How to Invest in Microcaps with Lumpy Revenue
Microcap companies can be prone to lumpy revenue performance, following a less linear growth trajectory which rivals an EKG chart. This is especially true if their end-markets have very strong sensitivity to customer cap-ex spending or if they have exposure to government-financed large-scale projects, which come and go.
Larger companies can better absorb pockets of market softness and “smooth-out" results via market and product diversification. So how to follow the bouncing ball and pick a good entry point or floor for these types of microcaps?
Evaluating microcaps with lumpy revenue requires a heightened scrutiny of valuation in an effort to arrive at an educated guess of a “margin of safety.” The sifting process involves dissecting the parts of the business and stripping out the fluff. Two microcap stocks we’ve recently launched coverage on are illustrative of this more detailed analysis.
The first company is Perma-Pipe International Holdings, Inc. PPIH. The company designs, engineers, and manufactures specialty piping and leak detections systems with applications in the oil, natural gas and district heating and cooling industries.
The company has always had a strong presence in the Middle East, and more than half of its revenue is outside the US. Recently the company was accepted into the Tawteen program in Qatar, whereby QatarEnergy plans to increase LNG production from 77 mtpa to 126 mtpa by 2026. The company is benefitting from additional energy infrastructure spending in Saudia Arabia, India and the UAE. The company’s backlog has consequently increased 78% YOY to $68.4 m.
“Tangible Book Value” is a good place to start for estimating a floor in price. This metric subtracts out subjective, “intangible” elements of the assets calculation like goodwill or intellectual property like patents, trademarks, etc. Importantly, this subtraction hedges against a company’s possible overpayment of a prior acquisition which can result in a “goodwill impairment” charge down the road and knock the valuation of the stock down a rung.
In the case of PPIH, its tangible book value per share is about $8/share. In “theory” this would be the liquidation value of the business, assuming the market price or liquidation values reasonably match what is carried on the books. The process should be simple: sell your assets, pay off debtors, and what is left is the value of the business, or the net assets.
But there is some devil in the details of these net assets. For example, market real estate prices could be higher or lower than what is carried on the books. And inventory and equipment market prices may not exactly match book value, so an implicit trust of auditors and internal accounting procedures is in play here. But we don’t sense examples of extreme obsolete equipment like coal-burning technology or gas-guzzling DC 10 planes.
Accounts Receivable is arguably the greatest risk factor, given that the company’s DSO’s (Days Sales Outstanding) run high at 140 days and have an international component. More risk-averse investors may want to factor this in. So, $8/share with a slight haircut for AR seems reasonable, in our opinion.
Effective and confident tangible book value evaluation also assumes the company is profitable going forward, as retained earnings factor into the calculation. If the company is consistently unprofitable, the corresponding growing liabilities will keep diminishing net assets.
The company has been profitable the last 3 years, and we assume it will continue to be for the foreseeable future. In the Covid calendar year 2020, the company lost ($.94)/share on sales of $84.7 m, which is 44% below the current annualized run rate. Sales would need to falter fairly dramatically for the retained earnings element of book value to be pressured and move the floor downwards.
The second company is a bit more complicated. Geospace Technologies Corp. GEOS manufactures seismic data acquisition equipment for the oil and gas industry, with a specialty in ocean bottom nodal surveying. The seismic segment is more than half of the business, but the company also manufactures industrial products like smart water meters, which is a more stable business.
The company’s marriage to the highly cap-ex sensitive world of oil and gas exploration results in revenue lumpiness due to commodity price risk. But the company is trading near tangible book value of about $10.29/share. Almost $4/share of this is cash earning attractive money market rates and contributing materially with interest income. The company has no debt.
Tangible assets also include unencumbered commercial real estate, mostly in the Houston area, which we believe is a solid real estate market. The company has twice successfully divested real estate over the past several years for healthy gains so the real estate number on the books is probably underestimated.
The company was unprofitable this past quarter ($.32)/share, due to lower fleet rental utilization. The company is prone to large, episodic equipment sales like what transpired in the December quarter. This resulted in substantial revenue in that quarter to the detriment of rental revenue that would have occurred in the March quarter-a pull-forward effect.
Management expects better fleet utilization over the next 6 months and has undergone a recent cost restructuring. The company is still very profitable over the last 6 months at $.62/share. Chartists out there will observe that the price has recently broken through a double-bottom and may conjure fears of a falling knife.
Our current Neutral rating is based on the preference for one more quarter of data and visibility into the cap-ex spending environment for the oil and gas space to gain better confidence that the company will remain profitable over the foreseeable future.
No valuation appraisal is fool-proof. Afterall, investors aren’t privy to the auditor and senior management meetings assessing possible asset write-downs. But an educated analysis of the big pieces of the assets bucket -- with readily available market pricing information -- can limit future asset write-down risk.
Lastly, be mindful of the trading volume around the tangible book value price. This can sometimes indicate what the market is thinking and if there might be some consensus about what the true floor is.
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Geospace Technologies Corporation (GEOS) : Free Stock Analysis Report
Perma-Pipe International Holdings, Inc. (PPIH): Free Stock Analysis Report
