Motley Fool Rebound Report

[Pages:22]Motley Fool Rebound Report

7 Small-Cap Rockets for the New Bull Market

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Published July 2009

The studies in this book are not complete analyses of every material fact regarding any company, industry, or investment and they are not "buy" or "sell" recommendations. The opinions expressed here are subject to change without notice, and the authors and The Motley Fool, Inc. make no warranty or representations as to their accuracy, usefulness, or entertainment value. Data and statements of facts were obtained from or based upon publicly available sources that we believe are reliable, but the individual authors and publisher reserve the right to be wrong, stupid, or even foolish (with a small "f"). It is sold with the understanding that the authors and publisher are not engaged in rendering financial or other professional services. Readers should not rely on this (or any other) publication for financial guidance, but should do their own homework and make their decisions. Remember, past results are not necessarily an indication of future performance.

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Motley Fool Rebound Report: 7 Small-Cap Rockets for the New Bull Market

Contents

I n t r o d u c t i o n ................ .......................................................... i v by Andrew Sullivan BJ's WHolesale Club................................................................ 1 by Charly Travers Co m pa s s Mi n e r a l s . ....... ........................................................... 3 by Joe Magyer Darling International........................................................... 5 by Todd Wenning H o l ly ......................................................................................... 8 by Jim Gillies Houston Wire & Cable........................................................... 11 by Rich Greifner T e l e dy n e T e c h n o lo g i e s ......................................................... 14 by Andrew Sullivan Waste Connections............................................................... 17 by Michael Olsen

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Motley Fool Rebound Report: 7 Small-Cap Rockets for the New Bull Market

Introduction

By Andrew Sullivan, CFA (TMFRedwood)

All big companies were once small, and that's not just something fledgling CEOs' mothers tell them. Consider the growth of The Walt Disney Company (NYSE: DIS). In 1965, 10 years after Disneyland opened, Warren Buffett bought 5% of Disney for $4 million. Today, buying 5% of the company would set you back more than $2 billion.

Even though we can't directly compare those numbers because of share dilution, you get the idea: Investing in a big company before it becomes big means big returns. That was true in 1965, and it's true today. Happily for us, many small companies are on sale right now -- the Russell 2000 small-cap index is down 32% from a year ago, making this an excellent time to go small-cap shopping.

Beating the Competition

Small-cap stocks can act like Miracle-Gro for your portfolio -- a little dose for a lot of extra growth. From 1926 to 2008, small-cap stocks returned 11.7% annually, compared with 9.6% for large caps and 5.7% for long-term government bonds, according to Ibbotson Associates. And they do even better as the economy improves. In the year after each of the past 10 recessions, small-cap stocks rose an average 28%, while largecap stocks returned 19%, according to T. Rowe Price.

Those relative returns look mighty attractive, but that doesn't mean we can simply write off the bigger fish: Large caps pack a mean competitive punch. That's why to be a successful small-cap investor, you need to own the strongest, toughest little companies out there -- the ones with the biggest competitive advantages.

positions that should grow over time. All but one have beaten the market since they started trading, and five of the seven have already knocked the ball out of the park, as you can see below.

Name

Ticker

Since

Stock Return

S&P Return

Holly

HOC 1989 475% 179%

Darling International DAR 1994 91%

98%

BJ's Wholesale Club BJ 1997 140% (1%)

Waste Connections WCN 1998 304% (17%)

Teledyne Technologies

TDY 1999 217% (35%)

Compass Minerals

CMP 2003 292% (14%)

Houston Wire & Cable

HWCC 2006 (17%) (26%)

Data as of 6/29/09. Start dates are earliest available pricing data.

Outperformance (percentage points) 296 (7) 141 321

252

306

9

Read on to learn more about these seven companies' competitive advantages and superior growth potential.

The Foolish Bottom Line

We all want to position ourselves for the market rebound, and investing in fast-growing small caps with an enduring competitive advantage is a great way to do so. The seven stocks we've hand-picked for you all have the goods to grow -- and are trading well below our estimates of their true value. Getting in on a few of them now just might make you an early investor in the next big thing.

After all, there's no sense in chasing growth unless the company can protect its competitive position. So for this special report, we searched for the fiercest small-cap companies around -- and found a salt miner, an electrical cable distributor, a warehouse operator, an oil refiner, a high-tech powerhouse, and two waste-services companies. You've probably never heard of most of them. But they all have strong, defendable market

Foolishly, Andrew Sullivan

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Motley Fool Rebound Report: 7 Small-Cap Rockets for the New Bull Market

BJ's Wholesale Club

By Charly Travers (TMFBreakerCharly)

BJ's Wholesale Club

NYSE: BJ Website:

FINANCIAL SNAPSHOT

Recent Price....................................................$32.64 Market Cap............................................ $1.8 billion Cash / Debt.................$40 million / $1.6 million Data as of 6/29/09

WHY BUY

? This warehouse retailer should thrive in a difficult economy as consumers hunt for bargains.

? A slow and steady grower, BJ's has significant long-term potential to expand.

? The share price gives us an attractive upside with only a moderate amount of risk.

With an economy on the ropes, unemployment at high levels, and consumers struggling to make ends meet, saving money on necessary products is more important than ever. That's why warehouse club operator BJ's Wholesale Club (NYSE: BJ) stands out as an attractive shopping destination for consumers -- and an excellent opportunity for Fools who want a safe, steady, small-cap investment with oodles of room for growth.

About the Company

BJ's introduced the warehouse club concept to the New England area when it launched in 1984. If you've ever walked into one of these behemoth stores and bought a 20-gallon drum of ketchup, you know how warehouse clubs work. They're best known for giving members bulk quantities of goods at a lower price than they can get at their local supermarkets or department stores. Because these chains move immense volumes of products, they have significant buying power with suppliers. As a result, shoppers can land excellent deals on all sorts of items, from food and beverages to TVs, computers, and even jewelry. BJ's has grown steadily over the past two decades, and today, it operates 180 warehouse clubs, all of which are on the East Coast.

About the Sector

Like other warehouse clubs, BJ's also charges members an annual fee to get into its stores. Its base plan, called Inner Circle, costs $45 per year while its Rewards Membership, which is aimed at high-volume buyers, costs $80. Competitors Costco Wholesale (Nasdaq: COST) and Wal-Mart's (NYSE: WMT) Sam's Club charge comparable fees and employ very similar business models. Warehouse clubs essentially make all of their profits from these membership fees and not from selling products, so attracting new members and keeping renewal rates high among existing members is critical for this business model.

These clubs also carry fewer stock-keeping units (SKUs) than traditional stores. BJ's and Costco have 7,000 and 4,000 SKUs, respectively, while a traditional supermarket carries 45,000 SKUs, and a supercenter (think Target (NYSE: TGT) or Wal-Mart) offers more than 100,000 items. But in exchange for sacrificing variety and consumer choice, warehouse clubs give members deals on popular items they frequently buy, such as cereal, soda, toilet paper, and laundry detergent. Offering them such a compelling value keeps them coming back again and again, allowing these stores to generate very high sales volumes and inventory turnover.

Thesis / Opportunity

BJ's has done a great job of accomplishing exactly that. It's a slow and steady grower with a history of strong returns on capital, and it uses the cash it generates to open new stores that earn attractive returns. With only 180 locations, the company also has room to expand across the country -- in the United States, there are nearly 400 Costco stores and more than 600 Sam's Clubs. But don't expect BJ's to catch up

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Motley Fool Rebound Report: 7 Small-Cap Rockets for the New Bull Market

overnight. This conservatively managed business opened just four stores in 2008 and expects to open six to eight in 2009.

Of course, BJ's doesn't have to depend solely on new store openings to improve its business. For one, it can boost sales at its existing locations -- each store currently generates about $56 million in sales per year. While that may sound like a lot, this lags both Costco and Sam's Club by a wide margin. Each Sam's Club brings in about $75 million a year in sales, while Costco delivers a staggering $142 million. BJ's has been increasing its per-store revenue by 3.2% annualized over the past five years; one way it can continue this trend is by signing up more members. At the end of the first quarter of 2009, it had 9 million cardholders.

If BJ's can continue its profitable expansion and improve the economics of its current locations, it will create heaps of value for shareholders for many years.

Financials and Valuation

Revenue (billions) Store Count Revenue Per Store (millions) Members (millions)

FY2004 $7.4 155 $47.6 8.3

FY2005 FY2006 FY2007 FY2008

$7.9 $8.5 $9.0 $10.0

163

172

177

180

$48.6 $49.4 $50.9 $55.7

8.6

8.7

8.8

9.0

The company has been able to grow revenue at a compound annual rate of 7.9% over the past five years by boosting its store count, attracting new members, and hiking its membership fees. Moreover, this modest growth rate could conceivably persist for a very long time, because at its current expansion pace, it would take BJ's more than 30 years to get its store count up near where Costco's and Sam's Club's are today.

Instead of trying to guess how fast BJ's will grow and making assumptions about the returns it will generate along the way, I valued the company based on the free cash flow it produces with its existing store base. By my estimates, BJ's will need $80 million for maintenance capital spending per year. This represents the money it will need to keep its stores and distribution facilities in their current condition. After backing out maintenance needs and stock option compensation from operating cash flow, BJ's has averaged $135 million in free cash flow over the past three years -- that is, cash that shareholders can take out of the business without impairing it.

Even without adding new stores, the company can slowly bump up that free cash flow by boosting the revenue at its existing locations. If it adds new members or raises its membership fees further, for example, and manages to increase free cash flow by 3% per year in perpetuity -- roughly the rate of overall economic growth -- the shares are worth $34 today.

The reality is that BJ's will continue to expand. Because the company generates attractive returns, this growth will improve its intrinsic value over time, which should reward shareholders with a price of around $50.

Risks / When to Sell

The risks associated with this business span far beyond getting squashed by a falling 20-gallon drum of ketchup. First, BJ's operates in an extremely competitive industry with notably strong peers such as Costco, Wal-Mart, and Whole Foods (Nasdaq: WFMI), among many others. All of these companies share an intense focus on serving their customers and providing a compelling experience and value proposition. Costco and WalMart in particular are notoriously efficient and well managed. However, this competitive threat is nothing new. BJ's has thrived for years, even in the presence of these formidable foes, and there's no reason to expect that to change.

That said, there are some more pressing issues. As I stated earlier, BJ's business model depends upon its ability to sign up new club members and collect annual membership fees. Once it has a member in its system, it needs to make sure that person sticks around year after year. As with any subscription model, an inability to sign up new members and a decline in renewal rates would be a big warning sign that the business is in trouble. But management reported in BJ's first-quarter earnings call that renewal rates were coming in stronger than expected. Because renewals account for 80% of member fee revenue, I view that as a sign that BJ's is providing its shoppers with the value they demand in the midst of a tough economic environment.

I would sell if this business begins to falter and show signs of deterioration. An exodus of members, the evaporation of already-thin margins, and repeated declines in comparable-store sales would be noticeable signs that this investment thesis has gone awry. On a brighter note, if the thesis plays out as expected, shareholders will earn plenty of money to bring with them on their next BJ's shopping excursion. And if the company becomes overvalued -- say, more than $50 per share anytime in the next three years -- I'd recommend selling.

The Foolish Bottom Line

BJ's is a well-managed company that profits from a proven business model. It has a pristine balance sheet, and it generates loads of cash that it can reinvest in building new stores that earn attractive returns on capital. When all of these qualities are packaged together into one business, they usually don't come cheap. But at today's price, BJ's stock offers investors a supersized opportunity at a warehouse club price.

The Motley Fools owns shares of Costco Wholesale.

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Motley Fool Rebound Report: 7 Small-Cap Rockets for the New Bull Market

Compass Minerals

By Joe Magyer (tmfjOEiNVEStor)

Compass Minerals

NYSE: CMP Website:

FINANCIAL SNAPSHOT

Recent Price....................................................$53.87 Market Cap............................................ $1.8 billion Cash / Debt......... $117.4 million / $486 million Data as of 6/29/09

WHY BUY

? Compass' stock has been unfairly squashed as a result of commodities' atlarge collapse.

? The company has truly unique assets with decades of low-cost production ahead of them.

? Salt and potash demand and prices are poised to rise over the long haul.

Oil, gas, silver, coal. If man, mule, or machine can strip it from the earth, I'll follow it. As the Fool's resident natural resources buff, I'm constantly on the prowl for unloved commodities and the companies that produce them. As swingin' as that sounds, the sad truth is that only a select few commodity dabblers are fit to produce winning long-run returns. Commodity production is capital intensive, and busts happen. Every now and again, however, a diamond in the rough comes along with the characteristics of a true winner, and that is exactly what I have discovered in my recent digging. Meet Compass Minerals (NYSE: CMP), one of the best commodity plays you've never heard of.

The exceptional commodity producer with market-beating prowess possesses two traits. First, the commodity it drills for, digs up, or otherwise procures and sells has enduring demand. Finding substitutes is difficult, and there's next-to-no chance of the material becoming obsolete. And second, these rare birds can produce these commodities cheaper than their peers, thanks to a mix of better processes and high-quality, low-cost reserves. There aren't many companies that fit this bill, and most are well-known titans like ExxonMobil (NYSE: XOM) or BHP Billiton (NYSE: BHP).

Imagine my surprise, then, when I stumbled across Compass Minerals, a small cap that boasts unique low-cost reserves of two commodities with fantastic prospects for long-run demand. Even better? It offers a 2.7% yield and is under the radar of most Wall Street players.

About the Company

When you go looking for commodity investments, salt and sulfate of potash (SOP) probably aren't the first two ideas that come to mind. Yet, Kansas-City based Compass has built an empire atop giant piles of salt ... and fertilizer. Led by CEO Angelo Brisimitzakis, Compass is the largest SOP producer in North America and the largest salt producer in both North America and the U.K., operating 10 production and packaging facilities across the U.S., Canada, and the U.K. Its Goderich, Ontario, mine is the world's largest rock salt mine, while its Winsford, Cheshire, mine is the largest in the U.K.

According to Compass, there are more than 14,000 uses for salt (not including tequila shots). In fact, of the 15,000,000 tons of salt that Compass produced last year, 81% went to states and municipalities to keep their highways ice-free. The other 19% was used for consumer and industrial purposes. Incredibly, the company's salt reserves are so vast that management believes there is more than a century's worth of reserves at most of its production facilities, including the key Goderich mines.

But while salt sales made up 80% of Compass' total 2008 revenue, the skyrocketing price of SOP (a high-end specialty fertilizer) helped to push fertilizer sales up to nearly 20% of last year's total sales. Compass produces its SOP in its solar ponds at the only source of naturally occurring SOP in North America: The Great Salt Lake. And for those of you who are also Luddites when it comes to technology, don't sweat that "solar" tag. Compass has been producing SOP at its solar ponds since 1967. And just like with its seemingly infinite supply of salt, management believes it can continue to produce SOP

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Motley Fool Rebound Report: 7 Small-Cap Rockets for the New Bull Market

at current levels at this facility to no end. Or, at least, well beyond the confines of any cash-flow model yours truly has devised.

About the Sector

I probably don't need to sell you on the demand for salt, but I will anyway. Compass believes that North Americans consume about 38 million tons of salt each year, while the U.K. market sits at about 2 million tons annually. U.S. salt demand, which is relatively seasonal thanks to high winter demand for de-icing salt, has crept up at about a 1% annual clip over the past couple of decades. Prices, meanwhile, have grown at between 3% and 4%.

SOP is the wild child of the Compass family. Global potash fertilizer demand has been creeping upward thanks to growing populations, and prices practically exploded last year when that growing demand smashed into tight, controlled supply. Canada's PotashCorp (NYSE: POT), which controls 22% of global potash capacity, is to potash what Saudi Arabia is to oil. The company is able to manipulate industry prices by constricting and loosening production at its whim. That's great news for secondary producers like Compass, which effectively piggybacks on PotashCorp's competitive strength. New supply takes a lot of cash and time to bring online, which means that Compass should benefit from fat margin prices on its SOP for quite some time.

Revenue (millions) Operating Margin Salt Avg. Price ($/ton) SOP Avg. Price ($/ton)

2005 $742.3 19.3% $52.78 $259.56

2006 $660.7 17.3% $52.35 $292.39

2007 $857.3 16.8% $55.59 $321.82

2008 $1,167.7 23.5% $61.19 $595.75

Compass carries $482 million in long-term debt, none of which matures before 2013. That slug of debt is nothing to sneeze at given the potential volatility of salt volumes and SOP prices, but I'm comfortable with it given that Compass has $117 million in cash and its operating profits have covered interest payments at least a couple of times over each of the past few years.

Compass' valuation is eye-catching right now. The shares are down nearly 37% from their 52-week high, and I peg them as worth $72 a stub, or about 34% above recent prices. That's assuming relatively conservative baseline prices of $59 per ton for salt and $300 per ton for SOP, both of which are less than trailing annual results. This is especially true for SOP, for which Compass pulled an average price per ton of nearly $600 in 2008. If Compass sees long-run SOP prices trend closer to $400 per ton -- which I think is entirely plausible -- my valuation estimate would increase to $82 a share. I recommend buying below $58 a share.

Risks / When To Sell

Thesis / Opportunity

The company's pitch is pretty straightforward: An unheralded, low-cost producer of essential (salt) and prized (SOP) minerals with an attractive valuation (more on that shortly). Compass' mines, including the cherished Goderich site, sit conveniently next to rivers and lakes, equating to fast and cheap transportation. That's key given salt's low value-to-weight ratio (about $60 per ton), and it prevents distant competitors from chipping away at Compass' pricing strength.

That Compass' key mines have more than 100 years worth of production ahead of them is mind-boggling. Let me put this in context: While most commodity producers have only a few years worth of reserves in the ground and must constantly spend their time and money on maintenance efforts, Compass should be able to produce salt and SOP at current levels for literally decades.

Financials and Valuation

The company's revenues and profits spiked in a big way in 2008 (as the nearby table shows). But while I'd like to spin a yarn here about innovation and the triumph of the entrepreneurial spirit, the reality is simply that Mr. Market was willing to pony up for salt and SOP. That's fine by me, of course, though I'm expecting salt and SOP prices to come back down to earth thanks to the recession.

Like any commodity producer, Compass' profits are dependent on the prices of what it produces.

Over a short time horizon, unseasonably warm winters hurt deicing salt prices and volumes. Over a longer horizon, increased domestic salt production capacity could pressure prices, as could meaningful climate change. One sneaky risk would be the development of a common substitute for highway de-icing salt. Given salt's proven effectiveness and low cost, though, color me skeptical that it will be knocked from its mantle anytime soon.

Finally, the leases to Compass' production facilities are highly stable, but there is always the possible (albeit small) risk that they won't be renewed. The company's prized Great Salt Lake facility, home of all of Compass' SOP production, is dependent on an annual renewal that must be approved by the state of Utah. Seeing as how this lease has been renewed each year for more than four decades, combined with the amount of jobs and tax revenue it provides the state, it is hard to imagine the company losing this facility. Still, it is a remote possibility.

The Foolish Bottom Line

Compass Minerals is the little engine that could. There's no whiz-bang, bleeding-edge technology here -- and that's why I love it. Its mines will still be producing the same ol' salt and fertilizer for decades. In the meantime, you just keep collecting your growing dividend checks as Compass' engine quietly hums along, with your portfolio in tow.

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