Never confuse Tom Gardner'sMotley Fool Hidden Gems with W.D.'s fallen angels. Hidden Gems has a track record of outperforming the broader market and is available by free trial. Gems are almost exclusively undiscovered or ignored smaller companies with strong and rising free cash flow and significant insider ownership. That's a much higher bar than ours is today, namely the first signs of a turnaround to fuel a return to former glory.
Cement shoes
Fallen angels can come with mountains of debt. And make no mistake: Carrying debt is like swimming with cement shoes. It is a fine way for shareholders to lose everything to the sharks -- the creditors, I mean.
Gym rat Bally Total Fitness
On the other hand, Bally's did manage to generate $15.7 million in free cash flow in 2003 and trades at a (lucky?) 13 times free cash flow. From that alone, you might gather that the market thinks the cement outweighs the free cash. If you're not convinced, check the chart: The stock is wallowing 44% below its 52-week max and 84% below its 1998 peak.
By the numbers, Bally's looks cheap at one-fifth revenues and one-third book value. If the turnaround is successful, that is. And thus far, 2004 is off to a strong start. True, since revenue is recognized when received (not booked), puny sales from 2001-2003 offer resistance to this year's top-line membership growth; however, committed membership fees were up markedly in January and February. If a 9% increase in marketing costs bears fruit, the company's projection of flat membership revenues could prove conservative.
Product sales, which will now include a focus on weight control, continue to remain strong and are projected to grow 15% to 20% in 2004. This business segment generated 20% of total 2003 sales. With margins of 17%, any added membership growth will help spike product sales and EBITDA (earnings before interest, taxes, depreciation, and amortization), which is currently forecast to grow a minuscule 2% to 3% this year.
With two-thirds of Americans overweight, Bally's stands ready to offer an exercise and weight control solution. Today's buyers want to see the company keep its other promise for 2004: an increase in free cash flow. Nothing will help this angel to its feet like generating free cash and paying down that mountain of debt.
Dot-bomb?
The dot-com revolution ended with few winners. Drugstore.com
In four years, debt-free Drugstore.com has burned through cash -- from $160.3 million to $43.6 million at the end of the last quarter. Acquisitions and options grants have swelled the shares outstanding from 40.3 million to 77.4 million. And, yes, the company has yet to earn a net profit (although it earned its first EBITDA profit last quarter).
But consider the positives. Last quarter, operating margins increased from 20.4% to 22.2%. The net loss dropped from $5.9 million to $2.4 million. Average net sales (the online equivalent to same-store sales for traditional retailers) rose 7%. Fulfillment and order processing expenses declined from 12.8% of sales to 10.7%. If this is a bomb, it is laser-guided toward profits.
And guidance for 2004 is relatively upbeat. Net sales will be up 45%, helped by an acquisition of Vision Direct that will be accretive to earnings. For the year, a net loss is expected between $9.5 million and $13.5 million -- an improvement from $18.7 million in 2003, while on an EBITDA basis, the company may reach breakeven. Results fell within guidance set a year ago, so the company has some credibility here.
Drugstore.com has the scent of a hidden gem -- less the free cash flow. Insiders own over 45% of the stock, so their fortunes are closely tied to the company's success. A trio of analysts follows the company. Better yet, institutions own less than 20% of this phoenix (oops, fallen angel) ready to rise from the ashes to profitability in 2005.
2004 fuel cell
We've climbed a debt mountain and handled a dot-bomb, so what's left? How about a product with no sales? If that's not the formula for disaster, what is? I don't know about angel, but micro-fuel cell developer Mechanical Technology
The company has a small $5.5 million test and measurement division, but mainly manufactures direct methanol fuel cells (DMFCs) for three markets: military, industrial, and consumer electronics. Government communications leader Harris
MTI expects to burn $1.5 million per month this year. With $23.6 million in cash, access to $26 million in additional funding before 2006, and security holdings in companies like PEM-fuel cell manufacturer Plug Power
As for future sales and royalties of DMFC, MTI makes no projections. The technology is too new, industry pricing is unknown, and there are competitors Samsung, Toshiba, NEC
All that said, MTI's first commercial product will be released this year (so it will be early in the marketplace). There are some solid partners and a simple product (which, hopefully, will translate into a low cost of production). Finally, there are less than 30 million shares outstanding, zero debt, and just 5% institutional ownership. If fuel cells replace batteries, and it certainly appears they will over time, MTI could be a big winner.
What now?
W.D.'s fallen angels are speculations. You do not invest in them with the rent money. All need to be monitored closely to make sure that their potential isn't overwhelmed by the competition. The hope is that just one will be a supernova and become extremely successful, even as the other two implode.
My sense is that one of these three might one day qualify as a true hidden gem. For those who want to sleep nights and monitor their lives instead of their stocks, there is Motley Fool Hidden Gems, where every pick is first run through the Tom Gardner crucible.
Take a free trial of Motley Fool Hidden Gems by clicking here. Fool contributorW.D. Crotty is a loyal member and enjoys researching speculations in his spare time. He owns Bally's but no other companies mentioned. The Motley Fool has a disclosure policy.
