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The goal when picking stocks off corporate rankings, such as Business Week's annual list of Hot Growth Companies is to uncover a hidden gem -- one that has escaped Wall Street's notice and is selling at a bargain price. Somera Communications (SMRA), which sells telecom equipment and came in No. 2 on this year's list, may prove to be just such an opportunity (see BW Cover Story, May 29, "Hot Growth Companies").
The Santa Barbara (Calif.) company, which primarily sells used equipment, earned a top spot on this year's list thanks to its 129% sales growth, 130% profit growth over the past year, and its remarkable 82% return on invested capital the past three years. For the first quarter of this year, reported on Apr. 25, the company earned $5.1 million, or 11 cents a share, up from $3.1 million the first quarter of 1999. Its revenues grew to $40 million last quarter, a 73% year-over-year increase.
Yet the stock, which closed on May 18 at $10 1/2, is trading more than 12% below its November initial public offering price of $12. Its forward price-earnings ratio is a measly 17 times the 2001 earnings estimate of Lehman Brothers analyst Steven D. Levy. This compares with an average p-e of 45 times 2001 estimates for other telecom equipment manufacturers, says Levy, who notes there are no other publicly traded companies like Somera that specialize in used telecom equipment. He expects Somera to boost earnings by 30% a year, and growth stocks are generally considered inexpensive when their p-e is lower than their expected growth rate.
MISPERCEPTION.
Levy, who says Somera is one of his favorite small-cap names, rates it a "strong buy" and has an end-of-year price target of $28, which would translate into a 167% gain from what the stock is trading at now. "It is fairly clear to us that investors are overlooking this jewel of a telecommunications company even as the business fundamentals accelerate," he wrote in an Apr. 28 report.
So why is the stock stalled? "Wall Street doesn't quite appreciate the business model," says Levy. There is a misperception that selling used equipment (the company prefers the term "de-installed") makes the business less attractive. Clearly, most investors relish the idea of investing in a tech company that is designing cutting-edge products.
But while you might think telecom equipment would hold its value about as well as a PC, which is outdated before it's paid for at the cash register, that's not the case. In fact, says Jeff Miller, Somera's executive vice-president for sales and marketing, telephone companies often need network equipment that is no longer manufactured. "Value increases even though the equipment might be 5 to 10 years old," he says.
More typically, while one company is upgrading a high-density urban area with brand-new equipment, another company can redeploy the old gear to upgrade a rural system. Part of a broader outsourcing trend, Somera can de-install, reconfigure, and redesign the equipment, often combining it with new components. Somera customers benefit by saving about 50% off the cost of buying new equipment and by finding a way to recoup some costs from old equipment. Somera has more than 800 customers (none accounting for more than 10% of its revenue), including Alltel, GTE, and Vodafone AirTouch.
"VIRTUAL INVENTORY."
And here's the beauty of selling de-installed equipment: Profit margins on it are more than twice as high as on the new equipment Somera sells. According to Levy, Somera earned 53% gross margins on the 58% of sales that came from de-installed equipment in the past quarter, compared with 22% gross margins on the 42% of sales that came from new equipment.
Somera has even found a way to sell de-installed equipment in wireless, the hottest sector in the telecom industry. The company says sales of de-installed and new wireless equipment account for about 45% of its business. But it is growing faster than the industry because outsourcing and the use of old equipment is gaining acceptance. And it is just starting to tap into international markets, which represent a huge opportunity, says Levy.
Rather than hold inventory, Somera mostly maintains what Miller calls a "virtual inventory" or database of equipment that companies plan to remove. Somera taps into the database when another customer needs equipment. It plans to turn that database into a business-to-business Web site. The site, scheduled to launch this fall, will allow customers to track orders, purchase equipment, and participate in auctions online.
Somera's lackluster performance is most likely related to overall market conditions. But misperceptions about its business model also seem to persist. Perhaps some critics still scoff at the idea that big profits lie in recycling used technology equipment. It also "doesn't help" that the stock isn't widely followed since analysts at some of the firms that underwrote the offering have changed jobs, Levy says. But if what you are looking for is an inexpensive telecom play that isn't on Wall Street's radar screen, Somera is worth honing in on.
Copyright 2000 , by The McGraw-Hill Companies Inc. All rights reserved.
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