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Summary

  • Shares are down at least 15% year to date.
  • Market capitalization is less than $1 billion.
  • Enterprise value to revenue is less than 2.5x.
  • Net Debt is less than 1x EBITDA.

For the most part, I find small cap stocks to be the most expensive in a pricey market as evidenced by the Russell 2000's forward P/E of 21x. However, given the inherent inefficiency in small cap land (stocks are less likely to be closely followed by both the buy-side and sell-side alike), there remain pockets of opportunity for enterprising investors. Today I will discuss 3 stocks which I believe could double over the next three years. My criteria are as follows:

  1. Market cap < $1 billion
  2. Year to date share price decline of at least 10%
  3. Enterprise value to revenue < 2.5x
  4. Net Debt < 1x EBITDA

In addition, two of the companies I will be discussing have short interests. As pessimism fades, these shares could produce meaningful returns for patient investors.

ServiceSource International (NASDAQ:SREV) is the leading provider of outsourced recurring revenue management solutions as well as a SAAS based platform to manage customer contract/subscription renewal (shares have fallen 49% year to date as investors are concerned about 1) slower than anticipated growth in the outsourcing business and (2) lower near term profitability as the company works its way through an investment cycle. While 2014 will be loss-making and 2015 is likely to be only break-even, I believe investors are overlooking several positives. First, SREV has over 1/3 of its market cap in net cash on the balance sheet - while the company is incurring some losses now, its survival is not in question. Secondly, SREV has a rapidly growing SAAS business. SAAS revenues are expected to grow 170% during 2014 to $34 million and another 100% in 2015 to $68 million. Other SAAS businesses with strong growth rates and a high gross margins (76%), are awarded revenue multiples of 12-17x. Assuming that SREV's business is worth 7x 2015 revenue (still a ~50% discount to larger public peers), valuing the outsourcing business at just 50% of revenue, and factoring in the company's net cash balance of $130 gets me to a total value for equity holders of $730 million, or $8.80 per share which represents 105% upside. The software industry is highly acquisitive and I would not be surprised to see SREV gobbled up by a larger player (or a private equity group who is cognizant of the value of SREV's SAAS business). It is worth noting that Altai Capital recently reported a 9.9% stake in ServiceSource.

Ebix Inc (NASDAQ:EBIX) is another software company trading at what I believe to be a bargain price. EBIX provides software solutions primarily to the insurance industry and has a high level (80% of recurring revenue). Shares have fallen 16% year to date (and 35% since a deal to be acquired by Goldman Sachs Private Equity fell through last year). Shares have been weak as 1) uninspiring first quarter results with slow growth and slight margin deterioration and (2) Gotham City Research, which had previously written very negative pieces on EBIX which criticized its accounting, scored a big win earlier this year as Spanish company Gowex imploded after Gotham accused them of fraud. This has likely created additional interest on Gotham's work which may have had a negative impact on the shares. Having reviewed Gotham's work, I think it is highly unlikely EBIX is a fraud for the following reasons: 1) strong cash generation which has allowed them to make acquisitions for cash, pay dividends, and pay down their debt (2) continued significant insider ownership/lack of meaningful insider selling - the point of a fraud is to make money and cash out at the public's expense but EBIX insiders have not done this and lastly (3) Goldman made its bid after Gotham's accusations - it had done some due diligence prior to making the bid. The withdrawal of Goldman's bid was related to a suit filed by Georgia alleging intentional misconduct in June of 2013. While this clearly is not great, nothing has yet come of this bid. At the core of all of these issues seems to be whether or not EBIX took accounting liberties to avoid paying taxes (as well as making earn-out payments to acquired businesses). Again, while negative, this seems to be more than in the price. Assuming EBIX starts to pay a higher tax rate (say 25% vs. 0-12% it has paid historically) on an EBIT base of $80 million, I get to net income of $60 million. Capping at just 13x (small software companies, even slow growing ones, usually fetch somewhat higher multiples due to their stable cash flows and that they tend to be acquisition targets), gets me to $20.25 per share. However, were EBIX to do a $160 million share buyback (would be less than 2x Net Debt to EBITDA; today EBIX has basically no debt and generates a significant amount of cash) at $13/share, EBIX could buy back over 30% of the company. Assuming a borrowing cost of 6% and a 25% tax rate, EBIX would have EPS o $1.95. At a 13x P/E multiple, the company would be worth $25.25 which is 104% more than today's price. Further, with 38% of shares outstanding sold short, a little bit of positive news could go a long way.

ITT Educational Services (NYSE:ESI) has been out of favor for many years as investors have fled (and continue to flee) the once hot for-profit education sector. Shares of ITT have fallen 56% year to date and are down 87% from their all-time high. Investor concerns include: greater regulatory scrutiny, reduced funding from the federal government, declining enrollment, potential competition from free online classes offered by Coursera. While some of these concerns are valid (particularly the government funding issues and declining enrollment), I believe ITT is simply to cheap to pass up. Trading at a forward P/E of just 5.5x (stripping out net financial assets, the P/E is below 4x). Though there are many negative factors which have weighed on shares, ITT offers a necessary service (there simply isn't enough capacity at junior colleges/universities to accommodate all of the students seeking higher education). While there will be changes made to both the recruiting policies and curriculum/career placement efforts, I expect that ITT will adjust (and continue to cut costs) and remain a viable business model. Eventually I think the company will resume its growth path and eventually think the company could be awarded a 12-15x P/E multiple which suggest a share price in the range of $30-40 or 100-160% greater than its current price. Over 40% of ITT's shares are sold short. If sentiment goes from terrible to ever-so-slightly better than terrible, these shares could advance quickly.

Though the securities mentioned above are clearly unpopular, I believe that investors who are willing to go against the crowd will ultimately be rewarded with strong returns.

Disclosure: The author is long EBIX, SREV, ESI. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Source: 3 Out Of Favor Small-Cap Stocks Which Could Double