Is This Company a Home Run?

Adam is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

It’s no secret that small cap investing can be risky business. However, following a few simple guidelines from investors like Peter Lynch or Fool co-founder Tom Gardner can help increase the chances of hitting a homerun.

In this article, I’ll look at small cap female condom maker, Female Health Company (NASDAQ: FHCO). The company operates in a small niche and is the only female condom maker with FDA approval. The company’s target market is government agencies in the developing world to help prevent the spread of HIV/AIDS and other STDs as well as consumers in developed countries, looking for alternative female birth control.

In his article, The Next Home Run Stock, Tom laid out some important criteria to look for in small cap companies. Female Health Company knocks them all out of the park.

“Small Companies With Strong Leaders”

Female Health is definitely a small company. With a market capitalization of just over $200 million, it pales in comparison to leading (male) condom producer Church & Dwight’s (NYSE: CHD) market cap of $7.5 billion. Leading healthcare company, and producer of The Pill, Pfizer (NYSE: PFE) has a market cap over $180 billion.

Chairman and CEO O.B. Parrish currently leads the company. He has a corporate vision to make the world a better place by preventing the contraction of STDs by women in developing countries and the developed world alike. If you read through the company’s annual reports, you’ll see this vision echoed throughout.

“Executive Ownership North of 10%”

Inside ownership is good with 31% of shares held by insiders. The largest share belongs to Director Stephen Dearholt who owns about 10% of the company. Parrish owns about 3%. It should be noted, however, that these numbers are shrinking. In the last six months, insiders have sold nearly 7% of the company. Most of these sales were automatic sales, and are likely not linked to insiders opinion that the company is particularly overvalued.

Peter Lynch liked companies with low levels of institutional investments. Currently, 26% of shares are held by institutional investors and mutual funds. By comparison, Church & Dwight is 82% owned by institutions, and Pfizer is 70% owned. Most of that 26% is in one company, Bares Capital, which own 14.5% of shares. All of the top five mutual funds holding shares are index funds save the Motley Fool Great America Fund.

“Companies Without Debt Concerns”

Female Health Company has a fantastic balance sheet. It definitely passes this criterion with no debt. Moreover, the company’s total liabilities to total assets ratio is just 22% well below the industry average of 64%. Church & Dwight and Pfizer have ratios of 46% and 55% respectively.

“Companies That Generate Excess Cash From Their Operations”

Female Health has generated positive operational cash flow every year since 2008. In the trailing twelve months, operational cash flows total $11.4 million. The company also limits capital expenditures to what they can afford internally, resulting in positive free cash flow.

Most recently, the company announced plans to increase production capacity of its FC2 female condom 20% to 100 million units annually. The expansion cost $700,000, and was completely funded through cash, keeping the company debt free. Increased production capacity initiated by the firm implies that Female Health expects to continue its excellent growth.

“Some of Which Already Pay Dividends”

Female health pays a very attractive quarterly dividend of $0.06 per share. That amounts to an annual yield of 3.4% at its current price.

“Companies That Function Without Any Real Reliance On Wall Street.”

There’s currently just two analysts following Female Health Company. Just one of them has an estimate for earnings this quarter, which means next week’s earnings report could be way off his or her estimate potentially causing the market to over react in the short term. A miss could present a good buying opportunity.

This is the advantage small cap stocks have over the large caps. With 18 analysts following both Church & Dwight and Pfizer, a lot of information is already built into the stock price, especially with a lot of those analysts working for the institutions that own the vast majority of shares. For small caps, price is driven more by individual investors, who generally gather information more slowly.

PEG

Tom didn’t specifically mention earnings ratios in his article, but PEG is a favorite ratio of Peter Lynch, a huge advocate for small cap investing. Female Health Company currently trades for 17.5 times past earnings. This is below Church & Dwight who has a P/E ratios of 23.2. It’s also below the industry average of 23.8.

A low P/E would imply that the market expects slow growth from Female Health. However, a 17.5 P/E is well below the company’s historical average P/E of 27.1, which is above the industry average, implying the stock is currently trading at a discount and has good growth potential.

The two analysts following Female Health expect earnings to grow at a 26.1% rate next year with earnings of $0.44 per share. With those numbers, Female Health trades for a PEG ratio of 0.62. Factoring in the dividend of 3.3% reduces it further to 0.55.

Concerns

Earnings are very inconsistent for Female Health Company. This is because Female Health Company’s main customers are governments, who buy huge bulk orders rather infrequently. For investors willing to stomach a bumpy ride in earnings reports, I believe earnings will continue to grow at a fast pace overall, but may not show growth every quarter.

A Home Run

Female Health Company exhibits all the traits Tom Gardner outline in The Next Home Run Stock. Additionally, it’s currently trading at a discount to its historical P/E and has a good PEG ratio under 1. It operates in a niche market where it’s essentially the only competitor. Its closest competitors have weak replacements, as many men refuse to wear a condom in developing countries, and The Pill, aside from being expensive, does not protect against STDs. With a recent increase in production capacity indicating further expected growth, I believe Female Health Company is a good small cap buy.


adamlevy has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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