The Rule Breaker Portfolio, Information on Innovex: 06/26/97

Fool Buys INVX
June 26, 1997

Foolish Figures

Innovex Inc.
Nasdaq: INVX
Type: Small-Cap Industry Leader

Closing prices: $27 1/4 bid, $27 7/8 ask

Market Cap: $381.6 million
Trailing 12-month sales: $109.5 million
Trailing 12-month earnings per share (eps): $1.60
Trailing gross margin: 43%
Trailing operating margin: 30.5%
Trailing net profit margin: 22%

Next quarter reported: Q3 '97 (June), on July 14th
Consensus EPS for third quarter: $0.70e
Consensus EPS for fiscal year '97 ended Sept: $2.47e
Consensus EPS for fiscal year '98 ended Sept: $2.90e
Fool Ratio: 0.28

Trade: Buying $9,000 worth of shares

OVERVIEW

With cash raised from recent sales, the Fool Portfolio has wired up its newest small-cap investment, Innovex Inc.

Many of us at the Fool have been following Innovex since early 1995, in part because it was a stock in the winning Port Folly portfolio run by our own Jeff Fischer for that entire year. So Innovex isn't exactly new to us, though only recently has it been making headlines with investors.

Over the past three years, Innovex's stock has compounded 110% annually, and over five years its returned a big 93% annually. Since 1995, sales have climbed from $30 million to $70 million annually, and net income from $5 million to $18.7 million. Margins have expanded, inventory turns and asset turns have doubled in the past year, and return on equity has grown to 36%. The company has positioned itself as the low-cost, industry leader, owning 70% of its market.

Only five analysts provide estimates on the company, though over the past three years the stock has consistently been in the top 95 percentile of performers, measured by both earnings per share and relative strength.

Innovex achieved record sales of $68 million in the first two quarters of this year alone, and is well on its way toward topping $100 million in annual sales for the first time. With $1.08 in earnings per share over the last two quarters, Innovex is on track to earn over $2.40 per share for the fiscal year ended in September.

A. The Actual Business: Gimme the details!

This company is dominating its industry, but what exactly does it do?

Innovex is the world's leading producer of thin film, lead wire assemblies for computer disk drives. The company supplies product to every major disk drive maker in the world, accounting for 70% of total market sales. Currently Innovex produces about thirteen million lead wire assemblies per week, and during fiscal 1998 (which begins October First), it should be churning out as many as 18 million per week. Major customers include Read-Rite, Seagate, Quantam, and Yamaha.

Wait a minute. What exactly are these lead wire thingys that Innovex sells?

Lead wire assemblies are thinner than a human hair and carry a signal from the computer "guts" to the disk drive, to read and write data on a disk. You currently can't read and write on a disk without the wires, but perhaps the largest challenge is attaching these thin wires to a disk drive's head, which is the size of a thumbtack head. Meanwhile, the expense to attach the wires must be kept low in order to keep disk drive costs down, and the need to do the delicate procedure in great volume is obvious as the demand for computer storage grows -- while the need for the product to be top quality is obvious as well.

Innovex is the company that provides these things to 70% of the world's disk drives, and the proprietary technology that it developed to do so, and the resulting cost, volume, and quality that it offers makes it very tough for competition to get into Innovex's game, or for clients to go elsewhere for the product.

B. There's More to Life than just Lead Wires

As much as it leads its market, Innovex is working to diversify, too. The company has four divisions which we'll describe in the next section, when we discuss The Biz. The four divisions are:

1. Precision Products
2. InnoMedica
3. Iconovex
and
4. Litchfield Precision Components

Innovex has manufacturing operations in the U.S., China, and Thailand, and plans to open a new $20 million facility in Minnesota in the near future. The company describes itself in one sentence as: "Innovex, Inc. is a diversified manufacturer of precision components for the computer disk drive market, medical device and flexible circuitry markets, as well as a developer of computer software."

Well said.

THE BIZ

Over twenty-five years, Innovex has developed proprietary technology that gives it the clear lead in its industry; meanwhile, growing demand, in part driven by Innovex-inspired changes in technology, is resulting in more and more sales.

Innovex sold over 336 million lead wire assemblies in fiscal 1996. The momentum of record sales coming out of that year led into two record quarters to begin fiscal 1997. The drive behind the strongly increasing sales is two-fold:

1) Innovex is the low-cost, high-quality leader in the product that it sells

and

2) The more storage that a disk drive needs, the more lead wires it needs. In the past the average disk drive needed only two lead wire assemblies from Innovex -- now it needs six to seven lead wires, because it requires much more memory capacity. Adding to demand is the fact that the latest technology -- aside from the memory capacity issue -- calls for more lead wires than ever before.

In 1996 Innovex shipped 5.5 million lead wire assemblies per week, up from 140,000 per week in the 1980s. The company is now shipping about 13 million per week, and expects that number to climb to 18 million by December. Innovex sells the assemblies at the lowest industry costs, while its quality is commonly regarded as the best in the business; finally, Innovex's volume capacity is another factor that has every drive maker in the world knocking on its door for product. Especially for its new products.

In late fiscal 1996 Innovex introduced its new wire alignment tab (WAT) technology, which the industry quickly accepted. By October of last year, 800,000 WAT units were being shipped per week. WAT technology is expected to account for over 50% of revenues in fiscal 1997. Innovex developed the new disk drive technology and successfully brought it to the market in quantity in part thanks to one of it other divisions.

A. The Other Divisions

Precision Products. Currently 89% of Innovex's sales come from the lead wire division, the division named Precision Products.

InnoMedica. Innovex's second operation, InnoMedica, makes leads and adapters for internal pacemakers and other medical devices. The medical division (begun over three years ago) recently achieved its first profitable quarter.

Iconovex. The third division, Iconovex, is a software arm that creates and sells indexing and World Wide Web software. In the most recent quarter Iconovex signed its first OEM contract for its EchoSearch software, and it plans to ship over 100,000 units through retail channels by early summer. EchoSearch won the "Best of Comdex" award from Byte Magazine. The year before Iconovex won the best software product award as well, with its AnchorPage program. The initial software that Innovex created helps individuals navigate and find information over the Web by using patented intelligent language searches. We'll cover this topic further in future Fool Portfolio recaps.

Litchfield Precision Components. In 1996 Innovex acquired Litchfield Precision Components, which makes electrical components for communications, computer, and medical equipment. This division works much in the same fashion as the Precision Products lead wire division, in that the process of production is delicate and specialized, and Litchfield aspires to offer the best quality at market-leading prices. Litchfield was essential in bringing about Innovex's new WAT technology successfully.

Litchfield is also Innovex's entry into a future market where disk drive heads may use a flexible circuit bonded with adhesives to the suspension assembly, rather than lead wires (called "flex connect"). Innovex is building a 50,000 square foot production facility in Minnesota (using internally generated cash) and plans to be cranking out 10 million of these new "flex connect" products per week by the turn of the century. If accomplished, Innovex should continue to lead the drive industry into the latest technology, as it did last year with its WAT technology.

Already Innovex's largest client has accepted the flex connect product, which has been tested for the past two years. The competition, Hutchinson Technology (Nasdaq: HTCH), is working on a more expensive solution. Analysts following Innovex are betting that disk drive producers -- ever conscious of keeping costs low -- will opt for the less expensive, but of like-quality, solution from Innovex.

B. Another Disk Drive Company in the Fool Portfolio?

Sure, Innovex has four divisions, but its disk drive division accounts for 89% revenues. The Fool Portfolio already holds Iomega, so why is it buying another disk drive related company?

On that argument, one could say that the Fool owns Lucent and AT&T, so why buy 3Com? They're all networks and communication-related. Or that if you own Intel, there's no reason to own Dell Computer -- when actually the two together have represented a great way to capture two streams of related growth. The performance of both stocks over the last decade present a very strong argument.

Innovex's products do end up in some Iomega drives after going down the food chain. Just as Intel chips end up in Dell computers. We'd never want to compare a tiny company like Innovex to Intel, but what Innovex does in the drive industry -- in its niche -- is dominate. It sells to every drive maker in the world, and controls 70% of the market. Iomega and Innovex are not at all dependent on each other, or over-lapping in any significant way.

In the sense that the computer industry (and not only the computer industry, but the storage industry) is growing steadily, Innovex is a great way to invest in that growth; and at these prices, we think that Innovex is a Foolishly attractive way to capture the industry growth, as well.

In the second half of this report we'll look at the company's financials, the stock valuation, its Fool Ratio (or PEG), and the risks involved.

FINANCIALS

Strong sales and earnings growth, widening margins, highly cash-flow positive, tightening inventory control and turn, and a consistently more efficient business operation. Very Foolish.

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

Three Years of Growth

                        1996     1995    1994
Revenue (Millions)     $69.5    $50.1   $30.5
Net Income              13.1     10.0     3.5
EPS (cont. operations)  $1.81    $1.40   $0.52
Shares Outstanding        7M       7M     4.7M

Innovex landed on Fortune magazine's list of fastest growing companies last year, and this year the company will set more records. Fiscal 1997 sales have already topped $67 million after only two quarters, nearly matching total sales for all of 1996. The current run rate (the latest quarter's performance multiplied by four) amounts to $153.6 million in sales over the next four quarters, and $40.4 million in net income, or $2.64 in earnings per share.

For the first half of fiscal 1997, earnings jumped to $16.4 million, or $1.08 per share, up 188% from the $5.7 million earned the year before. Revenues rose 148% to $67 million from $27 million. Margins have been expanding. Gross margins remain above the company's goal of 40%, operating margins have climbed from 24% to 36%, and net margins have risen from 18% to 26% in the last four quarters -- even while the company rolled out a new technology.

Management is running a much leaner business. Inventory turns have doubled in the last year, return on equity is up to 36%, days sales outstanding has improved dramatically, and, as a whole, assets are consistently creating more value for shareholders.

Earnings of $2.90 per share are expected in fiscal 1998, after $2.47 per share this year, ended September. The company recently stated that it's comfortable with these estimates. Innovex's estimated annual growth rate is 22%, and the disk drive market is expected to grow at least 20% annually. The company should at least mirror the growth rate of the industry, but as it possesses far better margins, has an industry-wide client base, and arguably has better asset management than many of companies in the industry, Innovex could grow slightly quicker than the industry.

Bumps Along the Way?

Not all is perfect, however. In mid-June Innovex announced that the fourth quarter ending in September will likely be flat to down sequentially compared to the third quarter, unless orders soon increase. Stocks in the disk drive industry have suffered declines this year while the market has risen. Some leading drive makers have announced slower sales, and that softness has touched Innovex. At first, though, Innovex had increased orders from other clients to make up for the lost ground of any decreased orders -- and even up to now that has been the case on some level. But lately soft orders have overcome the increased orders from other clients, so Innovex may see a flat quarter.

The company expects any slow-down to be temporary and not to carry into fiscal 1998, which it expects to be as strong as originally anticipated. The current quarter shouldn't be touched significantly -- if at all -- either. Innovex recently stated that it's comfortable with estimates of $0.70 per share. Looking ahead, assuming a flat to down fourth quarter, estimates look like this:

YTD    $1.08 EPS (trailing six months)
Q3     $0.70e    
Q4     $0.69e    

Recently revised estimates call for $0.70 per share next quarter and $0.69 the next. That gives $2.47 per share for the year, or a trailing P/E of 11 at the current $27 stock price. Meanwhile, the stock trades at 9 times the $2.90 estimate for 1998, six quarters away. Lately Innovex has been trading at around 17 to 20 times trailing earnings.

VALUATION

The current five-year estimated annualized growth rate for Innovex is 22%, and the company appears to be in a position to grow even faster over the next few years. The stock trades at 11 times estimates for the year ending in four months.

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 estimates on Innovex at our AOL site and you'll find estimates for the next two quarters, as stated, at $0.70 and $0.69, respectively. The company's fiscal year ends in September. For fiscal 1997, the five analysts that currently follow the company show consensus earnings per share of $2.47, with $2.90 slated for the year after. The current 5-year estimated annualized growth rate for the company is 22%.

We recently showed above how the stock trades at 9 times estimates for the year ending in six quarters, and it usually trades at a trailing multiple of twice that, implying that the stock has plenty of room to appreciate over the next six quarters if the business performs as anticipated. From here, let's do a quick Fool Ratio.

The Fool Ratio

If you're new to the Fool Ratio, 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 current price-to-earnings ratio.

Earnings per share for the trailing 12-month period is $1.60. Thus, at today's price of $27 and change, Innovex's P/E ratio is 17.

To do a 2-year earnings-based Fool Ratio (which in this case is only six quarters out), we consider the present earnings of $1.60 compared to the 1998 estimate of $2.90 -- representing 81% growth in trailing earnings over the next six quarters. Plugging the numbers into the handy PEG calculator (available for free on the Fool) the resulting PEG at $27 per share is only 0.28.

A PEG of 0.5 or lower implies that a stock is undervalued, and above 1.0 implies that a stock is fully-valued.

What good is the PEG?

But how meaningful is a PEG with this stock? The disk drive industry is cyclical, as is the computer industry and semiconductor industry, so a PEG arguably isn't so meaningful here as it would be with... with... what industry? Nearly all industries fluctuate, slow and speed up, and are in their own way "cyclical." Still, we'll discount the PEG value here, but we won't throw it out the window.

PEG is a meaningful way to value a stock based on its growth rate, and in Innovex's case the stock appears significantly undervalued. Trailing earnings are expected to climb 81% over the next six quarters and the stock trades at 9 times that estimate -- or at less than half of its long-term growth rate of 22%. We're not even going to suggest that Innovex should trade at 22 times trailing earnings -- its growth rate. It historically trades at a discount to its growth rate due to the industry (17 to 18 times trailing, lately). Putting that average 17 to 18 multiple beside the forward estimate multiple of 9 shows the possibility for significant stock appreciation, all else being equal.

Also, while earnings are expected to grow over 20% annually, the next few quarters are big in that earnings are growing about 180% quarter-over-same-quarter-last year, for each. Of course, the trailing earnings are increasing in like fashion. Two trailing quarters of $0.27 and $0.25 in earnings are going to be replaced with two trailing quarters of earnings of about seventy cents per quarter, cutting INVX's trailing multiple from 17 to 11 by the end of September. Then fiscal 1998 begins, and Innovex expects another record year for earnings.

Innovex is financed by internally generated funds, has no long-term debt to speak of, and the balance sheet is in good order. We'll talk more about the accounts receivables, for one, in future Fool Port recaps.

WHAT TO WATCH OUT FOR

The technology sector is volatile; Innovex's stock has been extremely volatile; the disk drive industry experiences cycles; Innovex isn't immune to such cycles.

We're not going to beat around the bush here. This report has already become too long and our intention isn't to hold your hand. We hope nobody else buys this stock with us when we buy it tomorrow, or within the next five days. It has taken us weeks to research the stock and make a decision. There's no way you could do it in one night. If you do, you do so at your own peril, and will likely be investing in something that you don't understand -- very unFoolish.

For one, do you know what magnito-resistive (MR) heads are? They're a large part of Innovex's technology and a big part of why 1997 has been such a strong year. The Biz section of this report attributes the new technology to the company's success, but doesn't explain or describe it. We're buying this stock because we feel we know it and we're comfortable holding it within our diversified portfolio. We've done our homework. If you haven't, you shouldn't invest at all. Call the company for information, good Fool. You have plenty of time if you're looking to invest for the next few years at least, as we are. You should never plan to invest for less time.

Moving on: The obvious risks are technology and industry related. The disk drive industry could continue to slow and hurt Innovex's sales and earnings further. Seagate, Gateway and Read-Rite recently announced slow-downs. While Innovex expects the slow-down to be temporary, that may not be the case. We may be waiting on this longer than anticipated.

Second: New technology challenges Innovex. While the company has led with the latest technology and the best means to utilize it and turn it into mass sales in the past, that may not always be the case. Its latest flex connect technology is around the corner. These changes suggest added risk. Also, relying on 89% of revenues from one main division should raise some caution flags, too, for the unsuspecting investor.

Third: The fourth quarter is going to be flat sequentially. This news is already out and the stock has been punished, but if future quarters don't pick up speed, the stock will get punished further. The worst enemy of a small-cap, high-growth stock is slowing or flat growth. Innovex doesn't expect the slow-down to continue, but they don't own a crystal ball.

Fourth: On the same day that this report was issued (June 25th), another disk drive company announced lower than anticipated results for the coming quarter. Komag (Nasdaq: KMAG) stated that Seagate, which accounted for 30% of sales in the recent past, was now down to 15% of sales in the current quarter. Seagate recently announced a slow-down and the need to cut back on its product orders for now. Innvoex's earnings estimates have already been lowered in relation to Seagate's woes. However, this may imply that the slow-down is more wide-spread than thought. How long will the "slow-down" last?

Finally, five large customers account for about 79% of Innovex's sales. These are some of the largest disk drive makers in the world (including Seagate), but relying on only a handful of customers is of course another added risk. Even though the company does sell to every maker in the world in some respect, the concentration of revenues from a specific few is key to an analysis of sales.

If you don't have a well-diversified portfolio -- grounded in something like large-cap Foolish Four stocks -- and you're not open to risk and don't recognize the potential for significant loss, we don't think that you should be investing in small cap stocks at all. If you do have such a portfolio, you should fully understand any small caps in which you do invest. Reading one buy report written by someone else will never do that for you. You need to dig into it yourself. After all, that's half of the fun and all the meaning behind being Foolish!