There is nothing as satisfying as owning a stake in a company that is just hitting its stride. Too young to be well known, too small to be noticed by institutional investors, emerging-growth companies can offer spectacular returns to early-bird investors who catch them before the crowds arrive.
Even though small-company stocks have been on a tear (the Russell 2000 small-stock index was up 33% in the year that ended June 30), it's still possible to catch some stars while they're on the rise. The five young companies profiled here can all claim track records of profitability, accelerating revenues and earnings, and healthy balance sheets, and they have a good chance of emerging as leaders in their respective markets. Plus, they're still selling at reasonable prices.
Fido's drug dealer
While PetsMart and Petco battle for leadership in the burgeoning pet-supply business, PetMed Express has found an overlooked and lucrative niche: It sells discounted pet medications by mail order and over the Internet. As noted in July (see "Trends That You Can Bank On"), Americans spent $32 billion last year caring for their personal menageries. Targeting a small piece of that pie -- the $3-billion market for dog and cat medications -- PetMed saw its revenues rise 71% last year, to $94 million. And those revenues have increased ninefold over the past four years. Profits at the Pompano Beach, Fla., company, which operates under the 1-800-PetMeds brand name, rose 79% last year, and its customer list grew by 572,000, to 1.1 million.
PetMed offers a carefully selected, 600-item inventory of over-the-counter and prescription drugs, and health and nutrition items that are likely to generate repeat business. Its best-selling treatments are for flea and tick control, heartworm, and bone and joint care. Last year, 55% of revenues came from repeat customers.
Analyst Frank Gristina of investment bank Avondale Partners estimates that PetMed has 40% of the market for pet medications sold via mail order or over the Internet. PetMed, which went public in 2000, competes with some two-dozen private firms. Its biggest competitors, though, are veterinarians, who have bitterly fought the company's incursions. "They have had a monopoly historically and, naturally, they don't like to have competition," says PetMed chief executive officer Mendo Akdag. The stock, at $8, trades at 25 times the 31 cents per share that analysts, on average, expect the company to earn in calendar 2004.
Health cost cutter
Keeping a lid on medication costs for humans is good business, too. With prescription-drug spending projected to rise 12% to 15% annually over the next decade, most large employers and managed-care organizations hire pharmacy benefit managers, or PBMs, to help control drug costs. Three companies -- Medco Health Solutions, Express Scripts and AdvancePCS -- are leaders in that business. But an upstart, HealthExtras, has found an opening by catering to smaller benefits providers and promising a transparent pricing process. Most plan administrators "have no idea how much a PBM is making" because of hidden fees and rebates from drugmakers, says CEO David Blair. HealthExtras tries to keep clients' drug costs low through programs that encourage generic drugs rather than high-price brand names. HealthExtras' clients use generics 51% of the time versus an industry average of 40%, says Blair. As a result, its clients' drug costs are rising just 7% per year, half the national rate.
The company serves more than 800 clients, and in May it landed its biggest account ever, a contract to handle drug benefits for the state of Louisiana. Shares of the Rockville, Md., company surged on the news, and at $15, they now trade at 35 times projected 2004 profits of 43 cents per share. Analysts peg the company's long-term earnings-growth rate at 25% per year, but that projection could rise as the impact of the Louisiana contract becomes clearer.
Originally a seller of supplemental benefit insurance policies, HealthExtras acquired three regional pharmacy benefit managers between 2000 and 2002; the PBM business now accounts for more than 80% of revenues. Historically, 40% of HealthExtras' growth has come from acquisitions. That trend should continue with the June purchase of Managed Healthcare Systems for $44 million in cash and stock.
Traders' favorite
Day trading supposedly flamed out when the stock-market bubble burst in 2000. But a core of survivors soldiers on (see "Day Trading, Take 2," April 2004). Given that the most active among them can trade hundreds of thousands of shares a day, a broker that services these traders can turn a nice profit.
TradeStation is a case in point. On average, its stock-trading customers place 630 orders per year apiece, compared with fewer than ten for customers of brokerages, such as E*Trade and Charles Schwab, that also serve mainstream investors. TradeStation's strategy is to lure the most lucrative, active customers away from rivals by offering a state-of-the-art software package with which they can devise, test and automate complex strategies for trading stocks, options, futures and currencies. In the first quarter of 2004, TradeStation added 1,400 new accounts, bringing its total to 13,723.
Although estimates of the number of day traders are essentially guesses, co-CEO Bill Cruz says conventional wisdom holds that 90% of transactions in the electronic-brokerage industry are generated by just 10% of the industry's 20 million online accounts. That indicates a potential two million TradeStation customers, he says. Later this year, the Plantation, Fla.-based company will launch a new brand targeted at professional traders at more than 8,000 hedge funds.
During the first quarter of 2004, which was generally a good one for stocks, TradeStation collected record revenues of $18 million, up 31% from the same period a year earlier. Profits rose 65%. But many investors seem to think that day traders will crash and burn in a more hostile environment, and TradeStation shares have lost more than half their value in the past year. But that perception "is the opposite of the truth," insists Cruz. "The active trader is more consistent. Our customers trade in good times and bad times."
At $6, TradeStation's shares sell for 19 times estimated 2004 profits. That's well below the company's estimated earnings-growth rate over the next few years of 35% per year, notes analyst Richard Bove of investment bank Hoefer & Arnett.
Laser upgrader
If popular TV shows like Extreme Makeover are any indication, Americans like to believe that ugly ducklings can indeed turn into swans. Last year, U.S. plastic surgeons treated nearly nine million patients, up 32% from 2002. About one million of those patients were treated nonsurgically with lasers for hair removal, skin rejuvenation and other therapies.
Cutera offers a new wrinkle to physicians and other practitioners who use cosmetic lasers, or want to: upgradeable laser systems. Buyers of its products, which are designed mainly for hair removal, can update their technology or add new treatment options without purchasing entirely new systems, which cost $70,000 and up. Since its start in 1999, Cutera has sold more than 1,200 laser systems and 240 upgrades in the U.S. and abroad.
Competition among sellers of aesthetic laser equipment is intense, with five public companies and dozens of private firms fighting for a share of a market still in its infancy. Analyst Mark Taylor of investment bank Roth Capital Partners estimates that laser-equipped doctors serve less than 4% of the potential market. For the full year, Cutera expects revenues of about $50 million, up 29% from 2003.
Dermatologists and plastic surgeons have been the traditional customers for cosmetic laser devices. But now more than half of sales are to general practitioners, gynecologists and other primary-care physicians looking for new business as reimbursements from health insurers fall. Insurance doesn't cover aesthetic procedures, but aging baby-boomers -- the target market -- "tend to have disposable income and want to improve their looks and slow down the aging process," says Ron Santilli, Cutera's chief financial officer.
Cutera went public in March at $14. It has since slipped to $13, even though it holds more than $5 per share in cash. The stock sells for a lofty 81 times estimated 2004 earnings. If Roth Capital's Taylor is even close to the mark with his call that earnings will grow 65% per year through 2007, the stock isn't excessively priced.
Traffic analyzer
You could hardly tell the telecommunications sector has been in a three-year slump from looking at the financial results of Ixia, a California-based company named for a South African flower. Founded in 1997 with $1.6 million in seed money, the company has been profitable for 24 straight quarters.
Ixia sells equipment that generates large volumes of traffic on high-speed data networks and then analyzes how well the networks and their components perform. Its primary customers are network-equipment makers such as Cisco Systems, which accounted for 35% of Ixia's first-quarter sales. Lately, though, Ixia has been trying to broaden its customer base, concentrating in particular on financial-services firms that run critical operations across highly complex networks. "When their networks go down, they literally lose millions of dollars in a minute," says Errol Ginsberg, Ixia's South African-born CEO. Government agencies represent another area of potential growth.
Ginsberg warns, however, that it will take a long time to penetrate these new markets. Still, even without the new clients, Ixia projects revenue growth of 25% to 30% this year. Spurring sales will be a steady growth in customers (74 were added in the first quarter of 2004, bringing the total to 816) and higher software sales. An expanding international business and a nascent rebound in telecom-equipment spending will also help.
Ixia is debt-free and has $122 million in cash. The stock, which went public in 2000, peaked in 2001 at $36, then sank to $3 in 2002. At $9, it sells for 30 times estimated 2004 profits.
--Research: Jessica Anderson
Small Sizzlers: Key numbers on our emerging-growth picks
On the basis of their price-earnings ratios, the stocks on this list are not cheap. But their prices are more palatable when viewed against the companies' estimated long-term earnings-growth rates of 21% per year or better.
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