The problem with all of this attention though is that it’s made it increasingly more difficult for investors to find value in the video on demand market. I don’t think that you’ll find a lot of people who will argue that Akamai is going to see a decline in revenue, but with a market cap of $7.2 billion, one could argue that it’s beginning to look awfully expensive for a stock that has yet to break $500 million in sales.
Instead of looking at large and midcap companies, I prefer to concentrate on undiscovered small cap companies with technology that I believe has a bright future. Small cap stocks often entail much higher risks, but the payoff can be much more substantial, if you can accurately identify up and coming technology.
Finding these hidden gems takes a lot more homework and even if you discover something exciting, it may never take off if Wall St. doesn’t take the time to understand the technology, but I still find small cap stocks much more exciting then the large cap stocks that the mainstream press is content to pay attention to. One such company that I believe Wall St. has overlooked is Smart Modular Technologies (SMOD).
While at first glance, their technology isn’t sexy, their products are difficult to understand, and their connection to the VOD market opportunity isn’t immedietely obvious, I believe that for investors who don’t mind taking on risk and doing a little bit of homework, that a real opportunity may be presenting itself.
Smart Modular creates a lot of things, but their core business is flash based memory that they implement into PCs, laptops, routers and most importantly the super fat servers that are required to run an efficient video on demand network. Over the last 6 months, the company has seen a tremendous amount of demand for these servers and is in an excellent position to benefit not just from the adoption of VOD, but also from the adoption of future portable devices and set-top boxes that rely on flash memory.
With the company there is a little bit of good news / bad news however, the bad news is that much of their revenue is concentrated with only two business partners. The good news is that these two partners are Hewlett Packard (HP) and Cisco (CSCO), two companies that are showing remarkable growth right now. HP makes up over 45% of the company’s revenue and Cisco’s importance has also increased substantially with the growth of the server market. Unlike Cisco or HP however, Smart Modular’s market cap isn’t quoted in the 100’s of bilions, it’s at an attractive $530 million and the stock hasn’t reacted to any of the positive news that’s been coming out on Cisco or HP lately.
Last quarter, Smart Modular blew away earnings expectations by demonstrating a 39% increase in year over year revenue for the quarter and a 55% earnings growth. They also said that they expect earnings for next quarter to come in at about .20 cents a share which would represent another 33% growth in year over year earnings if they can hit their numbers.
What I don’t like about the company is that gross margins are pretty skimpy. The company did say, on their latest conference call, that they are seeing a significant shift towards their higher gross margin 4GB memory modules, which should help improve these numbers, but regardless of how much improvement they see, it’s important to realize that in looking at the stock it’s not a software company, it’s a hardware company and fat gross margins are a lot harder to obtain when you are dealing with the hardware side of the business. The company also has a fair chunk of debt that they are sitting on. While overall, the company has a nice balance sheet, they are still paying an interest rate at 5.50% plus Libor, so at some point the company might be better off doing a secondary underwriting and getting that out of the way, if their stock does pop up.
What I like about the company though far exceeds my critcism. Nearly every single aspect of their business is in a hot growth market right now. They’ve got great exposure to Cisco and HP which are taking market share hand over fist from their competitors, the company has invested heavily in the video on demand market in Brazil and are currently making even more significant investments in India, which will only complement their current outsourcing revenues. Add to this that all five analysts that are tracking the stock currently have buy ratings on the company. Oh and did I mention that they make part of the technology behind LCD screens as well?
In looking at this company, I’m baffled as to why it’s trading at a P/E ratio of 15 when they’ve demonstarted an excellent ability to achieve growth and they are exposed to some of the hottest markets in the tech industry. As the company continues to execute on their business strategy, I expect that at some point Wall St will either no longer be able to look past their earnings or we could see HP or Cisco try and acquire the company and vertically integrate them into their existing business.
While small cap stocks carry significantly more risk, with $150 million in equity on their books and with the stock trading at a trailing 12 month price to sales ratio of 0.75, I see a real overlooked gem for investors who aren’t opposed to taking on that risk. With as much potential and as well exposed as this company is, I think that it’s easy to look past the low gross margins and find a little known, but attractive hardware company that the market has somehow missed.
If the VOD market continues to demand servers, if Moore’s law continues to hold true, if we continue to see higher demand for flash intensive memory devices, and if India and Brazil turn out to be at the beginning of their growth curve, Smart Modular Technologies should be well positioned to demonstrate impressive growth for years to come.
Disclosure: Author has no position in SMOD