By Jeff Meyers
The recent turmoil in Europe has spawned the risk-off purging of small-cap stocks in general and small-cap technology stocks in particular. The Russell 2000 Technology Index is off 14% from its late March highs, compared to 9% for the broader Russell 2000 Index, 6% for the S&P 500 Index, and 5.5% for the Dow Jones Industrial Average. As usual with a broad selloff of this type, many fundamentally sound companies with inexpensive valuations are discarded along with the more deserving, lower quality firms.
Significantly undervalued stocks were getting hard to find by March of this year, due to the doubling of the market off of its early 2009 lows. With many smaller stocks down 30% or more in the past two months, pickings are suddenly more plentiful in the small-cap universe. While the negative momentum in many of these stocks may continue, and it is always difficult to call the bottom, many opportunities exist where long-term appreciation will be significant from these levels.
One example is Silicom, a $100 million market cap company that designs network interface cards (NICs) that go into network appliances in such high-growth markets as security (firewalls, intrusion prevention), WAN optimization, and deep packet inspection. In addition to the underlying growth in its markets, the company has consistently added new customers to its roster and has added significant new products that have probably tripled its addressable market in the past three years. This combination resulted in 30% revenue growth in 2011 and 48% earnings growth. You might expect a pretty heady multiple for this kind of growth, yet the multiple is egregious only in how low it is. The stock is at $14 and has $7.40 / share in net cash on its balance sheet. It will likely earn $1.35 per share this year resulting in a P/E multiple of less that 5x when stripping out the cash. The company “only” grew its top line 10% last quarter but I expect this growth to once again reaccelerate through the remainder of this year.
Another example is Extreme Networks, a $340 million networking equipment company. New management came into the company two years ago and embarked on an ambitious plan to focus the sales and marketing organization, target higher growth vertical markets, strengthen the executive team, and cut costs. At about the same time, an activist investor took a 10% position and put two representatives on the company’s board of directors, further endorsing new managements’ plans for change. These plans are drawing near to completion now, and the company is set to become much more profitable on the same sales base during the next couple of quarters. Also, the company has released two very important new products in the past two quarters and growth from these should kick in during the second half of 2012. If these changes are successful, the company will sport a very cheap valuation for its June 2013 fiscal year: 0.4x EV / Revenue, 3.8x EV / EBIT, and a 9x P/E multiple are what I am looking at for that period.
These are just two examples of what values can be found in the small-cap tech sector. Whether or not we are at a market bottom is debatable, but I think that the two examples above and many others will generate very solid returns over time.
Jeffrey Meyers is the founder of Cobia Capital Management, a technology-focused U.S. long/short equity fund in New York. He previously worked as an analyst at Intrepid Capital Management, Ivory Investment Management and SC Fundamental.