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5 small stocks with big profits just ahead
As warnings roll in, we found stocks with strong earnings revisions and legitimate business success stories. They're the ones least likely to disappoint -- and most likely to move up.
By Michael Brush
With earnings warning season under way this week -- a time when pre-announcements can tank stocks -- its a good time to X-ray the market to find the companies that recently guided numbers up.
After all, youre unlikely to see any warnings from them. And if bad news from other companies takes them down, they may make good buys.
As a general rule, upward earnings-estimate revisions are a sign of sustainable business trends that will push a stock higher -- as long as you do your homework on whats behind the numbers bumps.
3 keys to playing the numbers
For example, in coming up with the list of five stocks below, I looked for the following characteristics.- Small-cap names. The information behind the numbers bumps in smaller names tends to spread through the market more slowly. Its less likely to already be priced in.
- Estimates moving up for some sustainable reason. Tiny Hersha Hospitality Trust (HT, news, msgs) looks good on paper. But dig beneath the impressive numbers bumps and it turns out theyre owed to acquisitions. Better to look for something more sustainable, like a new product cycle or the ability to keep finding new markets. I also looked for solid estimate revisions for both 2004 and 2005.
- Barriers to entry. Many paper companies are getting good numbers bumps. But paper is a commodity, and its price can change fast. Too much of a gamble.
The five companies listed below pass all the tests. That doesnt make them sure bets. But they're off to a good start.
Dont ignore tech
Many investors hate tech stocks right now, and its not hard to see why. First, theyre cyclical stocks. If economic growth slows, they wont do well. Second, the signs of a tech slowdown are all around. Semiconductor companies are bringing down estimates. Nortel Networks (NT, news, msgs), the electronics manufacturer Celestica (CLS, news, msgs) and Sony (SNE, news, msgs) all warned of slowing growth just last week.
But some earnings-estimate revisions at a few smaller tech companies are too strong to ignore. And when you dig into the fundamentals, you see their business may hold up, despite the overall weakness in tech.
First, lets look at Wind River Systems (WIND, news, msgs), a software company. Its doing well because producers of more and more goods, from digital cameras and cars to jet airplane cockpits, are relying on software to power snazzy features that set their stuff apart in the marketplace. For example, an astonishing 38% of the total cost of producing a car now goes to software, according to Jamie Friedman, an analyst who covers Wind River for Fulcrum Global Partners.
So its no surprise that Wind River recently posted solid sales growth and got excellent upward earnings-estimate revisions. Wind River Systems provides the software platforms, operating systems and tools used by companies such as Sony, Canon (CAJ, news, msgs), DaimlerChrysler (DCX, news, msgs) and Boeing (BA, news, msgs) to cook up code that makes their goodies work better.
We make the software that makes dumb devices intelligent, explains Wind River Systems Chief Executive Officer Kenneth Klein. Estimates for 2006 leapt 63% on Aug. 18, to 23 cents per share on average.
Hard times ahead for Wind?
But if companies from Sony to Nortel -- also a Wind River Systems customer -- are warning of a slowdown in sales, doesnt that spell trouble for Wind River?
Not necessarily. Unlike many chip makers, whose silicon only goes into consumer products, Wind River software also is used a few steps up the food chain. Engineers put it to work developing new products. Consumer-product companies wont cut back on development unless there is a pretty dramatic slowdown.
Next, while the company sells software to lots and lots of producers, it only has a small presence inside many of them. This means Wind River can spur growth by branching out inside existing customers, says Klein.
Another opportunity: The increasing popularity of the Linux open-source operating system. One big source of competition for Wind River has been the work of do-it-yourself code writers who go it alone. With Linux now proving its merit, the do-it-yourself code writers are turning to it for help. Klein thinks that will drive demand for Wind Rivers Linux-based VxWorks 6.0 and Wind River Workbench product lines, due out later this year.
Besides solid estimate revisions, Wind River saw convincing buying by insiders -- including Klein -- in the $10 range last spring.
A strong telecom play
Next, ECI Telecom (ECIL, news, msgs), a company that makes equipment used in metro optical networks and broadband access. It blew away the numbers in its most recent quarter, posting 32% year-over-year revenue growth in early August. Most of the strength came from its optical business, which was up 54%. Earnings estimates were moved up almost 100%, to 27 cents per share for 2005.
We believe this is not a one-time event given managements comments that they expect continued sequential growth throughout the rest of the year in both revenues and profits, says Jonathan Half, who covers the company for UBS Investment Research.
While the U.S. telecom market may be flat for the rest of this year, regions like Eastern Europe, India and the Far East are expected to keep spending more, says Half. Eastern European and former Soviet bloc countries in particular are investing heavily in telecom networks to catch up to Western Europe.
Health care
Alliance Imaging (AIQ, news, msgs), which offers equipment and services that help doctors perform MRI (magnetic resonance imaging) and PET (positron emission tomography) scans, is getting solid numbers bumps for the right reason. Over the past two years, it has shifted toward a business model that produces richer profit margins.
The company used to offer mainly mobile scanning services, rolling machines into hospitals and charging a set fee per scan. Then interest rates came down, and large medical equipment companies like General Electric (GE, news, msgs) stepped up their financing on big-ticket items to help hospitals. So hospitals began creating their own imaging centers.
Now, Alliance is using the same strategy, and it is paying off. Alliance has a strong enough balance sheet to offer financing, something hospitals need because of budget constraints. Alliance also can offer experts to help run the scanning centers.
The company also is providing more PET machines and services, which command a higher reimbursement rate, says Alliance finance chief R. Brian Hanson. In the first six months of 2004, PET revenue increased 46% over 2003 levels. Meanwhile, the deterioration of its core business -- mobile scanning services -- has stabilized. In early August, Alliance earnings estimates for 2005 went up 160% to 47 cents per share.
Two energy companies
Given the sharp rise in the price of oil and natural gas, finding energy companies with good estimate revisions is easy. But these estimate revisions are suspect because they are based on the price of a commodity: oil. That price can change abruptly. Many analysts think the price of oil has a huge terror premium in it -- a premium that could subside after the U.S. presidential elections, as fears of a terror strike subside.
Still, I like two small energy companies that are getting some of the most powerful earnings-estimate revisions. The reason: Each has something else going for it that suggests decent profits down the road, even if the price of oil drops.
Delta Petroleum (DPTR, news, msgs) received good numbers bumps in part because it made a series of smart acquisitions of oil and gas fields. In mid-September, estimates for its budget year ending in June 2004 went up more than 100% to 26 cents per share. Estimates for the next year went up 21% to 56 cents per share.
In the background, theres a potential legal settlement with the federal government that could be worth $4 per share, which could add 33% onto the recent share price of $12. Along with several other energy companies, Delta Petroleum is trying to get back money it paid the federal government for leases on energy fields, as well as money sunk into developing them. This makes sense because the Department of Interior took back the leases following challenges by environmental groups. Theres no telling when the lawsuit might be settled, but it seems like a pretty sure win.
Next, Goodrich Petroleum (GDP, news, msgs) saw its earnings estimates jump nearly 200% this summer to an average of 54 cents per share for 2005. We have been successful at achieving some pretty attractive rates of increase on production volumes, in the 20% range this year, explains Walter Goodrich, chief executive of the company. Goodrich may turn in similar production increases next year.
One particularly juicy asset now that the price of natural gas is so high: about 40,000 acres in the Cotton Valley in east Texas and northern Louisiana where Goodrich will be extracting natural gas from sandstone. But heres the kicker: Insiders, including Goodrich, have put more than $19 million into their stock so far this year at prices ranging from $5 to $9.31.
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