When you think of a small cap stock you automatically associate risk with the investment. One of the first lessons we are taught when we begin investing is that more risk is associated with smaller companies and less risk is attached to a larger company. But what happens when a small cap stock is fundamentally larger than its market capitalization, and is valued incorrectly? Sometimes this occurs, and then the market struggles to appropriately value the company. The two companies I am looking at fall in this category and compare favorably to both of its larger counterparts. Each has traded with large gains in 2012 but is now presenting additional upside due to a large value advantage.
After a five year 65% loss, Overstock.com has gone on to trade with gains of 135% in the last year. The company reported earnings on January 24 and rose another 7.50% with revenue growth of 9% and a 170 basis point rise in gross margin, to 17.9%. This is a company that is seeing vast improvements, which is leading investors to buy its stock as quickly as possible. Investors had sold the stock over the previous five years due to Amazon's (NASDAQ:AMZN) rise, but it appears the market is large enough for more than just Amazon and eBay in the online retail space.
At this point with a market capitalization of $386 million, Overstock.com is a better value play than Amazon. Yes, the company is growing slower, but is trading at a price/sales of only 0.36 compared to Amazon's 2.16. Therefore, the stock is much cheaper compared to sales alone and has seen an impressive trend at improving its margins. Investors should explore the data on a retailgeeks.com blog, showing the difference in direction between Overstock.com's operating margins and that of Amazon's operating margins.In comparison, Amazon has achieved operating margins of 0.93% over the last 12 months while Overstock.com has recorded margins of 1.11%.
When you look at the margins of both companies you find that both are similar, but as shown in the retailgeeks.com blog, it's the trend that is concerning. Since Q1 2006 Amazon's operating margins have fallen from 6% while Overstock.com's have risen from (2.50%). This shows that Overstock.com is becoming more efficient while Amazon is losing its profit with growth. However, we must acknowledge that Amazon has made large investments and is sacrificing profits now to produce larger profits in later years. Yet I still consider this to be an issue, as many have suggested that as Amazon grows its fees for shipping, taxes, etc. will create larger costs. Furthermore, Amazon's return on assets of 1.58% compared to Overstock.com's 4.23% shows a clear difference in efficiency on behalf of management. Because of these factors, I believe that Overstock.com might be the better investment.
While I do believe that Overstock.com is the better investment, we must also explore the risks. Yes, the company is improving its margins and is becoming more efficient, but is growing by less than 10% year-over-year. In the internet company space this is very conservative growth. Investors must be careful and pay close attention to changes in interest among the general public. This is probably the most important thing for internet based companies, having to remain "cool" or interesting to drawl in the consumer/user. At this point, Overstock.com is growing, but slower than I'd like to see, and an investment would be based on value and efficiency compared to the industry, and not necessarily rapid growth.
Both Amazon and Overstock.com have similar business models, therefore it's hard to deny that Overstock.com is fundamentally cheaper. The company has better margins, better returns on assets, and is valued cheaper compared to its fundamentals. With all things considered, I don't think Amazon is a bad company, and it's growing significantly faster than Overstock.com. But with Overstock.com now showing growth, improved margins, and efficiency, it's likely that the market will begin to value it correctly after years of it being pushed down in favor of Amazon. To put this in perspective, if Overstock.com's industry-low price/sales ratio was to reflect that of Amazon's then Overstock would be worth $2.2 billion, or $93 per share. It won't happen overnight, but is possible nonetheless.
Big 5 Sporting Goods Corporation (NASDAQ:BGFV)
With a P/E ratio of 27.80 there are many who are starting to believe that Big 5 Sporting Goods is getting expensive. The stock has increased over 75% during the last year as a result of margin improvements. This is a company with sales of almost $1 billion and growth in the mid-single digits. However, the company has had problems in the past maintaining its margins, currently with operating margins of just 2.21% in the last 12 months.
Big 5 is valued at $300 million, more than 4.5 times less than Hibbett Sports (NASDAQ:HIBB). The problem is that Big 5 is the larger company, by almost $200 million in annual revenue. However, Hibbett Sports has managed to maintain operating margins over 10%, currently 13.91%, therefore is awarded the higher valuation. The reason I believe that Big 5 is presenting further upside in this current year is because it's growing at the same rate as Hibbett and is now finally showing progress at improving its margins.
If in fact, Hibbett Sports has been awarded the higher valuation because of margin improvements then if Big 5 continues to grow its margins then it would make sense that we'd see continued returns in its stock. In 2012 Big 5 saw a five year worse in profit margins, with 1.3%, but saw a boost in November due to a sudden rise in long-term margin guidance. For the recent quarter, it improved its profit margin to 3.24%, which is a reflection of other fundamental improvements that we've seen during the recent year.
While Big 5 is just now showing progress at improving its profit margin, the company has made other strides in 2012. In the first nine months of 2012 the company reported operating cash flow of $28.5 million compared to just $2.22 million in the year prior. In previous years, the company had earned positive cash flow from other financing and investing activities; however operating margin is the true measure of efficiency.
If the company can continue to improve in margins, cash-flow, and become more efficient then it could easily grow in market capitalization, by a significant degree. Compared to Hibbett Sports, Big 5 still has a lot of work ahead of it. Hibbett Sports has profit margins of 8.72%, return on assets of 20.68%, and operating cash flow of more than $80 million. Overall, Hibbett is a great company that is efficiently managed, yet is valued according to fundamentals.
For those interested in investing in Big 5 I think the risks are obvious based on this article. The company has seen an increase in value due to margin strength, therefore it must maintain these higher margins. Furthermore, the company must continue to improve its cash flow, or correct the issues with cash from financing and investments. If the company can maintain or continue to grow margins from the last quarter, and operate efficiently in all phases of cash flow, then it will have no problem trading higher. However, these potential catalysts are also potential risks that must be monitored.
Big 5's profit margin of just over 1% and its return on assets of 3.17% doesn't even come close to that of Hibbett. However, Big 5 has reported almost exactly half as much operating cash flow, and if it can improve on its other areas of cash flow then it could become highly profitable. Right now, we are already seeing mass improvements in the business of Big 5, while margins and returns on assets and equity appear tapped for Hibbett Sports. Hence, with similar revenue growth, Big 5 showing the operational improvements, and being the cheaper stock, I believe it's the stock to own and presents the best upside potential.
Compared to the rest of the market these two companies appear greatly undervalued. Now granted there has been numerous reasons for why each is undervalued, whether it be years of underperformance or being mismanaged. Regardless of the reason, this fact is now creating gains for investors, as each company makes progress in its operational approach. And because these companies were so undervalued, each could now continue to grow if in fact the improvements continue. After looking at each company, and being familiar with each stock, I expect 2013 to be a great year for investors of these two companies.
Disclosure: I am long CBK, OSTK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: All fundamental data such as operating margins, returns on assets, etc. was obtained from Yahoo! Finance