The Microcap Speculator

I’m generally a value investor. I love a great balance sheet and fat dividends even if the underlying business shows little growth. But as the economy weakens, it seems that many of these are just value traps, and the true values are in what are traditionally called growth stocks.

At least for microcaps, the growth premium is as small as it has ever been. There are scores of promising companies that can be bought at valuations just slightly higher than their stodgy, underperforming counterparts.

Ideally, here are the criteria I like to see:

- strong year-over-year sales growth

- low, or at least reasonable price-to-sales and enterprise value-to-sales ratios (a nod to my value side)

- UPOD: under-promise, over-deliver. Executing on a fixed strategy is very important to both future growth prospects and management credibility.

- positive earnings. I don’t need to see huge earnings growth, as long as revenues are moving. But if margins are slipping I want it to be for a strategic reason, not because the company was forced to discount or had too much inventory, etc.

- No debt handcuffs. That means that debt must be manageable in amount, maturity and covenants. If its not shareholders will be diluted.

- Reasonable year-over-year growth in the # of shares. Why buy shares in a 50% grower if its share count is also growing by 50%? Obviously this consideration has to be flexible where acquisitions are involved, but beware of huge option grants.

Two examples of growth gems are Secured Digital Applications (SDGL.OB) and Air Industries (AIRI.OB).

Secured Digital, a microcap provider of mobile communications services and business process outsourcing (BPO), just announced stellar 2007 earnings. Revenues grew 30% year-over-year to $47.7 million, and net income grew a whopping 147% to $1,622,621. SDGL reaffirmed its previously announced 2008 revenue forecast between $55 - $60 million and net income in the range of $2.5 – $3.5 million.

What kind of multiple would you be willing to pay for that growth? Yahoo! indicates that the market cap. is only $16.89 million, giving Secured Digital a price-to-sales ratio of less than 0.4 on 2007 revenues and around 0.3 on 2008 projections.

Aerospace equipment manufacturer Air Industries also reported strong results this week. Net sales increased to $46.1 Million, up 40% year-over-year (versus a market cap. of only $16.59M). Gross profit margin shot up from 15.2% to 27.6%. While net income was only $627,900, at this trajectory it should grow pretty quickly. Air Industries has a record backlog, and that’s before the pending acquisition of Blair-HSM, which could add another 30% to revenues. Sure, there is some debt, but it appears manageable.

With stocks like AIRI.OB and SDGL.OB trading at such cheap prices, why bother with no-growth companies?

DISCLOSURE: Long AIRI.OB and SDGL.OB.

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A few news items worth mentioning:

• Advocat, Inc. [[AVCA]] received a letter from activist shareholder Paul Kessler of Bristol Investment Fund pressuring it, among other things, to let shareholders vote on whether to de-stagger the board of directors and to hire an advisor to weigh strategic alternatives.  Similar demands from Kessler, who controls about 5% of shares, have been disregarded by the company.  I expect no action here even though Kessler’s demands would probably increase shareholder value.
• China OTC Player has an interesting post on three companies that could benefit from China’s devastating snowstorms [via Seeking Alpha].  He names China Solar (CSOL.OB) (formerly Deli Solar), China Pharma Holdings (CPHI.OB), and Sino Gas (SGAS.OB)
• Air Industries (AIRI.OB) announced that its Welding Metallurgy subsidiary has won $1.07 million of new contracts during the month of January 2008. The company says that this is the largest aggregate amount of new contract awards in a single month for Welding Metallurgy since its inception in 1979.
• Bagel-maker BAB Holdings (BABB.OB) announced $.10 earnings for 2007, virtually identical to 2006 results.  That’s fine with me as long as they keep paying $.08 or more in annual dividends.

DISCLOSURE:  Long AVCA, AIRI.OB, BABB.OB.  No position in other stocks mentioned.

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From my family to yours… wishing you a Merry Christmas, Happy Holidays, and Peaceful and Prosperous New Year.

At a holiday party, I was asked what five stocks I would buy if I had to hold them for a year (no trading in and out). Most would fill that charge with a portfolio full of low volatility, low risk, low reward stocks. I would go the opposite direction — take a combination of fairly volatile but potentially very rewarding stocks. Sure, the portfolio would be weighed down by a few losers, but hopefully the home runs would more than make up the difference.

With that aim, and limiting myself to only microcaps, here is my holiday portfolio:

1. Advocat, Inc. [[AVCA]]: With a market cap. of approximately $65M, this nursing home provider trades at roughly a quarter of its trailing revenues. Earnings have fluctuated, but last quarter it earned $.32 per share. At this run rate, Advocat should see modest upside. Operational improvements could drive much stronger advances, and with M&A activity rampant in the sector, a buyout is certainly possible over the next twelve months.
2. Air Industries Group (AIRI.OB): As I have written previously, Air Industries has laid the groundwork for a strong push into the new year. The company plans on rolling up small, fragmented aerospace equipment manufacturers. Its a bit early to tell, but it looks like the company is executing well. At these prices, I like my odds.
3. Arrythmia Technology[[HRT]]: In the past four years, Arrythmia Technology has made three moves from sub-$10 to over $30. Is another in store for 2008? I have no idea, but with the stock trading less than 11 times its annualized last quarter earnings, and about $1 per share in cash, HRT is very cheap for a medical device company.
4. Paragon Technologies [[PTG]]: With a share price of $6.90, over half of which is covered by cash on the balance sheet, earnings of $.24 last quarter, and a strong backlog, PTG offers a very high risk/reward setup. If I had to pick just one, this would probably be it.
5. Synalloy [[SYNL]]: One glance at the chart leaves no doubt that Synalloy is a volatile stock. Shares took a hit recently as Synalloy, a producer of specialty chemicals and fabricated metal products, lost the benefit of nickel pricing surcharges. But Synalloy remains solidly profitable, and should benefit from secular growth in energy and water infrastructure projects.

I have entered this portfolio into Stockpickr, so you can track its performance throughout the year.
DISCLOSURE: I am long all of the stocks mentioned here.

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Air Industries (AIRI.OB) reported improved Q3 2007 earnings this week. Net sales increased 63% year-over-year to $12.8M, EBITDA increased 85% to $1.2M, and net income was $422k versus a loss in Q3 2006. Backlog is at a record $50 million.

More importantly, management reiterated guidance for hitting an annualized run rate (including AIM, Sigma Metals, and Welding Metallurgy) of $57-60M in revenues, EBITDA of $4.5-$6M, and net income of $2-$2.5M by the end of 2007.

“We are exceptionally proud of the entire Air Industries Group team,” said CEO Peter Rettaliata. “Our third quarter performance set records for financial performance by the Company. The contributions were derived from each operating area. Net sales were at the highest level in our history, driven by internally generated growth as well as through acquisitions. The aerospace industry is, we believe, in the early stages of a powerful secular growth trend and Air Industries Group should continue to be a beneficiary. Industry trends and the continued execution of our vertically integrated growth strategy should allow us to build on the momentum that we have generated.”

Bottom line: This was a solid performance, though not exceptional. I look for increased revenues and earnings in Q4, as the company works off some of its backlog.

UPDATE (11/19): Air Industries announced that it is buying Blair-HSM Group, a manufacturer of landing gear assemblies for commercial and military aircraft, in a $16.4 million consisting of cash, restricted stock, and debt.  According to Rettaliata, the deal “will be immediately accretive to earnings [and] is an exceptional fit for integration with our Air Industries platform. This combination provides us with impressive capabilities and a premier customer base for landing gear and other critical flight safety components and assemblies.”

DISCLOSURE: Long AIRI.OB

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