At the small-cap newsletter Motley Fool Hidden Gems, founder Tom Gardner believes in following good managers. When Michael Astrue -- the CEO of Hidden Gems recommendation TranskaryoticTherapies -- left the company after its buyout by Shire Pharmaceuticals (NASDAQ:SHPGY), Tom Gardner watched him land at EPIX Pharmaceuticals (NASDAQ:EPIX) and nominated it as a Tiny Gem -- that is, a promising company too small for a formal pick.
A good manager is hard to find
On the strength of Astrue's leadership, Tom felt confident that investors would do well with EPIX, just like they had at Transkaryotic, which more than tripled in price from when it was first recommended to subscribers.
I used the same concept when I heard that Jens Meyerhoff, the CFO of FormFactor (NASDAQ:FORM), a company I had recommended for Hidden Gems, was leaving his position. He was well respected in the analyst community and had also ably served as FormFactor's operating officer. The company is far and away the industry leader in advanced wafer test probe cards and is acknowledged as having excellent management depth. With FormFactor set to grow enormously in the coming years, it would take a lucky and potentially great organization to lure Meyerhoff away.
That lucky bidder was VirageLogic (NASDAQ:VIRL), a provider of semiconductor intellectual property in embedded memory, logic, and I/Os. With a market cap of only $284 million, it seems that Meyerhoff found himself at a company in the same position that FormFactor was just a few years ago. It certainly seemed worthy of further investigation.
My initial reaction, however, was one of disappointment. Though small, it had not yet found consistent profitability, and sales in 2005 had lagged those the year before. Yet after deeper investigation, I decided that Virage does have some great potential. Read on to find out why.
Investing in research
It's an axiom of investing that profits follow sales; both of these have a symbiotic relationship to an increase in share price. Intuitively, if a company sells more products and makes profits on those sales, then it's only a matter of time before the share price reflects those increases. But profits can also be in the eye of the beholder. Because of the way financial statements are constructed, a company can be penalized for investing in its future. Specifically, companies that invest heavily in research and development will be punished for that expense when it is subtracted from gross profits. R&D-intensive businesses are held down because they invest in those things that will drive future sales.
What I prefer to do is to give those companies the benefit of the doubt. Rather than subtract out R&D expenses, I leave them in, giving me what I refer to as profits including R&D, or PIRD.
PIRD = Gross Revenues - Cost of Sales - SG&A
I find this to be more useful in evaluating tech-laden companies, because research and development is truly their lifeblood, almost as important as investing in new plants and equipment. A tech company that fails to commit resources to its R&D budget will ultimately die. Thus, they have two options: invest and grow, or spend that money elsewhere and wither. And I don't think that those who invest should be penalized.
Nowhere is this more true than in the semiconductor industry, where the rate of change is lighting quick. Chips continuously improve, getting ever faster and ever smaller. As FormFactor has demonstrated, being able to stay on top of the tsunamis of change in design and architecture -- both of which evolve regularly -- is critical to maintaining a leadership position.
In my next article, I'll show how I applied that to Virage Logic and why I think the company has potential, if not as a formal Hidden Gems recommendation, then as a part of an investor's portfolio.
FormFactor is a recommendation of Motley Fool Hidden Gems. EPIX Pharmaceuticals was a Tiny Gem selection of the newsletter. A30-day free guest passgives you access to all the selections and lets you see what Tom Gardner will unearth next.
Fool contributor Rich Duprey owns shares of FormFactor but no shares of any other stocks mentioned in this article. You can see his holdings here. The Motley Fool has a disclosure policy.
