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Micro-cap stocks are often cited as good investments due to their low valuations and potential to grow into large-cap stocks, though they can be risky investments, especially as many micro-caps do not have the same resources to survive during long-term declines in the economic cycle. However, don't forget, some the biggest technology companies of today, such as Microsoft (NASDAQ:MSFT) and Apple (NASDAQ:AAPL), started out as micro-cap stocks.

For my research, I will define a micro-cap as having a market cap between $50 million to $300 million. I have sought out five micro-cap technology stocks to see whether they will deliver solid investor returns in 2012. I have found three which I consider to be firm candidates for further investigation; Zix (ZIX), Guidewire Software (NYSE:GWRE) and Guidance Software (NASDAQ:GUID), and two, Document Security Systems (NYSEMKT:DSS) and Mitek (NASDAQ:MITK), which I believe are not. As always use my analysis as a starting point for conducting your own due diligence prior to investing.

Zix Corporation (NASDAQ:ZIXI)

Zix Corporation provides Internet based applications software that enables the use of secure email for sensitive information exchange primarily in the healthcare, financial services, insurance and government sectors in the U.S. The company has a market cap of $196 million and it has a 52 week price range of $2.16 to $4.21.

For the fourth quarter 2011 the company reported a 3.5% rise in revenue to $9.9 million, which was the fourth successive quarter where revenue has risen. For the same period it reported a 482% increase in net income to $15 million. The company saw a weaker balance sheet during this period with cash and cash equivalents falling by 6% to $20.7 million and long-term debt remaining steady at nil. These are exceptionally impressive financial results which bode well for future performance. However, disappointingly the company reported a 45% drop in its 2011 annual net income to $22.6 million.

Zix's fundamental valuation and growth indicators do not indicate that it will experience particularly strong growth as it has a forward PE of 14 and a PEG 0.83. However, the company has a solid return on equity of 188%, which when coupled with a high profit margin of 121%, bodes well for the company's future profitability.

In fact when we compare these indicators to some of the company's competitors we can see that on the basis of PEG, profit margin and return on equity, it is performing quite strongly in comparison to the larger companies in its industry.

Company

PEG

Profit Margin

ROE

ZIX

0.83

121%

188%

Adobe Systems (NASDAQ:ADBE)

1.61

15%

15%

Oracle Corporation (NYSE:ORCL)

0.44

25%

24%

However, fundamental indicators are not the be all and end all of deciding when to invest in a company, especially software companies. Much of the decision making process needs to be based upon the quality, uniqueness and execution of the product and/or service that is being developed and sold by the company. In this case Zix is offering a unique product that is in demand across both government and private sectors, which is the provision of secure email and encryption services that meet the needs of law offices, government agencies, healthcare providers and insurance companies, financial services industry and the SEC. This service is provided using the Software as a Service (SaaS) model.

A key consideration with regard to this service is that there are many other competing service providers for secure email including Cisco Systems (NASDAQ:CSCO), McAfee and Trend Micro. In addition, the barriers to entry in this industry are relatively low, patents notwithstanding, which may see an increase in future competition. Also due to Zix's relatively small size it could be subjected to larger industry participants squeezing margins in an attempt to seize greater market share.

My view is that Zix is well positioned to further translate this into future success and solid investor returns. Finally the company has an earnings yield of 21%, which is more than six times greater than the risk free rate of return. This indicates to me that at its current price the stock is substantially under-valued by the market. For all of these reasons Zix presents as a compelling investment opportunity.

Guidewire Software (GWRE)

Guidewire Software provides system software to the property and casualty insurance industry, primarily in the United States, Canada and Australia. Its solutions serve as transactional systems that enable key insurance functions including underwriting and policy administration, claims management and billing. The company has a market cap of $345 million and it has a 52-week price range of $16.45 to $25.05.

For the fourth quarter 2011 the company reported a 3% rise in revenue to $52.4 million and for the same period it reported a massive 132% increase in net income to $4.8 million. The company reported a weaker stronger balance sheet for this period with cash and cash equivalents dropping by 25% to $108 million, although long-term debt remained steady at nil. The company reported a solid financial result for 2011 with a net profit of $36 million, which is 129% greater than its 2010 net profit. This is also the fourth successive year where the company has increased its annual net profit.

Guidewire Software is the tech industries' first IPO of 2012 and the company's stock was priced at $13 per share for the IPO. On its first day of trading, January 25, 2012, Guidewire Software's stock price rose by 17% to close at $17.12. To determine whether Guidewire Software is a solid investment opportunity I will lift the hood and examine its fundamental indicators in greater detail. The company has an aggressive trailing PE of 28, which is not particularly appetizing, although it is supported by its ongoing increases in revenue and net income, as well as its quarterly revenue growth rate of 51%. The company is also effectively converting revenue to profit with a solid profit margin of 20%.

When we compare these indicators to some of Guidewire Software's competitors we can see that the company is delivering a solid profit margin that is superior to its competitors.

Company

PEG

Profit Margin

ROE

Guidewire

N/A

20%

N/A

Accenture (NYSE:ACN)

1.37

8%

71%

Computer Sciences Corp (NYSE:CSC)

13

-25%

-75%

The company has a debt to equity ratio of 1.23, which indicates that it is using debt rather than equity to fund its operations, although the company is not heavily leveraged. While my preference is for investing in companies with a debt to equity ratio of less than one, the company's needs to use debt as it expands is understandable.

Overall I quite like Guidewire Software and due to the unique and flexible nature of its software I believe it is well positioned to grow, especially when it is considered that the company's web based claim filing system ClaimCentre is one of the most widely used in the property and casualty insurance industry.

Customers include global insurers like Zurich (OTC:ZFSVY), Allianz (OTCQX:AZSEY) and AXA (CS.PH) In addition, Guidewire has established long-term contracts with many of its clients and these give the company a steady stream of renewable revenue. Another significant aspect that bodes well for the company's performance is that to date Guidewire has had a 100% renewal rate for its ClaimCentre software platform.

Finally the company has an earnings yield of 3.5%, which is marginally higher than the risk free rate of return of 10-year Treasuries. This indicates that at its current price the stock is marginally over-valued, although this doesn't take into account the consistent growth in earnings per share that the company has experienced. Despite the company's recent listing and lack of hard data I do believe that it presents as a unique and solid investment opportunity for 2012.

Document Security Systems Inc (DSS)

Document Security Systems develops, manufactures and markets paper and plastic products to protect information from unauthorized scanning, copying and digital imaging in the United States and internationally. The company has a market cap of $91 million and it has a 52 week price range of $1.86 to $5.13.

For the third quarter 2011 the company reported a 26% rise in revenue to $3.6 million, which was the third successive quarter where revenue has risen. For the same period it reported a massive 32% increase in net income to -$757,052. However, the company reported a weaker balance sheet during this period with cash and cash equivalents dropping by 29% to $1 million and long-term debt rising by 53% to $3 million.

Document Security Systems has a quarterly revenue growth rate of 15% and a profit margin of -29%, which in my opinion does not bode well for future net income growth. The company also has a return on equity of -74%, which also does not bode well for profitability.

In fact when we compare the company's performance and growth indicators to some of the company's competitors we can see that on the basis of quarterly revenue growth, profit margin and return on equity that they are outperforming Document Security Systems.

Company

PEG

Profit Margin

ROE

Document Security Systems

N/A

-29%

-74%

Checkpoint Systems Inc (NYSE:CKP)

1.63

4%

-7%

Top Image Systems Limited (NASDAQ:TISA)

N/A

4%

14%

I like the company's debt to equity ratio of 0.93, which indicates that it is reliant upon equity rather than debt to fund its operations. This is a big plus for a micro-cap company as these companies generally do not have the resources to cope with interest rate rises that lead to increased debt costs or to weather a prolonged economic downturn that would significantly affect revenues and the ability to meet debt repayments. This in my opinion bodes well for net income growth as the company is not overly exposed to the costs associated with debt, as well as the possibility of those costs rising if interest rates were to increase.

Overall, the company's fundamentals do not paint a positive picture of the company's intrinsic value and future performance. Despite this the company is building up an impressive track record for membership of industry forums and providing guidance within the document security industry to both government agencies and corporations. These include the company being invited to give recommendations on document security to the NYS Senate Committee Hearing on SAT Exam Fraud Security Solutions as well as its VP of Research and Development being appointed as the chairman of the Committee on U.S. Drivers License Counterfeiting.

However, of some concern is during my research I was unable to find any tangible assets held by the company of any real value or any products and services offered by the company that directly contributed to growing profitability. Overall the only assets which the company holds of any significant value is a growing portfolio of patents, which combined with the other frequent reports concerning involvement in various committees and industry leads to the term "patent troll" coming to mind.

Finally, the company has an earnings yield of -4%, which is substantially lower than the risk free rate of return of 10-year Treasuries. This indicates to me that at its current price the stock is substantially over-valued and does not incorporate an adequate risk premium over the risk free rate of return, justifying the risk of investing. Overall, this is one company that even from a cursory analysis raises too many red flags for comfort.

Guidance Software Inc (GUID)

Guidance Software provides digital investigative solutions to government agencies and corporations in the United States, Europe, the Middle East, Africa and Asia. It offers the EnCase platform for organizations to search, collect and analyze electronically stored information to address human resources matters, litigation matters, allegations of fraud, suspicious network endpoint activity, and to defend data assets. The company has a market cap of $273 million and it has a 52 week price range of $5.54 to $11.79.

For the fourth quarter 2011 the company reported a 9% rise in revenue to $29.9 million, which was the third successive quarter where revenue has risen. For the same period it reported a massive 341% increase in net income to $2.3 million. The company also saw a stronger balance sheet during this period with cash and cash equivalents rising by 40% to $37 million and long-term debt dropping by 14% to $55,000. These are exceptionally impressive financial results which bode well for future performance. The company also reported a solid result for 2011 reporting a net profit of -$1.7 million, which is 64% greater than its 2010 net profit. This is also the second successive year where the company has increased its annual net profit.

Guidance Software's fundamental valuation and growth indicators do not bode well for its future performance, as it has an aggressive forward PE of 25 combined with a horrendous PEG of 3.24. These figures also indicate that the company's earnings forecast are excessively aggressive. Guidance Software also has a poor return on equity of -7%, which when coupled with a low profit margin of -1.6%, both of which do not bode well for the company's future profitability. In fact when we compare these indicators to some of the company's competitors we can see that on the basis of PEG, profit margin and return on equity, it is being outperformed as the table below shows.

Company

PEG

Profit Margin

ROE

Guidance Software

3.24

-1.6%

-7.5%

American Software (NASDAQ:AMSWA)

0.39

11.7%

13%

DTS (NASDAQ:DTSI)

1.45

14%

12%

I also do not like the company's debt to equity ratio of 1.3, which indicates that it is reliant upon debt rather than equity to fund its operations. My preference when investing is to look for those companies that are predominantly reliant upon equity to fund their operations as this bodes well for income growth and stability and leaves the company less exposed to additional borrowing costs should interest rates rise.

However, fundamental indicators are not the be all and end all of deciding when to invest in a company, especially software companies. Despite not having strong fundamental indicators, the company for the fourth quarter 2011 beat market expectations for both revenue and earnings per share. In addition, when compared to fourth quarter 2010, revenue grew significantly and GAAP earnings per share increased. The company also reported increased margins across the board with a gross margin for the fourth quarter of 77.2% and an operating margin of 7.4%. Such strong financial results coupled with solid margins can only bode well for Guidance's future financial performance.

The company has an earnings yield of -0.63%, which is substantially lower than the risk free rate of return. This indicates to me that at its current price the stock is substantially over-valued and does not incorporate an adequate risk premium over the risk free rate of return to justify taking the risk of investing in the company.

Furthermore, Guidance is offering a unique product that is in demand across both government and private sectors throughout the world. In addition, the company is recognized as the global leader in digital investigative solutions and as the explosion in corporate data continues and both government agencies and corporations increasingly rely upon digital solutions for conducting investigations, forensic analysis and compliance and risk management, it can only bode well for future demand for the company's products and services. I believe that Guidance Software is well positioned to continue growing.

Mitek Systems (MITK)

Mitek develops, sells and services software solutions related to mobile imaging solutions and intelligent character recognition software. The company is currently trading at around $12, which gives it a market cap of $291 million and it has a 52 week price range of $3.31 to $13.11.

For the fourth quarter 2011 the company reported a 16% rise in revenues, which was the fifth successive quarter where revenues have risen. For the same period it reported a massive 111% rise in net income to $26k. The company also saw a stronger balance sheet during this period with cash and cash equivalents rising by 10% to $17.5 million and long-term debt remaining steady at nil. We can already see that the company has been performing strongly delivering solid fourth quarter results.

Mitek has a nose bleed forward PE of 32, and a horrendous PEG of 3.4, neither of which bode well for future earnings growth. It also indicates that company's earnings forecast are excessively aggressive and in the current subdued economic environment such aggressive forecasts can be difficult to achieve. If the company doesn't meet its forecasts then its stock price would obviously take a significant hit.

Mitek also has a mediocre return on equity of 7%, which when coupled with a low profit margin of 6%, indicates that the company is moderately positioned to convert revenues to profits. It also indicates management weakness, which in a micro-cap stock is of significant concern. While this is not particularly negative it does not bode well for a substantial growth in income to justify the nose bleed forward PE.

In fact, when we compare these indicators to some of the company's competitors we can see that on the basis of PEG, profit margin and return on equity, they are outperforming Mitek as the table below shows.

Company

PEG

Profit Margin

ROE

Mitek Systems

3.4

6%

7%

EMC Corporation (NYSE:EMC)

1.03

15%

13%

Intuit Inc (NASDAQ:INTU)

1.38

16%

26%

Furthermore, for such a heavily leveraged balance sheet I'd expect to see the company delivering a substantially higher return on equity, and the fact that it isn't is of significant concern. In addition, it is highly unlikely that a company of Mitek's size has the resources to cope with a significant increase in the cost of funding its debt nor the ability to sustain debt repayments for a prolonged period if it saw a substantial drop in revenues.

However, on a positive note a recent report from AlixPartners, "Consumer Market Outlook for Mobile Photo Bill Pay" forecasts that mobile photo bill pay adoption could reach 33% among adult U.S. consumers by 2018. If reached this would see 1.4 billion bills migrating to the mobile payment channel. This can only bode well for the growth in adoption of Mitek's mobile bill payment technology. However, I am somewhat skeptical on whether there will be a substantial uptake in this technology as current smart phones allow easy Internet access and the ability to pay bills using conventional internet payment methods or proprietary applications already in existence.

Finally the company has an earnings yield of 0.27%, which is substantially lower than the risk free rate of return of 10-year Treasuries. This indicates to me that at its current price the stock is over-valued and does not incorporate an adequate risk premium over the risk free rate of return, to justify taking the risk of investing in the company.

While the company is certainly delivering on the financial front with solid fourth quarter 2011 results and a solid improvement in its 2011 net profit, I am not convinced the company is a particularly good investment opportunity. This is primarily due to its poor earnings yield, subdued growth prospects and nose bleed forward PE. For those reasons and the fact that Mitek does not as yet have significant uptake of its OCR and mobile bill paying software would prefer to take a wait and see approach.

Source: 3 Micro-Cap Software Stocks To Consider, 2 To Avoid