Boring But Beautiful: Small And Microcap Review

Nov. 01, 2019 2:30 PM ETGoGold Resources Inc. (GLGDF), MCHX, NGVC, IEHC, GGD:CA6 Comments
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  • In this review, we look at a number of small companies who are performing in under-covered industries.
  • We also look at a company who is transitioning from low to high margin product lines.
  • Finally, we look at a small cap gold/silver producer with a potential blue sky catalyst to re-rating the company.

Normally exclusive for Seeking Alpha PRO+ subscribers, the Small And Microcap Review compiles, evaluates, and puts in context recent analysis on small and under-covered companies. We are making this week's edition available to all readers. To find out more about PRO+, please click here.

By Dan Stringer

One subset of small and microcap companies consists of true operating companies that are generating revenues and/or cashflow. The opportunity usually comes from the fact that these companies have simply not yet gotten on analysts' or institutional investors' radars. Often these companies do not need to raise money on a regular basis, so there is no incentive for institutions to provide coverage. Sometimes these companies are overlooked because their businesses are not headline-grabbing or glamorous.

Going back in time, early in 2015 I highlighted Photon Control Inc. (OTCPK:POCEF) after the company had posted nice growth and grown a very sizable cash balance to offer a margin of safety. Photon's business is designing, developing and distributing various optical sensors to several different industries. The company was posting ever increasing revenues and margins while retaining its cash flow, but the market hadn't discovered it yet. The company was trading at an EV to Earnings of just over 6x with its EV to EBITDA well below that. This was similar to private company multiples because the company was small, under-covered (it is Canadian-listed and headquartered) and in a relatively boring industry. As the company continued to execute, the market began to revalue the stock and recognize that these products were part of the Internet of Things megatrend.

ChartData by YCharts

It clearly took some time, but eventually the business gained appreciation from investors with shares up 300% from that point. The subsequent sell-off took place after the company became more dependent on the very cyclical semi-conductor industry after a couple of management team changes. This week I am highlighting several opportunities in operating companies that have similar potential to re-rate with strong underlying businesses.

IEH Corporation: Undervalued Microcap With Strong FCF Generation

Author Jim Zimmerman highlights OTC:IEHC, a small cap manufacturer of specialized printed circuit board connectors and interconnects. The company has been in business for 78 years and has only one major competitor, making it a very sticky business. The valuation is very low at just 6.5x EV/EBITDA which gives a lot of potential for the company to re-rate.

The company is unique in that it has just 2.4m shares outstanding, which is why its share price is optically high ($22+) but its market cap is just about $50m. This makes it somewhat illiquid with a very small float of shares outstanding. The Offerman family owns 40% of the shares, making them a very invested owner. The company did a small special dividend last year of $0.25 but based on the author's view there seems to be a lot of potential to increase this. I could see this continuing as a means of compensating shareholders, though likely not as a regular dividend. The company's customer list is very strong. It is hard to find companies like this, so I could see a re-rating occurring, especially if the company makes a move with its cash balance, either via acquisition or in increasing its shareholder yield. Investors should watch what the company does with its cash balance, especially if it continues to post strong earnings and cash generation.

Marchex Shows Signs Of Life

Marchex (NASDAQ:MCHX) is nowhere near as clean an opportunity as IEHC is. The company is in the process of transitioning between a legacy search analytics business it is running off and transitioning to its higher growth call analytics business, which it has augmented with two recent acquisitions. Author Shareholders Unite posits that although its earnings metrics may not be there yet, the company is generating positive cash flow and its margins are steadily increasing, reflecting a good takeup by the business. This is difficult to determine when looking at the results on the surface, as the two businesses largely offset each other, which has been the case at MCHX.

I tend to agree with the author that the company is likely through the worst of its operations, having incurred integration costs with the acquisitions as well as handling the spool up of its new business. Shares have been in a strong downtrend though, and I would like to see some stabilization there. The market is likely looking for positive earnings to go with the increased sales levels. Many companies are now getting punished if sales growth is not bringing the commensurate profit growth that should come with scaled up operations. In my opinion, it is a little early to get involved but is worth monitoring as the company could easily return to substantial profitability without the market realizing it yet due to its recent lagging performance. Small caps can be punished for longer due to the lack of coverage and public analysis available.

GoGold Offers Plenty Of Upside Based On My Updated Valuation

Mining stocks are certainly an acquired taste for many investors. I like the space as it gives a lot of potential for asymmetric upside returns, from exploration to development to production. GoGold (OTCQX:GLGDF) is substantially less risky than most as it has a profitable producing mine at Parral that, combined with the cash the company has on its books, appears to have value in excess of the current market capitalization.

I agree with the author that this margin of safety separates GoGold from most other miners. They recently acquired an additional property Los Ricos that has historical gold findings that will help guide the company's exploration. With good finances, GoGold should be able to avoid a lot of dilution as it can fund its exploration through its operating business. These drill results can be potential catalysts to re-rate the Los Ricos portion of the business, while GoGold can also potentially re-rate if gold and silver prices continue their uptrend. I like that GoGold gives a lot of downside protection given its cash flow, which could improve results as well. Investors do need to watch the cost per ounce metric; if these start to creep up, either through inflation or operational issues, it could impact the base performance level. Like most small and microcaps, earnings will be the focus in the near term as it will take some time for the Los Ricos drill program to start generating results.

Natural Grocers: An Undervalued And Overlooked Player In The Organic Food Market

Author Andriy Blokhin gives a very detailed breakdown of Natural Grocers (NYSE:NGVC) in this Top Idea. It is positioned in the growing organic food market, which is only gathering steam as people's eating habits get healthier. The company has been rapidly expanding its footprint but has been slowing the pace in recent years. Blokhin is correct in that much of the cost of expansion has already been reflected in the company's business (like with Marchex), so reducing the pace of expansion should lead to improving operating results, which appear to have borne out in recent years. The company trades at a cheaper valuation than that of its other competitors but if it can improve its margins with fewer growth initiatives, it could end up being a real bargain.

I tend to agree with the author here; the due diligence supporting his case is very thorough and doesn't rely on the acquisition potential as a prime driver. Management seems to be really on the ball with how it is managing the company and if it can improve the operations even more, there is a potential that earnings could propel a re-rating of the company to be in line with its peers. It will be worth watching company margins, which should improve with less ramp up costs; if these don't improve, it could be a concern for investors hoping to benefit from an earnings bump combined with a multiple expansion.

All these companies are focused on improving their operations, in industries that are largely not "buzz-worthy." Their focus on improving the core business, rather than growing sales or expanding for the sake of it, will help to stabilize and improve their earnings profile. In the small cap space, eventually investors reward this behavior, though it can take time.

Please give these authors a follow and if you have any comments for me, please don't hesitate to leave them here or send me a DM. Thank you for reading!

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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in IEHC over the next 72 hours. 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.

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