Saturday, September 22, 2012

5 Great Growth Stocks

Despite some good moves lately I think this market still hates technology stocks. In a sense I can understand why; if we are headed towards a global slowdown then a cyclical sector like enterprise technology will surely get hit disproportionately. Nevertheless, investing is about balancing risk and reward. It is all very well loading up your portfolio with a collection of defensive stocks on high teens PE ratios but a balanced approach should include some growth kickers and right now some of these stocks are looking like good value. I want to discuss a few of them and also highlight a way to avoid a familiar evaluation pitfall.

Quite frequently with technology stocks, investors take a quick look at the PE and conclude that they look expensive so why bother investigate any further? For example, few could avoid wincing when taking a cursory look at the PE ratios on these stocks.

See what I mean?

However, I think that the PE ratio isn’t really the way to best judge these companies and the next time you come across someone who glibly argues to short one of these stocks based on the PE ratio alone you can send them a link to this article. There is more to investing than the PE ratio!


Equinix Stock Analysis

I’m going to separate data center service provider Equinix $EQIX from the rest because it has a different business model. What you are looking for here is the underlying cash flow generation at the company. Equinix builds out data centers and then it typically takes around four years to reach full capacity. Customers tend to be very sticky and much of the expansion in capacity utilization at a data center can be expected to come from existing customers.

I’ve discussed this issue at more length in an article linked here. The key metric to understand here is something called ‘discretionary cash flow’ which Equinix defines as ‘cash generated from operating activities less ongoing capex.’ In other words, this is the underlying cash flow generation if Equinix weren’t expanding capacity. For 2012 the company is forecasting $520-540 million, which roughly equates to 6% of its market cap or 5% of its enterprise value. For a company growing sales in the mid teens that is not expensive, however investors will want to keep an eye on gross margins. Any slippage will be an indication of over capacity in the industry and that could be the beginning of a problem


Cash Flow is King in Technology Stocks Too

Ever get bored of hearing how great Procter & Gamble $PG or Coca-Cola’s cash flow is? For some reason value investors usually like to focus on these sorts of companies when they discuss this metric, but why not with technology companies too? The usual counter argument is the idea of the factor of safety enhancing moat. However, consider that Riverbed Technology $RVBD has 50% of the market for WAN optimization and Citrix Systems $CTXS has a strong position in the fast growing Cloud computing segment. Check Point Software $CHKP has long been one of the top companies in the high end of IT security while Fortinet $FTNT is the global leader in Unified Threat Management (UTM). They all strike me as having pretty decent moats within their core markets.

Here is how cash flows are developing for these companies.

Frankly, they all look cheap. Fortinet looks a bit pricier but recall it is forecast to grow revenues at nearly 20% for the next two years.


Ok they are Cheap but What About Growth?

Here again there is a trap with just looking at earnings. With some tech stocks there are revenues and there are deferred revenues, and investors can only really see the underlying picture if they look at both. So what is the difference?

Essentially, technology companies sell products (hardware and software) but they also sell services which tend to be long term. So when a customer is taken on, the company books revenue for the products and bills for the full service contract. However, the full contract is not recognized as revenue until the service work is incrementally done. No matter, the work is billed. Therefore, investors can’t just look at top line revenues.

Moreover, the mix of sales between services and product sales, will dictate the mix between revenues and deferred revenues. For example, a company like Check Point is purposely increasing its software sales as it adds new solutions to its hardware. In order to get a better underlying picture I think investors should look at revenues plus the change in deferred revenues. This should help give a better picture for how the company is performing and what future cash flow growth to expect.

Here is how these companies are performing using this metric.

As you can see, Fortinet had a strong quarter and Riverbed looks like it is sorting out its sales alignment with its new products. Growth remains strong at Citrix and Check Point, even if the latter is reporting slowing product sales growth.


Where Next For These Companies?

On current trends, these evaluations look favorable and investors would do well to consider these stocks for the more cyclical parts of their portfolios. There is more to value (or in my case GARP) investing then just looking at the PE ratio.

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