Shoe retailer Stride Rite
Stride Rite is funding the acquisition entirely in cash, although the company will incur some long-term debt. Stride Rite expects Saucony to significantly increase revenue and earnings, and it anticipates that Saucony's labels will improve the Stride Rite product line. With Stride Rite shares up roughly 10%, the market seems to agree. Keep in mind that it is unusual for the stock price of the acquiring company to jump -- acquisitions usually come at a premium and represent massive dilution to earnings, pressure on the balance sheet, or both. The key issue for Stride Rite will be effectively incorporating the Saucony product line into its own business model to provide sustained shareholder growth over the long term.
It seems that small-cap investors aren't the only ones interested in underfollowed companies demonstrating strong financials and sustained growth -- so are large companies with boatloads of cash. For the third time in the history of the newsletter, a Motley Fool Hidden Gems stock recommendation is being bought out by a larger company. This last happened in April when Shire Pharmaceuticals
The overall market has not been so kind to the footwear industry. The average company in this industry maintains a price-to-earnings (P/E) ratio between 10 and 15. Such low P/Es present favorable buying opportunities, and interested investors should keep their eye out for future consolidation within the industry.
Guest analyst Zeke Ashton initially recommended Saucony in Hidden Gems because it exhibited some of the typical signs of small-cap companies poised for explosive growth: a turnaround in management focus propelling extremely strong free cash flow and growing profitability. While the 17% premium shareholders receive for this buyout is certainly a very nice boost, those fortunate enough to have been Hidden Gems subscribers during the initial recommendation in August 2003 have enjoyed a market-crushing 150% average return.
While the long-term financial picture is promising, those actively following the Saucony story may remember the company's weak recent earnings report, which showed flat expected sales and a disappointing level of share dilution. The report caused an immediate drop in the stock price and resurfaced serious questions about the quality of management.
The rise in Stride Rite's stock following the acquisition announcement reaffirms that Saucony was still seriously undervalued. That's not an indictment of market efficiency; rather, it's an indictment of Saucony's management. The market believes that Stride Rite will be able to deliver more value to its shareholders from Saucony's operations than the current management can, in spite of the 19% premium to market value it offered.
Saucony is valuable because it offers a long-proven ability to effectively dominate a very specific niche -- in this case, high-performance athletic footwear. While Wall Street analysts tend to pay scant attention to the average small cap, eventually the market responds to these underfollowed companies operating in profitable niches. Stride Rite has just responded, and Saucony investors are all the better for it.
Interested in finding other underfollowed small caps poised for explosive growth -- before Wall Street notices? A free trial to the Motley Fool Hidden Gems newsletter is just a click away.
Michael Sarill does not own any of the companies mentioned in this article. The Motley Fool has a disclosure policy.
