Alex Jantsch's  Instablog

     If you were looking for a small cap stock with the potential for outsized returns, then I believe that looking into DXP Enterprises might be worth your while. DXP Enterprises is an industrial wholesale company that specializes in maintenance, repair, operating, and production services (MROP), Innovative Pumping Solutions, and Precision Supply Chain Services. The company serves a wide array of industries which include general manufacturing, oil and gas, petrochemical, service and repair, wood products, mining, construction, chemical, municipal, food and beverage, agriculture, and pulp and paper industries. This diversity allows the company to hopefully hedge against downturns by spreading its end markets around to different industries as well as provides greater expansion opportunities.

     Now the numbers that arise from looking into this company’s annual reports aren’t really risk free type of numbers, especially not for a small cap business, but the potential is there and very noticeable. The company is one of the leading providers to the industrial sector for its main end markets mentioned above. This gives them the name recognition they need to survive in an economic downturn such as this one. With a 17-19% ROE, a $10 book value, 47% insider ownership, only 50% institutional ownership, current ratio of 2.2, EPS of 1.72, and a P/E of 5 (near the company’s all-time low), this company seems to be the type of company that is just about ready to make the jump to bigger revenues. The management team is making or contemplating acquisitions that will expand their customer base as well as their product offerings. Acquisitions can be a plague, but when the acquisitions fit well with the company’s main end markets it can be a true blessing. The last acquisition they had in 2007 almost doubled their sales with little focus lost on their main area of expertise. This makes the fact that their stock price has lost 66% of its value in the last year seem irrational and not a good interpretation of how well the business has been doing. To put that into perspective, within the last year DXP Enterprises has received a ranking of #16 out of the top 50 industrial suppliers as well as named the #2 best small business in the country by Forbes. Now we all know that these titles really mean little unless there is visible performance to back it up, and I believe they have outperformed all the expectations I had for them since I started following them a year ago. This feat does not justify losing 66% of their securities value.

     One thing to take note of is that small cap stocks are riskier than larger cap stocks because the smallest disruption in their business model and they could be in serious trouble. Many smaller companies in the current economic climate are having trouble with their debt load, which in turn has hurt their focus on their primary business. This is where I see one of the only negative statistics, which happens to be that DXP Enterprises has $140 million in debt (vs. $128 million market cap). This would easily alarm a lot of investors and keep them from looking into the company further, but in certain situations, such as small cap growth companies, an expanding debt load is somewhat necessary if they are intending to grow above the average. When I looked at their rising debt load I realized that their acquisitions are what are pushing their debt load higher in almost all cases. Their last major acquisition in 2007 of Precision Industries almost doubled their sales, which could easily more than justify the money spent on the company because of their increases in market share and worldwide influence. The easiest way to make your company’s name an industrial mainstay is to grow your influence by acquisition, but you have to be very careful about how you do so. The fact that the management team has almost a 50% stake in the company should vouch for their actions as responsible, for they stand to lose just as much as, if not more, than their shareholders if an acquisition ruins their company’s original business model.

     One of the facts that really made me open my eyes to look into DXP Enterprises is the fact that the largest private company and the largest public company in the United States (Koch Industries and Exxon Mobil) are two of major customers of DXP Enterprises products and solutions. Companies as big as those two aren’t going to purchase business solutions and industrial wholesale parts if they aren’t wholly satisfied with the business they are buying from. They have the power to negotiate prices with any industrial supplier so they can shop their business around until they are satisfied, just like Wal-mart does in retail. Other major customers of DXP Enterprises are Coca-Cola, ConAgra Foods, Union Pacific, Hormel, Goodyear, Bayer, Dow Chemical, Chevron Phillips, Huntsman, Shell Gas, and Hersey’s.

Bottom Line

     DXP Enterprises supplies industrial wholesale supplies and solutions to some of the biggest companies in the world. Their growth strategy includes organic growth, operations, and acquisitions, all of which have been major factors in the company increasing its revenue by 37.3% CAGR (compound annual growth rate) since 2003. Their EPS has increased 55.2% CAGR since 2003 and shows no signs of stopping. DXP Enterprises is the only provider of pumps, bearings, power transmission, hose, safety equipment, and industrial supplies on a first tier basis, which means they are the only provider of the complete components mentioned above. This is a significant advantage to attracting new business because everyone loves a one-stop shop. Their management has the right idea in trying to grow the business on a three-tiered basis and due to their insider ownership their intentions should be well aligned with those of the shareholders. If their strategy works then they should outperform the market and most other securities over the next 2 to 4 years.

Disclaimer: I am a previous owner before selling off in the middle of 2008 and before the end of the year I will be a shareholder yet again if all goes well.

To preface this article, I would have to state that the software side of the health care industry is a young industry with good industry economics. The idea that the Obama health care plan will push for more and more hospitals to become more efficient through use of IT products, that companies like Cerner offer, is a great advertisement for investors to find companies in this industry who excel above the rest. Finding a company in this industry with the sound financials and management to take advantage of the opportunity Obama has handed out on a silver platter could possibly be the investment many people have been waiting for. Personally, I think I have found that company, but my initial regret is that I could have figured it out earlier when the margin of safety was larger.

The following are some of the strong and weak points of my argument. My interpretation of intrinsic value and the overall valuation of the company extends much further than this article, yet this pitch is merely meant to show you the prospect for substantial return from a great company and what might possibly limit that return. The rest of the interpretations and valuations that make or break your decision are up to you to conclude not someone you don’t know, because that’s the way it should be.

Strong: 
•   Avg. Earnings Growth per share (5 yrs.) = 27.4%
•   2008 Revenue = 1.68 Billion
•   Contract Backlog = 3.49 Billion (up 7% from 2007)
•   26% increase in global operations
•   37% decrease in long term debt from 2007
•   3.08 Cash to Debt ratio
•   Consistent Increase of Retained Earnings (up 28% from last year)
•   15% insider ownership
•   Avg. 19 year tenure between top 10 directors and officers (Including the 3 founders (Chairman/CEO, Vice Chairman, and Senior VP))
•   Recent $45 million stock repurchase program enacted
•    Huge prospect for foreign growth (language expansion especially)
•   Huge prospect for domestic growth based on stimulus
•   Current Hospital Client Footprint: 1,700 hospitals (only 29% of U.S. hospitals)
•   No cash dividend

Weak:
•   Has not proven itself in many foreign markets
•   Price trading at more than 20 times earnings (only worthwhile long term investment if the company grows at least at the current rate or close to it for a number of years, which is more than possible)
•   No cash dividend

The strong points tend to speak to Cerner’s clean bill of financial health as well as their continued strong growth and opportunity for growth. While the weak points stand to ask questions about how poised is Cerner to take advantage of the incredible business opportunity the Obama stimulus plan is giving it as well as whether or not they can thrive in new markets, especially the global market. Cerner is a very well managed company with the long-term interests of all of the executives and officers aligned with the shareholders, many of whom have worked together for almost 2 decades and have substantial personal and monetary investments in the company themselves. 

The thing that I find fascinating about this opportunity is that even without the potential growth in contracts due to the stimulus and foreign markets, Cerner already has almost 3.5 billion contracted in their backlog. That’s more than 2 times what their entire 2008 revenue came in at. Now we look at future contracts and the opportunity for growth in foreign markets based on language diversification alone, not to mention the growth in new areas of business. Cerner’s newest software is only produced in 4 languages, which means broadening diversity in language application could stand to substantially increase Cerner’s primary end market, their so called bread and butter, without much spent on research and development. In a business where substantial initial R&D costs are normal to gain substantial long term returns, not having to do much to make a lot of money is a dream come true. When it comes to cash dividends, if Cerner is going to grow at the same rate it has, then it will need to reinvest everything back into the company, but if Cerner doesn’t grow at the same rate then no dividend leaves you with a much smaller yield for your investment. That is why it is under both strong and weak points for Cerner.

Bottom Line:
Cerner has a clean financial bill of health, good growth prospects, and a management team that is well aligned with the interests of the shareholders. If Cerner takes advantage of the Obama health care stimulus and continues to try and grow all aspects of their end markets at the same rate which they are currently growing, I think Cerner stands to make a phenomenal return on invested capital. This return will definitely be much to the shareholder's delight in the years to come. If Cerner does not place itself in the right place to take advantage of what is blatantly placed right in front of them then they do not stand to grow much because the competitiveness and future attractiveness of the industry will consume its growth rate and eat at its end markets. This will make the current price of $65 look a little on the expensive side and not really worth the investment, especially with no cash dividend anywhere in the foreseeable future. The government has allocated $19 billion towards health IT systems over the next 5 years and Cerner is the leading company in that industry. The only thing Cerner has no control over is whether or not they have the opportunity to be the company I am writing about, actually being that company is up to them.

Disclosure: No positions currently in Cerner

     There isn't much doubt, from my perspective, that Garmin is an undervalued stock. It is trading at only 7x its earnings, which is near the company's historic lows. This alone says nothing, but combined with no debt, a 28% ROE, $11 book value, an astounding 43% insider ownership, only 23% institutional ownership, $4.6 in cash per share, and a current ratio of 6, this stock looks considerably cheap. 



     Now whether or not this stock is a long-term opportunity is speculative as to whether they can hold off the rest of its competitors in all of Garmin's end markets. With a ROE of almost 30%, the returns that Garmin currently generates will probably be eaten away by an increase in competition in the GPS/Personal Navigation industry. The GPS industry looks like it will soon undergo a change from a specialty product to a near commodity with it becoming more common, and this change might take many years, but as far as I’m concerned that’s where I'm looking if I am going to value Garmin as a business. I see Garmin as the best placed company to grab a hold of the reins in this Industry looking to the future for many reasons, most of which are outlined below.

Reasons for Garmin's outperformance:

• Only GPS/Personal Navigation company that leads the market in almost all the sectors it participates in (hiking, fishing, marine, aviation, personal, etc.). Brand recognition combined with continuous quality driven innovation could easily keep Garmin on top.

• Most Garmin competitors specialize in only one or two of Garmin’s end markets whereas Garmin is present in almost all of their competitors markets and then some (Navico = fishing, hiking, hunting; TomTom = Personal and Automotive GPS) 

• Management has almost a 50% stake in the company (they want to see Garmin do well probably more than I do)



• Expansion outside the traditional GPS market (The Nuvi Phone could provide another extremely profitable end market for Garmin, but they need to iron out the kinks and release it before it becomes the “much talked about but never released” cross industry expansion that Garmin could use to solidify its position on top)



• Large amount of cash and no debt will allow Garmin to plow tons of money into R&D for future products, a task most other GPS/Personal Navigation companies cannot do because they do not have the cash hoard that Garmin does.

• The large cash hoard also allows management to buy back stock at the currently depressed price of the company (approximately $300,000 worth, most of which is still to come). With a 50% stake in the company already, buying back the company’s shares increases managements stake in the company as well as everyone else’s. This will align them more in the same mindset as the investors who buy their securities, which is consistently increased value.

• In a difficult economic landscape Garmin is systematically reducing its inventory to help cost cut by relying more on existing inventory rather than manufacturing more finished inventory. This allows the company to employ the cash elsewhere, such as buying back common stock.

Bottom Line:

     Garmin as of right now looks cheap in accordance with its current valuation, which I believe should be closer to $45 or $50. This is mainly because the stock took a severe hit, like a lot of companies did, with this current economic turmoil. The risk with this stock below 45 or 50 dollars looks to be very minimal in my eyes, but beyond that lies strictly with how well Garmin can defend its market leader position in GPS/Personal Navigation as well as extend beyond that as they are currently trying to.

     The main roadblock I see to Garmin being seen as a severely undervalued stock are the problems and lawsuits that surround the patents they use and the patents used by their competitors. There seems to always be some disagreement between companies in this industry as to whose patent stands for certain products. Since patents in GPS devices are mainly on the software and features of the products, there is a large possibility of one feature being similar enough to another that a lawsuit ensues, many of which never materialize and end up in a relative stalemate (at least on Garmin’s part). Most of the lawsuits seem to not have a major effect on how well the company can run the business, besides making them pay for litigation, so the current rundown from their peak price in the last quarter of 2007 seems to me to be illogical and not an accurate representation of the value of the business.

     The current risk is minimal at $23 dollars a share for the market leader in a changing industry, and the opportunity for even greater than expected return is evident, but not guaranteed (as nothing is guaranteed in the stock market, especially not tech stocks due to the obsolescence factor). If Garmin takes the reins as it should, the market will eventually recognize their industry prowess and price the stock accordingly, which could be well into the 100’s within the many years to come, but all else aside this stock should be currently valued at closer to $50.

Disclosure

     I do not currently own any Garmin stock, but within the next month or two I will most likely be a Garmin shareholder. As with any stock decision I make, I carefully analyze every aspect of the decision I’m about to make because I stand by the value investing principle of preservation of capital (To quote Buffett, “Rule #1: don’t lose money, Rule #2: never forget Rule #1”). To be able to do that, I need to look at the numbers from every viewpoint and within every scenario (kind of like cubism uses multiple views of objects to obtain a multidimensional picture). Value Investing is an art, and with few exceptions good art takes a immense dedication of time to develop the idea before painting the picture.