Wall Street pros have nothing on retail investors who stake small sums of money monthly on undervalued small-cap stocks. Because they're mostly ignored by the big guns, these types of stocks offer the best outsized opportunities for growth.
I screened for stocks with less than $3 billion in market cap, offering earnings surprises of 15% or more in the previous quarter, with long-term earnings growth forecast to be at least 15%. One stock that floated to the top was enterprise-facing VoIP provider 8x8 (NASDAQ:EGHT), which saw earnings jump 33% ahead of analyst expectations, while Wall Street still expects its earnings to grow 23% annually for the next five years. With a $422 million market cap, it falls squarely into our range for potential investment candidates.
Of course, don't jump on a stock just for those reasons. It should just be a starting point for more research as we need to look more closely to see whether analysts' faith in them is well-founded.
Dialing up opportunity
While VoIP service has yet to gain mass consumer acceptance despite the history and marketing prowess of Vonage (NYSE:VG) and magicJack VocalTec (NASDAQ:CALL), in the business world it is becoming a priority to farm out the responsibility to a hosted service. According to a 2011 Frost & Sullivan survey of C-level executives and IT pros, 40% use hosted services with more than two-thirds of them planning to increase their usage.
It's a very fragmented market, with the market researchers finding as many as 80 different providers that include industry heavyweights like Comcast (NASDAQ:CMCSA) and Verizon (NYSE:VZ) out of the vast array of offerings, 8x8 was deemed to be the market leader. Yet with just under an 8% share of the market, there's plenty of opportunity for a further land-grab.
8x8 recorded 36% revenue growth last quarter, hitting a record $25.3 million, as business customer revenue surged 46% from the year-ago period as it ended the quarter with nearly 30,000 business customers. Importantly, average monthly revenue per business customer grew 25% while the number of services they subscribed to rose to 10.1 from 8.6.
And in a sign that these customers are exceptionally satisfied with the service they're getting from the VoIP provider, churn plunged to 1.7% last quarter compared to 2.1% in the prior quarter. In short, 8x8 is gaining more customers who purchase more services and spend more money with them, and drop out at a decelerating rate.
Hanging up on future growth?
The market has recognized 8x8's achievements and its stock has soared 87% so far in 2012. While it trades at a very low multiple of just five times its trailing earnings, it's a more rich 21 times based on forward estimates. But factor in analyst growth scenarios, and you have the premier hosted service provider trading at just a fraction of its earnings.
More important for me, however, is how well it produces free cash flow to grow the business and is it valued appropriately based on that ability. 8x8 is proving adept at generating cash, with free cash flow up 168% year over year, but its enterprise value has increased accordingly and now goes off at 20 times cash flow, a tad high for my taste at the moment.
Still, that's much more reasonable than last year, when I actually rated it to outperform the broad market averages on Motley Fool CAPS, the 180,000-member investor community. Since then, the stock has appreciated by 40% compared to a 12% rise in the S&P 500.
Considering I think we'll see 8x8 continue to turn in improved business metrics, I think the IP telephony leader is a good long-term investment and any weakness in its stock should be seen as an invitation to dive in. But you can tell me in the comments section below whether you agree 8x8 is a bargain at this price.
Rich Duprey has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.