsourcing. We hate multi-syllabic phrases like that one, so let's explain. ATC is hired by other corporations to handle their phone services. In some cases, that may be to perform telephone customer support for glossy catalog orders; in others, ATC may cold call (oops... guess they call it "direct marketing" these days) potential new customers regarding an insurance plan. In other words, the company butters its bread with the money it makes handling inbound (three-quarters of business) and outbound (one-quarter of business) telephone services for its customers.

ATCT stock moved to the Nasdaq National Market from Nasdaq Small Cap on April 30th of this year, in conjunction with its name change from NRP Inc. (we're still trying to find out what that stood for) to its new name. The stock has risen pretty much in a straight line from $3 1/2 a year ago to its last trade close at $20 9/16 today. That gain parallels two things: (1) strong continued increases in excess of 50% for sales and earnings, and (2) recognition -- this company and its prospects were almost completely unknown a year ago. We believe both (1) and (2) will continue as significant factors in propelling ATCT's share price.

We aim, as we do with any small-cap investment, to double our money here in the next year.

THE BIZ

The telemarketing industry is racking up an estimated $80 billion dollars this year, growing 10% a year. Outsourced telemarketing, though, currently accounts for only 4% of that market.

ATCCommunications is one of the fastest growing providers of outsourced telemarketing in the good old U.S. of A. Inbound and outbound telemarketing is a $80 BILLION dollar industry, growing 10% per year. Actual outsourcing of this $80 billion pool of work currently stands at only $3 billion per year, and this number is estimated to be growing an impressive 35 to 40% every year.

There are a handful of publicly traded companies in the outsourcing industry, including APAC Teleservices (APAC, up 271% the last 52 weeks), Sitel Corporation (SITL, up 336%), Sykes Enterprises (SYKE, up 100% since coming public in May), and of course our own ATC Communications (ATCT, up 485% the last 52 weeks). All outsourcing companies combined only hold about 4% of the outsourcing market thus far (the rest is kept "in-house," though this is quickly changing). Obviously, the potential for growth in the industry is enormous, and the rapid ascent of these stocks demonstrates that the Street is grasping the possibilities. Foolishly, we don't consider the rise in these stock prices to be a disadvantage, but rather a good sign that recognition is being extended, and shareholders, rewarded. We see no significant short-term reasons to change this. Over the intermediate-to-long-term, things still look good, but you can never really project out that far in a dynamic industry.

ATC's main clients include AT&T, American Express, GTE, Pacific Bell, and Citibank, among others. So when you see those AT&T commercials on television, with the frowning men and women sitting at phone boards, answering calls, that may very well be our guys at ATC! And when, at night, just as you're about to sit down to a warm meal, the phone rings and someone blurts, "Is the lady of the house in? Join the American Express deluxe services club!" go easy on the hard-working fellow. He may have been directly responsible for a 1/4 uptick in our shares that day!

From payrolls to job training to, heck, actual employees, the nationwide move to outsourcing is a new and powerful trend, and a very promising sector. (Long-time readers will want us to remember the 40% we lost shorting Paychex... blackguards.) Large companies will continue to outsource work to companies which specialize in the area of their needs, rather than try to do it on their own. Makes sense, no? Sure it does! It costs too much to hire, train, provide offices, phones, programs, and benefits for hundreds of additional employees. Have someone else do all that! This is exactly what companies are doing, and in ever-increasing numbers.

FINANCIALS

Strong sales and earnings growth, margins widening, decent current ratio, cash-flow slightly positive. Pretty Foolish.

Let's start with a glance at the income statement numbers (and by the way, the complete 10-K is available for your perusal on EDGAR):

Three Years of Growth 

                          1996     1995    1994
Revenue (Millions)       $94.3    $61.3   $37.4
Income (cont. operations)  9.6      2.6     1.3
Net Income                 5.8      1.3     2.9
EPS (cont. operations)    $0.25    $0.06   $0.02
Shares Outstanding         21M      18M     14M

These numbers were enough to land ATCT the number 21 spot on Fortune magazine's list of 100 fastest growing companies.

ATC Communications earned net income of $5.8 million in fiscal 1996, on revenues of $94.3 million, vs. $1.4 million earned in 1995, on revenues of $61.3 million. Revenues for the year rose 53.7%, while net income and earnings per share climbed more than 300%. (1995 net income fell from 1994 due to one-time charges.) Meanwhile, profit margins are on the rise. Net margin rose from 2.3% in 1995 to 6.2% in 1996. For the company's latest quarter net margins rose further to an impressive 9.3%.

The company is on a roll. Revenue growth arose from the addition of new clients as well as increases in the volume of services provided to existing clients. A minor drawback: the company derived 44% of fiscal 1996 revenues from one of ATC's existing clients, believed to be AT&T. However, with the addition of new clients and increased business volumes with other clients, the percentage of revenues generated from that client decreased from the 53% it represented in fiscal 1995. The company continues to work, of course, on obtaining several more clients, rather than relying on a handful of large clients. Certainly, the dynamic growth in the industry bodes well for ATC's efforts to develop a more level field of clients.

In fast growing companies, general expenses can rise just as quickly, as management attempts to finance the quick growth. At ATC, management continues to work at improving the company's efficiency while accounting for the large revenue and capacity increases. Their efforts are working. Selling, general, and administrative expenses decreased as a percentage of revenues to 19.7% in fiscal 1996, from 21.8% in fiscal 1995.

One thing we Fools watch carefully in our small-cap highfliers is quarter-over-quarter growth. We like to see these numbers rockin' and rollin'. In the fourth quarter of fiscal 1996 revenues grew to $30 million, from third-quarter results of $23 million. That's 30%. Net income more than doubled from $1.1 million to $2.8 million, and earnings rose from $0.05 per share to $0.12, a 140% gain. And that wasn't an anomaly. Growth in previous quarters is impressive as well.

Some things to note on the balance sheet, and cash flow statement. The company is pretty much cash flow neutral. For the year ended in June operational cash flow was $720,000 in the black, nice but no great shakes. Not a lot of cash on this balance sheet ($1.7 million), but since the company is managing to grow 50% plus annually, and not consuming cash, we're not concerned. What does concern us somewhat is the $21.6 million in accounts receivable, which does represent 23% of annual revenues. However, that's endemic to the industry. It appears the company needs to improve its collection practices; you know, hire some more guys with blackjacks. The company's current ratio today (current assets divided by current liabilities, a measure of liquidity) stands at 2.5. (Current assets are $37 million; current liabilities, $15 million.)

VALUATION

The current five-year estimated annualized growth rate for ATCT is 50%, and the company appears to be in a position to grow even faster over the next few years. An expensive stock today, we think ATC's present valuation may look cheap looking back a year from now.

As we analyze the company's current valuation, it helps to remember that most stocks are priced off of earnings. Their share prices will move with the growth or shrinkage of earnings over the long term. But these stocks at any given moment are priced off their present expectations of future earnings.

Go to the First Call earnings report on the company at our AOL site and you'll find estimates for the next two quarters at $0.09 and $0.10, respectively. (Remember that ATCT is on a June fiscal year, meaning that when it reports earnings next week for the quarter ended September 30th, that'll be for the first quarter of fiscal '97.) For fiscal 1997, the three brokerage firms that currently follow the company show consensus earnings per-share of $0.40, with $0.64 slated for the year after.

And a final note, the current 5-year estimated annualized growth rate for this company is 50%.

Consider the information provided in the previous paragraphs in light of this one fact: the company earnings per share in its most recent reported quarter came to 12 cents per share.

As we do not detect any cyclicality in this business, this fact is of significant import. For one, we'd expect 12 cents or more this quarter, 12 cents or more the next one, and 50 cents or more for the year. But let's get to that in a bit.

First off, let's do a Fool Ratio. (If you're new to this, please read our 13 Steps to Investing Foolishly -- specifically, the Tenth Step -- in the Fool's School... or you can access The Fool Ratio section, directly via our Index.)

The first step is easy: find the price-to-earnings ratio.

Well, the earnings per share for the trailing 12-month period is 25 cents. Thus, at today's close, the P/E ratio is a lofty 82.

Next, we need to estimate this company's growth rate. Over the next five years, Wall Street consensus calls for this company to compound growth at 50% per annum. But over the next few years, our primary concern right now, we believe growth will be significantly higher. Our current expectations are for earnings per share (EPS) of 54 cents this year. How'd we arrive at that? Well, first off we tossed aside the Wall Street estimates because they don't seem useful. Instead, we were silly: we just estimated 12 cents, then 13 cents, then 14 cents, then 15 cents for the next four quarters. (This isn't as unscientific as it appears. ATC has had a record of reporting similar, slightly growing earnings quarter-over-quarter over the past few years.) That comes to 54 cents. Keep in mind, we're reduced to coming up with our own numbers by guessing because the current numbers are, to our Foolish way of thinking, obsolete. Heck, the company's fourth-quarter consensus estimates were for 6 cents in earnings; ATCT doubled that.

OK, what's 54 cents over 25 cents (the one-year growth rate)? Answer is 116%. A Fool Ratio off that figure yields 0.71. (That's the P/E -- 82 -- divided by the percentage of the growth rate -- 116). Going forward, let's assume a 50% EPS growth rate for the following year. That puts earnings estimates at 81 cents (1.5 x 0.54).

To do a 2-year Fool Ratio, then, you take the present earnings of 25 cents forward to the 1998 estimate of 81 cents. Annualizing that growth rate, you get 80%. With a P/E of 82, the stock's current Fool Ratio is 1.03.

"What's the Fool doing buying a stock with a Fool Ratio of 1.03?!" you ask. "In their book, they say look for a buy at 0.50, and consider SELLING around 1.00+."

Ah, but there are additional considerations in high-growth situations like this one. First, and primarily, ATCT estimates are in a "free-rise" situation (that's the Foolish opposite of "free-fall"). Today, First Call shows 1997 estimates of 40 cents per share... if you'd checked this two months ago, you'd've seen just 31 cents. In other words, a 29% "free-rise" in 60 days. The 9 cents you see estimated for this upcoming quarter were just 6 cents two months ago; the 10 cents estimated for next quarter were 8 cents two months ago. And so on. You begin to see the point.

Namely, all bets are off when companies' earnings gains -- and expectations -- are in a state of "free-rise."

Further, as has been pointed out in the past, if you buy a company growing 50% annually for five years at an initial Fool Ratio of 1.0 (which denotes "fair, full valuation"), you'll make a fair amount of money in the stock if the company just comes through and meets that growth rate. Because while a high-growth entity may look fully valued at the moment, five years of growth at 50% comes to overall growth of 659% over the period. You can thus expect your stock to multiply in value over that period, even with a seemingly "fair, full valuation" all the way up.

FOOLISH EIGHT CHECKLIST

The stock meets most of the criteria comprising our Foolish small cap checklist, published in The Motley Fool Investment Guide.

The Motley Fool Investment Guidelays out an eight-item checklist Fools use to locate promising small-cap growth stocks. Let's run down the list here and see how ATC Communications stacks up.

First, when considering high-growth stocks, we want a company that has current sales of $200 million or less. These companies can be gems, small gems, which have a good chance of doubling or tripling sales in the coming few years; and these are usually companies which institutions have yet to pile into, giving individual investors an advantage. ATC Communications racked up sales of $94 million last year, a record for them, but still much lower than the $200 million upper limit. Lookin' good.

Second, we look at daily dollar volume. We don't want a small cap that is trading too much volume, as that may indicate it has been "discovered" by institutions. Optimally, we want a stock that trades a daily dollar volume of between $50,000 and $3 million. ATCT is actually higher than our normal standard, at about $8 million a day. But we're not crying about this. Only three analysts currently cover the stock, and at least this sucker's pretty liquid.

Third: share price. We typically screen for small-cap highfliers with prices between $7 and $20 a share, though we're not big sticklers about this. That's one of the ways we found ATCT (it was below $20 when we first located it, and is today a fraction above). Nice price. Remember Ride Snowboard and Medicis Pharmaceuticals, two other Fool Hall o' Famers? They began in a similar price range. Anyway, this is a purely quantitative measure which we use as a guide.

Next is net profit margin. We like to find profitable companies that are getting more profitable. As noted earlier in the report, ATCT's margins were 2% in '95, 6% in '96, and in the most recent quarter were hitting the charts at 9.3%. That's a shade under the 10% mark we usually shoot for. Geez, close enough.

Fifth is the relative strength number, which measures a stock's performance over the last twelve months against all other stocks on the three major U.S. markets. The ranking runs from 1 to 99, with 99 being highest. A "99" means a stock has outperformed 99% of all other stocks over the last twelve months. OK, kick open your Investor's Business Daily and you'll find ATC Communications sporting a 99. You could look it up.

The sixth item we check involves earnings and sales growth. Both should be growing at a rate of 25% or more compared year-over-year. The main point in investing in high-growth stocks, is, of course, high-growth! ATCT easily surpasses these numbers, growing sales 53% and earnings more than 300% in the latest year. Forward estimates continue to show the company growing at rates substantially above 25%.

Seventh is insider holdings. It's a good sign if the people closest to the company --- actually inside the company -- own a substantial amount of shares. In ATC's case, insiders own 30% of the pie. Once again, very Foolish, because checklist requirement is 15% of a company's shares. Also of note -- though this isn't formally part of the checklist -- is that insiders have purchased approximately half a million shares in the past six months. Yowser.

Eighth and final, we follow cash flow from operations, looking for positive numbers here. We dislike companies with negative flow from operations, "cash consumers." A small cap may be doing almost everything right, but significant, negative cashflow can still bring a peremptory end to the party. As mentioned above, ATC Communications has positive cash flow.

WHAT TO WATCH OUT FOR

Keeping those phones active...

The company continues its strategy to secure recurring revenues from long-term relationships. However, as stated earlier, in fiscal 1996 44% of the company's revenues were attributable to one customer, and 73% were attributable to the top four customers. As noted, this is an improvement over fiscal 1995. For the company to maximize its long-term success it will need to continue to diversify its customer list. Meantime, ATC believes its relationships with major customers are very good and should continue; however, the company ATC cannot of course guarantee the continuation of any or all contracts. The loss of one or more of these customers would hurt.

Another potential risk: the company's call centers can have a significant amount of idle capacity during day-time hours. It's difficult to call people (or receive calls) when nobody is home, but working. As such, any additional calling volume taken during daytime hours can impact gross margins substantially -- in ATC's favor! This is believed to have happened in the most recent quarter. But the point is, if such volume isn't up next quarter, margins could go lower.

Additionally, analysts estimate that some of the strong growth in revenues during the recently completed fourth quarter resulted from a significant one-time piece of daytime inbound business received from one client. ATC won't say who that client was, or the amount of business, or if it could happen again in the next and subsequent quarters. Therefore, the last quarter completed MAY present the company in a stronger light than can normally be achieved. We obviously hope not, but that remains a risk. On the plus side, one could reasonably suspect in the current industry environment that lightning may strike more than once.

Finally, this is a high-growth, high-multiple, small-cap stock. For many investors, that line alone should read like a great, big DO NOT ENTER sign. Suffice to say that such investments are only for those with well-diversified portfolios founded on the Dow Dividend Approach. Small-cap stocks can be your biggest winners; they can drive the overall returns of your portfolio well past market gains. If something goes wrong, they can also get clocked. Don't buy shares of ATCT or anything like it if you can't afford to stomach potential losses of at least 50%. Because you never really know. We have a long and impressive record of buying occasional ugly losers among growth stocks, having given away half our money on KLA Instruments and Sonic Solutions, over the past couple of years.

FINAL CONSIDERATIONS

A stellar 1996 leads into a very promising 1997, and beyond.

ATC Communicatons had a great fiscal 1996, the best ever for the company, and is positioned in a healthy multibillion dollar growth industry. It's arguably a "new" industry, with plenty of market share open for the taking; we think that this company and its several public competitors will all continue to win together for at least the next year; there's a lot of business out there to attact. We believe this company is in the right place, at the right time. It's clearly already benefited shareholders handsomely; we expect that to continue.

We'll be picking up the shares at some point in the next five trading days. If ATCT opens up significantly tomorrow, you can probably expect us to delay purchase for a few days. We don't like to pay up due to the occasional "Fool Effect." The last several Fool trade announcements have given us prices 5%-10% worse than we would've gotten at the time we published the report. We're always willing to accept that penalty, since we champion accountability, and the sharing of our stock picks with a national public before we ever make any movesin our account. You won't see that much on Wall Street, which is, of course, the point.