I first heard of "shadow" companies in the '70s. The Wall Street Journal would report that Texaco hit a gusher in some Oklahoma county. The goal was to find a supply company or driller working in the "shadow" of the Texaco rig that might indirectly benefit from the news.
Before computers and internet, my best resource for stock information was the Moody's alphabetized volumes at the public library. They were thick 3-ring binders, each with thousands of tissue-paper pages of 4-point type. The better way to find the "shadow" stock would be for someone to drive to Oklahoma and read the brands on the trucks lined up outside the local diner. With the magic of the internet and screening filters, it is possible to detect growth companies that "shadow" established, well-known blue chips in some shared characteristics: business model, cash flow, revenue source, etc. This article focuses on two dividend-paying micro-caps and their similarities with well-known dividend payers.
We may ask: What does AT&T (NYSE:T) have in common with Telular Corporation (NASDAQ:WRLS)? Well, both are in the communications business, but the former is the quintessential dividend stock and the latter is a micro-cap supplier of wireless security products. They also both have managements committed to dividends for stockholders: they pay a 5%+ dividend yield at current prices of $30 for T and $8 for WRLS. Another key similarity is that they both have substantial recurring revenue: AT&T from telephone customers and Telular from Telguard wireless security system subscribers.
A major advantage for WRLS is that it has a higher growth trajectory than T and its smallness allows for nimble strategies within the niche. The implication of this is that WRLS may be in better position to increase dividends and also offer capital appreciation associated with its growth profile. An advantage for T is that it is venerable and predictable and immune to the challenges facing a small upstart company.
We should not focus on the favorable growth comparison without looking at the important financial metrics. As a dividend investor I am most interested in the dividend's reliability as measured by the payout as a percentage of net income, levered free cash flow, and cash in the bank. The lower the percentage the better the dividend coverage:
Dividend as % of 2012 Income: T = 78%, WRLS = 60%
Dividend as % of Levered Free Cash Flow: T = 382%, WRLS = 54%
Dividend as % of Cash: T = 326%, WRLS = 50%
The above info is from the Yahoo Statistics, except 2012 income, which is company guidance in the case of WRLS and analyst consensus in the case of T. Based on the above metrics; it appears that Telular compares quite favorably to T, and appears to have the financial strength to boost dividends further.
I expected the Dow member to have more conservative ratios than its shadow, but the triple-digit percentages in the case of AT&T are warning signs. That surprise induced me to double check the same ratios with competitor Verizon (NYSE:VZ): 80% (income), 75% (cash flow) and 40% (cash balance). I thought that maybe giant telecommunications companies had some kind of dispensation from old-fashioned dividend analysis, but VZ had the expected ratios and are in line with WRLS. Seven analysts rate AT&T a "Strong Buy," presumably satisfied that their projected income covers their dividend. I will defer to their analysis, but I am not buying.
Now that we are comfortable with the generous WRLS dividend yield, let's see how the shadow compares in terms of capital appreciation potential. In a capital-appreciation stock we are more interested in Price-to-Earnings and Price-to-Book Value, as well as growth projections:
Price to 2012 earnings: T = 12.7, WRLS = 10.7
Price to Book: T = 1.68, WRLS = 2.00
Projected 2012 Revenue Growth: T = 1%, WRLS = 20%
It appears that both of these can be classified as good value, but the WRLS 20% growth obviously can allow for more PE expansion. I consider this to be conservative as this projection is for existing business only, although WRLS will substantially increase that with their recent acquisition of SkyBitz, a global trailer tracking system. The Telular guidance for the combined companies indicates EBITDA of $1.00 per share for 2012, or a PE of 8.
I should mention that AT&T and their dividend reinvestment plan sent my daughter to an Ivy League university. If you are looking for a long-term, low-maintenance investment for that kind of goal, stocks like T or VZ probably are good choices. If you are seeking a good dividend with a potential capital growth pop, WRLS is worth a look.
I will not go into great detail about the WRLS business, but I do trust the growth projections given they are experiencing double-digit growth in the subscriber base of their signature Telguard home security system, which is a reliable revenue stream. They are also adding first-to-market products for personal security. Both in technology and marketing they seem to be ahead of the pack. For me, competition is the biggest concern, but they indicate that they are growing market share and have room for growth in further market penetration. Technically, WRLS is subject to some dramatic price moves so a long-term perspective is helpful with this investment.
Another good segment for dividend income is Property and Casualty Insurers. Both Allstate (NYSE:ALL) and Homeowners Choice, Inc. (HCII) are in that industry. Again, they both get recurring revenue from renewals of insurance policies and that allows them to pay regular dividends. Obviously HCII is just a "shadow" of ALL, since it limits its operations basically to condo and tenant insurance in Florida, and ALL is an insurance conglomerate. HCII pays a 5%+ dividend and ALL has a 2.7% yield at current prices of $11 for HCII and $30 for ALL.
Let's see if they can keep the dividend yield growing by looking at the dividend as a % of income, levered cash flow and cash in the bank for both:
Dividend as % of 2012 Income: ALL = 23%, HCII = 63%
Dividend as % of Levered Free Cash Flow: ALL = 3%, HCII = 37%
Dividend as % of Cash: ALL = 20%, HCII = 6%
Both companies seem to have very good dividend coverage with room to increase dividends in the near future. As expected,the blue chip has more conservative ratios, and Allstate seems to have room to match Homeowners Choice's 5% yield.
Let's see which company might be the best prospect for capital appreciation by checking PE and PB ratios, as well as revenue growth projections:
Price to 2012 earnings ratio: ALL = 8.5, HCII = 11.3
Price to Book: ALL = .83, HCII = 1.13
Projected 2012 Revenue Growth: ALL = 2.3%, HCII = 19.5%
Only taking into account these metrics, both companies appear to be undervalued and offering room for capital appreciation. Both have had a big run recently and are close to their 52-week highs. I see more upside for HCII for the long term given superior growth trajectory. I understand that Allstate is coming off a mediocre year and may be reluctant to raise dividends until the 2012 increased revenue trend is more assured. However, their conservative dividend policy eventually will hold the shares back.
HCII was an under-the-radar stock until recently, but it is still a good long-term value. Some of the recent movement may be attributable to the fact that the stock goes ex-dividend on February 15. They are conservative in their risk management with the use of reinsurance policies for the hurricane exposure. They have taken the opportunity to grab market share by acquisitions. The Florida insurance market was shaken by hurricanes in the past decade, causing some big insurers to reduce their exposure, leaving many Floridians without insurance. The state has had to step in, and this has created a special opportunity for HCII to work with the state to fill the void and increase policies. The process continues and although HCII revenue growth in 2012 is expected to grow 19.5%, the projected 2013 growth rate is 31.7%. Of course, a devastating catastrophe could change those numbers.
It is good to keep our perspective as we compare micro-caps with blue chips: the Allstate market capital is 230 times that of Homeowners Choice and AT &T is 1440 times the size of Telular. Obviously, there are facets that are completely incomparable between the big boys and WRLS and HCII. We hope that by sizing up their financial status with larger counterparts you have a better understanding of these two well-managed and high-yielding companies -- bringing them out of the shadows.
Disclosure: I am long HCII, WRLS.