Solid Risk/Reward Found Among Israeli Small Cap Stocks

As the second quarter has come to a close, it's fun to look back and see where the market's biggest gains occurred. In the second quarter of 2013, Tesla Motors, Inc. (TSLA) was the standout large cap stock, rising 183% during the quarter. One other large cap stock made my list of 100% gainers during the quarter -- Fannie Mae (OTCQB:FNMA) advanced 104% to $1.41 and sports an equity market capitalization of $8.1 billion, as investors consider the firm's value amidst the ongoing housing and mortgage recovery. The rest of my list consists of stocks that started the quarter as small cap stocks, with market capitalizations under $2 billion. Congratulations if you managed to hold Q2 winners such as YRC Worldwide Inc. (YRCW), up 281% for the quarter, Canadian Solar (CSIQ), up 217%, or Clovis Oncology (CLVS) which advanced 134% during the second quarter. (Source: Yahoo Finance)

Unfortunately, I don't own any of the above-referenced second quarter winners. Broadly speaking, I don't have the risk-tolerance required for these types of securities. FNMA, YRCW, and CSIQ all have leveraged balance sheets, while TSLA and CLVS are both discounting significant future growth and long-term profitability in their businesses. I would be just as happy as the next investor to see a monster move in any one of my holdings, but I'm more comfortable trying to find stocks with strong downside protection and possible catalysts that will drive financial performance and higher stock valuations. I've highlighted two such ideas in recent articles (UFPT) and (RWC), and I also think there are a few compelling small cap stocks based in Israel that meet these criteria.

G. Willi Food: Very Little Downside and Significant Upside

First up is G. Willi-Food International Ltd. (WILC), a distributor of kosher food mostly in Israel, but also in Europe and the United States. Admittedly, WILC has been reviewed favorably by Seeking Alpha contributors for the past seven years, starting at a point when the stock also sold for six dollars and change. After a recent phone conversation with the Chairman, Zwi Williger, I too, have become convinced that the company (and its stock price) is on the verge of a breakout.

At the end of the first quarter, WILC had current assets of $89.5 million and total liabilities of only $7.5 million. Book value is $7.23 per share compared to today's stock price of $6.86. At the same time, the company has embarked on a campaign to boost revenue growth and improve margins. First quarter revenue advanced 23% y/y, while gross margins improved to 23.6% from 21.3% in the year ago period. EPS came in at $0.18 vs. $0.10 in the 2012Q1.

During the most recent earnings call, the Chairman indicated that Q2 revenue growth could be in the 25-30% range, with an expectation that gross margins can exceed 25% for the year. I estimate earnings could approach $1.00 per share in 2013. WILC also has significant opportunities to expand its business in the multi-billion dollar U.S. market for kosher food. With any significant success in expanding in the U.S., WILC could see a dramatic increase in how it is currently being valued. Liquidity is quite low, and the insiders own more than 60% of the company, but I don't see how today's extreme low valuation will persist if the company continues to execute like it has in the most recent quarters.

images

Nova Measuring Instruments: Semi-Cap Equipment Leverage

Nova Measuring Instruments Ltd (NVMI) is a well-positioned metrology solution provider to the world's leading semiconductor foundries and memory manufacturers. I have been an investor in NVMI since December, 2011. I am up on my initial investment but clearly was early in my efforts to catch a big price move up. Ongoing investments in R&D have helped NVMI grow faster than its peers, but the spending has depressed earnings relative to my expectations. However, the secular winds towards smaller node technology (moving from 28 nm (i.e. nanometers) to 20 nm and smaller) continue, and NVMI is well positioned to see its addressable market grow.

Management has said that its market opportunity more than doubled from 2009 to 2011 as the standard node of production went from 65 nm and smaller in 2009 to 45 nm and smaller in 2011. Management has also indicated that the move from leading edge 28 nm production to 20 nm production will further expand the "capital intensity" by a significant amount. NVMI competes against several players in the chip equipment industry, notably Nanometrics (NANO), KLA-Tencor Corp. (KLAC), and Rudolph Technologies (RTEC).

However, NVMI has solid relationships with many of the world's leading foundries and memory customers. Leading edge producer Taiwan Semiconductor (TSM) is a close partner of Nova's and contributed 41% of NNVMI's revenue in 2012. Recent reports suggest the semiconductor capital spending outlook will be better as we move through the next couple of years, and I expect NVMI will continue to be well positioned to participate in the growth. NVMI has a market capitalization of $247 million but carries a net cash balance of over $90 million ($3.45/share). The stock has sold off during the past two weeks following the unexpected decision by President & CEO Gabi Seligsohn to step down at the end of July.

I spoke to the CFO on the day of the announcement, and he indicated to me that it was strictly a personal decision by Mr. Segligsohn, and that he is optimistic that the incoming President & CEO, Eitan Oppenhaim, (current EVP of the Global Business Group), will be well received by the investment community and customers of the company. At about 12x consensus 2014 EPS, with almost 40% of the firm's value in cash, NVMI appears to be a solid value, particularly in light of the improved outlook for industry spending in the coming quarters.

Silicom: Participating in Several Big Growth Trends

Silicom Ltd. (SILC) is a leading provider of high-end server networking cards. Demand for networking cards is driven by the continued expansion of internet traffic, as well the growth in cloud computing, virtualization, and the ongoing growth in "Big Data". While a small company with 2012 revenue of less than $50 million, SILC has gathered more than 90 OEM customers, including most industry leaders who provide network appliances for WAN Optimization, Internet Security, Application Delivery, and Network Monitoring. Revenue growth has accelerated to around 50% in each of the past two quarters, and management has been rather bullish in its recent commentary. Following 2012Q4 results, SILC CEO Shaike Orbach stated

With no end in sight to the growth of this demand, and with continued strong loyalty from our 90+ OEM customers throughout the world, we believe we are positioned to continue growing strongly in the years ahead.

[...]

As our strong momentum continues, we feel more empowered than ever to continue building Silicom to a whole new level. With a superb and growing product portfolio, an unmatched customer platform, a sterling reputation and virtually endless markets, we are positioned to deliver on our promises and to continue generating strong growth, profits and value for our shareholders in the years ahead.

Following the 2013Q1 results (49% revenue growth), management was equally as upbeat, with the CEO stating

We believe that we will be able to compound this accelerated growth in the future - both through the continued success and expansion of our existing businesses, and through new growth engines, as demonstrated by the announcements made during the past several months.

SILC has outlined a "mid-term" goal of doubling the current business to an annual revenue rate of $100 million per year. The financial results continue to show the operating leverage in the business, with net profit margins rising from 13.7% in the challenging environment of 2009 to 20.3% in 2012. In January of this year, SILC announced a plan to distribute annual dividends at a rate up to 50% of its annual distributable profits. While non-Israeli based investors are subject to additional withholding taxes on dividends, I applaud the company's efforts to return excess cash to shareholders.

Looking ahead, a single sell-side estimate is looking for an average 45% revenue growth in the next two quarters to be reported, before dropping to 8% revenue growth in the fourth quarter of this year. (Source: Yahoo Finance). If revenue growth were to average 45% for the balance of the year, and net profit margins averaged 21% for the year, GAAP EPS could be north of $2.00 in 2013 if the shares outstanding rose to 7.3 million given stock compensation expense. SILC has $7.93 in cash per share, so the stock could be selling for about 13x 2013 GAAP earnings after backing out the excess cash.

In summary, in my efforts to screen for small cap companies with the most attractive balance sheets, valuations, and catalysts for higher valuations, I have found a disproportionate number of companies based in Israel. I understand the currency risk of investing in companies with various blends of revenue and costs in US dollars and Israeli shekels, as well as the risks of the political environment in Israel, but I find these three stocks to be very attractive vs. many other small cap stocks I analyze. Each has a rock solid balance sheet with a very substantial percentage of net cash per share. Each has a strong competitive position and is growing faster than their peers, and each stock is selling at an attractive valuation. I am long each of the names and am looking forward to seeing their progress in the second half of this year.

Disclosure: I am long WILC, NVMI, SILC. 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.