On top of two formal recommendations, each month in our Hidden Gems newsletter (click here for a free 30-day trial), I feature a watchlist of companies that I think offer compelling values. These are small-cap businesses generating excess cash for their owners that I believe trade at a discount to their intrinsic value.
Atop that list last month was a total unknown on Main Street and Wall Street: Rimage Corporation
Rimage's mission statement is "Changing the way the world delivers digital information." Could this be the next Microsoft
When it was watchlisted in Hidden Gems, Rimage was priced below $12. Yesterday the stock was at $13.59 for a market capitalization of $119 million.
For its second quarter 2003, the company posted 24% top-line growth (when adjusted for a one-time large order from Kodak last year). Gross margins improved to just south of 50%. Net margins rose to 13.4%, with the company paying a 36.5% tax rate. On the balance sheet, Rimage finished up with $40 million in cash and no debt. That makes for $4.15 per share in cash for this $13 stock.
What you have, then, is a growing, profitable franchise, with solid core assets that is underfollowed. The fact that it is completely unknown increases the possibility that it is undervalued.
The cash-flow characteristics are quite promising. The company has a run-rate north of $6 million. In other words, it's on track to generate more than $6 million in cash that it won't need to run its business. That's the goal of every great business -- to spin increasing amounts of cash not necessary to the operation or survival of the venture. In Hidden Gems, these are exactly the sort of companies we're targeting -- those with rising free cash flow selling at a discount.
Common risk: What could go wrong
Unfortunately, what you'll frequently find in the universe of cash-generating, small-cap companies are organizations rapidly diluting their existing owners. Stock option grants, secondary offerings, and acquisitions can disburden shareowners of their cut of that cash. In too many cases, the early risk-takers in a stock are treated to executive gift-giving that washes away cash-flow growth per share. Here's the process: The company creates its recipe, outside investors fund the ingredients, but then insiders slice the pie up for themselves.
You wouldn't want me to feature a company and executive team engaged in self-dealing, would you? Well, over the past two years, Rimage executives have done the reverse -- buying back 2% of the company's stock at very attractive prices. By reducing the size of the pie, they've enlarged the stakes of existing owners -- owners that took a risk on an unknown and overlooked company and stock. And in its most recent quarter, Rimage diluted shareowners by just 1.5%. Elsewhere in the ownership structure, insider selling has been very light given how well the stock has done over the past year.
Valuation: But is it worth it?
The problem with individual stocks is that you can find a well-run company with super-strong financials that offers products meeting increased demand, that is not diluting its existing owners... all at a dangerously-high price.
Our challenge is to not invest unless we see a wide margin of safety. One great way to find wide margins of safety (i.e., inexpensive prices) is to look where other investors aren't. Our underlying philosophy at Hidden Gems is that large institutions can't and don't invest in small-capitalization companies. If you managed money and had $5 billion under management, would you invest in a business capitalized at $115 million? If you were to invest $50 million of your capital -- or just 1% of your total assets -- you'd be buying nearly half the business. The stock price would run away from you in the process.
In investing, as in life, giants can't survive eating insects. Rimage Corporation is a tiny mosquito. It is overlooked, underfollowed, and unknown. Let's see if it's undervalued.
On a multiple-based valuation, I consider Rimage Corporation inexpensive. With top-line growth of 24% (15% if you pull out the currency gains from its foreign business) and a run-rate above $6 million in free cash flow, with $37 million in cash and no debt, and with an executive team that is managing the company for its owners, I believe Rimage is a bargain. I value the entire company nearer $20 per share ($190 million total market cap) than yesterday's closing price of $13.59.
To be sure, my valuation relies on a continued resurgence in corporate spending on technology. It relies on management generating excess cash while keeping a lid on the dilution of their existing owners. Obviously, it relies on a stabilized U.S. economy. I don't consider any of those to be long shots.
Rimage is exactly the sort of company we are looking for each month (and each day in our private discussion folders) in Hidden Gems. If you'd like to take a 30-day free trial, click here.
Tom Gardner is a co-founder of The Motley Fool and the editor of Tom Gardner's Motley Fool Hidden Gems . Of the stocks mentioned in this column, he owns Cisco, Intel, and Microsoft. The Motley Fool has a disclosure policy .