It can be hard to pick future winners. In fact, it is almost impossible to consistently pick small cap stocks that are destined for greatness. However, based on vigorous screening criteria, I have picked three stocks that I believe are destined for greatness, based on their current financial information.
I have been searching for future winning equities based on the following criteria:
Small market cap. – greater than $300 million but smaller than $2 billion.
Liquidity – the stock must have an average daily volume of 400k shares traded.
Return on shareholder equity – the company must have achieved average return shareholder equity of more than 10% over a five year period.
Debt – debt must be low and interest payments must be well covered.
Cash – the company must have cash on its balance sheet and the cash balance should be growing.
Cash flow – free cash flow must be strong over a number of years to remove the effects of one off items.
Solvency – the company must have good quick and current ratios.
History of increasing shareholder returns – through either buybacks or dividends.
So here are the candidates:
Cyberonics, Inc. (NASDAQ:CYBX)
| Market Cap. | $1.2B |
| Average Share Volume (per day) | 500,000 |
Cyberonics is involved in the design and sale of implantable medical devices, a sustainable industry that is not effected by the economic climate or fashionable trends. A higher level of medical care around the world will require a larger amount of medical implants.
Cyberonics, Inc. (NASDAQ:CYBX) has achieved a return on shareholder equity of 20% on an average for the past three years, while the five year average is 109%. During 2012, the company produced a net income of $40 million on shareholder equity of $180 million. In addition, Cyberonics has a strong balance sheet with no debt, and large, positive shareholder equity.
| $US MILLIONS | 2009 | 2010 | 2011 | 2012 |
| Cash and Short Term Investments | $66 | $59 | $89 | $97 |
| Total Debt | $62 | $15 | $7 | $0 |
| Net Debt | -$4 | -$44 | -$82 | -$97 |
For the past four years, Cyberonics has had a net cash position and the company paid off its last bit of debt in 2011.
| $US MILLIONS | 2009 | 2010 | 2011 | 2012 |
| Net Operating Cash Flow | $25 | $43 | $50 | $75 |
| Net Investing Cash Flow | -$3 | -$6 | -$11 | -$22 |
| Free Cash Flow | $22 | $39 | $46 | $58 |
| Issue/(reduction of debt) | -$50 | -$43 | -$8 | -$7 |
| Stock buyback | $1 | $40 |
Cyberonics, Inc. (NASDAQ:CYBX) has a strong free cash flow, thanks in part to its 90% gross margin. The company has as free cash flow equivalent to about 80% of its operating cash flow for the past four years. This high margin gives plenty of room for dividends, stock buyback, or debt retirement.
| $US MILLIONS | 2009 | 2010 | 2011 | 2012 |
| Current Assets | $104 | $115 | $151 | $161 |
| Inventories | $13 | $14 | $15 | $14 |
| Current Liabilities | $18 | $23 | $29 | $23 |
| Current Ratio | 6 | 5 | 5 | 7 |
| Quick Ratio | 5 | 4 | 5 | 6 |
There is a trend developing here. Cyberonics has a quick ratio of 6, and a current ratio of 7, which indicate that the company could pay off its liabilities falling due within 12 months seven times – more than enough.
The last criteria, shareholder returns is where Cyberonics, Inc. (NASDAQ:CYBX) falls down. The company does not pay a dividend, but it did buy back a small amount of stock during 2012. However, the share price has risen 270% over the last five years, and due to Cyberonics highly cash generative operations, I would not rule out future cash return to shareholders.
Cooper Tire & Rubber Company (NYSE:CTB)
| Market Cap. | $1.6B |
| Average Share Volume (per day) | 600,000 |
Cooper Tyre and rubber is involved in the manufacture and selling of tyres across North America and internationally. Although tyres are generally thought of as cyclical, due to their relationship with auto manufacturing, Cooper has shown that a good company can still make profits in a slow market. Over the past five years, Cooper has managed to drive up sales and EPS 9% and 42%, respectively, despite the economic headwinds.
Indeed, return on shareholder equity has averaged 30% a year for the past three years, and the five year ROE average is 13.5%. During 2012, Cooper’s shareholder equity was $900 million, and the company’s net income was $220 million, giving a ROE of 24%.
In addition to growing sales and high return on equity, Cooper has its debt under control.
| $US MILLIONS | 2010 | 2011 | 2012 |
| Cash and Short Term Investments | $413 | $233 | $350 |
| Total Debt | $473 | $482 | $370 |
| Net Debt | $60 | $249 | $20 |
Cooper’s net debt grew to $250 million in 2011, but the company’s cash position grew rapidly in 2012. During 2012, Cooper paid off around $100 million of short-term debt, whilst improving the company’s cash position by $117 million.
I believe, Cooper will surge into a net cash position next year if the company continues to generate cash at its current rate. Indeed, Cooper’s cash flows highlight the company’s increasing profitability.
| $US MILLIONS | 2010 | 2011 | first 3 quarters of 2012 |
| Net Operating Cash Flow | $174 | $125 | $290 |
| Net Investing Cash Flow | $117 | $169 | $150 |
| Free Cash Flow | $29 | $56 | $150 |
| Issue/(reduction of debt) | ($32) | $6 | ($100) |
| Stock buyback | $8 | $112 |
Cooper has been highly cash generative over 2012, thanks in part to the falling price of rubber. The company has also seen increasing demand from the auto sector. The company’s management has not misused the cash from this good year, capitalizing on the opportunity to buy back debt and the same can be seen in 2010. During 2011, Cooper used excess cash to buy back stock – in all the company has a strong consistent cash flow.
| $US MILLIONS | 2008 | 2009 | 2010 | 2011 |
| Current Assets | $1,044 | $1,131 | $1,340 | $1,263 |
| Inventories | $420 | $300 | $386 | $465 |
| Current Liabilities | $707 | $636 | $694 | $651 |
| Current Ratio | 1.5 | 1.8 | 1.9 | 1.9 |
| Quick Ratio | 0.9 | 1.3 | 1.4 | 1.2 |
Cooper has 36% of its current assets tied up in inventories. However, even with inventories stripped out, the company has a quick ratio of greater than 1, signifying good liquidity and plenty of cover for liabilities due within twelve months. On the subject of shareholder returns, Cooper is returning cash to shareholders. Since 2009, the company has returned $200 million to shareholders, which is about 30% of the company’s net income of $670 million over the same period.
Sonic Corporation (NASDAQ:SONC)
| Market Cap. | $611M |
| Average Share Volume (per day) | 500,000 |
Sonic operates a chain of drive in restaurants throughout the U.S. The company both owns and leases restaurants, and was founded in 1953. Sonic is the smallest and oldest of the three firms in this article.
Shareholder equity at Sonic Corporation (NASDAQ:SONC) was negative until 2010, due to a high amount of borrowing. However, the company has put itself back together, and shareholder equity totalled $60 million at the end of 2012. Sonic earned net income of $40 million on this, giving a ROE of 67%. Since the company returned to positive shareholder equity in 2010, Sonic has achieved an average ROE of 50%.
Sonics improving debt position:
| $US MILLIONS | 2010 | 2011 | 2012 |
| Cash and Short Term Investments | $86 | $29 | $52 |
| Total Debt | $627 | $531 | $513 |
| Net Debt | $541 | $502 | $461 |
As I have mentioned, Sonic Corporation (NASDAQ:SONC) had negative shareholder equity up until 2010, but the company has since been working to improve this and has driven debt down 15% since 2010 – total debt has fallen nearly 20%. Sonic does have the highest level of gearing out of these three stocks, but the company is working hard to bring it down and that is why I chose it.
| $US MILLIONS | 2009 | 2010 | 2011 | 2012 |
| Net Operating Cash Flow | $89 | $78 | $84 | $95 |
| Net Investing Cash Flow | $52 | -$9 | -$16 | -$24 |
| Free Cash Flow | $52 | $53 | $63 | $71 |
| Issue/(reduction of debt) | ($50) | ($106) | ($129) | ($15) |
Sonic’s business is highly cash generative as shown above. The company does not need to spend a huge amount on investing, and its products have a very high margin leading to strong operating cash flows. Free cash flow has average about 70% of operating cash flow over the past four years, giving the company plenty of cash to pay off debt.
| $US MILLIONS | 2009 | 2010 | 2011 | 2012 |
| Current Assets | $202 | $133 | $93 | $107 |
| Inventories | $3 | $4 | $4 | $3 |
| Current Liabilities | $117 | $118 | $71 | $80 |
| Current Ratio | 1.7 | 1.1 | 1.3 | 1.3 |
| Quick Ratio | 1.7 | 1.1 | 1.3 | 1.3 |
As Sonic’s main business is food, the company cannot hold much stock, as it is perishable. Indeed, Sonic Corporation (NASDAQ:SONC)’s quick and current ratio are the same, but both strong and greater than 1, which shows the company is able to easily cover all of its liabilities falling due within 12 months.
Lastly, as shareholder retuns go, Sonic does let the team down. Sonic’s current debt reduction operations are not leaving much free cash for dividends, but the company did manage a $30 million share buyback during 2012, which cost nearly 100% of the company’s net income for the year – Sonic is trying hard.
So who wins?
Well, overall Cyberonics has the best balance sheet, the strongest cash flows and the most defensive product, but lags on shareholder returns. Cooper has good cash flows, a strong balance sheet, and is attempting to return cash to shareholders. Finally, Sonic is the recovery play of the group with good cash flows but a poor balance sheet that is held back with debt.
So overall I believe Cooper Tyre and Rubber is the best stock here, and the company that has the best potential.
The article Three Future Winners You Should Look At originally appeared on Fool.com and is written by Rupert Hargreaves.
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